Chapter 12: Liabilities - Amazon Web Services · 2014-01-03 · Solutions Manualto accompany Intermediate Accounting,Volume 2,5thedition 12-1 Chapter 12: Liabilities Suggested

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Solutions Manual to accompany Intermediate Accounting, Volume 2, 5th edition 12-1

Chapter 12: Liabilities

Suggested TimeCase 12-1 Dry Clean Depot Limited

12-2 Darcy Limited 12-3 Homebake Incorporated

Assignment 12-1 Liability issues ................................................. 2512-2 Liability recognition (W*) ............................... 2512-3 Warranty........................................................... 1012-4 Estimated obligations....................................... 2012-5 Liability measurement……………………….. 1512-6 Measurement of estimated liabilities ............... 2012-7 Long-term note—borrower and lender ............ 3512-8 Note with below-market interest rate............... 3512-9 Debt issuance, fair value .................................. 2512-10 Bonds—compare effective interest, straight-line 4512-11 Bonds—effective interest, straight-line (*W).. 5012-12 Bond interest .................................................... 3012-13 Bond interest .................................................... 3012-14 Bonds issued between interest dates (*W)....... 40 12-15 Bonds—between interest dates; effective interest 4012-16 Bonds issued between interest dates ................ 3512-17 Upfront fees ..................................................... 2512-18 Upfront fees and notes payable ........................ 2512-19 Borrowing costs ............................................... 2512-20 Borrowing costs ............................................... 2512-21 Retirement—open market purchase................. 2512-22 Bond retirement (W*) ...................................... 3012-23 Bond retirement .............................................. 4512-24 Bond retirement ............................................... 2012-25 Bond issuance and retirement, accrued interest 4012-26 Bond issuance, defeasance............................... 4012-27 Bonds, comprehensive ..................................... 40 12-28 Foreign exchange ............................................. 2012-29 Foreign exchange (*W).................................... 2012-30 Partial statement of cash flow .......................... 30

*W The solution to this assignment is on the text Web site and in the Study Guide. The solution is marked WEB.

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12-2 Solutions Manual to accompany Intermediate Accounting, Volume 2, 5th edition

Questions

1. The definition of a liability embodies a future sacrifice of assets or services, a presentobligation, as a result of a past transaction or event.

2. A financial liability exists when one company has a liability and another entity has a financial asset. Non-financial liabilities are all other liabilities; no correspondingfinancial asset arises on the books of the counter-party. Examples include liabilities for environmental remediation, lawsuits and warranties. [Other examples are acceptable.] Liabilities must be probable of payment (>50% probability) to be recognized. Amounts are measured at best estimate, which is expected value for large populations and most likely outcome for small populations. Most likely outcome is informed by expected value and cumulative probabilities. If suggested proposals for change are adopted, the liability will be measured at expected value as long as an obligating event takes place.

3. Accounting for the lawsuit is complicated at this stage because the company and/or the lawyer would be unwilling to admit in print (i.e., in the financial statements) that they would settle the lawsuit, and at what amount. This might provide too much information to the plaintiff. Note disclosure of the lawsuit, in general terms, is the likely outcome, although an accrual for $150,000 would be made if the company were to share this information with its accountants. This is the ethically appropriate outcome. If the accrual is made, separate disclosure would be minimal so its treatment would not be obvious to the plaintiff.

4. A purchase order is an executory contract, and is not a liability until the other party performs its obligations under the contract. That is, the amount becomes a liability when the goods are delivered, but not until then. Some liability would be recognized if the contract became an onerous contact. This would happen if the fair value of the goods were to fall below $10 per case. A liability would be recognized for the amount of the loss because that amount has no economic value.

5. No liability will be recorded for coupons that involve a modest decrease in purchase price. The only result of the coupon program is that gross profit will be lower in the period in which the coupons are used. A liability would only be recorded if the coupon program resulted in cash being paid out, or products sold at less than cost. Here, it is assumed that the $14 regular price involves more than $1 of gross profit.

6. The obligation under a self-insurance program is measured as the expected cash to be paid for losses that are filed but not yet settled, plus cash to be paid because of incidents that have taken place but where losses have not yet been discovered. The obligation cannot be inflated to also include expected events that have not yet happened, even if there is a statistical likelihood that such events will occur in the future.

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7. The loan should be valued at its present value: $10,000 (P/F, 10%, 2) = $8,265. Short-term debt is normally not discounted, so would more likely be valued at $10,000. The practice of not discounting current liabilities is justified on materiality grounds.

8. Par value (also known as the face value, principal or maturity value) is the principal amount paid on maturity. The (market) price of the bond is the present value of its cash flows (both principal and normal interest payments) discounted at the market interest rate on the issuance or valuation date. Par value and the market price will be identical when the stated (contractual) interest rate equals the market interest rate. The two values are different when the interest rates are different. If a $5,000 bond issold for 101, the proceeds would be $5,050 ($5,000 × 101%.)

9. The primary difference between straight-line and effective-interest amortization is the measurement of interest expense. Under the straight-line method, an equal dollar amount of expense and amortization is recognized each period; under the effective-interest method, a constant rate (i.e., the market interest rate on the day of issuance) is used to calculate interest. The expense is a function of the outstanding net liability; the dollar amount of interest expense and amortization recognized changes annually.The effective interest method is required practice because it provides a more accurate measure of the cost of borrowing.

10. The bond premium or discount is a contra account to the par value of the long-term liability, bonds payable, on the statement of financial position, and either increases (premium) or decreases (discount) it accordingly. The amortization of the bond premium or discount is part of interest expense, and either increases (discount) or decreases (premium) the expense to adjust the nominal rate to an approximation of the effective rate.

11. a) The amount of accrued interest expense recognized at the end of the accounting period is the amount of interest that has accumulated (i.e., incurred and not yet paid) since the last interest payment. It will be paid on the next interest date.

b) The amount of discount or premium amortization recognized is the amount that is required to reflect the yield rate in interest expense. Interest expense is not the cash paid after this adjustment. It is related to time and the carrying amount of the bond.

12. Accrued interest must be recognized when bonds are sold (or purchased) between interest dates because the full amount of the cash interest as specified in the bond agreement is paid to the holder of the bond on each interest date regardless of the sale (or issue) date. The purchaser advances to the seller that portion of the periodic interest accrued (i.e., incurred) up to the date of sale. The net amount reflects the period the bond was actually outstanding.

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13. The upfront administration fee would not be recognized as an expense when paid. Instead, it would factor into a calculation of the effective interest rate over the life of the loan, which would be higher than the stated interest rate of 6%.

14. Capitalization of borrowing costs begins at the earliest of the date when the money is borrowed, a payment is made on the asset, or work starts to make the asset ready for use.

15. The borrowing cost for general borrowings reflects the weighted average of loan sources, or 6.4% ((4% x $2 million) + (7% x $8 million)/$10 million total financing.)

16. A gain or loss will occur on the repayment of a bond payable at any time that the repayment price is different than the net carrying value of the bond, including unamortized premium or issuance costs, if any.

17. The bond discount or premium would be part of a bond retirement entry when the bond is retired prior to maturity, because the discount or premium would have a remaining balance to be eliminated. The amount that is eliminated is the unamortized balance.

18. A defeasance is a financial arrangement where the debtor irrevocably places investments in a trust fund for the sole purpose of using those resources to pay interest and principal on specified debt. The creditor agrees to this and legal release is given to the borrower. In an in-substance defeasance, the transaction is the same except there is no legal release by the creditor. Debt subject to a defeasance arrangement is derecognized, but debt subject to an in-substance defeasance is left on the books.

19. Exchange loss: $325,000 ($1.08 – $1.16) = $26,000. This is the change in the exchange rate during the year.

20. Cash flow for interest is $39,000 ($45,500 - $4,500 - $2,000).

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Cases

Case 12-1Dry Clean Depot Limited

Overview

Dry Clean Depot Limited (DCDL) is a private company that has elected to comply with IFRS. The company is reasonably small, with $7 million in sales, and 40 retail locations. DCDL has just negotiated a new equipment loan, with covenants that specify a maximum 2-to-1 debt-to-equity ratio. Other covenants require a minimum level of $500,000 in cash, and restrict dividends to $100,000 per year. These latter covenants require compliance, but are not affected by accounting policies. The debt-to-equity ratio restriction means that the company would prefer to maximize equity (earnings) and minimize debt.

Issues

1. Effective cost of loan2. Capitalization of borrowing costs3. Capital cost of equipment and depreciation4. Lease arrangement5. Environmental obligation6. Revenue recognition7. Lease terms

Analysis and conclusion

1. Effective cost of loan

The effective interest rate for the $2,000,000 loan is determined by looking at theannual carrying cost ($90,000 per year) and also the $377,000 upfront fee. When both are factored in, the effective interest rate is 7.2%:

Effective interest rate = Solve for x in,

$2,000,000 = $377,000 + $90,000 (P/A, x %, 10) + $2,000,000 (P/F, x %, 10)x = 7.2%

Upfront fees are recorded as a discount and amortized to interest expense (etc.) during the life of the loan. Since the discount is netted with the loan on the SFP, this helps modestly reduce debt balances for covenant calculations.

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2. Capitalization of borrowing costs

The loan is specific to the equipment purchase, and interest must be capitalized during the acquisition period, which is lengthy. After the acquisition period, interest is an expense. If there were investment earnings on idle loan cash, for the period between the time that the loan money is advanced and amounts are paid out to suppliers, such earnings are netted in the interest capitalization calculation. General borrowing costs for the portion of the purchase price financed through DCDL cash flows are also be capitalized, but no imputed costs for equity. The borrowing cost must be calculated on a weighted average basis.Further information on each of these issues must be gathered.

Interest to be capitalized:

Loan balance $2,000,000 × 7.2% × 10/12 $120,000

The ten month period consists of six months for production, three months for shipping plus one month for installation and testing. In terms of time line, the loan is assumed to be advanced and the equipment immediately ordered. If there is a time lag, the capitalization period will be longer because capitalization will start when the loan commences. Interest is capitalized when the loan monies are advanced, in the current fiscal period.

Additional interest will be capitalized for amounts financed from general borrowings. This amount is not determinable but information must be gathered to calculate the adjustment.

Interest capitalization will preserve levels of earnings (equity), making the debt-to-equity ratio easier to achieve.

3. Capital cost of equipment and depreciation

Many of the costs associated with equipment acquisition will be capitalized, as follows:

Description AmountInvoice price $2,450,000 Interest cost (above) 120,000Interest on general borrowing ??Shipping 34,000Duty ($2,450,000 x 20%) 490,000Installation & testing 38,000

$3,132,000 + ??

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Equipment is depreciated over its life using an acceptable depreciation method such as straight-line or declining balance. Policy for this must be set, along with a determination of the useful life and salvage value, or the declining balance rate. The equipment should be evaluated to see if components have various life spans; if so, then depreciation must be stratified to reflect this fact.

4. Lease Arrangement

DCDL must evaluate the need to record a liability for the onerous contract that is represented by the lease situation in Sudbury. The landlord has been informed that DCDL will vacate, and a sub-tenant located, with a signed contract for the sub-lease. This proves positive intent to act.

DCDL has an obligation to pay $27,500 for occupancy costs each year for the next three years, and has a sub-tenant that is willing to pay at least $5,000 per year. Therefore, there is an unfunded obligation of $22,500 per year. This may be less if the extra sub-rent in years 2 and 3, 10% of the sub-tenant sales in excess of $150,000, can be reliably estimated. However, since DCDL has had negative experience with this location, and the nature of the sub-tenant operation is unknown, no amount has been estimated in these calculations. This area must be explored further.

Since the payments take place over three years, the time value of money must be estimated to value the liability. Interest expense (accretion) will then be recorded each year. The interest rate to use should be a borrowing rate for operating activities over a three-year period. This rate is not known and must be established. A rate of 7%, based on the equipment loan (7.2%) has been used but this rate may not be comparable because term (10 years) and security are different.

Using the 7% rate, and assuming rent is payable at the beginning of each year:

Liability balance $22,500 × (P/AD, 7 %, 3) (rounded) $63,000

This amount will be recorded as a liability, worsening the debt-to-equity ratio. It is not avoidable.

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5. Environmental obligation

DCDL has a contractual liability in eight locations for environmental remediation in the event of contamination caused by dry cleaning operations, in particular,contamination caused by perc.

These obligations must be estimated and discounted for the time value of money if payment is delayed. As for the onerous contract obligation, an interest rate of 7% will be used as an estimate but a more appropriate interest rate (term and security)must be estimated.

The liability exists because DCDL stands ready to meet any potential costs. The major issue is measurement of the liability. If there is no contamination, then the liability has a zero value and there is no amount recorded. This appears to be the case for most premises, and regular testing provides comfort that liabilities are identified on a timely basis.

For one location, however, it appears as though there might be an environmental issue. Further testing is being done to confirm this, and the outcome of this testing will determine if remediation, and liability recognition, is needed.

If action is needed, then the cost and the timing of action must be determined. The cost has been suggested in the $250,000 to $500,000 range. Costs must be further explored, and an expected value established. If, for example, both of these estimates were equally likely, then the amount to be accrued would be $375,000. Discounted for two years at 7%, this is a $325,000 (rounded) liability. This amount is also capitalized as an asset, amortized over the remaining lease term.

Note that additional liability recognition of a significant amount such as this, has negative implications for the covenant agreement. Some covenant renegotiation might be considered, or perhaps additional equity financing might be possible.

More importantly, the environmental obligations call the business model into question, and appropriate pricing and management of operational risks should be considered and evaluated at a strategic level.

The cost of vacating premises at the end of the lease would also have to be identified and evaluated for recognition. If DCDL has agreed to move after environmental cleanup, and this has costs, then the amount must be reflected in the financial statements. It may well be immaterial.

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6. Revenue recognition

DCDL sold prepaid dry cleaning services cards this year. When cards are issued, a liability for unearned revenue is created, and when the cards are used, the liability is decreased and revenue is recognized. This is appropriate accounting. Card valueof $126,000 ($468,000 - $342,000) is outstanding at year-end, or 27% of the gross cards issued.

The issue that needs to be examined is how the initial $20 price reduction is treated. A $120 card costs $100 for the customer, which is in essence a sales discount. The amount must be relabeled as a sales discount, not an expense, and shown as a contra account to sales. This is a presentation issue. Revenue should reflect cash value.

This issue can be explained in one of two ways:

1. Services are being sold for a lower price, but this is not below cost (gross profit is usually 60%); services are still profitable after the reduction granted with the cards. Valuation of revenue and liability should be at the cash amount received not the regular price. Therefore, sales of the period should be $285,000 ($342,000/1.2), and the liability should be recorded at $105,000 ($126,000/1.2). This increases net income (now has $342,000 - $78,000 recorded) and liabilities.

2. Alternatively, valuation can be explained through the discount account. The discount amount, $78,000 for the cards issued, has been entirely expensed in the current period. The question is whether this relates to this period, or whether the $78,000 should be prorated consistent with card use. If it were prorated, the unused portion would reduce the reported liability.

There is no need to establish a liability for more than the proceeds received. Accordingly, the sales discount should be recognized as it is used. The discount should be adjusted to $57,000 ($78,000 x 342/468) and the remaining $21,000 recorded as a contra to the liability account, reducing it to $105,000 ($126,000 - $21,000).

Either of these explanations is acceptable.

DCDL expects that 5 to 10% of the value on the cards will not be used. At the volumes sold this year, this represents $23,400 to $46,800 of the liability (gross) outstanding at year-end or $19,500 to $39,000 when deflated to the lower cash amount. At year–end, this is approximately 20% to 45% of the outstanding liability, which is very high. The company has a legal obligation in perpetuity for these amounts, and must stand ready to honor the cards if they are used at any point in the future. The company lacks history to use in determining any unused

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percentage. Accordingly, at this stage in the life of this program, it would not be advisable to decrease the liability for expected unused cards.

In terms of covenant implications, scaling back the liability and increasingearnings this year are both positive outcomes. It would be preferable to reduce the liability for unused cards, but if this cannot be measured, it certainly cannot be manipulated.

7. Lease arrangements

DCDL is a tenant in forty locations. The leases have been described as short-term rentals, over three to five years As such, they would almost certainly qualify asoperating leases, and no liability for the leases would be recorded. DCDL should be aware, though, that the IASB is considering a proposal to capitalize all leases regardless of length of term. This would result in liability recognition for DCDL. The loan contract just negotiated puts a limit on debt-to-equity over a ten-year time span, and capitalization might be required within this window. Therefore, DCDL should negotiate in advance with the lender around the scenario of an eventual capitalization, perhaps asking that such lease obligations be excluded from the ratio, or that the ratio be increased to reflect the alternate accounting rules.

Conclusion

Overall, liabilities have been established for environmental issues, onerous contracts, and potentially for leases. If DCDL is now close to the debt covenant for debt-to-equity, this will be uncomfortable. It is still the inception of the loan contract. The company should look at projections for key financial variables and decide whether the loan covenant is reasonable. If not, re-negotiation or alternate financing sources must be explored.

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Case 12-2 Darcy Limited

Overview

Michel Lessard has requested that the financial statements of Darcy Limited, a company that manufactures equipment for the oil and gas industry, be reviewed for the purpose of valuation. Ethically, it is important to provide advice on a fair price to Mr. Lessard without overstating or understating the company’s situation; however, there is a natural bias to reduce earnings and assets given that Mr. Lessard represents a group of purchasersand this is the beginning of negotiations. Since no one else is relying on this report, this bias is ethically acceptable.

The valuation formula is based on net tangible assets and earnings, so any adjustment that changes either of these metrics will change the purchase price. Earnings must include only recurring items, assumed to repeat in the future. Ongoing items must be valued at the amount that would be expected to continue, and one-time items are not included in the valuation rule.

Issues

1. Financial health of Darcy Limited2. Valuation of low-interest loan3. Valuation of warranty expense and obligation4. Goodwill write-up5. Valuation of capital assets6. Revenue recognition7. Valuation of allowance for doubtful accounts8. Restatement of foreign currency accounts receivable9. Adjustments to earnings for non-recurring items now included10. Calculation of bid ranges/ Conclusion.


1. Financial health of Darcy Limited

The financial health of Darcy is somewhat suspect. There is no cash on the SFP, and there is a new operating loan that is likely needed just for day-to-day purposes. The current ratio has declined from 2.94 to 1.69, reflecting additional short-term debt. However, the company is carrying little long-term debt, and has significant capital assets. If land or other assets could be sold or mortgaged, liquidity may not be a concern.

There has been a large buildup in accounts receivable. Both the warranty liability and the allowance for doubtful accounts are very low, and research expenses have been curtailed,

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indicating that the company’s actions and policies may be affected by the potential sale of the company. This may reflect badly on the ethics of management.

Of critical concern is that there appears to be no real history of profits, as all the retained earnings balance comes from this current year plus the past year; retained earnings were only $20 prior to last year. Either there were no profits, or sizable dividends were declared.

Sales declined from $45 million to $32.7 million this year, indicating possible operating problems. Alternatively, the industry may be going through a cyclical downturn. Many expenses appear to be low – including research and administrative expenses – and this has helped keep earnings at a respectable level. This may not be reflective of ongoing operations, though. Return on equity is low, even with the curtailed expenses.

These factors must be investigated prior to any offer being made. Valuation rules of thumb are meaningless if the company has operating problems. Budgets and prospects for the coming years must be carefully investigated.

Assuming that the purchasers wish to go ahead, valuation adjustments have been examined in several areas.

2. Valuation of low-interest loan

Darcy purchased $2,600 of capital equipment this year, financed with a five-year low-interest loan. The loan is at 2%, while market rates are 6%. In such a case, the loan and the capital assets are valued at the present value of the loan, and interest is based on the 6% market rate. Amortization is based on the (lower) present value, not the nominal amount, of the transaction.

These adjustments are calculated in Exhibit 3. Including revaluation and three months of amortization, the loan balance reduces from $2,600 to $2,181, and the capital assets reduce from $2,519 to $2,094. Interest and amortization also change. These adjustments have a minor effect on the purchase price because they reduce both assets and liabilities, and increase and reduce earnings to net out to a small adjustment.

3. Valuation of warranty expense and obligation

The warranty obligation is very low, and has declined significantly over the year. Adequacy of this obligation has been evaluated by looking at the actual claims history, related to the year of sale. See Exhibit 4. Only two years’ data has been made available over the complete warranty term. Once the expenditures have been related to the year of sale, though, it appears that 3% of sales (or perhaps up to 3.4% of sales) is a more appropriate expense level than the 2% of sales used now. Additional evidence should be gathered to prove this calculation.

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If the warranty expense were increased to 3% of sales, an additional $330 of warranty expense would be recorded in the current year, and the warranty obligation should include accruals for one remaining year of 20X6 sales, and two remaining years for the 20X7 sales. This would increase the warranty obligation, and reduce net assets, by $1,534. Note that the cumulative effect of the change from 2% to 3% has not been adjusted to earnings as it would be non-recurring. 20X7 expense is adjusted to 3% of sales.

These amounts are approximate because part years have been disregarded.

4. Goodwill write-up

Goodwill is an intangible asset and is not included in the purchase price formula, which is based on net tangible assets. Therefore, goodwill has been excluded in Exhibit 2 in the initial calculation of net tangible assets.

However, management has written up goodwill by $50 each year as an assessment of the increase in goodwill over the year. This amount is included in earnings. This is not acceptable in the financial statements, as the increase is not verifiable and also is not related to a tangible asset. This amount has been removed from earnings in Exhibit 1.

5. Valuation of capital assets

The pre-20X 7 balances of capital assets has been revalued to fair market value. This is necessary to reflect fair value in the net tangible assets used to value the company.

Land, with a book value of $7,000, is likely worth $10,500, increasing net assets in Exhibit 2 by $3,500. The opening balance of capital assets in 20X7 (closing 20X6), excluding land, has be revalued by 20% and additional amortization on the higher fair value has been recorded. An average life of 6 years (range was four to eight years; six was used as the average). Additional verification may be done to ascertain whether this amortization period is reasonable. See Exhibit 7.

As a result of these adjustments, earnings declines by $320 for additional amortization, and net assets increase by another $1,600 for the net increase. See Exhibits 1 and 2.


Darcy has engaged in a barter transaction during the year, and has given up inventory with a cost of $23. This amount has been expensed but no revenue has been recorded. Since the company has received something of value (future services) it is tempting to record revenue at some reasonable amount.

However, this barter transaction is just one step in satisfying an order from a second customer, and value is not verified until that second order is complete. While it is not the

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classic acquisition of inventory to facilitate a second sale, it is not the end of the earnings process in a string of transactions. Thus, no revenue should be recognized.

It is not appropriate, though, to record only the $23 expense, because this can be recorded as the value of the machining work to be received in the future (book value). Both assets and earnings are adjusted to eliminate the $23 expense recorded. See Exhibit 6.

Others might argue that for the purposes of valuation, recognition of full value might be appropriate, and record revenue of $28, using the most conservative value in the range. The difference is not material to the calculations.

7. Valuation of allowance for doubtful accounts

The allowance for doubtful accounts has historically been recorded at the level of 5% of accounts receivable. The existing allowance is not this high. Refer to Exhibit 5. The foreign-denominated account receivable, which is agreed to be collectible, is first removed from the accounts receivable total. Five percent of the remaining balance is $569, or $299 different than currently recorded. Both net assets and earnings are reduced accordingly.

Note that this adjustment affects 20X7 earnings only because the allowance looked adequate up to the beginning of 20X7, which indicates that only the current year expense must be increased.

In general, valuation of accounts receivable is sensitive, and the purchaser group should carefully evaluate the collectability of all accounts receivable.

8. Restatement of foreign currency accounts receivable

The foreign account receivable is in US dollars, and it must be restated to the current exchange rate at the end of year, as the best predictor of its value at maturity. This increases net assets by $220. See Exhibit 5.

The exchange gain was not included in earnings because it would not be recurring, and therefore should not be included in a purchase price calculation.

9. Adjustments to earnings for non-recurring items now included

The gain on disposal of capital assets has been excluded from earnings used for valuation purposes. This gain is not likely a recurring operating item. Assets are being purchased at fair value and no gains or losses on sale should be considered.

In addition, research expenditures should be increased from $120 to the prior level of $350. Experts should be consulted to ensure that $350 is indeed an appropriate level of research activity.

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10. Calculation of bid ranges/Conclusions

One possible purchase bid was suggested as six times recurring operating earnings. This is calculated in Exhibit 1. Earnings is adjusted for all items identified and discussed, including additional warranty cost, bad debt expense, amortization on revalued assets and research. The result is that earnings is minimal, and produces a valuation of $1.3 million. This is unreasonably low and cannot be seriously used for valuation.

However, the low result serves to highlight the poor operating performance of the company this year, caused especially by the decline in sales. It appears as though other expenses were minimized to make the profit situation look better. Even if the reported profit were used, the price suggested would only be approximately $6 million ($990 x 6). This is not in line with asset-based valuation measures (see Exhibit 2) as Mr. Lessard had hoped.

Perhaps the company can be restructured to significantly increase profit performance, but this is different than buying an existing profitable company, and one can argue that it is the new owner, not the old owner, who should benefit from the improvement.

Net tangible assets are evaluated in Exhibit 2 and perhaps highlights the strength of the company. Existing assets are adjusted for the revalued low-interest loan, additional warranty liability and allowance for doubtful accounts. The US receivable is revalued, as are land and other capital assets. The result is revised net assets of $27,594, and a suggested purchase price in the range of $33 million.

This is a significant price to pay for a company with no real profit history. However, the company has little long-term debt, and it may be possible to reduce net assets by collecting receivables, selling some capital assets, or putting long-term debt into place. This would reduce the net assets outstanding, and generate cash.

Further analysis of the profit potential is necessary before one could recommend purchasing Darcy at a price of $33 million. The prospects for this company and the industry must be evaluated, and the financial statements are not helpful in this regard.

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Exhibit 1Valuation based on earnings

Earnings, as reported $990

Adjustments for accounting measurementsLoan interest (Exhibit 3) (19)Amortization (Exhibit 3) 13Warranty (Exhibit 4) (330)Bad debts (Exhibit 5) (299)Goodwill gain reversal (50)Expense capitalized (exhibit 6) 23

Restatement for sustainable items Gain on disposal – not recurring (80) Research (increase to $350 versus $120) (230) Administration ?? Revaluation of capital assets – amortization ( Exhibit 7) (320)

(1,292)Tax @40% 517 (775)Sustainable earnings 215Multiple 6XSuggested purchase price 1,290

Minimal earnings, therefore company cannot be valued on earnings.

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Exhibit 2Valuation based on net tangible assets

Assets less liabilities less intangibles ($41,645 - $12,720 - $2,600 - $1,835 - $400) $24,090

Adjustments for accounting measurementsLow interest loan (Exhibit 3) 419 Capital assets (Exhibit 3) (425)Warranty (Exhibit 4) (1,534)Allowance for doubtful accounts (Exhibit 5) (299)Foreign denominated receivable (Exhibit 5) 220

Reduce expense; additional asset (Exhibit 6) 23 Revaluation of land (Exhibit 7) 3,500 Revaluation of other capital assets (Exhibit 7) 1,600

Revalued net assets 27,594Multiple 1.2 XSuggested purchase price $ 33,113

Exhibit 3Low-interest loan financing

Present value of loan at market interest rates:

$2,600 x (P/F, 6%, 5) (.74726) = $1,943$52* x (P/A, 6%, 5) (4.21236) = 219

$2,162*$2,600 x 2% = $52

Earnings impact:Adjusted interest expense: $2,162 x 6% x 3/12 $32Current interest expense: $2,600 x 2% x 3/12 13 Increased interest expense $19

Adjusted amortization expense: $2,162/8 x 3/12 $68Current amortization expense: $2,600/8 x 3/12 81 Decreased amortization expense $13

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SFP impact:Adjusted loan balance: $2,162 + $19 $ 2,181Current loan balance 2,600 Decreased loan balance $ 419

Adjusted capital assets: $2,162 – $68 $2,094Current capital assets $2,600 - $81 2,519 Decreased capital assets $ 425

Exhibit 4Warranty expense/obligation

Year Sales Claims paid this year

Claims paid inyear 2

Claims paid in year 3

Totalpaid

Percent of sales

20X4 $31,020 $260 $320 $460 $1,040 3.35%20X5 37,810 190 325 630 1,145 3.03%20X6 44,960 230 300 incomplete20X7 32,670 190 incomplete

Reasonable percentage: around 3%

Earnings current year = $32,670 x 3%= $980 versus $650 expensed = additional expense $330

SFP, current yearShould be remaining claims for 20X6 and 20X7 sales

($44,960 + $32,670) x 3% $2,329 less: claims paid for 20X6 and 20X7 sales

($230 + $300 + $190) (720)Balance $1,609Additional liability ($1,609 - $75) ($1,534)

Note: overlap between years not considered.Note: catch up adjustment to expense not recorded in 20X7 because it is cumulative, and not recurring

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Exhibit 5Bad debts/allowanceAccounts receivable, gross($18,720 + $270) $18,990Less: foreign receivable (7,620)

$11,370

Estimated uncollectible – 5% 569Current allowance 270Additional expense and allowance $299

Foreign denominated receivable $7,620Correct balance $7,000 x 1.12 7,840Adjustment $220

The entire catch up amount for bad debt expense has been recorded as an expense in 20X7 because the 20X6 allowance seems adequate (4.8% of receivables). The problem seems all related to 20X7. No exchange gain is included in earnings for the foreign receivable because the item seems non-recurring.

Exhibit 6Revenue recognition

Valuation: Given up inventory @$31 (list price) and received services @$28-$30. Reliability of list prices is unclear. Cost of inventory given up, $23Not the end of the earning process because acquired to facilitate another sale; No revenue recognition.However, defer expense and create asset: $23

Exhibit 7 Capital asset revaluationCapital assets, net, pre-20X7 $16,600Less: land (7,000)

$9,600Increase in value – 20% $1,920

Additional amortization $1,920 / 6 (average life) $320Net increase to capital assets ($1,920 - $320) $1,600

Land balance $7,000Increase in value – 50% $3,500

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Case 12-3 Homebake Inc.

Overview

Homebake has sold 3,600,000 new breadmakers and recognized the revenue for all of these sales. The company has recorded a warranty obligation for normal returns and repairs and other expenses based on previous experience and the experience of other manufacturers; however, it has not yet recognized any warranty costs related to the faulty breadpan. The president has suggested that rather than accruing the full potential warranty costs, only costs incurred to date be recorded in the year-end statements. This recommendation will not provide appropriate valuation for the warranty situation that Homebake stands ready to correct.

Homebake is a growing company in the consumer small appliance industry. This is a highly competitive industry that produces high-quality, innovative products on a regular basis. Life cycles of some products may be short, while others are longer, but the market reaches saturation fairly quickly. Customer satisfaction is an important success factor.

It appears that Homebake has produced a quality product that is meeting consumer demands; however some of the products are flawed. The flaw can be fixed quickly and relatively inexpensively. Homebake has done everything it can to ensure customer satisfaction among the consumers who purchased a faulty product.

The company is in a growth phase and needs support from its banker. As a preparer of financial statements, management will want to report high earnings (profit maximization motive). The main financial statement users are bankers, shareholders, and potential shareholders. Users will want statements that reflect the performance of management (stewardship) and predict the company’s ability to pay dividends and make loan payments (cash flow prediction).

The ethics of the accountant are an issue here, as the accountant is being pressured to consider an accounting policy that is good for the company but does not completely reflect the obligations of the company. It is important that the accountant not give in to such pressure.

Analysis

a) Identification of alternatives

Revenue should be recognized when the significant risks and rewards of ownership,are transferred to the buyer, and all significant acts have been completed. In the case of consumer goods such as breadmakers, revenue is generally recognized at the point of sale, with provisions made based on past experience with sales returns and warranty obligations. Since Homebake is in the consumer small appliances industry,

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it can be assumed that it has made reasonable provisions for returns of its new breadmaker, based on past experience with other products. Homebake has also worked very hard to reduce the potential returns on the breadmaker due to the faulty breadpan.

The company has made an estimate and accrual for normal warranty obligations related to the breadmaker. The issue is how to accrue for the unique situation of the faulty breadmaker.

There are two main alternatives:

Cash basis

Record the costs of providing and shipping a new breadpan when the item is sent to the consumer. At that point, it will be clear that an obligation has arisen, and the company will have settled the obligation. This alternative is advocated by the president.

Estimated basis

Record an estimate of the breadpan obligation and related expense. Estimates of the potential obligation seem to exist, based on the sales and percentage of faulty breadpans that were manufactured. The company could accrue an amount equal to the cost of replacing all faulty breadpans and set it up as an additional estimated warranty obligation.

b) Analysis of Alternatives

Cash basis

The company requires an audit; thus, the recommended alternative must comply with GAAP. The revenue for the breadpans is being recorded in the 20x5 year end, and all estimable expenses related to that revenue should be matched to it. The breadpan expense may be estimated based on the number of faulty breadpans that were produced and the cost of replacing those pans. Since the cash basis would not result in an estimate and accrual of the potential costs of replacing the breadpans, it would not provide the correct matching of revenues and expenses, and therefore would not be acceptable under GAAP.

The president’s argument that the cost of replacing the breadpans should be delayed and recognized at the same time as compensation from the supplier received is not valid, since no court action has yet been filed. There is no way to determine at this time what the outcome of a lawsuit might be. In any case, the company will have to incur the costs of replacing the breadpans.

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Estimated basis

This alternative is acceptable under GAAP. The amount that should be recorded as an estimated warranty obligation and an expense of production (probably grouped into cost of goods sold) is:

Potential number of faulty pans3,600,000 ÷ 3 = 1,200,000Total cost of replacing all faulty pans:1,200,000 × $20.................................................. $24,000,000

Less: Pans already replaced100,000 × $20..................................................... ( 2,000,000)Remaining estimated obligation: ........................ $22,000,000

This additional cost would be recognized in the sale period as revenue from the sale of breadmakers, 3,600,000 × $125 = $450,000,000, resulting in an additional warranty provision equal to 5% of sales. The warranty obligation represents the expected future cash outflow.

The company currently estimates and records other warranty costs; to depart from this treatment would be inconsistent with accounting policies already in place and result in incorrect liability valuation. If the estimated amount is not accrued, liabilities will be significantly understated, which will affect financial statements ratios.

Recommendations

The liability must be values at its estimated amount, even though this recommendation is contrary to what the president wants. She wishes to show only the $2,000,000 in warranty costs incurred so far as expense for the year, while it is more appropriate that an additional $22,000,000 be recorded as an expense and a liability. This will ensure that the statements comply with GAAP and that the company receives a clean audit opinion. The additional allocation represents only 5% of sales revenue from this source ($22,000,000 ÷ $450,000,000).

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Assignments

Assignment 12-1

Item Accounting treatmenta. Record; specific plan that has been communicated in a substantive wayb. Do not record; liability exists for a guarantee but the amount is estimated to

be zero.c. Do not record; plans not yet concrete.d. Record; legislative requirement; amount has to be estimated and

discounted for the time value of moneye. Record; announced intent that can be relied on by outside parties; amount

has to be estimated and discounted for the time value of moneyf. Do not record; executory contract until time passesg. Record when tower is built; remediation required under contract; amount

has to be discounted for the time value of moneyh. Do not record; no firm offer or acceptance of out-of-court settlementi. Do not record; no obligation is established because the case has not been

settled and the company will likely successfully defend itselfj. Record; obligation for the expected value of $4 millionk. Record; some might claim that the expectation of successful defense

means that the amount might simply be disclosed, but the author is pessimistic about the success of appeals on CRA rulings and thus suggests recording.

l. Record; cash rebate is a required payout; liability for 65% x 500 x $10

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Assignment 12-2 (WEB)

Item Accounting treatmenta. Do not record; executory contract until goods are delivered.b. Loss and liability recognized; record $40,000 loss from decline in market

value (onerous contract.)c. Liability for $105,000 at year-end; originally recorded at $110,000 Cdn.

amount received and $5,000 foreign exchange gain recognized to reflect change in exchange rate.

d. Probable that there will be payout (70%)Record loss and liability at most likely outcome of $500,000. Expected value; $425,000($2 million x 5%) + ($500,000 x 65%); appropriate to record higher value of $500,000, reflecting payout.

e. Record loss and liability at expected value; company stands ready to make payment in the event of default; amount is $300,000 x 10%.

f. Record loss and liability at expected cash outflow; obligation to make payment; amount is $10,000 ( $100 x 1,000 x 10%).

g. Record as a liability; part of initial sales price allocated to liability; Amount is expected fair value of merchandise to be distributed.

Assignment 12-3

Requirement 1

Warranty expense in April, $24,750 ($550,000 × 4.5%)

Requirement 2

Balance in the warranty liability account at the end of April is $18,450($16,400 + $24,750 – $8,700 – $14,000)

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Assignment 12-4

Item Accounting treatmentA. Record at expected value because it is a financial instrument; company

stands ready to make payment in the event of default; amount is expected payout (net of any security) x 10%. ($200,000 x 10% = $20,000)

B. Not recorded; all that can be recorded is loss events of the year; no amount can be recorded to smooth out losses expected

C. Record at expected value; a warranty expense and a warranty liability are recorded at the expected $50,000 outflow. Subsequent payments reduce the liability.

D. Do not record; it is not likely that the lawsuit will result in a cash outflow. (Under proposed standards, would record expected value, or $500,000 x 20% = $100,000).

E. Record at expected value; company is required by legislation to remediate the site. Amount must be estimated, both timing and amount, even though uncertain. Amount to be discounted for interest rate over correct risk and term

F. Record costs of recall; may be an additional $780,000 expense and liability ($520,000 ÷ 0.4 x 0.6) if costs are linear with progress. Recall is a constructive liability.Company likely liable for any settlements or lawsuits for product damages, but testing must be completed to ascertain if there is indeed a problem with existing product.

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Assignment 12-5

Claim Requirement 1Current standards

Requirement 2Proposed standards

1. Not likely; <50% probability of payout; no accrual

Obligating event assumed to have happened (per question)

Accrued at expected value$50,000 ($500,000 x 10%)

2. LikelyAccrual at best estimate, which is the most likely payout informed by expected value$ 10,000,000 recorded


Accrued at expected value$7,000,000 ($10,000,000 x 70%)

3. LikelyAccrual at best estimate, which is the most likely outcome informed by expected value.

Combined odds:40% settlement(60% x 30%) = 18% court dismissed(60% x 70%) = 42% court payout

Overall, most likely outcome (42%) is $800,000 payout.Expected value is ($500,000 x 40%) + ($800,000 x 42%) = $536,000.

More information about the success of the settlement offer should be obtained before the financial statements are issued, but an accrual of $800,000 is supportable based on the information provided.


Accrued at expected value$536,000.

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Assignment 12-6

Product Requirement 1Current standards

Requirement 2Proposed standards

1.75 claims x (1/3) x $1,000 x 90%25 claims x $5,000 x 70%25 claims x 12,000 x 60%=$290,000 $290,000

2. Nothing recorded for the eight claims to be dismissedClaim #9 is likely to be paid (60%)Accrued at most likely outcome, $50,000

Nothing recorded for the eight claims to be dismissed

For claim #9, an obligating event has occurred (per question) and the amount recorded is expected value:

$50,000 x 60% =$30,000

3. Payout is not likely (60% chance of dismissal)

No accrual; most likely outcome


Accrued at expected value$160,000 ($1,000,000 x 10%) + ($200,000 x 30%)

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Assignment 12-7

Requirement 1

Principal $800,000 (P/F, 6%, 4) = $800,000 × (0.79209) ......................................$633,672Interest $32,000 (P/A, 6%, 4) = $32,000 × (3.46511) ............................................ 110,884

$744,556Requirement 2

1 January 20x9Cash ............................................................................................... 744,556Discount on notes payable ............................................................. 55,444

Notes payable......................................................................... 800,000

31 December 20x9Interest expense ($744,556 × .06).................................................. 44,673

Discount on notes payable ..................................................... 12,673Cash ....................................................................................... 32,000

31 December 20x10Interest expense ($744,556 + $12,673 = $757,229) × .06 ............. 45,434


31 December 20x11Interest expense ($757,229 + $13,434 = $770,663) × .06 ............. 46,240


31 December 20x12Interest expense ($770,663 + $14,240 = $784,903) × .06 ............. 47,097(1)

Discount on notes payable (balance) ..................................... 15,097Cash ....................................................................................... 32,000

(1) rounded up by $3

Notes payable ................................................................................ 800,000Cash ....................................................................................... 800,000

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Assignment 12-8

Requirement 1

Inventory, merchandise, or purchases ($5,000 + $18,217) ................... 23,217Discount on notes payable* .................................................................. 1,783

Cash............................................................................................... 5,000Note payable ................................................................................. 20,000*

*ComputationPrincipal: $20,000 × (P/F, 8%, 2) = $20,000 × (0.85734) = $17,147Interest: ($20,000 × 3%) × (P/A, 8%, 2) = $600 × (1.78326) = 1,070Present value of note...................................................... $18,217Discount: ($20,000 – $18,217) ...................................... $1,783

Requirement 2

a) Amount of cash interest payable each 31 December ($20,000 × 3%).......... $ 600b) Total interest expense for the two-year period

[($20,000 + $1,200) – $18,217] [or, see below]........................................... 2,983c) Amount of interest expense reported for 20x5

($18,217 × 8%) ............................................................................................. 1,457d) Amount of liability reported on 31 December 20x5 (see debt amortization schedule)................................................................... 19,074

Debt Amortization Schedule(not required)

At Year Cash Interest Expense Increase Carrying ValueEnd Payments @ 8% in Balance Balance

Start $18,21720x5 $600 $1,457 $857 19,07420x6 600 1,526 926 20,000

$2,983

Requirement 3

Entries for Sable Year End:

20x5 20x6 MaturityInterest expense............ 1,457 1,526Notes payable………… 20,000

Discount.......…….. 857 926Cash....................… 600 600 20,000

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Assignment 12-9

Requirement 1

Principal: $5,000,000 × (P/F, 3%, 12) = $5,000,000 × 0.70138 = $3,506,900Interest: ($5,000,000 × 2.5%) × (P/A, 3%, 12) = $125,000 × 9.95400 = 1,244,250Issue proceeds at 30 April 20X0 $4,751,150

Requirement 2

Principal: $5,000,000 × (P/F, 2%, 10) = $5,000,000 × 0.82035 = $4,101,750Interest: ($5,000,000 × 2.5%) × (P/A, 2%, 10) = $125,000 × 8.98259 = 1,122,824Issue proceeds at 30 April 20X1 $5,224,574

Requirement 3

Principal: $5,000,000 × (P/F, 4%, 7) = $5,000,000 × 0.75992 = $3,799,600Interest: ($5,000,000 × 2.5%) × (P/A, 4%, 7) = $125,000 × 6.00205 = 750,256Issue proceeds at 30 October 20X2 $4,549,856

Requirement 4

At 30 October 20X3, there are five interest periods remaining:

a. Book value

Principal: $5,000,000 × (P/F, 3%, 5) = $5,000,000 × 0.86261 $4,313,050Interest: ($5,000,000 × 2.5%) × (P/A, 3%, 5) = $125,000 × 4.57971 = 572,464

$4,885,514

b. Fair value

Principal: $5,000,000 × (P/F, 5%, 5) = $5,000,000 × 0.78353 $3,917,650Interest: ($5,000,000 × 2.5%) × (P/A, 5%, 5) = $125,000 × 4.32948 = 541,185

$4,458,835

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Assignment 12-10

Requirement 1Principal $5,000,000 x (P/F 4%, 40) (.20829) = $1,041,450Interest $212,500 x (PVA 4%, 40) (19.79277) = 4,205,964

$5,247,414Requirement 2

Period Cash interest paid

Interest expense

D or Pamortization

Closing net bond liab.

Op. balance 5,247,4141 212,500 209,897 2,603 5,244,8112 212,500 209,792 2,708 5,242,1033 212,500 209,684 2,816 5,239,2874 212,500 209,571 2,929 5,236,358

Requirement 3

1 October 20x4Cash ...............................................................................................5,247,414

Premium on bonds payable.................................................... 247,414Bonds payable........................................................................ 5,000,000

31 December 20x4Interest expense ($209,897 x 3/6).................................................. 104,949Premium on bonds payable ($2,603 × 3/6).................................... 1,301

Interest payable ($212,500 × 3/6) .......................................... 106,25031 March 20x5

Interest expense ($209,897 x 3/6).................................................. 104,948Interest payable .............................................................................. 106,250Premium on bonds payable ($2,603 × 3/6).................................... 1,302

Cash ....................................................................................... 212,50030 September 20x5

Interest expense ............................................................................. 209,792Premium on bonds payable ........................................................... 2,708

Cash ....................................................................................... 212,50031 December 20x5

Interest expense ($209,684 x 3/6).................................................. 104,842Premium on bonds payable ($2,816 × 3/6).................................... 1,408

Interest payable ($212,500 × 3/6) .......................................... 106,250

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Requirement 4


Interest expense

Discount or premium amortization

Closingnet bond liability

Opening balance 5,247,414

1 212,500 206,315 6,185 (1) 5,241,2292 212,500 206,315 6,185 5,235,0443 212,500 206,315 6,185 5,228,8594 212,500 206,315 6,185 5,222,674

(1) $247,414/40

1 October 20x4Cash ...............................................................................................5,247,414

Premium on bonds payable.................................................... 247,414Bonds payable........................................................................ 5,000,000

31 December 20x4Interest expense ............................................................................. 103,157Premium on bonds payable ($6,185 × 3/6).................................... 3,093


31 March 20x5Interest expense ............................................................................. 103,157Interest payable .............................................................................. 106,250Premium on bonds payable ($6,185× 3/6)..................................... 3,093

Cash ....................................................................................... 212,500

30 September 20x5Interest expense ............................................................................. 206,315Premium on bonds payable............................................................ 6,185

Cash ....................................................................................... 212,500

31 December 20x5Interest expense ............................................................................. 103,157Premium on bonds payable ($6,185 × 3/6).................................... 3,093


Requirement 5

The effective interest method is required under IFRS. It is preferable because it measures interest expense as a constant percentage of the outstanding liability – a better measure of cost of debt.

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Requirement 1Bond proceeds:

P = $3,000,000 × (P/F, 4%,20) + ($3,000,000 × 5%) × (P/A, 4%,20) = ($3,000,000 × 0.45639) + ($150,000 × 13.59033) = $1,369,170 + $2,038,550 = $3,407,720

Requirement 2

Effective-interest amortization:30 September 20x1:Cash ........................................................................ 3,407,720

Bonds payable ................................................ 3,000,000Premium on bonds ......................................... 407,720

31 March 20x2:Interest expense ...................................................... 136,309Premium on bonds.................................................. 13,691

Cash ................................................................ 150,000[interest expense = 4% of $3,407,720]

30 September 20x2:Interest expense ...................................................... 135,761Premium on bonds.................................................. 14,239

Cash ................................................................ 150,000[interest expense = 4% of ($3,407,720 – $13,691) = .04($3,394,029)]


Cash ................................................................ 150,000[interest expense = .04($3,394,029 – $14,239) = .04($3,379,790)]


Cash ................................................................ 150,000[interest expense = .04($3,379,790 – $14,808) = .04($3,364,982)]

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Requirement 3

Straight-line amortization:

30 September 20x1:Cash ........................................................................ 3,407,720

Bonds payable ................................................ 3,000,000Premium on bonds ......................................... 407,720

31 March 20x2:Interest expense ...................................................... 129,614Premium on bonds ($407,720 ÷ 20)....................... 20,386

Cash ................................................................ 150,000


Cash ................................................................ 150,000


Cash ................................................................ 150,000


Cash ................................................................ 150,000

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Requirement 4

The unamortized premium on 1 October 20x7, using the effective interest method, is the present value of the remaining cash flows at that date, less the principal amount of the bonds at 1 October 20x7, four years before maturity:

Unamortized premium = [$3,000,000(P/F, 4%, 8) + $150,000(P/A, 4%, 8)] – $3,000,000= [$3,000,000(.73069) + $150,000(6.73274)] – $3,000,000 = ($2,192,070 + $1,009,911) – $3,000,000 = $3,201,981 – $3,000,000= $201,981

Requirement 5

Premium amortization for next 6 months:

Using the answer to requirement 4: The present value of the bonds at 1 October 20x7 is $3,201,981. Interest expense for the next six months is 4% of the PV, or $128,080. Premium amortization is the difference between the expense of $128,080 and the

payment of $150,000, or $21,920.

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Assignment 12-12

Requirement 1

Price of bond:P $3,000,000 (P/F, 3%, 7) = $3,000,000 × (.81309)....................$2,439,270I $75,000 (P/A, 3%, 7) = $75,000 × (6.23028) ........................... 467,271

$2,906,541

Requirement 2

DateInterestPayment

InterestExpense

DiscountAmortization

UnamortizedDiscount

Net bondLiability

Opening $93,459 $2,906,5411 $75,000 $87,196 $12,196 81,263 2,918,7372 75,000 87,562 12,562 68,701 2,931,2993 75,000 87,939 12,939 55,762 2,944,2384 75,000 88,327 13,327 42,435 2,957,5655 75,000 88,727 13,727 28,708 2,971,2926 75,000 89,139 14,139 14,569 2,985,4317 75,000 89,563 14,569* 0 3,000,000

* Rounded by $6

Requirement 3

1 September 20x9Cash ........................................................................................ 2,906,541Discount on bonds payable ......................................................... 93,459

Bonds payable ..................................................................... 3,000,000

31 December 20x9 (adjusting entry):Interest expense (4/6)................................................................... 58,131

Discount on bonds payable................................................. 8,131Accrued interest payable ................................................... 50,000

28 February 20X10Accrued interest payable ........................................................... 50,000Interest expense (2/6)................................................................... 29,065

Discount on bonds payable (2/6) .................................. 4,065 Cash ................................................................................ 75,000

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31 August 20x10Interest expense .......................................................................... 87,562

Discount on bonds payable................................................ 12,562Cash ................................................................................... 75,000

31 December 20x10 (adjusting entry):Interest expense (4/6)................................................................... 58,626

Discount on bonds payable................................................. 8,626Accrued interest payable ................................................... 50,000

Requirement 4

20x9Interest expense $58,131

20x10Interest expense ($29,065 + $87,562 + $58,626) $175,253

Requirement 5

20x9Bonds payable, 5%, effective rate 6%, due 28 February 20X13 $3,000,000Discount on bond payable ($93,459 – $8,131) 85,328

$2,914,67220x10Bonds payable, 5%, effective rate 6%, due 28 February 20X13 $3,000,000Discount on bond payable ($85,328 - $4,065 - $12,562 - $8,626) 60,065

$2,939,925

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Assignment 12-13

Requirement 1

1 April 20x1Cash ........................................................................................ 814,003 Premium on bonds payable ................................................ 14,003

Bonds payable ..................................................................... 800,000

30 September 20x1Interest expense .......................................................................... 20,350Premium on bonds payable ........................................................ 1,250

Cash ................................................................................... 21,600

31 December 20x1 (adjusting entry):Interest expense (3/6)................................................................... 10,159Premium on bonds payable ......................................................... 641

Accrued interest payable ................................................... 10,800

30 March 20x2Accrued interest payable ........................................................... 10,800Premium on bonds payable ......................................................... 640Interest expense ........................................................................... 10,160 Cash ..................................................................................... 21,600


Cash ................................................................................... 21,600



Requirement 2

Bond is issued for $811,034 ($811,472 – (2/6 of $1,313)), plus 2 months’ accrued interest: $800,000 x 5.4% x 2/12 = $7,200

1 June 20x2Cash ($811,034 +$7,200) ........................................................... 818,234

Accrued interest payable (or interest expense).................. 7,200 Premium on bonds payable ............................................... 11,034

Bonds payable ................................................................... 800,000

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30 September 20x2Interest expense ($20,287 x 4/6) ................................................ 13,525Accrued interest payable (consistent with prior entry) .............. 7,200Premium on bonds payable ($811,034 - $810,159)................... 875

Cash ................................................................................... 21,600



30 March 20x3Accrued interest payable ........................................................... 10,800Premium on bonds payable ......................................................... 673Interest expense ........................................................................... 10,127 Cash ..................................................................................... 21,600


Cash ................................................................................... 21,600



Requirement 3

Bonds payable, 5.4%, effective rate 5%, due 30 March 20X6 $800,000Premium on bond payable ($7,433 – 707) 6,726

$806,726

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Requirement 1

Price of bond:P $200,000 (P/F, 4%, 8) = $200,000 × (.73069)..........................$146,138I $7,600 (P/A, 4%, 8) = $7,600 × (6.73274)............................... 51,169

$197,307

Requirement 2

DateInterestPayment

InterestExpense

DiscountAmortization

UnamortizedDiscount

Net bondLiability

Opening $2,693 $197,30731 Aug. 20x4 $7,600 $7,892 $292 2,401 197,59928 Feb. 20x5 7,600 7,904 304 2,097 197,90331 Aug. 20x5 7,600 7,916 316 1,781 198,21928 Feb. 20x6 7,600 7,929 329 1,452 198,54831 Aug. 20x6 7,600 7,942 342 1,110 198,89028 Feb. 20x7 7,600 7,956 356 754 199,24631 Aug. 20x7 7,600 7,970 370 384 199,61628 Feb. 20x8 7,600 7,984 384 0 200,000

Requirement 3

Proceeds of bond = $197,599 + 1/6 of ($197,599 -$197,903) = $197,650Accrued interest = $200,000 x 7.6% x 1/12 = $1,267

Requirement 4

30 September 20x4Cash ($197,650 + $1,267) .......................................................... 198,917Discount on bonds payable ($200,000 - $197,650) .................... 2,350

Bonds payable ..................................................................... 200,000Accrued interest payable ...................................………… 1,267

31 December 20x4 (adjusting entry):Interest expense ........................................................................... 3,952

Accrued interest payable ($200,000 × 7.6% × 3/12)......... 3,800Discount on bond payable ($304 × 3/6).............................. 152

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Note: If interest expense was credited in the first entry, it will have to be adjusted now, to set up the proper payable ($5,067) and expense ($3,952) at year-end. Crediting interest expense in the initial entry is only a “wash” after the first six month payment.

28 February 20x5:Interest payable ............................................................................ 5,067Interest expense ........................................................................... 2,634

Discount on bonds payable ($304 × 2/6)............................ 101Cash ..................................................................................... 7,600

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Assignment 12-15

Requirement 1

The effective interest rate is the internal rate of return which equates the future cash flows to the price of $485,635. The future cash flows are interest of $37,500 per year for eight years and the payment at maturity of $500,000. The equation would be as follows:

$485,635 = $500,000 (P/F, i, 8) + $37,500 (P/A, i, 8)An interest rate of 8% satisfies the equation:

P = $500,000 (.54027) + $37,500 (5.74664) = $485,635

Requirement 2

Price of bond:P $500,000 (P/F, 6%, 8) = $500,000 (.62741) .............................$313,705I $37,500 (P/A, 6%, 8) = $37,500 (6.20979) .............................. 232,867

$546,572

Requirement 3Effective Interest

Balance, interest payment Discount Balance,Period beginning @8% @7.5% Amortization ending

20x1 $485,635 $38,851 $37,500 $ 1,351 $ 486,98620x2 486,986 38,959 37,500 1,459 488,44520x3 488,445 39,076 37,500 1,576 490,02120x4 490,021 39,202 37,500 1,702 491,72320x5 491,723 39,338 37,500 1,838 493,56120x6 493,561 39,485 37,500 1,985 495,54620x7 495,546 39,644 37,500 2,144 497,69020x8 497,690 39,810(1) 37,500 2,310 500,000(1) rounded down by 5

Requirement 4

Proceeds of bond = $485,635 + (2/12 of $1,351) = $485,860Accrued interest = $500,000 x 7.5% x 2/12 = 6,250


Interest expense ($38,851 per table x 10/12 ) $32,376Net bonds payable (per table) $486,986

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Assignment 12-16

Requirement 1

Price of bond:P $30,000 (P/F, 4%, 6) = $30,000 × (.79031).............................. $23,709I $900 (P/A, 4%, 6) = $900 × (5.24214)..................................... 4,718


Bond Amortization Table(Stated rate 3%; effective rate 4%; semi-annual)

DateCash

PaymentEffective Interest

Discount Amortization

UnamortizedDiscount

NetBond

Liability

Opening 1,573 28,42731 May 20x6 900 1,137 237 1,336 28,66430 Nov. 20x6 900 1,147 247 1,089 28,91131 May 20x7 900 1,156 256 833 29,16730 Nov.20x7 900 1,167 267 566 29,43431 May 20x8 900 1,177 277 289 29,71130 Nov. 20x8 900 1,189* 289 0 30,000

*Rounded

Requirement 3

Proceeds of bond = $28,427 + 3/6 of ($28,427 -$28,664) = $28,546Accrued interest = $30,000 x 6% x 3/12 = $450

Requirement 4

Discount amortization to 31 May 20x6 is $118 ($237 x 3/6) or ($28,546 - $28,664)

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Assignment 12-17

Requirement 1

The company did not get a 2% loan. The upfront fee must be included when establishing the real borrowing cost, and its effect is to increase the interest rate to 5%.

Effective interest rate = Solve for x% in,

$750,000 = $61,273 + $15,000 (P/A, x %, 3) + $750,000 (P/F, x %, 3)x = 5%

Proof:$750,000 = $61,273 + $15,000 (P/A, 5%, 3)+ $750,000 (P/F, 5%, 3)$750,000 = $61,273 + $15,000 (2.72325) + $750,000 (.86384)$750,000 = $750,000

Requirement 2

The upfront fee is not expensed at the inception of the loan. It is deferred, and amortized over the life of the loan using the effective interest method.

Requirement 3

Beginning of Year 1

Cash ($750,000 - $61,273) ............................................................ 688,727Discount/ financing cost ................................................................ 61,273

Note payable .......................................................................... 750,000

End of Year 1 2 3

Interest expense 34,436 1 35,4082 36,4293

Cash 15,000 15,000 15,000Discount/ financing cost 19,436 20,408 21,429

(1) $688,727 x .05(2) ($688,727 + $19,436 = $708,163) × .05(3) ($708,163 + $20,408 = $728,571) × .05

End of Year 4

Note payable ................................ 750,000 Cash……………………….. 750,000

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Assignment 12-18

Requirement 1

Effective interest rate = Solve for x in,

$500,000 = $53,460 + $10,000 (P/A, x %, 3) + $500,000 (P/F, x %, 3)x = 6%

Proof:$500,000 = $53,460+ $10,000 (P/A, 6%, 3)+ $500,000 (P/F, 6%, 3)$500,000 = $53,460 + $10,000 (2.67301) + $500,000 (.83962)$500,000 = $500,000

Net amount advanced on borrowing: $500,000 - $53,460 = $446,540

Requirement 2

Interest expense: (table not required)


Int. expense (6%)

Amortization Closingnet liability

Op. balance 446,5401 10,000 26,792 16,792 463,3322 10,000 27,800 17,800 481,1323 10,000 28,868 18,868 500,000

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Assignment 12-19

Requirement 1

Any eligible borrowing cost that is directly attributable to the acquisition, construction or production of the inventory and the storage facility forms part of the cost of that asset and is capitalized. This includes interest on the specific loan for the storage facility and general borrowing costs for the storage facility and inventory.

Requirement 2

Inventory ............................................................................................... 29,948Interest expense ..................................................................... 29,948

Cost of borrowing: $520,000/(1,500,000 +$8,000,000) = 5.47%Capitalization ends when good are available for sale. Interest has already been expensed, so this entry re-allocates the amount to be capitalized.

Payment Calculation Capitalizable

Early March payment $730,000 × 9/12 ×5.47%(1 March – 30 November)

$ 29,948

Storage facility ...................................................................................... 21,788Interest expense ............................................................................. 15,955Interest payable ($1,000,000 x 7% x 1/12).................................... 5,833

Interest on the specific loan is capitalizable after the loan is issued, presumably concurrently with the $1,200,000 early December payment. Interest is not yet recorded. Other interest is capitalizable out of general borrowing cost. This interest has already been expensed, so this entry re-allocates the amount to be capitalized. Capitalization continues until the building is completed in January of next year.


Late July $500,000 × 5/12 ×5.47% $ 11,396Late October $400,000× 2/12 ×5.47% 3,647Early December ($1,200,000 - $1,000,000

through specific loan) × 1/12 ×5.47% 912

$15,955

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Assignment 12-20

Requirement 1

Cash ($90,000 - $15,165)...................................................................... 74,835Discount/ financing cost ....................................................................... 15,165

Note payable .......................................................................... 90,000

The company receives $74,835 in cash.Effective interest rate for specific loan = Solve for x in,

$90,000 = $15,165 + $1,800 (P/A, x %, 5) + $90,000 (P/F, x %, 5)x = 6%

Proof:$90,000 = $15,165 + $1,800 (P/A, 6%, 5)+ $90,000 (P/F, 6%, 5)$90,000 = $15,165 + $1,800 (4.21236) + $90,000 (.74726)$90,000 = $90,000

Requirement 2


Mid-January Invoice price $180,000July Customization $ 15,000August Training 10,000Specific loan ($90,000 - $15,165) x 6% x

7.5 /12 months(mid-January – early September)(1) 2,806

General borrowing ($180,000 - $74,835 paid through specific loan) x 5.67% (2) x 7.5/12 months $15,000 x 5.67% (2) x 1/12 $10,000 x 5.67% (2) x 0/12July and August payments are assumed to take place at the end of the month.

3,798

Note: may not exceed fair valueof a customized bulldozer

$211,604

(1) Capitalization period ends in early September(2) Average borrowing cost on general borrowing = 5.67% ($160,000 + $95,000)/(3,000,000 + $1,500,000)This excludes the mortgage loan for the manufacturing facility because it is not general borrowing. No cost for equity financing is capitalizable.

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Assignment 12-21

Requirement 1

Principal: $600,000 × (P/F, 3%, 20) = $600,000 × (.55368) = $332,208Interest payments: $15,000 × (P/A, 3%, 20) = $15,000 × (14.87747) = 223,162Bond price $555,370

1 July 20x2 - Issuance of bonds:Cash ..................................................................................... 555,370Discount on bonds payable ................................................. 44,630

Bonds payable, 5% ..................................................... 600,000

Requirement 2

1 July 20x5 - Purchased $200,000 bonds at effective rate of 8%:Bonds payable, 5%............................................................... 200,000

Gain, retirement of debt ............................................... 20,392Discount on bonds payable (1)..................................... 11,296Cash (2)........................................................................ 168,312

Computations:(1) Book value is present value with 14 periods remaining:

200,000 × (P/F, 3%, 14) = $200,000 × (.66112).................. $132,224($200,000 × 2.5%) × (P/A, 3%, 14) = $5,000 × (11.29607) 56,480Book value (PV) .................................................................. $188,704Discount ($200,00 - $188,704) ............................................ $11,296

(2) Purchase price:$200,000 × (P/F, 4%, 14) = $200,000 × (.57748)................ $115,496($200,000 × 2.5%) × (P/A, 4%, 14) = $5,000 × (10.56312) 52,816Purchase price (PV) ............................................................. $168,312

The gain is reported as an unusual item in earnings.

Requirement 3

Neither the issuer nor investor had an economic gain or loss because the cash paid was equal to the current present value of the 5% bonds. The change in market value, which did cause a gain for the issuer and a loss for the investor, occurred when interest rates changed.

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Case A

31 December 20x16 - Retirement of the debt:Bonds payable, 12%........................................................................ 200,000Premium on bonds payable (1) ....................................................... 21,340

Gain, retirement of debt .......................................................... 15,340Cash ($200,000 × 1.03)........................................................... 206,000

(1)$21,340 = $200,000 – [ $200,000 × (P/F, 10%, 8) + ($24,000) × (P/A, 10%, 8)]

Case B

Requirement 1

Principal: $200,000 × (P/F, 11%, 10) = $200,000 × (.35218) = $70,436Interest payments: $20,000 × (P/A, 11%, 10)

= $20,000 × (5.88923) = 117,785Bond price $188,221

1 January 20x2Cash ................................................................................................ 188,221Discount on bonds payable ............................................................. 11,779

Bonds payable, 10%, 10-year.................................................. 200,000

Requirement 2

Book value at the end of 20X4:Principal: $200,000 × (P/F, 11%, 7) = $200,000 × (.48166) = $96,332Interest payments: $20,000×(P/A, 11%, 7) = $20,000 × (4.71220)= 94,244

Bond price $190,576

1 July 20x5To update interest expense and discount amortization for 20x5:Interest expense ($190,576 x 11% x 6/12)...................................... 10,482

Discount on bonds payable .................................................... 482Interest payable ($200,000 × 10% × 6/12).............................. 10,000

To record the retirement:Bonds payable ................................................................................. 200,000Interest payable ............................................................................... 10,000Loss, retirement of debt .................................................................. 10,942

Discount on bonds payable* ................................................... 8,942Cash ($202,000 + $10,000)..................................................... 212,000*Unamortized balance:($200,000 - $190,576 = $9,424 - $482)

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Assignment 12-23

Case A

To update interest expense and amortization:Interest expense............................................................................... 22,533Premium on bonds payable ............................................................ 800 Cash ($10,000,000 × 20% × 7% × 2/12) ............................... 23,333

To record the retirement:Bonds payable ($10,000,000 x 20%) ..............................................2,000,000Premium on bonds payable ($84,000 x 20%) less $800 ................. 16,000Loss, retirement of debt .................................................................. 184,000

Cash......................................................................................... 2,200,000

Case B

To record interest payment:Interest expense ($360,000 + $12,000)........................................... 372,000Interest payable ($18,000,000 × 4% × 3/6) (from 31 Dec. 20X7) .. 360,000

Discount on bonds payable ....................................................... 12,000 Cash ($18,000,000 × 4%) ......................................................... 720,000

To record retirement:Bonds payable .................................................................................7,200,000 Gain, retirement of debt ............................................................ 122,000

Discount on bonds payable ($132,000 - $12,000) × 40%......... 48,000Cash........................................................................................... 7,030,000

Case C

To update interest expense and amortization:Interest expense............................................................................... 81,709

Discount on bonds payable ..................................................... 1,328 Upfront costs .......................................................................... 381Interest payable ($10,000,000 × 80% × 6% × 2/12) .............. 80,000

To record the retirement:Bonds payable .................................................................................8,000,000Interest payable (($10,000,000 × 80% × 6% × 8/12)..................... 320,000Loss, retirement of debt .................................................................. 46,451

Discount on bonds payable ($124,500 × 80%) less $1,328 .... 98,272 Deferred issue costs ($35,700 × 80%) less $381.................... 28,179

Cash ($8,000,000 x .99) + $320,000....................................... 8,240,000

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Assignment 12-24

Requirement 1

Interest expense (271,425 x .4 x 2/6) ................................................... 36,190Discount on bonds payable (31,425 x 2/6 x .4) ............................. 4,190Cash ($240,000 x .4 x 2/6)............................................................. 32,000

Requirement 2

Bonds payable .......................................................................................3,200,000Loss on bond retirement ....................................................................... 61,810

Discount on bonds payable ($245,000 x .4) – $4,190 ................... 93,810Cash ($3,200,000 x .99)................................................................. 3,168,000

Requirement 3

Interest expense ($271,425 x .6) ........................................................... 162,855Discount on bonds payable ($31,425 x .6) .................................. 18,855

Cash ($240,000 x .6)………………............................................ 144,000

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Assignment 12-25

Requirement 1

Issuance proceeds: $38,301,565 + 1/6 x $32,063 (see table) = $38,306,909Accrued interest = $40,000,000 × 7.5% × 1/12 = $250,000

Principal: $40,000,000 × (P/F, 4%, 29) = $40,000,000 × (.32065) = $12,826,000Interest payments: $1,500,000 × (P/A, 4%, 29)

= $1,500,000 × (16.98371) = 25,475,565Bond price (rounded) $38,301,565

Interest expense: (table not required) Period Cash interest

paidInt. expense (4%)

Amortization Closingnet liability

Op. balance 38,301,565*1 1,500,000 1,532,063 32,063 38,333,628**2 1,500,000 1,533,345 33,345 38,366,9733 1,500,000 1,534,679 34,679 38,401,652

* n = 29** n = 28

Requirement 2

Cash ($38,306,909 + $250,000)...................................................... 38,556,909Discount on bonds payable ...................................................................1,693,091

Bonds payable ............................................................................. 40,000,000Interest payable (or expense)....................................................... 250,000

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Requirement 3

Interest expense ....................................................................................1,276,719Interest payable ..................................................................................... 250,000

Discount on bonds payable ($32,063 x 5/6)) or ($38,308,909 - $38,333,628) .............................................. 26,719

Cash ($40,000,000 x 7.5% x 6/12) ................................................ 1,500,000

Requirement 4

Interest expense ($1,533,345 x 2/6) x 10%........................................... 51,112Discount on bonds payable ($33,345 x 2/6) x 10% .................... 1,112

Interest payable ($4,000,000 x 7.5% x 2/12)……………… ........ 50,000

Bonds payable ................................................................................. 4,000,000Interest payable .................................................................................... 50,000Loss on bond retirement........................................................................ 125,525

Cash ($4,000,000 x 99%) + $50,000 .......................................... 4,010,000Discount on bonds payable (1 )…..………………………….. 165,525

(1) ($38,333,628 - $40,000,000) x .10 = $166,637; $166,637 - $1,112 = $165,525

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Assignment 12-26

Requirement 1

1 July 20x1Cash1 ............................................................................................... 688,417Discount on bonds payable ............................................................. 111,583

Bonds payable ......................................................................... 800,0001 $800,000 (P/F, 6%, 19) (.33051) + $38,000 (P/A, 6%, 19) (11.15812)

31 December 20x1Interest expense*............................................................................. 41,305

Discount on bonds payable ..................................................... 3,305Cash......................................................................................... 38,000

*$688,417 × .06

Requirement 2

Book value at 30 June 20x6 of the $240,000 of bonds defeased 1 August 20x6 (9 semiannual period remaining) = $240,000 × (P/F, 6%, 9) + ($240,000 × 4.75%) × (P/A, 6%, 9) = $219,595.

Unamortized discount remaining = $20,405 = $240,000 – $219,595

1 August 20x6Interest expense (6% × $219,595 × 1/6) ......................................... 2,196

Discount on bonds payable ..................................................... 296Interest payable (4.75% × $240,000 × 1/6)............................. 1,900

Interest payable ............................................................................... 1,900Bonds payable ................................................................................. 240,000Loss on bond defeasance................................................................. 27,309

Discount on bonds payable ($20,405 – $296)......................... 20,109Cash [(1.03 × $240,000) + $1,900]......................................... 249,100

Requirement 3

The critical element of a defeasance that permits de-recognition of the liability is that the creditor agrees to the arrangement and legal release is given to the borrower. In an in-substance defeasance, the transaction is the same except there is no legal release by the creditor. Debt subject to a defeasance arrangement is derecognized, but debt subject to an in-substance defeasance is left on the books.

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Requirement 4

Interest rates have declined since Computer Medic issued its bonds. They were issued at a discount and now sell at a premium. The relative attractiveness has increased reflecting a drop in overall interest rates.

Requirement 5

The loss is caused by changing interest rates and valuation of the bond liability at a value based on its issuance price. The loss does not equal the change in Computer Medic’s economic status. Many would argue that Computer Medic has experienced no change in economic status because a liability has been defeased at market value. To the extent that a company’s financial position improves with an equal reduction of debt and assets, Computer Medic may be a stronger company. In addition, the defeasance may be a smart move. Computer Medic may be able to replace the 10% debt with lower interest rate debt, improving its long-run liquidity position.

Requirement 6

Book value at 30 June 20x6 of the $560,000 of bonds remaining = [$560,000 × (P/F, 6%, 9)] + [$560,000 × 4.75% × (P/A, 6%, 9)] = $512,389

31 December 20x6Interest expense (6% × $512,389)................................................... 30,743

Discount on bonds payable ..................................................... 4,143Cash (4.75% × $560,000) ....................................................... 26,600

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Assignment 12-27

Requirement 1

Cash (Given).................................................................................1,606,617Premium on bonds payable ................................................... 106,617Bonds payable........................................................................ 1,500,000

Requirement 2

Interest expense ($1,606,617 x 10% x 5/12) ................................. 66,942Premium on bonds payable .......................................................... 8,058

Interest payable ($1,500,000 × 12% × 5/12) ......................... 75,000

Requirement 3

Interest expense ($1,606,617 x 10% x 1/12) ................................. 13,388Interest payable ............................................................................. 75,000Premium on bonds payable ........................................................... 1,612

Cash ($1,500,000 × 12% × 6/12)........................................... 90,000

Requirement 4

Bonds payable ($1,500,000 × 40%)............................................... 600,000Premium on bonds payable ($40,849 × 40%) (1).......................... 16,340

Gain on bond retirement ........................................................ 28,340Cash ($1,500,000 × 40% × .98)............................................. 588,000

(1) Present value of the bond on this date = (n=3, i=5%) = $1,540,849Premium = $40,849

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Requirement 5

Financing section, Retirement of bonds payable, ($588,000)

Operating activities section, indirect method, Less: gain on bond retirement ($28,340)

If the direct method were used, the gain on bond retirement would not be listed.

Requirement 6

Long-term liabilities:Bond payable, 12%, due 31 January 20x7 $900,000Plus: premium on bonds payable 24,509*

$924,509* $40,849 × 60%

Requirement 7

At 31 July 20X5, the bonds have three more interest periods remaining. The market value will be the remaining payments discounted at 14% per annum, or 7% per interest period:

Principal: $900,000 × (P/F, 7%, 3) = $900,000 × 0.81630 = $734,670Interest: ($900,000 × 6%) × (P/A, 7%, 3) = $54,000 × 2.62432 = 141,713

$876,383

The company should include this market value in the disclosure notes.

Requirement 8

Cash required for defeasance:

Principal: $900,000 × (P/F, 4%, 3) = $900,000 × (0.88900) = $800,100Interest payments: $54,000 × (P/A, 4%, 3) = $54,000 × (2.77509) = 149,855

Bond price $949,955

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Assignment 12-28

Requirement 1

Cash ...................................................................................................13,520,000Long-term note payable (US$13,000,000 × 1.04) ................ 13,520,000

Requirement 2

Statement of financial position

Long-term note payable (US$13,000,000 × $1.01) $13,130,000Accrued interest payable (US$13,000,000 × 5% × 8/12 × $1.01) $ 437,667

Statement of comprehensive income

Interest expense (US$13,000,000 × 5% × 8/12 × $1.03) $ 446,333 dr.

Foreign exchange gain ($13,520,000 – $13,130,000) +($437,667 - $446,333) $ 398,666 cr.

Note that interest expense is measured at the average rate for the year, and the interest liability is measured at the closing exchange rate. There is an exchange gain for the difference.

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Assignment 12-29 WEB

Requirement 1

Date Loan Balance (Gain)/Loss1 May 20x2 @ $1.09 $8,720,00031 December 20x2 @ $1.12 8,960,000 $240,00031 December 20x3 @ $1.10 8,800,000 (160,000)

Earnings, year ended 31 December 20x2Exchange lossre: principal......................................................... 240,000

31 December 20x2 SFPLoan payable ......................................................... $8,960,000

Earnings, year ended 31 December 20x3Exchange (gain) re: principal......................................................... (160,000)

31 December 20x3 SFPLoan payable ......................................................... $8,800,000

Requirement 2

Interest Expense20x2 $8,000,000 × .0725 × 8/12 × $1.11 $429,20020x3 $8,000,000 × .0725 × $1.09 $632,200

Exchange G/L (Interest)20x2

Interest payable/paid at 31 December 20x2 ($8,000,000 × .0725 × 8/12 × $1.12) $433,067

Interest expense (above) 429,200Exchange loss $ 3,867

There is an exchange gain or loss on interest expense because it is accrued at the averagerate and paid at a specific date when the exchange rate is different than the average.

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Assignment 12-30

Requirement 1

Merit LtdPartial Statement of Cash FlowYear ended 31 December 20x9

Cash used for financing activities:Bond retirement (7% bond) ($3,000,000 x 101%).. (3,030,000)Bond retirement (6.5% bond) ($6,000,000 x 97.5%) (5,850,000)

Requirement 2

Gain or loss: 7% Bond 6.5% BondPrice paid ..................................................................... $3,030,000 $5,850,000

Book value.................................................................... 3,000,000 6,000,000 Discount *..................................................................... (21,000) (35,000) Total ..................................................................... 2,979,000 5,965,000

(Gain)/loss ................................................................... $51,000 $(115,000)

* $152,500 - $14,700 - $116,800 = $21,000; $61,500 - $5,200 - $21,300 = $35,000

Issuance of the 7.25% bond for land is a non-cash transaction and is excluded from the SCF. Supplementary disclosure is required.

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© 2011 McGraw-Hill Ryerson Ltd. All rights reserved.


Chapter 13: Shareholders’ EquitySuggested Time

Case 13-1 Topsail Ltd. 13-2 Birch Corporation 13-3 Lorenzoni Winery Assignment 13-1 Components of shareholders’ equity.................. 20

13-2 Effect of transactions (W*) ............................... 1013-3 Effect of transactions ......................................... 2013-4 Share issuance.................................................... 2013-5 Entries and reporting.......................................... 3013-6 Share retirement—entries and account

balances...................................................... 3013-7 Share retirement—analysis ................................ 1013-8 Equity, interpretation ........................................ 2013-9 Retired shares—entries and reporting................ 4013-10 Treasury stock—entries and reporting ............... 1513-11 Treasury stock—entries and account

balances (W*) ................................................ 3013-12 Compute dividends, preferred shares - four cases 3013-13 Compute dividends, comprehensive -

four cases ................................................... 4013-14 Compute dividends, retire shares ....................... 3013-15 Stock dividend and stock split ........................... 2513-16 Stock dividend recorded—dates cross two

periods........................................................ 2513-17 Stock split - adjustments .................................... 2013-18 Stock dividend with fractional shares ................ 2513-19 Stock dividends and splits; fractional share

rights ........................................................ 3013-20 Equity; retirement and stock dividend .............. 3013-21 Retained earnings calculation and equity......... 3013-22 Statement of changes in equity (*W)............... 2013-23 Statement of changes in equity ....................... 2013-24 Statement of changes in equity ....................... 3013-25 Entries and shareholders’ equity ........................ 4513-26 Shareholders’ equity (W*) ................................. 4513-27 Compute dividends, record share transactions... 4013-28 Effect of transactions ......................................... 3013-29 Transactions, statement of cash flow ............... 3013-30 Statement of cash flow..................................... 30

*W The solution to this exercise/problem is on the text Web site andin the Study Guide. The solution is marked WEB.

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Questions

1. The categories of shareholders’ equity are contributed capital from shareholders, retained earnings and reserves (unrealized amounts). Contributed capital represents the capital invested by shareholders. Other elements of contributed capital are created by share transactions with shareholders. Retained earnings represents cumulative earnings less dividends; reserves include unrealized gains/losses on FVTOCIfinancial assets, unrealized amounts from hedges, and foreign exchange translationgains/losses on certain foreign operations.

2. If shares were issued for a capital asset, the transaction would be valued by considering an appropriate fair value for the capital assets. The fair values can be difficult to assess, and it is a responsibility of the Board of Directors to determine the reliability of appraisals and/or reference prices.

3. When no-par shares are issued, all the consideration received is credited to the share capital account. When par value shares are issued, par value is credited to the share capital account, and consideration received in excess of par is credited to a contributed capital account.

4. Share issue costs can be netted with proceeds on sale of shares, and thus effectively debited to the share account (offset method), or debited directly to retained earnings.

5. If a company has 100,000 shares issued and 10,000 shares in the treasury, there are 90,000 shares outstanding. Cash dividends of $2 per share would be $180,000, because treasury shares may not receive cash dividends.

6. Shares may be bought on the open market by a company, even if not callable.Corporations must exercise caution in these transactions because of insider trading rules.

7. EPS will increase when shares are retired if the earnings on the funds used to retire shares (idle cash) are proportionately less than the EPS. That is, if denominator (shares outstanding) is reduced, and the numerator is reduced (income) but not by as much, proportionately, EPS increases.

8. Reacquisition and retirement of shares for less than the original issuance price causes assets to decline (the cash paid), leaves liabilities unchanged, and increases other contributed capital (surplus) by the difference between the price paid and the original issuance price.

9. If the price paid is lower than average issue price, then proceeds are allocated:

a) To share capital, for the average issue price to date, and the excess,

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b) To contributed capital from share retirement.

If shares are reacquired at a price higher than average issue price to date, then the proceeds are allocated as follows:

a) To share capital, for the average issue price to date,b) To contributed capital created by prior retirements of this share class, if any, and

then,c) To retained earnings.

10. No, the individual issue price of shares is not relevant on retirement. The average issue price to date is used in the retirement entry. The individual issue price affects the average, of course.

11. Treasury stock is reported as a contra account in shareholders’ equity. A company cannot report its own shares as an asset.

12. Effects of treasury stock on total:Purchase Sale

a) Assets Decrease Increaseb) Liabilities None Nonec) Shareholders’ equity Decrease Increase

13. Non-cumulative preferred shares provide that dividends not declared for any year, or series of years, are lost permanently as far as the preferred shareholder is concerned. Cumulative preferred shares provide that dividends passed (dividends in arrears) for any year, or series of years, accumulate and must be paid to the preferred shareholders when dividends are declared, before the common shareholders are entitled to receive a dividend. Dividends in arrears are not a liability.

Preferred shares are non-participating when the dividends for each year are limited to a specified preference rate per share. Partially participating means that the preferred shareholders participate in dividends above the stated rate, but only up to an additional amount specified.

Preferred shares are fully participating when the preferred shareholders are entitled todividends (above the stated rate) on a pro rata basis with the holders of common shares. In this case, the preference relates to a prior claim to dividends up to the basic preference (with common entitled to a matching amount), after which both classes share ratably.

14. Dividend Assets Liabilities Total Shareholders’ EquityCash Decrease No effect DecreaseStock No effect No effect No effect

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15. Fractional share rights are certificates that can be accumulated and redeemed, in proper multiples, for the common shares of a company. They are issued when stock dividend declarations result in shareholders that are entitled to less than one full share.

16. A normal cash dividend reduces retained earnings, while a liquidating dividend reduces share capital, or other contributed capital. Both dividends reduce shareholders’ equity; they are different only in the choice of account to be debited.

17. Shareholders receive a certificate of some sort when a scrip dividend is declared. If the dividend is a liability dividend, the scrip is a promissary note and the dividend wil be paid in the future, often with interest. The company records a payable and the shareholder records a receivable.

18. A stock dividend involves the issuance of additional shares to the shareholders in proportion to the shares that they held prior to the dividend. It can reduce retained earnings and increase contributed capital by the same amounts, but does not change total shareholders’ equity. Alternatively, it can be recorded as a memo and have no impact on individual accounts within shareholders’ equity.

A stock split involves replacing the old shares with a larger number of new shares with a proportionately lower value per share. A stock split does not change the components or total of shareholders’ equity.

Neither a stock dividend nor a stock split requires the disbursement of corporate assets; both reduce earnings per share. They are similar in substance. They may be accounted for in the same way (memo) or differently (memo for split, recognition for dividend); an obvious anomaly.

19. A company does not record a gain on the donation of an asset by a shareholder. The asset is recognized on the books at fair value, and contributed capital is credited.

20. In general, the amounts shown as reserves are unrealized gains and losses. Management has no classification discretion. That is, the only sources of reserves are:

Gains and losses on FVTOCI financial instruments; Gains and losses on certain hedging instruments, and Translation gains and losses on certain foreign operations.

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Cases

Case 13-1Topsail Ltd.

Overview

Topsail is a private company that must company with GAAP because a major new lender, a credit union, requires an audit. The company could adopt IFRS, but is more likely to adopt the less complicated ASPE. Within GAAP, there are many choices allowed. The debt-to-equity covenant imposed by the credit union creates a bias to minimize debt and maximize equity (e.g., by maximizing earnings) to improve the ratio. Where acceptable choices exist, accounting policies that help improve this ratio should be adopted. All choices must be ethically appropriate, though, not just picked because of their effect on the ratio.

Issues

1. Revenue recognition2. Asset impairment3. Preferred shares4. Investment in Abel5. Non-monetary related party transactions6. Advertising7. Lawsuit

Analysis and conclusions

1. Revenue Recognition

Topsail must decide whether to recognize revenue on the Skyline cabinets, a $250,000 transaction, in the current fiscal year or next year. This transaction is material given the $300,000 level of net income.

On the one hand, the Skyline order may meet the criteria as a “bill-and-hold” transaction, and therefore could be recorded in the current year. The cabinets are complete and ready for shipment. A contract is in place, so Skyline has made a fixed commitment to purchase the goods. Skyline has requested that delivery be delayed, for a sound reason - the delay in the opening of the new store. It is likely that the goods have been segregated from general inventory sale given the fact that they are custom made. There appears to be a fixed delivery date of January 15th.

On the other hand, revenue is normally recognized on delivery, which is in the next fiscal year. The delivery date might be uncertain given that the store opening has been delayed. Uncertainties are further exacerbated by the potential inability for Skyline to arrange inventory financing. This suggests some question as to the collectability of the

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balance of the contract due to Topsail. Further, there could be significant performance obligations in terms of installation of the cabinets.

Given the lack of certainty surrounding delivery and collection, revenue must be deferred until delivery and acceptance of the cabinets by Skyline. If the $100,000 deposit was recognized as revenue it will need to be reversed and set up as deferred revenue. This goes against Topsail’s reporting objective of wishing to maximize income and therefore equity, thus worsening the debt-to-equity ratio.

2. Impaired assets

Topsail intends to replace a major piece of machinery when a new machine/technology comes out on the market next year.

The old machinery on Topsail’s books might be impaired, since Topsail intends to cease using the asset in the next several months and its expected proceeds are $20,000 lower than net book value. On the other hand, the value in use (future cash flows from revenue streams) of the machine may not be much lower than before. If new technology is not tested and produced on time, the machine may well be usable for some time to come.

Overall, as long as the plans to replace the machine are likely to proceed, the evidence seems stronger that an impairment write-down should be recorded. This amount should be recognized as a loss in the current period because the carrying amount of the machine is not recoverable and exceeds its fair value. The asset must be recorded at the expected net realizable value of $10,000. Recognition of this loss will decrease earningsand equity, worsening the debt-to-equity covenant.

3. Preferred Shares

Preferred shares are legally equity and are usually reported in shareholders’ equity.However, if shares have the characteristics of a liability, they must be reported as debt. The Topsail preferred shares must be repaid, with dividends in arrears, if any, in two years’ time. Any contract that involves a required cash outflow for the company meets the definition of a liability. The liability is long-term this year, and likely a current liability next year. Related dividends are classified as an expense and reduce earnings. This would worsen the debt-to-equity ratio in two ways: first, it would increase debt, and second, it would decrease earnings by the dividend amount.

Dave plans to avoid the preferred dividend until maturity, and Doug has agreed to this. The dividend on the preferred shares must be declared and recorded each year, though, because no dividend can be declared on the common shares unless this is done. Dave wishes to declare common dividends as advised by his tax planner. If the dividends are accrued but not paid on Topsail’s books, liabilities will again increase. Doug believes that he can defer tax on his dividend income by delaying payment; he should seek professional tax advice before implementing this plan.

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The accounting outcome outlined above seems highly undesirable. Topsail would prefer to improve, not worsen, their debt-to-equity ratio. Dave should consider ways to deal with this situation prior to the end of the fiscal year. First, he could consider re-negotiating the terms of the shares. Even though the legal contract exists, Doug, as an employee, may be willing to accept some legal wording that will avoid the need to classify the shares as a liability. Second, Dave could contact his lender and request that the debt-to-equity ratio be redefined to exclude the preferred shares or simply increased. Note that the preferred shares DO have to be repaid, so if the credit union is trying to capture the extent of cash obligations, there is no particular reason to exclude the preferred shares.

Under ASPE, certain preferred shares issued as part of tax planning arrangements, that are mandatorily redeemable, can continue to be classified in equity. It does not seem that these shares would qualify for the exemption.

3. Investment in Abel Electricity Ltd.

Topsail has significant influence in Abel with a 25% ownership. Significant influence seems likely, given the 25% ownership and regular intercompany transactions. However, the operation of the Abel Board of Directors should be investigated before this conclusion is finalized. If there is significant influence, Topsail could report this investment using the equity method or the cost method under ASPE.

Under the cost method, the investment would initially be recorded at its cost of $120,000. Dividends declared would be recorded as revenue, and there were none in this year.

Under the equity method, the investment would initially be recorded at cost. Topsail would record a proportionate amount of Abel’s income in earnings with an equal amount increasing the Abel investment account. Since Abel has positive income this year, this equity pick-up would improve income and equity by $50,000 (subject to certain adjustments, to be investigated). This would improve the ratio subject to the loancovenant. Any dividends declared by Abel would decrease the investment account and be recorded as a receivable when declared. Since there were no dividends this year, the overall impact on the investment account is an increase of (approximately) $50,000.

Use of the equity method for this (significant influence) investment is recommended because it presently appears to have a more positive impact on the debt-to-equity ratio. (Note, though, that in a future year, if Abel were to incur losses, the pick up of the loss would worsen the debt-to-equity ratio.)

4. Non-monetary related party transaction

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Topsail has received electrical services from Abel as part of a swap of services for a used van. This is a non-monetary transaction and must be recorded at fair value. The value of the goods and services received is ascertainable from a knowledgeable person in the industry. This estimate should be compared to the value of the used van, obtainable through current black book values. IFRS requires that fair value be set according to the services received, electrical contracting work done. ASPE looks at both values and usesthe one that is more verifiable. As ASPE evolves, this may be a grey area of valuation, but if the swap was equitable, the two values should be very close and valuation at fair value should be easily achieved.

The fair value should be used to value the transaction, with the van and its related accumulated amortization removed from assets and an increase to work-in-progress established for electrical work fair value. Any difference would be reflected as a gain or loss on disposition of the van. If there is a gain, then income and the debt-to-equity ratio will be improved. If a loss, then the ratio will worsen because of the impact on earnings.

This transaction is a related party transaction and must be disclosed in the notes to Topsail’s financial statements. Other dealings with Abel are also related party transactions, and also qualify for disclosure. The valuation of the services rendered should be investigated; if the price was less than fair value, as Topsail implies, then disclosure would be needed.

5. Advertising

The advertising and marketing campaign has been recorded as an intangible asset. Expenditures relating to advertising and promotional activities must be expensed when incurred; there is no severable asset that would justify treatment as an intangible asset. The impact of this is again to reduce income and worsen the debt-to-equity ratio.

6. Lawsuit

The lawsuit put forth by Bob Swaine appears to have no merit as supported by the opinion of Topsail’s lawyer that the case will be thrown out of court. Accordingly, neither accrual nor disclosure of the lawsuit is warranted. Topsail may include disclosure if they wish.

SummaryThe overall direction of these policy choices is to worsen the debt-to-equity ratio

in most cases. Topsail should prepare draft financial statements to assess whether they will be in violation of the covenant or not. If there are difficulties with the covenant, then the preferred share agreement should be re-assessed, and the credit union terms should be explored to see if re-negotiation is possible. In addition, it may be possible to arrange payment from Skyline, and firm up delivery dates, which will allow revenue recognition in the current fiscal year. These activities should take place before the end of the fiscal year.

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Case 13-2Birch Corporation

OverviewBirch is a small owner-managed company that manufactures and distributes wood mouldings. The minority shareholder (Fran) is buying out the majority shareholder (Reg). This report includes commentary on Birch’s accounting policies as well as on the proposed purchase price formula. GAAP (ASPE?) is the basis for any accounting policy decision the company must adopt as it is specifically mentioned in the proposed purchase agreement between Reg and Fran. However, GAAP must be defined, and then it must be the basis of recommendations made. Use of GAAP in the formula does not imply that internal accounting, as prepared by Fran to date, has been prepared on that basis.

As Fran has been maintaining the accounting records for Birch and is now interested in acquiring Reg’s 70% interest in the company using a formula that is based on accounting numbers, it is obvious that she may have had ethical conflicts. Her bias may be to understate earnings and cash flow. Given this bias, it is quite feasible that any information generated internally by Fran should be suspect. It is important to do this review from Reg’s perspective, but looking at the issues from a fairness perspective as well.

Issues1. GAAP definition2. RubberWood® revenue3. Investment accounting; Feine Corporation4. Share repurchase5. Valuation of capital assets6. Calculation of purchase price7. Commentary on purchase price agreement

Analysis

GAAP definition

GAAP has been referred to as a standard of reference in the agreement, but this could refer to IFRS, or to ASPE. The two are similar in many regards, but there are some differences that could impact the purchase price. ASPE is the most logical choice for this company, given its small size, but the shareholders should be consulted, and clarification sought, before finalizing any recommendations.

RubberWood® revenue

RubberWood®’s market has been reasonably proven as it has been offered for sale, by Birch, during the last three years. From the financial statements, it is obvious that Fran has been deferring recognition of the revenue from this product on the basis that the

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company has offered a lifetime guarantee on the product. The history of returns for the company has been very minor in relation to total sales for the product. Further, Reg has indicated that Birch’s customers for this product have been satisfied.

Complete deferral of the revenue is overly conservative. In addition, it is not reasonable to be both deferring revenue completely and recognizing a warranty expense related to the same product. The warranty expense is not being recognized along side the revenue earned.

RubberWood® revenue should be recognized as the goods are delivered. Given that the majority of customers appear to be happy with the product, and have not returned it to Birch, recognition is appropriate. Therefore, earnings should be adjusted for $605,000 -$390,000 = $215,000 in the current period and as a positive adjustment to current year earnings (see Appendix I).

However, it is appropriate to provide for some warranty based on the history of warranty being utilized by customers. The current warranty accrual is assumed to be adequate, but this should be reviewed.

Investment accounting; Feine Corporation

Feine Corporation is an investment held by Birch; Birch holds a 40% interest in the company and also has 40% (4 of 10) representation on Feine’s Board of Directors. As a result, it seems likely that Birch has a significant interest in the company and could report it using the equity method of accounting.

Fran has used the equity method of accounting for this associate; however, under equity accounting, only 40% (i.e., Birch’s share) of Feine’s loss should be reflected in its financial statements. Fran has included 100% of Feine’s loss which has understated Birch’s earnings, and net assets, by the other 60% of Feine’s loss for the current year.

Alternatively, using ASPE, the cost method could be used. The cost method reports only dividends declared as revenue. Utilizing this method, which would be GAAP, none of Feine’s loss would be reflected in the current year income of the company. Fran would likely not support this choice since Feine has had losses for at least the last two years. Leaving out the loss would increase the purchase price, and this would not be in Fran’s best interests. It also seems logical to sugget that the investment is not as strong as it once was since the investee has reporting losses; a reduction in purchase price as reflected by the losses might be reasonable.

Use of the equity method has been assumed to be approriate policy; this must be reviewed with both shareholders before finalizing any calcuations. Earnings has been adjusted by $53,000 ($88,000 x .6; rounded) to reverse investment losses from $88,000 to $35,000 (see Appendix 1)

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Share repurchase

Fran recorded a loss of $240 as a result of the share repurchase transaction. The common share account has declined by $10, and cash paid was $250, so this appears to be the residual amount from the share retirement transaction. When shares are retired, common shares are reduced by the average capital paid in to date, and any residual gain or loss is a capital transaction, which is recorded in the equity accounts, not in earnings. In the current situation, where cash paid was higher than the reduction to common shares, the $240 should be a reduction to retained earnings, not a loss. Fran may have been motivated by a desire to reduce earnings. It is important to review the calculation of the $10 decrease to common shares, as well, to make sure it is accurate.

Earnings has been increased by $240 (see Appendix 1) to eliminate the loss.

Valuation of capital assets

Capital assets contributed when Birch was formed were valued at a nominal amount on the books because of valuation uncertainty. The financial arrangements appear to have been fair, in that the value of the capital assets were appropriately considered in allocating the common share ownership at the time.

These assets should have been recorded at fair value, with amortization recorded on themin subsequent years, so that the representational faithfulness of the financial statements is preserved. Amortization on these assets is an appropriate component of earnings, since the assets are used to generate revenue. The use of these assets in profitable operation for the last six or seven years clearly indicates that they have/had a fair value. Because of the measurement uncertainty, the lowest value presented has been used. Recording the assets does not work in Reg’s favor when using earnings as a valuation metric, but it does not affect cash flow.

Earnings has been reduced by amortization of $33 ($500,000/15).

Calculation of purchase price

As can be seen from Appendix I (revised earnings) and Appendix II (projected cash flows), the following potential purchase prices would be considered:

Valuation based on earnings $2,610,000Valuation based on cash flow $3,095,000

We therefore recommend that Reg choose the purchase price formula that is based on 1.2 times the sum of the present value of cash flows, subject to a review of the data and assumptions used.

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Comments on purchase price agreement

GAAP-based financial statements are not meant to reflect the value of a business, and Reg was ill-advised to enter into an agreement with a price based on GAAP. GAAP was not defined in the sale agreement, and could be taken to mean one of several sets of reporting standards. GAAP is not a set of hard-and-fast rules, but rather is judgementally oriented, with much leeway in policy choice and estimation. Fran has been placed in an unenviable conflict of interest, preparing a set of financial statements with such an incentive to reduce earnings. Fortunately for both parties, the cash flow data is less subject to manipulation, and has produced the higher valuation. However, this is still an area that Fran controls, and excess spending on maintenance, for instance, would reduce both income and cash flow, and affect the transaction price.

A more appropriate approach would have been to have the business professionally assessed by a Chartered Business Valuator, and work based on that recommendation. Valuations can be based on fair values of net asset, normalized earnings, and cash flow, looking for convergence around a reasonable range.

APPENDIX I

BIRCH CORPORATION - REVISED EARNINGS(in thousands of dollars)

20X6

Earnings as reported $ 47Recognition of RubberWood ® revenue +215Feine equity income adjustment + 53 Reversal of share retirement loss +240Additional amortization -33

Revised earnings $522

Purchase price, 5.0 multiplier: $2,610

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APPENDIX II

BIRCH CORPORATION - PROJECTED CASH FLOWS(in thousands of dollars)

20X7 20X8 20X9

Gross profit - regular sales (1) $1,174 $1,233 $1,307RubberWood ® sales (2) 237 260 286

1,411 1,493 1,593

Operating expenses (3) 438 460 478

973 1,033 1,115

PV @ 10% 0.91 0.83 0.75

$885 $857 $836

Total of PV of 3 years: $2,578

Purchase price, 1.2 multiplier: $3,094

Note 1:Increased from $1,118; +5%;+5%;+6%Note 2:Increased from $215; +10%, +10%,+10%Note 3:Operating expenses = $716 plus tax of $27 less amortization of $326 = $417; +5%; +5%; +4%.

Taxes are included in operating expenses; more sophisticated analysis will project earnings and predict the tax on this number. However, the tax rate is not obvious from the numbers reported in earnings, and various permanent and temporary differences likely exist.Since receivables, payables and inventories will be stable over the projection period, cash flow is equal to the revenue and expense streams.

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Case 13-3Lorenzoni Winery

Overview

The interested parties and their needs are as follows:

Investor Investor's needsGiovanni Maintain voting control; doesn't need income; wishes to

encourage more interest from his immediate familyWine master Wants regular income for his retirementPension fund Wants high return on investment with opportunity to participate

further in the futureBank Initial provider of capital, wants repayment.Future investors Participation in earnings

Analysis

The most important participants in this venture are Giovanni, the wine master, and the pension fund. The bank is also an important participant, but they are debt holders and they are expected to be paid off in the near future by investment from the pension fund.

Giovanni is not concerned about income in the foreseeable future, but he is very concerned about retaining voting control of the company as it grows and has more participants. His desire to construct and operate a restaurant will call for more capital. Eventually, he may want to have an initial public offering. At the same time, he wants to encourage his family to become involved in the venture in the future, which implies that he may wish to give some of his shares to his family at some point.

Recommendations

Giovanni should establish a multi-share corporate structure. He should consider the following classes of shares:

a. Class A preferred shares, cumulative and non-participating convertible into Class Bcommon shares. These can be issued to the pension fund to give the fund a reasonable return on their investment, in preference to other shareholders. If the venture is successful, the fund may wish to convert to common shares.

b. Class B preferred shares, cumulative and participating, subordinated to the Class A preferred shares. These can be issued to the wine master. They will provide a steady return to the extent that the venture is successful. The participation feature will permit the wine master to enjoy added dividends in the future if common dividends are issued.

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c. Class A multiple voting common shares. These shares would be issued solely to Giovanni, some of which he may wish to give to his family. They will permit him to retain voting control without the necessity to accept dividends.

d. Class B restricted voting shares. These will have a vote, but also less (in total) than those held by Giovanni. Dividends can be paid on the Class B common without paying dividends on the Class A common, thereby satisfying the needs of both groups. These shares can be issued to other investors, and may also be used as compensation for the wine master (and perhaps the sous chef).

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Assignments

Assignment 13-1GRL Trading LimitedShareholders’ Equity

As at 31 December 20x1

Contributed Capital:Share capital:

Preferred shares, no-par value, $2, unlimited shares authorized,cumulative and fully participating, 27,000 shares issued and outstanding ....................................... $168,000

Common shares, no-par, unlimited shares authorized,45,000 shares issued, 44,900 shares outstanding...................... 1,350,000

Common shares subscribed, 100 shares.......................................... 9,000Fractional common share rights ..................................................... 9,200Other contributed capital: common share retirement..................... 18,900

Total contributed capital ........................................................... 1,555,100Retained earnings.................................................................................. 653,000Reserve for unrealized exchange gain on translation of foreign subsidiary 150,500

Total ................................................................................................ 2,358,600Less: Treasury shares, 100 common shares ......................................... ( 8,600)Total Shareholders’ Equity ................................................................... $2,350,000Less: Subscriptions receivable* ............................................................ (3,000)Net Shareholders’ Equity...................................................................... $2,347,000

* Some classify this as an asset, but classification as a contra equity account avoids overstatement of equity from “promises” to inject capital.

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Terminology:

Preferred shares Shares with one or more preferences over common shares; usually preferences as to dividends or claims to assets on dissolution. Dollar value indicates valueinvested by shareholders.Common shares Shares with residual interest in the net assets of the company. Dollar value indicates value invested by shareholders.Common shares subscribed Prospective shareholders have agreed to buy shares at the indicated amount but have not fully paid the consideration, so the shares cannot be issued. Fractional common share rights outstanding Likely as a result of a stock dividend, common shareholders hold rights which, if tendered in the correct multiples (e.g., five rights for one share), must be exchanged for common shares.Other contributed capital: common share retirement The corporation has repurchased common shares and retired them. This amount is the excess of original average issue price over the retirement price paid.Retained earnings Cumulative earnings less dividends, and other specific charges.Unrealized exchange gain on translation of foreign subsidiary When translating the financial statements of a foreign subsidiary into Canadian dollars for consolidation, this is the gain that resulted. The annual change is excluded from earnings, but is included in comprehensive income. The cumulative amount is reported in equity as a reserve.Treasury shares Common shares have been bought by the company, its own common shares, which may be resold or reissued in the future.Subscriptions receivable, common shares Outstanding balance of money to be paid for shares purchased under a subscription agreement.

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Item Assets Liabilities Share Capital(PreferredandCommon)

Retained Earnings

Reserve for foreign exchangegains and losses

Total Shareholders’ Equity(combined effect of prior three columns)

a. (given)

NE I NE D NE D

b. NE NE I D NE NEc. D D NE NE NE NEd. I NE I NE NE Ie. NE NE NE NE NE NEf. I* NE NE I I Ig. D NE D D NE D

* net assets are assumed to increase by the net effect of comprehensive income; if this is marked “NE” there is an assumption that the effect has already been recorded and this is acceptable.

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Assignment 13-3

a) Income summary............................................................................ 210Retained earnings..................................................................... 210

b) Cash .............................................................................................. 320Preferred shares ....................................................................... 120Common shares ....................................................................... 200

May be presented as two entries

c) Retained earnings (share issue costs) ............................................ 11Cash ......................................................................................... 11

d) Preferred shares ............................................................................ 54Retained earnings........................................................................... 18

Cash ......................................................................................... 72

e) Common shares ............................................................................. 26Contributed capital, common share retirement........................ 4Cash ........................................................................................ 22

f) Retained earnings (or, stock dividend) .......................................... 98Common shares ....................................................................... 98

g) Retained earnings (or, cash dividend) ........................................... 42Cash ......................................................................................... 42

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Assignment 13-4

a) Authorization:Memo: unlimited common shares authorized.

b) Cash ...............................................................................................3,840,000Common shares, no-par, 120,000 shares ................................. 3,840,000

Common shares, no-par ................................................................. 71,100Cash ......................................................................................... 71,100

c) Cash ...............................................................................................1,071,000Stock subscription receivable ........................................................ 459,000

Common shares subscribed, 45,000 shares ............................. 1,530,000

d) Trademark...................................................................................... 15,000Common shares, no-par, 500 shares ........................................ 15,000

The fair value of the service received is used to value the transaction.

e) Building ......................................................................................... 310,000Mortgage payable .................................................................... 80,000Common shares, no-par, 10,000 shares ................................... 230,000

f) Cash ............................................................................................... 459,000Stock subscription receivable .................................................. 459,000

Common shares subscribed, 45,000 shares ...................................1,530,000Common shares, no-par, 45,000 shares ................................... 1,530,000

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Assignment 13-5

Requirement 1(not required) Memo: Common shares, no-par, unlimited shares authorized.(not required) Memo: Preferred shares, no-par, $0.30, unlimited shares authorized.

Entries:a) Cash ............................................................................................... 960,000

Common shares, no-par (80,000 shares × $12) ....................... 960,000

b) Retained earnings (share issue costs) ............................................ 18,200Cash ......................................................................................... 18,200

c) Cash (4,000 shares × $25) ............................................................. 100,000Preferred shares, no-par (4,000 shares) ................................... 100,000

d) Common shares (8,000 × $12) ...................................................... 96,000Retained earnings........................................................................... 4,000

Cash (8,000 × $12.50) ............................................................. 100,000

e) Preferred dividends declared (or retained earnings) (4,000 × $0.30) 1,200Common dividends declared (or retained earnings) ...................... 8,800

Cash ......................................................................................... 10,000

f) Capital assets; manufacturing facility............................................ 80,000Common shares, no-par ($80,000 × 83%)............................... 66,400Preferred shares, no-par ($80,000 × 17%)............................... 13,600Common shares: 5,000 x $12 = 60,000 83%Preferred shares: 500 x $25 = 12,500 17%

72,500 100%It is also acceptable to value common shares at $12.50 based on the buy-back, increasing the percentage allocated to them; $12 is used here because there is more share volume.

Requirement 2DONROY CORPORATION

Shareholders’ EquityContributed Capital:Share capital:

Preferred shares, no-par, $0.30, unlimited shares authorized, 4,500 shares issued and outstanding........................................................... $ 113,600Common shares, no-par, unlimited shares authorized, 77,000 shares issued and outstanding......................................................... 930,400

Total contributed capital ......................................................................... 1,044,000Retained earnings ($216,400 – $18,200– $4,000 – $10,000) .............................. 184,200

Total shareholders’ equity ......................................................................$1,228,200

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Assignment 13-6

a) 5 Jan. Common shares ($235,000/20,000) = $11.75 × 2,000 . 23,500Contributed capital on common share retirement ... 3,500Cash......................................................................... 20,000

6 Jan. Preferred shares ($72,000 /3,000) = $24 x 1,500.......... 36,000Retained earnings.......................................................... 1,500

Cash ($25 × 1,500).................................................. 37,500

20 Feb. Common shares ($11.75 × 2,000)................................. 23,500Contributed capital on common share retirement ......... 2,500

Cash (2,000 × $13).................................................. 26,000

20 Feb. Preferred shares ($24 x 300) ......................................... 7,200Contributed capital on preferred share retirement .. 4,200Cash (300 × $10)..................................................... 3,000

15 Mar. Common shares ($11.75 × 3,000)................................ 35,250Contributed capital on common

share retirement ($3,500 - $2,500).......................... 1,000Retained earnings.......................................................... 5,750

Cash (3,000 × $14).................................................. 42,000

b) Preferred shares ($72 – $36 – $7.2)............................................... $ 28,800Common shares ($235 – $23.5 – $23.5 – $35.25)......................... 152,750Contributed capital on share retirement

Common ($3.5 – $2.5 - $1).................................................... 0Preferred................................................................................. 4,200

Retained earnings ($75 – $1.5– $5.75).......................................... 67,750

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Assignment 13-7Common Preferred

1. Change in share account ....................................................... $100,000 $50,000Shares retired ........................................................................ 2,000 1,000Original issue price, average................................................. $50 $50

2. Change in share account ....................................................... $100,000 $50,000Change in retained earnings 1............................................... 15,000Change in contributed capital ............................................... (27,000)Cash paid for shares.............................................................. $115,000 $23,000

1 $120,000 + $50,000 – $20,000 = $150,000 vs $135,000;$15,000 charge to RE, due to share transaction

Journal entries:

Common shares .................................................................... 100,000Retained earnings.................................................................. 15,000

Cash.................................................................................. 115,000

Preferred shares .................................................................... 50,000Contributed capital........................................................... 27,000Cash.................................................................................. 23,000

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Assignment 13-8

Requirement 1

The preferred shares are non-voting, while the common shares likely have voting privileges. The preferred shares likely have first claim to dividends as declared and first claim to the proceeds from net assets on dissolution.

Requirement 2

The term cumulative means that if the cumulative preferred dividends are not declared in a given year, the missed dividend must be declared in a later year before the common shares are entitled to any dividend.

Requirement 3

The preferred shares would receive $197,000 (49,250 × $4), and the common shareholders would receive $153,000 ($350,000 – $197,000).

Requirement 4

The average issuance price for all common shares at 31 December 20x4 was $17.27 ($16,774,900 ÷ 971,550). During the year, shares were issued for $36 ($151,200 ÷ 4,200) and under option contracts for $19.50 ($39,000 ÷ 2,000).

Requirement 5

To record common shares retired:Common shares ($17.27 × 2,500)................................................... 43,175Retained earnings............................................................................ 14,325

Cash ($23 × 2,500) ..................................................................... 57,500This entry assumes that there is no contributed capital from prior retirement transactions.

Requirement 6

To record purchase of 8,200 shares of treasury stock:Treasury stock ($21 × 8,200) .......................................................... 172,200

Cash ........................................................................................... 172,200

To record issuance of treasury stock:Cash ($28 × 8,200).......................................................................... 229,600

Treasury stock ............................................................................ 172,200 Contributed capital from treasury stock transactions ................. 57,400

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Assignment 13-9

Requirement 1

15 Jan. Preferred shares ($4.8251 × 7,000)..................................... 33,775Retained earnings................................................................ 2,625

Cash ($5.20 × 7,000)..................................................... 36,4001($386,000/80,000 = $4.825)

12 Feb. Common shares ($8.0252 × 2,000)..................................... 16,050Contributed capital on common share retirement ............... 5,950

Cash ($11 × 2,000)........................................................ 22,0002($642,000/80,000 = $8.025)

25 Feb. Preferred shares ($4.825 × 4,000)....................................... 19,300Contributed capital on preferred share retirement ........ 3,300Cash ($4 × 4,000).......................................................... 16,000

26 April Preferred shares ($4.825 × 5,000)....................................... 24,125Contributed capital on preferred share retirement .............. 3,300Retained earnings................................................................ 2,575

Cash ($6 × 5,000).......................................................... 30,000

16 July Common shares ($8.025 × 8,000)....................................... 64,200Contributed capital on common share retirement ......... 4,200Cash ($7.50 × 8,000)..................................................... 60,000

30 July Stock dividend (or retained earnings) ................................ 27,125Common shares............................................................. 27,125

70,000 shares × 5% = 3,500 × $7.75

30 Nov. Preferred dividend declared (or retained earnings ) ............ 44,800Common dividends declared ( or retained earnings) .......... 73,500

Preferred dividends payable (64,000 × $.70) ................ 44,800Common dividends payable (73,500 × $1)................... 73,500

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Requirement 2

BC VENTURES CORPORATIONShareholder’s Equity

As at 31 December 20x5

Contributed capital:Preferred shares, no-par value, $0.70, cumulative, authorized unlimited

shares, issued and outstanding, 64,000 shares ($386,000 – $33,775 – $19,300 – $24,125)............................... $ 308,800

Common shares, no-par value, authorized unlimited shares, issued and outstanding 73,500 shares

($642,000 – $16,050 – $64,200 + $27,125)................................. 588,875Contributed capital on common share retirement

($14,000 –$5,950 + $4,200)......................................................... 12,250Total contributed capital .......................................................................... 909,925

Retained earnings ($1,250,000 + 308,200 – $2,625 – $2,575

– $27,125 – $44,800 - $73,500).......................................................... 1,407,575Reserve for foreign exchange gains on foreign subsidiary ............................ 80,800Total shareholders’ equity.............................................................................. $2,398,300

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Assignment 13-10

Not required: To record original sale of 10,000 shares at $50:

Cash (10,000 × $50)........................................................................ 500,000Common shares, no-par (10,000 shares)................................... 500,000

Entries:

15 January – To record purchase of 100 shares of treasury stockat $55:

Treasury stock (100 shares × $55) .................................................. 5,500Cash........................................................................................... 5,500

1 March - To record sale of 20 shares of treasury stock at $62:Cash (20 shares × $62).................................................................... 1,240

Contributed capital from treasury stock transactions................ 140Treasury stock (20 shares × $55) .............................................. 1,100

31 March - To record sale of 10 shares of treasury stock at $59:Cash (10 shares × $59).................................................................... 590

Contributed capital from treasury stock transactions................ 40Treasury stock (10 shares × $55) .............................................. 550

1 June - To record sale of 70 shares of treasury stock at $48:Cash (70 shares × $48).................................................................... 3,360Contributed capital from treasury stock transactions ($140 + $40) ............................................................................................ 180Retained earnings............................................................................ 310

Treasury stock (70 shares × $55) .............................................. 3,850

Requirement 2Shares Amount

Account balances:Common shares issued and outstanding ....................................... 10,000 $500,000Retained earnings ($25,000 – $310) ............................................. 24,690

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Requirement 1

a) Memo entry:Split common shares 3 for 1; there are now 666,000 (222,000 × 3) shares outstanding,With an average issuance price of $ 1.31 ($875,000/666,000).

b) To record purchase of 8,000 shares of treasury stock at $4.25:Treasury stock ............................................................................ 34,000

Cash (8,000 shares × $4.25) .................................................. 34,000

c) To record purchase of 6,000 shares of treasury stock at $5:Treasury stock ........................................................................... 30,000

Cash (6,000 shares × $5) ....................................................... 30,000

d) To record issuance of 5,000 shares of treasury stock at $9.25:Cash (5,000 shares × $9.25)....................................................... 46,250

Treasury stock (Average cost = $64,000/14,000 = $4.57 × 5,000) 22,850Contributed capital from treasury stock transactions ............ 23,400

Note: allow for rounding throughout.

e) To record issuance of 6,000 shares of treasury stock at $3.00:Cash (6,000 shares × $3)............................................................ 18,000Contributed capital from treasury stock transactions................. 9,420

Treasury stock (6,000 shares × $4.57)................................... 27,420

f) Common shares (500 × $1.31)................................................... 655Contributed capital from treasury stock transactions ................ 1,630

Treasury stock (500 × $4.57 )................................................ 2,285Since prior treasury stock transactions were in this class (i.e., common), the contributed capital that existed was used to absorb the debit.An argument can also be made to debit retained earnings but corporate legislation should be consulted.

g) Cash dividends declared (or retained earnings) (666,000 - 2,500[treasury shares] )× $0.25)................... 165,875

Cash ....................................................................................... 165,875

Requirement 2

Common shares ($875,000 - $655).................................................. $ 874,345Contributed capital from treasury stock transactions ($23,400 –$9,420 – $1,630) .............................................................................. 12,350Retained earnings ($673,500 + $472,000 – $165,875) .................... 979,625Treasury stock ($64,000 – 22,850 -$27,420 - $2,285), or (2,500 shares x average cost, $4.57, rounded) ................................. (11,445)

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Assignment 13-12 Dividends

Preferred $0.75 Common(18,000 shares) (54,000 shares) Total

Case A (Preferred – cumulative; non-participating)

Arrears (18,000 x $0.75 x 3).................... $40,500 $40,500Current preference (18,000 × $0.75)........ $13,500 13,500Balance to common.................................. $10,800 10,800

Total ................................................... $54,000 $10,800 $64,800Per share....................................... $3.00 $0.20

Case B (Preferred – non-cumulative; non-participating)

Current preference (18,000 × $0.75)........ 13,500 13,500Balance to common.................................. _____ $27,000 27,000

Total ................................................... $13,500 $27,000 $40,500Per share....................................... $0.75 $0.50

Case C (Preferred - cumulative; fully participating)

Arrears (18,000 × $0.75 × 2)..........................$27,000 $27,000Current preference (18,000 × $0.75).............. 13,500 13,500Common, to match (54,000 × $1)............. $54,000 54,000Balance, $25,500 x ratio 1/5:4/5 * ............ 5,100 20,400 25,500

Total.................................................. $45,600 $74,400 $120,000Per share...................................... $2.53 $1.38

Case D (Preferred - cumulative; partially participating)

Current preference (18,000 × $0.75)........ 13,500 13,500Common, to match (54,000 × $1)............ $54,000 54,000Balance, $92,500 x ratio 1/5:4/5 * and max of (18,000 x $0.90 = $16,200)to pref..................................................... 16,200 76,300 92,500

Total ............................................. $29,700 $130,300 $160,000Per share....................................... $1.65 $2.41

* Proportions: Pref: $13,500 ÷ ($13,500 + $54,000); Common: $54,000 ÷ ($13,500 + $54,000)

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Copyright 2011 McGraw-Hill Ryerson Ltd. All rights reserved.


Assignment 13-13

Case A - Preferred cumulative, non-participating; Note; full dividend for pref is is $0.40 x 15,000 = $6,000

Year Total Paid Preferred Common1 Partial.................................................. $ 1,000 $1,000 $ 02 Partial.................................................. $4,000 $4,000 $ 02 Arrears................................................. $7,000

Current ................................................ 6,000 $19,000 Total..................................................... $32,000 $13,000 $19,0004 Partial.................................................. $ 5,000 $5,000 $ 05 Arrears................................................. $1,000

Current ................................................ 6,000 $83,000 Total.................................................... $90,000 $7,000 $83,000

Case B - Preferred non-cumulative, non-participating:

Year Total Paid Preferred Common1 ............................................................... $ 1,000 $1,000 $ 02 ............................................................... $4,000 $4,000 $ 03 ............................................................... $32,000 $6,000 $26,0004 ............................................................... $ 5,000 $5,000 $ 05 ............................................................... $90,000 $6,000 $84,000

Case C - Preferred non-cumulative, fully participating:Year Total Paid Preferred Common

1 Preferred, current ................................ $ 1,000 $1,000 $ 02 Preferred, current ................................ $4,000 $4,000 $ 03 Preferred, current ................................ $6,000

Common, to match.............................. $22,500Balance: preferred 25%, common 75% 875 2,625Total .................................................... $32,000 $6,875 $25,125

4 Preferred, current ................................ $ 5,000 $5,000 $ 05 Preferred, current ................................ $6,000

Common, to match.............................. $22,500Balance: preferred 25%, common 75% 15,375 46,125Total .................................................... $90,000 $21,375 $68,625

*Participation allocation based on shares: Preferred = 25% = 15,000 ÷ (15,000 + 45,000) Common = 75% = 45,000 ÷ (15,000 + 45,000)

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Case D - Preferred, non-cumulative, partially participating up to an additional $0.40 or $6,000 (15,000 × $0.40):Year Total Paid Preferred Common

1 Preferred, current ................................ $ 1,000 $1,000 $ 02 Preferred, current ............................... $ 4,000 $4,000 $ 03 Preferred, current ................................ 6,000

Common, to match.............................. $22,500Balance, preferred 21% (not to exceed 15,000 × $0.40 = $6,000), common 79% .................................... 735 2,765Total .................................................... $32,000 $6,735 $25,265

4 Preferred, current ............................... $ 5,000 $5,000 $ 05 Preferred, current ................................ 6,000

Common, to match.............................. $22,500Balance: preferred 21% but (limit ($6,000), Common, remainder ......................... 6,000 55,500Total .................................................... $90,000 $12,000 $78,000

*Participation allocation based on base dividend: Preferred = 21% = $6,000 ÷ ($6,000 + $22,500) Common = 79% = $22,500 ÷ ($6,000 + $22,500)

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Assignment 13-14

Requirement 1

Preferred CommonArrears.............................. 960,000 ($4 x 2 years x 120,000 shares)Current preference............ 480,000Common; to match........... $1,440,000 ($2.40 x 600,000 shares outstanding)Balance**......................... 905,000 2,715,000

Total ...........................$2,345,000 $4,155,000

** Remaining pool = $6,500,000 - $960,000 - $480,000 - $1,440,000 = $3,620,000 preferred: $3,620,000 × [$480,000 ÷ ($480,000 + $1,440,000)] common: $3,620,000 × [$1,080,000 ÷ ($480,000 + $1,440,000)]

Note that the allocation of participating dividends is one year’s base dividend, and does not include the dividend in arears.

Requirement 2

Common shares (($28,800,000/640,000) × 30,000) .......................1,350,000Retained earnings............................................................................ 937,500

Cash ($76.25 × 30,000)............................................................. 2,287,500

Preferred shares (($13,500,000/120,000) × 5,000) ......................... 562,500Contributed capital (balance) .......................................................... 37,200Retained earnings............................................................................ 300

Cash ($120 × 5,000).................................................................. 600,000

Cash (10,000 shares × $80)............................................................. 800,000Contributed capital from treasury stock transactions................ 200,000Treasury stock ($2,400,000 / 40,000) × 10,000)....................... 600,000

Retained earnings (dividends) (580,000 shares × 10% × $77) .......4,466,000Common share fractional rights outstanding (2,000 shares × $77) 154,000Common shares (56,000 shares × $77)..................................... 4,312,000

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Assignment 13-15

Requirement 1

Case 1 (1) Case 2 (2) Case 3 (3)Shareholders’ EquityContributed Capital:Share capital:Preferred shares, no-par value, $1.25, cumulative and non-participating, unlimited shares authorized, 40,000 shares issued and outstanding

$1,000,000 $1,000,000 $1,000,000

Common shares, no-par value, unlimited shares authorized, 1,098,000 shares issued and outstanding

2,675,000 10,727,000 2,675,000

Other contributed capital: common share retirement

45,900 45,900 45,900

Total contributed capital 3,720,900 11,772,900 3,720,900Retained earnings 12,001,000 3,949,000 12,001,000Reserve for unrealized exchange

gain on translation of foreign subsidiary 90,500 90,500 90,500Total Shareholders’ Equity $15,812,400 $15,812,400 $15,812,400

Calculations:(1) Case 1Stock dividend recorded as a memo entry only; no change to any equity account but the number of common shares increases from 366,000 to (366,000 + (366,000 x

200%) = 1,098,000

(2) Case 2Stock dividend recorded at $11 per share; retained earnings decreases and commonshares increases by (366,000 x 200% x $11) = $8,052,000 $2,675,000 + $8,052,000 =$10,727,000$12,001,000 - $8,052,000 = $3,949,000

(3) Case 3Stock split; no change to any equity account but the number of shares increases from 366,000 to (366,000 x 3) = 1,098,000

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Requirement 2

None of the alternatives change total shareholders equity. All have identical economic effect. The market value of the shares should move to one-third of the prior level - from $11 to $3.67. This is not recorded on the books.

The stock split can only be recorded one way, through a memo entry. Only the shares outstanding are changed. If the stock dividend is viewed as the same economic transaction as the split, then memo treatment (Case 1) is the only approach that makes the reporting of these two alternatives the same.

However, the company can choose to record the stock dividend with a value, reducing retained earnings and increasing share capital. This is shown in Case 2. An unsuspecting reader might assume that the company in Case 2 has less of an earnings history and has had more shareholder investment than the company in Cases 1 and 3. This would be an erroneous conclusion.

If the company is trying to communicate to shareholders that retained earnings balances are not available for dividends, Case 2 might help convey his message. However, it is clear that the split shares will not be worth $11, so the use of this value to record the stock dividend is suspect. Use of $3.67 per share might be more supportable.

The Board should be consulted as to their objectives in issuing additional shares. If they wish to capitalize earnings, they may follow the approach in Case 2, perhaps with a lower value. Otherwise, the memo treatment appears to make sense.

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Assignment 13-16

Requirement 1

5 November 20x5 - Declaration date of stock dividend: Memo entry only.20 December 20x5 - Record date; no entry; obtain list of shareholders of record31 December 20x5 - End of accounting period; no entry (Disclosure required)10 January 20x6 - Issue date:

Amount CapitalizedCase A Case B Case C

Market Value Stated Value Average Paid In

Stock dividend (or RE)..... 100,000 80,000 68,860Share capital, no-par

(8,000 shares)*....... 100,000 80,000 68,860*40,000 shares ÷ 5 = 8,000 shares issued as a stock dividend.Capitalize: Market value: 8,000 shares × $12.50 = $100,000

Stated value: 8,000 shares × $10 = $80,000Average paid in: $344,300/40,000 = $8.6075; 8,000 sh × $8.6075 = $68,860

Requirement 2

Valuation is up the the Board of Directors. Market value is often used when there is a “small” stock dividend. (In the US, “small” is defined as less than 20 to 25 percent of the outstanding shares prior to the dividend.) A small stock dividend is believed to usually have a relatively small impact on the market price per share.An arbitrary amount ($10), or average paid in to date, may be used, after Board of Directors approval, if the incorporating jurisdiction so allows. Either of these values may be adopted if market value is not determinable or not appropriate.Large stock dividends should be recorded with a memo entry to demonstrate that nothing of substance has changed. The “pie” – net assets – is now cut into smaller pieces.

Requirement 3

At the end of 20x5, the only requirement is a disclosure note that explains the stock dividend declared but not issued; it is not a liability.

Requirement 4

The financial statements at 31 December 20x5 would report the stock dividend as follows, if the dividend were recognized when declared:a) The stock dividend would be recorded, reducing retained earnings and shareholders’

equityb) A stock dividend distributable account would be recognized, increasing

shareholders’ equity.Total shareholders’ equity is therefore unchanged.

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Assignment 13-17

Requirement 1

Common shares ($320,000 ÷ (160,000 x 4)) × 22,000 ................. 11,000Retained earnings........................................................................... 253,000

Cash (22,000 x $12) ................................................................ 264,000

Requirement 2

Preferred shares: 5,000Conversion terms: 3 shares x 4 (split) = 12 sharesShare entitlement 5,000 shares x 12 = 60,000 shares

This assumes that the terms of the preferred share contract requires automatic adjustmentof the conversion terms after a split. It would be very unusual if such a term were not present.

Requirement 3

Basic earnings per common share: $207,000 (unchanged) ÷ (160,000 shares x 4) $ 0.32

Dividends per common share ($160,000 total unchanged)($160,000 / 640,000 shares) $ 0.25

Requirement 4

Other changes to the 20X8 comparative statements due to the stock split:

a. Common shares shown as 640,000 shares issued and outstanding $320,000

b. Note disclosure will report that each preferred share is convertible into 12 common shares.

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Assignment 13-18

Requirement 1

Stock dividends (retained earnings) (452,000 shares × 5% × $4.50) ... 101,700Common shares .................................................................. 101,700

Requirement 2

Stock dividends (retained earnings) (452,000 shares × 5% × $4.50) ... 101,700Common share fractional rights outstanding (1,600 shares × $4.50) 7,200Common shares (452,000 shares × 5% = 22,600; 22,600 – 1,600

= 21,000 × $4.50) ............................................................... 94,500

Common share fractional rights outstanding ........................................ 7,200Common shares (70%).................................................................... 5,040Contributed captial, lapse of share rights (30%)............................ 2,160

Requirement 3

Stock dividends (retained earnings) (452,000 shares × 5% × $4.50) ... 101,700Cash (1,600 shares × $4.50)..................................................... 7,200Common shares ( 21,000 shares x $4.50)× $4.50) .................. 94,500

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Requirement 4

Stock dividends (retained earnings) (452,000 shares × 5% × $4.50) ... 101,700Stock dividend distributable ............................................... 101,700

It is also acceptable to set up a fractional share rights distributable account, but the corporate reporting result would not be changed by the use of two accounts versus one account for the credit.

Stock dividend distributable ................................................................. 101,700Common share fractional rights outstanding (1,600 shares × $4.50) 7,200Common shares (452,000 shares × 5% = 22,600; 22,600 – 1,600

= 21,000 × $4.50) ............................................................... 94,500

Common share fractional rights outstanding ........................................ 7,200Common shares (70%).................................................................... 5,040Contributed captial, lapse of share rights (30%)............................ 2,160

Requirement 5

In requirement 2, an equity account is created for fractional shares, which either becomes common share equity (on exercise) or contributed capital (on lapse). In requirement 3, cash is distributed, decreasing equity.

The disadvantages of a cash distribution might be that it will cost the company moneyand decrease total equity; the stock dividend may have been formulated to avoid both these outcomes. On the other hand, fractional shares might be unattractive to the company and the shareholders because they have to be accumulated, tracked and traded. Some may also expire, which means that the value intended is not transferred. Cash is the “cleaner”option.

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Assignment 13-19

Requirement 1

Case AStock dividend (500,000 shares × 14% = 70,000 additional shares):

Stock dividend declared (or retained earnings)(70,000 shares × $37)...................................................... 2,590,000

Common shares, no-par (70,000 shares) .............................. 2,590,000

Case BMemo entry only to record the split.500,000 common shares were called in and replaced with 1,500,000 new shares.

Case CStock dividend (500,000 shares × 6% = 30,000 additional shares):

Stock dividend declared (or retained earnings) (30,000 shares × ($14,000,000/ 500,000); $28)…………….. 840,000

Common shares, no-par (28,000 shares × $28) .................... 784,000Common share fractional share rights outstanding (2,000 sh. × $28) 56,000

Common share fractional share rights outstanding ................... 56,000Common shares, no-par (1,500 shares × $28) ...................... 42,000Contributed capital, lapse (500 shares × $28) ...................... 14,000

Requirement 2

Case ACommon shares ($14,000,000 + $2,590,000) $16,590,000Retained earnings ($26,533,100 – $2,590,000) 23,943,100

$40,533,100Case BNo change to equity accounts:Common shares $14,000,000Retained earnings 26,533,100

$40,533,100Case CCommon shares ($14,000,000 + $784,000 + $42,000) $14,826,000Contributed capital, lapse of rights 14,000Retained earnings ($26,533,100 – $840,000) 25,693,100

$40,533,100Requirement 3

None of the transactions change total shareholders’ equity. The split has no effect on the components of equity, while the stock dividend will transfer amounts from retained earnings to common shares or contributed capital.

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Assignment 13-20

Requirement 1

20 February: redemption of preferred shares:Preferred shares ($2,040,000 ÷ 20,000) × 1,000............................. 102,000Retained earnings............................................................................ 5,000

Cash ($107 × 1,000) ................................................................... 107,000

28 February: dividend declaration:Preferred dividends declared (or retained earnings) ....................... 19,000Common dividends declared (or retained earnings) ....................... 81,000

Preferred dividends payable (19,000 × $1)................................. 19,000Common dividends payable ($100,000 – $19,000).................... 81,000

31 March: common shares retired:Common shares (8,000 × ($640,000 ÷ 80,000)) ............................. 64,000Contributed capital on retirement of common shares ..................... 32,000

Cash (8,000 × $12) ..................................................................... 96,000

2 April: stock dividend:Stock dividend declared (or retained earnings)

(72,000 shares × 3% = 2,160 shares × $11.50)……………… 24,840Common shares, no-par (2,160 – 200) × $11.50 ........................ 22,540Common share fractional share rights outstanding (200 sh. × $11.50) 2,300

30 April: exercise and lapse of rights:Common share fractional share rights outstanding ...................... 2,300

Common shares, no-par (200 shares × 40% × $11.50)............ 920Contributed capital, lapse (200 shares × 60% × $11.50)......... 1,380

Requirement 2

Contributed CapitalPreferred shares, $1, no-par, 100,000 shares authorized, cumulative,

redeemable at company’s option at $107 plus dividends in arrears. Each preferred share is convertible into 10.3 common shares.Issued and outstanding, 19,000 shares $1,938,000

Common shares, no-par, 100,000 shares authorized and 74,040issued and outstanding 599,460

Contributed capital on lapse of rights 1,380Contributed capital on retirement of common shares 88,000

2,626,840Retained earnings* 2,290,160

$4,917,000*$1,600,000 – $5,000 – $100,000 – $24,840 + $820,000 (earnings)

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Assignment 13-21

Requirement 1

Retained earnings, 1 January 20X1 ..................................................... $ 7,800,300Increases: Error correction, net of tax ................................................................. 104,200Earnings ($655,400 - $9,400) ............................................................. 646,000

Total .............................................................................................. 8,550,500Deductions:

Cash dividendsPreferred .................................................................................. (150,000)Common ................................................................................... (140,000)

Stock dividends, common shares.................................................. (533,000)Share retirement

Excess of retirement price over issuance price......................... (20,000)Retained earnings,31 December 20X1 ............................................... $7,707,500

Requirement 2

Serious Sound Corp.Shareholders’ Equity

As at 31 December 20X1

Contributed Capital:Preferred shares, Class A ................................................................ $3,750,000Common shares............................................................................... 2,631,700Stock dividend distributable, common shares ................................ 220,100Fractional common share rights outstanding .................................. 31,500Contributed capital on preferred share retirement .......................... 6,500

Total contributed capital ........................................................... 6,639,800Retained earnings.................................................................................. 7,707,500Reserve re: unrealized gain on investment ($100,600 + $15,000)........ 115,600

14,462,900Less: Treasury stock, common............................................................. (72,000)Total Shareholders’ Equity ................................................................... $14,390,900

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Preferred shares

Common shares

Fractional shares

o/s

Retained earnings

Reserve for foreign exchange gains of foreign

subsidiary

Total equity

Balance at 1 January 20X1 3,000 7,400 240 6,780 451 17,871 Comprehensive income, including earnings of $871 and foreign exchange on subsidiary, a gain of $39

871 39 910

Common shares issued for cash of $788

788 788

Preferred shares bought back; ten percent of opening balance bought back for cash; paid $85 more than average issue price

(300) (85) (385)

Cash dividends to shareholders; $170 to preferred and $367 to common

(170)(367)

(170)(367)

Fractional shares turned in for common (80% of fractional rights); remainder are still outstanding

192 (192) --

Balance at 31 December 20X1 $ 2,700 $ 8,380 $ 48 $ 7,029 $ 490 $ 18,647

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Assignment 13-23

Requirement 1

The reserve represents unrealized gains on FVTOCI investments. At the beginning of the year, investment assets are valued at fair value, which is $48 higher than cost. By the end of the year, this differential is $61. The reserve is on the statement of financial position, inequity, below retained earnings

Requirement 2

Comprehensive income is the combination of earnings and the changes in unrealized amounts; $1,993 ($1,980 + $13).

Requirement 3

Cash of $1,361 ($1,005 + $356) was paid to retire common shares.

Requirement 4

Cash of $781 ($630 + $116 + $35) was paid to retire preferred shares. Contributed capital is reduced only to the extent that it had previously been created by preferred share retirement. Once contributed capital from this source is “used up” ($116), any additional excess over original issuance price paid ($35) is then allocated to retained earnings.

Requirement 5

Another alternative for share issuance costs is to reduce the share capital account, which effectively reports the net amount raised as share capital.

Requirement 6

A stock dividend is a distribution of shares to existing shareholders. It has been recorded by reducing retained earnings and increasing share capital. Total equity does not change, but earnings are, in effect, capitalized to the share capital account.

The value per share assigned to a stock dividend is up to the Board of Directors. They may value the dividend at the market value per share, or some assigned value, including average capital paid in to date. There is some implication that the value used to record the dividend implies the value received by shareholders, although it is not clear why increasing the number of shares should be thought to increase wealth. A stock dividend can also be recorded as a memo entry which does not affect the value assigned to any equity account. The memo entry approach is common for larger stock dividends and is the required treatment for a stock split.

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Assignment 13-24

Preferred shares

Common shares

Cont’d capital

retirement of pref.

Retained earnings

Reserve for foreign exchange gains of foreign

subsidiary

Treasury stock

Total equity

Balance at 1 January 20X2 (1)

6,000 7,500 40 2,165 (320) (2,200) 13,185

Common shares retired (2)

(568.75) (310.3) (879.05)

Treasury shares re-sold

(24.6) 2,200 2,175.4

Comprehensive income

421.8 131 552.8

Preferred dividend (240) (240)Common dividend (86.5) (86.5)Preferred shares retired (3)

(1,500) 90 (1,410)

Share retirement costs (4)

(133) (133)

Error correction$90 (1-.4)

54 54

Balance at 31 December 20X2

4,500 6,931.25 130 1,846.4 (189) -- 13,218.65

Note: 1. The stock split does not affect recorded values and is not included on the

statement.2. $7,500,000/1,200,000) = $3.125 x 182,000 = $568,7503. ($6,000/240) = $25; $25 x 60,000 = 1,500 versus $23.50 x 60,000 = 1,410,0004. This amount increases the loss on both share retirements, which would increase

the charge to RE in both cases.

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5. Assignment 13-25

Requirement 1

15 Jan. Series A preferred shares (25,000 × $25.21*) ............ 630,250Retained earnings........................................................ 144,750

Cash (25,000 × $31).............................................. 775,000*($12,100,000 ÷ 480,000) = $25.21; allow for rounding

15 Jan. Machinery ................................................................... 1,600,000Common shares, no-par, 80,000 shares ................ 1,600,000

The value of the machinery is used to value the transaction because it is the value of assets received.

11 March Series B preferred shares (15,000 × $105*)................ 1,575,000Contributed capital on retirement, Series B................ 101,000Retained earnings........................................................ 64,000

Cash (15,000 × $116)............................................ 1,740,000*($10,500,000 ÷ 100,000) = $105

30 April Common shares (60,000 × $15.78*)........................... 946,800Retained earnings........................................................ 373,200

Cash (60,000 × $22).............................................. 1,320,000* Shares Book value1 Jan. 1,200,000 $18,600,00015 Jan. 80,000 1,600,000 1,280,000 $20,200,000 $15.78 ($20,200,000 ÷ 1,280,000)

30 Dec. Dividends declared, Series A (or retained earnings)... 341,250Dividends declared, Series B (or retained earnings)

($42,500 + $21,250 + $6,500) .............................. 70,250Dividends declared, Common (or retained earnings)

($305,000 + $93,500)............................................ 398,500Cash....................................................................... 810,000

Series A: (480,000 – 25,000) × $0.75 = $341,250Series B arrears (100,000 – 15,000) × $0.25 × 2 = $42,500Series B: base (100,000 – 15,000) × $0.25 × 1

= $21,250 (6.5% of $326,250 base (base is $21,250 + $326,250))Common matching: ( 1,280,000 – 60,000) × $0.25

= $305,000 (93.5% of $326,250 base)Total: $341,250 + $42,500 + $21,250 + 305,000 = $710,000Remainder: $100,000; $6,500 to preferred and $93,500 to commonDoes not exceed $0.50 cap on pref. participation ($0.50 x 85,000 = $42,500)

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31 Dec. Stock dividend (or retained earnings) ......................... 2,684,000Common shares..................................................... 2,673,000Common share fractional share rights .................. 11,000

Total = 1,220,000 × 10% = 122,000 shares × $22 = $2,684,000Issued = (122,000 – 500) × $22 = $2,673,000Fractional = 500 × $22 = $11,000Shares outstanding: 1,220,000 + 121,500 = 1,341,500

Requirement 2

Kingdom CorporationShareholders’ Equity as of 31 December 20x2

Contributed Capital

Series A preferred shares, no-par, $0.75, cumulative, 455,000shares issued and outstanding ...................................................... $11,469,750

Series B preferred shares, no-par, $0.25, cumulative, participating in dividends with common shares to an additional $0.50 after the common shares have received a $0.25 matching dividend; 85,000 shares issued and outstanding. Participation is based on relative annual total base dividends. .... 8,925,000

Common shares, 1,341,500 shares issued and outstanding....................... 21,926,200Common shares fractional share rights...................................................... 11,000Total contributed capital ............................................................................ 42,331,950

Retained earnings ($14,600,000 + $1,609,000 – $144,750 –$64,000 – $373,200 – $810,000 (total dividend) – $2,684,000) ............... 12,133,050

Total shareholders’ equity.............................................................................. $54,465,000

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a) 1 February 20X5Cash .................................................................................... 36,000,000

Common shares, no-par (2,000,000 shares × $18) ....... 36,000,000

b) 15 February 20X5Cash .................................................................................... 11,000,000

Preferred shares, no-par (100,000 shares) .................... 11,000,000

c) 1 March 20X5Common shares, no-par (20,000 shares) ............................ 313,000

Contributed capital on common share retirement......... 23,000Cash (20,000 × $14.50) ................................................ 290,000

Cash required to retire shares (20,000 × $14.50)................ $290,000Average proceeds on issuance $15.65 × 20,000 ($266,000,000/17,000,000 = $15.65) ............................... 313,000Excess of original issue price over cash paid ..................... $ 23,000

d) 15 March 20X5Common shares, no-par ($15.65 × 10,000) ........................ 156,500Contributed capital (balance from c) .................................. 23,000Retained earnings ($200,000 – $156,500 – $23,000)......... 20,500

Cash ($20.00 × 10,000) ................................................ 200,000

e) 31 March 20X5Declared cash dividend:Common dividend declared (or retained earnings)

(16,970,000 sh. × $.10)*.............................................. 1,697,000Common dividends payable ......................................... 1,697,000

Payment date of cash dividend:Common dividends payable ............................................... 1,697,000

Cash .............................................................................. 1,697,000

* Number of common share at beginning of period ........ 15,000,0001 February issuance of additional shares ...................... 2,000,000

Total common shares issued .................................... 17,000,000Less: retired shares

1 March .................................................................... 20,00015 March .................................................................. 10,000 30,000

Number of shares outstanding subject to cash dividend 16,970,000Cash dividend rate (given)............................................ $ 0.10

Total dividend (debited to retained earnings) .......... $ 1,697,000

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f) 15 April 20X5Treasury stock (18,000 × $17.50)....................................... 315,000

Cash .............................................................................. 315,000

g) 30 April 20X5Cash (12,500 × $19.25) ...................................................... 240,625

Treasury stock (12,500 × $17.50)................................. 218,750Contributed capital from treasury stock transactions........................................................ 21,875

h) 31 May 20X5Stock dividend (or retained earnings)................................. 19,509,175

Common shares, no-par (845,925 × $23) ..................... 19,456,275Common share fractional share rights .......................... 52,900

Shares: (16,970,000 – 5,500) × 5% = 848,225Amount: 848,225 × $23 = $19,509,175Fractional: 2,300 × $23 = $52,900Common Shares: $19,509,175 – $52,900 = $19,456,275

i) 6 July 20X5Cash (300,000 × $25) ......................................................... 7,500,000

Common shares, no-par ................................................ 7,500,000

j) 30 September 20X5Common dividend declared (or retained earnings)............. 1,811,043Preferred dividend declared (or retained earnings)............. 800,000

Common dividends payable (18,110,425 × $.10)......... 1,811,043Preferred dividends payable (100,000 × $8)................. 800,000

Common shares: 16,970,000 – 5,500 + 845,925 + 300,000 = 18,110,425

30 October 20X5Common dividends payable ............................................... 1,811,043Preferred dividends payable................................................ 800,000

Cash .............................................................................. 2,611,043

k) 31 December 20X5Common share fractional rights.......................................... 52,900

Common shares (1,850 × $23) ..................................... 42,550Contributed capital, lapse of rights............................... 10,350

l) 31 December 20X5No entry is needed; however, as part of the closing entries, earnings and dividends would be formally closed to retained earnings.

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Assignment 13-27

Requirement 1 Preferred CommonCurrent dividend $2,400Common; to match........... $27,600 ($0.30 x 92,000 shares outstanding)Balance**......................... 640 7,360

Total ........................... $3,040 $34,960** Remaining pool = $38,000 - $2,400 - $27,600 = $8,000 preferred: $8,000 × [$2,400 ÷ ($2,400 + $27,600)] common: $8,000 × [$27,600 ÷ ($2,400 + $27,600)]

Requirement 2

Preferred shares.....................................................................................$ 360,000Less: retirement (($360,000/4,000) × 500) ......................................... (45,000) Balance .............................................................................................$ 315,000

Common shares.................................................................................. 1,080,000Plus: issuance for land ...................................................................... 50,000Plus: stock dividend ((96,100*) × 10%) – 350) × $40) ..................... 370,400 Balance ..........................................................................................$1,500,400 * 97,000 shares issued less 900 in the treasury

Contributed capital on retirement of preferred shares ($17,000 less retirement used $17,000) .......................................... $ 0

Retained earnings...............................................................................$ 4,356,900Plus: earnings ..................................................................................... 1,450,000Less: Cash dividend ........................................................................... (38,000)Less: preferred share retirement ($65,000 - $45,000 - $17,000)........ (3,000)Less: treasury stock transaction ($12,200 – (600 × $15)) .................. (3,200)Less: stock dividend ((97,000 – 900) = 96,100 × 10% × $40)) ........... (384,400) Balance ..........................................................................................$ 5,378,300

Treasury stock ....................................................................................... $ 18,000Plus: additional shares purchased ........................................................ 12,500Less: shares issued (($30,500/1,500) x 600) ....................................... (12,200) Balance ............................................................................................. $ 18,300

Fractional share rights (350 x $40) .......................................................$ 14,000

Requirement 3

The appraisal value of land was used to value the non-monetary exchange. This is based on the requirement to value non-monetary exchanges at the value of the asset received.

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Assignment 13-28

Item Share Capital

Fractional Share Rights

Other Contributed Capital

Retained Earnings

Reserve: unrealized gains on investments

Treasury Stock

a. (given) NE NE NE NE NE NEb. NE NE I NE NE NEc. NE NE NE NE NE Id. NE NE NE NE I NEe. NE NE NE D NE NEf. (1) NE NE I* D NE NEg. I I D NE NE NEh. I D I NE NE NEi. D NE NE D NE NEj. NE NE I NE NE Dk. NE NE D** D** NE Dl. NE NE NE I NE NE

(1) Assuming that stock dividend is recorded when declared; otherwise, NE across all categories; g should be answered consistently.* Also acceptable to increase share capital to represent stock dividend distributable; g to be done consistently.* * Since contributed capital from prior transactions has been recorded, it is reduced to zero before retained earning is reduced; retained earnings is only decreased if needed

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Assignment 13-29

Requirement 1

Retained earningsop. bal. 5,940,000earnings.2,600,000

sh. issuance 200,300cash div. (1)334,700

________________________________bal. 8,005,000

(1) to balance

Requirement 2

Cash from financing:Issued common shares, for cash (1) .................................... 4,040,800Preferred share subscription payment ................................. 3,300,000Dividends paid (as above)................................................... (334,700)Retirement of preferred shares (2) ...................................... (878,000)Share issue costs ................................................................. (200,300)

Cash for investing:Purchase of patent ............................................................... (2,000,000)

(1) $36,000,000 + $4,500,000 (patent) + 459,200 (fractional shares) = $40,959,200 versus $45,000,000

(2) $1,000,000 - $122,000

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Assignment 13-30Ottawa Limited

Partial Cash Flow StatementFor the year ended 31 December 20x5

Financing activities

Issuance of preferred shares ($100,000 – $2,000) ..................................... $ 100,000Share issuance costs (1) ........................................................................ (2,000)Retirement of preferred shares ($40,000 – $7,000) ................................... (33,000)Retirement of common shares ................................................................... (360,000)Issuance of common shares ....................................................................... 832,600Payment of dividends ........................................................................ (256,000)

(1) May also be shown net with issuance, for $98,000

Common shares:Opening balance (570,000 × $12) $6,840,000Retirement (20,000 × $12) (240,000)Stock dividend (55,000 – 3,200) × $17.50 906,500Rights (2,700 × $17.50) 47,250Issued for land, 3,000 shares* 52,000Issued for cash (to balance) 832,600Closing balance $8,438,350

Retained earnings:Opening balance $3,911,500Earnings 1,200,000Share issue costs – preferred (2,000)Stock dividend (55,000 × $17.50) (962,500)Common share retirement ($360,000 –(20,000 x $12) = $120,000. $120,000 – $96,000 (24,000)Cash dividend (to balance) (256,000)Closing balance $3,867,000

* Non-cash transaction, omitted from CFS

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Solutions Manual to accompany Intermediate Accounting, Volume 2, 5h edition 14-1

Chapter 14: Complex Debt and Equity Instruments

Suggested TimeCase 14-1 Techno Wizard Ltd.

14-2 On-the-Crest Ltd.14-3 Creative Traders Limited

Assignment 14-1 Impact of debt versus equity ............................ 2014-2 Classification (*W) .......................................... 1514-3 Classification.................................................... 2514-4 Classification.................................................... 2514-5 Convertible debt (*W) ..................................... 2514-6 Convertible debt, investor’s option.................. 2514-7 Convertible debt, investor’s option.................. 2514-8 Convertible debt, comprehensive scenarios..... 3014-9 Convertible debt, three cases ........................... 3514-10 Convertible debt, investor's option .................. 2514-11 Convertible debt, conversion mandatory ........ 2514-12 Convertible debt, investor option versus

conversion mandatory..................................... 4014-13 Warrants........................................................... 2014-14 Share rights and warrants................................. 3514-15 Share rights - recognition................................. 1514-16 Share rights - recognition ................................ 2014-17 Share-based compensation, cash-settled .......... 3014-18 Share-based compensation, cash-settled (*W). 3014-19 Share-based compensation, cash-settled .......... 3014-20 Stock options.................................................... 1514-21 Share-based compensation, equity-settled ....... 3014-22 Share-based compensation, compound plan .... 3014-23 Share-based compensation............................... 1514-24 Share-based compensation............................... 3014-25 Derivatives ....................................................... 1514-26 Derivatives ....................................................... 1514-27 Derivatives ....................................................... 1514-28 Cash flow statement - individual

transactions .............................................. 3514-29 Cash flow statement – comprehensive equity.. 4514-30 Comprehensive equity (*W) ............................ 45

*W The solution to this assignment is on the text Web site and inthe Study Guide. The solution is marked WEB.

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14-2 Solutions Manual to accompany Intermediate Accounting, 5th edition

14-A1 to 14-A4 Financial restructuring; based on OLC posted material

14-A1 Restructuring (OLC) ........................................ 3514-A2 Comprehensive revaluation (OLC) ................. 2514-A3 Restructuring (OLC) ........................................ 4014-A4 Reorganization - entries and reporting

(OLC)....................................................... 40

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Questions

1. Historically, financial instruments were classified as debt or equity based on their legal form. The financial instrument rules require classification based on the substance of the financial instrument—liabilities carry firm commitments to pay out cash or other financial instruments and equities are residual interests in net assets.

2. A compound financial instrument is a security that has elements of both debt and equity. An example is convertible debt, where the investor essentially holds an option on the company’s common shares in addition to a liability that guarantees interest and principal payments.

3. The distinguishing feature of debt is that it must be paid in cash at a certain time, or paid in cash on the investor’s demand. The company has no ability to avoid the cash payment.

4. If the instrument is classified as debt, the annual payments are classified as interest expense, which reduces earnings, and the redemption premium is recorded as a loss on retirement, also reducing earnings. (If the $6,000 excess of retirement price over par were contracted in advance, it would be accrued over the life of the liability). If the financial instrument were equity, both items would reduce retained earnings directly, by-passing earnings.

5. Retractable preferred shares are preferred shares that must be paid back with cash, or paid in cash at the option of the shareholder. Because the agreement to pay out the redemption price is legally enforceable, such shares are classified as debt.

6. The principal of convertible debt is classified as equity if it is mandatorily convertible into a fixed number of shares. The portion related to annual interest is an unavoidable cash obligation of the company and must be classified as a liability. Thus, the security is compound financial instrument. If the convertible debt is convertible at the investor’s option, the initial proceeds are divided between the debt element (both principal and interest) and the equity element, the conversion option.

7. If a convertible bond has a conversion price that is set in reference to the fair market value of shares on the conversion date, then the bond is classified entirely as debt. No risk or reward is transferred to the investor and therefore there is no equity element.

8. When a convertible bond is converted, the common share conversion option account is transferred into the common stock account. If the bond is not converted, this account is still left in equity, but transferred to a different contributed capital account.

9. Interest expense, $76,400 x .08 = $6,112Annual payment, $400,000 x .08 = $32,000

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10. Stock options provide the holder with an option to acquire a specified number of shares in a corporation under prescribed conditions and within a stated future time period. Options that are issued as an attachment to other securities are called stock warrants. Warrants may trade separately while options do not. Options often have a limited life while warrants often have no expiry date.

11. A share-based payment to a supplier is measured based on the fair value of the goods or services rendered. In the rare circumstances that these cannot be valued, then the fair value of the rights is used to measure the transaction.

12. If stock rights are recognized on issuance, the stock rights account is transferred into the common stock account on exercise and into a different contributed capital account if options are allowed to lapse. This is identical to the treatment given to the common share conversion option account for convertible bonds.

13. A share-based compensation contract would result in recognition of an equity account if the contract is share-settled, or required issuance of shares. The contract would result in recognition of a liability element if the contract was cash-settled, meaning that compensation is required to be paid in cash. Both a liability and an equity component are recognized if settlement is in cash or shares at the employee’s option.

14. At the end of year 2, a total of $70,000 is recorded ($175,000 x 2/5). The required accrual by the end of year 3 is $240,000 ($400,000 x 3/5). Compensation expense is $170,000 ($240,000 - $70,000).

15. At the end of year 2, a total of $52,500 is recorded ($175,000 x 2/5 x 75%). The required accrual by the end of year 3 is $144,000 ($400,000 x 3/5 x 60%). Compensation expense is $91,500 ($144,000 - $52,500).

16. A cash-settled plan is trued up to the cash paid out (fair value) and the retention rate. An equity-settled plan is trued up only to the retention rate; the fair value is estimated on initial grant date and is not adjusted to the value that employees receive.

17. A SARs program involves a payment to the employee at the settlement date. The value paid is equal to the fair value of the shares on the payment date, less some reference price, which is usually the fair value of the shares when the SARs were granted. That is, the employee receives a payment (cash or shares) equal to the appreciation in stock price over the life of the SARs.

18. A derivative is an exchange contract meant to transfer risk. It is a secondary financial instrument whose value is linked to a primary financial instrument, an index, or a commodity. Derivatives are options, futures or forward contracts, or a

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combination of these. Derivatives embody an exchange of financial instruments at fixed terms.

A hedge is a way to offset risk to which the company would otherwise be exposed. For an item to be a hedge, the company must first have risk in an area, and then put a hedge in place to counter the risk. That is, a loss on a primary instrument will offset a gain on a hedge instrument.

19. The company could hedge against the risk of exchange fluctuations by entering into a forward exchange contract with a bank to deliver US dollars. The price to be paid would be set by the terms of the contract, and would not fluctuate. The contract would be recorded at cost, and revalued to fair market value annually. Changes in market value of BOTH the transaction balance and the hedge would be reported as gains/losses in earnings and offset.

20. Disclosure for financial instruments is required in the following general categories [ per text listing]:

1. The accounting policy used for reporting each type of financial asset and financial liability.

2. The fair value for each class of financial asset or financial liability, presented insuch a way that enables the user to compare the fair value with the reported carrying value. The methods and assumptions used to measure fair values must be disclosed.

3. Information to assess the significance of financial instruments for the entity’s financial position and performance.

4. The nature and extent of risks arising from financial instruments. This includes objectives, policies and processes for managing risk, and changes in risk profile or policies during the period. Risks are categorized as credit risk, liquidity risk, and market risk, with such disclosures made through the eyes of management to provide an insider perspective. Quantitative disclosures and sensitivity analysis is required.

Extensive disclosure is required to describe the terms of the financial instrument.

14-A1 to 14-A4 Financial restructuring; based on OLC posted material

1. A financial restructuring happens when a company that is in legal violation of debt agreements is financially reorganized and allowed to continue operating, rather than be placed in receivership or bankruptcy. Restructuring can involve a financial reorganization (substantial realignment of debt and equity) or a troubled debt restructuring (lenders ‘settle’ for less).

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2. Financial restructuring may be bound by the following principles or rules, although there are no explicit standards in Canada:

a. Accounting entries must reflect the terms of the agreements made by debt and equity holders.

b. Conversions of debt to equity are made at book value.c. Debt forgiveness is recognized as a gain in earnings.

3. The debt and the assets would be removed from the books. A $150,000 gain on asset disposal and a $200,000 gain on debt restructure would be recognized to balance the entry.

4. In a comprehensive revaluation, all assets and liabilities are revalued to fair value, whether fair value is higher or lower than book value. Retained earnings (if any) is reclassified; any debit balance of retained earnings is eliminated by reducing other equity accounts. Gains and losses go directly to retained earnings and by-pass earnings.hzzled



Cases

Case 14-1Techno Wizard Ltd.

Overview

Techno Wizard Limited (TWL) has been purchased by Omni Services Limited with the transaction price to be adjusted based on the book value of assets less liabilities, measured in accordance with IFRS. Based on the financial statements provided by TWL, this would dictate a purchase price of $8,016 [($11,200 - $7,192) x 2]. Omni is concerned that this is high, and I have been engaged to evaluate the financial statements from Omni’s perspective. While TWL prepared the financial statements from their viewpoint, with a view to maximizing net assets and the purchase price, Omni has incentive for the opposite, to minimize net assets and the purchase price.

Issues

1. Foreign exchange losses2. Recording convertible bond3. Valuation of customer account receivable4. Classification of preferred shares5. Valuation of deferred revenue6. Valuation of SARs plan7. Recognition of foreign currency contract8. Revised statement of financial position


1. Foreign exchange losses

Foreign exchange losses are treated as an asset of $160. Assets represent future economic benefits, substantiated by future cash flow; exchange losses are not assets and must be written off. (See adjustment #1 in Exhibit 1)

2. Recording convertible bond

TWL has apparently recorded the convertible bond as $2.1 million of debt and $0.3 million of equity. This would be appropriate if the bond allowed the investor to convert to common shares at some point. However, the debenture holders are entitled to 1,000 hours of printing facility time, exclusive of paper costs. They are not entitled to any equity interest. This lending arrangement appears to be part debt, and partly aprepaid contract for services. The obligation to provide printing facility time is, in

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substance, unearned revenue. None of the services have yet been used, so the amount is still outstanding.To value this right, it would be appropriate to determine the fair value of 1,000 hours of printing facility time. No information has been provided to allow this. Alternatively, the present value of the bond could be calculated at current market interest rates, and the residual amount allocated to deferred revenue. Using an interest rate of 8%, based on a transaction in the same time frame, but with another company:

Present value:Principal $2,400 (P/F,8%,10 yrs) $1,111

Interest 84 (P/A,8%,10 yrs) 564 $1,675

Unearned revenue: $2,400 - $1,675 = $725

Carrying value of bond as of 31 October 20X7:Effective interest $1,675 x 8% = $134Interest paid $2,400 x 3.5% (84)Discount amortization 50 x 11/12 = $46

Carrying value = $1,675 + $46 $1,721

This may not be the correct interest rate; the reference company may have a different credit rating or there may be other factors that require adjustment. Before this adjustment is finalized, Omni must obtain information about the fair value of printing time, and the applicability of the 8% interest rate.

However, an adjustment to the financial statements (based on available information) has been made to eliminate the equity portion, revalue the debt, and recognize unearned revenue. In addition, some of the bond discount is amortized this year, to reflect the passage of time. See adjustments marked #2 in Exhibit 1. This adjustment has a significant impact on net assets.

3. Valuation of customer account receivable

The accounts receivable for the company include a $710 account receivable at an interest rate below market rate. The receivable must be reclassified as long-term, and restated to its present value, acknowledging the time value of money.Present value:

Principal $710 (P/F,7%,2 yrs) $620Interest 21.3 (P/A,7%,2 yrs) 39

$659Carrying value of receivable as of 31 October 20X7:Effective interest $659 x 7% = $ 46

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Interest paid (21.3)Discount amortization 25 x 10/12 = $21

Carrying value = $659 + $21 $680Interest receivable $21.3 x 10/12 $18

Again, the interest rate used for discounting must be examined. While it is stated to be the correct rate for term, risk is also a factor; the credit rating of the customer must be considered. Further information is required, and other accounts receivable should be reviewed to ensure there are no other long-term amounts included.

An adjustment to the financial statements has been made to revalue and reclassify the receivable. Interest revenue ($39; $21 + $18) is also accrued. See #3 in Exhibit 1.

4. Classification of preferred shares

Preferred shares are classified in equity. Omni has the right to redeem these shares of cash at book value. The investors, the founding family of TWL, cannot force repayment, or dividend declaration. These shares are correctly classified as equity. This is unfortunate for Omni, because reclassification as a liability would reduce the purchase price by $500 x 2, or $1,000.

5. Valuation of deferred revenue

TWL has $1,740 of deferred revenue, a significant liability. This implies that many customer pay in advance. Measurement of this liability is based on work performed versus work still to be done in the future.

The disclosure notes indicate that customers pay up front under long-term contractsand long-term contracts often involve a “free” year of service or a “free” renewal year. Revenue must be recognized as the work is performed, or, if service is even, pro-rata over the life of a contract, including “free” years.

No information is provided to ascertain whether revenue recognition policies are appropriate or not. Recognition of up-front fees when received would not be appropriate if they are in substance payment for later service. Omni must request more information in this area, and the unearned revenue account may increase or decrease, changing the payout amount.

6. Valuation of SARs plan

TWL’s SARs plan is cash-settled, and accordingly creates a liability, not an equity account. It must be valued at the best estimate of the cash to be paid. Since TWL is a private company, and now has a new majority shareholders, share price will be

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difficult to estimate. The $15 price in the buyout agreement has been used for the current balance, but is subject to adjustment if Omni pays more than $7 million.

Furthermore, forfeitures have to be estimated. Two managers have left, but with new owners, others might also turn over. Omni needs to consider this possibility and provide information.

The suggested balance of the liability to be recorded to date is $200,000 (10,000 x 6 managers x ($10-$15) x 2years/3 years. See #6 in Exhibit 1.

7. Recognition of foreign exchange contract

The fair value of a derivative financial instrument, including exchange contracts, is recognized as an asset. The gain or loss is recorded in earnings. Assets are correctly stated as long as the fair value of the swap has been recorded correctly. Omni must request information regarding the valuation model used.

8. Revised statement of financial position

The revised SFP, reflecting the adjustments in each section of the analysis, is shown in Exhibit 1. This SFP can be the basis for discussion in the pre-closing negotiations scheduled for next week. The revised purchase price is now the base level of $7 million, per contract ($11,028 - $7,738 = $3,290 x 2 = $6,580; less than the $7 million floor).

This amount is based on preliminary information, and might be adjusted for any revenue recognition issues. Other amounts may change based on additional measurement.

Given the number of adjustments, Omni should suggest that an audit be completed on these financial statements to ensure that other assets, especially the high dollar-value inventory and receivables, are correctly stated. This will delay closing, but is the prudent course of action in case there are additional material misstatements.

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Exhibit ITechno Wizard Ltd. Revised SFP 31 October 20X7

SFP (in thousands)Assets As previously

reportedAdjustments

(# per analysis)Revised

Current Assets Cash $ 1,420 1,420 Receivables 2,690 3. (710)

3. 181,998

Inventory 3,700 3,700 Prepaid expenses 290 1. (160) 130

8,100 7,248Non-current Assets Account receivable 3. 659

3. 21680

Capital assets, net 3,100 3,100$11,200 11,028

LiabilitiesCurrent Liabilities Bank indebtedness $ 860 860 Accounts payable 2,100 2,100 Deferred revenue 1,740 2. 725 2,465

4,700 5,425Non-current liabilities Bonds payable 2,100 2. (425)

2. 46 1,721 Future income tax 162 162 SARs plan liability 6. 200 200 Other 230 230

$ 7,192 $ 7,738Equity Preferred shares 500 500 Share equity - bond 300 2. (300) -- Contributed capital - share plan 320 6. (320) -- Common shares 1,080 1,080 Retained earnings 1,808

4,0081. (160)2. (46)3. (51)3. 396. 120

1,7103,290

$11,200 $11,028

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Case 14-2On-the-Crest Ltd.

Overview

On-the-Crest Ltd. (OCL) sells and services software, sells products to car dealers, and also sells used vehicles. The company has recorded rapid (25%) growth in revenue annually for the last five years, and is planning to go public in the next year. An IPO puts a lot of pressure on a company to maintain good results, and OCL has financing contracts in place that hinge on the IPO. This may lead to ethical dilemmas in accounting policy choice. GAAP must be carefully followed to serve the interests of potential new shareholders.

Issues

1. Convertible debt2. Options granted to a supplier3. Fair value investment4. Exchange rate hedge5. Convertible preferred shares6. Pricing agreement

Analysis and Conclusions

1. Convertible debt

OCL recorded a $7 million long-term liability on the issuance of ten-year convertible debt during the year. Bond issue costs of $300,000 are being amortized over ten years.

The debt is convertible to common shares at OCL’s option if it is submitted for cash payment on the date of the IPO. The number of shares to be issued is based on the IPO price (market value). The lender may demand cash repayment after three years or at maturity in 10 years.

One issue is whether a value should be assigned to the conversion option, reducing the liability value and increasing equity. Since this option is OCL’s option and the conversion ratio is based on the IPO price, standards indicate that this is debt, not equity. No change to current recording is suggested.

However, the amortization period for the bond issue costs is now set at ten years. The term of the loan may be until the IPO, three years or ten years. OCL may have been motivated to choose ten years because it has the minimum (negative)impact on earnings, but the term of the bond is quite likely to be until the IPO, which will take place in the coming year.

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Amortization of the bond issue costs must be done using the effective interest method, not the straight-line method.

An alternate (shorter) amortization period using the effective interest method must be discussed at the meeting with Mr. Valarian, with an emphasis on ethicalaccounting policy choice, and an explanation of the impact of irregular accountingtreatments and restatements on financial markets.

2. Options granted to a supplier

Options for 40,000 shares have been granted in order to cement relations with a key supplier. The options are non-revocable and are exercisable six months after the IPO. If there is no IPO, a cash price is to be assigned to the options and this amount paid to the supplier. At present, the options are disclosed but not recorded in the financial statements.

The other recording alternative is to value the options and record the amount as an expense and an equity element. The equity element would be folded into the common share account on exercise, into contributed capital if the options lapsed, or eliminated if cash were paid.

Recording the options seems appropriate, as something of value is being both given up and received. Recording seems to reflect the substance of the transaction.

If the options were recorded, the fair value of the consideration received should be used to value the transaction. Since there are no explicit deliverables from the supplier, this is not easily accomplished. Therefore, the value of the options should be used. Experts would have to be consulted to determine a value, using option pricing models if possible. Some retroactive valuation (i.e., after the IPO) may be possible since the time is short to the IPO date.

The amount is a cost of supplier relations, an expense. This might possibly be amortized over the period of expected benefit, but the intangible asset is not severable, and the duration of good relations or the need for this particular supplier is highly speculative. Therefore, recording an expense seems more appropriate.

The issue must be reviewed with Mr. Valarian. Recording a loss will reduce earnings and not necessarily support values perhaps needed to launch an IPO. Ethical accounting policy choice is still clearly required.

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3. Fair value investments

OCL has an investment, recorded at fair value, for which the market value has declined below cost. OCL has written down the investment to market value, (with the loss by-passing earnings, recorded in an equity reserve.) This does not affect earnings.

The other possibility is that the decline in value is permanent, and a $100,000 loss should be recorded in earnings. Market price is unchanged in the last year, indicating that the decline in value is not temporary. In fact, management believes it may take another two to five years for value to rebound. Again, this does not appear temporary. Other opinions should be sought.

Recording the loss in earnings will reduce earnings and not help support values perhaps needed to launch an IPO. However, the investment decision was made and economic events must be appropriately reflected in the financial statements.

4. Exchange rate hedge

According to established Canadian standards for accounting for foreign exchange, the price of goods purchased is set by the exchange rate on the delivery date. Subsequent fluctuations in the exchange rate cause exchange gains or losses, but hedged amounts have offsetting gains and losses and have no impact on earnings. However, the spread on the exchange contract must be recognized in earnings.

For OCL, this means that

i. the goods should be recorded at $171,000 [($161,500/0.0085) x 0.0090]according to the exchange rate on acquisition, not $161,500;

ii. no exchange gain or loss is recognized on the account payable because the risk was hedged;

iii. an amount of $9,500 ($171,000 − $161,500) will be recorded as a gain on hedging.

Amounts are likely not material. In addition, this is primarily a presentation issue. Assuming that the goods have been resold, there is NOW $161,500 of COGS. After adjustment, there will be $171,000 of COGS and a $9,500 gain, so there is no change to earnings. If goods have not been resold, there will be minor changes to current assets and earnings.

Perhaps the most significant implication is that other foreign-currency-denominated transactions must be reviewed to ensure they are recorded correctly.

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5. Convertible preferred shares

Convertible preferred shares were issued during the year that require

i. Conversion to 600,000 common shares after the IPO. However, cash payment can be demanded by the investor at this time.

ii. The preferred shares continue as preferred shares if there is no IPO;iii. A cash dividend payment of $100,000 per year, paid at the latest on

conversion, accrued to date whether declared or not.

Since the investor can demand cash on the event of an IPO, there appears to be some element of liability in the principal portion of the instrument. However, if there is no IPO, there is no conversion and the cash amount would not have to be paid. Intent of OCL is not legally binding. However, likely events have influence in classification.

Another question is whether the dividend should be recorded as a liability, with appropriate recording of later cash payments. The significant question is whether the company is obliged to pay the dividend amount, with no ability to avoid the cash outflow. On conversion, the amount clearly has to be paid. Again, because the IPO is an uncertain event, accrual could be avoided. (After any IPO, the status would change and an accrual as time passed would be needed.)

Current reporting might have to be changed to reflect the liability element of the financial instrument. This situation should be reviewed with Mr. Valerian for his views.

The contractual features of the shares must be clearly disclosed in the financial statements to safeguard potential investors and allow prediction of future equity holdings and cash flows.

6. Pricing agreement

OCL has, for the first time, guaranteed re-sale values for goods sold to customers. If re-sale prices slip, OCL will collect lower proceeds. OCL has recorded these transactions as sales, with an allowance for reduced sales amounts recorded. This is one alternative. If it is followed, the accuracy of recorded allowances must be established.

Alternatively, the sale may be deferred until the amount ultimately collectible can be established. Using revenue recognition criteria, risks and rewards must pass to the buyer before a sale can be recorded. If the buyer is protected from reduction in re-sale price, a major risk has remained with the seller. Recording unearned revenue seems an appropriate approach.

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OCL may be motivated by the imminent IPO to generate sales growth, and this new pricing arrangement may be offered to preserve sales trends. There is no track record on which to base expected returns. The series of sales transactions must be re-evaluated per a discussion with Mr. Valarian. Deferral seems more appropriate in the circumstances.

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Case 14-3 Creative Traders Ltd.

Overview

Creative Traders has disclosures related to financial instruments. The impact of fair value treatment is discussed, along with a discussion of disclosure versus recognition of fair values. The company has an ethical responsibility to ensure that its financial statements fairly present its financial position.

Issues

1. Impact of fair value recognition2. Justification for recording3. Concerns regarding fair value measurement

Analysis1. Impact of fair value recognition

Derivatives would be shown at their fair value, a $146 liability related to foreign currency contracts and a $25 asset related to interest rate derivatives. This represents a change of $191 (see below) for the foreign currency derivative (less asset/more liability) and a change of $43 (see below) for the interest rate derivative (more asset/less liability). Note that the fair value of these derivatives is the net difference between amounts owing and receivable. Since both legal right and intent are present, netting is appropriate.The change in fair value would be recognized in earnings for the year. Since this is the initial year of application, the cumulative adjustment may be treated differently, as the standard requires on initial adoption. On a go-forward basis, it is the change in fair value that impacts earnings.

Fair Value 20x1 20x0Gain(loss)

Foreign currencyderivatives $ (146) $ 45 $ (191)Interest rate derivatives 25 (18) 43

$148

No information is available to assess the materiality of these numbers.

On the statement of financial position, financial liabilities would still be recorded at book value. The difference between fair value and book value would continue to be disclosed.

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2. Justification for fair value recognition

Many argue that fair value is the most relevant to financial statement users, who are more concerned with what an investment is worth, or the fair value of a liability, than its original value. Increased relevance outweighs other factors, including lack of reliability.

Derivatives are a common form of risk management, and their impact must be measured to properly portray the financial position of the company.

3. Concerns with fair value measurement

Historic cost is based on transaction values. These values represent the sacrifice made by the entity to acquire a financial asset, and the cash benefit received in the case of borrowing. The values are well understood as transaction values by shareholders and other financial statement users, and have been used for hundreds of years in the primary financial statements.

A change to fair values may introduce volatility into the financial statements. For instance, under fair value reporting, if the fair value of derivatives increases, a gain will be reported. If fair value declines in the next year, a loss will be reported. Neither the gain nor the loss is realized, and would not provide or use cash flow. Volatile earnings figure can be problematic for some companies.

Fair values are estimates, and are subject to errors. Estimates of the amount and timing of cash flows and appropriate discount rates are subject to error. This lack of reliability is a major problem when considering fair value recognition. Fair values may be Level 1 estimates, where the financial instrument itself is traded and fair value is directly observable. If the fair value of similar financial instruments is used as a surrogate, with adjustments to extrapolate for different variables, fair value is deemed to be a Level 2 estimate and is less reliable. If significant adjustments must be made to observed market prices of surrogates, to allow for firm-specific variables including factors observable only by management, then the fair value is a Level 3 estimate and is even less reliable.

Fair value based financial statements may be more useful to financial statement readers. The expectation is that fair values will help assess risk. Fair values must be reliable to achieve this outcome.

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Assignments

Assignment 14-1

Requirement 1Preferred shares: The dividend is not tax-deductible, nor is the call premium. Therefore, the after-tax cost of the preferred will be $420,000 per year for annual dividends plus the one-time $200,000 excess paid over par at the end.

Bonds: The annual interest and the call premium are tax deductible. Therefore, the annual after-tax cost of interest is $420,000; that is, $600,000 × (1 – 30%). The call premium will be $140,000 after tax.

Requirement 2

Issuance: Equity DebtCash……………… 7,000,000 7,000,000

Preferred shares. 7,000,000Long-term debt.. 7,000,000

Annual dividends or interest:Dividends (RE)….. 420,000Interest expense….. 600,000

Cash…………... 420,000 600,000(Income tax would be recorded separately for the interest alternative)

Retirement:Preferred shares….. 7,000,000Long-term debt…… 7,000,000Retained earnings... 200,000Loss on retirement.. 200,000

Cash…………... 7,200,000 7,200,000

Note: If the $200,000 loss on retirement were contractually set at inception (i.e., if the retirement price and date were specified), the $200,000 would be recognized (accrued) over the life of the financial instrument under both options.

Requirement 3

Earnings before interest and tax $2,000,000 $2,000,000Interest expense 0 600,000Loss on retirement 0 200,000Earnings before tax 2,000,000 1,200,000Income tax (30%) 600,000 360,000

Earnings $1,400,000 $840,000

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a. This is a liability. The investor can demand redemption of principal, which makes the instrument debt.

b. This is perpetual debt, and it is recorded as a liability. Strictly speaking, this is a hybrid instrument. The principal portion is equity since it never has to be repaid (but can be repaid voluntarily by the company.) The obligation to pay annual interest is a financial liability. However, the value assigned to the indefinite equity payment is zero, so the equity component is zero. All that is left is the interest liability, which represents all of the proceeds on issuance.

c. These shares are equity because they are convertible into common equity at the option of the investor. The company has the option to redeem for cash, but it cannot be forced to do so by the investor; this feature does not make the financial instrument a liability.

d. This financial instrument is a compound instrument, part debt and part equity. The interest payments have to be made semi-annually, so the present value of the interest obligation is debt. The residual is assigned to principal and it is equity because the company cannot be forced to pay cash.

e. This financial instrument is debt. The interest payments must be made in cash or shares priced at current market values, and as long as the market price is not fixed, this is debt. Price risk has not transferred to the lender. Principal can, at the company’s option, be converted into common shares, also at the market price of shares at the conversion date. The present value of the principal is therefore a liability as well.

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Assignment 14-3

Case 1Financial Instrument: Liability. The company can avoid a cash payout but the price of shares is not pre-determined. This is a liability, not a residual equity interest.

Case 2Financial Instrument: Equity. Both principal and interest may be satisfied with common shares and the price is pre-determined, transferring price risk to the investor.

Case 3Financial Instrument: Liability: Term preferred shares involve a requirement for the company to pay out cash for principal at maturity. The dividend is also a liability (must be paid in cash) and must be accrued over time.

Case 4Financial Instrument: Liability. The company has a legal obligation to pay annual interest, so it (present value of interest payments) is clearly a liability. The principal portion may be converted to equity if the company wishes, but the price is not set and price risk is not transferred to the investor. This is a liability, not a residual equity interest.

Case 5Financial Instrument: Equity. The company cannot be forced to pay out cash.

Case 6Financial Instrument: Liability. The terms of the shares are such that any prudent Board of Directors would arrange to retire the shares prior to the dividend and retirement price escalation. This represents a probable future cash outflow: a liability.

Case 7Financial Instrument: Compound: Part liability (interest) and part equity (principal). The company has a legal obligation to pay annual interest, so the present value of interest payments is a liability. The principal portion may be converted to equity at a set price if the company wishes, and thus the price risk has passed to the lender. The company cannot be forced to pay out cash: this is a residual equity interest.

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Assignment 14-4

1. Convertible debentures. This financial instrument is compound: part liability and part equity. The liability is the discounted cash flow of the interest and principal, discounted at the effective rate of interest. The value of the conversion option is the difference between the total issuance proceeds and the value assigned to the liability. The equity element is reported as a component of shareholders’ equity. The proceeds of the debentures, net of the value assigned to the conversion option, will be shown as a long-term liability.

2. Convertible debentures, redemption mandatory. This financial instrument is compound: part liability and part equity. The interest must be paid regularly, in cash. The present value of the interest obligation will be shown as a financial liability, discounted at the market rate of interest. The difference between the present value of the interest and the proceeds from the debentures will be shown as a component of shareholders’ equity because the obligation must be settled in common shares.

3. Redeemable preferred shares. This financial instrument is a liability. These shares require the company to pay cash “dividends” and to redeem the shares in cash at the holder’s option. This share issue is a liability for the company. Dividends are a liability and would be accrued as time passed even if not declared.

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Requirement 1

Cash.................................................................................. 5,325,000Discount on bonds payable (2)......................................... 760,000

Bonds payable .......................................................... 5,000,000Contributed capital: common stock conversion rights (1) ................................................ 1,085,000

(1) $5,325,000 – $4,240,000(2) $5,000,000 – $4,240,000

The conversion rights are valued at the difference between the actual proceeds and the amount that would have been received had the bond not been convertible.

Requirement 2

Present value:Principal $5,000 (P/F,10%,15 yrs) (.23939) $1,197Interest 400 (P/A,10%,15 yrs) (7.60608) 3,042Price $4,239 (rounded to $4,240)

Requirement 3

Interest expense ($4,240,000 × .10) $424,000

Requirement 4

Less interest expense would be recorded if the bond were initially valued with a premium. Annual premium amortization would reduce interest expense to an amount lower than the cash paid, versus discount amortization, which increases interest expense over cash paid.

Another way to express this is to point out that issuance at a premium means a yield rate higher than the stated rate, while issuance at a discount means that the yield rate is higher than the stated rate.

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Assignment 14-6

Requirement 1

Principal: $800,000 × (P/F, 7%, 3) (.81630) = $653,040Interest payments: ($800,000 × 6%) × (P/A, 7%, 3) (2.62432) = 125,967

Bond liability $779,007(rounded to $779,000)

Requirement 2

Cash........................................................................................ 806,000Discount on bonds payable (1)............................................... 21,000

Bonds payable................................................................. 800,000Contributed capital: common stock conversion rights (2) ..................................................................... 27,000

(1) $800,000 – $779,000(2) $806,000 - $779,000

Requirement 3

Year 1Interest expense ($779,000 x 7%) .................................. 54,530 Discount on bonds payable ........................................ 6,530 Cash ........................................................................... 48,000

Year 2Interest expense (($779,000 + $6,530 = $785,530) x 7%) 54,987 Discount on bonds payable ........................................ 6,987 Cash ........................................................................... 48,000

Year 3Interest expense (($785,530+ $6,987) x 7%) + $7(rounding) 55,483 Discount on bonds payable (balance) ........................ 7,483 Cash ........................................................................... 48,000

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Requirement 4

Bonds payable ....................................................................... 800,000Contributed capital: common share conversion rights .......... 27,000

Common shares, no-par.................................................. 827,000

Requirement 5

Bonds payable ....................................................................... 800,000Cash ................................................................................ 800,000

Contributed capital: common share conversion rights .......... 27,000Contributed capital: lapse of conversion rights ............................. 27,000

Requirement 6

Bonds payable ....................................................................... 800,000Contributed capital: common share conversion rights .......... 27,000Loss on bond retirement ($802,000 – ($800,000 - $7,483)) .. 9,483

Discount on bonds payable ($21,000 - $6,530 - $6,987) 7,483Cash ................................................................................ 810,000Contributed capital, retirement of conversion option ($8,000 - $27,000) .......................................................... 19,000

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Assignment 14-7

Requirement 1

Principal: $7,500,000 × (P/F, 5%, 20) (.37689) = $2,826,675Interest payments: ($7,500,000 × 4%) × (P/A, 5%, 20) (12.46221) = 3,738,663

Bond price $6,565,338

Requirement 2

The option would be valued, on the incremental basis, as the difference between proceeds of issuance, $7,400,000, and the PV of the bond alone, $6,565,338. This gives an amount of $834,662.

Requirement 3

Cash........................................................................................ 7,400,000Discount on bonds payable (1)............................................... 934,662

Bonds payable................................................................. 7,500,000Contributed capital: common share conversion rights (2) ..................................................................... 834,662

(1) $7,500,000 – $6,565,338(2) $7,400,000 – $6,565,338

Requirement 4

Interest expense ($6,565,338 x 5%)....................................... 328,267Discount on bonds payable ............................................ 28,267Cash ($7,500,000 × 4%)................................................. 300,000

Requirement 5

Bonds payable ....................................................................... 7,500,000Contributed capital: common share conversion rights .......... 834,662

Common shares, no-par.................................................. 8,334,662

Requirement 6

Bonds payable ....................................................................... 7,500,000Cash ................................................................................ 7,500,000

Contributed capital: common share conversion rights .......... 834,662Contributed capital: lapse of conversion rights .............. 834,662

Fair value of common shares must be less than $1,000/70 = $14.28 per share

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Assignment 14-8

Requirement 1

Cash........................................................................................... 5,350,000Discount on bonds payable ....................................................... 403,000

Bonds payable ..................................................................... 5,000,000Contributed capital: common share conversion rights........ 753,000

Requirement 2

One must first determine the interest rate implicit in the bond price. The interest rate must be higher than 8%, since the 8% bonds sold at a discount. 9% is the rate:Present value:

Principal $5,000 (P/F,9%,15 yrs,) (.27454) $1,372.7Interest 400 (P/A,9%,15 yrs) (8.06069) 3,224.3Price $4,597.0

Interest expense (9% x 6/12 x $4,597,000)............................... 206,865Discount on bonds payable ................................................. 6,865Interest payable (8% x 6/12 x $5,000,000) ......................... 200,000

Requirement 3

If the bond were convertible at a conversion price equal to the market value of the shares on the conversion date, then there is no equity portion to the bond. It is straight debt. The bond proceeds would be recorded as a debit to cash, and the difference between cash received and par value would be a premium or discount on the bond. This premium/discount would be amortized over the life of the bond using the effective interest method, making interest expense not equal to cash paid.

The bond would sell for a lower price in this case – only the present value of cash flows ($4,597,000). The investor receives no option on common share price, and would not pay for an option.

Requirement 4

If the bond were mandatorily convertible, and the conversion price was set at a specific price, then the bond is considered to be a compound financial instrument. The present value of annual interest is established, on the issuance of the bond, as an interest liability. The remainder of the issuance proceeds relates to principal and is the equity element. Annual interest on the interest liability only is recognized, while “interest” paid reduces the liability.

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Assignment 14-9

Case A

Cash ................................................................................ 5,200,000Discount on bonds payable (1) ....................................... 432,295

Bonds payable ............................................................ 5,000,000 Contributed capital: common stock conversion

rights (2)................................................................. 632,295(1)Principal: $5,000,000 × (P/F, 4%, 30) (.30832) $1,541,600Interest payments: ($5,000,000 × 3.5%) × (P/A, 4%, 30) (17.29203) = 3,026,105

Bond price $4,567,705Discount = $5,000,000 – $4,567,705(2) $5,200,000 – $4,567,705

Interest expense (1)......................................................... 60,903 Discount on bonds payable ...................................... 2,570 Interest payable (2) ................................................... 58,333

(1) $4,567,705 × 8% × 2/12(2) $5,000,000 × 7% × 2/12

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Case B

Original bond valuation:Issuance price: $10,000,000 × 101 = $10,400,000Interest payments: ($400,000) × (P/A, 4%, 40) (19.79277) = 7,917,108Equity component $2,482,892

On the SFP:Long-term liabilitiesInterest liability on bonds ...................................................... $7,917,108

EquityShare equity-bond ............................................................... $2,482,892

In 20X1 earnings:

Interest expense: $7,917,108 x 4% $316,684 ($7,917,108 + $316,684 – $400,000 ) × 4%

= $7,833,792) × 4% = 313,352 $630,036

Case C

1. Interest expense (1)......................................................... 761,992 Discount on bonds payable ...................................... 161,992 Cash (2) .................................................................... 600,000

(1) $5,442,798 × 14%(2) $6,000,000 × 10%

On conversion: Bonds payable................................................................. 6,000,000Contributed capital: common share conversion rights ... 107,000 Discount on bonds payable ($557,202 – $161,992) . 395,210 Common shares (810,000 shares) ............................ 5,711,790

2. On cash repayment:Bonds payable................................................................. 6,000,000Contributed capital: common share conversion rights ... 107,000Loss on bond retirement ................................................. 390,210 Discount on bonds payable ($557,202 – $161,992) . 395,210 Contributed capital: retirement of conversion option ($107,000 - $25,000) ..... 82,000

Cash ............................................................................ 6,020,000

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Assignment 14-10

Requirement 1This debenture is a compound financial instrument: part liability (bond principal and interest) and part equity (option on share value at investor’s option); the option exists because the exchange ratio is fixed.

Requirement 2The bond value:

Principal: $7,000,000 × (P/F, 4%, 20) = $7,000,000 × 0.45639 = $ 3,194,730

Interest: ($7,000,000 × 6.7% × 6/12) × (P/A, 4%, 20) = $234,500 × 13.59033 = 3,186,932

$6,381,662Cash........................................................................................ 6,950,000Discount on bonds payable ($7,000,000 - $6,381,662) ......... 618,338

Bonds payable ............................................................ 7,000,000 Contributed capital: common stock conversion

rights ($6,950,000 - $6,381,662) ........................... 568,338

Requirement 3

The amount reported as a liability will be the present value of the remaining 16 payments:Principal: $7,000,000 × (P/F, 4%, 16) = $7,000,000 × 0.53391 = $ 3,737,370

Interest: ($7,000,000 × 6.7% × 6/12) × (P/A, 4%, 16) = $234,500 × 11.6523 2,732,464

$6,469,834In equity:Common stock conversion rights (unchanged) $568,338

Requirement 4

Bonds payable ........................................................................ 7,000,000Contributed capital: common share conversion rights........... 568,338

Common shares ...................................................... 7,568,338

Requirement 5If the conversion rate were not fixed, but depended on market value at the time of conversion, then this debenture would be straight debt. Since the price of conversion was not fixed, price risk was not transferred to the investor and no option of value was created. If it were issued in the same market conditions, the issuance price would likely fall to $6,381,662. There would be a small price adjustment for the 1% differential.

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Assignment 14-11

Requirement 1

Issuance price $4,790,000Liability portion: Interest payments: ($5,000,000 × 5%) × (P/A, 6%, 5) (4.21236) = 1,053,090Equity portion $3,736,910

Requirement 2

Cash ...............................................................................................4,790,000Interest liability on bond ........................................................... 1,053,090Share equity - bond ................................................................... 3,736,910

Requirement 3

Interest:

YearBeginning balance

Interest Liab

Interest@6%

Payment Ending InterestLiability

1 $ 1,053,090 $ 63,185 $250,000 $866,2752 866,275 51,977 250,000 668,2523 668,252 40,095 250,000 458,3474 458,347 27,501 250,000 235,8485 235,848 14,152* 250,000 0

*Rounded

Requirement 4

Over the life of the bond, retained earnings may be reduced, and the equity portion of the bond increased, by $1,263,090 ($5,000,000 - $3,736,910). This increases the equity portion to par value. The charge may be annual, using an effective interest approach, or it may be in one lump sum at the bond’s maturity.

Requirement 5

At maturity, the interest liability is extinguished by virtue of the payments made. By this point, the share equity element may be measured at par value by virtue of a capital charge made to retained earnings over time. The share equity element is then extinguished and $5 million is transferred to the common share account.

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Assignment 14-12

Requirement 1

Cash............................................................................................ 500,000Discount on bonds payable ........................................................ 37,908

Bonds payable..................................................................... 500,000Contributed capital: common share conversion rights ...... 37,908


Interest@10%

Payment EndingBalance

1 $ 462,092 $ 46,209 $40,000 $468,301 2 468,301 46,830 40,000 475,131 3 475,131 47,513 40,000 482,644 4 482,644 48,264 40,000 490,908 5 490,908 49,092* 40,000 500,000

*Rounded

Contributed capital: common share conversion rights .............. 37,908Bonds payable ............................................................................ 500,000

Common shares .................................................................. 537,908

On cash repayment:Bonds payable................................................................. 500,000Contributed capital: common share conversion rights ... 37,908Loss on bond retirement ($508,000 - $482,644) ............ 25,356 Discount on bonds payable ($482,644 - $500,000).. 17,356 Contributed capital: retirement of conversion option ($32,000 - $37,908) ....... 5,908 Cash ...................................................................................... 540,000

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Requirement 2

Bond price $500,000Liability portion: Interest payments: ($500,000 × 8%) × (P/A, 8%, 5) (3.99271) = 159,708Equity portion $340,292* rounded

Initial entry:Cash .................................................................................... 500,000

Interest liability on bond ................................................ 159,708Share equity - bond ........................................................ 340,292

Interest:Note: a table is not required. The annual interest must be calculated.


Interest Liab.

Interest@8%

Payment Ending InterestLiability

1 $ 159,708 $ 12,777 $40,000 $132,485 2 132,485 10,599 40,000 103,084 3 103,084 8,247 40,000 71,331 4 71,331 5,707 40,000 37,038 5 37,038 2,962* 40,000 0

*Rounded

At maturity, the interest liability is extinguished because of the payments made. By this point, the share equity element may be measured at par value by virtue of a capital charge made to retained earnings over time or by a one-time charge at maturity. The share equity element (par) is then transferred to the common share account.

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Assignment 14-13

Requirement 1

Cash........................................................................................... 1,040,000Premium on bonds payable ($1,000,000 – $1,008,800) ..... 8,800Bonds payable ..................................................................... 1,000,000Contributed capital: detachable stock warrants .................. 31,200

Relative value:Warrants $ 32,000 3% × $1,040,000 $ 31,200Bond 1,020,000 97% × 1,040,000 1,008,800

$1,052,000 $1,040,000

Requirement 2

In substance, the two financial instruments are similar, allowing investors guaranteed money market returns along with potential to participate in capital appreciation. However, warrants can be detached from the related bond, and traded separately. They can be exercised independently of the bond itself. This is not true for the conversion rights embedded in a convertible bond.

Note that the detachable warrant is easier to value than the option, because a market develops for the warrants.

Requirement 3

Cash (1)..................................................................................... 33,600Contributed capital: detachable stock warrants ........................ 31,200

Contributed capital: lapse ($31,200 × 40%) ....................... 12,480Common shares (2) ............................................................. 52,320

(1) ($1,000,000/$1,000) = 1,000 options1,000 options × 60% = 600 exercised; 600 × $28 × 2

(2) ($31,200 × 60%) + $33,600

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Assignment 14-14

Requirement 1

a) Memorandum entry: options issued allowing purchase of 2 shares for each existing share held, purchase price set at $1.

b) Cash (12,300 × 3 × $26)................................................. 959,400Contributed capital: common share warrants outstanding ..................................................................... 110,000

Common shares ........................................................ 1,069,400

c) Contributed capital: share options outstanding* ............ 35,000Cash (10,000 × $19) ....................................................... 190,000

Common shares ........................................................ 225,000*$161,000 × (10,000 ÷ 46,000)

d) Rent expense ($4,000 × 4) ............................................. 16,000Contributed capital: share options outstanding ........ 16,000

e) Cash ................................................................................ 45,000Contributed capital: share options outstanding ........ 45,000

f) Cash (10,000 × $35) ....................................................... 350,000Contributed capital: share options

outstanding ($45,000 × 1/4) ......................... 11,250Common shares ........................................................ 361,250

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Requirement 2Shareholders’ Equity

Common shares, no-par, unlimited shares authorized,issued and outstanding, 4,600,300 shares (1) ................. $18,532,050

Contributed capital: stock options outstanding...................... 126,000Contributed capital: stock options outstanding...................... 16,000Contributed capital: stock options outstanding...................... 33,750Retained earnings (2) ............................................................. 34,544,900

Total equity .............................................................. $53,252,700

(1) Shares ValueOpening 4,543,400 $16,876,400Warrants in (b) 36,900 1,069,400Options in (c) 10,000 225,000Shares in (f) 10,000 361,250

4,600,300 $18,532,050

(2) $34,560,900 – $16,000 rent expense closed out

Requirement 3

Financing activitiesIssuance of shares for cash (3)........................................ $1,499,400Issued options for cash ................................................... 45,000

(3) See requirement 1: $959,400 + $190,000 + $350,000 = $1,499,400.

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Assignment 14-15

Requirement 1

Consulting expense (etc)................................................................. 31,000Contributed capital: stock rights outstanding.......................... 31,000

This entry should be valued at the fair value of the services rendered. Some will support the consultant’s estimate of value, and some the corporation’s; additional evidence would likely be gathered in practice. The more conservative number is chosen here. Option pricing models would only be used if the services rendered could not be valued.

Legal expense..................................................................................31,000Contributed capital: stock rights outstanding.......................... 31,000

The value of legal services rendered must be ascertained. The options should be valued based on services received. No information is available for this value. Since the two sets of options appear to be identical, the same value is used for both.

Requirement 2

Cash (4,000 × $0.20)....................................................................... 800Contributed capital: stock rights outstanding ................................. 31,000

Common shares (4,000 shares)................................................ 31,800

Note that the fair value of the shares ($56,000) is not recognized.

Requirement 3

Contributed capital: stock rights outstanding .................................31,000Contributed capital: stock rights expired................................. 35,000

Note that the company has recorded an expense but the lawyer did not end up with shares.

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Assignment 14-16

a. Cash............................................................................................. 71,200Contributed capital: stock rights outstanding.......................... 71,200

The entry is valued at the cash transaction value, which is fair value by virtue of the transaction.

b. Legal expense..............................................................................65,000Contributed capital: stock rights outstanding.......................... 65,000

Since the two sets of options appear to be identical, the same value might be used for both. However, this entry should be valued at the fair value of the services rendered. Some will support the lawyer’s estimate of value, and some the corporation’s; additional evidence would likely be gathered in practice to reconcile the two option values in a and b. The more conservative number is chosen here.

c. Operating expense .......................................................................16,000Contributed capital: stock rights outstanding.......................... 16,000

The value of services rendered is intangible, and cannot be estimated. At this point in time shares are trading for $8, and intrinsic value of $16,000 has been granted. An option pricing model should be used to incorporate expected value. Note that this is an expense of the year, because the rights vest immediately and there are no service conditions over the period before exercise.

d. Cash (2,000 × $4)........................................................................ 8,000 Contributed capital: stock rights

outstanding ($71,200 + $16,000) ...................................... 87,200Common shares (3,000 shares)($71,200 + $8,000+ $16,000) 95,200

Contributed capital: stock rights outstanding ......................................................................... 65,000Contributed capital: stock rights expired................................. 65,000

Note that the fair value of the shares is not recognized.

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Assignment 14-17

Requirement 1SARs may be issued instead of an option plan because the managers may prefer to receive additional compensation in the form of cash rather than shares. The managers may not be willing or able to buy shares and then sell them for cash, if cash is more desirable. (For example, they may not want to borrow money to buy the shares if they lack liquid resources. There may be insider trading rules that prevent selling shares at certain times, or it may not be politically acceptable for the senior management group to be selling shares. Or, there may not be a market for the shares.)

Requirements 2 and 3

Year 1 2 3 4 5Fraction 1/5 2/5 3/5 4/5 5/5

Retention 75% (6/8) 75% 75% 75% 62.5% (5/8 actual)

Value ($4) x 500,000 =$2,000,000

($1) x 500,000 =$500,000

($2) x 500,000 =$1,000,000

($17) x 500,000 =$8,500,000

($53-$34) x 500,000 =$9,500,000

Cumulative amount(Req. 3)SARs Liability

$300,000 $150,000 $450,000 $5,100,000 $5,937,500

Current balance

$0 $300,000 $150,000 $450,000 $5,100,000

Adjustment(Req.2)Compensationexpense(expense recovery)

$300,000 ($150,000) $300,000 $4,650,000 $837,500

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Requirement 4

Long-term compensation liability...................................................5,937,500Cash ......................................................................................... 5,937,500

(Note: this entry assumes that the years’ entry for expense has been made.)

Requirement 5

If the managers could take cash or shares, then a compound instrument is reflected in the financial statements. The value of the option is estimated when the plan is initiated, and is accrued over the vesting period, trued up to the retention rate. The liability portion is also recorded over the vesting period, using the same pattern as illustrated in requirements 2 and 3 above, with estimates corrected annually for fair value and retention.

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Requirement 1

20X3Compensation expense ($3 x 25,000 x 1/3 x 83%) ............................. 20,750

Long-term compensation liability.................................................. 20,75020X4Compensation expense ($12 x 25,000 x 2/3 x 80%) - $20,750 ............ 139,250

Long-term compensation liability.................................................. 139,25020X5Compensation expense (($19-$10) x 25,000 x 22/30 ) - $160,000 ...... 5,000

Long-term compensation liability.................................................. 5,00020X5 - paymentLong-term compensation liability (($19-$10) x 25,000 x 22/30 ) ........ 165,000

Cash ............................................................................................... 165,000

Requirement 2

The actual turnover in 20X4 was four people, bringing the 20X3 and 20X4 turnover to five people. An estimate of five people leaving, as was used at the end of 20X3, was lowand leaves no room for departures in 20X5. The estimate used at the end of 20X4 assumed that one more manager would leave in 20X5 and this, too, was optimistic, since two left.

Requirement 3

If the managers could take cash or shares on settlement, then a compound instrument is reflected in the financial statements. The value of the option is estimated when the plan is initiated, and is accrued over the vesting period, trued up to the retention rate. The liability portion is also recorded over the vesting period, as shown above, with estimates corrected annually for fair value and retention.

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Assignment 14-19

Requirement 1

End of year 20X1 20X2 20X3 20X4Fair value $100,000 $50,000 $110,000 ($2.90 -

$2.00) x 100,000 =

$90,000× Cumulative vesting fraction 1/4 2/4 3/4 4/4× Estimate of retention 63% 70% 75% 77.5%

(actual 31/40)

= Required balance in the liability account at year-end

$15,750 17,500 61,875 69,750; zero after payment

Opening balance 0 15,750 17,500 61,875Expense for the period (recovery)(Debit expense, credit liability)

$15,750 $1,750 $44,375 $7,875

Requirement 2

Actual turnover is seven people by the end of 20X2; turnover at the end of 20X1 had beenestimated to be 15 people. Fewer people might be expected to leave later in the vesting period, so low initial turnover is evidence to increase the retention rate.

Requirement 3

Expense is volatile because the value of the plan changes each year, retention estimates change each year, and the balance is being adjusted to a higher cumulative fraction (1/4, then 2/4 , 3/4 and 4/4) each time.

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Assignment 14-20

20X3:Compensation expense ........................................................... 15,000

Contributed capital: stock rights outstanding .................. 15,000[Amortization of ½ of $30,000 value for first year of the 2-year vesting period]

20X4:Compensation expense ........................................................... 15,000

Contributed capital: stock rights outstanding .................. 15,000[Amortization of ½ of $30,000 for the second year of the 2-year vesting period]

20X6: (partial exercise)Cash (1,000 × $60) ................................................................. 60,000Contributed capital: stock rights outstanding ($30,000 × 1,000/1,200) ................ 25,000 Common shares ................................................................ 85,000

20X8: (expiration)Contributed capital: stock rights outstanding................. 5,000 Contributed capital: share options expired............... 5,000

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Assignment 14-21

Requirement 1

20X3 – options granted; cost to be amortized over 5-year vesting period:

Compensation expense*……………………………….. 165,600Contributed capital, stock options outstanding…. 165,600

*($900,000 ÷ 5 years) = $180,000 x 92% retention

20X4:

Compensation expense*………………………………….. 147,600Contributed capital, stock options outstanding… 148,200

* $180,000 x 2 x 87% = $313,200 required balance - $165,600

20X5:

Compensation expense*…………………………………. 135,000Contributed capital, stock options outstanding… 135,000

*$180,000 x 3 x 83% = $448,200 required balance - $313,200

20X6:Compensation expense*…………………………………. 91,800

Contributed capital, stock options outstanding… 91,800*$180,000 x 4 x 75% = $540,000 required balance - $448,200

20X7:

Compensation expense*………………………………….. 171,000Contributed capital, stock options outstanding… 171,000

*$180,000 x 5 x 79% = $711,000 required balance - $540,000 (allow for rounding)

20X7 – options exercised:

Contributed capital, stock options outstanding*…………. 600,000Cash (2,000 × $110 per share × 16)………………….. 3,520,000

Common shares………………………………… 4,120,000*$711,000 x 16/19, rounded

20X8 – options lapsed:

Contributed capital, stock options outstanding*…………. 111,000Contributed capital, stock options lapsed……… 111,000

*$711,000 - $600,000

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Requirement 2

Fair value is not re-estimated each year, and the accrual is straight-line (one-fifth each year.) This should provide an equal expense each year. The volatility is caused by the different retention levels estimated each year. The cumulative balance is corrected, increasing volatility as the plan gets later into its life.

Requirement 3

Each individual who exercised received intrinsic value of $116,000 (($168 – $110) x 2,000 shares). The expense recorded was $37,500 per individual ($900,000 / 24). Note that for the options that expired, the individual received nothing, and $37,500 of expense was recorded.

Stock option accounting does not record the intrinsic value, that is, does not true up the initial measure of fair value. Instead, fair value is established at the beginning, acknowledging both the time value of money and the chance that the options will be worthless.

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Assignment 14-22

Requirement 1

Equity measurement

Equity alternative fair value, plan initiation ($21.20 × 5,000 × 5)

$ 530,000

Cash alternative fair value, plan initiation (liability)

($20 × 3,500 × 5) 350,000

Equity portion $180,000

Requirement 2

Year 1 entry Compensation expense ..............................................................170,833 Contributed capital: common share options outstanding

($180,000 x 1/3 ) ............................................................... 60,000Long-term compensation liability ($332,500 (1) x 1/3) ......... 110,833

(1) Fair value as intrinsic value,

end of year 1 ($19 × 3,500 × 5) $ 332,500

Year 2 entry Compensation expense ...............................................................217,500 Contributed capital: common share options outstanding

($180,000 x 1/3 ) .............................................................. 60,000Long-term compensation liability ($402,500 (1) x 2/3 = $268,333 less $110,833)................................................... 157,500


end of year 2 ($23 × 3,500 × 5) $ 402,500

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Year 3 entry Compensation expense ..............................................................141,667 Contributed capital: common share options outstanding

($180,000 x 1/3 ) ..................................................................... 60,000Long-term compensation liability (($ 350,000(1) x 3/3) less $268,333)..................................................................... 81,667


end of year 3 ($20 × 3,500 × 5) $ 350,000

Disbursement:

Contributed capital: common share options outstanding ...........180,000 Long-term compensation liability..............................................350,000 Cash ($350,000 x 4/5) ............................................................. 280,000

Common shares ($350,000 x 1/5) + ($180,000 x 1/5) ............ 106,000Contributed capital: lapse of options(($180,000 x 4/5).......... 144,000

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Assignment 14-23

Requirement 1

The SARs program is payable in cash, given that a liability is recorded. The employee receives the excess of common share fair market value over $52 at the exercise date.

Calculation: $8.75 x 40,000 x 80% retention x ¼ = $70,000 The option program allows the employee to buy shares, on the exercise date, at the

exercise price of $42 per share. Calculation: $700,000 x 80% retention x 3/5 = $336,000

Requirement 2

SARsCompensation expense ($9.25 x 40,000 x 2/4 x 75%) - $70,000 ......... 68,750

Long-term compensation liability.................................................. 68,750

OptionsCompensation expense ($700,000 x 4/5 x 75%) - $336,000 ........ 84,000

Contributed capital: stock rights outstanding ............................... 84,000

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Assignment 14-24

Requirement 1

20x3SARsCompensation expense.......................................................................... 84,000

Long-term compensation liability ($7 x 40,000 x 1/3 x 90%) ...... 84,000

Phantom stock planCompensation expense................................................................... 21,000

Contributed capital: share options outstanding ($14,000 x 1/3 x 90%) 4,200Long-term compensation liability ($56,000 x 1/3 x 90%)............. 16,800

OptionsCompensation expense ($260,000 / 4) x 90% ............................... 58,500

Contributed capital: share options outstanding ............................ 58,500

20x4SARsCompensation expense ($9 x 40,000 x 2/3 x 80% = $192,000) - $84,000......................................................................... 108,000

Long-term compensation liability.................................................. 108,000

Phantom stock planCompensation expense ….............................................................. 26,467

Contributed capital: share options outstanding ($14,000 x 2/3 x 80%) = $7,467 - $4,200 3,267

Long-term compensation Liability ($75,000 x 2/3 x 80%) = $40,000 - $16,800 ................ 23,200

OptionsCompensation expense ($260,000 x 2/4 x 80%) = $104,000 - $58,500 45,500

Contributed capital: share options outstanding ............................ 45,500

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20x5SARsLong-term compensation liability (($22-$16) x 40,000 x 70% =

$168,000) - $192,000..................................................................... 24,000Compensation expense.............................................................. 24,000

Long-term compensation liability......................................................... 168,000Cash ($22-$16) x 40,000 x 70% ............................................... 168,000

Phantom stock planCompensation expense...................................................................…. 32,333

Contributed capital: share options outstanding ($14,000 x 3/3 x 70%) = $9,800 - $7,467 ............ 2,333

Long-term compensation liability ($22 x 3,200) = $70,400 - $40,000............................... 30,400

Contributed capital: share options outstanding..................................... 9,800Long-term compensation liability......................................................... 70,400

Common shares ............................................................................. 80,200

OptionsCompensation expense ($260,000 x ¾ x 70% = $136,500) - $104,000 32,500

Contributed capital: stock options outstanding ............................ 32,500

Requirement 2

Short-term liability:Long-term compensation liability SARs.............................................. $192,000Long-term liability:Long-term compensation liability ($75,000 x 2/3 x 80%) ................... $40,000Equity:Contributed capital: share options outstanding ($14,000 x 2/3 x 80%) $7,467Contributed capital: share options outstanding ($260,000 x 2/4 x 80%) $104,000

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Assignment 14-25

Requirement 1

This is a futures contract. It is an obligation to buy shares at a given price and a given time. It has been done through a broker, and a margin payment is required.

Requirement 2

The company is hedging the risk that the price of the shares will be higher than $3, the current market price. They give up the possibility that they might be able to buy the shares for less than $3.

Requirement 3

InceptionDerivative instrument ............................................................ 3,000

Cash (10,000 × $3 × 10%).............................................. 3,000

Year-endDerivative instrument............................................................. 10,000

Gain on derivative instrument ($4 - $3) × 10,000 ......... 10,000

Derivative instrument ............................................................ 1,000Cash ($10,000 × 10%).................................................... 1,000

MaturityDerivative instrument ............................................................ 5,000

Gain on derivative instrument ($4.50 - $4) × 10,000..... 5,000

Investment in YCo ($4.50 × 10,000) ..................................... 45,000Cash ($30,000 - $4,000) ................................................. 26,000Derivative instrument .................................................... 19,000

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Assignment 14-26

Requirement 1

This is a forward contract. It is an obligation to buy shares at a given price and a given time. It has not been done through a broker, and no margin payment is required, so it is not a futures contract.

Requirement 2

The company is hedging the risk that the price of the shares will be higher than $62, the current market price. They give up the possibility that they might be able to buy the shares for less than $62.

Requirement 3

Inception: no entry

Year-end:Loss on derivative instrument ($54 - $62) × 5,000................ 40,000

Derivative instrument .................................................... 40,000

Maturity:Derivative instrument ............................................................ 5,000

Gain on derivative instrument ($55 - $54) × 5,000........ 5,000

Investment in YCo ($55 × 5,000) .......................................... 275,000Derivative instrument ............................................................ 35,000

Cash ($62 × 5,000) ......................................................... 310,000

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Assignment 14-27

Requirement 1

A futures contract hedges an exchange risk by creating an offsetting exchange risk. Notting Hill has US-denominated accounts receivable that will increase or decrease in value when the exchange rate for the US dollar changes. An exchange contract will create a liability, an obligation to deliver US dollars, that will change value in the opposite direction, causing a loss when the receivable causes a gain, and vica versa. At the same time, the amount to be received for US dollars, collected from the customer in the future, is set by the terms of the contract.

Requirement 2

An exchange contract is an asset when it is in the money (in a gain position) and it is a liability when it is under water (in a loss position). Changes in the exchange rates after the contract is entered into dictate its status as an asset or liability.

Requirement 3

Yes, gains and losses from derivative financial instruments are included in income. These will serve to offset gains and losses on the related hedged financial instruments. For Notting Hill, exchange contracts reported as liabilities have caused $733 of losses and exchange contracts reported as assets have caused $192 of gains. The only gains that are not included in earnings are the $43 that are recorded in the reserve account. These amounts will be recognized in earnings when the related hedged item is recognized. Note that the amounts on the SFP are cumulative amounts and the effect on any given year is the change in the SFP account.

Requirement 4

Hedge accounting allows gains and losses to be recorded in reserves until the related hedged item is recognized in the financial statements. It is voluntary, and is allowed only when there is an established strategy for risk management that involves hedging, when there is designation and documentation of the hedge relationship between two items, and the hedge is expected to be effective; this must be regularly reviewed.

Requirement 5

The most likely explanation of the hedge reserve is that customer purchase orders havebeen hedged. Purchase orders for sales denominated in US currency create economic exposure to exchange losses, which is not recognized on the books until the account receivable is booked on delivery. A derivative used to hedge this situation is recognizedin the financial statements. To deal with the mismatch, gains on the hedge are deferred until the exchange exposure from the customer account receivable is recognized.

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Assignment 14-28

Case A

Financing ActivitiesIssuance of convertible bonds (1)............................................................ $5,447,000

(1) $5,000,000 – ($234,000 + $14,000) + $695,000

Case B

Financing ActivitiesIssuance of common shares (1) ............................................................... $4,365,000

Note: bond conversion is a non-cash transaction and is not included on the CFS.

(1) Opening common shares ......................................................................... $7,100,000Bond conversion ($5,000,000 + ($1,390,000 – $695,000)......................– ($346,000 – $26,000 – $160,000)) ....................................................... 5,535,000 As calculated ........................................................................................... 12,635,000Actual ...................................................................................................... 17,000,000Issuance for cash...................................................................................... $4,365,000

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Case C

Financing ActivitiesIssuance of common shares (1) ............................................................... 140,000Issuance of common shares (2) ............................................................... 2,255,000

(1) 10,000 × $14 = 140,000

(2) Opening balance ...................................................................................... $6,550,000Exercise of rights ($140,000 + $55,000) ................................................. 195,000As calculated ........................................................................................... 6,745,000Actual ...................................................................................................... 9,000,000Issuance for cash...................................................................................... $2,255,000

Note:

On the CFS, both share issuances would likely be shown together.Rights issued as a poison pill are not recognized in the financial statements.

Case D

Financing ActivitiesRedemption of bonds..............................................................................($10,000,000)

Note: Since the bonds were redeemed at maturity, the discount must have been amortized to zero prior to maturity through a charge to earnings.

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Assignment 14-29

Requirement 1

Retained earnings, opening $ 5,940,000

Earnings 2,600,000

Stock dividend (544,000)

Share issue costs (200,300)

Cash dividend (to balance) ($790,700 total)

6% Preferred dividend – in earnings --

5% Preferred share dividend 5% ($1,600,000 – $300,000 face

value in treasury; no dividends to treasury)

(65,000)

Common ($790,700 - $65,000) (725,700)

Retained earnings, closing $7,005,000

Requirement 2

Common shares, opening $ 5,000,000

Retired shares (655,000)

Issued shares on stock dividend ($544,000-$34,000) 510,000

Issued shares under options ($50,000 cash + $40,000contributed capital) ($160,000 + $267,500 = $427,500 versus $387,500)

90,000

Issued shares for cash (to balance) 3,055,000

Common shares, closing $8,000,000

Requirement 3

Financing activities

Retirement of common shares ($655,000 - $122,000) $ (533,000)

Purchase of treasury stock ($700,000 x 2) (1,400,000)

Sale of treasury stock ($700,000 + $65,000) 765,000

Issued shares under option 50,000

Issued convertible bond payable ($4,000,000 – ($320,000 +$23,600) + $255,000) 3,911,400

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Requirement 1

a) Contributed capital: employee share options outstanding 64,000*Cash [(16,000/2) × $27.50] ............................................ 220,000 Common shares, no-par, 8,000 shares...................... 284,000*160,000 × (16,000 ÷ 40,000) = $64,000

b) Land ................................................................................. 75,000Contributed capital: common share rights outstanding............................................................... 75,000

Note: Transaction valued at the value of land received.

c) Common shares, no-par (1), 40,000 shares...................... 1,440,000Retained earnings ........................................................... 440,000 Cash ($47 × 40,000) ................................................. 1,880,000

(1) $32,940,000 + $284 ÷ (915 + 8) = $36 × 40,000

d) Treasury shares (10,000 × $44)........................................ 440,000 Cash .......................................................................... 440,000

e) Dividends, common 857,000 (1) × $1 ............................. 857,000Dividends, preferred 60,000 x $8 .................................... 480,000 Cash .......................................................................... 1,337,000

(1) 915,000 + 8,000 – 40,000 – 26,000 treasury shares

f) Preferred shares, 24,000 shares (1) .................................. 2,424,000 Common shares, 64,000 shares (24,000 × 8/3) ........ 2,424,000

(1) $6,060,000/ 60,000 = $101 × 24,000

g) Interest expense ($4,997,000 x 7.8%).............................. 389,766 Interest liability - 8% bond ....................................... 389,766Interest liability – 8% bond ($10,000,000 x 8%) ........... 800,000 Cash .......................................................................... 800,000

h) Contributed capital: common share warrants................... 660,000Cash (60,000 × $32.50).................................................... 1,950,000 Common shares, no-par, 60,000 shares (1) .............. 2,390,000 Contributed capital: lapse of warrants...................... 220,000

(1) $1,950,000 + $440,000

i) Employee stock option expense ($720,000 x ¼ x 90%)………….162,000Contributed capital: employee share options outstanding 162,000

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j) Preferred shares (10,000 × $101 (see f)).......................... 1,010,000Contributed capital on preferred share retirement (balance) 55,000Retained earnings............................................................. 5,000 Cash (10,000 × $107) ............................................... 1,070,000

k) Cash (20,000 x $32)......................................................... 640,000Retained earnings, loss on sale of treasury shares .......... 92,400 Treasury shares (1) ................................................... 732,400

(1) $512,000 + $440,000 ÷ (16,000 + 10,000) = $36.62 × 20,000

l) Stock dividends, common (1) ............................................. 3,003,000 Common shares, no-par, 96,000 shares × $30......... 2,880,000

Contributed capital: common share fractional share rights (4,100 × $30) .................................... 123,000

(1) 915,000 + 8,000 – 40,000 + 64,000 + 60,000 – 6,000 treasury shares = 1,001,000 × 10% = 100,100 shares × $30

Requirement 2

Interest liability – 8% bond ($4,997,000 +$389,766 - $800,000) $ 4,586,766Share equity - 8% bonds 5,102,000Convertible $8, no-par preferred shares ($6,060,000 – $2,424,000 – $1,010,000) 2,626,000Class A no-par common shares ($32,940,000 + $284,000 – $1,440,000 + $2,424,000 + $2,390,000 + $2,880,000) 39,478,000Employee share options outstanding 258,000 ($160,000 – $64,000 + $162,000)Common share options (non-employee) 75,000Contributed capital: common share fractional share rights 123,000Contributed capital: lapse of warrants 220,000Retained earnings ($116,300,000 + $6,200,000 (includes newly recorded expenses) – $440,000 – $857,000 – $480,000 - $5,000 – $92,400 – $3,003,000)

117,622,600Treasury shares ($512,000 + $440,000 – $732,400) (219,600)

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Financial restructuring;OLC assignments

Assignment 14-A1

Case ALoan payable ................................................................................ 300,000Interest payable ............................................................................ 56,700

Redeemable preferred shares ................................................. 356,700Cash.............................................................................................. 100,000

Common shares (assumed) .................................................... 100,000

Case BLoan payable ................................................................................ 300,000Interest payable ............................................................................ 56,700

Redeemable preferred shares ................................................. 316,000Gain on debt restructure......................................................... 40,700

Cash.............................................................................................. 200,000Common shares...................................................................... 200,000

Case CLoan payable ................................................................................ 300,000Interest payable ............................................................................ 56,700

Loan payable .......................................................................... 245,600Gain on debt restructuring...................................................... 111,100

Case DLoan payable ................................................................................ 300,000Interest payable ............................................................................ 56,700Loss on asset disposal ($410,000 – $356,700)............................. 53,300

Assets (net)............................................................................. 410,000

Note: there is no gain or loss on debt restructure as the fair value of assets equaled the book value of the loan.

Case ELoan payable ................................................................................ 300,000Interest payable ............................................................................ 56,700

Gain on asset disposal ($310,000 – $280,000) ...................... 30,000Gain on debt restructure ($310,000 – $356,700) ................... 46,700Assets (net)............................................................................. 280,000

Note that the two gains would likely be disclosed together in earnings.

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Assignment 14-A2

Wilcox CorporationStatement of financial position

1 January 20x5

Current assets (1) $150,000 Liabilities (3) $ 300,000Operational assets (2) 950,000

Share capital (5) 800,000Retained earnings (4) 0

Total assets $1,100,000 Total liabilities and equity $1,100,000

(1) $200,000 – $50,000; loss of $50,000(2) $1,300,000 – $350,000; loss of $350,000(3) $1,300,000 – $1,000,000(4) ($1,400,000 + $50,000 + $350,000) = $1,800,000 deficit reclassified(5) $1,600,000 – $1,800,000 (reclassified deficit) + $1,000,000hzzled



Assignment 14-A3

1. Accounts payable, Rodan ..................................................... 245,000Cash ($245,000 × .85) .................................................... 208,250Gain on debt restructure ................................................. 36,750

2. Demand loan payable ........................................................... 574,700Mortgage loan payable ................................................... 478,406Gain on debt restructure ................................................. 96,294

PV of new arrangement:$100,000 (P/A, 9%, 5) = $100,000 × 3.88965………… $388,965$150,000 (P/F, 9%, 6) = $150,000 × .59627………….. 89,441 $478,406

3. Mortgage loan payable .........................................................1,856,800Interest payable, mortgage loan ............................................ 24,800Accumulated amortization ...................................................1,377,000

Building .......................................................................... 2,569,000Land................................................................................ 400,000Gain on asset disposal (1)............................................... 58,000Gain on debt restructure (2)............................................ 231,600

(1) ($2,569,000 – $1,377,000 + $400,000) – $1,650,000(2) ($1,856,800 + $24,800) – $1,650,000

4. Bonds payable..................................................................... 2,500,000Interest payable, bonds ....................................................... 113,500

Bonds payable............................................................... 1,859,667Gain on debt restructure ............................................... 753,833

PV: $30,000 ................ $ 30,000$50,000 (P/A, 12%, 3) = $50,000 × 2.40183 …….. 120,092$1,000,000 (P/A, 12%, 3) (P/F, 12%, 3)

= $1,000,000 × 2.40183 × .71178 .................. 1,709,575 $1,859,667

5. Memorandum entry: 40,000 common shares issued to preferred shareholders.

6. Cash .................................................................................... 550,000Common shares (or contributed capital) ...................... 550,000

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Assignment 14-A4

Requirement 1

a) To increase allowance for doubtful accounts:Retained earnings ............................................................... 2,000

Allowance for doubtful accounts.................................. 2,000

b) To write down inventory:Retained earnings ............................................................... 50,000

Inventory ($150,000 – $100,000) ................................. 50,000

c) To write down operational assets:Retained earnings ($500,000 – $400,000).......................... 100,000

Accumulated depreciation ............................................ 100,000

d) To reduce liabilities:Current liabilities ($150,000 × 5%).................................... 7,500Long-term liabilities ($240,000 × 5%)............................... 12,000

Retained earnings ......................................................... 19,500

e) To transfer $70,000 from the preferred share account to retained earnings:Preferred shares .................................................................. 70,000


f) To transfer from common share account to retained earnings:Common shares .................................................................. 282,500*


*Computation:Debits in retained earnings $372,000Credits in retained earnings ( 89,500)Credit required to reduce to zero balance $282,500

g) Long-term debt ................................................................... 200,000Common shares ............................................................ 200,000

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Requirement 2

Norwood CorporationStatement of financial position

Immediately after Reorganization

AssetsCash................................................................................................................... $ 20,000Accounts receivable .......................................................................................... 94,000Allowance for doubtful accounts ...................................................................... (6,000)Inventory ........................................................................................................... 100,000Operational assets ............................................................................................. 800,000Accumulated depreciation................................................................................. (400,000)Land .................................................................................................................. 40,000

Total assets ................................................................................................ $648,000

Liabilities and Shareholders’ Equity

Current liabilities .............................................................................................. $142,500Long-term liabilities.......................................................................................... 28,000Preferred shares, no-par (1,000 shares)............................................................. 60,000Common shares, no-par (70,000 shares)........................................................... 417,500Retained earnings (Note A)............................................................................... 0

Total liabilities and shareholders’ equity................................................... $648,000

Note A:

On (date) the corporation completed a reorganization to eliminate the deficit in retained earnings and to achieve a more realistic accounting basis for assets, liabilities, and shareholders’ equity. Thus, the balance in retained earnings is the balance beginning with the date given above and accordingly does not reflect the entire earnings and loss history of the company.

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Solutions Manual to accompany Intermediate Accounting Volume 2, 5th edition 15-1

Chapter 15: Accounting for Corporate Income Tax

Suggested TimeCase 15-1 Software Incorporated

15-2 Deep Harbour Limited15-3 Canadian Products Limited

Assignment 15-1 Income tax allocation—two-year period................................ 1515-2 Income tax allocation—two-year period................................ 2515-3 Temporary differences ........................................................... 1515-4 Income tax allocation, alternatives (*W) ............................... 3515-5 CCA-amortization differences ............................................... 2015-6 Cumulative CCA/amortization differences............................ 3015-7 Cumulative temporary differences......................................... 3015-8 Tax calculations…………………………………………….. 2515-9 Tax calculations ..................................................................... 2015-10 Tax calculations ..................................................................... 2015-11 Tax calculations ..................................................................... 2515-12 Tax calculations ..................................................................... 2015-13 Tax calculations ..................................................................... 2015-14 Future income tax, change in tax rates (*W) ......................... 2015-15 Future income tax, change in tax rates (*W) ......................... 4015-16 Future income tax, change in tax rates................................... 3015-17 Tax calculations; change in tax rates ..................................... 3015-18 Tax calculations; change in tax rates……………………….. 3015-19 Tax calculations—tax rate change ......................................... 4015-20 Tax calculations—tax rate change ......................................... 3515-21 Tax-rate change—two-stage .................................................. 3515-22 Tax calculations ..................................................................... 3015-23 Tax calculations, rate change ................................................. 3015-24 Tax calculations, change of rate (*W) ................................... 4015-25 Tax calculations ..................................................................... 4015-26 Tax expense; comprehensive ................................................. 3515-27 Tax expense; comprehensive ................................................. 3515-28 Tax calculations, comprehensive ........................................... 5015-29 Tax calculations, comprehensive ........................................... 5515-30 Investment tax credit (appendix)............................................ 40

*W The solution to this exercise/problem in on the text Web site andin the Study Guide. The solution is marked WEB.

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15-2 Solutions Manual to accompany Intermediate Accounting Volume 2, 5th edition

Questions

1. It is common for companies to label income tax expense as a provision to cover all circumstances. When a company has a loss the entry for income tax may be a credit rather than a debit. Rather than switch from expense to benefit they use the word provision.

2. Differences between accounting and taxable income can be:

a) Temporary differences—asset or liability where accounting and tax basis are different. Where in accounting income in one period and in taxable income in another period (under tax law). Temporary differences reverse in one or more subsequent periods; they require interperiod income tax allocation.

b) Permanent differences—items which are reported on the income statement or tax return but not on both. They do not reverse; they are not subject to income tax allocation.

3 a) Straight-line versus accelerated amortization causes a temporary difference because (1) the amounts in the financial statements will differ from those in the tax return, and (2) the tax effect will reverse or turn around over the life of the asset.

b) Golf club dues cause a permanent difference because (1) the expense is recognized for accounting purposes but not for income tax purposes and (2) the differences will not reverse or turn around in any subsequent period.

4. A temporary difference is said to originate when the difference between accounting and taxable income first arises, or if it is increasing in a given direction. A reversal follows origination and causes the accumulated temporary difference to decrease.

5. Examples of permanent differences: (see also Exhibit 15-1) dividends received from taxable Canadian corporations equity earnings of significantly–influenced investees golf club dues.Examples of temporary differences: (see also Exhibit 15-1) depreciation vs CCA warranty expense vs claims paid sales revenue vs cash collected (contracts where payment is delayed) fair value gains/losses (i.e. derivatives mark-to-market) foreign exchange mark-to-market

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6. The two alternatives that exist to deal with the extent of tax allocation (i.e., the extent to which temporary differences are allowed to give rise to deferred income tax balances and tax expense):a) No allocation: Income tax expense equals tax payable or receivable and no

deferrals exist.b) Comprehensive or full allocation: All temporary differences cause future

income tax and affect tax expense.

7. The taxes payable method is sometimes called the flow-through method because the amount of taxes assessed for the current period (i.e., the taxes payable) flows throughto the income statement as an expense. Many people believe that this method is appropriate because:

a) Income tax expense reflects the cash expenditure for income tax relating to the period, thereby facilitating the cash flow prediction objective of financial reporting.

b) The resulting income tax expense mirrors the basis of determination by the government; taxes are assessed on the entity as a whole, and not on individual items as implicitly assumed under tax allocation.

c) The method avoids establishing a “liability” that in fact does not represent an amount owed to a third party (i.e., the government) at the time that the financial statements are prepared.

The taxes payable method is permitted under Canadian GAAP for private enterprises.

8. Discounting is considered inappropriate for deferred income tax liabilities because both the discount rate and the timing of reversals are difficult to determine. This is explicitly not allowed in the standards.

9. 20x4 20x5 20x6 TotalIncome tax payable .................. $60,0001 $120,000 $180,0002 $360,000Income tax expense.................. 40,0001 120,000 200,0002 360,0001($100,000 + $50,000) x .42($500,000 – $50,000) x .4

Income tax expense and income tax payable are equal over time because the temporary difference has reversed.

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10. Income tax expense ($80,000 + $20,000 – $15,000)………… 85,000Deferred income tax asset (Given) ........................................... 15,000

Deferred income tax liability (Given) .................................. 20,000Income tax payable ($200,000 x .40)................................... 80,000

11. Balance in deferred income tax: $80,000 ($200,000 x .40)

12. The accounting carrying value of the gain at the end of year 1 is $1,000,000: the receivable. The tax basis of the gain is zero, as nothing has been recognized for tax purposes. The balance in deferred income tax would be $400,000 at the end of Years 1 and 2, (a credit), $350,000 at the end of Year 3, and zero at the end of Year 4.

13. The tax basis of the assets is $900,000 ($1,000,000 - $100,000). The accounting carrying value of the assets is $800,000 ($1,000,000 - $200,000). This would result in a deferred tax asset of $20,000 (($900,000 - $800,000) x .20.)

14. Statement of financial position items have a different accounting and tax basis when their treatment is different for tax and accounting purposes. This is usually because the timing of the related revenue or expense takes place in different periods for accounting than for tax. One has to imagine a tax statement of financial position, and compare book values for tax to the accounting statement of financial position.

15. The tax basis and accounting carrying value of statement of financial position items related to permanent differences are identical.

16. Deferred income taxes may be debits or credits on the statement of financial position.

They are debits if originating temporary differences cause,

a) Tax expense to be less than accounting expenseb) Tax revenue to be more than accounting revenue.

They are credits if originating temporary differences cause,

a) Tax expense to be more than accounting expenseb) Tax revenue to be less than accounting revenue.

A debit to a future income tax account may either increase or decrease the account, depending on its nature (asset or liability/ deferred credit), as may a credit.

17. If the tax rate were to decrease when the liability method was used, the deferredincome tax account would decline, remeasured using the new tax rate.

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18. Most of the differences between effective and statutory rates are explained bypermanent differences. Another factor is different tax rates in other jurisdictions(other examples exist), when the business operates globally.

19. An investment tax credit is a reduction in tax payable that a corporation is given because of a qualifying expenditure of some type.

20. a) The flow-through approach, where the reduction to income tax payable directly reduces the tax expense and thus income for the year increases.

b) The cost-reduction approach, where the ITC is deducted from the expenditure that qualified for the ITC. Since the ITC relates to a capital asset, the ITC will end up amortized to income over a period of years.

21. An ITC that relates to a capital asset can be shown on the statement of financial position, to the extent it has yet to be depreciated, as,a) A deduction from the related asset, orb) A separate deferred credit.

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Cases

Case 15-1

Overview

This case involves a private company that is contemplating going public. They currently as using accounting standards for private enterprises and if they go public would need to switch to international accounting standards. This case includes a large number of issues. SI has a bank loan with a covenant that requires a minimum current ratio. They have a strong motivation to maintain this ratio. It is critical that recommendations are ethical and not just made to meet this ratio. With taxable losses in the current year income minimization is not a current objective.

Issues1. Revenue recognition2. Warranty3. Accounting for income tax4. Forward contract and shares5. Asset retirement obligation6. Convertible bonds7. Stock options


1. Revenue recognitionThe earliest revenue is recognized when there is performance. The fee paid by the customer includes the software, monitoring and maintenance. The fee would need to be split between the amount related to the product the software compared to the amount related to the services of monitoring and maintenance.

Performance for the software would be when it is delivered to the customer and installed. There is still a risk related to payment since the fee is due 30 days after installation. There is also a risk related to the warranty. For the portion of the fee related to the software one alternative is to recognize revenue when the software is installed and estimate bad debt and warranty expense. Since SI has been in business since the 1990’s they have historical evidence on which to make estimates. A second alternative is to recognize the revenue when the cash is received in 30 days. A third alternative would be to delay revenue recognition until the warranty expires. I recommend for the portion of the fee related to the software revenue be recognized when the software is installed since this is when performance has occured.

Performance for the service portion of the fee is over time as the service is provided over three to five years. Assuming the service would be provided on an even basis revenue should be recognized on a straight-line basis over the service period.

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If SI goes public the accounting for this issue would be similar.

2. Warranty

As mentioned above the warranty relates to the sale of the product. A warranty expense and estimated warranty liability should be recognized when revenue for the software is recognized. The liability decreases the current ratio, which is undesirable but necessary.

The estimated warranty liability for 20x9 is $12 million (8+5-1). This creates a temporary difference. Since SI uses the taxes payable method of accounting for income taxes SI will not recognize any deferred tax assets or liabilities. If SI goes public the liability method would be required. The temporary difference for SI would then be recognized as a deferred tax asset if it is probable SI will generate taxable income.

3. Accounting for income tax

SI is currently a private company and has elected to use the taxes payable method which is an option in accounting standards for private enterprises. This option will no longer be allowed if SI makes the decision to go public. They will be required to adopt the liability method that will recognize deferred tax assets and liabilities.

SI has an anticipated taxable loss of $10 million in 20x9. They will carryback the loss for the last three years and recognize an income tax receivable. The amount that they will carryback will be $2 million in 20x6, $5 million in 20x7 and $1 million in 20x8. They will recover the taxes they actually paid in those years which would be $2 million x38%=$760,000; $5 million x 39%=$1,950,000; and $1 million x 40%=$400,000 for a total of $3,110,000. There remains a taxable loss of $2 million which will be carried forward and applied against future income taxes. If SI goes public this loss would then be recognized as a deferred tax asset if it is probable SI will generate taxable income.

4. Forward contract and shares

The forward contract is a derivative. SI will need to decide if they want to elect hedge accounting or not. Since they often enter into hedging relationships it may be beneficial. If SI does not elect hedge accounting the forward contract would be measured at fair value every reporting date. The changes in value would impact net income.

The shares would be a non-strategic investment. It must be determined if these shares are quoted in an active market. If they are which is likely since they are a portfolio of investments then the shares would be measured at fair value every reporting date and the changes in value would impact net income. If the shares are for companies not traded in an active market then they would be measured at cost. If SI went public the shares would be recorded either in fair value through profit or loss or in available for sale. In both situations they would be recorded at fair value every reporting date. In fair value through

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profit and loss the changes would impact net income. Or if in available for sale the changes would impact other comprehensive income.

5. Asset retirement obligation

The satellite towers would be recorded as an item of property, plant and equipment. The regulatory obligation to dismantle the towers would be an asset retirement obligation. This would be measured at the present value of $2.5 million using an appropriate discount rate. The incremental borrowing rate of 10% would provide an asset retirement obligation of $2.5 (10%,20 years)(.14864)=$371,600. The satellite towers would be recorded at $15,371,600 and depreciated over 20 years. At the end of the first year depreciation expense would be $768,580. The asset retirement obligation would be recorded at $371,600 and accretion expense of $37,160 would be recognized at the end of the year. If SI goes public the accounting for this issue would be similar. The asset retirement obligation would be classified as a long term liability and would have no impact on the current ratio.

6. Convertible bonds

The convertible bond is a hybrid instrument. In accounting standards for private enterprises SI can assign a zero amount to the equity component. The convertible bond would all be measured as debt. The current portion of the debt would have a negative impact on the current ratio. If SI went public in international standards they would need to record the conversion rights at fair value using the incremental method in fair value through profit and loss. The debt portion would recorded at fair value and any remaining amount would be allocated to the conversion rights.

7. Stock optionsStock option expense needs to be recorded using a fair value model. The Black Scholes method would be considered an appropriate model. A decrease in the expected life of the options would decrease the stock option expense since the time period in which to exercise the options is less. A decrease in the stock price volatility would also decrease stock option expense since there it is likely the shares would be at a favourable price. A decrease in the risk free interest rate will decrease stock option expense.

Case 15-2

Assessment

Deep Harbour Limited (DHL) is a plastic molding company with a profitable past and a strong equity position ($5.7 million on total assets of $17.4 million; 33%). They have new CBC (bank) financing of $7 million this year, incurred to finance manufacturing equipment. As a result, they must adopt the tax allocation accounting method for corporate income tax and meet several ratio requirements. It is unclear if DHL is using accounting standards for private enterprise or international accounting standards. This

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must be clarified with the bank. I am assuming the bank requires international accounting policies. An equally valid assumption is that the bank would allow accounting standards for private enterprises to be used and the bank would specify which accounting policy must be applied where there is a choice as there is in income taxes. The current ratio is 1.08 in the draft financial statements and must be at least 1. The total-debt-to-equity ratio is 2.06 and must be less than 4. The current ratio is a concern, as DHL has no cash and an operating line of credit.

Issues

1. Interest capitalization2. Investment tax credit3. Warranty4. Depreciation method5. Accounting for income tax6. Current liquidity


Before income tax accounting can be applied, accounting policies must be evaluated and changed in other areas to provide a “clean” starting point.

1. Interest capitalization

DHL has capitalized interest on the new machinery for the period during which it was being installed. Interest is capitalized for qualifying assets that take a substantial amount of time for completion. Otherwise, interest is an operating cost, and is expensed as a period cost. It is hard to see how this asset has enhanced future cash flow because of delays in installation. Therefore, $35,000 of interest has been expensed. Amortization of $3,500 on the capitalized amount has been eliminated.

On the financial statements, this reduces the value of capital assets (see Exhibit 1) and reduces accounting income (Exhibit 2). Reconciliation items in the calculation of taxable income change (Exhibit 3), but changes do not affect the total taxable income.

2. Investment tax credit

The investment tax credit (ITC) is assumed to be correctly calculated, at $1,200. On the revised statement of financial position (Exhibit 2), the $1,200 receivable has been offset to income tax otherwise payable (see tax entries, Exhibit 5).

As an offset to the cost of capital assets, the ITC may be credited directly to capital assets or shown as a deferred credit. DHL has chosen the latter, which is

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acceptable. However, to eliminate the deferred credit, which would be a liability in the debt-to-equity ratio, the ITC has been netted with capital assets in Exhibit 1.

Furthermore, the ITC must be amortized over the same term as the capital assets to which it relates; that is, ten years, not four. This means that 20X8 amortization must be $120, not $300. The adjustment is $180 and the balance is $1,020.

On the financial statements, this decreases capital assets (Exhibit 1) and reduces accounting income (Exhibit 2). It changes the starting point and reconciliation items of taxable income, but not the total taxable income (Exhibit 3).

3. Warranty

Accounting policies recognize a warranty liability when it is probable and estimable. This allows the financial statements to report the financial position of the company with greater integrity, and also promotes matching on the income statement. These policies are GAAP, and likely required to satisfy the primary financial statement user, CBC. The liability decreases the current ratio, which is undesirable but necessary.

Since a range has been given, the low value is recorded at $60,000. This reflects concern that the current ratio remain over 1. Exhibit 1 reflects this liability as a current liability. Accrual has decreased net income this year (Exhibit 2). Retrospective application is not possible, as experience was not available at the beginning of the year. Taxable income starts with the revised net income, but now must be adjusted for the temporary difference. Again, the end result is no change to taxable income.

4. Depreciation method

DHL should consider its depreciation policies. Capital assets are material, and thus depreciation will impact on current earnings and net assets in significant terms.

Existing policies are acceptable and have not been changed. However, DHL should consider their policy for:

(i) Partial year amortization

A full year of depreciation is charged for assets purchased halfway through the year. DHL has recorded $820,000 of depreciation on assets used only for April to November (nine months). Half-year or exact proration could be considered.

(ii) Depreciation method

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DHL now uses straight-line amortization but may prefer declining balance, because it will decrease the book-tax difference and future income tax. This would help with the debt-to-equity ratio. It would lower total assets, too, but this may be less of a concern. If a change is made the depreciation policy must reflect the consumption of benefits for the assets not just to have a favourable ratio.

(iii) Estimates of useful life

DHL should carefully review estimates of useful life on an annual basis. Longer lives would lower depreciation and increase net assets; shorter lives would have the opposite effect.

5. Accounting for income tax

Using comprehensive income tax allocation, future income tax is established in all cases where the tax basis of assets is different than the accounting basis. DHL has three such differences:

(i) Inventory

The write-down to LCM is recorded for accounting purposes, but not for tax. It is tax-deductible only when the inventory is sold. The accounting carrying value, after write-down, is $513, but the tax basis is $40 higher, at $553. This creates a deferred tax asset of $16.8. (See Exhibit 4.)

(ii) Capital assets

Accounting carrying value is $11,738.5, after the capitalized interest and ITC are removed (see Exhibit 1) . The tax basis, after the ITC, is given at $9,100. More CCA has been charged to date than depreciation, creating a deferred tax liability of $1,108.2 (see Exhibit 4).

(iii) Warranty

The warranty liability is $60,000 on the revised statement of financial position, but the tax basis is zero as the warranty expense is not claimed for tax purposes until cash is paid. This creates a deferred tax asset of $25.2 (see Exhibit 4).

The deferred tax liability caused by the capital assets is a long-term liability. The deferred tax assets caused by current inventory and warranty are both long-termassets, classified as one element in Exhibit 1.

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To adjust DHL’s financial statements to the tax allocation method, deferredincome tax amounts are combined with income tax payable to record the expense. Note that some of this expense would impact prior years, but this breakdown has not been requested by DHL at this time. The entry to record tax is shown in Exhibit 5, and the deferred income tax amounts are reflected on the statement of financial position in Exhibit 1. Note that taxable income (Exhibit 3) did not change as a result of adjustments.

The adjustments in Exhibit 5 also show application of the ITC to the current year payable, and consideration of the $120 of current year instalment payments. A refund of $84 can be claimed because instalment payments were too high.

Note the large decrease to shareholders’ equity caused by:

(i) The current tax on 20X8 income, not recorded in the draft financial statements.

(ii) The large net deferred income tax liabilities, now recorded.

6. Current liquidity

Revised financial statements show a current ratio of .99 or close to one and a debt-to-equity ratio of 3.84. The covenant for the current ratio is just below the allowable limit of 1 and the debt to equity ratio is met, but not with any margin for comfort. DHL would be well advised to review its current position. Accounts receivable are high, as are accounts payable. Both should be reduced, beginning with collections from customers, to provide some liquidity. DHL could also consider increasing long-term debt, using capital assets as collateral, to improve the current position. If the bank allows accounting standards for private enterprises the current ratio would not be violated since the deferred tax asset would be classified as a current asset not long-term.

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EXHIBIT 1DHL—REVISED STATEMENT OF FINANCIAL POSITION

as of 30 November 20X8(in thousands)

AssetsCurrent

Accounts receivable ..................................................................... $ 2,690.0Inventory, at lower of cost or market ........................................... 513.0Prepaid expenses ($219 – $120) .................................................. 99.0Investment tax credit receivable ($1,200 – $1,200)..................... 0.0Income tax refund receivable ($84) ............................................. 84.0

3,386.0Deferred income tax ($16.8 + $25.2)....................................................... 42.0Capital assets, net of depreciation ($12,850 – $35 + $3.5) – $1,080)...... 11,738.5

$15,166.5

LiabilitiesCurrent liabilities:

Bank operating line of credit....................................................... $ 295.0Accounts payable and accrued liabilities ..................................... 3,071.0Deferred ITC ($900 – $900) ........................................................ 0.0Warranty payable ($60)................................................................ 60.0

3,426.0Long-term debt................................................................................... 7,500.0

Deferred income tax ($1,108.2) ............................................................... 1,108.2Total liabilities ........................................................................................ 12,034.2Shareholders equity ($5,706 – $271.5 (Exhibit 2) – $2,302.2)................ 3,132.3

$15,166.5

EXHIBIT 2DHL—REVISED ACCOUNTING INCOME

(in thousands)

Accounting income, as previously reported ................................ $ 2,252.0Less: Additional interest expense ............................................ (35.0)

Amortization eliminated ................................................. 3.5 (31.5)ITC amortization change ................................................. (180.0)Warranty accrual ............................................................. (60.0)

Revised net income .................................................................... $ 1,980.5

Net income has been reduced by $271.5 ($1,980.5 – $2,252)

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EXHIBIT 3DHL - REVISED TAXABLE INCOME

Accounting income (Exhibit 2).......................................................... $ 1,980.5Depreciation ($1,306 – $3.5) ................................................. 1,302.5Capital cost allowance ........................................................... (404.0)Inventory write-down to LCM ............................................... 40.0Interest capitalized ($35 – $35) (1) ........................................ 0.0Non-deductible entertainment and marketing expenses ........ 84.0Amortization of deferred investment tax credit ..................... (120.0)Warranty accrual .................................................................... 60.0

Taxable income unchanged................................................................ $ 2,943.0Income tax payable (@42%).............................................................. $ 1,236.0(1) Allowable tax expense now on the income statement.

EXHIBIT 4DHL - DEFERRED INCOME TAX BALANCES

(in thousands)

TaxBasis

Accounting Basis

Diff. DeferredIncome

Tax @ .42

OpeningBalance Adjustment

Inventory 553 1 513 40 16.8 0 16.8Capital Assets

9,100 11,738.5 2 (2,638.5) (1,108.2) 0 (1,108.2)

Warranty 0 (60) 60 25.2 0 25.21 $513 + $402 See Exhibit 1

EXHIBIT 5DHL—INCOME TAX ENTRIES, 20X8

Deferred income tax – inventory............................................ 16.8Deferred income tax – warranty ............................................ 25.2Retained earnings................................................................... 2,302.2

Deferred income tax – capital assets................................ 1,108.2Income tax payable (Exhibit 3) ........................................ 1,236.0

Income tax payable ................................................................ 1,200Investment tax credit receivable ...................................... 1,200

Income tax receivable ........................................................... 84Income tax payable ................................................................ 36

Prepaid expenses.............................................................. 120

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Case 15-3

Issues raised in the letter:

1. Probable non-reversal of temporary differences.

The president is viewing his capital assets as one amount, and points out that if assets grow indefinitely, temporary differences will not reverse. This is true. However, for each individual asset, deferred income tax does reverse by the time the asset is sold or retired. This reversal may not be visible when it is masked by new originating temporary differences from new assets. Nonetheless, the assertion that temporary differences do not reverse is simply not true.Accounts payable are repaid and replaced by new accounts payable when new inventory is bought: their relative permanence on the balance sheet is no argument that they should not be recognized.The future is uncertain. Who is to say that circumstances for this company will never change? Past growth does not guarantee future growth. Tax rules could also change to affect the rate and nature of reversals. Accounting cannot be based on uncertain future predictions.

2. Accounting standards

The president is correct in saying that using accounting standards for private enterprisesthe company's temporary differences would not have to be recognized. These standards allow the use of the taxes payable method instead of the liability method. The advantage of using international accounting policies is that CPL would be comparable to other companies using international accounting standards. If CPL is thinking of going public they would need to switch to international accounting standards.

3. Discounting

The conceptual arguments in favour of discounting are very appealing. If deferred income taxes are to be classified as a liability, then to be consistent with the accounting practices for other low-interest or non-interest-bearing debt, discounting should be used.Discounting would also have the happy effect of decreasing the size of the deferredincome tax amounts on the balance sheets. Future income would be decreased by the annual interest recognized, and the liability would grow over time because of the interest accrual.

Unfortunately, discounting is not a practical alternative. In order to be workable, the discount rate and the stream of cash payments has to be established in a relatively objective fashion. In the case of deferred income tax, the appropriate discount rate to use is not clear, and the cash flow stream is dependent on various assumptions about the reversal of temporary differences.

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Assignment 15-1

Requirement 1

Tax expense:

20x4 $ 96,000 ($240,000 × .40)20x5 240,000 ($600,000 × .40)

$ 336,000

This measurement of tax expense is potentially misleading because of its poor correlation with accounting income. The implied tax rate is 24% ($96,000/$400,000) in 20x4 and 54.5% ($240,000/$440,000) in 20x5.

Requirement 2

Tax expense: Deferred income tax:

20x4 $ 160,000 ($400,000 × .40) $64,000 credit increase; $64,000 cr. balance20x5 176,000 ($440,000 × .40) $64,000 debit decrease; $0 balance

$ 336,000

Total expense is the same because the $160,000 temporary difference between accounting and taxable income has reversed over the two-year time frame.

Assignment 15-2

Requirement 1a—Taxes payable method

20X6 20X7Income from continuing operations, before unusual item,

discontinued operation, and income tax $300,000 $250,000Gain on sale of capital assets 10,000 –Income before income tax 310,000 250,000Income tax expense* 105,000 91,000Income from continuing operations 205,000 159,000Gain from discontinued operations—net of $7,700 income tax – 14,300Net income $205,000 $173,300

* 20X6: $300,000 × 35% = $105,00020X7: ($250,000 + $10,000) × 35% = $91,000

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Requirement 1b—Comprehensive allocation method

20X6 20X7Income from continuing operations, before unusual item,

discontinued operation, and income tax $300,000 $250,000Gain on sale of capital assets 10,000 –Income before income tax 310,000 250,000Income tax expense 108,500 87,500Income from continuing operations 201,500 162,500Gain from discontinued operations—net of $7,700 income tax – 14,300Net income $201,500 $176,800

Requirement 2

Private corporations can chose to use accounting standards for private enterprises or international accounting standards. In accounting standards for private enterprises both the taxes payable method and liability method are allowed as an accounting policy for income taxes.

Assignment 15-3

a. creditb. debit c. creditd. credit e. debit f. debit

These answers are appropriate for normal circumstances.


Requirement 120x4 20x5 20x6 20x7

Revenues ...................................... $110,000 $124,000 $144,000 $164,000Expenses ...................................... (80,000) (92,000) (95,000) (128,000)Depreciation, straight line ............ (10,000) (10,000) (10,000) (10,000)Pretax accounting income (given) 20,000 22,000 39,000 26,000Temporary differences for depreciation:

Add accounting depreciation expense................................. 10,000 10,000 10,000 10,000Less capital cost allowance .... (16,000) (12,000) (8,000) (4,000)

Net temporary difference ............. (6,000) (2,000) 2,000 6,000Taxable income............................ $ 14,000 $ 20,000 $ 41,000 $ 32,000

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Computation of income tax payable:Taxable income............................ $ 14,000 $ 20,000 $ 41,000 $ 32,000Income tax rate............................. × .40 × .40 × .40 × .40Income tax payable ...................... $ 5,600 $ 8,000 $ 16,400 $ 12,800

Net income, taxes payable method20x4 20x5 20x6 20x7

Income before income tax............ $20,000 $22,000 $39,000 $26,000Income tax expense...................... 5,600 8,000 16,400 12,800

$14,400 $14,000 $22,600 $13,200

Requirement 2

Deferred income tax, balance sheetNet temporary differences (see req 1) (6,000) (2,000) 2,000 6,000Tax rate ........................................... .40 .40 .40 .40Change in period ............................. (2,400) (800) 800 2,400Cumulative balance in DIT ......... (2,400) cr. (3,200) cr. (2,400) cr. ____0

A table can also be used for calculations:Tax Carrying Temp Deferred Op. Bal. Adjustment

(in 000's) Basis Value Diff Tax20x4 40%Cap.Assets $ 24 $ 30 $(6) $ (2.4) 0 $ (2.4) 20x5 40%Cap.Assets 12 20 (8) (3.2) (2.4) (.8)20x6 40%Cap.Assets 4 10 (6) (2.4) (3.2) .820x7 40%Cap.Assets 0 0 0 0 (2.4) 2.4

Income tax expense, liability method of tax allocation:20x4 20x5 20x6 20x7

Income tax expense:Income tax payable ...................... $5,600 $8,000 $16,400 $12,800Temporary differences ................. 2,400 800 (800) (2,400) $8,000 $8,800 $15,600 $10,400

Net income, liability method of tax allocation20x4 20x5 20x6 20x7

Pretax ........................................... $20,000 $22,000 $39,000 $26,000Income tax expense...................... 8,000 8,800 15,600 10,400

$12,000 $13,200 $23,400 $15,600

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Requirement 3

The taxes payable method records tax paid as the expense, reflecting cash flow. Tax allocation methods accrue tax as income is recognized for accounting purposes, regardless of when it will be paid. Matching is well served, and deferred taxes are reflected on the statement of financial position, thus providing a more accurate portrayal of the company's financial position. Since all individual temporary differences do reverse, accrual of tax is appropriate.

Assignment 15-5

20X4 20X5 20X6 20X7Tax basis $200,000 $ 75,000 $ 0 $ 0Accounting basis $300,000 $200,000 $100,000 $ 0Temporary difference $(100,000) $(125,000) $(100,000) $ 0Deferred income tax expense $30,000 dr. $7,500 dr. $7,500 cr. $30,000 cr.Deferred income tax balance $30,000 cr. $37,500 cr. $30,000 cr. $ 0

Assignment 15-6


The depreciation pattern for each asset is as follows:

Year Book Tax1 1/3 ½2 1/3 1/33 1/3 1/6

For the asset acquired in 20X1, the book-tax depreciation and DIT balance is:

YearBook

depreciationTaxCCA

TD originating (reversing)

Accumulated TD balance

DIT liab.@30%

20X1 $30,000 $45,000 $15,000 $15,000 $4,50020X2 30,000 30,000 0 15,000 4,50020X3 30,000 15,000 (15,000) 0 0

The cost of new equipment goes up to $96,000 in 20X2 and $99,000 in 20X3. Therefore,the amount of the TD will rise proportionately for each year’s additional acquisition. The lapsing schedule for the temporary differences will appear as follows:

Cumulative balancesYear of asset acquisition 20X1 20X2 20X3

20X1 $15,000 $15,000 020X2 16,000 $16,00020X3 16,500

Requirement 1: TDs, end of year $15,000 $31,000 $32,500Requirement 2: DIT liability @ 30% $ 4,500 $ 9,300 $ 9,750

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Requirement 3

If Agnew maintains the 20X3 level of investment in equipment (in dollar terms), the temporary differences will never reverse and therefore the DIT liability will not be drawn down it will just continue to increase.

Requirement 4

In order for the accumulated timing difference to fall, the monetary investment in these assets must decline. This can happen either because (1) prices are falling, permittingmaintanence of productive capacity with a lower monetary investment, or (2) Agnew ceases to replace assets.

Requirement 5

A reversal will cause a cash outflow (through higher taxes) only if the company has taxable income during the period during which the reversals occur.

Assignment 15-7


Requirement 3 Requirement 1

Accounting basis Tax basisTemporary difference

31 December 20X3:Equipment $4,800,000 $2,200,000 $2,600,000Development costs 1,200,000 0 1,200,000

Total $6,000,000 $2,200,000 $3,800,000

Accounting basis Tax basisTemporary difference

31 December 20X4:Equipment $4,830,000† $2,940,000†† $ 1,890,000Development costs 1,000,000 0 1,000,000

Total $5,830,000 $2,940,000 $2,890,000

† Asset balance, Y/E 20X4 ($8,000,000 + $1,200,000 – $500,000) $8,700,000 Accumulated depreciation:

Beginning balance ($8,000,000 × 40%) $3,200,000Less depreciation on retired equipment ($500,000 × 40%) (200,000)20X4 depreciation

($8,000,000 + $1,200,000 – $500,000) × 10% 870,000* 3,870,000Accounting basis $4,830,000

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* Assuming full 1st-year convention, based on 40% depreciation (i.e., 10% × 4) at Y/E 20X3. Other assumptions could be used.

††Tax basisUCC beginning of 20X3 $2,200,000Assets acquired 1,200,000Assets retired (assuming no residual value, there is no net effect on UCC) —20X4 CCA = [($2,200,000 – $500,000) × 20%] + [$1,200,000 × 10%] (460,000)Tax basis, Y/E 20X4 $2,940,000

Requirement 2

Deferred income tax balance (long term):Year-end 20X3: $3,800,000 × 40% = $1,520,000 credit balanceYear-end 20X4: $2,890,000 × 40% = $1,156,000 credit balance

Requirement 4

The balance is decreasing in 20X4 because most of the existing CCA tax shield has already been used, which suggests that the $8,000,000 in equipment probably was all acquired at the same time. However, if Foster now maintains a policy of continuous equipment reinvestment and renewal, CCA again become greater than accounting amortization, causing an increase in the temporary difference and an increase in future income tax. The dollar volume of assets in the early stages of CCA will offset the volume in the later stages, thereby stabilizing the balance of temporary differences. The balance will decline again only when Foster slows its investment in new assets, due either to non-renewal or to declining prices for replacement equipment.

Assignment 15-8

Requirement One20x6

Income tax payable:Accounting income subject to tax ........................................ $750,000Permanent difference:

Golf club dues .................................................................. _35,000Accounting income subject to tax ........................................ 785,000Temporary differences:

Warranty costs accrued .................................................... 95,000Warranty costs incurred ................................................... (75,000)Depreciation..................................................................... 150,000CCA ................................................................................. (250,000)Taxable income................................................................ $705,000

Income tax payable (at 40%) ................................................ $ 282,000

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Deferred income tax:Tax Accounting Temporary Deferred tax Opening Adjustment

Basis Basis Difference Balance20x6Capital assets1,250,000 ($1,350,000) $100,000 $40,000 0 $40,000Warranty 0 (20,000) 20,000 8,000 0 8,000

Income tax expense................................................ 314,000Deferred income tax............................................... 8,000

Deferred income tax .................................. 40,000Income tax payable ................................... 282,000

Requirement Two

Income tax expense................................................ 282,000Income tax payable ................................... 282,000

Assignment 15-9

Requirement 1

a. Permanent difference, $16,000. The expense will never be tax deductible.b. Permanent difference, $700,000. Revenue will never be taxable.c. Temporary difference, $260,000. Total book and tax revenue are identical, only

timing is different.d. Capital gain of $960,000 total: 50% temporary difference, $480,000; and 50%

permanent difference, $480,000. The temporary difference will reverse in 20X6.

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Requirement 2

Income tax expense (4) .......................................... 174,400Deferred income tax (3) ......................................... 104,000

Deferred income tax (2) ............................. 192,000Income tax payable (1)............................... 86,400

(1) Accounting income $ 1,600,000Permanent differences:

Golf club dues 16,000Investment income (700,000)Gain on land (480,000)

Accounting income subject to tax 436,000Temporary differences:

Gain on land disposal (480,000)Estimated expense 260,000

Taxable income $ 216,000Income tax payable (40%) $ 86,400

(2) ($480,000) × .40 = $192,000 Cr.(3) $260,000 × .40 = $104,000 Dr.(4) $86,400 + $192,000 – $104,000 = $174,400 Dr.

Requirement 3

Statement of Financial PositionNon-current assets

Deferred tax asset................................. $104,000Current liability Income tax payable .............................. $86,400Non-current liabilities

Deferred tax liability ............................ $192,000Income statement

Income tax expense– current ............... $ 86,400– deferred ............. 88,000

Total income tax expense..................... $174,400

Assignment 15-10

Requirement 1

This is a temporary difference because the rent revenue is reported for accounting purposes in 20x4 and 20x5, but the full amount is included in 20x4 as taxable income. The $2,400 amount ($400 per month × 6 months) is an adjustment that will reverse in 20x5, and gives rise to a deferred income tax debit.

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Requirement 2

At the end of 20x4, the accounting basis for unearned rent is $1,200. The tax basis is zero; $1,200 less $1,200 to be taxable in future periods.

Requirement 3

20x4:Pre-tax accounting income..................................................... $150,000Temporary differences:

Advance collection of rent ............................................. 1,200Taxable income...................................................................... 151,200Tax rate .................................................................................. × .40Income tax payable ................................................................ $60,480Deferred income tax debit, 31 December 20x4 ($1,200 × .4) $480

Computation of income tax expense:Income tax payable ........................................................ $60,480Increase in deferred income tax debit ............................ (480)Income tax expense in 20x4........................................... $60,000

The journal entry to record income tax for 20x4 is:

Income tax expense................................................................ 60,000Deferred income tax............................................................... 480

Income tax payable ........................................................ 60,480

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20x5:

Pre-tax accounting income..................................................... $92,000Temporary differences:

Advance collection of rent ............................................. (2,400)Taxable income...................................................................... 89,600Tax rate .................................................................................. × .40Income tax payable ................................................................ $35,840Deferred income tax debit, 31 December 20x5 ..................... $0

Computation of income tax expense:Income tax payable ........................................................ $35,840(Increase) decrease in deferred income tax debit ........... 960Income tax expense in 20x5........................................... $36,800


Income tax expense......................................................................... 36,800Deferred income tax ................................................................ 960Income tax payable .................................................................. 35,840

Requirement 4

Partial statement of profit and loss 20x4 20x5

Accounting income before income tax ...................................... $150,000 $92,000Income tax expense – current ................................................... 60,960 35,840

– non-current ............................................ (960) 960 60,000 36,800

Net income................................................................................. $90,000 $55,200

Requirement 520x4 20x5

Statement of Financial Position:Non-current assets

Deferred income tax..................................................... $960 0

Assignment 15-11

Requirement 1 Unearned rent Warranty

Accounting carrying value, 20x5 (both liabilities) ............... $45,000 $32,000Tax basis, 20x5 .................................................................... 0 0

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Accounting and tax basis for both would be zero at the end of 20x6.


Income tax payable:Accounting income subject to tax ........................................ $100,000 $115,000Permanent difference:

membership dues ............................................................. _ _ ____ 40,000Accounting income subject to tax ........................................ 100,000 155,000Temporary differences:

Unearned rent revenue ..................................................... 45,000 (45,000)Warranty expense............................................................. 32,000 (32,000)

Taxable income..................................................................... $177,000 $ 78,000Income tax payable (at 30%) ................................................ $ 53,100 $ 23,400

Deferred income tax:Tax Accounting Temporary Deferred Opening Adjustment

Basis Basis Difference tax Balance20x5 Unearned revenue 0 ($45,000) $45,000 $13,500 0 $13,500Warranty 0 (32,000) 32,000 9,600 0 9,60020x6 Unearned revenue 0 0 0 0 13,500 (13,500)Waranty 0 0 0 0 9,600 (9,600)

Income tax expense:Income tax payable ............................................................... $53,100 $23,400Deferred income tax:

Related to rent revenue ($30,000 × 30%) ........................ (13,500) 13,500Related to warranty ($24,000 × 30%).............................. (9,600) 9,600

Income tax expense............................................................... $30,000 $46,500

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Income tax expense......................... 30,000 46,500Deferred income tax ……............... 23,100 23,100

Income tax payable...................... 53,100 23,400

Requirement 4

Statement of Profit and Loss: 20x5 20x6Revenues............................................................................... $740,000 $800,000Expenses ............................................................................... 640,000 685,000Income before tax ................................................................. 100,000 115,000Less: income tax expense (current portion, $53,100 in

20x5 and $23,400 in 20x6) ............................................. 30,000 46,500Net income............................................................................ $ 70,000 $ 68,500

Requirement 5

Statement of Financial PositionNon-current asset: 20x5 20x6

Deferred income tax asset ................................................ 23,100 None

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Assignment 15-12

Tax calculations:20x1 20x2 20x3

Accounting income before income tax .................. $500,000 $600,000 $540,000Temporary difference:

Revenue recognized ................................... (60,000) (200,000) –Cash received ............................................. – 50,000 100,000

Taxable income...................................................... 440,000 450,000 640,000Tax rate ...................................................... 40% 40% 38%

Current income tax ................................................ $176,000 $180,000 $243,200


Basis Basis Difference tax Balance20x1 Account receivable 0 $60,000 ($60,000) ($24,000) 0 ($24,000)20x2 Account receivable 0 210,000 (210,000) (84,000) (24,000) (60,000)20x3 Account receivable 0 110,000 (110,000) (41,800) (84,000) 42,200

Journal entry for 20x1Income tax expense.......................................................... 200,000

Deferred income tax liability ............................... 24,000Income tax payable .............................................. 176,000

Journal entry for 20x2Income tax expense.......................................................... 240,000

Deferred income tax liability ............................... 60,000Income tax payable .............................................. 180,000

Journal entry for 20x3Income tax expense.......................................................... 201,000Deferred income tax liability ........................................... 42,200

Income tax payable .............................................. 243,200

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Assignment 15-13

Tax calculations:20x5 20x6

Accounting income before income tax ...................... $ 145,000 $ 160,000Less permanent difference – equity in sub earnings .. (22,000) (40,000)Accounting income subject to tax.............................. 123,000 120,000Temporary differences:

Amortization expense .................................... 40,000 40,000CCA ............................................................... (34,000) (44,000)

Taxable income.......................................................... $ 129,000 $ 116,000Tax rate .......................................................... 36% 38%

Current income tax .................................................... $ 46,440 $ 44,080

Tax Tax Accounting Temporary Deferred Opening AdjustmentBasis Basis Difference tax Balance

20x5Capital asset 366,000 360,000 6,000 2,160 0 2,16020x6Capital asset 322,000 320,000 2,000 760 2,160 1,400

Journal entry for 20x5Income tax expense.................................................... 44,280Deferred income tax asset .......................................... 2,160

Income tax payable ........................................ 46,440

Journal entry for 20x6Income tax expense.................................................... 45,480

Deferred income tax asset .............................. 1,400Income tax payable ........................................ 44,080

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Income tax payable:20x4 20x5 20x6

Accounting income .............................................. $550,000 $123,000 $310,000Temporary difference........................................... (300,000) 150,000 150,000Taxable income.................................................... 250,000 273,000 460,000Tax rate ................................................................ .30 .35 .42Income tax payable .............................................. $75,000 $95,550 $193,200

Income tax expense:20x4 20x5 20x6

Income tax payable (above) ................................. $75,000 $95,550 $193,200Change in deferred income tax

See calculations, below.................................. 90,000 (37,500) (52,500)Income tax expense.............................................. $165,000 $58,050 $140,700

Deferred income tax liability balance .................. $ 90,000 cr. $52,500 cr. None


Basis Basis Difference Tax Balance20x4 Accounts receivable 0 $300,000 ($300,000) ($90,000) 0 ($90,000)20x5 Accounts receivable 0 150,000 (150,000) (52,500) (90,000) 37,50020x6 Accounts receivable 0 0 0 0 (52,500) 52,500

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Requirement 1

This is a temporary difference because (a) pretax accounting income and taxable income are different for each year, and (b) the difference will reverse in subsequent years.

Requirement 220x4 20x5 20x6 20x7

Accounting net book value $90,000 $60,000 $30,000 $0Tax basis (UCC) 72,000 36,000 12,000 0

Requirement 3

Accounting and taxable income 20x4 through 20x7:20x4 20x5 20x6 20x7

Pretax income (excluding depreciation) ..... $60,000 $80,000 $70,000 $70,000Depreciation................................................ 30,000 30,000 30,000 30,000Income before tax........................................ 30,000 50,000 40,000 40,000Add back depreciation ................................ 30,000 30,000 30,000 30,000Deduct depreciation for tax purposes (given):

20x4........................................................ $(48,000)20x5........................................................ $(36,000)20x6........................................................ $(24,000)20x7........................................................ _____ _____ _____ $(12,000)

Taxable income........................................... 12,000 44,000 46,000 58,000Tax rate ....................................................... 30% 30% 40% 40%Income tax payable ..................................... $ 3,600 $13,200 $18,400 $23,200

Income tax expense:Income tax payable................................. $ 3,600 $13,200 $18,400 $23,200Change in deferred income tax............... 5,400 1,800 0 (7,200)Income tax expense ................................ $9,000 $15,000 $18,400 $16,000

Tax Accounting Temporary Deferred Opening AdjustmentBasis Basis Difference Tax Balance

20x4 Capital asset $72,000 $90,000 $(18,000) $(5,400) $0 $(5,400)20x5Capital asset $36,000 $60,000 (24,000) (7,200) $(5,400) (1,800)20x6 Capital asset $12,000 $30,000 (18,000) (7,200) (7,200) 020x7 Capital asset 0 0 0 0 (7,200) 7,200

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Journal entries

20x4 20x5 20x6 20x7Income tax expense 9,000 15,000 18,400 16,000

Deferred income tax 5,400 1,800 -- 7,200Income tax payable 3,600 13,200 18,400 23,200

Statement of Financial PositionLong-term liabilities:Deferred income tax liability$5,400 $7,200 $7,200 None

Assignment 15-16


Accounts receivableAccounting basis (accounts receivable per books) ............... $500,000 $200,000Tax basis [$500,000 (or $200,000) less amount

to be taxed in the future] .................................................. 0 0Warranty liability

Accounting basis (20x5 expense of $150,000, paid in 20x6) 0 $150,000Tax basis ($150,000 less amount to be deducted

in the future)..................................................................... 0 0The income tax rate at 31 December 20x4 was 40% ($200,000/$500,000)

Requirement 2 20x5Pretax accounting income .............................................................................. $650,000Temporary differences:

Revenue collected................................................................................... 300,000Warranty expenses.................................................................................. 150,000

Taxable income.............................................................................................. 1,100,000Tax rate .......................................................................................................... × .35Income tax payable ........................................................................................ $385,000

Income tax expense:Income tax payable ........................................................................................ $385,000Change in deferred tax:

Accounts receivable................................................................................ (130,000)Warranty liability.................................................................................... (52,500)

Income tax expense........................................................................................ $202,500

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Tax Accounting Temporary Deferred tax Opening AdjustmentBasis Basis Difference (Liab)/Asset Balance

@35% (given)20x5Accounts receivable 0 200,000 (200,000) (70,000) (200,000) 130,000Warranty 0 (150,000) 150,000 52,500 0 52,500


Income tax expense ......................................................................... 202,500Deferred income tax liability—receivable ....................................... 130,000Deferred income tax asset—warranty ............................................. 52,500

Income tax payable ................................................................... 385,000

Requirement 3Deferred income tax asset ................................................................ $52,500Deferred income tax liability ........................................................... $70,000

Assignment 15-17

Calculation of taxable income/tax payable

Accounting income ............................................................ $170,000Non-deductible expenses ................................................... 42,000Dividend revenue ............................................................... (12,000)Depreciation....................................................................... 75,000CCA ................................................................................... (99,000)Warranty expense............................................................... 39,000Warranty claims paid ......................................................... (51,000)Taxable income.................................................................. $164,000Tax payable (41%) ............................................................. $ 67,240

DIT Table (in thousands)

TaxBasis

CarryingValue

Temp.Diff.

Deferredtax


Capital assets

$1,351 1 $1,675 2 $(324) $(132.84) $(120) $(12.840)

Warranty 0 (28) 3 28 11.480 16 (4.520)

1 $1,450 – $992 $1,750 – $753 $40 + $39 – $51

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Entry

Tax expense ............................................................................. 84,600Deferred income tax—Warranty............................................ 4,520Deferred income tax —Capital assets.................................... 12,840Tax payable ............................................................................ 67,240

Assignment 15-18

Requirement 1

Calculation of taxable income/tax payable

Accounting income ............................................................ $1,600,000Non-deductible expenses ................................................... 22,000Depreciation....................................................................... 200,000CCA ................................................................................... (300,000)Warranty expense............................................................... 90,000Warranty claims paid ......................................................... (60,000)Taxable income.................................................................. $1,552,000Tax payable (40%) ............................................................. $ 620,800


TaxBasis

CarryingValue

Temp.Diff.

Deferred tax


Capital assets

$680 1 $1,180 2 $(500) $(200) $(182) $(18)

Warranty 0 (40) 3 40 16 20 (4)

1 $980 – $3002 $1,380 – $2003 $10 + $90 – $60

Entry

Tax expense ............................................................................. 642,800Deferred income tax—Warranty............................................ 4,000Deferred income tax —Capital assets.................................... 18,000Tax payable ............................................................................ 620,800

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Requirement 2

a. Deferred income tax asset $ 16,000b. Deferred income tax liability 200,000c. Estimated warranty liability 40,000d. Capital assets (NBV) 1,180,000e. Capital assets (UCC) 680,000

Assignment 15-19

Requirement 1

The golf club dues are a permanent difference because they are not tax deductible and therefore will never reverse. The rent revenue and warranty costs are temporary differences because both will be reported on the income statements and tax return, although in different periods.

Requirement 2

a) Income tax payable: 20x4 20x5Pretax income before permanent and timing differences ........ $38,000 $56,000

Add permanent difference (not tax deductible) .................. 20,000 20,000Accounting income subject to tax ........................................... 58,000 76,000Timing differences:

Rent revenue collected in advance...................................... 20,000 (20,000)Warranty costs..................................................................... 16,000 _ ____

Taxable income (given) ........................................................... 94,000 56,000Computation of income tax payable:Income tax rate ........................................................................ × .38 × .40Income tax payable .................................................................. $35,720 $ 22,400


Income tax expense:Current income tax expense .................................................... $35,720 $ 22,400Deferred income tax expense................................................... (13,680) 7,280

$22,040 $29,680

Balance in deferred income tax:Non-current ......................................................................... 13,680 dr 6,400 dr

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Tax Accounting Temporary Deferred tax Opening AdjustmentBasis Basis Difference (Liab)/Asset Balance Dr.(Cr.)

20x4 – 38%Rent 0 ($20,000) $20,000 $7,600 0 $7,600Warranty 0 ( 16,000) 16,000 6,080 0 6,080

20x4 Y/E Balance 13,680

20x5 – 40%Rent drawdown 0 0 0 0 7,600 (7,600)Rate adj.–warranty 0 (16,000) (16,000) 6,400 6,080 320

20x5 Y/E balance $7,280

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Assignment 15-20

Requirement 1

Year 1 Year 2 Year 3 Year 4Pretax accounting income ............... $58,000 $70,000 $80,000 $88,000Prepaid expense .............................. (30,000) 10,000 10,000 10,000Taxable income (given) .................. 28,000 80,000 90,000 98,000Tax rate ........................................... 30% 35% 40% 40%Income tax payable ......................... $ 8,400 $28,000 $36,000 $39,200

Requirement 2

Income tax payable ......................... $ 8,400 $28,000 $36,000 $39,200Change in deferred income tax

See schedule, below .................. 9,000 (2,000) (3,000) (4,000) $17,400 $26,000 $33,000 $35,200


Year 1 – 30%Ppd expense $0 $30,000 ($30,000) ($9,000) 0 ($9,000)Year 2 – 35%Ppd expense 0 20,000 ( 20,000) ( 7,000) ( 9,000) 2,000Year 3 – 40%Ppd expense 0 10,000 ( 10,000) ( 4,000) ( 7,000) 3,000Year 4 – 40%Ppd expense 0 0 0 0 ( 4,000) 4,000

Requirement 3

Under the liability method, the effect of a change in tax rate on existing deferred income tax balances is reflected in income when the tax rate changes. This can distort income tax expense and earnings, but it does reflect the events of the year (change in rate) during the year.

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Assignment 15-21

Requirement 1

20X5 20X6 20X7Net income before tax $200,000 $220,000 $250,000Permanent differences 8,000 10,000 6,000Net income subject to tax 208,000 230,000 256,000Temporary differences (44,000) (50,000) (52,000)Taxable income 164,000 180,000 204,000

tax rate 40% 34% 30%Current income tax $ 65,600 $ 61,200 $ 61,200

Temporary differences 44,000 50,000 52,000tax rate 40% 34% 30%

17,600 17,000 15,600Adjustments for rate changes:

($500,000 + $44,000) × (40% – 34%) (32,640)($544,000 + $50,000) × (34% – 30%) (23,760)

Deferred income tax 17,600 (15,640) (8,160)Income tax expense $ 83,200 $ 45,560 $ 53,040

Requirement 2

If the reduced rates for 20X6 and 20X7 had been enacted in 20X5, the lower future rates would be used to calculate the deferred income tax expense for 20X5. This would require estimating the years in which the temporary differences will reverse. If no reversals are expected, then the furthest known future tax rate (i.e., 20X7) would be used both for reducing the beginning balance for 20X5 and for recording the increases in temporary differences in each year. The rate reduction is recorded when it becomes enacted.

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Assignment 15-22

Requirement 1Income tax payable: Year 1 Year 2Accounting income $1,500,000 $ 1,750,000Permanent difference:

Entertainment 55,000 —Temporary difference:

Depreciation 120,000 120,000CCA (67,000) (370,000)Warranty expense 257,000 287,000Warranty claims (174,000) (242,000)

Taxable income $1,691,000 $1,545,000Income tax payable (rate 38%; 40%) $ 642,580 $ 618,000

Requirement 2Year 1 Year 2

Income tax payable (see Req.1) .... $642,580 $618,000Change in future tax:

Depreciation vs CCA (1) .......... (20,140) 58,660Warranty................................... (31,540) (19,660)

Income tax expense....................... $590,900 $657,000


Year 1 38%Cap. assets $893 $840 $53 $20.14 0 $20.14Warranty 0 (83) 83 31.54 0 31.54Year 2 40%Cap. assets 523 720 (197) (78.80) 20.14 (98.94)Warranty 0 (128) 128 51.20 31.54 19.66

Entries:Year 1

Income tax expense................................ 590,900Deferred income tax-warranty ............... 31,540Deferred income tax-capital assets ........ 20,140

Income tax payable......................... 642,580

Year 2Income tax expense................................ 657,280Deferred income tax–warranty............... 19,660

Deferred income tax–capital assets 98,940Income tax payable......................... 618,000

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Assignment 15-23

Year 1Accounting income $2,000,000Depreciation expense 300,000CCA (180,000)Warranty expense 400,000Warranty payments (160,000)Taxable income $2,360,000

Journal entry for Year 1:

Income tax expense 720,000Deferred income tax – Capital assets 43,200Deferred income tax – Warranty liability 86,400

Income tax payable ($2,360,000 × 36%) 849,600

DIT table:Temporary Deferred tax Less Adjustmentdifference asset beginning for current

Tax Carrying deductible (liability) balance yearbasis value (taxable) yr.-end dr. (cr.) dr. (cr.)

Capitalassets 1,620,000 1,500,000 120,000 43,200 — 43,200

Warrantyliability — (240,000) 240,000 86,400 — 86,400

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Year 2

Accounting income $2,400,000Entertainment expense 50,000Accounting income subject to tax $2,450,000Depreciation expense 300,000CCA (324,000)Warranty expense 500,000Warranty payments (440,000)Taxable income $2,486,000

Journal entry for year 2:

Income tax expense 923,800Deferred income tax – Warranty liability 27,600

Deferred income tax – Capital assets 6,720Income tax payable ($2,486,000 × 38%) 944,680

DIT table:Temporary Deferred tax Less Adjustmentdifference asset beginning for current

Tax Carrying deductible (liability) balance yearbasis value (taxable) yr.-end dr. (cr.) dr. (cr.)

Capitalassets 1,296,000 1,200,000 96,000 36,480 43,200 (6,720)

Warrantyliability — (300,000) 300,000 114,000 86,400 27,600

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Assignment 15-24 (WEB)20x3 20x4 20x5

Net income before tax .......................................... $75,000 $ 90,000 $80,000Timing differences:

Warranty: expense.......................................... 60,000tax deduction................................ (15,000) (20,000) (25,000)

Franchise: accounting fee revenue ................. (90,000)fees for tax purposes .................... 9,000 51,000 30,000

Taxable income.................................................... $39,000 $121,000 $85,000Income tax payable (38%, 40%, 45%)................. $14,820 $48,400 $38,250Income tax expense:

Income tax payable ........................................ $14,820 $48,400 $38,250Change in deferred income tax (see schedule) 13,680 (11,680) (2,000)

Income tax expense.............................................. $28,500 $36,720 $36,250

Deferred income tax:Tax Accounting Temporary Deferred tax Opening Adjustment

Basis Basis Difference (Liab)/Asset Balance20x3 (38%)Warranty $0 ($45,000) $45,000 $17,100 $0 $17,100Franchise 0 81,000 (81,000) (30,780) 0 (30,780)

(13,680)20x4 (40%)Warranty 0 (25,000) 25,000 10,000 17,100 (7,100)Franchise 0 30,000 (30,000) (12,000) (30,780) 18,780

11,68020x5 (45%)Warranty 0 0 0 0 10,000 (10,000)Franchise 0 0 0 0 (12,000) 12,000

2,000Entries:20x3 Income tax expense ................................. 28,500

Deferred income tax—warranty............... 17,100Deferred income tax—franchise.......... 30,780Income tax payable .............................. 14,820

20x4 Income tax expense ................................. 36,720Deferred income tax—franchise .............. 18,780

Deferred income tax—warranty .......... 7,100Income tax payable .............................. 48,400

20x5 Income tax expense.................................. 36,250Deferred income tax—franchise .............. 12,000 Deferred income tax—warranty.............. 10,000 Income tax payable ............................. 38,250

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Assignment 15-25

Requirement 1

A. Grossery Ltd.Partial Statement of Profit and Loss 20x4

Income from operations, before income tax ........................... $90,000Income tax expense:

Current ............................................................................. $ 27,861Deferred ........................................................................... 16,139 44,000

Net income.............................................................................. $46,000

Statement of financial position presentation:

Income tax payable (current liability; $27,861 × 25).............. $ 6,965

Deferred income tax liability (long-term liability).................. $16,139

Cash flow statement:Operating activities:

Cash paid for income tax ($27,861 × 75) ........................ $(20,896)

Supporting schedules:Income tax payable:Net operating income before tax............................................. $90,000Plus: permanent difference; golf club dues............................ 20,000Accounting income subject to tax........................................... 110,000Temporary differences:

Depreciation expense....................................................... $50,000Capital cost allowance ..................................................... (80,000)Pension expense............................................................... 44,747Pension funding ............................................................... (48,395)Lease amortization/interest .............................................. 14,300Lease payments................................................................ (21,000) (40,348)

Taxable income from operations ............................................ $ 69,652

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Income tax expense on ordinary income:Income tax payable ($69,652 × 40%) ..................................... $ 27,861Future income tax ($40,348 × 40% or

see table) .......................................................................... 16,139Income tax expense................................................................. $44,000

(in 000’s)Tax

BasisAccounting

BasisTemporaryDifference

DeferredTax Liability

OpeningBalance

Adjustment

Cap. assets

$570 $600 $(30.000) $(12.000) $0 $(12.000)

Pension 0 3.648 (3.648) (1.459) 0 (1.459)Lease 0* 6.700* (6.700) (2.680) 0 (2.680)

(16.139)

* Tax and accounting basis are given in the question. The accounting basis would be the net difference between the leased asset and lease liability, neither of which are recognized for tax purposes.

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Assignment 15-26

Taxable income/tax payable:Accounting income ........................................................... $1,200,000Non-deductible expenses ................................................... 22,000Depreciation....................................................................... 240,000CCA ................................................................................... (300,000)Collection............................................................................ 300,000Taxable income.................................................................. $1,462,000Tax payable @ 38%........................................................... $ 555,560

DIT TableTax

BasisAccounting NBV

TemoraryDifference [email protected]

OpeningBalance Adj.

AR 0 150,000(1) (150,000) (57,000) (180,000) 123,000

Capital assets 2,260,000(2) 3,460,000(3) (1,200,000) (456,000) (456,000) (0)

The tax rate in 20X8 was 40% ($180,000 ÷ $450,000).(1) $450,000 – $300,000(2) 20X8 DIT = $456,000; $456,000 ÷ 40% = $1,140,000 gross difference

NBV was $3,700,000; $3,700,000 – $1,140,000 = $2,560,000$2,560,000 – $300,000 = $2,260,000

(3) $3,700,000 – $240,000 = $3,460,000

Requirement 1

Tax expense ........................................................................... 432,560Deferred income tax............................................................... 123,000

Income tax payable .......................................................... 555,560

Requirement 2

Income tax payable ...................................................................... $555,560Deferred income tax (non-current liability) (See column 4 )....... $513,000

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mailto:[email protected]



Assignment 15-27

Calculation of taxable income/tax payable20X9

Accounting income …………………. $175,900Dividend revenue……………………. (16,000)Entertainment exp. – not deductible… 30,000Depreciation…………………………. 63,000CCA…………………………………. (50,000)Warranty expense…………………… 71,400Warranty claims paid………………... (71,400)LT Receivable………………………. 42,000Taxable income……………………… $244,900Tax payable@38%............................... 93,062


Taxbasis

AccountingNBV

Temporary difference

Deferredincome

tax @38%

Openingbalance

Adust.

Capital Assets 430 732 (302) (114.76) (110.250) (1) (4.510)Warranty 0 (49) 49 18.62 17.150 (2) 1.470LT Receivable 0 78 (78) (29.64) (42.000) (3) 12.360

(1) $795 – $480 = $315 × 35% = $110.250(2) $49 × 35%(3) $120 × 35%

Entry:Tax expense ................................................................................ 83,742Deferred income tax – warranty................................................... 1,470Deferred income tax – LT receivable .......................................... 12,360

Deferred income tax – capital assets ............................... 4,510Tax payable ...................................................................... 93,062

Requirement 1Income tax expense is $83,742

Requirement 2Non-current asset

Deferred income tax …………………………………… $18,620Current liability

Income tax payable………………………………….. $93,062Non-current liability

Deferred income tax($114,760 + $29,640)……………..$144,400

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Assignment 15-28

20x1 20x2 20x3Net income before tax .......................................... $100,000 $100,000 $100,000Permanent differences:

Dividend income............................................ (2,000) (2,000) (3,000)Accounting income subject to tax ....................... 98,000 98,000 97,000Temporary differences

Warranty expense........................................... 3,000 3,000 3,000Warranty costs................................................ (1,000) (4,000) (3,000)Depreciation ................................................ 10,000 10,000 12,000CCA ............................................................... (25,000) (15,000) (7,000)Pension expense ............................................. 5,000 7,000 10,000Pension funding ............................................. (7,000) (8,000) (9,000)

Total temporary differences ..................... (15,000) (7,000) 6,000Taxable income.................................................... $ 83,000 $ 91,000 $103,000Tax rate ................................................................ 40% 44% 48%Income tax payable .............................................. $ 33,200 $ 40,040 $ 49,440

Income tax expense:Income tax payable .............................................. $ 33,200 $ 40,040 $ 49,440Change in deferred income tax (see schedule) .... 6,000 3,680 (2,000)Income tax expense.............................................. $ 39,200 $ 43,720 $ 47,440

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TaxBasis

Accounting Basis

Temp.Difference

DeferredIncome Tax

OpeningBalance

Adjustment

20x1 – 40%Warranty $0 ($2,000) $2,000 $800 $0 $800Capital Assets 95,000 110,000 (15,000) (6,000) 0 (6,000)Pension 0 2,000 (2,000) (800) 0 (800)

(6,000)20x2 – 44%Warranty $0 ($1,000) $1,000 $440 $800 ($360)Capital Assets 80,000 100,000 (20,000) (8,800) (6,000) (2,800)Pension 0 3,000 (3,000) (1,320) (800) (520)

(3,680)20x3 – 48%Warranty $0 ($1,000) $1,000 $480 $440 $40Capital Assets 73,000 88,000 (15,000) (7,200) (8,800) 1,600Pension 0 2,000 (2,000) (960) (1,320) 360

2,000

Entries20x1

Income tax expense................................................................ 39,200Deferred income tax – warranty ............................................ 800

Deferred income tax – capital assets................................. 6,000Deferred income tax – pension ........................................ 800Income tax payable ........................................................... 33,200

20x2Income tax expense................................................................ 43,720

Deferred income tax – warranty........................................ 360Deferred income tax – capital assets................................. 2,800Deferred income tax – pension ........................................ 520Income tax payable ........................................................... 40,040

20x3Income tax expense................................................................ 47,440Deferred income tax – capital assets ..................................... 1,600Deferred income tax – pension ............................................. 360Deferred income tax – warranty ............................................ 40

Income tax payable ........................................................... 49,440

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Assignment 15-29

Requirement 1 20x1 20x2

Income tax payable (A)....................... $206,800 cr $473,340 crDeferred income tax liability(B) 611,200 cr 560,700 crDeferred income tax liability(C) 18,000 dr 22,260 dr

Calculations:

(A) Income tax payable: 20x1 20x2

Net income………………............... $625,000 $916,000Permanent differences:

Golf dues.................................... 8,000 9,000Tax penalties.............................. 3,000 1,000

Temporary differencesWarranty expense...................... 22,000 41,000Warranty claims paid................ (16,000) (50,000)Depreciation.............................. 287,000 309,000CCA.......................................... (395,000) (116,000)Percentage-of-completion......... (17,000) (10,000)Completed contract................... 0 27,000

$517,000 $1,127,000Tax payable (40%, 42%)........... $206,800 $ 473,340

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(B) Deferred tax liability Tax Carrying Temp. Deferred Opening Adjustment

(In 000's) Basis Value Diff Tax Liability Balance @40%,@42%

Capital Assets20x1 $ 461 (1) $1,989(2)($1,528) ($611.2) ($497) ($114.2)20x2 345 (3) 1,680(4) (1,335) (560.7) (611.2) 50.5

Warranty20x1 0 (62)(5) 62 24.8 19.6 5.220x2 0 (53)(6) 53 22.26 24.8 (2.54)

% of Completion20x1 0 17 (17) (6.8) 0 (6.8)20x2 0 0 0 0 (6.8) 6.8

(1) $856,000 – $ 395,000 (4) $1,989,000 – $309,000(2) $2,276,000 – $287,000 (5) $56,000 + $22,000 – $16,000(3) $461,000 – $116,000 (6) $62,000 + $41,000 – $50,000

(C) $24,800 (column 4, above) – $6,800 (column 4, above) = $18,000$22,260 column 4, above


Income before tax ……….................. $916,000 $625,000Income tax expense (D)

Current ................................. $ 473,340 $206,800Deferred (E)................................. (54,760) 418,580 115,800 322,600

Net Income………………………......... 497,420 302,400

(D)Income tax payable.................. $ 473,340 cr $206,800crPlus/minus change in deferred tax:Capital assets................ 50,500 dr 114,200 crWarranty...................... 2,540 cr 5,200 dr% of completion.......... 6,800 dr 6,800 cr

$418,580 $322,600(E) $50,500 – $2,540 + $6,800; for 20x1, $114,200 + $6,800 – $5,200

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Assignment 15-30

Requirement 120x4 20x5 20x6

Depreciation$40,000/10 = $4,000 ............................................ $4,000$4,000 + $53,000 ($689,000/13).......................... $57,000$4,000 + $53,000 + $37,500 ($450,000/12) ........ 94,500ITC Amortization:20x4 ($5,600/10) = $560 ..................................... (560)20x5 $560 + ($96,460/13) $7,420 ....................... (7,980)20x6 $560 + $7,420 + ($63,000/12) $5,250 ........ (13,230)

................................................ $3,440 $49,020 $81,270


Income before tax ................................................ $165,000 $456,000 $468,000Plus: non-deductible advertising......................... 20,000 20,000 20,000Temporary differences

Depreciation (Part 1)...................................... 3,440 49,020 81,270CCA (given) ................................................ (12,000) (135,000) (216,000)

Taxable income ................................................ 176,440 390,020 353,270Income tax payable (25%) ................................... 44,110 97,505 88,318Less: ITC

20x4: $40,000 × 14%..................................... (5,600)20x5: $689,000 × 14%................................... (96,460)20x6: $450,000 × 14%................................... (63,000)

Net income tax payable........................................ $ 38,510 $ 1,045 $25,318


Income tax expenseIncome tax payable ........................................ $44,110 $97,505 $ 88,318Increase in deferred income tax:($12,000 – $3,440) × 25% ............................. 2,140($135,000 – $49,020) × 25% ......................... 21,495($216,000 – $81,270) × 25% ......................... 33,683

$ 46,250 $119,000 $122,001

Requirement 4

Income tax expense (tax payable) (Req. 2) .... $ 38,510 $ 1,045 $25,318

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Requirement 5

The cost reduction approach is preferable because it better matches the tax benefit with its root cause. It shows the net cost of assets to the owners and eliminates the potential to materially manipulate earnings.

Requirement 6

Capital Assets:Capital assets.................................................. $40,000Less: Accumulated depreciation.................. (4,000)

Deferred investment tax credit (1) ..... (5,040) $30,960

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Solutions Manual to accompany Intermediate Accounting,Volume 2, 5th edition 16-1

Chapter 16: Accounting for Tax Losses

Suggested TimeCase 16-1 Downhill Ski Company

16-2 Sigma Auto Parts Ltd.16-3 Ellis Ingram Corporation

Assignment 16-1 Income tax explanation ...................................... 3016-2 Loss carryback/carryforward................................ 2016-3 Benefits of carryback and carryforward ............... 2016-4 Carrybacks and carryforwards in successive

years ............................................................. 2016-5 Loss carryback; entries and reporting .................. 1516-6 Loss carryforward, valuation allowance .............. 2516-7 Loss carryforward, valuation allowance, rate change 3516-8 Recognition of loss carryforward......................... 3016-9 Calculate loss carryback and its benefit,

temporary differences (*W) ......................... 1516-10 Recording temporary differences, loss, rate

change (*W)................................................. 2016-11 Calculate a loss carryback and its benefit,

Temporary differences ................................ 2016-12 Loss carryforward, temporary difference ............. 3016-13 Loss carrybacks and loss carryforwards,

rate change ................................................... 3016-14 Deferred tax asset revaluation; rate change ......... 2016-15 Loss carryback/carryforward; temporary difference 3016-16 Loss carryback/carryforward................................ 3016-17 Loss carryback/carryforward, valuation allowance 1516-18 Loss carryback/carryforward; entries ................... 2016-19 Loss carryback/carryforward; rate change ........... 3016-20 Loss carryforward, temporary differences;

rate change, entries (*W) ............................. 4016-21 Loss carryback/carryforward, temporary

differences; rate change................................ 5016-22 Loss carryback/carryforward, temporary

differences; rate change................................ 5016-23 Loss carryback/carryforward, rate change;

comprehensive ............................................. 5016-24 Loss carryback/carryforward, temporary and

permanent differences, use in subsequent year............................................................... 30

16-25 Loss carryback/carryforward, comprehensive, rate change ................................................... 60

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16-2 Solutions Manual to accompany Intermediate Accounting,Volume 2, 5th edition

16-26 Tax losses: subsequent recognition and revaluation.................................................... 50

16-27 Tax losses: intraperiod allocation, income statement (*W)................................................. 30

16-28 Explain impact of temporary differences, tax losses ............................................................ 30

16-29 Tax losses, temporary differences........................ 4016-30 Tax losses, temporary differences........................ 4016-31 Integrative problem, chapters 12 - 16 .................. 90

*W The solution to this exercise/problem is on the text Web site and in the Study Guide. The solution is marked WEB.

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Questions

1. The benefit that arises as a result of a tax loss is that the loss may be carried back to obtain a refund of taxes paid in the last three years, and carried forward to avoid taxes otherwise payable in the next twenty years.

2. A tax loss may be carried back three years and forward twenty.

3. Companies prefer to use tax losses as carrybacks prior to carryforwards because they receive a refund immediately. The carryforward benefit is also contingent on earning future taxable income, while prior years’ tax paid is definite.

4. Recognition and realization coincide for tax losses if the loss is recognized for accounting purposes in the same year that it results in cash flow. This is the case of a tax loss used as a loss carryback: it is recognized in the loss year, and a refund is requested at the same time.

5. Companies may prefer to recognize the benefit of a loss carryforward in the period of the accounting loss because the resulting credit to tax expense reduces the net accounting loss recorded. It is also good matching of the benefit to the event that triggered it. The benefit will be realized in some future year when the tax loss is offset against taxable income.

6. In order to recognize the benefit of a loss carryforward in the period of the accounting loss, it must be probable that the benefit of the loss carryforward will be realized.

7. The potential benefit of a $100,000 taxable loss at a tax rate of 40% is $40,000.

8. The tax loss is $180,000: ( – $75,000 + $216,000 – $321,000)

9. The company would have taxable income of $141,000: ( – $75,000 + $216,000). Alternatively, the company could report a taxable amount of anything in the range of ($180,000) to $141,000 by varying the CCA charged. Some would choose to claim CCA of $141,000 and report zero taxable income. CCA is optional and does not need to be claimed in any one year. The Income Tax Act only specifies maximum claims.

10. A company does not have to claim CCA in a given year. The Income Tax Act only specifies maximum claims. A company might choose to not claim CCA in a year of accounting income to maximize taxable income to fully use a tax loss carryforward. They may choose to not claim CCA in a year of an accounting loss to minimize the taxable loss. Minimizing the taxable loss would be important if there was doubt that the loss could all be used in the carryback/carryforward period (e.g., if losses were close to expiry or if rates are expected to increase significantly in future years).

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11. ‘More likely than not’ means that the probability is greater than 50%.

12. Strategies that will increase the likelihood of a tax loss being used involve maximizing taxable income by speeding up revenue recognition for tax purposes or reducing expenses for tax purposes (primarily the optional CCA charge.)

13. Three examples of favourable evidence in assessing the likelihood of tax loss carryforward usage are:a) A strong earnings history, along with evidence that the loss was caused by non-

recurring causes.b) Existing orders or sales backlogs sufficient to create positive taxable income

when recognized.c) Existing temporary differences that can be manipulated to create taxable income

in the carryforward period (e.g., CCA, which does not need to be charged).

14. The tax loss carryforward should be recorded at $208,740 ($497,000 x .42) if it meets the appropriate criteria. The tax rate used should be the best (i.e., enacted) estimate of the rate in effect when the tax loss will be used. The 20x5 enacted rate is a better/more objective predictor than the 20x4 enacted rate or any expectations about 20x6.

15. An accounting entry is needed to write off the deferred tax asset, if it is no longer probable. This creates a charge to income, and income goes down. The entry would debit tax expense and credit the deferred income tax account.

16. An accounting entry is needed to recognize the benefit of an unrecorded loss carryforward in any period where the benefit first becomes probable of realization. This may well be a year that is not the year of the loss, or the year of realization. The probability of loss carryforward realization must be assessed annually. Initially:Deferred income tax asset ......................................................... XXX

Valuation allowance ............................................................. XXXThen:Valuation allowance ................................................................... XXX

Income tax expense (recovery)............................................. XXX

17. Income will decrease if a previously recognized loss carryforward is now considered unlikely to be recognized and written off. The resulting charge to earnings is additional tax expense.

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18. Deferred tax amounts are recorded at the best estimate of the resulting cash flow. Therefore, enacted tax rates are used. Thus, the $40,000 asset would be changed to $35,000, with an offsetting increase to tax expense:

Income tax expense .................................................................... 5,000Deferred income tax asset .................................................... 5,000

19. Possible objections to the practice of recording a loss carryforward prior to realization:– Realization is contingent on future earnings and is not based on a transaction.– Too much faith is placed on management’s judgement without ability of an

auditor to challenge that judgement.– Potential for income manipulation is present because loss carryforward

recognition significantly increases income. This increase may not be recorded in the year of the loss, based on a judgement call of management.

20. Required disclosure consists of the amount of benefit arising from previously unrecognized tax loss that is used to reduce current income tax expense or reduce current deferred tax expense; amount of deferred tax expense arising from write-down or reversal of previous write-down of deferred tax asset; and amount and expiry date of unused tax losses.

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Cases

Case 16-1 Downhill Ski Company

Overview

Downhill Ski Company (DSC) is a company that has experienced their first loss in ten years. Since all of the loss cannot be carried back the company must determine if it is “probable” to have taxable income in the future and to recognize any remaining loss as a deferred tax asset. In determining the appropriate accounting treatment consideration to any tax planning strategies to minimize the amount of the taxable loss is appropriate. It must be clarified if DSC is a private company using accounting standards for private enterprises or a public company using international standards.


Loss Carryback

DSC should first carryback the loss for the past three years. Since DSC has barely maintained profits over the past four years and we are told that the amount of the loss are significantly greater than profits for the past three years there will still be taxable losses remaining after carryback. The taxable loss would be carried back for the past three years and DSC would recover past taxes paid at the actual rates in those years. A tax planning strategy would be to refile tax returns for the past three years and not deduct CCA. This would maximize the amount of the taxable income in the past three years to carryback the loss.

Loss Carryforward/Deferred Tax Asset

DSC can carryforward any unused losses for the next twenty years. If DSC is a private company they have the option of using the taxes payable method instead of the liability method in accounting for income taxes. With the taxes payable method DSC would not have deferred tax assets or deferred tax liabilities. They would just use the loss to reduce future taxable income. It is assumed that DSC is using the liability method.

To recognize a deferred tax asset DSC must show that it is “probable” that they will have sufficient taxable income to utilize the taxable loss.

The following factors support it would be probable.

This is the first loss in ten years. Older athletes switching back to skiing will increase sales. New sales and marketing manager with strong relationships in industry expected

to increase sales. Development of new ski.

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Buyers lined up for new ski. Forecast profit for next year. New equipment will reduce costs for manufacturing and repairs.

The following factors support it would not be probable.

Earnings have been declining over the past several years. Substantial loss this year. Competition from large manufacturers. Margins shrinking. Popularity of snowboarding.

I conclude that it is “probable” that the company will have taxable income and that a deferred tax asset can be recorded. (Students could make a conclusion that not probableor could conclude to recognize only a portion). To maximize the amount of taxable income in future years and minimize the taxable loss this year I recommend that we do not take CCA this year and stop taking CCA in the future until the taxable loss has been used up. The new equipment would have substantial CCA.

Case 16-2 Sigma Auto Parts Ltd.

Overview

This is a fairly straight-forward case that raises several issues pertaining to matters raised in earlier chapters, as well as one issue pertaining to this chapter. The issues are:

Disclosure relating to a contested liability to a supplier arising from a pricing disagreement

Asset retirement obligations (decommissioning costs) Recognition of tax loss carryforwards Foreign currency exposure arising from direct foreign investment Classification of debentures that are convertible at maturity at the option of the

issuer

Sigma is a private company but undoubtedly is audited, given the size of the company and the many stakeholders involved. Therefore, GAAP is most likely a constraint. As a private company, Sigma could use accounting standards for private enterprises but has decided to use international accounting standards.

Supplier disagreement

Sigma is refusing to pay a higher price now being demanded by a supplier with whom Sigma did have a fixed price contract. There is strong potential for legal action, but Sigmaand the supplier have agreed to binding arbitration. The issue, therefore, is how to report the $30 million contested liability. The options are to (1) record it as current payable or

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(2) show it only in the notes as a contingent liability. Recording the ‘excess’ liability will increase liabilities and decrease profitability (since purchases will increase).

Resolution of the issue depends on the probability and measurability of the obligation. Measurability may not seem to be a problem, since the contested amount is clear. However, an arbitration decision may rule that Sigma must pay anywhere between zero and the full amount—splitting the difference is a common outcome, resulting in possibility at $15 million decision. Probability also is not clear.

Given the uncertain nature of the arbitration outcome, Sigma determine the best estimate assume a liability provision of $15 million, with clear disclosure of the nature of the contingency.

Asset retirement cost (decommissioning costs)

Sigma has recently become liable for site restoration costs at a plant site that is about to be abandoned. The company must set up a liability for the estimated demolition and restoration costs. The current estimated cost is $35 million which should be used as the estimate of future cost. However, the $35 million should be treated as the future cost, and then discounted to its equivalent present value. At the end of the year Sigma would recognize interest expense and depreciation expense.

One unusual aspect of this situation is that Sigma’s liability is contingent on not finding a buyer for the site who is willing to bear the cost of demolition and/or restoration. On the surface, this may seem to make Sigma’s obligation a contingent liability rather than a measurable one. However, if a buyer is willing to undertake the demolition and restoration, then the buyer also will pay comparably less to buy the site. Either way, it’s costing Sigma, either directly or through a lower selling price for the site.

Tax loss carryforwards

The issue is whether Sigma can recognize the future benefit of tax loss carryforwards. Tax losses cannot be carried across jurisdictional borders, and there is no way that the U.S. losses can be offset against profitability in Sigma’s foreign operations. Given the declining profitability of the U.S. automobile market, it does not seem ‘probable’ that thetax loss carryforward benefits can be realized within the carryforward period. However, to the extent that Sigma can recognize benefit through the reversal of temporary differences, Sigma still may be able to recognize some of the future benefit.

Direct foreign investment in China

Sigma is making significant direct investment in China. This investment is exposed, in an accounting sense, to changes in the value of the yuan (or RMB) against the U.S. dollar. As the value of the yuan increases, the notional value of Sigma’s investment declines. On Sigma’s books, the U.S. dollar investment will not change. However, the value of the China subsidiary’s net assets will change. The issue is how to report the increase or decrease of the subsidiary’s net assets when the subsidiary is consolidated.

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Sigma must determine what their functional currency is for this subsidiary if it is US dollars or the RMB. If Sigma has the RMB as the functional currency for this subsidiary, each year’s translation gain or loss will be reported as a component of other comprehensive income, with the cumulative amount reported in shareholders’ equity as accumulated other comprehensive income.

If Sigma views the functional currency as US dollars, each year’s translation gain/loss must be disaggregated and reported in earnings as though the subsidiary’s operations were being directly engaged in by the parent company. It is most likely that Sigma will report the functional currency as RMB.

German debentures

The German subsidiary has issued debentures that are payable in common shares instead of cash, at Sigma’s option. If the share option is used, the number of shares depends on the market value of the shares at the time of the debentures’ maturity. This is equivalent to a cash payment. Therefore, the debentures should be reported on Sigma’s statement of financial position as debt; they do not qualify as a compound financial instrument. hzzled



Case 16-3 Ellis Ingram Corp.

Overview

Ellis Ingram Corp. (EIC) has recorded large losses ($31.4 million) in 20X5, including an $8.4 million goodwill impairment. Their financial position is accordingly risky. Lenders have waived the return ratio covenant this year, but will be concerned that the financial statements fairly reflect the financial performance of the company. Management, who received no bonus in 20X5, has incentive to maximize 20X6 net income to generate bonuses and appease lenders. There are ethical considerations to the fair treatment of users, and also in relation to a transaction with a supplier late in 20X5. EIC is a private company therefore it must be determined if they are following accounting standards for private enterprises or international accounting standards. The bank has requested an audit but has not specified which accounting standards are required. For the issues below the accounting treatment would be the similar in both standards since EIC is using the liability method in accounting for their income taxes. I assume that EIC has selected accounting standards for private enterprises.

Issues

1. Revenue recognition2. Tax loss accounting


Revenue recognition

The transaction with Luciano Ltd. appears to fall under the definition of a “round trip” transaction; that is, both EIC and Luciano have gross profit on a cash transaction in December. This assumes the goods purchased/sold are reasonably similar. The motive for the transaction may well have been to artificially create sales and profits. Luciano instigated the transaction and is under SEC scrutiny for similar transactions. While EIC is a private company and not under SEC jurisdiction, the ramifications are still significant.

To comply with SEC opinion and precedent for such cases, the gross profit on the Luciano sale ($2,050,000 – $1,685,000, or $365,000) should not be recognized until the merchandise acquired from Luciano is sold, likely in February of 20X6. The gross profit will enter into taxable income in 20X5, although accounting recognition will not take place until 20X6. The deferred gross profit is a temporary difference.

As a result of these adjustments, assets will decline, and the deficit increase. However, the gross profit will be recorded in 20x6, and 20x6 results will improve as a result.

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The ethics of this transaction should be reviewed with the board of directors. While EIC did not instigate the transaction, they did agree to it. This reflects poorly on management.

Tax loss accounting

Taxable income is calculated in Exhibit 1. The revised accounting loss (higher due to elimination of gross profit) is adjusted for permanent and temporary differences. The result is a loss for tax purposes of $21,720.

Deferred income tax is affected by current year temporary differences, depreciation and the deferred gross profit, and the change in the tax rate in 20X5, from 44.3% to 41.6%. The result is shown in Exhibit 2, a long-term income tax credit of $549 and a current debit of $152. Note if international standards are selected the debit would be classified as long-term not current. These are statement of financial position elements. (The adjustment is calculated in Exhibit 2).

The tax loss of 20X5 will first be carried back to trigger a refund of tax paid in 20X2, 20X3 and 20X4. This tax refund of $3,394 is recorded as an account receivable of $3,394, which is a current asset (see Exhibits 3 and 4). This will improve the current ratio, a debt covenant ratio.

The remaining tax loss is a loss carryforward of $14,058 (see Exhibit 3). This tax loss may be used to avoid taxes otherwise payable in the next 20 years. The tax loss expires after this period of time.

The benefit of the tax loss will be recorded in the tax loss year (20X5) if it is likely that it will be used. This will result in recognition of a non-current asset of $5,848, the benefit of the tax loss. This would not be a current asset unless it would be used in 20X6. The income statement would reflect a $5,848 tax recovery and a net loss of $22,023. Refer to the first column of Exhibit 4. Note if international standards are selected then to recognize the loss you would determine if it is probable which is a similar concept to more likely than not. The asset would be classified as long-term not current.

If usage of the loss was not judged likely in 20X5, the $5,848 asset would not be recorded, and the net loss would be $5,848 higher, at $27,871 (see the second column of Exhibit 4). The loss carryforward benefit would be recorded when used in 20X6 or later, or when its use probability shifts to likely, also in 20X6 or later. In this case, 20X6 or later net incomes will receive a material boost. The timing of this boost is largely a management decision, and there is potential for conflict of interest, because of the bonus entitlement.

Evidence must be collected to support likelihood at the end of 20X5. It is noted that the loss was the result of a one-time event (a strike), but that customers have been slow to return. Goodwill was impaired in 20X5. Previous earnings levels have been relatively modest in relation to the size of the loss. These factors, along with future prospects and

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industry projections, must be evaluated by the board. A conclusion of “not probable” seems supportable, which works to the advantage of both the company and management in future years.

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Ellis Ingram Corp.Exhibit 1

Taxable loss, 20X5 (in thousands)

Accounting loss ($31,420) + ($365) ............................................ $(31,785)Plus: Non-deductible expenses

Goodwill impairment ....................................................... 8,410Non-deductible expenses ................................................. 540

(22,835)Plus: Taxable gross profit ......................................................... 365

Depreciation expense ($6,950 – $6,200) ......................... 750$(21,720)


Deferred income tax 20X5 (in thousands)

TaxBasis

AccountingBasis

Difference After tax41.6%

OpeningBalance

Adjustment

Capital Assets $4,880 1 $6,200 $(1,320) $(549) $(917) $368Gross Profit 0 (365) 2 365 152 0 152

$5201 Unchanged; $917/.443 = 2070; $6,950 – $2,070 = $4,8802 Deferred gross profit is a liability.


Tax Loss carryback/carryforward (in thousands) Gross TaxRefund

20X5 Taxable loss (Exhibit 1) ............................................... $(21,720)Carried back to 20X3 and 20X2 ............................................ 2,680 $1,187Carried back to 20X4 ($2,030 + $177) /.443………………. 4,982 2,207

$3,394Tax loss carryforward……………………………………… $(14,058)

Benefit of tax loss carryforward (41.6%)............................... $5,848

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Financial Statement impact in 20X5

Tax loss carry forward Likelihood > 50% Likelihood< 50%

Statement of Financial Position

Assets – CurrentTax refund receivable………………………… $3,394 $3,394Deferred income tax – deferred gross profit(1)……. 152 152

Assets – Non-currentDeferred income tax – benefit of loss carry forward $5,848 –

Liabilities – Non-currentDeferred income tax – capital assets……………… $549 $549

(1) If international standards were selected all deferred tax balances would be non-current

Income statement

Accounting loss before income tax……………. $(31,785) $(31,785)Tax recovery

Current (tax refund - loss carryback)………. 3,394 3,394Deferred income tax ($368 + $152)………….. 520 520LCF recognition…………………………… 5,848 –

9,762 3,914Net loss………………………………………… $(22,023) $(27,871)

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Assignments

Assignment 16-1

Requirement 1

The current portion of the income tax provision is the tax that would be payable on net income if there was no loss carryforward.

The deferred tax portion of the provision is the tax expense that will be paid in a future period, not this year. It is the change in deferred income tax.

The impact of the loss carryforward reflects the benefit of having a loss carryforward to eliminate the tax payable on ordinary income. The loss was not recorded in prior years.

Essentially, no tax is payable this year, because of the loss carryforward. There is tax expense solely because of deferred income tax ($58,500).

Requirement 2

A deferred income tax asset would be cause by a liability, such as unearned revenue or warranty liability.

A deferred income tax liability would be caused by an asset, such as capital assets.Other examples, if logical, are acceptable.

Requirement 3

The loss carryforward could be recognized in its entirety unless use of the loss wasconsidered to be probable. If the loss is not recorded, then this condition must not have been met.

The remaining unrecognized loss carryforward is $253,200. The tax benefit of this, at 40%, is $101,280. If the loss carryforward were recognized, net income and retained earnings would increase by $101,280, and a deferred tax asset would be recognized in the amount of $101,280.

Requirement 4

No tax is currently payable. The current portion of tax expense, $37,500, would be payable if there was no loss carryforward.

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Assignment 16-2

Requirement 1

20x4:Income tax expense ($2,000 × 36%)...................................... 7,200


20x5:Income tax receivable ($20,000 × 36%) ................................ 7,200

Income tax expense (recovery) ........................................ 7,200

[Future incomes are uncertain. No tax loss carryforward benefit may be recognized until realized. LCF = $70,000; $25,200 net future tax benefit.]

20x6:Income tax expense ($30,000 × 36%).................................... 10,800


Income tax payable ................................................................ 10,800Income tax expense (recovery) ........................................ 10,800

LCF = $40,000 gross; $14,400 net

20x7:Income tax expense ($110,000 × 36%).................................. 39,600


Income tax payable ($40,000 × 36%) .................................... 14,400Income tax expense (recovery) ........................................ 14,400

Summary (not required):

20X4 20X5 20X6 20X7Net income (loss) before tax $ 20,000 $(90,000) $ 30,000 $110,000Income tax – current (recovery) 7,200 (7,200) 10,800 39,600Loss carryforward — — (10,800) (14,400)Income tax expense (recovery) 7,200 (7,200) 0 25,200Net income $ 12,800 $(82,800) $ 30,000 $ 84,800

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Requirement 2

20x5:Income tax receivable ($20,000 × 36%) ................................ 7,200Deferred income tax asset ($70,000 × 36%) ......................... 25,200


20x6:Income tax expense................................................................ 10,800

Deferred income tax asset ($30,000 × 36%).................... 10,800

[LCF = $40,000 gross; $14,400 net future benefit]


Deferred income tax asset ($40,000 × 36%).................... 14,400Income tax payable [($110,000–$40,000) × 36%]........... 25,200

Summary (not required):

20X4 20X5 20X6 20X7Net income (loss) before tax $ 20,000 $(90,000) $ 30,000 $110,000Income tax – current (recovery) 7,200 (7,200) — 25,200Loss carryforward (recovery) — (25,200) 10,800 14,400Income tax expense (recovery) 7,200 (32,400) 10,800 39,600Net income $ 12,800 $(57,600) $ 19,200 $70,400

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Assignment 16-3

YearPre-tax

earningsTax rate

1. Current tax payable (receivable)

2. Income tax expense (recovery)

3. Net income (loss)

20X3 $ (60,000)1 42% — — $ (60,000)20X4 360,000 43% $ 154,800

Loss C/F realized (60,000) 43% (25,800)Taxable income 300,000 43% 129,000 $ 129,000Net income 231,000

20X5 440,000 41% 180,400 180,400Net income 259,600

20X6 (1,300,000) 38% —Loss C/B to 20X4 300,000 43% (129,000)Loss C/B to 20X5 440,000 41% (180,400)Taxable income (560,000)2 (309,400) (309,400)Net income (990,600)

20X7 140,000 34% 47,600Loss C/F realized (140,000)3 34% (47,600)Recognize C/F future asset (142,800)4

Taxable income — 34% —Net income 282,800

20X8 300,000 36% 108,000Loss C/F realized (300,000)5 36% (108,000)Adjust rate for remain. C/F6 (8,400)Taxable income — 36% — —Net income 308,400

1 Loss carryforward: $60,0002 Remaining loss carryforward: $560,0003 Remaining loss carryforward: $560,000 – $140,000 = $420,0004 Future benefit of remaining C/F recognized: $420,000 × 34% = $142,800 5 Remaining loss carryforward recognized but unrealized: $420,000 – 300,000 = $120,000

Notes:1. This problem illustrates that:

a. carrybacks give tax recovery at the rates originally paid, andb. carryforwards reduce taxes at the rate that is in effect when they are used.

2. In this example, no DIT from the tax loss carryforward is recognized in 20X4-20X6because the probability of realizing the carryforward benefits is less then 50%. In 20X7, the probability exceeds 50% (in management’s judgement), at which point the full amount of the remaining C/F benefit is recognized, with a further adjustment in 20X8 due to an increase in tax rate (which increases the benefit of the remaining C/F).

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Assignment 16-4

Year

Taxable income

(loss)

Tax rate %

Income tax expense

(recovery)20X0 $ 95,000 40 $ 38,00020X1 60,000 40 24,00020X2 35,000 40 14,00020X3 (140,000) 40 (56,000) Carryback to 20X0 and 20X120X4 30,000 40 12,00020X5 (265,000) 40 (106,000) Assuming recovery is likely.20X6 (45,000) 38 (5,750) Assuming recovery is likely. Includes

effect of change in tax rates20X7 65,000 35 22,750 C/F used = $65,000; $180,000C/F remains20X8 95,000 35 33,2500 C/F used = $95,000; $85,000C/F remains20X9 380,000 35 133,000 C/F used = $85,000

20X5:Available carryback = $35,000 for 20X2 + $30,000 for 20X4 @40% = $26,000.Carryforward = $265,000 loss – $65,000 carryback = $200,000.

Deferred tax benefit = $200,000 40% = $80,000.

20X6:No carryback is available. This year’s loss increases total carryforward to $245,000. The future benefit of $245,000 at the enacted tax rate of 35% is $85,750. The DIT account now has a balance of $80,000. Income tax expense is the adjustment necessary to increase the balance of DIT to $85,750.

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Assignment 16-5

Requirement 1

Webb reported $210,000 accounting income in 20x4, and this was equal to taxable income. Tax of $84,000 ($210,000 × .40) would be paid.

Webb reported an accounting loss of $90,000 in 20x5, again equal to the taxable loss. This loss would be used as a carryback to generate a refund of $36,000 ($90,000 × .40)

Requirement 2



20x5:Income tax receivable ............................................................ 36,000


Requirement 3

Income statement 20x5 20x4Income tax expense (recovery) .............................................. $(36,000) $84,000

Statement of financial positionIncome tax receivable ............................................................ $36,000 –

Income tax payable ................................................................ – $84,000

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Assignment 16-6

Requirement 1

20X3 20X4 20X5Revenues $ 550,000 $ 600,000 $ 650,000Expenses 665,000 575,000 615,000Earnings (loss) before income taxes (115,000) 25,000 35,000Income tax expense (recovery) – – (16,500)Net Income $(115,000) $ 25,000 $ 51,500

Requirement 2

The only statement of financial position amount would be a 20X5 non-current asset for the deferred tax benefit of the unrealized tax loss carryforward: ($115,000 – $25,000 –$35,000) 30% = $16,500.

Requirement 3

20X3: Deferred income tax asset – LCF ($115,000 30%)..................... 34,500

Valuation allowance – DIT asset (LCF) ................................ 34,500

20X4: Part of the carryforward has been utilized, and therefore the balance of both the DIT asset and its valuation allowance must be reduced:

Valuation allowance – DIT asset (LCF) ........................................ 7,500Deferred income tax asset – LCF ($25,000 30%)............... 7,500

Or:Tax expense ................................................................................... 7,500

Income tax payable ................................................................ 7,500

Income tax payable ........................................................................ 7,500Deferred income tax asset – LCF.......................................... 7,500

Valuation allowance – DIT asset (LCF) ........................................ 7,500Tax expense ........................................................................... 7,500

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20X5:The DIT asset must be reduced by the amount of carryforward benefit used in 20X5:

Valuation allowance – DIT asset (LCF) ....................................... 10,500Deferred income tax asset – LCF ($35,000 30%)............... 10,500

The remaining carryforward benefit must now be recognized by reducing the balance of the valuation account to zero:

Valuation allowance – DIT asset (LCF) ........................................ 16,500Income tax expense [($115,000–$25,000–$35,000)30%] ... 16,500

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Assignment 16-7

Requirement 1

20X1No entry required because there is no tax due or receivable.

20X2

Deferred income tax asset [($300,000 + $60,000) × 60%× 40%] 86,400Income tax expense (benefit) 86,400

[Recognition of 60% of the accumulated carryforward benefit]

20X3

Income tax expense 4,320Deferred income tax asset ($360,000 × 60% × 2% ) 4,320

[Adjustment for rate reduction]

Income tax expense 15,200Deferred income tax asset ($40,000 × 38% ) 15,200

[Realization of part of previousy recognized carryforward benefit]

20X4



Deferred income tax asset ($360,000 × 40% × 38% ) 54,720Income tax expense 54,720

[Recognition of previously unrecognized carryforward benefit]

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Requirement 2

20X1Deferred income tax asset ($300,000 × 40% ) 120,000

DIT–valuation allowance 120,000[Recognition of C/F benefit, completely offset by valuation allowance]

20X2

Deferred income tax asset [$60,000 × 40% tax rate] 24,000DIT–valuation allowance 24,000

DIT–valuation allow. [($120,000 + $24,000) × 60% probability] 86,400Income tax expense (benefit) 86,400

[Recognition of 60% of the accumulated carryforward benefit]

20X3Income tax expense 4,320DIT–valuation allowance ($360,000 × 40% × 2% ) 2,880

Deferred income tax asset ($360,000 × 2% ) 7,200[Adjustment for rate reduction]



20X4Income tax expense 106,400

Deferred income tax asset ($280,000 × 38% ) 106,400[Realization of part of previousy recognized carryforward benefit]

DIT–valuation allowance ($360,000 × 40% × 38% ) 54,720Income tax expense 54,720

[Recognition of previously unrecognized carryforward benefit]


20X1 20X2 20X3 20X4Earnings (loss) before taxes $(300,000) $ (60,000) $ 40,000 $ 280,000Income tax expense (benefit) — (86,400) 19,520 51,680Net income (loss) $(300,000) $ 26,400 $ 20,480 $ 228,320

Effective tax rate* 0% –144% 49% 18%

* Income tax expense ÷ earnings before taxes

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Assignment 16-8

Requirement 1

The 20x7 $60,000 taxable income was fully offset by use of a $60,000 tax loss carryforward. The unrecognized tax loss carryforward is now $337,500.

Tax loss carryforward:Tax loss carryforward 20x5 ..................................................................... $354,500Tax loss carryforward 20x6 .................................................................... 43,000Tax loss used, 20x7.................................................................................. (60,000)Remaining tax loss carryforward ............................................................. $337,500

20x7:

Income tax expense ($60,000 × .36) ...................................... 21,600Income tax payable .......................................................... 21,600

Income tax payable ................................................................ 21,600Income tax expense (recovery) ........................................ 21,600

The first entry records tax on 20x7 income as though there were no loss; the second records the benefit of the loss. The two entries obviously cancel out to a zero income tax expense but recording the two components helps keep track of the loss carryforward. The remaining tax loss carryforward is not recorded.

Requirement 2

20x8 Entries:Income tax expense ($520,000 × .38) .................................... 197,600


Income tax payable ...................................................................... 128,250Income tax expense (recovery) ....................................... 128,250

$337,500 (see Requirement 1) × .38

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Requirement 3

20x7 Entries:Income tax expense ($60,000 × .36) ...................................... 21,600


Income tax payable ................................................................ 21,600Deferred income tax asset – LCF ($337,500 × .36)............... 121,500


Requirement 4

20x8 Entries:Income tax expense................................................................ 197,600


Income tax payable ($337,500 × .38)..................................... 128,250Deferred income tax asset - LCF ..................................... 121,500Income tax expense.......................................................... 6,750

Note that the effect of a change in tax rate is adjusted to theincome tax expense: $337,500 × (.38 – .36) = $6,750.


Requirement 1

Taxable income: 20x3 20x4 20x5 20x6Accounting income $ 10,000 $ 15,000 ($40,000) $ 10,000Permanent difference:

Golf club dues 3,000 4,000 3,000 4,000Accounting income

subject to tax 13,000 19,000 (37,000) 14,000Temporary difference:

DepreciationCCA

6,000(3,000)

6,000 (6,000)

6,000(12,000)

6,000(10,000)

Taxable income 16,000 19,000 (43,000) 10,000Tax rate × 20% × 20% × 30% × 35%Income tax payable $ 3,200 $ 3,800 n/a* $ 3,500

* Part of loss is carried back at rate of 20%; current year rate is not applicable. See Requirement 2

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Requirement 2

TaxableAmounts Benefit

Tax loss ............................................................................ $(43,000)Carryback ($16,000 + $19,000) ....................................... 35,000 $7,000 (20%)Carryforward .................................................................... $ (8,000)

The $8,000 loss carryforward would be recorded at a rate of 30% ($2,400) if recorded in 20x5. This is the enacted tax rate in 20x5. The 20x6 rate cannot be used until enacted.

This data is used further in Assignment 16-10.

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Note: Students should have completed Assignment 16-9 prior to this assignment.

Income tax receivable (1)............................................................. 7,000Deferred income tax asset – LCF (2) ........................................... 2,400

Deferred income tax – long term (3)...................................... 1,500Income tax expense (4) .......................................................... 7,900

(1) Taxable income, 20x3 & 20x4: (see solution to Assignment 16–9) $16,000 + $19,000 = $35,000. Amount paid, $3,200 + $3,800 = $7,000

(2) Taxable loss in 20x5 (see solution to Assignment 16-9) ............................ $43,000Loss carryback to 20x3 and 20x4 ($16,000 + $19,000).............................. (35,000)Tax loss carryforward ................................................................................. 8,000Benefit of tax loss carryforward (@ 30%) .................................................. $ 2,400

(3)

(in 000’s)

TaxBasis

AccountingBasis

TemporaryDifference

DITLiability


20x5 @ 30%Capital assets $54 (a) $57 (b) $(3) $(.9) $.6 (c) ($1.5)

(a) $75,000 – ($3,000 + $6,000 + $12,000)(b) $75,000 – ($6,000 × 3)(c) [($75,000 – $9,000) – ($75,000 – $12,000)] × .20

(4) $7,000 + $2,400 – $1,500

In order to record the benefit of the tax loss carryforward in 20x5, the company must be able to establish that its realization during the carryforward period is more likely than not. This is defined as a probability of more than 50%.

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Assignment 16-11

Requirement 1

Taxable income, 20x3($50,000 + 20,000 – 25,000) ......................................... $ 45,000Taxable income, 20x4 ($90,000+20,000-43,750)............................................. 66,250Taxable income, 20x5($130,000+20,000-32,813)………………………….... 117,187 Taxable loss, 20x6($(150,000)+20,000)……………………………………. (130,000)

(in 000’s)Tax

BasisAccounting


DITLiability


20x3 $175,000 $180,000 $(5,000) (1,500) $ 0 $ (1,500)20x4 131,250 160,000 (28,750) (10,063) (1,500) (8,563)20x5 98,437 140,000 (41,563) (16,625) (10,063) (6,562)20x6 98,437 120,000 (21,563) (8,625) (16,625) 8,000

Entry, 20x3Income tax expense................................................................ 15,000

Deferred income tax (see table) ....................................... 1,500Income tax payable (45,000 x .30)................................... 13,500

Entries, 20x4Income tax expense................................................................ 31,751

Deferred income tax (see table) ....................................... 8,563Income tax payable (66,250 x .35)................................... 23,188


Deferred income tax (see table) ....................................... 6,562Income tax payable (117,187 × .40)................................. 46,875

Entries, 20x6Income tax receivable ............................................................ 44,188Deferred income tax (see table) ............................................. 8,000


If Radvani is worried about having another loss in 2007 they would want to carryback the loss three years to make sure they could recover taxes paid in that year.

Taxable loss (130,000) recover taxes paid in 20x3 13,500 + taxes paid in 20x4 23,188 + portion taxes paid in 20x5 7,500 (18,750 taxable income x .40) = 44,188

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Requirement 2

Entries, 20x6Income tax receivable ............................................................ 51,360Deferred income tax (see table) ............................................. 8,000


If Radvani wants to maximize the amount of taxes they recover they will go back to the years that they paid the highest taxes.

Taxable loss (130,000) less taxes payable 117,187 recover taxes paid in 20x5 of 46,875 + portion taxes paid in 20x4 4,485 (12,813 taxable income x .35) = 51,360

Assignment 16-12

Requirement 1

Taxable income, 20x3[((80,000)+94,000–106,000+90,000-70,000] ............... $ (72,000)Taxable income, 20x4 (given) .......................................................................... 250,000

Accounting income, 20x3 (given)..................................................................... (80,000)Accounting income, 20x4 (250,000–94,000+130,000-100,000+85,000)......... 271,000

(in 000’s)Tax

BasisAccounting


DITAmounts

@ 40%


20x3Capital assets 894,000 906,000 (12,000) (4,800) 0 (4,800)Warranty 0 20,000 20,000 8,000 0 8,00020x4Capital assets 764,000 812,000 (48,000) (19,200) (4,800) (14,400)Warranty 0 35,000 35,000 14,000 8,000 6,000

Entry, 20x3Deferred income tax asset - LCF ($72,000 × .40).................. 28,800Deferred income tax asset – warranty (see table) .................. 8,000Deferred income tax liability – capital assets (see table) ....... 4,800


Entries, 20x4Income tax expense................................................................ 108,400Deferred income tax asset – warranty (see table) .................. 6,000

Deferred income tax liability – capital assets (see table) . 14,400Income tax payable ($250,000 × .40)............................... 100,000

To record 20x4 income before the tax loss

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Income tax payable ................................................................ 28,800Deferred income tax asset - LCF ..................................... 28,800

All the LCF is used; $71,200 ($100,000 – $28,800) is still owing.

Income statement 20x4 20x3Income before tax................................................................... $271,000 $(80,000)Income tax.............................................................................. (108,400) 32,000Net income (loss) ................................................................... $162,600 $(48,000)

Requirement 2

Entry, 20x3Income tax expense................................................................ 4,800

Deferred income tax liability – capital assets .................. 4,800

The benefit of the LCF cannot be recorded and assume deferred tax asset cannot be recognized. The effect of the temporary difference must be recorded and this makes the income tax expense a debit, even though this is a loss year.


Deferred income tax liability – capital assets .................. 14,400Income tax payable .......................................................... 100,000

Income tax payable ................................................................ 28,800Income tax expense (recovery) ....................................... 28,800

Total income tax expense is $85,600 ($114,400 – $28,800). Income tax payable is still $71,200.

Income statement 20x4 20x3Income before tax................................................................... $271,000 $(80,000)Income tax expense................................................................ 85,600 4,800Net income (loss) ................................................................... $185,400 $(84,800)

Requirement 3

Since Haines was a new company in 20x3, one might expect that they would find it difficult to gather appropriate evidence to show that use of tax loss carryforwards and deferred tax asset for warranty was probable. On the other hand, they did earn adequate taxable income in 20x4. If forecasts were considered reliable, or sales orders in hand at the end of 20x3, then recording the LCF and deferred tax asset would have been appropriate.

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Assignment 16-13

Requirement 1

20x4 EntryNo deferred income tax arises from the differences between accounting and taxable income because permanent differences are the cause.No entry—loss carryforward cannot be recognizedThe tax loss carryforward is $62,000

20x5 EntryIncome tax expense ($50,000 × 34%).................................... 17,000



$50,000 of the tax loss carryforward is used. $12,000 remains.

20x6 EntryIncome tax expense ($82,000 × 32%).................................... 26,240



Net taxable income is ($82,000 – $12,000) = $70,000 after the tax loss carryforward. Tax of $22,400 is paid ($26,240 – $3,840)

20x7 EntryIncome tax receivable ($70,000 × 32%) ................................ 22,400

Income tax expense (recovery) ........................................ 22,400The tax loss is $88,000. $70,000 is carried back for a refundand $18,000 is carried forward but not recorded.

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Requirement 2

20x4 EntryDeferred income tax asset—LCF ($62,000 × 32%)............... 19,840


20x5 EntriesIncome tax expense................................................................ 17,000


Income tax payable ................................................................ 17,000Deferred income tax asset—LCF (1) ............................... 15,760Income tax expense (2) .................................................... 1,240

(1) Opening balance in deferred income tax asset................. $19,840Required closing balance ($62,000 – $50,000) × 34%.... 4,080Decrease to account ......................................................... $ 15,760

(2) Opening LCF × change in tax rate: $62,000 × (34% – 32%)

20x6 EntriesIncome tax expense................................................................ 26,240


Income tax payable ($12,000 × 32%) .................................... 3,840Income tax expense (1) .......................................................... 240

Deferred income tax asset—LCF (balance) ..................... 4,080

(1) Opening LCF × change in tax rate: $12,000 × (34% – 32%)

20x7 EntriesDeferred income tax asset—LCF ($18,000 × 30%).............. 5,400Income tax receivable ($70,000 × 32%) ................................ 22,400

Income tax expense.......................................................... 27,800

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Assignment 16-14

Requirement 1

Tax loss carryforward ($334,400 ÷ 38%) ...................................................... $880,000Tax loss used in 20x6..................................................................................... (50,000)Tax loss carryforward remaining ................................................................... $830,000

Opening balance, deferred income tax asset .................................................. $334,400Required closing balance ($830,000 × 40%) ................................................. 332,000Credit to deferred income tax asset................................................................ $ 2,400

20x6 EntriesIncome tax expense ($50,000 × .40) ...................................... 20,000


Income tax payable ................................................................ 20,000Deferred income tax asset—LCF (see above) ................. 2,400Income tax expense.......................................................... 17,600

Note that the second entry combines two things—the elimination of the income tax payable account, $20,000, and the effect of the tax rate change on the opening balance of the deferred income tax asset account, $17,600 ($880,000 × .02 = $17,600).

Requirement 2

Tax loss carryforward (above) ....................................................................... $ 880,000Tax loss, 20x6 ................................................................................................ 220,000Tax loss carryforward .................................................................................... $1,100,000

Opening balance, deferred income tax asset .................................................. $ 334,400Required closing balance ($1,100,000 × .40) ................................................ 440,000Debit to deferred income tax asset................................................................. $ 105,600

20x6 Entry:Deferred income tax asset—LCF........................................... 105,600

Income tax expense.......................................................... 105,600

$105,600 is the benefit of the current year loss, $88,000 ($220,000 × .40), plus an$17,600 increase to the opening balance.

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Assignment 16-15

Requirement 1Taxable loss:

Accounting loss........................................................................................ $(480,000)Add back: depreciation ............................................................................ 67,500Taxable loss ............................................................................................. $(412,500)

Requirements 2, 3 and 4

The loss carryback will be $324,750, resulting in a refund (benefit) of $81,450. This leaves $87,750 ($412,500 – $324,750) as a tax loss carryforward. The benefit of this tax loss carryforward is $35,100 at 20x5 tax rates of 40%. The tax loss can be recorded as an asset if it is more probable than not that the company will realize the tax loss carryforward in the carryforward period.

Requirement 5

Income tax receivable .................................................................. 81,450Deferred income tax (LCF).......................................................... 35,100Deferred income tax *.................................................................. 27,000

Income tax expense (recovery) .............................................. 143,550*$7,455,000 – ($9,630,000 – $67,500) = $(2,107,500) × 40% = $(843,000) vs. $(870,000)op.

Requirement 6

Income tax receivable .................................................................. 81,450Deferred income tax..................................................................... 27,000

Income tax expense (recovery) .............................................. 108,450

Requirement 7

(a) LCF has been recorded:

Income tax expense ($150,000 × 40%)........................................ 60,000Deferred income tax (LCF)................................................... 35,100Income tax payable ($62,250 × 40%) .................................... 24,900

(b) LCF has not been recorded:

Income tax expense...................................................................... 60,000Income tax payable ............................................................... 24,900Income tax expense—LCF recognition ................................. 35,100

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Assignment 16-16

Requirement 1

20X6 entry

Income tax receivable1 .......................................................... 503,200Future income tax asset—LCF ($300,000 × 38%) ................ 114,000


1 Carryback for past three years:

YearTaxable income

Tax rate Tax paid

20X3 $440,000 34% $149,60020X4 680,000 34% 231,20020X5 340,000 36% 122,400

$1,460,000 $503,200

Carryforward available: $2,680,000 loss – $1,460,000 carryback = $1,220,000

Requirement 2

20X7 entry

Income tax expense ($300,000 × 38%).................................. 114,000Deferred income tax asset—LCF..................................... 114,000

Deferred income tax asset—LCF ($920,000 × 38%)............. 349,600Income tax expense.......................................................... 349,600

[To recognize the previously unrecognized loss carryforward]

At the end of 20X7, the unrealized loss carryforward is $920,000, all of which has been recognized.

20X8 entry

Income tax expense ($760,000 × 40%).................................. 304,000Deferred income tax asset—LCF..................................... 304,000

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Assignment 16-17

Loss carryforward from 20X4 tax loss = $550,000 – $150,000 carryback = $400,000.

20X4 balances:Deferred income tax asset– LCF ($60,000 38% + $340,000 36%) ......... $145,200

Valuation account – DIT asset ($200,000 36%).......................................... 72,000Net DIT asset reported on the balance sheet

($60,000 38% + $140,000 36%) .................................................. $ 73,200

20X5 balances:Deferred income tax asset – LCF [($400,000 – $80,000) 36%].................. $115,200

Valuation account – DIT asset ($200,000 36%).......................................... 72,000

Net DIT asset reported on the balance sheet ($120,000 36%) $ 43,200

20X6 balances:Deferred income tax asset–LCF [($400,000– $80,000 – $100,000) 36%].. $ 79,200Valuation account – DIT asset........................................................................ 0Net DIT asset reported on the balance sheet ($220,000 36%) .................... $ 79,200

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Assignment 16-18

Requirement 1

20x5 20x6 20x7 20x8 20x9

Pretax income (loss) $ 10,000 $12,000 $ 15,000 $(106,000) $ 13,000Add depreciation 10,000 10,000 10,000 10,000 10,000Deduct CCA (10,000) (18,000) (14,000) ______ ______Taxable income (loss) $ 10,000 $ 4,000 $ 11,000 $(96,000) $23,000

Tax loss carryforward available:Loss for tax purposes, 20x8 ........................................................................... $96,000Loss carryback (20x5 $10,000 + 20x6 $4,000 + 20x7 $11,000): .................. (25,000)Tax loss carryforward available, 20x8........................................................... $71,000

20x8 Entry:

Income tax receivable ($25,000 × .4) .................................... 10,000Deferred income tax asset—LCF ($71,000 × .4)................... 28,400Deferred income tax—long term ($10,000 × .4, or see table) 4,000


20x9 Entries:

Income tax expense................................................................ 5,200Deferred income tax—long term ($10,000 × .4, or see table) 4,000

Income tax payable ($23,000 × .4)................................... 9,200

Income tax payable ................................................................ 9,200Deferred income tax asset—LCF..................................... 9,200

Requirement 2

Balance in deferred income tax (a long-term asset):Deferred income tax asset—LCF ($28,400 – $9,200) ............................. $19,200 dr.Deferred income tax—long term (see table)............................................ 3,200 dr.Total ......................................................................................................... $22,400 dr.

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Schedule of Temporary Differences(amounts in thousands)

Taxbasis

Accountingbasis

Temporarydifference

Deferredincome tax

Opening balance Adjustment

20x5–40%Capital assets $190 $190 $ 0 $ 0 $ 0 $0

20x6–40%Capital assets 172 180 (8) (3.2) 0 (3.2)

20x7–40%Capital assets 158 170 (12) (4.8) (3.2) (1.6)

20x8–40%Capital assets 158 160 (2) (.8) (4.8) 4.0

20x9–40%Capital assets 158 150 8 3.2 (.8) 4.0

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Assignment 16-19


Accounting income (loss) ......................................................... $(536,000) $ 450,000Depreciation.............................................................................. 50,000 50,000CCA .......................................................................................... 0 (50,000)Taxable income (loss) ............................................................... $(486,000) $450,000

Disposition of tax loss:Carryback ...................................................................................$359,000 × .38 = $136,420Carryforward .............................................................................. 127,000 × .40 = 50,800

Total .....................................................................................$486,000


Taxbasis

Accountingbasis

Temporary

differenceDeferredincome

tax


20x5 – 35%Capital asset $630 $750(1) $(120) $(48) $(64.6)(2) $16.6

20x6 – 35%Capital asset 580(3) 700(1) (120) (48) (48) 0

(1) $800,000 – $50,000; $750,000 – $50,000(2) ($630,000 – $800,000) × .38(3) $630,000 – $50,000

Tax expense:20x5 20x6

Income tax receivable .............................................................. $136,420 $ 0Income tax payable ($450,000 – $127,000) × .40..................... 0 129,200Income tax—LCF ..................................................................... 50,800 0Use of LCF ($127,000 × .40) (drawdown of asset) .................. 0 50,800Deferred tax liability, change in year ........................................ 16,600 0Total tax expense (recovery)..................................................... $(203,820) $180,000

Net income20x5 20x6

Income (loss) before tax........................................................... $(536,000) $450,000 Income tax expense (recovery) ................................................ (203,820) 180,000 Net income (loss) ..................................................................... $(332,180) $270,000

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Requirement 2

Net income20x5 20x6

Income (loss) before tax........................................................... $(536,000) $450,000Income tax expense (recovery) ................................................ (153,020)* 180,000Income tax expense (recovery) LCF recognition ..................... — (50,800)Net income (loss) ..................................................................... $(382,980) $320,800

* $203,820 – $50,800

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Schedule of Accounting and Taxable Income(amounts in thousands)

20x5 20x6 20x7 20x8 20x9

Accounting income (loss) $ 0 $ (980) $ 0 $2,000 $4,000Less: non-taxable dividends 0 (20) (20) 0 0

0 (1,000) (20) 2,000 4,000Temporary differences:

Warranty expense 60 120 160 200 300Warranty claims paid (60) (80) (200) (90) (75)Depreciation expense 600 600 600 600 600CCA (600) 0 (500) (450) (400)

Taxable income $ 0 $ (360) $ 40 $2,260 $4,425


Taxbasis

Accountingbasis

Temporarydifference

Deferredincome tax


20x5–40%Capital assets $5,600 $7,600 $(2,000) $(800) $(800) $0Warranty 0 0 0 0 0 0

20x6–40%Capital assets 5,600 7,000 (1,400) (560) (800) 240Warranty 0 (40) 40 16 0 16

20x7–40%Capital assets 5,100 6,400 (1,300) (520) (560) 40Warranty 0 0 0 0 16 (16)

20x8–45%Capital assets 4,650 5,800 (1,150) (517.5) (520) 2.5Warranty 0 (110) 110 49.5 0 49.5

20x9–45%Capital assets 4,250 5,200 (950) (427.5) (517.5) 90Warranty 0 (335) 335 150.75 49.5 101.25

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Journal Entries (amounts in thousands):

20x6 EntryDeferred income tax—capital assets....................................... 240,000Deferred income tax—warranty.............................................. 16,000Deferred income tax asset—LCF ($360 x .40) ....................... 144,000

Income tax expense (recovery) ......................................... 400,000

20x7 EntriesDeferred income tax—capital assets....................................... 40,000

Deferred income tax—warranty........................................ 16,000Income tax payable ($40 x .4)........................................... 16,000Income tax expense (recovery) ......................................... 8,000

Income tax payable ................................................................. 16,000Deferred income tax asset—LCF...................................... 16,000

Gross LCF now $360,000 – $40,000 = $320,000; recorded at 40%, or $128,000

20x8 EntriesIncome tax expense................................................................. 965,000Deferred income tax —capital assets...................................... 2,500Deferred income tax —warranty............................................. 49,500

Income tax payable ($2,260 × .45).................................... 1,017,000Income tax payable ($320 × .45)............................................. 144,000

Deferred income tax asset—LCF ($144 – $16) ................ 128,000Income tax expense ($320 × (.45 – .40)) .......................... 16,000

20x9 EntryIncome tax expense................................................................. 1,800,000Deferred income tax—warranty.............................................. 101,250Deferred income tax—capital assets....................................... 90,000

Income tax payable ($4,425 × .45).................................... 1,991,250

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Assignment 16-21

Requirement 1

Calculation of Taxable Income/Tax payable

(table in thousands)

TaxBasis

CarryingValue

Temp.Diff.

Future taxLiability


CA - 20x6 700 950 (250) (90) 0 (90)CA - 20x7 700 900 (200) (76) (90) 14CA - 20x8 575 850 (275) (110) (76) (34)

20x6 20x7 20x8Accounting inc/(loss)…. 502,200 (754,000) 1,200,000Depreciation………… 50,000 50,000 50,000

CCA………………… (300,000) 0 (125,000)Dividend revenue……... (10,000) (75,000) (10,000)Golf club dues………... 19,000 20,000 20,000

261,200 (759,000) 1,135,000 × .36 × .40

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Entries

20x6

Tax expense ........................................................................... 184,032Deferred income tax—capital assets................................ 90,000Tax payable ...................................................................... 94,032

20x7

Tax receivable . ...................................................................... 94,032Deferred income tax—LCF ($759,000 – $261,200) × .38..... 189,164Deferred income tax—capital assets ..................................... 14,000

Tax expense ..................................................................... 297,196

20x8

Tax expense ........................................................................... 488,000Deferred income tax—capital assets ............................... 34,000Tax payable ..................................................................... 454,000

Tax payable ($759,000 – $261,200) × .40 ............................. 199,120Deferred income tax (LCF) ............................................. 189,164Tax expense ($759,000 – $261,200) × (.38 – .40)........... 9,956

Requirement 2

If the taxes payable method were used, tax expense would equal cash paid (or received ) each year. There would be no deferred income tax recognized, and no loss carryforward recognition. In the year of loss carryforward use, there would be no tax expense as none is paid.

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Assignment 16-22

Calculation of Taxable Income/Tax Payable:

20x1 20x2 20x3 20x4Accounting income………… $220 $(1,200) $130 $200Depreciation………………... 200 200 200 200CCA……………………….. (250) 0 (100) (190)Rental revenue…………….. (65) 0 65 0Taxable income $ 105 $(1,000) $295 $210

36% 34% 32% 30%$ 37.8 $94.40 $63.00

DIT Table

TaxBasis

Accounting Difference DIT Balance


CA20x1 36% 3,850 3,900 (50) (18) 0 (18)20x2 34% 3,850 3,700 150 51 (18) 6920x3 32% 3,750 3,500 250 80 51 2920x4 30% 3,560 3,300 260 78 80 (2)A/R20x1 36% 0 65 (65) (23.4) 0 (23.4)20x2 34% 0 65 (65) (22.1) (23.4) 1.320x3 32% 0 0 0 0 (22.1) 22.1LCF20x3 32% 600(1) 192 0 19220x4 30% 390(1) 117 192 (75)

(1) $1,000,000 – $105,000 – $295,000 = $600,000; $600,000 – $210,000 = $390,000

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Entries

20x1

Tax expense .......................................................................... 79,200Deferred income tax—capital assets................................ 18,000Deferred income tax—accounts receivable ..................... 23,400Tax payable ..................................................................... 37,800

20x2

Tax receivable ....................................................................... 37,800Deferred income tax—capital assets...................................... 69,000Deferred income tax—accounts receivable .......................... 1,300

Tax recovery ................................................................... 108,100

20x3

Tax expense .......................................................................... 43,300Deferred income tax—capital assets...................................... 29,000Deferred income tax—accounts receivable .......................... 22,100

Tax payable ..................................................................... 94,400

Tax payable ........................................................................... 94,400Deferred income tax—loss carryforward............................... 192,000

Tax expense .................................................................... 286,400

20x4

Tax expense .......................................................................... 65,000Deferred income tax—capital assets................................ 2,000Tax payable ...................................................................... 63,000

Tax payable ........................................................................... 63,000Tax expense ......................................................................... 12,000

Deferred income tax—loss carryforward......................... 75,000

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Assignment 16-23

Requirement 1

20x5 EntryIncome tax expense ($8,000 × .4) ............................................. 3,200

Income tax payable ............................................................. 3,200[Taxable income: $8,000]

20x6 EntryIncome tax expense................................................................... 6,000

Deferred income tax—long-term (see table)....................... 3,200Income tax payable ($15,000 + $10,000 – $18,000) × .4 ... 2,800

[Taxable income : $7,000]


Deferred income tax—long-term (see table)....................... 1,600Income tax payable ($9,000 + $10,000 – $14,000) × .4 ..... 2,000

[Taxable income: $5,000]

20x8 EntryDeferred income tax— long-term (see table)............................ 4,000Income tax receivable ($3,200 + $2,800 + $2,000) .................. 8,000Deferred income tax asset—LCF (1) ........................................ 26,000

Income tax expense (recovery) ........................................... 38,000

(1) ($95,000) + $10,000 = ($85,000); LCB = $20,000 ($8,000 + $7,000 + $5,000)LCF = $85,000 – $20,000 = $65,000 × .4 = $26,000

20x9 EntryIncome tax expense................................................................... 2,400Deferred income tax—long term (see table)............................. 4,000

Income tax payable ($6,000 + $10,000) × .4 ...................... 6,400

Income tax payable ................................................................... 6,400Deferred income tax asset— LCF....................................... 6,400

(1) TaxBasis

CarryingValue

Temp.Diff.

Deferredtax


20x5 $90,000 $90,000 $ 0 $ 0 $ 0 $ 020x6 72,000 80,000 (8,000) (3,200) 0 (3,200)20x7 58,000 70,000 (12,000) (4,800) (3,200) (1,600)20x8 58,000 60,000 (2,000) (800) (4,800) 4,00020x9 58,000 50,000 8,000 3,200 (800) 4,000

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Requirement 2


Income tax payable ............................................................. 3,200


Deferred income tax—long-term (1) .................................. 3,200Income tax payable ............................................................. 2,800


Deferred income tax—long-term (1) .................................. 1,960Income tax payable ($5,000 × .43)...................................... 2,150

20x8 EntryDeferred income tax—long-term (1) ........................................ 4,260Income tax receivable ............................................................... 8,150Deferred income tax asset—LCF ($65,000 × .45).................... 29,250


20x9 EntriesIncome tax expense................................................................... 2,860Deferred income tax—long-term (1) ........................................ 4,660

Income tax payable ($16,000 × .47).................................... 7,520Income tax payable ($16,000 × .47).......................................... 7,520

Deferred income tax asset—LCF (2) .................................. 6,220Income tax expense [$65,000 × (.47 – .45)] ....................... 1,300

(1) TaxBasis

CarryingValue

Temp.Diff.

Deferredtax


20x5 $90,000 $90,000 $ 0 $ 0 $ 0 $ 020x6 40% 72,000 80,000 (8,000) (3,200) 0 (3,200)20x7 43% 58,000 70,000 (12,000) (5,160) (3,200) (1,960)20x8 45% 58,000 60,000 (2,000) (900) (5,160) 4,26020x9 47% 58,000 50,000 8,000 3,760 (900) 4,660

(2) ($65,000 – $16,000) = $49,000 × .47; $23,030 versus $29,250 opening balance

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Requirement 3

20x8 Entry:Deferred income tax—long-term........................................... 4,000Income tax receivable ............................................................ 8,000


20x9 Entries:Income tax expense................................................................ 2,400Deferred income tax—long-term........................................... 4,000


Deferred income tax asset—LCF ($26,000 – $6,400) ........... 19,600Income tax payable ................................................................ 6,400

Income tax expense (recovery) ........................................ 26,000hzzled



Assignment 16-24

20x5 EntriesIncome tax expense (4) ...................................................... 417,600

Deferred income tax—capital assets (2)(3) ................. 56,400Deferred income tax—rent (2)(3) ................................ 64,000Income tax payable (1)................................................. 297,200

Income tax payable ($75,000 × 40%) ................................ 30,000Deferred income tax asset—LCF................................. 30,000

(1) Income tax payable:Accounting income before tax ........................................... $1,024,000Permanent differences:

Tax-free dividend revenue ........................................... (60,000)Non-deductible entertainment...................................... 80,000

Temporary differences:Rent revenue ................................................................ (160,000)Depreciation................................................................. 160,000CCA ............................................................................. (301,000)

Taxable income.................................................................. $ 743,000Income tax payable (40%) ................................................. $ 297,200

(2) TaxBasis

CarryingValue

Temp.Diff.

Deferred taxLiability


Capital Assets $1,864,000(a) $2,756,000(b) $(892,000) $(356,800) $(300,400) $(56,400)Rent 0 160,000 (160,000) (64,000) 0 (64,000)

(a) $2,165,000 – $301,000(b) $2,916,000 – $160,000

(3) Alternative calculations($301,000 – $160,000) × 40% = $56,400($160,000 – $0) × 40% = $64,000

(4) $297,200 + $56,400 + $64,000 = $417,600

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Assignment 16-25

Requirement 1


Deferred income tax—long term (($350 – $360) × .40)..... 4,000Income tax payable (($60 – $10 + $40 – $50) × .40).......... 16,000

Taxable income: $40,000

20x6 EntryIncome tax receivable ............................................................... 16,000Deferred income tax—long term (($350 – 320 + 10) × .40)..... 16,000Deferred income tax asset—LCF.............................................. 52,000

Income tax expense (recovery) ........................................... 84,000Taxable loss (($200,000) – $10,000 + $40,000) = ($170,000)LCF: $170,000 – $40,000 = $130,000 × .40

20x7 EntriesIncome tax expense................................................................... 36,000

Deferred income tax—long term (($40 – $50) × .40)......... 4,000Income tax payable (($100 – $10 + $40 – $50) × .40)........ 32,000

Taxable income: $80,000

Income tax payable ................................................................... 32,000Deferred income tax asset—LCF........................................ 32,000

Requirement 2


Deferred income tax—long term ........................................ 4,000Income tax payable ............................................................. 16,000

20x6 EntryIncome tax receivable ............................................................... 16,000Deferred income tax—long term .............................................. 16,600Deferred income tax asset—LCF ($130 × .42)......................... 54,600


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Deferred income tax—long term ........................................ 3,800Income tax payable ($80,000 × .44).................................... 35,200

Income tax payable ................................................................... 35,200Future income tax asset—LCF ........................................... 32,600Income tax expense (recovery) ........................................... 2,600

Temporary differences:

Capital Assets:

TaxBasis

CarryingValue

Temp.Diff.

Deferredtax


20x5 40% $350,000 $360,000 ($10,000) ($ 4,000) $ 0 ($ 4,000)20x6 42% 350,000 320,000 30,000 12,600 ( 4,000) 16,60020x7 44% 300,000 280,000 20,000 8,800 12,600 ( 3,800)

LCF

20x6 42%20x7 44%

130,00050,000

54,60022,000

054,600

54,600(32,600)

Requirement 3

20x5 Entry (no change)Income tax expense................................................................... 20,000

Deferred income tax—long-term........................................ 4,000Income tax payable ............................................................. 16,000

20x6 EntryIncome tax receivable ............................................................... 16,000Deferred income tax—long-term ............................................. 16,000



Deferred income tax—long-term........................................ 4,000Income tax payable ............................................................. 32,000

Income tax payable ................................................................... 32,000Income tax expense (recovery) ........................................... 32,000

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Assignment 16-26

Requirement 1

20x5 EntriesDeferred income tax—long term, capital assets (1).................. 18,250

Income tax payable (2)........................................................ 5,100Income tax expense (recovery) ........................................... 13,150

Tax expense .............................................................................. 112,000Income tax payable ................................................................... 5,100

Deferred income tax asset—LCF (opening balance (3)...... 117,100[Net income tax expense is caused by the change in tax rate on DIT debits.]


Deferred income tax —long term, capital assets (1)........... 15,050Income tax payable (4)........................................................ 11,840

Income tax payable ................................................................... 11,840Income tax expense—LCF write-off ........................................ 655,060

Deferred income tax asset—LCF (opening balance) (5) .... 666,900

(1)(in 000’s)Capital Assets

TaxBasis

CarryingValue

Temp.Diff.

Deferred taxLiability


20x5 30% $1,497.5 $2,570 $(1,072.5) $(321.75) $(340.00) $18.250 dr.20x6 32% $1,497.5 $2,550 (1,052.5) (336.80) (321.75) (15.050) cr.

(2) ($27,000 + $80,000 – $90,000) = $17,000 × .30 = $5,100

(3) Gross loss Cf = 784,000/.35 = $2,240,000. At the end of the year, 2,223,000 x .30 = $666,900 vs $784,000 recorded; a decrease of $117,100

(4) $17,000 + $20,000 = $37,000 × .32 = 11,840 cr.

(5) Adjusted balance at the end of 20x5, $666,900 (above, 3). The gross tax loss carryforward is now $2,223,000 – $37,000 = $2,186,000, but it is now unrecorded.

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Requirement 2

20X6 Entries

Income tax expense 26,980Deferred income tax – long term, capital assets .... 15,050Income tax payable ($37,000 32%) .................... 11,840

Income tax payable......................................................... 11,840Deferred income tax asset—LCF........................... 11,840

Income tax expense (recovery)....................................... 655,060Deferred income tax asset—LCF (6) ............................. 44,460

Valuation allowance—FIT asset ........................... 699,520

(6) Loss carryforward and DIT asset for LCF:Carryforward DIT asset

Tax loss carryforward, end of 20X5 (t=30%) $2,223,000 $ 666,900LCF used in 20X6 (@32%) 37,000 11,840Remaining balance 2,186,000 655,060Correct balance at new rate of 32% 699,520Adjustment for tax rate change $ 44,460

Explanation: The first entry is the same as in requirement 1. The second entry records the elimination of tax payable. The third entry adjusts DIT to the new balance (debit adjustment of $44,460) and sets

up the valuation allowance for the full remaining balance of the DIT asset ($699,520).

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Carryback

Of the $220,000 tax loss, $120,000 can be carried back to the preceding three years. The carryback will result in CTC’s realizing a full refund of taxes paid in 20x1, 20x2, and 20x3. The total refund will be $45,600.

Carryforward

The remaining $100,000 of the 20x4 tax loss can be carried forward and applied against taxable income in the next 20 years. Since management believes that the probability of realizing the future tax benefits is greater than 50%, the deferred income tax benefit should be recognized in the year of the loss, 20x4. The 20x5 enacted rate of 36% can be used. A deferred income tax asset of $36,000 will be recognized.

Temporary differences 20x3 – 40% Temporary Difference Ending Balance

Capital assets $95,000* deferred $38,000* cr.Pensions 55,000* deferred 22,000* cr.

$60,000 cr.

20x4 – 36%

Capital assets $85,000** deferred $30,600 cr.Pensions 85,000** deferred 30,600 cr.

$61,200 cr.* given** ($95,000 – $10,000); ($55,000 – $30,000 + $60,000)

Journal entry to record income tax:

Income tax receivable ............................................................ 45,600Deferred income tax—LCF ................................................... 36,000

Income tax expense.......................................................... 80,400Deferred income tax—long term ($61,200 – $60,000).... 1,200

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Lower portion of income statement

Income (loss) from operations before income tax ......................................... ($200,000)Income tax (recovery) .................................................................................... 80,400Net income (loss) ........................................................................................... ($119,600)

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Assignment 16-28

Impact of income taxes on 20x5 financial statements:

1. Deferral of product development expensesThis expenditure will be deductible for tax purposes now although it will be expensed for accounting purposes later. This will result in a deferred income tax liability, as the tax benefit has been received.

2. Depreciation vs. CCAIn prior years, CCA has been greater than depreciation, causing a $460,000 (credit) deferred tax liability to be recognized on the balance sheet. This year, no CCA is claimed so the credit will be reduced.

3. Statement of Financial Position presentation of deferred income tax liabilitiesThe deferred income tax liabilities will be shown together, as long-term liabilities.

If the tax rate were to change, this liability would also change, and the adjustment would be part of income tax expense.

4. Effect of the tax lossThe tax loss of $3 million would first be used to trigger a refund of taxes paid in the last three years. This will result in income tax receivable, a current asset, and a tax recovery (negative expense) on the income statement. The remainder of the tax loss ($3 million less amount that was carried back) is a tax loss carryforward and can be used to avoid taxes otherwise payable on future taxable income over the next 20years. After that, it expires. The benefit of the loss carryforward is measured as the gross carryforward multiplied by the enacted tax rate.

If CCL can establish that it is probable (probability greater than 50%) that the tax loss carryforward will be used during the next 20 years, it can be recorded in 20x5. This will result in recognizing a deferred income tax asset and a tax recovery (negative expense) on the income statement. This will help offset the loss.If the probability of using the loss carryforward is less than 50%, the benefit of the loss carryforward is not lost, but won’t be recognized on the books until used or until the probability rises to above 50%. This later period will then experience the boost to earnings caused by the tax recovery.

Is the probability of loss carryforward usage greater or less than 50%? Forecasts should be consulted. However, unless the capital upgrades can be financed, a ‘less than probable’ assessment seems appropriate.

5. Projected capital asset replacementWhen capital assets, are replaced, the company will be able to claim CCA, reducing taxable income, and will also perhaps be able to claim investment tax credits. Taxable income must be earned for both to have value. CCA may be claimed at thecompany’s discretion, up to the calculated yearly maximum, allowing flexibility in tax planning. This has no impact on 20x5 financial statements.

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Assignment 16-29

Laredo Inc.Income Statement

for the year ended xx 20x6

Income before tax................................................................... $124,000Income tax expense, of which $7,106 is current.................... 52,310*Net income ........................................................................ $ 71,690

*See calculations, below: $56,060 – $3,750. Current portion payable, $30,856 – $23,750

20x6 Entries:Income tax expense................................................................ 56,060

Deferred income tax—warranty (1) ................................. 130Deferred income tax—capital assets (1) .......................... 25,074Income tax payable (2)..................................................... 30,856

Income tax payable ($20,000 ÷ .32 = $62,500; $62,500 × .38) 23,750Deferred income tax (LCF).............................................. 20,000Income tax expense ($62,500 × (.32 – .38)) .................... 3,750

(1) Schedule of Temporary Differences

Taxbasis

Accountingbasis

Temporarydifference

Deferredincome tax


20x6–38%Capital assets $384,700 $577,000 $(192,300) $(73,074) $(48,000) $(25,074)Warranty 0 (500) 500 190 320 (130)

Accounting carrying value = $618,000 – $41,000 = $577,000Tax carrying value = $468,000 – ($41,000 + $42,300) = $384,700

(2) Taxable income (given) $81,200 × .38 = $30,856

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Assignment 16-30

Requirement 1

20x4 20x5 20x6Income before income tax $ 0 $(1,700,000) $ 900,000Income tax expense (recovery) (1,520) 668,080 338,400Net income $1,520 $(1,031,920) $561,600

Taxable income (in thousands):20x4 20x5 20x6

Income before income tax…………………….. $ -- $(1,700) $900Plus/minus:

Non-deductable expenses…………………….. -- 40 50Non-taxable revenues………………………… (4) (10) (12)

Plus/minus:Excess of CCA versus depreciation………….. -- 150 (250)Taxable income (loss)………………………... (4) (1,520) 688

Tax payable (prior to using loss carryforward) … n/a n/a $309.6


Taxbasis

Accountingbasis

Temporarydifference

DIT Opening balance Adjustment

20x4– 38%Capital asset

LCF$225 $225 $0

4$0 1.52

$00

$0 1.52

20x5 – 40%Capital asset

LCF3,220 3,070 150

1,52460

609.601.52

60608.08

20x6– 45%Capital asset

LCF2,770 2,870 (100)

836 (1)(45)376.2

60609.6

(105) (233.4)

(1) $1,524,000 - $688,000 = $836,000

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Entries (not required)

20x4 Deferred income tax (LCF; $4,000 × .38) ....................... 1,520Income tax expense (recovery) ................................. 1,520

20x5 Deferred income tax (TD’s; see above) ........................... 60,000Deferred income tax (LCF; see above) ............................ 608,080

Income tax expense (recovery) ................................. 668,080

20x6 Income tax expense.......................................................... 414,600Deferred income tax (TD’s)....................................... 105,000Income tax payable ($688,000 × .45)......................... 309,600

Income tax payable ($688,000 × .45)............................... 309,600Deferred income tax (LCF)........................................ 233,400Income tax expense (LCF; rate change)*................... 76,200

*$1,524,000 × (.40 – .45)

Requirement 2

20x4 20x5 20x6Income before income tax........................................ $ -- $(1,700,000) $ 900,000Income tax expense (recovery)* .............................. -- 60,000 105,000Net income............................................................... $ 0 $(1,640,000) $795,000

* $414,600 – $309,600; components may be disclosed separately.

20x4 no entry; likelihood of tax loss carryforward realization is indeterminable.

20x5 Deferred income tax (TD’s; see above) ........................... 60,000Income tax expense (recovery) ................................. 60,000

20x6 Income tax expense.......................................................... 414,600Deferred income tax (TD’s)....................................... 105,000Income tax payable ($688,000 × .45)......................... 309,600

Income tax payable ($688,000 × .45)............................... 309,600Income tax expense (recovery)(LCF)......................... 309,600

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Chapter 17: Accounting for Leases

Suggested TimeCase 17-1 Warmth Home Comfort Limited 17-2 Sandsupport Corporation

17-3 Bliss Air Line Limited Assignment 17-1 Operating lease................................................. 15

17-2 Operating lease—lessee inducement ............... 1517-3 Terminology, classification, entries ................. 2517-4 Finance lease fundmentals ............................... 1517-5 Terminology, classification, entries (*W)........ 2517-6 Amortization table; entries............................... 2017-7 Amortization table; entries............................... 6017-8 Lease motives................................................... 2017-9 Finance lease—lease year ≠ fiscal year (*W) .. 3017-10 Finance lease; quarterly payments;

current-noncurrent classification............. 2517-11 Finance lease, reporting (*W).......................... 4017-12 Finance lease, guaranteed residual................... 3017-13 Finance lease, guaranteed residual................... 4017-14 Finance lease, guaranteed residual,

future balance..........................................17-15 Implicit interest rate; future balance ................17-16 Finance lease, quarterly payments;

fair value cap...........................................17-17 Finance lease .................................................... 4017-18 Sale and leaseback (*W).................................. 4017-19 Sale and leaseback ........................................... 2517-20 Sale and leaseback ........................................... 2017-21 Classify two leases ........................................... 40

continued...

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Copyright 2011 McGraw-Hill Ryerson Ltd. All rights reserved


17-22 Finance lease—lessor....................................... 2017-23 Finance lease—lessor....................................... 3017-24 Finance lease—lessee and

lessor (*W)............................................... 3517-25 Finance lease—lessee and

lessor ........................................................ 2517-26 Sales-type lease ................................................ 2017-27 Finance lease; lessor, lessee ............................ 3017-28 Classification, lessor and lessee financial

statements.................................................. 4017-29 Cash flow statement review ............................. 2517-30 Cash flow statement review ............................. 45

*W The solution to this exercise/problem is on the text Web site and in the Study Guide. The solution is marked WEB.

Note to instructors: This material typically assumes that students will use financial calculators

or computer spreadsheets to ascertain the implicit interest rate (discount rate) of a lease payment stream. If this is not true for your students, provide the implicit interest rate (discount rate) when assigning material.

Compound interest tables are available to students on the Online Learning Centre. Present value tables are included in the back of the textbook.

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Questions

1. The total rent over the lease term is $30,000 ($1,000 × 30). One-third, or $10,000, is recognized as rent expense each year

2. A lease is normally classified as a finance lease if:

there is reasonable assurance that the lessee will obtain ownership of the leased property at the end of the lease term, through automatic transfer of title or a bargain purchase option;

the lessee receives substantially all the economic benefits to be derived from the leased property; the lease term should be a major portion of the asset's useful life;

the lessor will recover the investment in the leased property plus receive a return on investment; the present value of the minimum lease payment should besubstantially all of the fair value of the leased equipment; or

the leased asset is highly specialized to the lessee.

These four criteria require the use of judgment in specific situations: use of words like “reasonable assurance”, and “substantially all” leave interpretation to managers and accountants.

3. A lease may be preferable to outright acquisition because the lease may: not have to be capitalized (i.e., the company may achieve off-balance sheet

financing), provide 100% financing, be more flexible, lock in an interest rate for a long time period, and/or transfer tax benefits between the lessee and lessor.

4. The lease is, in substance, a means to finance the sale of the car, which belongs to the lessee at the end of the lease term. This is a finance lease (or, under ASPE, a capital lease).

5. Deferred rent liability would appear in a lessee's books if there is a low or no-rent period at the beginning of a multi-year lease term.

6. Definitions (per text):

A bargain purchase option exists when there is a stated or determinable price given in the lease that is sufficiently lower than the expected fair value of the leased asset at the option’s exercise date to make it likely that the lessee will exercise the option.

The lease term is the length of the lease and includes:

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all terms prior to the exercise date of a bargain purchase option, all bargain renewal terms, and all renewal terms at the lessor’s option.

Minimum net lease payments is the total of all payments over the lease term, net of any operating or executory costs that are implicitly included in the lease payment, plusany bargain purchase option or guaranteed residual value.

Contingent lease payments are additional payments that are based on subsequent events, such as rent calculated on a percentage of a lessee’s gross sales revenue. These are not included in the minimum lease payments.

Bargain renewal term is a period for which the lessee has the option of extending the lease at lease payments that are substantially less than would normally be expectedfor an asset of that age and type.

A guaranteed residual value is an amount that the lessee agrees to assure that the lessor can get for the asset by selling it to a third party at the end of the lease term.

The lessee’s incremental borrowing rate (IBR) is the interest rate that the lessee would have to pay if they obtained financing through the bank (or other credit sources) to buy the asset.

The interest rate implicit in the lease is the interest rate that discounts the minimum net lease payments (plus the initial direct costs and the estimated residual value) to equal the fair value of the leased property at the beginning of the lease. It is the internal rate of return (IRR) for the lease, which is also referred to as the lessee’s implicit rate.

7. Renewal options are not part of the lease term unless they are bargain renewal options or options at the lessor's discretion. The lease term is three years.

8. The lease term is six years and includes the renewal option, since it is at the lessor’s option. It would also be six years if the rent were $1 in the renewal period, implying a bargain price.

9. Minimum net lease payments: [($14,000 – $2,500) × 2] + $1,000 = $24,000

10. The interest rate implicit in the lease terms for the lessee:

$48,500 = ($10,000 –1,000) (P/A, i, 6) + ($6,000) (P/F, i, 6)By trial and error (or spreadsheet, financial calculator, etc.) i = 6% (approximate)

This is not the implicit rate for the lessor as the lessor would include any initial direct costs, may expect an actual residual value that is higher than the guaranteed amount, and may include the benefit of CCA tax shields and other implications in thecalculations. The lessor may also be working from a different fair market value, such as by bulk purchase.

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11. A non-profit organization is not typically not subject to income taxes and therefore is not able to benefit from the tax shield of CCA. As a result, the organization can oftenobtain cheaper financing through lease arrangements because a lessor who is taxable can claim the CCA tax deduction and pass the tax savings back to the lessee in the form of lower lease payments.

12. Interest in the first year: ($135,180 – $20,000) × 10% = $11,518. Interest in the second year: ($115,180 + $11,518 – $20,000) × 10% = $10,670.

13. The depreciation period would be the lease term, ten years. Ten years is the period of use.

14. If lease payments are paid at the end of the fiscal year, the current portion of the liability is only the principal portion of the next lease payment. If payments are made at the beginning of the period, the current portion is the entire next payment, both principal and interest, because the full amount of interest is due on the next day, as well as the principal payment.

15. A sale and leaseback is a financing arrangement whereby the lessee sells an asset to a lessor and simultaneously leases the asset back. The gain on sale is deferred and amortized to income (1) over the lease term under IFRS or (2) in proportion to depreciation on the asset following ASPE.

16. Under IFRS, the treatment of the gain depends on the relationship between the sale price and the fair value of the building. If the sale price is equal to the building’s fair value, the gain is recognized in earnings in the period of the sale. If the sale price is higher than the fair value, the gain is deferred and amortized over the lease period in proportion to the lease payments.

17. Before a private Canadian corporate lessor can record a lease as a capital (i.e., finance) lease, two additional conditions must be satisfied:

1. The credit risk concerning the lease payments must be normal as compared to similar receivables, and

2. Any unreimbursable costs that the lessor will incur during the lease term must be estimable.

If these two conditions are satisfied and at least one of the general criteria for lease capitalization is also satisfied, then the lessor can record the lease as either a capital lease (if a financial intermediary) or as a sales-type lease (if a manufacturer or dealer). Otherwise, the lease is recorded as an operating lease.

18. The lessor always uses the interest rate implicit in the lease as a discount rate. [In practice, this is an after-tax calculation that is far more complex than those

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illustrated in the chapter.]

19. A sales-type lease is exactly like a direct financing lease in that it establishes a payment scheme for a lessee over a period of years. However, the lessor in this case is not a financing entity, but rather a manufacturer or dealer whose objective in establishing the lease is to sell their product. A sales-type lease will result in recognition of gross profit (a sale and cost of sales) on the lessor’s books at the inception of the lease.

20. The profit from the sales transaction flows into income in the year of the transaction.No part of the sales profit can be deferred to later years. During the lease term, the seller/lessor will recognize earnings from finance income only.

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Cases

Case 7-1 Warmth Home Comfort Limited

(CICA, adapted)

MEMORANDUM

To: PartnerFrom: CARe: Warmth Home Comfort Limited engagement

Overview

This year the WHCL engagement poses a number of issues that are of particular concern. Management believes the company can be a major player in the heating and cooling markets, and steps have been taken to achieve this goal. In particular, the company has increased its debt significantly in the last year and the new debt has covenants specifying a minimum current ratio and a maximum debt-to-equity ratio. Violating these covenants may result in renegotiation of the terms of the loan or even a demand for immediate repayment. The financial statements will undoubtedly be used by the lenders to monitor WHCL’s adherence to the loan covenants.

The debt-to-equity ratio on 31 December 31 20X7, calculated using the preliminary financial statements, is 1.96 and the current ratio is 1.26. The ratios have worsened since 20X6, when the debt-to-equity ratio was 1.13 and the current ratio was 1.51. The ratios still meet the conditions of the loan, but some accounting issues need to be addressed, and their resolution may have a negative impact on these ratios.

The preliminary financial statements are very close to violation of the debt-to-equity ratio restriction and violation of the current ratio covenant. Because of the risks associated with violating the covenants, the company has an incentive to choose accounting policies that improve or at least do not worsen the ratios. The choices that WHCL must make for a number of controversial accounting issues present WHCL with the opportunity to use “aggressive” accounting methods to increase equity and current assets, and to avoid increases in liabilities. Any such violation of covenants will have to be disclosed in the notes to the financial statements.

Warranty

Probably the most serious business and accounting problem facing WHCL is the potential warranty liability. Problems have arisen with a product that the company has sold since 20X1 raising the prospect of large out-of-pocket costs for the company. The reporting issue is how much, if any, of these costs should be accrued and expensed in the 20X7financial statements (in accordance with IAS 37). The $4,500 actually spent in 20X7on warranty service was expensed in fiscal 20X7.

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According to IAS 37, if the probability of having to pay out is greater that 50% (more likely than not) a provision is required under IAS 37. In this particular case, the lawyers are likely to confirm that there is a greater than 50% chance of settlement. Therefore a provision should be recorded. [Note: should WHCL be unable to estimate the potential liability or should probability of settlement be less than 50% (not more likely than not), then WHCL has a contingent liability. A contingent liability is disclosed, and not recognized. Disclosures include the nature of the contingency and, when practicable, the estimated financial effect and indication of uncertainties.]

A variety of estimates could be made. WHCL obviously wants to minimize the charge to the current period whereas fair reporting might require a larger accrual. The various outcomes are outlined below.

The estimate suggested by Mr. Kovacs is between $6,000 and $7,500. He argues that the problems are due to poor installation by contractors, which would limit the extent of the problem. However, Mr. Kovacs’ incentive to minimize expenses makes his position less reliable. At the other extreme, if all the furnaces require repair the cost will be $2.1 million (14,000 × $150). This cost is not as improbable as it may seem since the government could decide that there is a significant health risk and require the company to inspect and repair all the furnaces. Accruing repair costs for all the furnaces is very conservative—perhaps too conservative.

The chief engineer has suggested that the damage may be due to heavy usage, which occurs in more northerly communities. Since 1,500 to 2,000 furnaces were sold in the north, warranty costs ranging from $225,000 to $300,000 ($150 × 1,500 to $150 ×2,000) could arise. The chief engineer has expertise in the field, but she too is speculating as to the actual cause of the problem.

Yet another basis is the year of manufacture. All of the furnaces repaired so far were made in 20X5 or 20X6. If the problem is associated with those furnaces only, the accrual would be about $600,000, assuming an equal number of furnaces were made in each year (2,000 per year × 2 years × $150). Combining the year of manufacture with the number sold in northern communities results in an estimate of about $120,000 (2,000 sold in northern climates × 40% (two years out of five) × $150).

All of these estimates, except Mr. Kovacs’, put WHCL in violation of the covenants. At this point the estimate of the chief engineer combined with the year of manufacture presents a credible and supportable amount. However, I cannot say I have more confidence in that estimate than in any other. If necessary, we should call in experts to help determine the source of the problem. The accrual made should be the amount less the $4,500 actually expended in the current period.

If the effect of the time value of money is material, then the estimate made should be discounted at a pre-tax rate that reflects the time value of money and the risks specific to

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the provision. IFRS requires that the estimate be remeasured at each reporting period based on the best estimate of the settlement amount.

There are also potential additional liabilities from the health hazards associated with the damaged units. It is virtually impossible to estimate the potential cost of these liabilities since no claims have been made to date and we are not even sure of the number of furnaces affected. As a result, it is not possible to accrue this liability. We should consult independent experts to report on the potential health hazards caused by the damaged furnaces. However, WHCL likely has a contingent liability (IAS 37). A contingent liability is disclosed, and not recognized. Disclosures include the nature of the contingency and, when practicable, the estimated financial effect and indication of uncertainties.

The warranty liability could have a short-term provision (current liability) and long-term provision element, depending on the length of time that the repairs will have to be made. WHCL would prefer to have more of the amount classified as a long-term liability to minimize the impact on the current ratio. The effect on the debt-to-equity ratio is the same regardless of the classification as current or non-current. If the company plans to fix units over the next few months, then the liability should be classified as a short-term provision (current liability). We should examine the company’s action plan to determine how it is planning to proceed.

If WHCL was aware of this liability at the time it sold the furnaces but failed to accrue it, the accrual could be accounted for retroactively as a correction of an error. If it is proved to be an error, there would be no impact on 20X7 income, and therefore no impact on the current ratio. However, the debt-to-equity ratio would be adversely affected since equitywould be reduced as a result of the correction.

Fixed price contract

In January 20X7 WHCL won a fixed price contract to supply heating and air conditioning for a large project. WHCL is recognizing the revenue from the contract on a percentage-of-completion basis, which is the acceptable method to account for the contract. If any uncertainty were to exist with respect to the contract, (a) revenue should be recognised only to the extent of contract costs incurred that it is probable will be recoverable; and (b) contract costs should be recognised as an expense in the period in which they are incurred. The completed contract method is not allowed under IFRS. WHCL should accrue any penalty expected for delaying the project. A penalty is possible because of the strike by WHCL’s factory workers that put production behind schedule.

We should determine how similar sales are accounted for to ensure that similar contracts, if any, are treated consistently. Of course, if the terms of this contract are different, different accounting would be acceptable. We need to evaluate the revenues and expenses allocated to 20X7. WHCL has incentives to overstate revenue and understate expenses because of the covenants. We need to determine how management estimated the total

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costs of the contract and the costs attributed to 20X7. We should assess the reasonableness of the method WHCL used to determine the amount of revenue to be recognized in 20X7. The percentage-of-completion method could be applied in different ways. The percentage could be determined based on costs incurred, furnaces produced, or furnaces delivered. Of potential concern is the amount owed by the contractor. The percentage-of-completion method does not require that any money be collected, but collectibility is required. As a result, we need to satisfy ourselves that the contractor will be able to pay.

Finally, we need to determine if the penalty clause is likely to take effect. At present, even a small penalty could put WHCL in violation of its debt-to-equity covenant. We have to be concerned about whether WHCL will be able to meet the required timetable. We should determine whether WHCL is able to catch up and meet the terms of the contract and whether management plans to do so. In either case, if the answer is no, then a penalty cost should be accrued and the offset recognized as a reduction in contract revenue.

Monthly fees/lease

The furnace rental plan is a new source of revenue for WHCL, and we need to advise the company on how to account for it. The choice is whether to treat this arrangement as an operating lease or as a finance lease. A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership. WHCL would prefer the finance lease because it would allow the revenue from the sale of the furnaces to be recognized immediately, thereby increasing revenue and net income and lowering the debt-to-equity ratio. The finance lease classification would also improve the current ratio because there would be a current receivable. Given what we know at this point, it is not certain whether the criteria for a finance lease are met. Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:

(a) the lease transfers ownership of the asset to the lessee by the end of the lease term;

(b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;

(c) the lease term is for the major part of the economic life of the asset even if title is not transferred;

(d) at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and

(e) the leased assets are of such a specialised nature that only the lessee can use them without major modifications.

IFRSs do not provide a hierarchy to be applied when evaluating the indicators outlined above, and these indicators may not be conclusive. It appears that some of the above

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criteria are met, but more information is required. Transfer of ownership would likely occur because the price is nominal. Whether the lease covers the major part of the life of the furnace or if the present value of the minimum leave payments amounts to substantially all of the fair value of the asset is not clear. The term of the lease seems to be fairly long, so the credit risk may be higher than normal, in which case classification as an operating lease might be more appropriate. To classify the lease as a finance lease, the customers must be able to pay.

The maintenance costs should be accrued and matched against the revenue from the lease. WHCL is responsible for maintenance of the equipment. If the maintenance costs cannot be reasonably estimated, it may be appropriate to classify the lease as an operating lease because the risks associated with the asset are not transferred. Since WHCL has been in the heating business for many years, it is reasonable to assume that the company will be able to estimate the costs.

Accordingly, it is reasonable to classify the lease as a finance lease. However, the accounting treatment of the lease is a less important issue for WHCL since it affects 20X8only. WHCL must first deal with its covenant issues in 20X7.

Conclusion

WHCL is in difficulty. It appears likely that the debt-to-equity covenant will be violated given the accrual required for the warranty costs and the reduction in income necessitated by the aggressive accounting for the EEL arrangement. For example:

A reduction of income of more than $20,000 will reduce equity by the same amount and thereby increase the debt-to-equity ratio to 2:1.

A warranty accrual will increase debt and worsen the debt:equity ratio; an accrual of just $13,333 will put the debt-to-equity ratio at 2:1. The future warranty costs will almost certainly be more than that amount.

Given how close the company is to violating the covenants, financing for the new technology are less likely to be found. As a result, the lender may call WHCL’s loan, which raises the question of whether WHCL is a going concern. The situation facing the company should be disclosed in the notes to the financial statements. We may have to qualify our opinion unless some assurances can be obtained from the lender or the loan can be satisfactorily renegotiated. WHCL should be encouraged to try to work out an arrangement with the lender as soon as possible.

If the covenants are breached and the loan is payable on demand, the loan would be classified as current even if Colo Investors Ltd. has agreed, after the reporting date but before the financial statements are authorized for issue, not to demand repayment as a result of the breach.

Case 17-2 Sandsupport Corporation

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Overview

This case posits three possible scenarios for leasing needed equipment, none of which is an ordinay “vanilla” lease arrangement. Ethical issues arise, given that a large part of the motivation seems to be to enter into a capital lease and yet keep the liability off of the balance sheet.

Analysis

1. Capital leasing directly from GWC. This is the most straightforward of the lease options. If the lease qualifies as a capital lease from SC’s point of view (as lessee), SC would have to report the NPV of the net lease liability as a liability and as a capital asset. Due to the restrictive debt covenant, SC would prefer not to show the debt on the balance sheet. The need to show the debt is the motivation behind GWC’s suggestion of making an outside agreement with a client to underwrite a substantial guaranteed residual value.

For this device to function as SC hopes, the guaranteed residual value must not be written into the lease agreement or it would have to be included in the net lease payments for discounting. Instead, the residual value would have to be guaranteed in a side letter. This seems to be an unethical practice, since it is intended to deliberately misrepresent the situation. To compensate the guarantor by reducing service fees also is highly questionable.

In terms of financial statement impact of a capital lease, the leased capital asset is amortized over the minumum lease term while the liability is reduced each payment period to the extent that each lease payment exceeds the implicit interest in the lease. Since the lease is front-loaded, the obligation will be paid off fairly quickly.

2. Leasing via a special-purpose entity. In this scenario, SC would lease the asset from a related company (via an operating lease) that would be specially created solely for the purpose of leasing the asset from GWC. This is one of the most common devices for keeping lease liabilities and leased assets off of the balance sheet. Although this is a common method of imposing a 3rd-party between the lessor and the lessee, the ethicsare questionable unless there is another reason for such a separatation, such as tax benefits.

3. Issuing convertible preferred shares. The intent in this approach is to replace debt with share equity. However, the intent will be defeated because the conversion is at a cash-equivalent number of shares rather than a specific number of shares. In substance, this is like issuing new shares for cash and then using the cash proceeds to pay off a loan. The convertible shares must be classified as debt.

None of the alternatives would be very successful at keeping the debt off of the balance sheet which is, in the final analysis an ethically questionable practice. SC wants to avoid extra costs (i.e., higher interest fees) that most likely would arise from violating the debt covenant and renegotiating the debt agreement. SC would be better advised to issue

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straight convertible shares to accomplish their objectives, or else enter in an operating lease arrangement, even though it would cost a bit more due to increased risk-bearing by the lessor.

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Case 17-3 Bliss Air Line Limited

Overview

This case provides a lease-or-buy situation within the context of a complex capital structure. Sale and leaseback is also an option. The options are not mutually exclusive; any or all of them can be adopted. The case focus is on the reporting implications of the various options, rather than on the economics of the options themselves.

Acquiring new 737-700s

The lease-or-buy decision relates to Michael's intent to acquire the latest generation of planes, each of which costs $50 million to buy. The purchase option would require debt financing, which is available to BALL. The debt would be floating-rate debt, which exposes the company to potentially unfavourable interest rate risk. However, the interest rate risk can be hedged.

If the new planes are purchased, both the assets and the related liability will appear on BALL's balance sheet. Recognized expenses consist of interest on the debt and depreciation on the planes. The acquisition would be reported on the cash flow statement as both a financing activity and an investing activity. As well, the depreciation on the planes will be added back to net income in operating activities, thereby improving the apparent cash flow from operations.

The lease does not appear to meet the criteria for a finance lease. At BALL's IBR of 6.5% p.a., the monthly interest rate is 0.54%. Discounting the 168 monthly payments yields a present value of the lease payments of slightly less than $40 million per plane, which is appreciably less than the price of the planes. The 14-year term of the lease is 70% of the industry-standard depreciation period of 20 years, which suggests thatsubstantially less than the full risks and benefits of ownership would be passed on toBALL. The lease option is an operating lease for accounting purposes.

Leasing, therefore, provides off-balance sheet financing.1 As well, the interest rate risk is eliminated because the interest rate is implicit in the lease and therefore is a fixed rather than floating rate. On the other hand, BALL may prefer to have floating rate debt since their business is apt to fluctuate with economic conditions. The lease locks the company into the implicit rate. If a floating rate is more desirable, the company will have to engage in an interest-rate swap.

With an operating lease (under current IFRS), the company will not report the assets on its balance sheet (thereby improving the apparent return on assets) and will report no debt as well (thereby improving the debt-to-equity ratio). Recognized expense is only the amount of the lease payments (i.e., rent expense) incurred during the reporting period. Anoperating lease has no impact on the cash flow statement.

While the operating lease does provide some reporting advantages, especially regarding the balance sheet, BALL loses the CCA tax shield from owning the planes. On

1 If and when IASB’s new proposals for lease accounting come into effect, the present value of the lease payments would have to be reported both as a liability and an asset, regardless of whether the lease meets the current criteria for finance lease treatment.

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an after-tax cash-flow basis, it is quite possible that leasing is more expensive than owning.

Sale and leaseback

The company wants additional cash for operating purposes (possibly because of the rather rapid expansion), and is considering selling three intermediate-age planes and then leasing them back. The proposed lease is for four years at $125,000 per month. Again, using the company's IBR of 0.54% per month, the present value of the lease payments is $5.3 million per plane. Given the short lease period, it is highly unlikely that substantially all of the risks and benefits of ownership have been passed onto BALL. This almost certainly is an operating lease.

Sale of the planes is expected to yield a profit of $2 million per plane ($6 million in total). If we assume that the planes’ “professional evaluation” reflects fair value and that BALL actually does sell for that price, the gain would be recognized in earnings in the year of the sale (under IFRS), thereby enhancing earnings in the year of the sale. On the other hand, if the sales prices is less than fair value, the gain would be deferred and amortized over the minimum lease period.

Other issues

The retractable preferred shares raise another issue. The share issue price was $4,000. The call price is $4,100. Although there is no legal obligation to pay the dividend, the shares contain a provision that permits the holder (GE Capital) to demand repayment (at a significant $500 premium, plus dividends in arrears) if BALL misses a dividend. In substance, this appears to be firm commitment by BALL to pay the dividend.

The annual dividend is $220 per share. If this is obligation is capitalized at 6.5% IBR, the present value of the continuing obligation is $3,385 per share (i.e., $220 ÷ 6.5%).

The financial reporting issue is how these shares should be reported in the balance sheet – as debt or equity, or as a hybrid? Given the obligation to pay the dividend, the $4,000 share proceeds should be divided between debt and equity: $3,385 as long-term debt, and $615 as share equity.

Conclusions

Leasing the new planes will keep both the planes and the debt off of the balance sheet. It also will reduce the overall expense in the early years of the lease because the rent expense will be less than the combination of interest expense and depreciation that would result from buying the planes. However, the company will lose the advantage of the CCA tax shield.

Sale-and-leaseback of the older planes will get them off the balance sheet, will improve the company's cash position, and the profit on the sale will enhance net income.

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On the balance sheet, the retractable preferred shares need to be split between debt (for the commitment to pay dividends) and equity (for the principal). As a result, dividends paid on the preferred must be reported as interest expense and included in net income, rather than as dividends to be deducted directly from retained earnings.

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Assignments

Assignment 17-1

Requirement 1– Argyle Ltd:

15 August 20X1(lease inception):

Prepaid rent expense 30,000Cash 30,000

31 October, 30 November, and 31 December 20X1:

Rent expense 10,000Prepaid rent expense 10,000

Summary entry for 20X2:

Rent expense 120,000Cash 120,000

Requirement 2—Basil Ltd:

15 August 20X1(lease inception):

Cash 30,000Deferred rent income 30,000

Acquisition and installation of equipment:

Equipment on lease 820,000Cash, accounts payable, etc. 820,000

31 October, 30 November, and 31 December 20X1:

Deferred rent income 10,000Rent income 10,000

Summary entries for 20X2:

Cash 120,000Rent income 120,000

Depreciation expense* 205,000Accum. depr.—equipment on lease 205,000

*$820,000 × 25%

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Assignment 17-2

Requirement 1

Total rent to be paid: $4,000 × 54 months (60 months – 6 free) ...... $216,000Cost per month ($216,000 ÷ 60) ........................................................ 3,600

Monthly entries:Month 1 – 30 November 20x1

Rent expense......................................................................... 3,600Deferred rent liability....................................................... 3,600

Month 6 – 30 April 20x2Rent expense......................................................................... 3,600

Deferred rent liability....................................................... 3,600

Month 7 – 1 May 20x2Rent expense......................................................................... 3,600Deferred rent liability............................................................ 400

Cash ................................................................................. 4,000

Requirement 2

Income Statement, year ending 31 December 20X2:

Rent expense: $3,600 × 12 . $43,200

Statement of Financial Position, 31 December 20X2:

Deferred rent liability: $400 × 46 months amortization remaining $18,400(or $21,600 total deferral minus 8 months amortizationat $400 per month: $21,600 – $3,200 = $18,400)

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Assignment 17-3

Requirement 1

a. The lease term is eight years.b. Guaranteed residual value, none.c. Unguaranteed residual value exists as the value of the asset to the lessor at the

end of the lease term. There is no way to calculate this amount.d. BPO, none.e. Minimum net lease payments, ($24,000 – $4,000) × 8 years = $160,000.f. Incremental borrowing rate, 7%.

Requirement 2

To be a finance lease, the lease would have to meet one of the following four criteria, applied judgementally:

1. Transfer of title No2. Lease term vs. economic life Improbable; only 2/3 of the asset’s

economic value3. PV of MLP vs. fair value No; $127,786* = only 75% of asset FV4. Specialized asset Not evident

*PV of MLP: ($24,000 – $4,000) × (P/AD, 7%, 8) =$20,000 × (6.38929) = $127,786

$127,786 ÷ $170,000 = 75%

On the basis of this analysis, it does not appear that substantially all of the risks and benefits of owning the asset have been transferred to the lessee. This should be reported as an operating lease.

Requirement 3

1 January 20X1:Prepaid rent and maintenance expense ....................................... 24,000

Cash ..................................................................................... 24,000Monthly entries:

Equipment lease expense ($20,400 ÷ 12) ................................... 1,700Maintenance expense ($3,600 ÷ 12) .......................................... 300

Prepaid rent and maintenance .............................................. 2,000

Requirement 4

If the lease had a $50,000 guaranteed residual value, the present value of the lease payments would rise by $50,000(P/F, 7%,8) = $50,000 × 0.58201 = $29,100. The PV of the minimum lease payments would then total $156,887, which is 92% of the asset’s value. Under this circumstance, it seems that Burril is promising to pay substantially the full cost of the asset over only 2/3 of the asset’s economic life. Finance lease treatment would be appropriate.

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Assignment 17-4

Requirement 1

Minimum lease payments:

[($104,000 – $9,600) × 5] + $26,500 = ($94,400 × 5) + $26,500 = $498,500. Only the guaranteed residual is included despite higher expectations of resale value.

Requirement 2

The asset will be recorded at the present value of the minimum lease payments (including the guaranteed residual value), discounted at 10%:

PV = $94,400(P/AD, 10% 5) + $26,500(P/F, 10% 5) = $94,400(4.16987) + $26,500(0.62092)= $393,635 + $16,454= $410,089

Requirement 3

If the residual value is unguaranteed and will not be included in the minimum lease payments. The asset will be recorded at the NPV of the annual lease payments:

PV = $94,400(P/AD, 10% 5) = $94,400(4.16987) = $393,635

Requirement 4

A leased asset cannot be recorded at more than its fair value. The asset must be recorded at $375,000. Subsequent accounting for the lease must be at the implicit interest rate that discounts the stream of $498,500 lease payments to a present value of $375,000.

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Assignment 17-5

Requirement 1

a. The lease term is 10 years. The second five-year lease term is a bargain renewal option, based on the information regarding market rental rates.

b. Guaranteed residual, none.

c. Unguaranteed residual exists as the value of the asset to the lessor at the end of the lease term. There is no way to calculate this amount.

d. Bargain purchase option, none.

e. Bargain renewal terms, $29,500 per year for the second five-year lease term

f. Minimum net lease payment:

(a) ($79,600 – $7,900) × 5 years $358,500(b) ($29,500 – $2,500) × 5 years 135,000

$493,500g. Incremental borrowing rate, 8%

Requirement 2

To be a capital lease, the lease would have to meet one of three criteria, applied judgementally:

1. Transfer of title or BPO No2. Economic life vs. lease term Yes; 10/12 > 75%3. PV of MLP vs. fair value Yes; $388,418* = 90% of $430,000

* PV of MLP:

(a) PV1 = ($79,600 – $7,900) (P/AD, 8%, 5) = $71,700 × 4.31213 = $309,180

(b) PV2 = ($29,500 – $2,500) (P/AD, 8%, 5) (P/F, 8%, 5)= $27,000 × (4.31213) × (.68058) = 79,238

$388,418

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Requirement 3

Beginning of fiscal year and lease term:

Asset under capital lease....................................................... 388,418Lease liability................................................................... 388,418

Insurance expense................................................................. 7,900Lease liability........................................................................ 71,700

Cash ................................................................................. 79,600

End of fiscal year:

Interest expense .................................................................... 25,337Lease liability................................................................... 25,337

[($388,418 – $71,700) × .08]

Depreciation expense............................................................ 38,842Accumulated depreciation................................................ 38,842

[$388,418÷ 10]

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Assignment 17-6

Requirement 1

The lessor’s implicit interest rate is known. Therefore:

For a publicly-accountable enterprise, the lessor’s implicit rate must be used, if known.

For a Canadian private enterprise following the ASPE, the lower of the implicit rate or the lessee’s IBR must be used.

In either instance, the discount rate would be 8% in this scenario.

(a) ($28,600 – $2,600) (P/A, 8%, 5) = $26,000 × (3.99271) $103,810(b) ($11,500 – $1,500) (P/A, 8%, 2) (P/F, 8%, 5)

= $10,000 × (1.78326) × (0.68058) 12,137$115,947

The renewal term is included even though it is not a bargain renewal term because there is a bargain purchase option of $1 at the end of the renewal term; all terms prior to a bargain purchase option must be included in the present value calculation.

Lease Amortization Schedule – End of Year Payments

Lease Outstanding Interest End of Period Inc/(Dec) EndingYear Balance at 8% Cash Flow in Balance Balance

1 $115,947 $9,276 $26,000 ($16,724) $99,2232 99,223 7,937 26,000 (18,063) 81,1603 81,160 6,493 26,000 (19,507) 61,6534 61,653 4,932 26,000 (21,068) 40,5855 40,585 3,247 26,000 (22,753) 17,8326 17,832 1,426 10,000 (8,574) 9,2587 9,258 741 10,001 (9,260) (2)

[rounding]

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Requirement 2

1 JanuaryAsset under capital lease 115,947

Lease liability 115,947

31 DecemberInterest expense 9,276Maintenance expense 2,600Lease liability 16,724

Cash 28,600

Depreciation expense ($115,947 ÷ 10)* 11,594Accumulated depreciation 11,594

*Depreciation is over 10 years rather than the lease term because the BPO assures that the lessee can obtain title.

Requirement 3

Interest expense ....................................................................... 741Maintenance expense............................................................... 1,500Lease liability........................................................................... 9,259

Cash ................................................................................ 11,500

Lease liability........................................................................... 1Cash ................................................................................... 1

The asset remains on the books and continues to be amortized over its useful life. The BPO is simply one more payment in the lease payment stream. The liability

should be zero at this point.

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Assignment 17-7

Requirement 1

(a) $104,300 × (P/AD, 10%, 5) = $104,300 × (4.16987) ................................... $434,917(b) $75,000 × (P/F, 10%, 5) = $75,000 × (0.62092) .......................................... 46,569

$481,486

Lease Amortization Schedule – Beginning of Lease Year Payments

Lease Outstanding Interest Inc/(Dec) EndingYear Balance at 10% Payment in Balance Balance

1 $481,486 $ 0 $104,300 ($104,300) $377,1862 377,186 37,719 104,300 (66,581) 310,6053 310,605 31,061 104,300 (73,239) 237,3664 237,366 23,737 104,300 (80,563) 156,8035 156,803 15,680 104,300 (88,620) 68,1835 (end) 68,183 6,818 75,000 (68,182) 1

[rounding]

Requirement 2

1 JanuaryAsset under capital lease 481,486

481,486

Lease liability 104,300Cash 104,300

31 DecemberInterest expense 37,719Maintenance expense 16,500

Lease liability 37,719Cash* 16,500

Depreciation expense 81,297Accumulated depreciation 81,297

($481,486 – $75,000) ÷ 5

*Assumed paid at year-end; other assumptions are acceptable.

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Requirement 3

Interest expense ....................................................................... 6,818Lease liability..................................................................... 6,818

Lease liability [$68,182 + $6,818 + $1 (rounding)] ................ 75,001Accumulated depreciation, leased asset ( $81,297 × 5)........... 406,485Loss on sale of leased asset ..................................................... 15,000

Cash ................................................................................... 15,000Asset under capital lease.................................................... 481,486

The asset was disposed of for $60,000, $15,000 less than the expected residual value. The asset ($60,000) and cash ($15,000) were used to retire the lease liability.

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Assignment 17-8

1. Abbaz is preserving its flexibility. It is also likely not in a position to buy, since its space needs are likely to be small.

2. This non-profit organization is probably transferring CCA tax advantages to the lessor. The lessee can get lower lease payments as a result, thereby saving money. The motivation is to reduce costs and cash outflow as compared to buying the vehicle.

3. Cahil is arranging off-balance sheet financing. They have no contractual capacity for more debt. The contingent lease payments aren’t counted in the calculation of minimum lease payments, thereby making it likely that the lease can be classifiedas an operating lease. Avoiding finance lease treatment will prevent a violation of the debt-to-equity covenant.

4. The motivation for entering this lease would be to provide more protection from interest rate swings. Note that since title passes, the lessee retains the tax advantages.

5. The College is likely leasing because they have an immediate need for cash, and the sale lease-back arrangement locks in an interest rate for 20 years. They may also receive more from the lender/lessor than they would if they arranged a loan using the collection as collateral.

6. The motivation for leasing is that they can get 100% financing under the lease (payments are due at the end of the year) but only 80% under the lending arrangement; second. Also lease fixes the interest rate over the 'loan' period.

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Assignment 17-9 WEB

Requirement 1 – Present value of the lease payments

PV = $7,500 × (P/AD, 8%, 5) = $7,500 × (4.31213) = $32,341

The present value is 90% of the fair value of $36,000. Also, the lease is for a major portion (5/7) of the equipment’s economic life. The remaining two years of life (after the end of the lease term) are not likely to be of any value to NLC. Thus, this clearly is a finance lease.

Requirement 2 – Amortization table

Outstanding Interest 1 October Inc/(Dec) EndingYear Balance at 8% Cash Flow in Balance Balance

20x1 32,341 — 7,500 (7,500) 24,84120x2 24,841 1,987 7,500 (5,513) 19,32820x3 19,328 1,546 7,500 (5,954) 13,37420x4 13,374 1,070 7,500 (6,430) 6,94420x5 6,944 556 7,500 (6,944) 0

Requirement 3 – Entries for 20X1 and 20X2

1 October 20x1:Asset under capital lease ..................................................... 32,341

Lease liability................................................................ 32,341Lease liability...................................................................... 7,500

Cash............................................................................... 7,500

31 December 20x1:Interest expense ($24,841 × 8% × 3/12) ............................. 497

Lease liability................................................................ 497Depreciation expense ($32,341 × 3/60) .............................. 1,617

Accumulated depreciation—leased asset...................... 1,617

1 October 20x2:Lease liability...................................................................... 7,500

Cash............................................................................... 7,500

31 December 20x2:Interest expense*................................................................. 1,877

Lease liability................................................................ 1,877Depreciation expense ($32,341 × 12/60) ............................ 6,468

Accumulated depreciation, asset under lease................ 6,468

*($24,841 × 8% × 9/12) + ($19,328 × 8% × 3/12)= $1,490 + $387 = $1,877

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Requirement 4

Lease liability, 31 December 20X2: 32,341 – 7,500 + 497 – 7,500 + 1,877 = 19,715

Reconciliation to amortization table:Lease balance after 2nd payment = $19,3283/12 of 3rd year interest = 1,546 × 3/12 = 387

$19,715

Requirement 5

The current liability is the amount of principal payment on 1 October 20X3, plus the interest accrued between 1 October 20X2 and 31 December 20X2:

Principal component of 1 Oct 20X3 payment* ....................... $ 5,954

Accrued interest (see requirement 4, above) ........................... 387

Current portion of lease ........................................................ 6,341

Long-term portion ($19,715 – $6,341) ................................ 13,374

Lease liability, total ................................................................. $19,715

* from amortization table

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Assignment 17-10

Requirement 1

The present value of the quarterly lease payments, at Packard's IBR of 8% per annum, is:

P = $26,000 (P/AD, 2%, 12) = $26,000 × 10.78685 = $280,458

20x4 journal entries:

1 October 20x4:Computer equipment 280,458



31 December 20x4:Interest expense* 5,089

Lease liability 5,089* ($280,458 – $26,000) × 2% = $254,458 × 2% = $5,089

Requirement 2

Packard's 31 December 20x4 balance sheet will show a total lease liability of $259,547:

$280,458 – $26,000 + $5,089 = $259,547

The portion shown as a current liability will be the present value of principal due in the next four payments plus the accrued interest of $5,089. The current portion can be determined either (1) by finding the present value of the principal at the end of 20x5 (which is the long-term portion), or (2) by constructing an amortization table.

(1) Present value approach:

Lease liability, 31 December 20x4 $259,547Long term portion: P31-12-20x5 = $26,000 (P/AD, 2%, 7) = $26,000 × 6.60143 171,637Current portion, 31 December 20x4 $ 87,910

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(2) Amortization table – payments at the beginning of each quarter (but SFP date just one day prior; see note below):

Payment date

Beginning Interest Lease Incr/(Decr) Qtr-end

balance @2% payment in balance balance

Initial paymt1 Oct 20x4 280,458 26,000 (26,000) 254,458 1 Jan 20x5 254,458 5,089 26,000 (20,911) 233,547

1 April 20x5 233,547 4,671 26,000 (21,329) 212,218

1 July 20x5 212,218 4,244 26,000 (21,756) 190,462

1 Oct 20x5 190,462 3,809 26,000 (22,191) 168,272

1 Jan 20x5 168,272 3,365 26,000 (22,635) 145,637

1 April 20x6 145,637 2,913 26,000 (23,087) 122,550

1 July 20x6 122,550 2,451 26,000 (23,549) 99,001

1 Oct 20x6 99,001 1,980 26,000 (24,020) 74,981

1 Jan 20x6 74,981 1,500 26,000 (24,500) 50,481

1 April 20x7 50,481 1,010 26,000 (24,990) 25,490

1 July 20x7 25,490 510 26,000 (25,490) 0

Note that the total liability balance on the SFP at the end of each calendar quarter will be the amount one day prior to the 1st-of-the-month payment due on the next day for the following quarter. For example, the SFP balance on 31 December 20x4 will be:

$233,547 + $26,000 = $259,547

Thus, the SFP balance on 31 December 20X5 will be:

$145, 637 + 26,000 = $171,637

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Requirement 1

The lease is a finance lease to the lessee because the term, including the three bargain renewal terms, is substantially equal to the economic life of the asset. The PV of the MLP’s is equal to 96% of the asset’s fair value ($17,316* ÷ $18,000)

*PV:(a) ($5,800 – $1,700) (P/AD, 12%, 5) = $4,100 × (4.03735) ...................... $16,553(b) ($2,600 – $2,100) (P/AD, 12%, 3) (P/F, 12%, 5)

= $500 × (2.69005) × (.56743) ...................................................... 763$17,316

Requirement 2 – Lease Amortization Schedule, Beginning of Lease Year Payments

Lease Outstanding Interest 1 January Inc/(Dec) EndingYear Balance at 12% Payment in Balance Balance

20x2 $17,316 $ 0 $4,100 $(4,100) $13,21620x3 13,216 1,586 4,100 (2,514) 10,70220x4 10,702 1,284 4,100 (2,816) 7,88620x5 7,886 946 4,100 (3,154) 4,73220x6 4,732 568 4,100 (3,532) 1,20020x7 1,200 144 500 (356) 84420x8 844 101 500 (399) 44520x9 445 54 500 (446) (1) rounding

$4,683

Requirement 3 – Entries 20x2 20x3

1 JanuaryAsset under finance lease ................. 17,316

Lease liability............................ 17,316Lease liability.................................. 4,100 4,100Insurance and maintenance expense 1,700 1,700

Cash.......................................... 5,800 5,800

31 DecemberInterest expense............................. 1,586 1,284

Lease liability.......................... 1,586 1,284Depreciation expense................... 2,165 2,165

Accumulated depreciation, leased asset ($17,316 ÷ 8)... 2,165 2,165

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Requirement 4

Income Statement 20x2 20x3Maintenance and insurance expense $1,700 $1,700Interest expense 1,586 1,284Depreciation expense 2,165 2,165

Statement of Financial PositionCapital assets

Assets under capital leases 17,316 17,316Accumulated depreciation (2,165) (4,330)

15,151 12,986

Current liabilitiesCurrent portion of lease liability 4,100 4,100

Long-term liabilityLease liability 14,802* 11,986*Less: current portion 4,100 4,100

10,702 7,886*$13,216 + $1,586; $10,702 + $1,284

Statement of Cash FlowsOperations:

Addbacks: depreciation 2,165 2,165 Increase(decrease) in interest payable 1,586 (302)

Financing:Repayment of lease liability (4,100)* (2,514)**

*$17,316 – $14,802 = $(2,514); $1,586 interest and $(4,100) repayment. May also be shown as the net $(2,514) change in lease liability. Practice differs.

**$14,802 – $11,986 = ($2,816); ($302) interest ($1,586 versus $1,284) and $(2,514) repayment. May also be shown as the net ($2,816) change in lease liability.

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Requirement 5

Allocation of Interest Expense to Fiscal Years

Implicit Allocation InterestLease Payment Interest (5/12: 7/12) Expense Year End

20X2 $ 0 0

20X3 1,586 661 $661 31 May 20x2

925

20X4 1,284 535 1,460 31 May 20x3

749

20X5 946 394 1,143 31 May 20x4

552

20X6 568 237 789 31 May 20x5

331

20X7 144 60 391 31 May 20x6

84

20X8 101 42 126 31 May 20x7

59

20X9 54 23 82 31 May 20x8

31

20X10 0 0 31 31 May 20x9

$4,683 $4,683 $4,683

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Assignment 17-12

Requirement 1

This seems to be a finance lease, but it requires an analysis with and without the renewal term, due to the change in guaranteed residual value. The present values of the two scenarios are as follows:

Initial term: (a) ($105,000 – $5,000) (P/AD, 8%, 5) = $100,000 × (4.31213) = $431,213 (b) $150,000(P/F, 8%, 5) = $150,000 × 0.68058 = 102,087

Present value of inital lease term $533,300

Initial term + renewal term: (a) ($105,000 – $5,000) (P/AD, 8%, 5) = $100,000 × (4.31213) = $431,213 (b) ($43,000 – $3,000) (P/AD, 8%, 3) (P/F, 8%, 5)

= $40,000 × (2.78326) × (.68058) = 75,769Present value of inital lease and renewal terms $506,982

The interesting aspect of this is that the PV is higher if the lease is not renewed. In effect, the high guaranteed residual value acts as a penalty for not renewing. Clearly, the lessor wants Access Limited to renew the lease and keep the equipment. Thus, the renewal term is a bargain renewal because it actually costs Access less to renew than to pay the guaranteed residual value. Also, the high residual value may indicate a high value for the equipment after 5 years—Imperial Leasing probably recovers its investment (perhaps with the help of tax advantages) over the 8-year lease term, but not over the shorter 5-year lease term.

Requirement 2

Since the PV is less under the renewal option, the renewal must be a bargain renewal option. Therefore, use $506,982 as the PV of the minimum lease payments.

Lease Amortization Schedule – Beginning of Lease Year Payments

Lease Outstanding Interest Lease Inc/(Dec) Ending Year Balance at 8% Payment in Balance Balance

20X1 $ 506,982 — $ 100,000 $(100,000) $ 406,982 20X2 406,982 $ 32,559 100,000 (67,441) 339,541 20X3 339,541 27,163 100,000 (72,837) 266,704 20X4 266,704 21,336 100,000 (78,664) 188,040 20X5 188,040 15,043 100,000 (84,957) 103,083 20X6 103,083 8,247 40,000 (31,753) 71,330 20X7 71,330 5,706 40,000 (34,294) 37,036 20X8 37,036 2,964 40,000 (37,036) 0

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Requirement 3

1 January 20x1Asset under capital lease....................................................... 506,982

Lease liability.................................................................. 506,982Insurance expense................................................................. 5,000Lease liability........................................................................ 100,000

Cash ................................................................................ 105,000

31 December 20x1Interest expense .................................................................... 32,559

Lease liability.................................................................. 32,559Depreciation expense............................................................ 63,373

Accumulated depreciation ($506,982 ÷ 8) ..................... 63,373

Requirement 4

1 January 20x1Asset under capital lease....................................................... 506,982

Lease liability.................................................................. 506,982

Insurance expense................................................................. 5,000Lease liability........................................................................ 100,000

Cash ................................................................................ 105,000

31 March 20x1Interest expense ($32,559 × 3/12) ........................................ 8,140

Lease liability.................................................................. 8,140

Depreciation expense ($63,373 × 3/12)................................ 15,843Accumulated depreciation .............................................. 15,843

Prepaid expenses ($5,000 × 9/12)......................................... 3,750Insurance expense........................................................... 3,750

31 December 20x1No entries needed unless this is a (quarterly) reporting date. The prepaid insurance has expired, but this can be adjusted at 31 March 20x2.

Requirement 5

The total lease liability at 31 March 20X1 is $406,982 + $8,140 interest = $415,122

Current lease liability:Principal payment due 1 January 20X2 (from amortization table) $ 67,441 Accrued interest, 1 January to 31 March 20X1 (req. 4, above) 8,140

Current liability $ 75,581Noncurrent lease liability $339,541Total $415,122

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Assignment 17-13

Requirement 1

This is a finance lease for the lessee. Title does not pass and the lease term is only 66% (4/6) of the useful life, but the PV of the minimum lease payments is substantially all of the fair value.

* Present value:(a) ($8,626 – $1,100) × (P/AD; 10%, 4) = $7,526 × 3.48685 $26,242(b) $6,000 × (P/F, 10%, 4) = $6,000 × 0.68301 4,098

$30,340

Requirement 2 – Lease Amortization Schedule

Beginning of Lease Year Payments

Lease Outstanding Interest Inc/(Dec) EndingYear Balance at 10% Payment in Balance Balance20x1 $30,340 – $7,526 $(7,526) $22,81420x2 22,814 $2,281 7,526 (5,245) 17,56920x3 17,569 1,757 7,526 (5,769) 11,80020x4 11,800 1,180 7,526 (6,346) 5,45420x4 (residual) 5,454 545 6,000 (5,455) (1) rounding

20x1 entries:

1 January 20x1:Asset under capital lease............................................................. 30,340Insurance and mantenance expense ............................................ 1,100

Lease liability............................................................... 22,814Cash ............................................................................. 8,626

31 December 20x1:Depreciation expense ($30,340 × 30%)...................................... 9,102

Accumulated depreciation ................................................. 9,102Interest expense .......................................................................... 2,281

Lease liability..................................................................... 2,281

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Requirement 3

Income Statement

Insurance and maintenance expense $1,100Interest expense (accrued) 2,281Depreciation expense ($30,340 × 30%) 9,102

Statement of Financial Position

Capital Assets:Assets under finance lease $30,340Less: accumulated depreciation (9,102) 21,238

Current liabilities:Current portion of lease liability 7,526

Long-term liabilitiesLease liability ($22,814 + $2,281) $25,095

Less: current portion (7,526) 17,569

Statement of Cash Flows

Operations:Add back: depreciation 9,102

Increase in interest payable 2,281Financing:

Reduction of lease liability* (7,526)

*Could also be shown as a reduction to the lease liability of $(5,245) (i.e., $25,095 –$30,340), with no adjustment for interest in operations. Practice varies.

Disclosure notes

The company is obligated under capital leases for the following payments:

20x2 ........................$ 8,62620x3 ........................ 8,62620x4 ........................ 14,626

$ 31,878Less: maintenance (3,300)Less: interest* (3,483)

$ 25,095

* $1,757 + $1,180 + $545 + $1 (rounding)

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Assignment 17-14

Requirement 1

On the surface, this appears to be an operating lease because there is no BPO, no bargain renewals, and no transfer of title at the end of the lease. Although the equipment is being installed for Ready’s use, conveyor equipment usually is converible to other uses and users, and thus this does not seem to be special-purpose equipment. We still must examine the cash flow stream, however.

Under the definitions, the minimum lease term in this instance is the 4-year period, which is no more than 50% of the equipment’s life, given that the lessor may choose to renew for another four years at the same rate. Thus, since there are no bargain renewals and no bargain purchase options, the analysis must be performed on just the 4-year lease period, including the residual value. The present value of the payments due over the initial lease period is:

PV = $30,000(P/AD, 2%, 16) + $300,000(P/F, 2%, 16)= ($30,000 × 13.84926) + ($300,000 × 0.72845) = $415,477 + 218,535 = $634,012

[Note that the interest rate is per quarter, and thus the expression must be 2% for 16 quarters, not 8% for 4 years.]

The PV is 88% of the fair value of the equipment. It is probable that the lessor is recovering the cost of investment plus a return.

[Note: The lessor may well recover the full investment plus profit over the minimum lease term (including residual), even if the lessor has to pay full price to acquire the equipment. The impact of the lease on delaying cash flows (due to CCA) can significantly improve the present value of the lessor’s cash flows.]

Requirement 2 – Entries at lease commencement

1 October 20X1Equipment under finance lease 634,012



31 December 20X1Interest expense (accrued)* 12,080

Lease liability 12,080* ($634,012 – $30,000) × 2%

Depreciation expense (634,012 – 300,000) ÷ 4) 83,503Accumulated depreciation 83,503

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Requirement 3 –Statement of financial position, 31 December 20X3

Short-cut method (required):

PV at 31 December 20X3:

$30,000(P/AD, 2%, 7) + $300,000(P/F, 2%, 7)= ($30,000 × 6.60143) + ($300,000 × 0.87056) = $198,043 + $261,168 = $459,211

PV at 31 December 20X4:

$30,000(P/AD, 2%, 3) + $300,000(P/F, 2%, 3)= ($30,000 × 2.94156) + ($300,000 × 0.94232) = $88,247 + $282,696 = 370,943

Reduction in principal = current at Y/E 20X3 $ 88,268

The Y/E lease liability will appear on the SFP as follows:Lease liability — current $ 88,268Lease liability — non-current (or long term) $370,943

The question asks for the short-cut method, not an amortization table. Nevertheless, an amortization table is presented below for instructor convenience. Note that the balance in the last column is the amount due just after the beginning-of-period payment. The actual outstanding balance on the day previous (i.e., at the end of each quarter) is $30,000 higher.

Beginning Net lease Balance,Lease balance Interest payment Incr/(Decr) start of

quarter current qtr. @ 2.0% beg. of qtr. in balance next qtr.20X1-Q4 $ 634,012 $ — $ 30,000 $ (30,000) $ 604,012 20X2-Q1 604,012 12,080 30,000 (17,920) 586,092 20X2-Q2 586,092 11,722 30,000 (18,278) 567,814 20X2-Q3 567,814 11,356 30,000 (18,644) 549,170 20X2-Q4 549,170 10,983 30,000 (19,017) 530,154 20X3-Q1 530,154 10,603 30,000 (19,397) 510,757 20X3-Q2 510,757 10,215 30,000 (19,785) 490,972 20X3-Q3 490,972 9,819 30,000 (20,181) 470,791 20X3-Q4 470,791 9,416 30,000 (20,584) 450,207 20X4-Q1 450,207 9,004 30,000 (20,996) 429,211 20X4-Q2 429,211 8,584 30,000 (21,416) 407,796 20X4-Q3 407,796 8,156 30,000 (21,844) 385,952 20X4-Q4 385,952 7,719 30,000 (22,281) 363,671 20X5-Q1 363,671 7,273 30,000 (22,727) 340,94320X5-Q2 340,944 6,819 30,000 (23,181) 317,763 20X5-Q3 317,763 6,355 30,000 (23,645) 294,118 20X5-Q4 294,118 5,882 300,000 (294,118) 0

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Assignment 17-15

Requirement 1 – Implicit interest rate

$10,027,266 = [($820,000 – $80,000) × (P/AD, i, 25)]$10,027,266 = $740,000 × (P/AD, i, 25)

(P/AD, i, 25) = $10,027,266 ÷ $740,000 = 13.55036

From Table I-3, P/AD of 13.55036 equals an implicit rate of 6% per annum.Students may also use a financial calculator.

Requirement 2 – Liability at 31 December 20X15

PV at 31/12/15:$740,000 × (P/AD, 6%, 10) = $740,000 × 7.80169 = $5,773,251

PV at 31/12/16, Long-term lease liablility, noncurrent:$740,000 × (P/AD, 6%, 9) = $740,000 × 7.20979 = 5,335,245

Lease liablility, current $ 438,006

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Assignment 17-16

Requirement 1

Present value of the lease payments at Christal's IBR:

$30,000 (P/A, 2%, 12) = $30,000 × 10.57534 = $317,260The present value is higher than the asset's fair value. Therefore, the asset must be recorded at its fair value of $300,000:

Computer equipment under capital lease 300,000Capital lease liability 300,000

Requirement 2

The implicit rate is the unknown "i" in the following formula:$300,000 = $30,000 (P/A, i, 12)(P/A, i, 12) = $300,000 ÷ $30,000 = 10.0

In the P/A table for 12 periods:(P/A, 2.5%, 12) = 10.25776(P/A, 3.0%, 12) = 9.95400

Therefore, the implicit interest rate is just slightly less than 3% per quarter.

A financial calculator yields a rate of 2.923% (or, more precisely, 2.9228541%).

Requirement 3

Lease liability balance, 31 December 20x5:

Beginning balance, 1 May 20x5 $300,000Accrued interest, 1 May to 31 July 20x5 ($300,000 × 2.923%) 8,769Payment 1, 31 July 20x5 – 30,000Balance, 31 July 20x5 278,769Accrued interest, 1 August to 31 October 20X5 ($278,769 × 2.923%) 8,148Payment 2, 31 October 20x5 –30,000Balance, 31 October 20x5 256,917Accrued interest, 1 November to 31 December 20x5

($256,917 × 2.923% × 2/3) 5,006Balance, 31 December 20x5 $261,923

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Assignment 17-17

Requirement 1

Cost of the machine = $20,000 (P/AD, 14%,6) = $88,662.

Amortization schedule

Beginning Interest Cash Decrease EndingPayment balance @ 14% Payment in balance balance

1 $88,662 $ 20,000 $20,000 $68,6622 68,662 $9,613 20,000 10,387 58,2753 58,275 8,158 20,000 11,842 46,4334 46,433 6,501 20,000 13,499 32,9345 32,934 4,610 20,000 15,390 17,5446 17,544 2,456 20,000 17,544 0

Requirement 2

a. 31 December 20x1:

Leased asset...................................... 88,662Cash...................................... 20,000Lease liability ...................... 68,662

b. 31 December 20x2:

Depreciation expense ....................... 14,777Accumulated depreciation..... 14,777

Interest expense................................. 9,613Lease liability.................................... 10,387

Cash....................................... 20,000

c. 31 December 20x3:

Depreciation expense........................ 14,777Accumulated depreciation..... 14,777

Interest expense................................ 8,158Lease liability................................... 11,842

Cash.................................….. 20,000

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Requirement 3

a. 31 December 20x1:

Leased asset...................................... 77,273Cash...................................... 20,000Lease liability ...................... 57,273

Interest rate; 22%: $20,000 (P/AD, i, 6)

b. 31 December 20x2:

Depreciation expense ($77,273/6).....12,879Accumulated depreciation..... 12,879

Interest expense ($57,273 × .22)......... 12,600Lease liability.................................... 7,400

Cash....................................... 20,000

c. 31 December 20x3:

Depreciation expense........................ 12,879Accumulated depreciation..... 12,879

Interest expense ($57,273 – $7,400) × .22 10,972Lease liability................................... 9,028

Cash.................................….. 20,000

Requirement 4

The asset will be shown along with property, plant and equipment. On 31 December 20x4, the balances will be as follows:

Leased machine $88,662Less accumulated depreciation * 44,331

$44,331*3 × $14,777

Lease liability:Current liabilities

Current lease liability $15,390

Long-term liabilitiesLease liability* 32,934Less: current portion* (15,390)

$17,544

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*The total liability will be shown at the net present value of the remaining cash flows:

PV = $20,000 (P/A,14%,2) = $32,934 (see table)

Of this amount, the portion that will be paid as part of the next payment (at 31 December 20x5) must be classified as current. This is $15,390 (see table). Alternatively, the current portion of the liability is the 20x5 payment less the interest for 20x5, since interest will not be accrued until next year:

20x5 payment $20,00020x5 interest on 31 December 20x4 balance:

$32,934 × 14% 4,610Current portion of lease liability, 20x4 $15,390

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Requirement 1

20x2 31 March Cash........................................................... 9,000,000Accumulated depreciation......................... 3,600,000

Distribution facility............................... 10,400,000Deferred gain on sale and leaseback..... 2,200,000

Distribution facility under lease................ 8,706,346Lease liability........................................ 8,706,346

($875,000 × P/AD 9%,20) (9.95011)

Lease liability............................................ 875,000Cash ...................................................... 875,000

31 Dec. Interest expense......................................... 528,616Lease liability........................................ 528,616

($8,706,346 – $875,000) × 9% × 9/12New balance: $8,706,346 – $875,000 + $528,616 = $8,359,962

Depreciation expense ................................ 217,659Accumulated depreciation, leased distribution facility.............................. 217,659

($8,706,346 × 1/30 × 9/12)

Deferred gain on sale and leaseback ......... 55,000Depreciation expense............................ 55,000

($2,200,000 × 1/30 × 9/12)

Requirement 2

20x3 31 March Interest expense......................................... 176,205Lease liability........................................ 176,205

($8,706,346 – $875,000) × 9% × 3/12Lease liability............................................ 875,000

Cash ...................................................... 875,000New balance: ($8,706,346 – $875,000 + $528,616 + $176,205 –

$875,000) = $7,661,167

31 Dec. Interest expense......................................... 517,129Lease liability........................................ 517,129

($7,661,167 × 9% × 9/12)Balance: $7,661,167 + $517,129 = $8,178,296

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Depreciation expense ................................... 290,212Accumulated depreciation, leased distribution facility.............................. 290,212

$8,706,346 × 1/30Deferred gain on sale and leaseback ......... 73,333

Depreciation expense............................ 73,333$2,200,000 × 1/30

20x4 31 March Interest expense......................................... 172,376Lease liability........................................ 172,376

($7,661,167 × 9% × 3/12)

Lease liability............................................ 875,000Cash ...................................................... 875,000

New balance : ($7,661,167 + $517,129 + $172,376 – $875,000) = $7,475,672

Dec 31 Interest expense......................................... 504,608Lease liability........................................ 504,608

($7,475,672 × .09 × 9/12)New balance: $7,475,672 + $504,608 = $7,980,280

Depreciation expense ................................ 290,212Accumulated depreciation, leased distribution facility.............................. 290,212

Deferred gain on sale and leaseback ......... 73,333Depreciation expense............................ 73,333

Requirement 3

Statement of Financial Position: 20x2 20x3 20x4Capital Assets

Distribution facility under capital lease ... $8,706,346 $8,706,346 $8,706,346Less: accumulated depreciation .............. 217,659 507,871 798,083

$8,488,687 $8,198,475 $7,908,263Deferred credits

Deferred gain on sale and leaseback ........ 2,145,000 2,071,667 1,998,334

Long-term liabilityLease liability........................................... 8,359,962 8,178,296 7,980,280

Income Statement:Interest expense........................................ 528,616 693,334 676,984Depreciation expense ............................... 162,659 216,879 216,879

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Assignment 17-19

Requirement 1

Cash ......................................................................................... 480,000Accumulated depreciation, building........................................ 375,000*

Building ............................................................................. 825,000Deferred gain on sale and leaseback of building ............... 30,000

*($825,000 – $450,000)

Building under capital lease..................................................... 480,000Lease liability..................................................................... 480,000

PV = ($77,000 – $6,000) × (P/A, 10%, 12) (6.81369) = $483,772; limited to $480,000 fair value for accounting purposes. This is a capital lease as it covers all the remaining useful life, the NPV of the lease payments is equal to 100% of the fair value, and the building reverts to the lessee at the end of the lease.

The lease must be accounted for at the implicit interest rate:

$480,000 = $71,000 × (P/A, i%, 12)

i = 10.16% (more exactly, 10.1601574)

Requirement 2

Interest expense ....................................................................... 48,768Lease liability($480,000 × .1016)...................................... 48,768

Lease liability........................................................................... 71,000Property tax expense................................................................ 6,000

Cash ................................................................................... 77,000

Depreciation expense, leased building .................................... 30,000Accumulated depreciation, leased building....................... 30,000[$480,000 ÷ 16]*

Deferred gain on sale and leaseback ($30,000 ÷ 12)** ........... 2,500Depreciation expense, leased building .............................. 2,500

* The building will be depreciated over its useful life of 16 years rather than the lease term of 12 years because the building reverts to the lessee at the end of the lease.

** Under IFRS, the gain will be amortized over lease term. Under ASPE, the gain will be amortized proportionate to the depreciation. Under ASPE, the annual amortization of the gain will be $30,000 ÷ 16 = $1,850. Either response should be accepted, although it will affect part of requirement 3 as well.

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Requirement 3

Statement of Financial Position (assuming IFRS treatment of the deferred gain)

Capital assetsBuilding under capital lease $480,000Accumulated depreciation (30,000) $450,000 dr

Deferred credits (L-T)Deferred gain on sale and leaseback 27,500 cr

Short-term liabilitiesCurrent portion of long-term lease liability* 27,577 cr

Long-term liabilitiesLease liability ($480,000 + $48,768 – $71,000) 457,768Less: current portion (24,491)* 433,277 cr

* Current portion of lease principal:Payment, 20x3 $71,000Interest, 20x3 ($457,768 × .1016) 46,509Principal portion $24,491

Statement of Comprehensive Income—earnings section:

Depreciation expense $30,000Property tax expense 6,000Interest expense 48,768

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Assignment 17-20

The sale and leaseback transaction has the following characteristics:

The company has a book gain of $1,500,000 on the sale: $1,750,000 – $250,000. The present value of the lease payments is $1,705,457; i.e., [$175,000 (P/AD, 7%,

15) = $175,000 × 9.74547]; this is a capital lease because the present value is 97.5% of the property’s fair value.

The repurchase provision is based on the estimated fair value at the end of the lease term; it is not a bargain purchase option.

The transaction should be accounted for as follows:

The asset and the related lease liability should be capitalized at the PV of the lease payments of $1,705,457; the repurchase price should not be included because it is not guaranteed by the lessee.

The asset’s fair value should be allocated 40% to land and 60% to building. The building should be depreciated at a rate that reflects the 15-year lease term; the

10% declining balance rate may be too low because it probably is based on ownership with a useful life of greater than 15 years. A double-declining rate based on 15 years would be 13.3%.

If the company is complying with ASPE, the gain on the sale of the property (both land and building) should be deferred and amortized on the same basis as the asset value is depreciated (i.e., either 10% or 13.3% per year). If the company uses IFRS, the gain is amortized over the lease term (i.e., not based on the depreciation method).

Each year, interest at 7% on the outstanding lease liability balance should be accrued; the lease balance is reduced by the amount by which each lease payment exceeds the accrued interest.

The lease is a capital lease because substantially all of the benefits and risks of ownership have been retained by Sportco (the lessee) after the transaction. The gain on sale should not be recognized in 20X2 earnings because there has been no substantive change in the ownership of the property; the gain and leaseback affects cash flow and results in a legal change in ownership, but it is not an earnings transaction.

Instructional note: Journal entries are not required.

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Assignment 17-21

Requirement 1

Handling equipment:

Present value calculations, based on net lease payments:

$50,000 × (P/AD, 8%, 4) = $50,000 × 3.57710 = $178,855$20,000 × (P/AD, 8%, 3)(P/F, 8%, 4) = $20,000(2.78326)(0.73503) = 40,915

$219,770

The total lease term, including the renewal options, is seven years. Compared to the estimated total life of 8-10 years, this appears to transfer substantially all of the rewards and risks of ownership to Belangier Corporation.

The total PV of $219,670 is 80% of the fair value of the equipment, which mayindicate that Belangier is returning substantially all of the lessor’s investment in the equipment given that the lease payments may reflect a tax shield or other cost-reduction opportunities available to the lessor that reduces the lessor’s after-tax investment in the asset. The 80% portion returned is lower than the ASPE guideline of 90%, however.

The underlying question is whether the renewal terms qualify as bargain renewals. The basic 4-year lease amounts to approximately half of the asset’s life and about 65% of the equipment’s FV. However, the sudden drop in lease payments for the renewal periods suggests that the lessor has already recovered most of the investment over the first four years; the drop in lease payments may not be proportional to the actual reduction in the asset’s fair value. On the other hand, insurance and taxes do drop almost proportionately to the drop in the lease payments after the first 4-year term, suggesting that the fair value of the equipment has declined significantly by the end of the lease term.

A decision is not absolutely clear, but the decision seems to lean towards finance lease treatment. Students should identify the pros and cons, and the ambiguity in deciding whether it’s a finance or operating lease.

Truck:

PV = $5,000 × (P/AD, 2%, 16) = $5,000 × 13.84926 = $69,246

The PV of the lease payments = 57% of the truck’s FV of $121,500 (after the 10% discount). Renewal terms are to be negotiated, which clearly indicates that there are no bargain renewals. Also, the lease term is only 40% of the truck’s ten-year estimated life. Contingent rents cannot be taken into account when evaluating the lease. This is an operating lease.

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Assignment 17-22

Requirement 1

The lease payments can be verified by dividing the cost of the machine by the present value of an annuity due for 6 years:

A = $239,650 (P/AD, 8%, 6) = $239,650 4.99271 = $48,000

Beginning Interest Cash Incr/(Decr) EndingYear balance at 8% flow in balance balance20X1 $239,650 — $ 48,000 $(48,000) $191,65020X2 191,650 $15,332 48,000 (32,668) 158,98220X3 158,982 12,719 48,000 (35,281) 123,70120X4 123,701 9,896 48,000 (38,104) 85,59720X5 85,597 6,848 48,000 (41,152) 44,44420X6 44,444 3,556 48,000 (44,445) —

$48,351 $288,000 $239,650

Requirement 2 (ignoring the $20 discrepancy)

31 December 20x1: Lease receivable……………… 239,650

Cash………………….. 239,650Cash…………………………. 48,000

Lease receivable…….. 48,000

31 December 20x2: Cash…………………………. 48,000

Finance income…….. 15,332Lease receivable……. 32,668

31 December 20x3: Cash………………………… 48,000

Finance income……. 12,719Lease receivable…… 35,281

Two entries, one to recognize revenue and the other to recognize cash collection, may be prepared each 31 December rather than the compound entries shown above.

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Requirement 3

31 December 20x1:

Lease payments receivable. 288,000Unrealized finance income 48,350Cash……………… 239,650

Cash……………………… 48,000Lease receivable…. 48,000

31 December 20x2: Cash……………………… 48,000

Lease payments receivable 48,000Unrealized finance income.. 15,332

Finance income….. 15,332

31 December 20x3: Cash……………………… 48,000

Lease payments receivable 48,000Unrealized finance income. 12,719

Finance income…. 12,719

The 31 December entries can be combined as illustrated in requirement 1.

Requirement 4

On 31 December 20x3, the lessor has just received a payment. The remaining net balance of the receivable will be the present value of the remaining three payments, which are due on 31 December 20x4, 20x5 and 20x6:

PV = $48,000 (P/A, 8%, 3) = $48,000 × 2.57710 = $123,701 (also see amortization table.)

The lessor would disclose a net lease receivable of $123,701 on the balance sheet, regardless of whether the gross or net method is used in the accounting records.

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Assignment 17-23

Requirement 1

The interest rate implicit in the lease is 7.09%:

$46,550 = ($14,000) (P/A, i%, 2) + ($9,000)(P/A, i %, 3) (P/F, i %, 2) + $1,000 (P/F, i%, 5)

i = 7.09% (solved by spreadsheet)

Trial and error would come close at 7%:

$46,550 = ($14,000) (P/A, 7%, 2) + ($9,000)(P/A, 7%, 3) (P/F, 7%, 2) + $1,000 (P/F, 7%, 5)

$46,550 = ($14,000) (1.80802) + ($9,000)(2.62432) (.87344) + $1,000 (.71299)

$46,550 = $46,654

Requirement 2Lessor’s Amortization Schedule - End of Year Payments

Beginning Interest 31 December Decrease in EndingYear Balance 7.09% Cash Flow Balance Balance

20x2 $46,550 $3,301 $14,000 $10,699 $35,85120x3 35,851 2,542 14,000 11,458 24,39420x4 24,394 1,730 9,000 7,270 17,12420x5 17,124 1,214 9,000 7,786 9,33820x6 9,338 662 10,000* 9,338 0

$9,450** $56,000

* $9,000 + $1,000 residual value** Rounded up by $1

Requirement 3

2 January 20x2Lease receivable ........................................................................ 46,550

Cash (to purchase equipment for lease) .............................. 46,550

31 December 20x2Lease receivable ........................................................................ 3,301

Finance income ................................................................... 3,301

Cash........................................................................................... 16,000Lease receivable .................................................................. 14,000Maintenance expense .......................................................... 2,000

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Maintenance expense ................................................................ 2,000Cash..................................................................................... 2,000

31 December 20x3Lease receivable ........................................................................ 2,542

Finance income ................................................................... 2,542

Cash........................................................................................... 16,000Lease receivable .................................................................. 14,000Maintenance expense .......................................................... 2,000

Maintenance expense ................................................................ 2,000Cash..................................................................................... 2,000

Requirement 4

2 January 20x2Lease payments receivable*...................................................... 56,000

Cash..................................................................................... 46,550Unrealized finance income.................................................. 9,450

31 December 20x2Cash........................................................................................... 14,000

Lease receivable .................................................................. 14,000Unrealized finance income........................................................ 3,301

Finance income ................................................................... 3,301

31 December 20x3Cash........................................................................................... 14,000

Lease receivable .................................................................. 14,000Unrealized finance income........................................................ 2,542

Finance income ................................................................... 2,542

* ($14,000 × 2) + ($9,000 × 3) + $1,000 residual value = $56,000

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Assignment 17-24 (Web)

Requirement 1

PV of lease payments: $100,000 (P/AD, 6%, 5) = $100,000 × 4.46511 = $446,511

Outstanding Interest cash Incr/(Decr) 31 Dec.

Year balance @6% payment in balance balance

20x4 446,511 – 100,000 (100,000) 346,511

20x5 346,511 20,791 100,000 (79,209) 267,301

20x6 267,301 16,038 100,000 (83,962) 183,339

20x7 183,339 11,000 100,000 (89,000) 94,340

20x8 94,340 5,660 100,000 (94,340) 0

Requirement 2

Statement of financial position:Equipment under finance lease $446,511Accumulated depreciation (assuming full year depreciation) (89,302)

$357,209

Current liability for capital lease* $100,000Long-term liability for capital lease** $267,302

The total lease liability at 31 Dec 20x4 is $346,511 principal plus $20,791 interest = $367,302.

* Of that amount, the current portion is the $100,000 due the next day, (consisting of $79,209 principal plus $20,791accrued interest)

** The long-term portion is (1) the total liability of $367,302 minus the next-day payment of $100,000, or(2) the remaining principal payments: 83,962 + 89,000 + 94,340

Statement of comprehensive income, earnings section:Depreciation expense $ 89,302Interest expense (from amortization table) 20,791

Cash flow statement:Operating activities—non-cash expense add-backs:

Depreciation $ 89,302Interest 20,791

Financing activities—finance lease payment 100,000

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Requirement 3

Yvan Limited entries for 20x5:

2 January 20x5:


31 December 20x5:

Interest expense 16,038Lease liability 16,038

Depreciation expense 89,302Accumulated depreciation—asset under finance lease 89,302

Requirement 4

Jeffrey Leasing Inc. entries for 20x5:

2 January 20x5:

Cash 100,000Lease payments receivable 100,000

31 December 20x5:

Unrealized finance income 16,038Finance income 16,038

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Assignment 17-25

Requirement 1

Present value of lease payments for Sondheim:$600,000 (P/AD, 6%, 10) = $600,000 × 7.80169 = $4,681,014

1 April 20x2:

Equipment under capital lease 4,681,014Lease liability 4,681,014


31 December 20x2:

Depreciation expense* 234,051Accumulated depreciation – equipment 234,051

*$4,681,014÷ 10 × ½

Interest expense* 183,646Lease liability 183,646

*($4,681,014– $600,000) × 6% × 9/12

Requirement 2

Statement of financial position:Equipment under capital lease $4,681,014Accumulated depreciation 234,051

$4,446,963

Cash flow statement:Operating activities, non-cash items add-backs:

Depreciation expense $ 234,051Interest expense 183,646

Financing activities – capital lease payment $ 600,000

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Requirement 3

Present value of lease for New Age Leasing:$600,000 (P/AD, 7%, 10) = $600,000 × 7.51523 = $4,509,138

1 April 20x2:

Lease payments receivable ($600,000 × 10) 6,000,000Unrealized finance income* 1,490,862Cash 4,509,138

*$6,000,000 – $4,509,138

Cash 600,000Lease payments receivable 600,000

31 December 20x2:

Unrealized finance income 205,230Finance income* 205,230

*($4,509,138– $600,000) × 7% × 9/12

Net lease receivable at 31 December 20x2:Lease payments receivable $5,400,000Unrealized finance income ($1,490,862 – $205,230) 1,285,632Net balance $4,114,368

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Requirement 1

The lease is a finance (or capital) lease, both (1) because the lease term covers all the expected life, since the residual value is zero at the end of the lease term, and (2) the NPV of the MLPs is equal to fair value). There is no risk of non-collection or material cost uncertainties. The lease is a sales-type lease because of the nature of the lessor: Jordin uses leases to sell its products. The fair value implicit in the lease payments is different from book value.

Requirement 2

The gross loss recognized by Jordin is $2,102, the difference between cost of the equipment and the PV of the MLP’s ($17,898 – $20,000). Total finance income over the lease is $5,178, the difference between gross and net lease payments receivable.

PV of MLP’s $5,769 (P/A, 11%, 4) (3.10245) $17,898Gross amount of lease payment $5,769 × 4 23,076Finance income $23,076 – $17,898 $ 5,178

Requirement 3

If the implicit rate is 4%, the gross profit recognized is $941 ($20,941 – $20,000). Total finance income is $2,135. Notice that gross profit (loss) plus finance income equals $3,076 in both parts 2 and 3.

PV of MLP’s $5,769 (P/A, 4%, 4) (3.62990) $20,941Gross amount of lease payments $5,769 × 4 $23,076Finance income $23,076 – $20,941 $ 2,135

Requirement 4

1 January 20x1

Lease payments receivable ...................................................... 23,076Unrealized finance income ................................................ 5,178Sales revenue ..................................................................... 17,898

Cost of goods sold ................................................................... 20,000Equipment inventory ......................................................... 20,000

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Assignment 17-27

Requirement 1

Payment Balance Interest Cash Incr/(Decr) Balance afterdate for year at 9%* flow in balance payment

1 Jan 20X2 $104,929(1) — $15,000 $(15,000) $ 89,929 1 Jan 20X3 89,929 8,094 15,000 (6,906) 83,0221 Jan 20X4 83,022 7,472 15,000 (7,528) 75,4941 Jan 20X5 75,494 6,794 15,000 (8,206) 67,2891 Jan 20X6 67,289 6,056 15,000 (8,944) 58,3451 Jan 20X7 58,345 5,251 15,000 (9,749) 48,5961 Jan 20X8 48,596 4,374 15,000 (10,626) 37,9691 Jan 20X9 37,969 3,417 15,000 (11,583) 26,3871 Jan 20X10 26,387 2,375 15,000 (12,625) 13,7621 Jan 20X11 13,762 1,239 15,000 (13,761) 0

* Interest accrues in the fiscal prior to the payment date.

(1) [$15,000 × (P/AD, 9%, 10)] = $15,000 × 6.99525 = $104,929

At 31 December 20x5, the end of the fourth year of the lease, the amounts relating to the lease on the SFP will be as follows:

Assets:Leased asset $104,929Accumulated depreciation ($104,929 ÷ 10 × 3.5 years) (36,725)

$ 68,204Liabilities:

Current portion of lease liability $ 15,000 (1)Long term portion of lease liability 58,345 (2)Total liability $ 73,345

(1) $8,944 principal + $6,056 interest = $15,000(2) The long term portion is the 31 December 20x5 principal balance ($67,289)

minus the portion of the 1 January 20x6 that will reduce the principal ($8,944) : $67,289 – $8,944 = $58,345.

Income statement:

Depreciation expense $10,493

Interest expense $ 6,056

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Requirement 2

At 31 December 20x5,SFP:

Gross lease payments receivable ($15,000 × 6 years remaining)$90,000

Unrealized finance income (last 5 years on amortization table)16,656

Net lease receivable $73,344

This corresponds to the lessee’s balance sheet, which shows a total of $73,345 of liability ($58,345 + $15,000). The lessor and lessee’s records will correspond when interest rates used are identical. The $1 difference is due to rounding.

Since leasing is the lessor’s normal business activity and defines its operating cycle, no distinction is made between current (i.e., one-year) and long-term liabilities.

Statement of comprehensive income, earnings section:Finance income $ 6,056

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Requirement 1

Lease payment

$40,308 = [–$2,200 + (x (P/AD, 8%, 3)] + [$1,200 × (P/AD, 8%, 3) × (P/F, 8%, 3)]

$40,308 = [–$2,200 + (x (2.78326)] + [$1,200 × (2.78326) × (.79383)]x = $14,320

Lease payment = $14,320 + $1,100= $15,420

Requirement 2

For the lessee, this is a finance/capital lease, as the lease term (including the bargain renewal) is 100% of the economic life. The renewal is a stated to be a bargain renewal term.

Capitalizable value:

= [($15,420 – $1,100) (P/AD, 7.5%, 3)] + [$1,200 (P/AD, 7.5%, 3) (P/F, 7.5%, 3)]= $42,933 (solved by spreadsheet)

Requirement 3

For the lessor, this is also a capital lease due to economic life vs term, plus the fact that credit risk is normal and no unreimburseable costs are present.

Since the fair value appears to be equal to cost at the beginning of the lease, it appears to be a direct financing lease.

Requirement 4Lessor Amortization Table

Beginning Interest Decrease EndingYear Balance @ 8% Payment in Balance Balance

20x3 $40,308 $0 $12,120* $12,120 $28,18820x4 28,188 2,255 14,320 12,065 16,12320x5 16,123 1,290 14,320 13,030 3,09320x6 3,093 247 1,200 953 2,14020x7 2,140 171 1,200 1,029 1,11120x8 1,111 89 1,200 1,111 0

* $14,320 – $2,200 in initial direct costs

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Requirement 5

Lessee’s SFP, 31 December 20x3 Capital assets: Leased asset $42,933 Less: depreciation (1/6) (7,156) $35,611 Current liabilities: Current portion of lease liability $14,320

Long-term liabilities: Lease liability $30,759* Less: current portion (14,320) $16,439

*[$42,733 – $14,320 + .075 × ($42,933 – $14,320)]

Lessee’s Income Statement, year ended 31 December 20x3:

Depreciation expense $7,156Insurance expense $1,100Interest expense $2,146

Lessor’s SFP, 31 December 20x3:

Lease receivable, net $30,443 ($28,188 + $2,255); see amortization table for calculations

Lessor’s Income Statement, year ended 31 December 20x3:

Finance income $2,255

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Assignment 17-29

Operating/Investing/Financing Inflow/Outflow Amount

1. Investing—sale of capital assets Inflow $3,125 Operating—adjustment for loss included in NI Inflow $ 375

$3,125 proceeds – ($10,000 cost – $6,500 accum. depr.)

2. Operating—adjustment of sales revenue not realized Outflow $23,456* 3. Operating—increase to NI for non-cash expense Inflow† $5,000

4. Financing—sale of common shares Inflow $8,000

5. Operating—increase to NI for non-cash expense Inflow† $1,200

6. Financing—redemption of bonds Outflow $12,360**

7. Financing—repayment of lease liability Outflow $1,088***

Notes:

† These items are not really inflows—they are adjustments to net income (indirect method) to add back amounts that did not require cash.

* Phillie would have reported sales revenue of $32,156 ($8,700 + $23,456) and no Finance income, since the lease had just started. The only portion of the sales revenue that was collected was $8,700; the remainder is represented by the increase in the long-term net lease receivable. Sales revenue (i.e., net income) must be reduced by the difference between sales revenue recognized and cash received: $32,156 – $8,700 = $23,456.

** Redemption of the bonds at 103 amounts to $12,360, which exactly offsets the unamortized premium. No gain or loss on redemption would have been included in NI, and thus no operating adjustment is necessary.

*** There will also be an outflow for interest in operations.

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Assignment 17-30

Laker CompanyCash Flow Statement

Year ended 31 December 20x5Operating activities:

Net income for 20X5, as reported $11,710Items of income and expense not affecting cash:

Depreciation expense $ 8,100 Lease finance income (5,080)Bond premium amortization (interest expense) (1,110) 1,910

Changes in current assets and liabilities:Accounts receivable (910)Inventory (1,400)Prepaid rent 1,800Prepaid insurance (240)Office supplies (50)Accounts payable (1,000)Taxes payable 200Wages payable 400 (1,800)

Cash provided by operating activities 12,420

Financing activities:Payment of dividends (4,800)Repayment of long-term notes payable (2,000)Issuance of common shares 6,500

Cash provided by financing activities (300)

Investing activities:Cash received from lease investment* 15,880Purchase of equipment (25,000)

Cash provided by investing activities (9,920)

Net change in cash $ 2,200Opening cash 800Closing cash $ 3,000

* $35,000 – $25,000 + $5,080 = $15,080

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© 2011 McGraw-Hill Ryerson Ltd. All Rights Reserved.

Solutions Manual to accompany Intermediate Accounting, Volume 2, 5 th edition 18-1

Chapter 18: Pensions and Other Post-Retirement

Benefits

Suggested TimeCase 18-1 Deliveries-R-Us

18-2 Recognition Issues18-3 Candida Ltd.

Assignment 18-1 Pension terms ......................................................................... 1018-2 Amortization periods ............................................................. 1518-3 Defined contribution plan ...................................................... 1518-4 Defined contribution plan ...................................................... 1518-5 Defined contribution plan ...................................................... 1518-6 Accrued pension asset (*W) .................................................. 1518-7 Defined benefit obligation and pension fund assets............... 1518-8 Pension expense (*W)........................................................... 3018-9 Pension expense ..................................................................... 3018-10 Pension expense ..................................................................... 3018-11 Pension expense ..................................................................... 2018-12 Recognition alternatives: actuarial gains and losses .............. 2518-13 Recognition alternatives: actuarial gains and losses .............. 2518-14 Corridor rule........................................................................... 2018-15 Corridor rule........................................................................... 2018-16 Pension spreadsheet ............................................................... 3018-17 Pension expense; spreadsheet (*W)....................................... 4018-18 Pension expense; spreadsheet ............................................... 3018-19 Other post-employment benefits ............................................ 3018-20 Other post-employment benefits; spreadsheet ....................... 3018-21 Pension information, interpretation ....................................... 3018-22 Pension information, interpretation ....................................... 3018-23 Pension expense ..................................................................... 3018-24 Pension expense; spreadsheet (*W)....................................... 4518-25 Pension issues, comprehensive .............................................. 4518-26 Pension spreadsheet ............................................................... 4518-27 Pension issues, comprehensive .............................................. 4018-28 Pension expense, explanation, calculation............................. 3518-29 Pension expense ..................................................................... 3518-30 Comprehensive; Chapters 12, 13, 14, 17, 18 ......................... 120

18-A1 to 18-A5 Actuarial cost methods; based on OLC posted material18-A1 Pension funding calculation (OLC) ................. 2518-A2 Actuarial cost methods (OLC) ........................ 2018-A3 Actuarial cost methods (OLC) ........................ 3518-A4 Explain; pension calculations (OLC)............... 4018-A5 Actuarial cost methods (OLC) ......................... 40

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18-2 Solutions Manual to accompany Intermediate Accounting, Volume 2,5th edition

*W The solution to this exercise/problem is on the text Web site andin the Study Guide. The solution is marked WEB.

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Questions

1. A defined contribution pension plan does not define specific benefits to be paid at employees’ retirement. Rather, it specifies the periodic amount that the employer must pay into the pension fund. The employees receive whatever benefits can be paid from the pension fund; the accumulated balance of contributions and earnings. That is, the plan has variable benefits and defined contributions.

A defined benefit plan specifies the amount of benefits to be received by employees after retirement. Employers must fund this amount over time. That is, the plan has fixed benefits and variable contributions.

Employers find defined contribution plans attractive because their contributions are predictable; there is no risk to the employer as is associated with defined benefit plans.

2. Contributory pension plan—The employees make contributions to the plan as well as the employer.Non-contributory pension plan—The employer pays all of the contributions needed to pay for future benefits.

3. An employee’s contributions vest immediately; this is appropriate as it is the employee’s money and should be returned if the employee leaves. The employer contributions, on the other hand, will permanently benefit those who have been with the employer for some minimum period of time.

4. A registered pension plan has a significant advantage over an unregistered plan in that a contribution to a registered plan is tax-deductible for the employer at the time of the contribution. Registered plans must have a trustee and meet certain other criteria.

5. The expense associated with a defined benefit plan will be affected by changes in the underlying assumptions and variables:

a) Increased rate of return on assets—Reduce.b) Lower mortality rates—Increase.c) Higher turnover—Reduce.d) Wage roll-back—Reduce.

6. Three funding approaches and the likely funding amount in the first year:a) The accumulated benefit method: $1,100. No projections are made, so this is the

lowest amount.b) The projected unit credit method: $2,600. Salaries are projected, but not years of

service; this is the second lowest amount.

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c) The level contribution method: $6,300. Salaries and years of service are projected. This is the highest amount.

7. The most appealing funding method to:a) Conserve current cash balances—The accumulated benefit method. Since it

involves no projections, it has the lowest initial funding requirement.b) Equal cash requirements each year—The level contribution method is the only

method that produces this pattern.c) Same method as for accounting—The projected unit credit method must be used

to measure the accounting expense for external reporting.

8. Continuing components of pension expense:

(a) Current service cost—The cost (using the projected unit credit method) of future pension benefits earned by employees during the current accounting period.

(b) Interest cost—The defined benefit obligation multiplied by the borrowing rate. This component increases pension expense.

(c) Expected earnings on plan assets—The expected return on pension plan investments, based on portfolio composition and earnings projections at the beginning of the year. This component decreases pension expense.

(d) Past service cost—Past service cost is caused by pension entitlements given for service before the plan was in force or when plans are improved after inception. The cost is recognized over the vesting period, which may be immediate or a period of years.

(e) Actuarial gains or losses—Change in the projected benefit obligation of fund assets due to (a) experience and (b) changes in actuarial assumptions. If outside a 10% corridor, the cost must be amortized to pension expense over ARSP. Companies may also elect to amortize a greater amount, include the entire amount in pension expense in the year of origin, or exclude the amount from pension expense and recognize it through reserves and other comprehensive income.

9. Interest on the defined benefit obligation is measured by multiplying the defined benefit obligation by the borrowing rate (market interest rate on high-quality bondswith similar term at the year-end date). The beginning-of-the year obligation may be used to approximate the obligation during the year. Alternatively, the actuary may provide the calculation.

10. Past service cost is the actuarial present value of pension entitlements granted for work done prior to the initial adoption of a pension plan or prior to the improvement of an existing pension plan. It is recognized as part of pension expense over the vesting period, which may be immediate (lump sum) or over a period of years (straight-line amortization).

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11. The ARSP is the average remaining service period of employees in a pension plan. It measures the period of time before retirement. ARSP is used to amortize actuarial gains and losses outside the corridor, if the company chooses the 10% corridor rule for this element.

12. Experience gains and losses are caused when actual (past) experience is different from the assumptions made in the measurement process. As a result, the pension benefit obligation is different (higher or lower; loss or gain). Alternatively, fund earnings may be greater or less than expected.

A change in assumptions causes the defined benefit obligation to change (higher or lower; loss or gain) because of different assumptions concerning the future. Actuarial gains and losses recognition alternatives:a. Include in pension expense (amortized over the ARSP) if they are outside a 10%

corridor. Accumulated actuarial gains and losses (the total of both experience and changes in assumptions) are calculated as of the beginning of the year. The amount is compared to 10% of the larger of opening pension assets or the defined benefit obligation. Any excess over the 10% is amortized to pension expense over the ARSP.

b. Amortize using any faster method than the corridor method. c. Include in pension expense all in one year. d. Recognize all in one year through reserves and include as an element of other

comprehensive income.

13. Required amortization: ($27,000 - ($230,000 x 10%)) = $4,000; $4,000 / 10 = $400.

14. The limit on pension fund assets is the amount that can be recovered in the future. Future benefits might be a pension holiday (no required contributions) in an over-funded plan, or the presence of amounts that will be amortized to pension expense (realization through use).

15. Gains and losses related to pension plan settlements and curtailments are recognized in income immediately, sometimes as part of discontinued operations or an unusual item (restructuring) rather than in pension expense.

16. The costs of special termination benefits related to pension cost are included in income immediately, sometimes as a restructuring cost or as part of discontinued operations.

17. Net pension accrued asset $25,000 ($400,000 versus ($250,000 + $175,000))

18. Justification for recording the net position of the fund, excluding unrecognized amounts, rests on the following arguments (from the text material)

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1. The net position of the plan appears to meet the definition of a liability, since it is a present economic obligation for which the company is reponsible.

2. Pension amounts are subject to certain estimates, but these estimates can be made in reliable enough form that recognition is appropriate.

3. Some research indicates that analysts and other users react differently to the under-funded status of the plan if it were recorded in the SFP, versus if it were simply disclosed in the notes. If this is true, then disclosure is not a good substitute for recognition.

19. Post-employment benefits other than pensions are less likely to be fully funded because it makes no financial sense for the sponsoring company to fund the amounts. Amounts paid are not tax deductible until such time as they are spent on retirees. On the SFP, this makes it more likely that a net liability will exist; the expense will likely be higher because there will be little or no reduction to the expense from expected fund earnings.

20. A private company using the simplified version of pension accounting under ASPE will account for a pension as follows:

Use the same actuarial cost method for accounting and for funding. Record pension expense as the current service cost, plus interest on the defined

benefit obligation, less the actual return on fund assets, plus all PSC, and plus allactuarial gains and losses. There are no amortizations.

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Cases

Case 18-1 Deliveries-R-Us

Overview

Deliveries-R-Us is a public company with a 0.65 debt-to-equity ratio. No corporate reporting objectives are established, but it seems reasonable to suggest that stable profits and debt minimization are both reporting objectives. The company is likely capital-intensive because of the need for transportation equipment and physical infrastructure in the delivery business.

Issues

The presence of off-balance sheet liabilities is a concern, in the following areas:

1. Lease obligations2. Lawsuit liability3. Pension and post-employment healthcare obligations4. Restatement of debt-to-equity ratio

Analysis

1. Lease obligations

Deliveries-R-Us has $294 million of capital leases recorded as debt. However, sizeable operating leases are not capitalized. Leases must be capitalized if the risks and rewards of ownership have transferred. Presumably, capitalization criteria are not met, since the company is public and certainly would comply with GAAP.

However, some might consider the operating leases to represent obligations of the company, to be included when evaluating the company’s debt load. The operating leases of Deliveries-R-Us, with an average term of six years, are material.If assets that are essential to the business model are primarily acquired through rental arrangements, and represent ongoing needs, an understanding of the company’s business model might be enhanced through liability recognition. An IFRS proposal suggests that essentially all operating leases should be capitalized.

The liability has been estimated using an interest rate of 6%. This is the upper range of long-term debt interest rates per the SFP, assumed to be appropriate for higher risk. Other assumptions are that the payments are due at the beginning of the year, and payments listed as “thereafter” are all due in Year 6. Alternate assumptions are acceptable. The resulting liability is:

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YEAR DOLLAR VALUE DISCOUNT FACTOR @6%*

PRESENT VALUE

20X3 $1,759 1.0 $1,75920X4 1,612 0.94340 1,52120X5 1,451 0.89000 1,29120X6 1,316 0.83962 1,10520X7 1,166 0.79209 924Thereafter 7,352 0.74726 5,494

$12,094

Liabilities and capital assets would increase by this significant amount.

2. Lawsuits

Deliveries-R-Us is the defendant in numerous lawsuits regarding wage-and-hour violations. The number of these lawsuits, and the fact that 19 have been certified as class action lawsuits, indicate that the potential problem is not localized. However, the cases have not progressed far enough in the court system for the company to be willing or able to assess the amount or the probability of payment. At present, Deliveries-R-Us states that they do not believe that material loss is probable. It is certainly possible. With no other information, though, it is not possible to suggest a liability to be recorded. One must be aware, though, that these lawsuits may result in a material obligation in the future, which is not now on the SFP.

3. Pension and post-employment healthcare obligations

Deliveries-R-Us has recorded $813 as the net liability position of their pension fund ($572) plus post-employment healthcare plans ($241). However, these amount are different than the underfunded status of the plans themselves, which total $4,041 ($3,600 + $441). The reason that the full underfunded amount is not recorded is because there are unrecognized past service costs for the pension plan, in the amount of $417, and unrecognized actuarial losses of $2,611 in the pension fund plus $200 in the post-employment healthcare plan. The recognized SFPposition is therefore different than the overall fund status. There are good reasons why the fund status might be reflected in the SFP, although GAAP does not require such recognition. Reasons for recognition cited, per the text:

The net position of the plan appears to meet the definition of a liability, since it is a present economic obligation for which the company is reponsible. Pension amounts are subject to certain estimates, but these estimates can be made in reliable enough form that recognition is appropriate. Some research indicates that analysts and other users react differently to the under-funded status of the plan if it

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were recorded in the SFP, versus if it were simply disclosed in the notes. If this is true, then disclosure is not a good substitute for recognition.

Note that the company may choose to recognize all the actuarial losses in the current period, either through pension expense or through reserves and other comprehensive income. The fact that they have not is simply a matter of policy choice that actually promotes under-recognition.

If the net position of the funds were to be recognized, liabilities would increase by $3,228 ($4,041 - $813). This amount would reduce equity (earnings or reserves)or some combination of both.

4. Restatement of debt-to-equity ratio

Before any adjustment, the debt-to-equity ratio is 0.65. If adjustments for operating leases and pension obligations are included as debt, and equity (reservesor retained earnings) is adjusted for the unrecognized pension amounts, the ratio changes to 2.3 (($4,524 + $1,930 + $2,342 + $12,094 + $3,228) ÷ ($13,630 -$3,228)). This does not include any amount for the result of the class action lawsuits outstanding against the company.

This level of debt-to-equity implies a significantly different risk profile for the company. It calls into question the usefulness of the financial statements as presented, and underscores the importance of understanding disclosure information and the intricacies of the current GAAP model that allow such practices.

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Case 18-2Recognition Issues

Overview

The discussion between a CFO and a financial analyst suggests reasons why the net status of a defined benefit pension fund should be recorded on the employer’s SFP, and the reasons why companies may oppose such a move. The issue is under consideration by standard setters, and is a source of potential difference between accounting standards in the U.S. and internationally. There are ethical issues regarding the duty to appropriately reflect the obligations of a company on the SFP, and appropriate concern for economic consequences.

Issues

1. Recognition criteria applied to pension obligations2. Disclosure versus recognition3. Legal status of the plan/reporting entity4. Recognition arguments5. Use of the projected unit credit method for liability measurement6. Reliability of estimates7. Audit implications8. Economic consequences

Analysis

1. Recognition criteria applied to pension obligations

Liabilities are current economic obligations for which the company is responsible. The pension plan obligation appears to meet this threshold; the pension obligation must be met by a company over time. Thus, the pension plan obligation is a liability. The organization may exercise its legal right to terminate or amend the plan, but that does not affect the liability it has already incurred.

2. Disclosure versus recognition

Disclosure is not a substitute for recognition, if recognition is appropriate. In fact, disclosed items are often those that fail one or more recognition criteria. All liabilities must be shown on the SFP provided that they can be estimated or measured with a reasonable degree of certainty. Since the pension plan obligation is a liability, it should appear on the SFP if it can be measured with a reasonable degree of certainty.

3. Legal status of the plan/reporting entity

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The fact that the pension plan is a separate legal entity does not change the analysis. Companies are required to report many separate legal entities as part of one set of financial statements – for example companies are required to consolidate subsidiaries.

4. Recognition arguments

The chief arguments in favour of including the pension fund net status on the SFP are as follows:

The organization, not the pension fund, carries the entire responsibility for meeting any cash deficiencies in the pension fund.

The fact that the pension fund is a distinct legal entity is a question of form, not of substance. It is the company that has a commitment to the employee and not the pension fund trustee.

The chief arguments against recording the net position are the following:

The organization has only limited access to the assets of the pension fund because the pension fund is a separate legal entity. With only limited access, the control criterion for recognition is not met.

As long as the organization pays all the amounts determined by the actuaries, it is fully discharging its obligations, past and present. Furthermore, the future retirement benefits will be paid by the pension fund, not by the organization.

The net status of the pension fund is disclosed in the notes to the financial statements; therefore, there is no need to report the assets and liabilities of the fund on the organization’s SFP.

Generally, the arguments for recognition are stronger.

5. Use of the projected unit credit method for liability measurement

The projected unit credit method has always been the actuarial method of choice for accounting measurements related to pensions. Since this company’s pension is based on average career earnings, not current earnings, using current earnings to project future cash flows would understate the best estimate of the obligation. Career average earnings would be expected to increase over time. The SFP is meant to help project future cash flows, so the projected unit credit method is the most useful.

Companies may be acting unethically in suggesting use of the accumulated benefit method to measure the pension plan liability, as this would likely be the lowest value and might mislead financial statement users.

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6. Reliability of estimates

The treatment of pension plan obligations requires extensive estimates, but this difficulty is not unique to pensions. Accountants are accustomed to estimating items such as provisions for bad debts or long-term warranties. The pension plan obligation is not different from other liabilities in this respect and should not be excluded from the SFP on these grounds.

It may be argued, however, that the pension plan obligation is more difficult to measure than other liabilities because it entails measuring more, and more complex, uncertainties than is the case with other liabilities. For example, estimates and assumptions must be made about highly unpredictable future events or matters, such as interest and inflation rates, mortality rates, staff turnover, and so on. This line of reasoning concludes that the resulting information is simply too “soft” to permit the pension plan obligation to be recorded on the SFP and that it should therefore be reported in the notes to the financial statements.

This argument can be countered by the fact that the amount of the defined benefit obligation is estimated by professional actuaries, who use widely accepted and rigorous statistical methods in arriving at the amount. The uncertainty of “softness” is therefore not as great as critics claim. Further, accountants regularly rely on other professionals, such as appraisers, for estimates that may appear on the SFP, so relying on actuaries for measurement does not create a precedent. It can even be argued that their methods of estimating are much more rigorous than some of the methods used in estimating other SFP items. Finally, uncertainty about the size of the obligation is not an acceptable reason for failing to meet the information needs of the users of financial statements.

7. Audit implications

The supposed difficulty of auditing the pension liability, and the incremental cost of doing so, are not valid objections. Accountants use established procedures when working with specialists (such as actuaries) during an audit. The auditor’s obligation is to render an opinion on the financial statements as a whole, including the disclosure notes. Thus, the information presented in the notes is audited no less thoroughly than the information in the rest of the financial statements, and there are no incremental costs.

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8. Economic consequences

The possible economic consequences of including the pension obligation on the SFP fuel the intensity of the debate on accounting for pension plans. The efficient market hypothesis suggests that the stock market reacts to information made available publicly but not to the manner in which the information is made available. If so, the question of where in the financial statements the pension obligation is recorded becomes irrelevant, since its manner of presentation will not affect stock price.

It may be argued that including these items as debt could affect the borrowing capacity of an organization. On the other hand, disclosure in the notes could have the same effect since it is unlikely that a rational lender would ignore information presented in the notes.

Debt covenants could be adversely affected, given the potential impact of the total pension obligation on financial statement ratios. For example, the revised debt:equity ratio could conceivably trigger a technical breach of a covenant if obligations exceeded plan assets by a large amount. The question then is whether such covenants can be revised to reflect new generally accepted accounting principles and at what cost.

It is conceivable that management compensation contracts could also be affected as a result of the impact of pension plan obligations on the financial statement ratios. For example, consider the effects of including the performance of the plan with the performance of an organization in earnings. Many executives would take the view that the assessment of their stewardship should not be affected one way or the other by the assessment of the pension plan trustee’s stewardship.

In the final analysis, the accounting profession cannot tailor GAAP to real or conjectured economic consequences. GAAP is aimed at describing economic reality in an objective manner, not at determining it. Thus, the economic consequences, important though they may be, cannot be allowed to determine the manner of reporting pension obligations.

(CICA adapted)

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Case 18-3 Candida Ltd.

Overview

Candida is a public company with both defined benefit and defined contribution pension plans. The nature of the plans must be analyzed, along with related financial statement elements, the impact of large unrecognized actuarial losses, and future cost increases.

Issues

1. Nature of defined benefit and defined contribution plans2. Financial statement elements relating to pension plans3. Projections for 20x64. Assumptions for review

Analysis

1. Nature of plans

Candida has both defined benefit and defined contribution plans. Defined benefit plans set out a pension entitlement for the retired employee, and Candida bears the risk of providing funding for the earned entitlement. A defined contribution plan establishes the employer obligation to provide resources to a pension trustee, and the employee accepts risk as to the size of pension payments. Candida’s shift to defined contribution plans (now $12 of $24 in pension expense) is consistent with a program to reduce financial risk.

2. Financial statement elements

For Candida’s defined contribution plans, the expense is equal to payments made to the trustee. No other financial statement elements result.

For Candida’s defined benefit plans, pension expense is defined as:1. Current service cost (expected present value of pension benefits earned

during the year)2. Interest cost on the defined benefit obligation3. Amortization of past service cost granted on plan initiation or amendment4. Amortization of experience losses,5. LESS, expected earnings on fund assetsOther items may be included in exceptional circumstances.

Under a pension arrangement, an actuary determines the expected present value of future benefits paid after retirement. This is called the defined benefit obligation, and is $228 million for Candida. It is based on the terms of the plans, and expected mortality rates and discount rates (interest rates on long-term debt). The growth in this liability due to work performed in a given year is item (1) above, current service cost. Interest on the obligation balance is item (2). The present

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value of defined benefit obligations granted on plan initiation or amendment is item (3).

Pensions are based on many estimates: interest rates, salary growth, investment earnings, etc. When estimates are different than actual, experience gains or losses are created, and these (losses to date for Candida) are amortized to pension expense (4). Finally, pension expense is reduced by expected earnings or assets. If assets are material, pension expense may be significantly reduced.

Pension expense will not equal the amount paid. For example, Candida expensed $12 for its defined benefit plans in 20x5, but paid $38 ($50 – $12 for defined contribution). The cumulative difference is an SFP account – an accrued pension asset for Candida. To date, more has been funded than expensed.

The asset position is the sum of unrecognized amounts:Defined benefit obligation $(228)Fair value of plan assets 113Underfunded position of plan (115)Unamortized net actuarial loss 147Unamortized past service cost 13Accrued pension asset $ 45

The nature of the defined benefit obligation has already been described. Note that for Candida, it also includes $14 of unfunded benefit obligations related to the Company’s other post employment benefits (health care, etc.)

Pension plan assets are funds placed with a pension trustee. They are only available for pension plan obligations, and include contributions to the plan plus fund earnings, less benefits paid, and less investment losses.

The pension plan assets and obligation ($113 and $228, respectively) are on Candida’s SFP, but are NET of unrecognized amounts.

3. Projections for 20x6

Candida has experienced sizeable actuarial losses caused by experience losses to date in the plan. These are losses on investment performance – expected earnings were higher than actual earnings. However, such losses are included in pension income gradually (amortized over the average remaining service life of affected employees, 12 years) and are only included if they are larger than 10% of the opening actuarial liability. This 10% corridor rule allows for long-term fluctuations.

Note that the 10% corridor method sets minimum amortization only: more amortization, or the loss in whole, could be included in pension expense.

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Alternatively, Candida could write these losses off to reserves, reported through other comprehensive income and by-pass the earnings entirely. This would increase the pension liability recorded, and decrease total equity.

20x6 pension expense for the defined contribution programs should be close to 20x5 expense, although increased to reflect compensation expense $12.6 ($12 x 1.05).

20x6 pension expense for the defined benefit plans might be as follows:1. Current service cost (20X5 - $7 x 1.05) $ 7.42. Interest cost ($228 x 6%) 13.73. Past service cost amortization ($13/4) 3.34. Amortization of experience losses ($147 - $23)/12 10.35. Expected earnings ($113 x 6.2%) (7.0)

$27.7

Pension expense for the defined benefit plans is materially increased, to $27.7from $12 in 20x5. A major cause is the amortization of experience losses.

4. Assumptions for review

To minimize pension expense in 20x6, the following assumptions should be reviewed with the actuary:

1. Mortality and turnover. These assumptions dictate pension payout, and reduce the defined benefit obligation. This would create an experience gain to reduce amortization in item 4. It would also reduce interest cost in item 2.

2. Discount rate. This interest rate determines interest expense in item 2; lowering the discount rate will lower pension expense. The estimate must be based on interest cost for long-term debt.

3. Expected earnings rate. This earnings rate determines expected earnings in item 5; increasing the earnings rate will lower pension expense. The estimate must be a best estimate based on rates of return over the long term for invested assets.

Note that since Candida has reported material cumulative losses in investment accounts up to 20x5, increasing earnings rates may be aggressive; actuaries and auditors may urge decreasing these amounts.

Finally, the company could recognize all the actuarial loss in reserves and other comprehensive income, and thus avoid the amount in pension expense. If they did this, the pension liability on the SFP would increase (decrease asset and create a liability) by $147, and reserves, and total equity, would decline by this amount. Pensions expense would decline by $10.3.

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Assignments

Assignment 18-1

1. The actuarial cost method that must be used to determine current service cost is the projected unit credit method.

2. Actuarial gains and losses have two causes: experience gains and losses and changes in assumptions.

3. The 10% corridor method uses 10% of the greater of two amounts as a corridor. These are the pension plan assets and the defined benefit obligation.

4. The SFP will include one of two accounts when there is a defined benefit pension plan; either an accrued pension asset or an accrued pension liability.

5. If actuarial gains and losses are to be recognized all in one year, they can be recognized in pension expense or in reserves/through other comprehensive income.

6. The ARSP is defined as the average remaining service period of employees (or, the period to retirement or, period used for corridor amortization).

7. Past service cost will be included in pension expense in the year it is granted if it vests immediately.

8. An experience gain or loss related to annual return on plan assets is the difference between actual return and expected return.

9. The costs of pension benefit changes caused by plan settlement and plan curtailment (or, termination benefits) are often included in discontinued operations rather than pension expense.

10. The expected present value of future pension benefits, evaluated using present value and actuarial expectations, including mortality, turnover, and the effects of current and future compensation levels, is called the defined benefit obligation.

11. Expected return on plan assets (or, amortization of actuarial gains, gains on settlements or curtailments, or gains on PSC) will decrease pension expense.

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Assignment 18-2

Requirement

ARSP is the average remaining service period of employees. It is the period to retirement. Vesting means that the employee has legal rights to the pension amount, and can retain these benefits if the employee leaves the company.

Requirement 2

Past service cost is the actuarial present value of pension benefits given in a newly introduced pension plan for service rendered by the employee before the plan was in place. Past service cost may also be caused by plan amendment, where improved pension plan benefits are awarded for work rendered by the employee before the plan was improved. There is an unamortized balance because the past service cost is amortized to pension expense over time.

Actuarial losses may arise after actuarial revaluation, where an actuary evaluates the actual performance factors since the last revaluation, and factors affecting the future outlook, and restates the defined benefit obligation accordingly. An increase to the defined benefit obligation causes a loss. This category also includes experience gains and losses, the difference between actual and expected earnings on fund assets, or the actual and expected pension obligations to date. There is an unamortized balance because the actuarial loss is amortized to pension expense over time.

Requirement 3

1. Actuarial loss – corridor method – ($224,000 versus 10% of $7,004,000) – none2. Actuarial loss – faster amortization – any scheme deemed desirable with positive

amortization (ie, greater than the zero obtained in #1)3. Actuarial loss – immediate recognition - none; If the $224,000 had been

recognized when it arose, there would be no balance carryforward and no actuarial amount would be left to recognize this year unless there were new actuarial gains or losses. Prior expense would have been higher, though.

4. Actuarial loss – recognize through reserves and as an element of other comprehensive income – no amount included in pension expense. Either this year or in a prior year (depends on when it was assumed to arise) the entire $224,000 would be recognized through other comprehensive income, not a P & L account.The amount would accumulate on the SFP, in a reserve account in equity.

Requirement 4

Past service cost - over vesting period - $880,000 (remaining balance)/ ((10-4) = 6) = $146,667

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Assignment 18-3

Requirement 1

A defined contribution plan gives the employee a pension based on their assigned assets at the retirement date. While the overall target might be 60% of final pay, the actual pension assigned might be higher or lower than this amount. The employees take the risk. In contrast, a defined benefit plan would assign 60% of final pay as a pension, along with other specific terms agreed to in the plan, regardless of the actual assets in the plan. The company takes the risk.

Requirement 2

If the targets were guaranteed, then this would be a defined benefit pension plan, and the company would have to base pension expense on actuarially determined calculations.

Requirement 3

TGY expenses the amount paid to the plan for current service, or $234,000.

Requirement 4

The immediate beneficiary of higher rates of return on assets (8% versus 5%) is the employee, since pensions are based on assets in the plan when the employee retires, and the more assets, the higher the pension.

However, if the amount of the annual payment is re-evaluated every three years, the employer’s required contribution to the plan might be scaled back, or at least not increased as much, if plan earnings are robust. Much depends on the bargaining position of the company and its employees with respect to plan contributions.

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Assignment 18-4

Requirement 1

A defined benefit plan places financial risk with the sponsoring company, which is not appealing to many companies. In particular, if investment portfolios perform poorly, sponsoring companies have to address the asset shortfall. If workers live longer into retirement, or if specified benefits such as health care coverage are more expensive than the initial prediction, the sponsoring company again is responsible. Additional funding requirements may come at a time when the company is in challenging financial times in relation to its core operations.

Note, though, that the company has some potential for upside benefit. If pension assetportfolios perform well, or mortality and cost estimates swing the other way, the employer benefits. In particular, when stock markets provide healthy returns, it is the company that holds the benefit through lower required contributions.

Requirement 2

The employee group carries financial risk under defined contribution plans. The risk is that employees will not have accumulated sufficient assets during their working lives to support themselves in retirement, especially if mortality rates decline and retirement lasts longer. Higher than expected medical care costs may also be a factor. In addition to being an individual issue, this may be a social issue as governments attempt to cope with the challenges of the elderly poor.

Some employees, though, would prefer to make their own investment decisions, prefer the flexibility of having access to retirement savings, and expect that they will not stay with one employer long enough to make a significant claim on pension fund assets. These individuals may prefer a defined contribution program. For others, it is not an attractive form of compensation and may affect an employee’s ability to recruit if there are alternatives.

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Assignment 18-5

Requirement 1

Pension expense could be $219,000 for the year, based on the amount paid. It could also be $195,000, which is 3% of actual salaries, and is the amount that the company should have paid.

The correct answer depends on the disposition of the $24,000 difference. If this amount has irrevocably passed to the plan, then the expense is $219,000. If the company can get a refund, or apply the overpayment to the contribution for the following year, then pension expense is $195,000.

Requirement 2

Zio would have pension expense of $130,000, the net amount to be contributed to the fund. Cash paid is $165,000 less the $35,000 forfeited payment.

Requirement 3

20X9: Expense $144,500 Cash paid = $100,000 ($100,000 + ($50,000 (P/AF 6%,2)) = ($100,000 + $44,500))

20X10: Expense $150,000 + ($44,500 x .06) = $152,670 Cash paid = $150,00020X11: Expense $150,000 + ($47,170 x .06) = $152,830 Cash paid = $200,000

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Assignment 18-6 WEB

Requirement 1

To record 20x6 pension expensePension expense ($165,000 + $15,000 – $18,000) ......................... 162,000Accrued pension asset..................................................................... 23,000

Cash ......................................................................................... 185,000

Requirement 2

Accrued pension asset $43,00020x5: ($170,000 – $150,000) $20,00020x6: (above) 23,000. $43,000

Requirement 3

The limit on pension fund assets is the amount that can be recovered in the future. Futurebenefits might be a pension payment holiday in an over-funded plan, or amounts that will be amortized to pension expense.

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Assignment 18-7

Requirement 1

Pension plan assets:31 December.............................................................................................. $344,1001 January ................................................................................................... 342,800

Increase in pension plan assets ............................................................ $1,300

Three causes of changes in pension plan assets:1. Increase or decrease: Actual return on plan assets 2. Increase: Cash received from employer or employees (latter for contributory plan)3. Decrease: Pension benefits paid to retirees

Requirement 2

Defined benefit obligation:31 December .................................................................................................... $704,2001 January .......................................................................................................... 599,690

Increase...................................................................................................... $104,510

Five causes of changes:

1. Increase: Current service cost2. Decrease: Pension benefits paid to retirees3. Increase or decrease: Losses or gains on changes in actuarial assumptions4. Increase: Interest cost5. Increase: New past service cost

Requirement 3Beginning End

Defined benefit obligation ............................. $599,690 $704,200Plan assets at fair value .................................. 342,800 344,100Underfunded ................................................. $256,890 $360,100

The underfunded pension status is the cash shortage that would exist if all of the pension benefits (at actuarial present value, including the effects of future salary adjustments) were to be paid on each of the measurement dates. There is no intention of doing so. This accounting measure will poorly reflect the “real” status of the plan if different actuarial valuation methods or assumptions are used for funding purposes. In this case, however, the increasingly-underfunded trend is of some concern. The fact that asset growth was minimal during the year implies that fund earnings were an issue, or, less likely, contributions to the plan were minimal.

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Assignment 18-8 WEB

Requirement 1

Pension expense, 20x5Current service cost ........................................................... $ 14,000Amortization of PSC ($20,000/10) ................................... 2,000Interest cost ($60,000 x .08) .............................................. 4,800Expected earnings.............................................................. (4,000)Actuarial gain amortization (1) ......................................... (267)Gain on plan curtailment (reduction of liability)............... (18,000)

Pension expense (negative)....................................................... $( 1,467)

(1) Corridor test:Actuarial gain, 1 January........................................................... $10,000Obligation x 10% ($60,000 x 10%) .......................................... (6,000)Excess ....................................................................................... 4,000Amortization ($4,000 / 15) ....................................................... $267 (gain)

Entries:Accrued pension asset/liability.......................................... 1,467

Pension expense (recovery)........................................... 1,467Accrued pension asset/liability.......................................... 16,000

Cash............................................................................... 16,000

Requirement 2

Pension expense, 20x5Current service cost ........................................................... $ 14,000Amortization of PSC ($20,000/10) ................................... 2,000Interest cost ($60,000 x .08) .............................................. 4,800Expected earnings.............................................................. (4,000)Actuarial gain ($4,000 - $6,000) ....................................... (2,000)Gain on plan curtailment ................................................... (18,000)

Pension expense (negative)....................................................... $( 3,200)

Note that this is equivalent to including actual return ($6,000 = $4,000 + $2,000) in pension expense.

Entries:Accrued pension asset/liability.......................................... 3,200

Pension expense (recovery)........................................... 3,200Accrued pension asset/liability.......................................... 16,000

Cash............................................................................... 16,000

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Requirement 3

The company could calculate pension expense as follows if the simplified approach were adopted: Pension expense, 20x5

Current service cost ........................................................... $ 14,000Amortization of PSC (recognized when granted) ............. noneInterest cost ($60,000 x .08) .............................................. 4,800Actual earnings.................................................................. (6,000)Actuarial gain (no carryforwards; recognized immediately) nonePension expense ................................................................ $12,800

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Assignment 18-9

Requirement 1

Pension expense:Current service cost ..................................................... $97,100Past service cost (remainder)....................................... 18,000Interest cost.................................................................. 39,700Amortization of actuarial gain (see below) ................. (1,671)Expected earnings ($560,000 x 4%)............................ (22,400)

Total expense ..........................................................$130,729

Restructuring expensePension benefits increased........................................... $8,000

The cost of the restructuring IS expensed, but is included with other restructuring expenses, and NOT within pension expense.

Corridor test for actuarial gain or loss amortization:Unrecognized actuarial gain................................................ $95,40010% of opening obligation (larger) ($720,000 x 10%)....... 72,000Excess ................................................................................. 23,400Amortization (over 14 years) .............................................. 1,671

Requirement 2

Unrecognized prior service cost ($18,000 - $18,000)......... noneUnrecognized actuarial gains/losses ($95,400 gain - $1,671 recognized -$10,000 loss -$20,400 loss ($22,400 - $2,000 earnings experience)) ....... $(63,329) (net gain)

Requirement 3

Pension expense ...................................................... 130,729Restructuring expense............................................. 8,000

Cash ................................................................. 103,200Accrued pension liability................................. 35,529

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Requirement 4

The company could calculate pension expense as follows if the simplified approach were adopted:

Pension expense:Current service cost ..................................................... $97,100Loss due to change in assumptions ............................. 10,000Interest cost.................................................................. 39,700Actual earnings ........................................................... (2,000)

Total expense ..........................................................$144,800

Restructuring expense (no change)Pension benefits increased $8,000hzzled



Assignment 18-10

Requirement 1

Projected benefit obligation, 1 January................................... $52,560Value of plan assets................................................................. (32,520)Unrecognized past service cost ............................................... (4,380)Unrecognized losses................................................................ (5,460)Accrued pension liability ........................................................ $ 10,200

Requirement 2

Pension expense (1)................................................................. 9,446Restructuring expense………………………………………. 4,000 Accrued pension liability ................................................ 3,846

Cash................................................................................. 9,600

The cost of the restructuring IS expensed, but is included with other restructuring expenses, and NOT within pension expense.

(1) Current service cost................................................................. $ 7,140Interest cost ............................................................................. 4,200Expected return on plan assets ($32,520 7%)...................... (2,276)

Amortization of past service cost ($4,380 12) ..................... 365

Amortization of unrecognized losses ($5,460-$5,256*) 8)) 11Pension expense ...................................................................... $ 9,440

* ($52,560 x 10%)

Requirement 3

Opening balance, accrued pension liability............................. $10,200Plus: Pension expense ............................................................. 9,440 Restructuring expense………………………………… 4,000Less: funding........................................................................... (9,600)Closing balance, accrued pension liability.............................. $ 14,040

Alternatively, students may prove the closing balance through an updated reconciliation as done in requirement 1.

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Assignment 18-11

Requirement 1

Current service cost................................................................................................. $1,200Interest cost ............................................................................................................. 1,840Past service cost amortization ($10,000 / 6) ........................................................... 1,667Expected return on plan assets ($2,408 x 7%)........................................................ ( 169)

$4,538

The accumulated unrecognized experience gain or loss (actual vs. expected earnings; $190 - $169; gain) is well within the 10% corridor (10% of $25,640) for next year.

Requirement 2

31 December 20x5:Pension expense ............................................................................ 4,538

Accrued pension liability ........................................................ 4,538Accrued pension liability .............................................................. 3,214

Cash......................................................................................... 3,214

Requirement 3

The past service cost is amortized over the vesting period. If the company were private, PSC would be amortized over the period to full eligibility for pension benefits. If the company was private and the simplified version of pension accounting were used, PSC would be included immediately in pension expense and not amortized.

Requirement 4

Balances at 31 December 20x5:

Accrued pension benefits ................... $25,640Pension plan assets (fair value).......... 5,412

($20,228)Unamortized past service cost ($10,000 - $1,667)......................... 8,333Unrecognized experience gain ........... (21)

($11,916) (credit)

The plan is underfunded, according to accounting measures, by $20,228.

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Assignment 18-12

Case A Current service cost.................................................................................................$280,000Interest cost ............................................................................................................. 107,000Past service cost amortization ................................................................................ 15,000Expected return on plan assets ($600,000 x 4%).................................................. (24,000)Actuarial loss amortization ($340,000 – 10% of defined benefit liability, opening, $210,000) / 20 ARSP. 6,500

$384,500Note that the actuarial loss of the year, and the experience loss of the year with respect to assets, are not factors in the calculations until 20X3.



Cash......................................................................................... 280,000

Case BCurrent service cost.................................................................................................$280,000Interest cost ............................................................................................................. 107,000Past service cost amortization ................................................................................ 15,000Expected return on plan assets ($600,000 x 4%).................................................. (24,000)Actuarial loss amortization ($340,000 / 20 ARSP) ........................................... 17,000

$395,000



Cash......................................................................................... 280,000

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Case CCurrent service cost.................................................................................................$280,000Interest cost ............................................................................................................. 107,000Past service cost amortization ................................................................................ 15,000Expected return on plan assets ($600,000 x 4%).................................................. (24,000)Actuarial loss amortization ($340,000 – 10% of defined benefit liability, opening, $210,000) / 5.............. 26,000

$404,00031 December 20x2:

Pension expense ............................................................................ 404,000Accrued pension liability ........................................................ 404,000

Accrued pension liability .............................................................. 280,000Cash......................................................................................... 280,000

Case DCurrent service cost.................................................................................................$280,000Interest cost ............................................................................................................. 107,000Past service cost amortization ................................................................................ 15,000Expected return on plan assets ($600,000 x 4%).................................................. (24,000)Actuarial loss – earnings ($24,000 expected, actual loss of $18,000) ................. 42,000Actuarial loss, arising in the year......................................................................... 105,000

$525,000Note that for earnings, this is the same as including actual loss in pension expense ($24,000 - $42,000 = $18,000 actual loss)31 December 20x2:



Case ECurrent service cost.................................................................................................$280,000Interest cost ............................................................................................................. 107,000Past service cost amortization ................................................................................ 15,000Expected return on plan assets ($600,000 x 4%).................................................. (24,000)Actuarial loss ....................................................................................................... none

$378,00031 December 20x2:


Reserve: actuarial loss($42,000 loss on assets plus $105,000 assumptions).............. 147,000Accrued pension liability ....................................................... 147,000


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Assignment 18-13

Case A Current service cost.................................................................................................$ 67,000Interest cost ............................................................................................................. 32,000Past service cost amortization ................................................................................ 20,000Expected return on plan assets ($505,000 x 5%).................................................. (25,250)Actuarial loss amortization ($87,000 – 10% of defined benefit liability, opening, $910,000) / 10 ARSP... nil

$93,750Note that the actuarial loss of the year, and the experience loss of the year with respect to assets, are not factors in the calculations until 20X3.



Cash......................................................................................... 80,000

Case BCurrent service cost.................................................................................................$ 67,000Interest cost ............................................................................................................. 32,000Past service cost amortization ................................................................................ 20,000Expected return on plan assets ($505,000 x 5%).................................................. (25,250)Actuarial loss amortization ($87,000 / 10 ARSP) .............................................. 8,700

$102,450



Cash......................................................................................... 80,000

Case CCurrent service cost.................................................................................................$ 67,000Interest cost ............................................................................................................. 32,000Past service cost amortization ................................................................................ 20,000Expected return on plan assets ($505,000 x 5%).................................................. (25,250)Actuarial loss – earnings ($25,250 expected, actual of $3,000) .......................... 22,250Actuarial loss, arising in the year.......................................................................... 54,000

$170,000Note that for earnings, this is the same as including actual earnings in pension expense ($25,250 - $22,250 = $3,000 actual earnings)

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Cash......................................................................................... 80,000

Case DCurrent service cost.................................................................................................$ 67,000Interest cost ............................................................................................................. 32,000Past service cost amortization ................................................................................ 20,000Expected return on plan assets ($505,000 x 5%).................................................. (25,250)Actuarial loss – earnings ($24,250 expected, actual of $2,000) ......................... nil

$93,75031 December 20x2:


Reserve: actuarial loss($22,250 loss on assets plus $54,000 assumptions)................ 76,250Accrued pension liability ....................................................... 76,250


Requirement 2

In cases C and D, the actuarial amounts are recorded in the year that they occur, with no amortizations. These methods reflect the net funded position of the pension plan more completely. (Amortization of PSC implies some unrecognized amounts for all cases, so accounting recognition is still incomplete.)

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Assignment 18-14


20X0 20X1 20X2 20X3 20X4

1. Opening balance, actuarial gains and Losses

$ 0 $ 100 $ 300 $ 117 $(199)

2. Amortization (see below) 0 0 (8) 0 0 3. New actuarial losses/(gains) 100 200 (175) (316) (60)4. Closing balance $ 100 $ 300 $117 $(199) $(259)

5. Corridor; 10% of larger of opening Defined benefit obligation or assets

0 (1) 105(2) 145 189 235

6. Excess (1-5 if 1 is larger) 0 0 155 0 07. Amortization (ARSP 18,20,19,21,20) 0 0 (8) 0 0

(1) Zero in 20x0 as pension plan is new(2) Closing balances for 20x0 are opening balances for 20x1

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Assignment 18-15

Requirement 1

Fenerty could, with respect to its actuarial gain and losses:

1. Amortize only the portion of cumulative actuarial gains and losses, at the beginning of each year, that are outside the 10 % corridor (10% of the greater of defined benefit obligation or assets). Amortization period is the ARSP.

2. Amortize over any basis that is faster than the corridor method. This might involve faster amortization of the excess, or amortization of the full amount with no reference to an excess over the corridor.

3. Recognize the full amount in pension expense in the year in which they arise.4. Recognize the full amount as a charge or credit to reserves and other

comprehensive income in the year in which it arises.

Requirement 2

Actuarial (gains) and losses, as they arise, to be included in pension expense:20x3 $ (46)20x4 1620x5 (45)20x6 2120x7 (4)

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Pension expenseDr./(Cr.)

Unamortized losses/(gains)

20X3Opening balance...................................................... $ 0Actuarial losses (gains) ........................................... (46,000)Closing balance ....................................................... (46,000)

20X4Actuarial losses (gains) ........................................... 16,000Amortization test: $46,000 vs. ($500,00010%).... Amortization ........................................................... nilClosing balance………………………………….. (30,000)

20X5Actuarial losses (gains)…………………………. (45,000)Amortization test: $30,000 vs. ($410,00010%)....Amortization ........................................................... nil Closing balance ....................................................... (75,000)

20X6Actuarial losses (gains) ........................................... 21,000Amortization test: $75,000 vs. ($360,00010%)....Amortization: $(75,000–$36,000) 12 .................. (3,250) 3,250Closing balance ....................................................... (50,750)

20X7Actuarial losses (gains) ........................................... (4,000)Amortization test: $50,750 vs. ($350,00010%)....Amortization: ($50,750–$35,000) 10 .................. (1,575) 1,575Closing balance ....................................................... $ (53,175)

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Assignment 18- 16

Memorandum Accounts Statement AccountsPension Plan Unrecognized Pension Accrued

Obligation Assets Actuarial G/L PSC Expense Asset (Liab)20x7Opening ($4,975,000) $3,705,000 987,000 $180,000 $(103,000)CSC (430,000) $430,000Interest (6%) (2) (298,500) 298,500Actual return 276,000 (276,000)Expected ret. (4%) (3)

148,200 (148,200)

Revaluation (406,000) 406,000PSC amort (4) (60,000) 60,000Actuarial loss amort (1)

(20,400) 20,400

$660,700 (660,700)Benefits paid 235,000 (235,000)Funding 510,000 510,000

($5,874,500) $4,256,000 $1,244,800 $120,000 ($ 253,700)

(1) $987,000 versus corridor of $497,500; = $489,500/24 ARSP = $20,400 rounded(2) $4,975,000 x 6%(3) $3,705,000 x 4%(4) $180,000 / 3 years

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Obligation Assets Actuarial G/L PSC Expense Asset (Liab)20x8Opening ($5,874,500) $4,256,000 1,244,800 $120,000 $(253,700)CSC (488,000) $488,000Interest (6%) (352,500) 352,500Actual return 80,000 (80,000)Expected ret. (4%)

170,200 (170,200)

PSC amort/ 2 years

(60,000) 60,000

Actuarial loss amort (1)

(28,600) 28,600

$758,900 (758,900)Benefits paid 295,000 (295,000)Funding 525,000 525,000

($6,420,000) $4,566,000 $1,306,400 $60,000 ($ 487,600)

(1) $1,244,800 versus corridor of $587,450; = 657,350/ARSP of 23 = $28,600 (rounded)

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Requirement 1

Pension expense, 20x5Current service cost.......................................................$67,000Past service cost ($200,000/10) .................................... 20,000Interest, opening liability ($200,000 x .05)................... 10,000

Total expense ..........................................................$97,000Accrued pension asset ($99,500 - $97,000)........................ $2,500

Requirement 2


Obligation Assets Actuarial G/L

PSC Expense Asset(Liab)

20x5Beginning ($200,000) 0 0 200,000CSC (67,000) $67,000Interest (10,000) 10,000PSC Amort (20,000) 20,000

$97,000 ($97,000)Funding 99,500 _____ 99,500

($277,000) $99,500 0 $180,000 $2,500

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Copyright 2008 McGraw-Hill Ryerson Ltd. All Rights Reserved.

40 Solutions Manual to accompany Intermediate Accounting, 4th edition

Requirement 3


Obligation Assets Actuarial G/L PSC Expense Asset (Liab)20x6Opening ($277,000) $99,500 0 $180,000 $2,500CSC (96,000) $96,000Interest$277,000 x .05; Given

(13,850) 13,850

PSC (new)(vested)

(40,000) 40,000

Actual return 8,900 (8,900)Expected returnAssets, $99,500 x .05

4,975 (4,975)

Revaluation (35,000) 35,000PSC amort. per last year

(20,000) 20,000

$164,875 (164,875)Funding 118,000 118,000

($461,850) $226,400 $31,075 $160,000 ($44,375)

Note: no corridor test for actuarial amounts because opening balances are nil.

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Assignment 18-18

Requirement 1

Corridor test: 20x3 20x4Actuarial losses at 1 January........................................................$133,600 $250,280*Corridor: 10% of 1 January defined benefit obligation ............... $50,910 $63,180*Excess .......................................................................................... $82,690 $187,100Amortization (20 years in 20x3, 17 years in 20x4) ................. $4,135 $11,006

* See spreadsheet; corridor 10% of 20x3 closing liability.

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Requirement 2Memorandum Accounts Statement Accounts

Pension Plan Unrecognized Pension AccruedObligation Assets Actuarial G/L PSC Expense Asset (Liab)

20x3Opening balance ($509,100) $356,300dr. $133,600 dr. $158,400dr. $139,200CSC (49,000) $49,000Interest (33,200) 33,200Actual return (17,000) 17,000Expected return* 17,815 (17,815)PSC amort. (79,200) 79,200Act. G/L amort. (4,135) 4,135Assumptions (86,000) 86,000 $147,720 (147,720)Funding 65,000 65,000Benefits paid 45,500 ( 45,500)

(631,800) 358,800 250,280 79,200 56,48020x4CSC (42,000) $42,000Interest (41,700) 41,700Actual return 21,000 (21,000)Expected return* 19,734 (19,734)PSC amort. (79,200) 79,200Assumptions (34,000) 34,000Act. G/L amort. (11,006) 11,006Funding 82,000 82,000Benefits paid 106,000 (106,000) $154,172 ( 154,172)

($643,500) $355,800 $272,008 $ -- ($15,692)*$356,300 x .05 = $17,815 $358,800 x .055 = $19,734

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Assignment 18- 19

Requirements 1-4

Requested information is in bold below

Projected Plan Unrecognized OPRB Accruedobligation assets OPRB expense OPRB dr./(cr.) dr./(cr.) Actuarial

lossesdr./(cr.) asset

(liability) Beginning balances $(56,000) $7,000 $42,200 $(6,800) (R1)Current service cost (16,000) 16,000Interest on obl. (7%) (3,920) 3,920Actual return on assets 350 (350)Expected return (6%) 420 (420)Actuarial loss amort. (1,830)(1) 1,830

$21,330 (R3) (21,330)Benefit payments 12,000 (12,000)Funding contribution 9,000 9,000

(R2) $(63,920) $4,350 $40,440 (R4)(19,130)

(1) ($42,200 – (10% of $56,000)) = $36,600/20

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Assignment 18-20

Projected Plan Unrecognized OPRB Accruedobligation assets OPRB expense OPRB dr./(cr.) dr./(cr.) amounts dr./(cr.) asset

(liability) Beginning balances $(566,300) $21,500 $254,900(1) $(289,900)Current service cost (67,800) $67,800Interest on obl. (5%) (28,315) 28,315Actual return on assets 600 (600)Expected return (2%) 430 (430)PSC amortization (22,050)(2) 22,050Actuarial loss amort. (1,215)(3) 1,215

$118,950 (118,950)Benefit payments 43,900 (43,900)Funding contribution 46,400 46,400

$(618,515) $24,600 $231,465(4) $(362,450)

(1) $176,400 + $78,500(2) $176,400/8(3) ($78,500 – (10% of $566,300)) = $21,870/18(4) ($176,400 - $9,800) + ($78,500 - $1,215) ($430 - $600)

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Assignment 18-21

a) The unrecognized net loss of $226 was likely caused by experience (the experience of the plan in relation to expectations) or estimate changes (the forward effect of a change in basic assumptions.) The amount need not be recognized in pension expense as long as it is less than 10% of the larger of the opening pension liability or the pension asset. The liability is larger; the amount is $182 ($1,820 x 10%) at year-end. Some amortization of the excess thus would be included annually. The amortization period is the average remaining service period, but the amount can be amortized on a faster basis. The entire amount can also be recognized in the year it arises, in pension expense or through reserves and other comprehensive income. If the latter is chosen, it by-passes earnings entirely.

b) Net amortization is likely amortization of PSC plus amortization of the excess portion of the net actuarial loss. It increases pension expense because it is an expense/loss itself.

c) The plan is underfunded using accounting measures by $803, but this is not what is reflected in the financial statements to date. The SFP shows an asset because payments have exceeded the amount expensed to date. That is, PSC, etc. are being amortized slowly to income but being paid off faster. This is consistent with the information provided—the plan is underfunded by $803, but still has $950 of cost and $226 of loss to amortize (($803) + $950 + $226 = $373).

d) All pension numbers are based on estimates to some degree. Numbers that are dependent on estimates or the choice of actuarial cost method are service cost and the defined benefit obligation. As a result of the defined benefit obligation estimate, interest cost and (unrecognized) net loss are also estimates. PSC is also an estimate. The return on plan assets may be based on an estimate of long-term returns, or estimates of market values. While returns are more objective than other numbers, subjectivity remains. Estimates must be good faith (“best”) estimates.

e) Past service cost is amortized over the vesting period. This is set by legislation, but a faster period may be set by contract.

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Assignment 18-22

Requirement 1

The discount rate for the defined benefit pension obligation is based on interest rates forlong-term debt in corporate bond markets. Long-term interest rates for a similar term are used. The rate has declined, which means that there is less interest cost for pension expense, but the discounted present value of benefits is higher. The interplay of these two factors dictates the exact change to pension expense.

The weighted average rate of compensation increase would be set with reference to future salary levels, which are based in part on the inflation rate. Other factors are labour force composition, industry trends, and overall trends in the economy. Salary rate increases are lower this year, which means that future benefits are lower and pension expense should decline.

The weighted average expected long-term rate of return for fund assets is based on coherent, defensible methodology. Asset allocation within the pension fund must be specified, volatility and duration of fund assets, historic rates of return, and market assessments by fund managers and other experts. The rate is lower, meaning that expected earnings are lower and pension expense is higher.Note that “best estimates” must be used for all assumptions.

Requirement 2

In 20X2, the pension fund has obligations of $612 and assets of $545. It is therefore underfunded in the amount of $67 by accounting measures. This is an improvement from the underfunded position of $91 in the prior year.

The SFP shows a pension asset of $34 in 20X2, increased slightly from $32 in the prior year. The reason that the SFP reflects an asset is because there are unrecognized past service costs (a minor amount) and large unrecognized actuarial losses ($94 in 20X2 and $113 in 20X1). Since the SFP shows the net position of the fund adjusted for unrecognized amounts, the unrecognized amounts distort the SFP position if the reader is looking for the net position of the plan. In this case, the pension fund deficit has reduced ($91 to $67) but this is offset by the fact that unrecognized amounts have declined (from $123 to $101). As a result, the SFP account has not changed significantly. Note that actuarial gains and losses are brought to income very slowly if the 10% corridor method is used.

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Requirement 3

If actuarial gains and losses were recognized immediately through reserves and other comprehensive income, the SFP would reflect the following:

20X2 20X1

Plan assets, at fair value $545 $484

Defined benefit obligation 612 575

Deficiency (67) (91)

Unamortized past service cost 7 10

Accrued pension liability $ (60) $ (81)

Reserves (equity)Unamortized net actuarial loss (debit balance) $94 $113

This approach would reflect more of the pension fund status on the SFP as a liability but by-pass earnings for actuarial amounts.

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Assignment 18-23

Requirement 1

Pension expense:Current service cost........................................................................................... $ 87,500Interest on defined benefit obligation (see below)............................................ 87,169Less: expected earnings on plan assets ($611,471 @ 6%)............................... (36,688)Experience gain on PBO, 20x4......................................................................... (21,870)Experience gain on fund earnings ($55,055 - $36,688) .................................... (18,367)Amortization of past service cost (over 10 years)............................................. 100,000Pension expense for 20x4 ................................................................................. $197,744

Interest on defined benefit obligation:

20x1: Past service cost (opening balance) .....................................................$1,000,000Interest (6%).......................................................................................... 60,000Current service cost............................................................................... 80,000Balance at year-end 20x1 ...................................................................... 1,140,000

20x2: Interest on balance @ 6% ..................................................................... 68,400Current service cost............................................................................... 82,000Balance at year-end 20x2 ...................................................................... 1,290,400

20x3: Interest on balance @ 6% ..................................................................... 77,424Current service cost............................................................................... 85,000Balance at year-end 20x3 ...................................................................... 1,452,824

20x4: Interest on balance @ 6% ..................................................................... $ 87,169

Requirement 2

Pension expense:Current service cost........................................................................................... $ 87,500Interest on defined benefit obligation .............................................................. 87,169Less: expected earnings on plan assets ........................................................... (36,688)Experience gain, 20x4....................................................................................... nilExperience gain on fund earnings (to equity) ................................................... nilAmortization of past service cost (over) ........................................................... 100,000Pension expense for 20x4 ................................................................................. $237,981

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Requirement 3

Pension expense:Current service cost........................................................................................... $ 87,500Interest on defined benefit obligation .............................................................. 87,169Less: actual earnings on plan assets ................................................................ (55,055)Experience gain, 20x4....................................................................................... (21,870)Amortization of past service cost (none; all included in year 1)....................... nilPension expense for 20x4 ................................................................................. $97,744

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Obligation Assets Actuarial G/L PSC Expense Asset (Liab)20x4 - Opening ($216,000) 0 0 216,000 0CSC (51,000) 51,000Interest* (12,960) 12,960PSC amort.** (43,200) 43,200Fund–1 Jan. 20,000 20,000Exp.earnings*** 1,200 ( 1,200)Actual earnings 1,000 (1,000) 105,960 (105,960)Fund 31 Dec**** _______ 71,000 71,000

(279,960) 92,000 200 172,800 ($14,960)Corridor test: No actuarial gain or loss on 1 January. No amortization.* $216,000 x .06 = $12,960 *** $20,000 x .06 = $1,200** $216,000/5 = $43,200 **** $51,000 + $20,000

20x5 - Opening ($279,960) $92,000 $ 200 $172,800 ($14,960)CSC (57,000) $57,000Interest* (16,798) 16,798PSC Amort (43,200) 43,200Fund - 31 Dec** 93,000 93,000Exp.earnings*** 5,520 ( 5,520)Actual earnings 6,800 (6,800) $111,478 (111,478)Assumptions ( 16,000) 16,000 ______

($369,758) $191,800 $14,920 $129,600 ($33,438)Corridor test: $200 is less than 10% of $279,960. No amortization.* $279,960 x .06 = $16,798** $20,000 + $57,000 + $16,000*** $92,000 x .06 = $5,520

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Obligation Assets Actuarial G/L PSC Expense Asset (Liab)20x6 - Opening ($369,758) $191,800 $14,920 $129,600 ($33,438)CSC (65,000) $65,000Interest* (22,185) 22,185PSC Amort (43,200) 43,200Fund– 31 Dec** 80,000 80,000Exp.earnings*** 11,508 (11,508)Actual earnings 12,610 (12,610) $118,877 (118,877)Benefits paid 12,000 (12,000)Assumptions 5,000 ( 5,000)

($439,943) $272,410 $ 8,818 $86,400 ($72,315)Corridor test: $14,920 vs 10% of $369,758. No amortization.* $369,758 x .06** $65,000 + $20,000 – $5,000 *** $191,800 x .06

20x7Opening ($439,943) $272,410 $8,818 $86,400 ($72,315)CSC (72,000) $72,000Interest* (26,397) 26,397PSC Amort (43,200) 43,200Fund– 31 Dec** 92,000 92,000Benefits paid 23,000 (23,000)Exp.earnings*** 16,345 (16,345)Actual earnings 11,440 (11,440) $125,252 (125,252)

$(515,340) $352,850 $ 13,723 $43,200 ($105,567)Corridor test: $8,818 vs 10% of $439,943. No amortization.* $439,943 x .06** $20,000 + $72,000 *** $272,410 x .06

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18-52 Solutions Manual to accompany Intermediate Accounting, Volume2, 5th edition

Requirement 3

20x4:Pension expense ................................................................ 105,960

Accrued pension asset................................................... 105,960Accrued pension asset (aggregate) .................................... 91,000

Cash ($20,000 + $71,000)............................................. 91,00020x5:

Pension expense ................................................................ 111,478Accrued pension asset................................................... 111,478

Accrued pension asset ...................................................... 93,000Cash............................................................................... 93,000

20x6:Pension expense ................................................................ 118,877

Accrued pension asset................................................... 118,877Accrued pension asset ....................................................... 80,000

Cash............................................................................... 80,00020x7:

Pension expense ................................................................ 125,252Accrued pension asset................................................... 125,252

Accrued pension asset ....................................................... 92,000Cash............................................................................... 92,000

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Assignment 18-25

Requirement 1

The projected unit credit method must be used to calculate current service cost. In this method, salary is projected but years of service are not.

Requirement 2

An abbreviated spreadsheet (spreadsheet format not required)

Projected Plan Unrec’d Pension Accrued obligation assets Pension expense Pension dr./(cr.) dr./(cr.) amounts dr./(cr.) asset

(liability) Beginning balances $(2,567) $2,117 $(450)Change in assumptions (332) 332 PSC (675) 675

(3,574)Current service cost (246) $ 246Interest on obl. (5% of $3,574)

(178.7) 178.7

Actual return on assets (156) 156Expected return (3%) 63.5 (63.5)PSC amortization /5 (135) 135Actuarial loss amort.($332 - $357)/18

-- --

$ 496.2 (496.2)Benefit payments 219 (219)Funding contribution 386 386

$(3,779.7) $2,128 $1,091.5 $(560.2)

Requirement 3

At the end of 20x0, both the economic status and the recorded status are ($450,000) because there are no unrecognized amounts. At the end of 20x1, the funded status is (1,651,700) by accounting measures but the recorded amount is ($560,200). These two are different because of new unrecognized actuarial losses, experience losses and unrecognized PSC.

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Requirement 4

Pension expense:Current service cost $ 246Interest on obligation 178.7Expected return (3%) (63.5)PSC amortization /5 135Experience loss ($156 + $63.5) 219.5Changes in assumptions 332

$1,047.7The expense has more than doubled.

Requirement 5

Pension expense:Current service cost $ 246Interest on obligation 178.7Expected return (3%) (63.5)PSC amortization /5 135

$496.2


Reserve: actuarial loss($219.5 loss on assets plus $332 assumptions)....................... 551,500Accrued pension liability ....................................................... 551,500


Requirement 6

There is little difference in earnings between requirements 2 and 5; 2 includes no amortization of the actuarial loss in expense because of the corridor rule. Requirement 5has no expense from this source. In requirement 2, though, there are large unrecognized balances from actuarial losses. In requirements 4 and 5, the actuarial losses are recorded. Requirement 4 has a large pension expense, decreasing earnings. Requirement 5 by-passes earnings and records the actuarial losses in reserves and other comprehensive income, decreasing equity but not earnings. In all cases, the unamortized past service cost is unrecognized.

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Requirement 7

Pension expense: Current service cost $ 246Interest on obligation 178.7Actual return (loss) 156PSC (all) 675Actuarial losses 332

$1,587.7There are no deferrals; the expense is very high.

Requirement 8

Pension expense:Current service cost $ 246Interest on obligation 178.7Expected return (3%) (63.5)PSC amortization /18 (EPFE) 37.5Experience loss (corridor per #2) --

$398.7The expense is lower because of slower PSC amortizaation and use of the corridor

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Assignment 18-26 Note: Bolded numbers were added to complete the spreadsheet Memorandum Accounts Statement Accounts

Pension Plan Unrecognized Pension Accrued20X3 Obligation Assets Actuarial G/L PSC Expense Asset (Liab)

Opening balance (476,100) 272,300 3,400 dr 158,400 (42,000)CSC ( 78,000) 78,000Interest (28,566) 28,566Actual return 36,000 (36,000)Expected return 16,338 (16,338)Amort of PSC (10,560) 10,560

100,788 (100,788)Change in assumptions (79,800) 79,800Funding 95,000 95,000Benefits paid 31,500 (31,500)Closing balances (630,966) 371,800 63,538 147,840 (47,788)

20X4CSC (48,000) 48,000Interest (37,858) 37,858Actual return 66,000 (66,000)Expected return 22,308 (22,308)Amort of actuarial G/L (29) 1 29Amort of PSC (10,560) 10,560

74,139 (74,139)Change in assumptions (56,200) 56,200Funding 81,000 81,000Benefits paid 194,000 (194,000)Closing Balances (579,024) 324,800 76,017 137,280 (40,927)1 $63,538 – (10% of $630,966) = $441/15 = $29

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Assignment 18-27

Requirement 1

An abbreviated spreadsheet (spreadsheet format not required)

Projected Plan Unrec’d Pension Accrued obligation assets Pension expense Pension dr./(cr.) dr./(cr.) amounts dr./(cr.) asset

(liability) Beginning balances (309.4)

(to balance)244 117.9 52.5

PSC (25) 25(334.4)

Assumptions (16) 16Current service cost (19.2) 19.2Interest on obl. (4.5% of $334.4)

(15.05) 15.05

Actual return on assets

(2) 2

Expected return (4%) 9.8 (9.8)PSC amortization /5 (5) 5Actuarial loss amort.($117.9-33.44)/16 (5.3) 5.3

34.75 (34.75)Benefit payments 7 (7)Funding contribution ______ 24 _____ 24

(377.65) 259 140.4And 20

41.75

Requirement 2

At the end of the year, the fund is underfunded by accounting measures in the amount of $118,650 ($377,650 - $259,000). The SFP reflects an asset of $41,750. This does not reflect the economic position of the plan. The divergence is caused by unrecognized amounts.

Requirement 3

Required note disclosures (per chapter; major items only)

A description of the plan. Accounting policy choices (particularly the method chosen for recognition of

actuarial gains and losses) and information about measurements used for pension accounting.

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A reconciliation of relevant pension amounts to the SFP account (that is, the first four spreadsheet columns, to equal the SFP account);

Amount of expense recognized for the period, and the components of the expense;

A reconciliation of the defined benefit obligation, from the beginning to the end of the year, labeling each major element of change;

A reconciliation of pension plan assets, from the beginning to the end of the year, labeling each major element of change;

Description of the basis used to determine expected return on plan assets

Actual return on assets during the year;

Amount of funding contributions made by the company expected for the next period; and

Principle actuarial assumptions—the discount rate, expected long-term rate on plan assets, the projected rate of salary increase, and the assumed health care cost trend rate

Requirement 4

Pension expense:Current service cost $ 19.2Interest on obligation 15.05Expected return (9.8)PSC amortization /5 5

$29.45


Reserve: actuarial loss($11.8 loss on assets plus $16 assumptions)........................... 27,800Accrued pension liability ....................................................... 27,800


At the end of the year, the SFP shows a liability of $98,650 ($65,400 + $27,800 + $29,450 - $24,000). The reserve account has a debit balance of $145,700 ($117,900 + $27,800). The fund is underfunded by accounting measures in the amount of $118,650 ($377,650 - $259,000). The SFP reflects a liability of $98,650 – a different amount, because of the $20,000 unrecognized past service costs. This liability is closer to the economic position of the fund because there are lower unrecognized amounts.

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Assignment 18-28

Note that Neotech’s management team may be unduly concerned with profit management. An efficient market reacts to cash flow, and all public information. A small difference between actual and projected earnings is not likely to materially effect stock price.

Pension expense must be calculated in accordance with GAAP, since this is a public company interested in an unqualified audit report.

Pension expenseCurrent service cost.................................................................................... $650,000Past service cost ($3,000,000/24) .............................................................. 125,000Interest cost ($3,000,000 x .07).................................................................. 210,000Earnings ($264,653 x .07)*........................................................................ ( 18,526)

$966,474

Payments madePast service cost* ....................................................................................... $264,653Current service cost.................................................................................... 650,000

$914,653

*PSC Funding: $3,000,000/(P/AD, 7%, 20) = $264,653

Earnings, pre-tax .............................................................................................. $1,100,000Plus: pension payments................................................................................... 914,653Less: pension expense..................................................................................... ( 966,474)Revised pre-tax income.................................................................................... $1,048,179

Pre-tax income is still very close to the president’s target.

Assumptions to which pension expense is sensitive:

1) Interest rate (for both earnings and interest expense) 2) Future salary levels. 3) Mortality and turnover rates.

Best estimates must be used for accounting purposes, but some biases may creep in. Revaluation by an actuary would be necessary to remeasure pension amounts.

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Assignment 18-29

Pension expense:

Current service cost.......................................................................................... $85,375Past service cost ($300,000/15) ....................................................................... 20,000Interest on accrued obligation, beginning of year

($1,296,330 x 5%)................................................................................ 64,817Less: earnings on plan assets, estimated

($1,375,790 x 6%)................................................................................ (82,547)Amortization of actuarial gains (below) .......................................................... (833)

$86,812

Restructuring gain (reduction of pension obligation) ...................................... $20,000

Evaluation of the need for actuarial gain or loss amortization and carry forward:

Cumulative unrecognized gain, beginning of the year..................................... $154,250 gainOpening pension fund assets $1,375,790 x 10% ............................................. 137,579Excess .............................................................................................................. 16,671Amortization ($16,671 / 20) ............................................................................ $ 833New experience gains/losses

Actuarial revaluations (gain) ($70,000 - $20,000)............................... $50,000Experience, pension assets ($151,685 - $82,547)................................ $69,138

Balance forward ($154,250 + $50,000 + $69,138 – $833) .............................. $272,555

Year-end defined benefit obligation: Defined benefit obligation, beginning of the year............................................ $1,296,330Interest @ 5%.................................................................................................. 64,817Actuarial revaluation........................................................................................ (70,000)Current service cost.......................................................................................... 85,375Defined benefit obligation, end of year............................................................ $1,376,522

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Assignment 18-30

Requirement 1

Preferred dividends declared ($51 x $6) .................................. 306Preferred dividends payable......................................... 306

Common shares ($11,050 / 6,621) x 865................................. 1,540Contributed capital, common share retirement (balance) ........ 788Retained earnings..................................................................... 3,912

Suspense....................................................................... 6,240

Premium on bond payable........................................................ 83Interest expense............................................................ 83

Compensation expense (administrative) .................................. 225Stock options outstanding ............................................ 225

$900 / 4 = $225

Pension expense (operating) ($1,848 x .85)............................. 1,571Pension expense (administrative) ........................................... 277Defined benefit obligation ($1,848 - $2,098) .......................... 250

Suspense....................................................................... 2,098Pension expense = $1,700 + ($9,716 x 6%) - $495 + ($600 / 10) = $1,848

Stock dividend ......................................................................... 4,276Common shares outstanding ........................................ 4,276

(6,210 – 865) x .10 x $8

Interest expense ($3,985 x 7%)................................................ 279Lease liability............................................................... 279

Lease liability........................................................................... 612Current bank loan......................................................... 612

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Solution

Exhibit 1

Assets

Cash 14,960$ 14,960$

Accounts receivable 30,497 30,497

Inventory 1,958 1,958

Prepaid expenses and deposits 930 930

Current assets 48,345 48,345

Capital assets, net 78,441 78,441

Intangible assets 890 890

Suspense 8,338 -2,098 - 6,240 -

Total Assets 136,014$ 127,676$

Liabilities

Accounts payable and

accrued liabilities 19,511$ 306 19,817$

Income tax payable 1,600 1,600

Current bank loan 12,100 612 12,712 Current liabilities 33,211 34,129

Lease liability 3,985 +279 - 612 3,652

Long-term debt 30,000

Premium 1,210 31,210 -83 31,127

Future income tax 6,900 6,900

Deferred pension obligation 620 -250 370

Total Liabilities 75,926 76,178

Shareholders' Equity

Preferred shares 5,100 5,100

Common shares 11,050 -1,540 + 4,276 13,786

Contributed capital

on common stock retirement 788 -788 -

Stock options oustanding 450 225 675

Retained earnings 42,700 31,937

Total Shareholders' Equity 60,088 51,498

Total Liabilities & Shareholders' Equity 136,014$ 127,676$

Balance Sheet

Oilfield Multiservices Ltd

Draft Financial Statements

for the year ended December 31, 20X7

(in thousands)

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Requirement 3

Key financial targets:

Before After

Retained earnings $42,700 $31,937

Debt/Equity 1.26 1.47

Comment : Financial targets are met in the revised financial statements. Retained earnings has been significantly reduced by the stock dividend and the common share repurchase. The value of the stock dividend was at the discretion of the Board of Directors and could have been recorded at a lower amount. The Board may be able to change their resolution on this issue. Retained earnings levels are still above the $30 million target, but OML must be cautious in the coming year with any share transactions that will decrease this account; leeway in the coming year depends on the level of income.

Solution

Exhibit 1

Sales 146,560$ 146,560$

Expenses

Operating 103,490 1,571 105,061

Selling, general & admin 8,385 +225 + 277 8,887

Interest 2,355 -83 + 279 2,551

Depreciation 8,420 8,420

122,650 124,919

Income before tax 23,910 21,641

Income tax 5,950 5,950

Net Income 17,960 15,691

Opening retained earnings 27,965 27,965

Common share retirement 3,912 3,912

Dividends

Preferred - 306 306

Common 3,225 3,225

Stock - 4,276 4,276

Closing retained earnings 42,700$ 31,937$

Oilfield Multiservices Ltd

Draft Financial Statements

for the year ended December 31, 20X7

(in thousands)

Statement of Income and Retained Earnings

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Debt-to-equity is acceptable but very close to the 1.5 margin. Debt should be reduced, and equity increased, over the coming year. The company has adequate current resources (cash) to accomplish some debt repayment; there is a large current bank loan coming due, and if this is repaid with available cash, the debt/equity ratio will improve.

(CGA-Canada, adapted)

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Actuarial cost methods;OLC assignments Assignment 18-A1

Mary’s final salary: $25,000 (F/P, 5%, 24) = $25,000 3.225 $ 80,625Mary’s annual pension: 25 2% $80,625 $ 40,313Value of pension at retirement:

$40,313 (P/AD, 7%, 20) = $40,313 11.3356 $ 456,972Level annual contribution:

$456,972 (F/A, 7%, 25) = $456,972 67.676[alternatively: $456,983 (P/F, 7%, 25) (P/A, 7%, 25)] $ 7,225

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Assignment 18-A2

Requirement 1

The accumulated benefit method calculates the contributions that an employer must make in order to fund the pension to which the employee is currently entitled, based on the years of service to date and on current salary.

Annual annuity earned = 2% x 1 year x $16,000 = $320.00APV = $320 x (P/A, 6%, 20) = $320 x 11.46992 = $3,670.37Funding = $3,670.37 x (P/F, 6%, 24) = $3,670.37 x .24698 = $906.51

The projected unit credit method calculates the required funding based on the years of service to date but on a projected estimate of the employee’s salary at the retirement date.

Life annuity earned = $51,602 x 2% x 1 year = $1,032.04APV = $1,032.04 x (P/A, 6%, 20) = $1,032.04 x 11.46992 = $11,837.42Funding = $11,837.42 (P/F, 6%, 24) = $11,837.42 x .24698 = $2,923.61

The level contribution method projects both the final salary and the total years of service, and then allocates the cost evenly over years of service.

Annual annuity = APV/(F/A, 6%,25 years) = ($11,837.42 x 25) ÷ (F/A, 6%, 25) = $295,935 ÷ 54.865 = $5,393.88

Requirement 2

Jack would likely prefer the level contribution method, as it requires the largest up-front funding of his pension, making the pension more secure in the event of corporate failure. Excluding the risk of corporate failure, however, Jack should be indifferent, since his defined benefit plan specifies his eventual pension irrespective of funding.

Requirement 3

The company, wishing to conserve current cash balances, would likely prefer the accumulated benefit method, which has the lowest cash requirement in early years.

Requirement 4

The projected unit credit method must be used for accounting.

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Assignment 18-A3

Requirement 1

a) Accumulated benefit method

First year Annual pension annuity = 1.5% x 1 year x $30,000 = $450PVretirement = $450 x (P/AD, 7%, 12) = $450 x 8.49867 = $3,824PVnow = $3,824 x (P/F, 7%, 24) = $3,824 x .19715 = $754

Note that the pension is paid at the beginning of each retirement year.

Second year Annual pension annuity = 1.5% x 2 years x $31,800 = $954; $954 - $450 = $504PVretirement = $504 x (P/AD, 7%, 12) = $504 x 8.49867 = $4,283PVnow = $4,283 x (P/F, 7%, 23) = $4,283 x .21095 = $904

b) Projected unit credit method

First year Salary in age 64 year: $30,000 x (F/P, 6%, 24)$30,000 x 4.049 = $121,470

Annual annuity: $121,470 x 1.5% x 1 year = $1,822PVnow = $1,822 (P/AD, 7%, 12) x (P/F, 7%, 24)

= $1,822 (8.49867) (.19715)= $3,053

Second year PVnow = $1,822 (P/AD, 7%, 12) x (P/F, 7%, 23)= $1,822 (8.49867) (.21095)= $3,266

Note that as long as the expected lifetime salary increase continues to be expected to be 6%, the actual salary in year 2 is irrelevant.

c) Level contribution method

First and second years:Annual pension annuity:

1.5% x 25 x $121,470 = $45,551

Contribution annuity= $45,551 (P/AD, 7%, 12)/(F/A, 7%, 24)= $45,551 (8.49867)/58.177= $6,654

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Assignment 18-A4

Requirement 1

The final funding requirement is calculated as follows:a) Project the salary at retirement. b) Calculate Calamari’s pension based on final salary (2% per year to a maximum of 60%.)c) Determine Calamari’s life expectancy after retirement.d) Calculate the present value of the salary entitlement at 7% for the years of life.

Requirement 2

Accumulated benefit method— Annuity = $40,000 x 2% = $800; PV = $800 x (P/AD 7%,15) (9.74547) = $7,796;

Funding = $7,796 x (P/F, 7%,19) (.27651) = $2,156

Projected unit credit method— Annuity = $81,700 x 2% = $1,634;PV = $1,634 x (P/AD 7%,15) (9.74547) = $15,924

Funding = $15,924 x (P/F, 7%,19) (.27651) = $4,403

Level funding method— Annuity = $81,700 x 2% x 20 = $32,680;Funding = $32,680 (P/AD 7%,15) (9.74547)/ (F/A 7%,20)

(40.995) = $7,769 or, $318,482 / 40.995 = $7,769

Requirement 3

Pension expense $4,403 see requirement 2Accrued pension asset $3,366 ($4,403 - $7,769)

Requirement 4

Assumptions:• the average compounded rate of salary increase• the long-term rate of earnings on plan assets• the life expectancy for the employee from retirement age

Requirement 5

Effect on funding requirement:a) Calamari lives longer Funding increasesb) Return on assets higher Funding decreasesc) Salary increase, unexpected Funding increasesd) Salary freeze, unexpected Funding decreases

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Assignment 18-A5

Requirement 1

Accumulated benefit method$35,000 x 1.75% x 1 year = $612.50PV50 = $612.50 (P/AD, 5%, 18) = $612.50 x 12.27407 = $7,518PV25 = $7,518 x (P/F, 5%, 24) = $7,518 x .31007 = $2,331

Projected unit credit methodAnnual annuity = $35,000 (F/P, 4%, 24) = $89,716 x 1.75% = $1,570PV50 = $1,570 (P/AD, 5%, 18) = $1,570 x 12.27407 = $19,272PV25 = $19,272 (P/F, 5%, 24) = $19,272 x .31007 = $5,976

Level Contribution methodAnnual annuity = $89,716 x (25 x 1.75%) = $39,251PV50 = $39,251 x (P/AD, 5%, 18) = $39,251 x 12.27407 = $481,766PV25 = $481,766/(F/A, 5%, 25) = $481,766/47.727 = $10,094

Requirement 2

Accumulated benefit methodPV50 = $612.50 x (P/AD, 8%, 18) = $612.50 x 10.12164 = $6,200PV25 = $6,200 x (P/F, 8%, 24) = $6,200 x .15770 = $978

Projected unit credit methodAnnual annuity = $35,000 (F/P, 6%, 24) = $141,713 x 1.75% = $2,480PV50 = $2,480 (P/AD, 8%, 18) = $2,480 x 10.12164 = $25,102PV25 = $25,102 (P/F, 8%, 24) = $25,102 x .15770 = $3,959

Level contribution methodAnnual annuity = $141,713 x (1.75% x 25) = $61,999PV50 = $61,999 x (P/AD, 8%, 18) = $61,999 x 10.12164 = $627,536PV25 = $627,536/(F/A, 8%, 25) = $627,536/73.106 = $8,584

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Requirement 3

Accumulated benefit methodPV50 = $612.50 (P/AD, 5%, 10) = $612.50 x 8.10782 = $4,966PV25 = $4,966 x (P/F, 5%, 24) = $4,966 x .31007 = $1,540

Projected unit credit methodAnnual annuity (see Requirement 1) = $1,570PV50 = $1,570 (P/AD, 5%, 10) = $1,570 x 8.10782 = $12,729PV25 = $12,729 (P/F, 5%, 24) = $12,729 x .31007 = $3,947

Level contribution methodAnnual annuity = $39,251 (Requirement 1)PV50 = $39,251 (P/AD, 5%, 10) = $39,251 x 8.10782 = $318,240PV25 = $318,240/(F/A, 5%, 25) = $318,240/47.727 = $6,668

Requirement 4

The accumulated benefit method bases funding requirements on existing salary and service years. No projections—of final pay or total years of service—are made.

The projected unit credits method bases funding requirements on projected final salary but on existing years of service.

The level contribution method projects both salaries and years of service, then allocates level funding to periods or salary dollars.

Requirement 5

The variables to which the funding formula is particularly sensitive, as demonstrated in requirements 1 and 2, include:

1. The discount rate (return on fund assets)2. The rate of expected increase in salary (although 1 & 2 work in opposite directions)3. Turnover estimates4. Mortality rates.

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Chapter 19: Earnings per Share

Suggested TimeCases 19-1 Drugstore Depot Limited

19-2 G Shoes Ltd.19-3 ThurTech Limited

Assignment 19-1 Basic EPS......................................................... 1519-2 EPS interpretation ............................................ 2519-3 Basic EPS, intepretation................................... 2519-4 Basic EPS, intepretation .................................. 2519-5 Weighted average common shares (W*) ......... 2019-6 Weighted average common shares .................. 2019-7 Basic EPS for three years................................. 2019-8 Basic EPS......................................................... 2019-9 Multiple common share classes ....................... 2019-10 Multiple common share classes ....................... 2019-11 Contingently issuable shares ............................ 2019-12 Contingently issuable shares ............................ 2019-13 Basic and diluted EPS...................................... 2519-14 Diluted EPS, actual conversions ...................... 2519-15 Basic and diluted EPS; actual conversions ...... 3019-16 Basic and diluted EPS...................................... 2519-17 Basic and diluted EPS...................................... 3019-18 Basic and diluted EPS (*W) ............................ 3019-19 Basic and diluted EPS...................................... 3019-20 Basic and diluted EPS; split............................. 3019-21 EPS computation.............................................. 3019-22 EPS computations, financial instruments (W*) 3019-23 Diluted EPS, cascade ....................................... 2019-24 Diluted EPS, cascade ....................................... 3019-25 Diluted EPS, cascade ...................................... 2019-26 Loss per share................................................... 3019-27 Basic and diluted EPS...................................... 3019-28 Complex EPS ; interpretation .......................... 4019-29 Basic and diluted EPS; split............................. 4019-30 Complex EPS (*W) ......................................... 40

*W The solution to this assignment is on the text Web site and in the Study Guide. The solution is marked WEB.

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Questions

1. The formula for basic EPS is:

Net profit or loss available to ordinary shareholdersWeighted-average number of ordinary shares outstanding

The numerator is net earnings, less preferred dividends declared (or preferred dividend entitlements, if shares are cumulative). Other returns to senior securities, like losses on share retirement, must also be deducted from the numerator. The denominator is the average number of ordinary shares outstanding, weighted to their day of issuance. Shares issued due to a stock dividend or a stock split are weighted back to the beginning of the period, an exception to the weighted-average rule.

2. Dividends on non-cumulative preferred shares are deducted to establish earningsavailable to common shareholders. Such dividends are deducted only to the extentthat they are declared by the Board of Directors during the year. If the dividend is “passed over,” then the preferred shareholders lose their claim and all remaining profit accrues to the benefit of the common shareholders. (Dividends on cumulative preferred shares are deducted whether declared or not, as they are a permanent claim on retained earnings if undeclared.)

3. In addition to preferred share dividends, the numerator of the basic EPS calculationmust be adjusted for any loss on retirement of preferred shares and any capital charges (charges directly to retained earnings) related to financial instruments. These adjustments render the numerator equal to earnings available to ordinaryshareholders.

4. Weighted average ordinary shares outstanding are used to relate earnings to the capital base used to generate those earnings. Since profit was earned over the year, the capital base must also be measured over that period—not at the beginning, end, or middle. Ordinary, or common, shares are used because the ratio relates only to common equity, not total equity investment.

5. Shares issued for little or no cash consideration under a contingent share agreement are included in a weighted average calculation as of the date that the contingency cleared. If there is a delay between clearing the contingency and issuing the shares, the shares are effectively backdated.

6. The stock split should be accounted for retroactively when determining the number of shares outstanding. The 30 June stock split would be backdated to 1 January of the current year, and back through the comparatives. Therefore, 8,000 (4,000 x 2) shares would be used this year. If 4,000 shares had been outstanding in the prior year, this would be doubled to 8,000 to recast the EPS comparatives.

7. If there are gains/losses from discontinued operations reported, EPS (basic, diluted) must be shown for:

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1. Earnings from continuing operations, and2. Net earnings

The per-share impact of the discontinued operation may be shown in the notes but the other disclosures must be on the face of the statement of comprehensive income.

8. If a company has two classes of shares with the characteristics of common shares, both are treated as common shares in the calculation of basic EPS. The two classes are weighted based on their relative dividend entitlement—here, one is worth ten times the other. The company will disclose two basic EPS statistics, one for each class. One will be ten times the other.

9. Diluted EPS is a ‘what if’ figure that reports the impact of dilutive elements in a company’s capital structure. A company with agreements in place which have resulted, or could result, in the issuance of common shares will evaluate the need to calculate diluted EPS. Convertible bonds, convertible senior shares, contingently issuable shares, and options all must be considered, as well as actual issuances/conversions. Diluted EPS indicates the maximum potential decline in earnings if the company’s financing strategy – the conversion of securities, issuance of shares and exercise of options –comes to pass. This statistic is designed to serve users who are trying to assess future prospects.

10. The element is dilutive. EPS is $4.50 based on earnings from continuing operations, and this is the reference point. The potentially dilutive element has an individual effect of $4, which is less than $4.50. EPS based on net earnings, $3.50, is less than the $4 dilutive element, but classifications are made once based on EPS from continuing operations and done consistently thereafter.

11. Changes to the numerator and denominator for diluted EPS: Element Numerator DenominatorConvertible Increase by dividend Increase by shares issuedPreferred shares claim avoided

Convertible Increase by after-tax Increase by shares issuedDebt interest avoided

Contingently issuable None Increase by shares issuedshares if appropriate

Options None Increase by shares issuedDecrease by shares retired(Proceeds/ market value)

12. In relation to the outstanding options, the denominator of diluted EPS would increase by 100,000 shares assumed issued, and decrease by 40,000 ((100,000 x $10)/$25) shares assumed retired.

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13. Dilutive and anti-dilutive securities are defined when calculating diluted EPS. Adilutive security is one that causes a reduction in the earnings per share amount. An anti-dilutive security is a security that causes the opposite effect, that is, an increase in the earnings per share amount above that which would otherwise be reported. The distinction is important in earnings per share considerations because dilutive securities are included in the computation of diluted earnings per share, whereas anti-dilutive securities are omitted.

14. Options are said to be in-the-money if the exercise price is less than the market value of the shares. Options are handled in diluted EPS calcuations using the treasury stock method, where shares are assumed to be issued and then the proceeds used for retirement. If the exercise proce is less than average market price, then they are then dilutive, because more shares would be issued than assumed retired.

15. A share agreement that requires a company to issue shares if a contingency is met is evaluated for the purposes of diluted EPS based on whether the shares would be issued if all that changed were the date that the contingency closed. If the contingent period were to end as of the end of the fiscal period, then the contingency was met. Shares would be issued under the terms of the contract, and the shares are included in diluted EPS. If conditions are not met for share issuance at this time, then shares are excluded from diluted EPS calculations.

16. Diluted elements are included from most dilutive to least dilutive, in a cascade. Convertible bonds are the most dilutive, at $6, and would be included first. The convertible preferred shares, with an individual effect of $12, would be second. If bonds reduce EPS to a subtotal below $12, then the convertible preferred shares would be anti-dilutive and excluded.

17. Interest expense is different than interest paid when there is premium or discount amortization (discount amortization, in this case). The premium or discount would have been recognized when the bond was originally issued. Interest expense, not interest paid, is relevant in the calculation of diluted EPS, because the focus is on the change in net earnings.

18. Diluted EPS is unchanged from basic, a loss of $(1.11). All potentially dilutive elements are anti-dilutive in a loss year, as they reduce the loss per share.

19. EPS of prior years must be restated if there has been a retrospective change in accounting policy or an error correction that altered the reported results of prior periods. EPS is also restated if there was a stock dividend or split in the current year.

20. When a company issues shares and redeems debt after the fiscal year-end but before the audit report is signed, the effect on outstanding shares and EPS must be disclosed. This is required because the new capital structure will be in place during the next fiscal year, and financial statement readers must be alerted.

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21. When per share figures are presented in addition to EPS, the denominator used must be the same as that used for EPS, and the items included in the numerator must be defined. Securities regulators require that such figures be given less prominance than GAAP-required diclosure; such per share numbers might be included in the disclosure notes.

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Cases

Case 19-1 Drugstore Depot Limited

Overview

Drugstore Depot Limited (DDL) is a public company, with debt and equity traded in public markets. They must file GAAP financial statements annually, and comply with IFRS. The company has major retail operations, and is involved in real estate activities. Corporate reporting objectives are not mentioned, but increasing profit levels are a logical objective for a public company, and ethical accounting policy choice is desirable. The company has sporadic gains on sale of real estate, which would create volatility in earnings.

Issues

1. Sale and leaseback2. Insurance claim3. Revenue on referral contract4. EPS presentation5. EPS calculation


1. Sale and leaseback

DDL sold real estate to Dixon REIT this year, in a transaction that was primarily cash-based. At the same time, DDL renegotiated their tenancy leases in the properties that were transferred. This transaction has the appearance of a sale-leaseback transaction, although if there are a lot of other tenants in the properties, this might simply be a sale.

The standards on sale-leaseback transactions require that, in some circumstances, gains on the sale of property be deferred and amortized over the life of the lease, which in this case would be 17 to 23 years. However, if the lease contracts represent fair value of lease costs, then gains can be recognized on the sale of property. Lease rates are specified to be in the range of $8 to $14, plus a percentage of gross revenue, with base rent increases every five years. Appropriate evidence must be gathered to verify that this reflects competitive market lease rates for the quality of property involved. (Note: at the time this case was written, these rates are representative of fair value, but evidence is needed.)

If the lease rates represent fair value, then DDL can record the gain on sale in the financial statements this year. The gain would be $178, and additional income tax of $31 (Proceeds of $424 ($374 + $50) less costs of $7, book value of assets of $239.) The gain is reported pre-tax.

DDL labels gains on sale of real estate as “capital gains” on the statement of comprehensive income. This is a term used for tax purposes, and its use for external

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reporting might be misconstrued. A more appropriate term might be “gain on sale,” or some other term chosen by the company. Earnings has been adjusted to reflect this gain on sale (Exhibit 1.)

2. Insurance claim

A property owned by DDL burned down late in the year, and DDL has filed an insurance claim for $32.2 million. Insurance proceeds would trigger a gain on the involuntary disposal of the building and inventory of $7, and additional income tax of $2.1 (Proceeds of $32.2, less the deductible amount of $1 million, less book value of $24.2 ($17 plus $7.2)) Insurance claims over inventory appear to reflect cost recovery; the gain relates to the building. Tax is $2.1 ($1.4 current and $0.7 deferred.)

The issue with recording this gain in the 20X2 year is that the reports from the investigator and the insurance adjustor team have not yet been filed. If there is some gap in insurance coverage that means that the loss is not covered, then no insurance proceeds would be received and there would be a sizeable loss from the fire, rather than a gain.

At present, the suggestion is that the fire was electrical in nature, and lawyers for DDLreport that they believe DDL is entitled to the insurance proceeds. Appropriate documentary evidence of these facts should be collected, and the expected time line for the reports should be ascertained. If any reports were to be filed before the financial statements are released, this evidence would be most useful.

Assuming, though, that the facts presented can be corroborated, the gain should be recorded in 20X2. Clearly, the building and inventory must be removed from the books, since they were destroyed prior to year end. An asset for the insurance proceeds, net of the deductable, can be recognized on the basis that it is measurable and probable.

The gain on sale should be presented as an unusual item on the statement of comprehensive income with accompanying note disclosure. Unusual items are shown gross, with the related income tax included in income tax expense.

3. Revenue on referral contract

DDL has a new, multi-year referral contract in place, beginning in 20X2. During the first year of the agreement, DDL is entitled to a minimum of $1 million, but may be entitled to more, if 30% of billings from referrals are in excess of $1 million. No revenue has yet been recorded for fiscal year 20X2, which covers approximately three months of the agreement.

Revenue can be recorded when it is earned, if it is measurable and collectible. Reports are that referrals have been active, so DDL appears to be living up to their side of the agreement. Evidence of these referrals should be documented to prove this activity. In terms of measurability, the minimum payment is a $1 million fee. It would not bepossible to estimate and measure the percentage of billings, because these depend on the yearly activity and this will not be known for some time. In fact, in years 2 and on, there

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is no minimum fee and measurability will be a major issue. The final element is collection; revenue cannot be recognized if there is doubt of collection. No payments have been made under the contract, but none are due. The credit rating and general financial condition of Nature Force must be ascertained. If the company is credit-worthy, then there seems no reason to avoid recognizing revenue.

Therefore, revenue of $0.25 should be recorded. Additional income tax would also be incurred; an additional $0.10 has been recorded, based on 40% overall corporate tax rates for large companies in Canada. It is not likely this amount is material, but it has been included for completeness.

4. EPS presentation

DDL reports basic and diluted EPS, before and after “capital gains.” The company emphasizes the numbers before capital gains in communication with shareholders and users because capital gains are not stable. However, EPS before capital gains is not a required disclosure item. IFRS allow the reporting of EPS numbers based on other earnings items, so the company is complying with IFRS with this extra disclosure. The same denominator must be used, and the definition of the numerator must be disclosed. DDL must be aware, though, that security regulators have taken the position that additional EPS numbers should not be given the same attention as the IFRS-mandated numbers; disclosure in the notes instead of on the main financial statements might be prudent. The tone of company communications around the additional EPS numbers should be carefully considered.

5. EPS calculations

As shown in exhibit 1, revised profit is $424.05, increased from $272. EPS figures are as follows:

For Class A and B shares: 20X2 20X1 (given)Basic – before gain on sale and tax $5.82 $5.60Basic – net earnings $6.36 $5.03

Diluted – before gain on sale $5.79 $4.56Diluted – net earnings $6.32 $4.99

EPS has been calculated acknowledging that Class A and Class B shares have equal dividend rights and thus are both included in the denominator of basic EPS. Redemptionsand issuance of Class A shares during the period have affected the weighted average number of shares outstanding. Dividends to preferred shares are deducted from the numerator, as well as the loss on redemption of preferred shares. Diluted EPS reflects the impact of options and the convertible preferred shares.

In terms of trend, basic EPS has increased from $5.03 to $6.36 based on net earnings, reflecting the additional gains on property disposition. There is a more modest $0.22 increase in EPS before tax and gains.

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Exhibit 1Drugstore Depot Limited Revised Net Earnings and EPS31 December 20X2

(in millions) 20X2Draft

20X1

Earnings before gain on sale ($0.25 added) 388.25 368Gain on involuntary disposal 7 --Gain on property sale 178 89Less: Income tax ($116 +$0 .1 + $2.1 + $31) (149.2) (126)Net earnings $ 424.05 $ 331

Earnings Weighted Earningsavailable to average per

common shareholders number of shares ShareBasic EPS:

Net earnings $424,050 Less: preferred dividends

65,000 x 3%; full year - redemption in Dec. (1,950)

Less: loss on redemption of preferred($25 - ($65 - $42)) (2,000)

420,100Shares outstanding

Class A; retirement and issuance assumed at end of month31,300 x 3/12(31,300 – 1,200) x 4/1234,000 x 5/12 32,025

Class B 34,000 34,00066,025

Basic EPS $6.36Based on earnings before gains and tax: ($388,250 – $1,950 - $2,000)/66,025 = $5.82

Diluted EPS:Basic EPS $420,100 66,025 $6.36

Options Shares issued 190 Shares retired (nil – no proceeds) --

Preferred shares Change to earnings 3,950 Shares issued (1,680,000 x .5) 840

Diluted EPS - Subordinate $424,050 67,055 $6.32Based on earnings before gains and tax: $388,250/67,055 = $5.79

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Case 19-2 G Shoes Ltd.

Overview

G Shoes Limited (GSL) is a manufacturer and retailer of fashion footwear, leather goods and accessories, with mall retail operations across Canada. As a public company, GSL is obliged to follow IFRS. No information is provided regarding reporting objectives or motivations, although the closure of the U.S. operation and reportedly disappointing results in 20X9, flat share price and limited options granted in 20X9 indicate some financial stress within the company. This could create ethical issues around choice of reporting policies.

Issues

1. Stock option compensation cost calculation2. Reporting of closure of U.S. stores as a discontinued operation3. EPS calculation and reporting

Analysis

1. Stock option compensation cost calculation

Compensation cost is allocated over the vesting period, which is thirty-six months for GSL. Since options are granted at 31 December, there would be no expense for 20X9 options, but one-third of the cost of compensation associated with 20X6, 20X7 and 20X8 options (granted on December 31 each year; impact following three years). The cost of options has been measured using the Black-Scholes option pricing model, which is acceptable. Assumptions used in the model should be reviewed to ensure that they are reasonable and in line with a comparable group of companies.

If the assumptions used are in line, the stock option compensation cost would reduce profit in 20X9 by $1,059 (thousand). See Exhibit 1.

2. Reporting of closure of U.S. stores as a discontinued operation

To qualify as a discontinued operation, which can be segregated in a separate section of the statement of comprehensive income, after tax, an operation must represent a separate major line of business or geographical area of operations, or be part of a single, coordinated plan to dispose of a separate major line of business or geographical area of operations, or be a subsidiary acquired exclusively with a view to resale. Operations and cash flows have to be separately distinguishable, operationally and for financial reporting purposes, from the rest of the entity. The operations will have been a separate cash-generating unit or group.

On one hand, the U.S. stores appear to have been run as a separate division, with their own management and different product choices and risk factors. The US is a different

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country. On the other hand, these three retail stores are much like all others and would have common costs of information systems, support services and so on. Perhaps only the direct costs have been isolated. The US and Canada are in the same geographic area. The argument might be made that the US operation is not a separate line of business, but that the different geographical area test is met.

In general, one would expect management of GSL to prefer the segregated discontinued operation disclosure because it shows higher profits for the continuing elements, which financial statement users may use to predict operating activities for the next year. With complete disclosure, this appears to be ethical, especially given that the division appears to have been separately reported prior to discontinuance.

Required disclosure of the discontinued operation is shown in the second column of the statement of comprehensive income in Exhibit 2. This numeric treatment assumes that all costs of the U.S. operation were classified in operating costs. Some amount will likely have been amortization and would have to be reclassified. This will not affect the bottom line. In addition, it is assumed that the relevant tax rate is 40%. An effective rate of 39% is inherent in the numbers as reported. ($5,180/$13,280). If there are permanent differences in the closure costs, this assumption is erroneous and further investigation may dictate adjustments.

3. EPS calculation and reporting

With respect to earnings per share, calculations are provided in Exhibit 3 and the results are reported on the face of the statement of comprehensive income. The bond capital charge of $590 (given), although not an expense, reduces the earnings available to common shareholders and is a deduction from the numerator when calculating basic EPS.

Both types of voting shares are common shares, since they are identical in rights except for the number of votes per share. Basic and diluted EPS have been calculated for each type of share, with the multiple voting shares entitled to four times the entitlement of the subordinated shares.

When calculating diluted EPS, the convertible bond, with an individual effect of $0.42 is dilutive. Both the interest and capital charge are adjusted on the numerator and shares issued are added to the denominator. The most dilutive conversion price is used, as is required by accounting standards. The bond results in modest dilution of basic EPS, indicating that if the bond converted, current common shareholders could expect slightly lower earning per share.

Options must be considered using the options outstanding at year end, not the options exerciseable at year-end. Average share price is used, as is average exercise price. Since the average option price is very close to market value, the effect of the options is negligible. Adjustment also is made to backdate shares issued for dilutive options during the year.

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If the U.S. operations are reported as discontinued operations, EPS is reported for continuing operations and for net earnings. The individual effect of the discontinued operation can be reported in the disclosure notes. Earnings per share, both basic and diluted, are higher without the U.S. operation, and may be more indicative of continued operation without the U.S. operation. Management may prefer this presentation option as a result.

Exhibit 1GSL Compensation cost for options, 20X9

Year of grant Per share value

Share entitlements

Sum ; then multiplied by one-third

20X6 $4.27 210,000 $ 298,90020X7 6.473 176,000 379,74920X8 5.540 206,000 380,413

$1,059,062~$1,059

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Exhibit 2GSLDraft P&L – Alternative treatments(in $ thousands)

For year ended 31 December20X9Closure as unusual item

20X9Closure as discontinued operation

Revenue Sales $166,200 $165,668 (2) Investment and other revenue 4,320 4,320

170,520 169,988Expenses Cost of sales, selling and administrative 143,919 (1) 142,920(3) Amortization 10,700 10,700 Closure costs, US operations 1,450 -- Interest, net 2,230 2,230

158,299 155,850Operating earnings, before tax 12,221 14,138Income tax 5,180 5,947(4)Net earnings $ 7,041Earnings from continuing operations $8,191Discontinued operations Operating activities, $467 net of tax of $187 (280) Closure costs, ($1,045 + $405) net of tax of $580 (870)

(1,150)Net earnings $7,041EPSBasic – continuing ops – Multiple voting $2.77 - continuing ops - Subordinated voting 0.69Basic – NI - Multiple voting $2.36 $2.36 - NI - Subordinated voting 0.59 0.59

Diluted – continuing ops - Multiple voting $2.47 - continuing ops -Subordinated voting 0.62Diluted – Multiple voting $2.16 $2.16 - Subordinated voting 0.54 0.54

(1) $142,860 + $1,059 option compensation cost(2) $166,200 - $532 (sales revenue of DO)(3) $142,860 + $1,059 – (operating costs of DO; if sales were $532 and operating loss

was $467, expenses were $999)(4) $5,180 + (.4 x ($467+$1,450)

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Exhibit 3GSL Calculation of EPS, 20X9, Option 1, closed stores are an unusual item

Earnings available to Weighted average Earningscommon shareholders number of shares per Share

Basic EPSNet earnings $7,041Less: Capital charge, bond (590)

$6,451Shares outstandingA. Multiple voting shares 1,580,000 x 4 6,320B Subordinated voting shares

5,225,000 x 3/12 1,306.25(5,225,000 – 816,000) x 5/12 1,837.08(4,409,000 + 78,000) x 4/12 1,495.67

4,639.00Total weighted shares, both classes 10,959Basic EPS per subordinated voting share $0.59Basic EPS per multiple voting share (x 4) $2.36

Individual effect for diluted EPS:$40,000,000 Bonds:

$1,780 (1-.40) after-tax interest expense + $590 capital charge = $1,658Shares: most dilutive option used; $40,000/10 = 4,000

$1,658 / 4,000 = $0.42 – dilutiveOutstanding Options:

Shares issued: 642 – 25 in 20X9 = 617Shares retired, ((642 – 25) x $11.10)/$11.25 = (608)

Exercised Options: Shares issued: 78 x 8/12 (backdated from 31 August) = 52Shares retired, ($6.62 x 78,000)/$11.25 x 8/12 = (31)


Options Exercised Shares issued 52 Shares retired (31)

Outstanding Options Shares issued 617 Shares retired _________ (608)Bonds 6,451 10,989 $0.59

Change to earnings 1,658 Shares issued 4,000

Diluted EPS - Subordinate $8,109 14,989 $0.54Diluted EPS – Multiple ( x 4) $2.16

Continued…

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Exhibit 3 continuedGSL Calculation of EPS, 20X9, Option 2, closed stores are a discontinued operation


Basic EPSNet earnings from cont. $8,191Less: Capital charge, bond (590)

$7,601Shares outstandingA. Multiple voting shares

1,580,000 x 4 6,320B. Subordinated voting shares

5,225,000 x 3/12 1,306.25(5,225,000 – 816,000) x 5/12 1,837.08(4,409,000 + 78,000) x 4/12 1,495.67

4,639.00Total weighted shares, both classes 10,959

Basic EPS per subordinated voting share $0.69Basic EPS per multiple voting share (x 4) $2.77

Individual effect for diluted EPS:As above; all items are still dilutive


Options Exercised Shares issued 52 Shares retired (31)

Outstanding Options Shares issued 617 Shares retired _________ (608)

7,601 10,989 $0.69 Bonds

Change to earnings 1,658 Shares issued 4,000

Diluted EPS - Subordinate $9,259 14,989 $0.62Diluted EPS – Multiple ( x 4) $2.47

In addition to the EPS numbers for net earnings from continuing operations calculated above, those for net earnings would also be reported.

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Case 19-3 ThurTech Limited

Overview

ThurTech Limited (TTL) is a Canadian public company, obliged to be IFRS-compliant. They operate in a high-tech field, supplying network technology to mobility telecommunications firms. TTL is reporting 8% improvement in EPS through the third quarter, after publicly predicting growth of 12%. There appears to be internal pressure, caused by compensation agreements and stock options, to drive reported profit to the 12% target by year-end, regardless of the strategic or operating logic of the methods used. This is ethically weak, and indicates problems in the way the organization is managed.

Issues

Growth in reported EPS through:1. Share buy-back2. Sale of land3. Re-valuation of debt4. Revenue recognition5. Valuation of non-monetary transaction


EPS projections for the year are at $2.46 for basic and $2.26 for diluted EPS. This represents 8% growth over the prior years’ reported results of $2.27 and $2.10, respectively. If 12% growth were to be reported, the required target would be $2.54 for basic EPS ( an $0.08 shortfall) and $2.35 for diluted EPS (a $0.09 shortfall).

1. Share buy-back

Management has suggested borrowing $16.15 million and using the funds to retire 850,000 common shares. The price implied is $19 per share. Shares issued and retired are weighted to the date of the transaction, so this scheme would have to be implemented quickly for the transaction to have any impact on current year EPS. Net earnings would bereduced by the after-tax effect of interest. If the transaction were completed at the beginning of the fourth quarter, basic EPS would increase to $2.48 (see exhibit 1) and a similar increase would be reported for diluted EPS. This transaction would provide $0.02 of the required growth.

The ethical component of this management decision is problematic in that the moneyborrowed would not have prior board of directors approval, as TTL’s management are currently empowered to borrow up to $2 billion, and they have enough room under this blanket approval to effect this transaction. One would expect board of directors approval for plans to issue or retire shares, and thus from a corporate governance perspective, going ahead with this transaction without specific board approval raises significant concerns.

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It is quite common for companies to offset the dilution caused by shares optioned to senior management with share buy-back schemes. However, complete authorization for the strategy seems a necessary first step.

2. Sale of land

Sale of the idle land for a gain of $485,000 would increase earnings by the after-tax amount of $291,000 (assuming the gain is fully taxable). This provides an increase to EPS of an additional $0.01(see Exhibit 1).

While the transaction moves the company in the direction of the desired reporting result, the real question is the desirability of the transaction. The idle land was acquired to accommodate future expansion, and while management feels that other land sites will be available, it is a strategic decision to sell this land now and be more dependent on future market conditions for expansion. Governance is again an issue, and a full discussion of this transaction, which provides only marginal improvement in EPS, should be undertaken before any sale is completed.

It is common practice in many companies to engineer reported results through the sale of such undervalued assets; this does not mean that the practice is preferable. The market should not be fooled by such actions, which do not represent operating profits. Such window dressing is regrettable.

Note that the company could revalue property, plant and equipment by class to report fair values on the balance sheet. However, revaluation would result in recongition of equity reserves, not earnings.

3. Re-valuation of debt

Revaluation of debt would produce a $30 million value change, which would have a significant impact on current earnings. Debt is carried at historic cost in financial statements, however, and valuation at present values would be a deviation from IFRS. One assumes that a public company will not pick an accounting policy that results in a qualified audit report. This alternative action is not analyzed further as a result.


TTL is suggesting early delivery of certain orders to customers, with delivery shifted from the first quarter of 20X4 to the final quarter of 20X3. Projections indicate that this will increase operating profit by $800,000 to $1,200,000, before tax. If the lower range were applied, basic EPS would increase further to $2.52 (Exhibit 1). There would be a similar impact on diluted EPS.

Revenue may only be recognized if the criteria for revenue recognition are met. That is, the risks and rewards of ownership must pass to the customer. This is usually accomplished on delivery, and TTL is confident that they can complete production and physical delivery by the end of the fiscal year. However, the substance of delivery is

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installation in the client system, and it appears that this is not possible within the fiscal year 20X3; indeed, such installation appears problematic for at least one customer. The substance of the transaction appears to be that this is a 20X4 transaction, as is indicated by the payment terms that remain unchanged regardless of the early delivery date. Thus, the concern is that revenue recognition is being cynically altered to portray a questionableresult. Another factor is that if the 20X4 transaction is reported in 20X3, 20X4 first quarter results will be adversely effected, necessitating further aggressive strategy in 20X4, just to keep up. This is most undesirable.

Ethical consideration regarding the reporting of earned revenue must be considered. The timing of these transactions appears to be purely manipulative, with no substance for the fourth quarter. From a governance perspective, they indicate questionable ethical behavior of management. Such activities would be poorly received by the financial markets and by regulators, rendering the shortfall in current earnings trivial when compared to other long-term negative repercussions of meddling with financial statements.

5. Valuation of non-monetary transaction

TTL is involved in a non-monetary transaction, where they will provide certain technology in exchange for manufacturing equipment. Non-monetary transactions are usually valued at fair market value, unless the transaction lacks commercial substance (changed cash flows). If there is no commercial substance, the transaction is valued at book value. In this case, network technology and manufacturing equipment are considerably different, and could be expected to have differenct cash flows. Alternatively, one could argue that both companies are acquiring assets that will be used as factor of production: assets used to create goods or services that their eventual customers will buy. Eventuial cash flow is not significantly different.

If the exchange were recorded at fair market value, this value would have to be established. The manufacturing equipment received is reported to be unique, with no value assigned to it. However, the value of the asset received is to be used to value the transaction. TTL must explore the value in more depth, and attempt to establish an appraised value. One might expect them to do this to ensure that the terms of the agreement are “fair. ” That is, they know that the network technology sold has a cost of $600,000 and a reported market value of $1.5 million. This latter value would represent fair market value, but is suspect because of the few transactions in this line. TTL must be confident that they are receiving equal value in return.

Another alternative is to establish value in use by looking at eventual sales of end product, although there appears to be too much uncertainty to establish a value through this means.

If the $1.5 million figure were to represent the fair value of the assets received, operating profit will increase by $900,000 before tax, and $540,000 after tax. Cumulatively, this would increase basic EPS to $2.54.

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The substance of this transaction must be explored in more depth by TTL management, and the audit committee, to establish appropriate accounting policy. A reasonable suggestion in the current reporting climate is that the transaction be classified as the exchange of similar assets, and no gain recorded. This will benefit future earnings, as the profit from the product line supported by the manufacturing equipment will be assigned lower depreciation, as the asset will be valued at a lower cost. The bias of management to record current profits is thwarted in this instance.

Conclusion

If these suggestions of management were adopted, the company would be successful in increasing reported basic EPS to $2.54, which would reach the 20X3 established target. This appears to be ethically undesirable, as many questionable transactions and accounting policies would have to be adopted to achieve this end. The focus on current results, at the expense of sound management practice and future earnings, is not to be encouraged. The audit committee and the board of directors should be made aware of the current ethical climate in the organization, and should alter the leadership model and perhaps the compensation package to improve the situation for this company.

Exhibit 1Revised basic EPS


Basic: $48,621,900 19,765,500 $2.46

1. Share buy backInterest: ($16,150,000 x .08 x 3/12) (1-.4) (193,800)Shares retired: 850,000 x 3/12 (212,500)Basic: $48,428,100 19,553,000 $2.48

2. Sale of landGain: ($485,000) (1-.4) 291,000

Basic: $48,719,100 19,553,000 $2.49

3. Revaluation of debtNot GAAP

4. Revenue recognitionGross profit: ($800,000*) (1-.4) 480,000*other assumptions acceptableBasic: $49,199,100 19,553,000 $2.52

5. Non-monetary transaction

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Gain: ($900,000) (1-.4) 540,000

Basic: $49,739,100 19,553,000 $2.54

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Assignments

Assignment 19-1

Requirement 1

Computations of EPS amounts:

a) Preferred dividend claim for current year:

$20,000 (given). Recognized on the noncumulative preferred shares only to the extent declared.

b) Weighted average number of common shares outstanding during year:

Actual Retroactive MonthsTime Period Shares Adjustment Outstanding Shares

1 January, shares outstanding 34,000,0001 January to 31 March 34,000,000 x 1.10 x 3/12 = 9,350,0001 April, sold additional shares 3,240,0001 April to 30 September 37,240,000 x 1.10 x 6/12 = 20,482,00030 September, 10% stock dividend 3,724,00030 September to 31 December 40,964,000 x 3/12 = 10,241,000

Total 40,073,000

c) Earnings per share on common:

Earnings from continuingoperations ($3,336,000 - $20,000*) 40,073,000 shares = $.08

Discontinued operations ($432,000 / 40,073,000 shares) = .01 ** Net earnings ($3,768,000 - $20,000*) / 40,073,000 shares = $.09

* Preferred dividend claim.** Disclosure of individual effect may be included in the notes instead of on the

statement of comprehensive income.

Requirement 2

If the preferred claim were cumulative, the entire claim would be deducted, declared or not.

Earnings from continuing operations ($3,336,000 - $450,000*) 40,073,000 = $.07Discontinued operations ($432,000 / 40,073,000) = .01Net earnings ($3,768,000 - $450,000) / 40,073,000 = $.08

*500,000 x $0.90 = $450,000

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Assignment 19-2

Requirement 1

The formula for basic EPS is:Profit available to common shareholders

Weighted average number of common shares outstanding

The numerator is net earnings, less preferred dividends declared (or preferred dividend entitlements, if shares are cumulative). Other returns to senior securities, like losses on share retirement, must also be deducted from the numerator. The denominator is the average number of common shares outstanding, weighted to their day of issuance. Shares issued due to a stock dividend or a stock split are weighted back to the beginning of the period, an exception to the weighted-average rule.

EPS is used to indicate each share’s proportionate amount of company earnings. It is a widely used indicator of a corporation’s financial performance in financial markets and is important to managers, analysts and shareholders. Trends are often significant when projecting future performance.

Requirement 2

It seems logical to suggest that discontinued operations will cease to be a factor in earnings, and thus the better predictor of future earnings would be earnings from continuing operations.

For Foran, basic EPS from continuing operations has grown from $2.98 in 20X2 to $3.38 in 20X3, an increase of 13%. If an increasing trend continues, and there is again growth of 13%, then $3.82 is the target. 20X4 earnings predictions may be more valid if based on company predictions, the state of the economy and prospects for this particular industry.

Requirement 3

Diluted EPS is a ‘what if’ figure that reports the impact of dilutive elements in a company’s capital structure, elements that could convert to common shares in the future. Convertible bonds, convertible senior shares, contingently issuable shares, and options,all might be in Foran’s capital structure. Diluted EPS indicates the maximum potential decline in earnings if the company’s financing strategy – the conversion of securities and exercise of options – is successful. This statistic is designed to serve users who are trying to assess future prospects.

Requirement 4

Diluted EPS from continuing operations was $2.75 in 20X2, compared to basic EPS of $2.98. This is an 8% reduction. In 20X3, the reduction was from $3.38 to $2.62, a 22% reduction. This implies that there were additional dilutive elements in the capital structure, and is meant to be a red flag for common share investors.

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Assignment 19-3

Requirement 1

20X4 Earnings Weighted Earningsavailable to average per


Net earnings $700,000Preferred shares (100,000 x $3) (300,000)Preferred shares (50,000 x $2) (100,000)

$300,000Shares outstanding

600,000 x 10/12 500,000900,000 x 2/12 150,000

650,000Basic EPS $0.46

20X3

Basic EPS:Net earnings $400,000

Preferred shares non-cumulative --Preferred shares (50,000 x $2) (100,000)


600,000 x 12/12 600,000Basic EPS $0.50

Requirement 2

The company has much higher profit in 20X4 than in 20X3, but basic EPS has declined. This is because the non-cumulative dividend was not declared in 20X3; it was declared in 20X4. These investors received no return in 20X3, but did receive a return in 20X4.

The company issued additional shares in 20X4, providing more capital which should havegenerated more return. Earnings increased, but not did not increase enough to provide a both a return to the non-cumulative shares and the additional common shares issued.

In requirement 3, the new shares are assumed to have brought in no new capital. The company’s improved operating results are entirely consumed by the payment to non-cumulative shares.

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Requirement 3



As above $300,000Shares outstanding

600,000 x 10/12 x 1.5 750,000900,000 x 2/12 150,000

900,000Basic EPS $0.33

20X3As above $300,000Shares outstanding

600,000 x 12/12 x 1.5 900,000

Basic EPS $0.33

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Assignment 19-4

Requirement 1



Net earnings $877,000Preferred shares B (120,000 x $0.7) (84,000)Preferred shares A (non-cumulative) --


100,000 x 11/12 x 3 275,000300,000 x 1/12 25,000

300,000Basic EPS $2.64

Basic EPS:Earnings from continuing operations $993,000As above - Pref B (84,000)


As above 300,000Basic EPS $3.03



Net earnings $1,096,000Preferred shares B (not issued) --Preferred shares A (non-cumulative) --

$1,096,000Shares outstanding

150,000 x 10/12 x 3 375,000100,000 x 2/12 x 3 50,000

425,000Basic EPS $2.58

Basic EPS:Earnings from continuing operations $1,019,000As above – Pref --


As above 425,000Basic EPS $2.40

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Requirement 2

Both net earnings and earnings from continuing operations has decreased in absoute dollars from 20X1 to 20X2. However, basic EPS from continuing operations has increased from $2.40 to $3.03. Basic EPS based on net earnings has increased from $2.58 to $2.64. This has happened because the number of common shares outstanding decreased toward the end of 20X1. With a lower capital base, the company can record higher EPS with lower earnings. This reflects more efficient use of the capital base. The company may have essentially replaced common with preferred shares, because there are new Class B preferred shares outstanding in 20X2.

Also note that the non-cumulative shares are receiving no return over this period, because no dividend was declared. Earnings will have to increase to cover this dividend when it is declared in order to maintain existing levels of basic EPS.hzzled




Case AActual Retroactive Months

Time Period Shares Adjustment Outstanding Shares

1 January, shares outstanding 2,860,0001 January to 28 February 2,860,000 x 1.10 x 2/12 = 524,3331 March, stock dividend 286,0001 March to 31 May 3,146,000 x 3/12 = 786,5001 June, retired shares (200,000)1 June to 31 July 2,946,000 x 2/12 = 491,0001 November, shares

issued but backdated to 1 August (contingency cleared) 400,000

1 November to 31 December 3,346,000 x 5/12 = 1,394,167Total 3,196,000

Case BActual Retroactive Months


1 January, shares outstanding 3,000,0001 January to 28 February 3,000,000 1.20 x 2/12 = 600,0001 March, sold add’l shares 400,0001 March to 30 June 3,400,000 1.20 x 4/12 = 1,360,0001 July, retired shares (200,000)1 July to 31 October 3,200,000 1.20 x 4/12 = 1,280,0001 November, stock dividend

20% (640,000/3,200,000) 640,0001 November to 31 December 3,840,000 x 2/12 = 640,000

Total 3,880,000

Case C


1 January, shares outstanding 6,950,0001 January to 31 December 6,950,000 x 1/4* x 12/12 = 1,737,500

Total 1,737,500

* Split occurred in the next fiscal year, but before the financial statements wereissued for this year, and thus must be is included for this year.

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Assignment 19-6

Case A

The Series B shares are (voting) common sharesActual Retroactive Months


1 January, shares outstanding 250,0001 January to 30 September 250,000 x 9/12 = 187,5001 October, shares issued ( A x 4) 160,0001 October to 30 November 410,000 x 2/12 = 68,3331 December, retired shares (100,000)1 December to 31 December 310,000 x 1/12 = 25,833

Total 281,666

Case BBoth share classes are common shares. Since rights are identical except for votes, the dividend entitlement must be equal. Class A shares are not multiplied by ten; they are only multiplied if the dividend entitlement is not equal.


1 January, shares outstanding(A+B) 140,0001 January to 29 April 140,000 x 4/12 = 46,66730 April, sold additional shares 100,00030 April to 31 December 240,000 x 8/12 = 160,000

Total 206,667

Case CActual Retroactive Months


1 January, shares outstanding 1,000,0001 January to 27 February 1,000,000 x 2 x 2/12 = 333,33327 February, sold add’l shares 200,00027 February to 31 March 1,200,000 x 2 x 1/12 = 200,0001 August, issued contingent shares

backdated to late March 300,0001 April to 30 August 1,500,000 x 2 x 5/12 = 1,250,00030 August, split 1,500,00030 August to 31 December 3,000,000 x 4/12 = 1,000,000

Total 2,783,333

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Assignment 19-7

Requirement 1

20x5: (100,000 x 3/12) + (120,000 x 9/12) = 115,000

20x6: (150,000 x 12/12) = 150,000Stock dividend is weighted back to the beginning of the period.Alternate calculation: (120,000 x 1.25 x 6/12) + (150,000 x 6/12)

20x7: (150,000 x 2 x 6/12) + (300,000 x 3/12) + (350,000 x 3/12) = 312,500

Requirement 2

20x7: (No change) 312,500

20x6: (150,000 x 2; stock split in 20x7) 300,000.

20x5: 115,000 x 2 x 1.25 287,500( factor of 2 for 20x7 stock split and 1.25 for 20x6 stock dividend)

Requirement 3

20x7 20x6 20x5

Net earnings $375,000 $330,000 $299,000Average shares outstanding (including stock

dividend and split) 312,500 300,000 287,500Earnings per share $1.20 $1.10 $1.04

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Assignment 19-8

Computation of EPS amounts:

a) Preferred dividend claims for current year:

Class A— Exclude because noncumulative and no current preferred dividends were declared.

Class B— Include whether declared or not because cumulative:30,000 x $0.70 = $21,000.

b) Average number of common shares outstanding during year:


1 January, shares outstanding 186,0001 January to 30 April 186,000 x 4 x 4/12 = 248,0001 May, retired shares ( 36,000)1 May to 1 November 150,000 x 4 x 6/12 = 300,0001 November, 300% stock

dividend 450,0001 November to 31 December 600,000 x 2/12 = 100,000

648,000

c) Earnings per share on common:

Earnings from continuing operations ($160,500 - $21,000) /648,000 shares $0.22 Discontinued operations $10,000 / 648,000 shares .01*Net earnings ($170,500 - $21,000) /648,000 shares $0.23

* Disclosure of individual effect may be included in the disclosure notes.

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Assignment 19-9

Requirement 1

Class A and Class B shares are participating and basic EPS must be reported for each.

Step 1 – Calculate earnings minus base dividendNet earnings is $8,040,000, less $2,250,000 ( base dividend: ($0.90 x 500,000 Class A) and ($1.20 x 1,500,000 Class B shares))Undistributed net earnings is $5,790,000

Step 2 – Allocate undistributed earnings to the share classesClass A receives $5,790,000 x 500/(500 + 1,500) (= 1/4) = $1,447,500Class B receives $5,790,000 x 1,500/(500 + 1,500) (= 3/4) = $4,342,500

The 1/4 and 3/4 split is based on the number of shares outstanding, since remaining profit is split on a per-share basis. There are 2,000,000 (500,000 + 1,500,000) shares outstanding and all are treated equally in further distributions.

Step 3 – Determine per share amounts (from Step 2) Class A - $1,447,500/500,000 shares = $2.895Class B - $4,342,500 /1,500,000 shares = $2.895 (equal)

Step 4 – Add base dividend to the Step 3 amountsClass A - $0.90 + $2.895= $3.795Class B - $1.20 + $2.895 = $4.095

Requirement 2

In these circumstances, both shares are included in the deniminator according to their dividend weight:Net earnings $8,040,000/ ((500,000 Class A x 10) + (1,500,000 Class B) = $8,040,000/ 6,500,000 shares = $1.24

Reported as:Basic EPS Class A ( x 10) $12.40Basic EPS Class B 1.24

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Assignment 19-10

Requirement 1

Multiple Voting Shares and Subordinated Voting Shares shares are participating and basic EPS must be reported for each.

Step 1 – Calculate earnings minus base dividendEarnings are $984,000, less $630,000 ($3 x 60,000 Multiple Voting Shares) +($0.60 x 750,000 Subordinated Voting Shares )Undistributed net earnings is $354,000

Step 2 – Allocate undistributed earnings to the share classesMultiple Voting Shares receive $354,000 x (900 / (900 + 750)) = $193,091Subordinated Voting Shares receive $354,000 x (750/ (900 + 750)) = $160,909Multiple Voting Shares = 60,000 x 15 = 900,000; Subordinated shares are 750,000 so the base is 900 + 750 = 1,650

Step 3 – Determine per share amounts (from Step 2) Multiple Voting Shares - $193,091 / 60,000 shares = $3.22Subordinated Voting Shares - $160,909 / 750,000 shares = $0.22 (1/15)

Step 4 – Add base dividends to the Step 3 amountsMultiple Voting Shares - $3.00 + $3.22 = $6.22Subordinated Voting Shares - $0.60 + $0.22 = $0.82

Requirement 2

EPS = Net earnings/ shares outstanding; weighted by dividend entitlement = $984,000/ (60,000 x 5) + (750,000) = $984,000 / 1,050,000 = $0.94 per Subordinated Voting Share $4.70 ($0.94 x 5) per Multiple Voting Share

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Assignment 19-11



Net earnings $3,741,000

Shares outstanding3,650,000 x 3/12 912,5003,850,000 x 9/12

(shares assumed to be issued on 31 March when lawsuit dismissed) 2,887,500

3,800,000Basic EPS $0.99

Diluted:Contingent shares:LawsuitShares included in diluted - backdate to beginning of year200,000 x 3/12 50,000 shares

Operating profitShares included in diluted because if the condition were to end in 20X1, profit targets to date have been met 2,500,000 shares

PatentShares not included in diluted because if the condition were to end at the endof 20X1, the product is not yet under patent and shares would not be issued.

Diluted EPS:Basic EPS $3,741,000 3,800,000 $0.99Shares backdated 50,000Shares _________ 2,500,000

Diluted EPS $3,741,000 6,350,000 $0.59

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Assignment 19-12



Net earnings $1,445,000

Shares outstanding11,500,000 x 1/12 958,33312,000,000 x 11/12

(shares assumed to be issued early Feb. when fifth outlet opened) 11,000,000

11,958,333Basic EPS $0.12

Diluted:Contingent shares: OutletShares included in diluted - backdate to beginning of year500,000 x 1/12 41,667 shares

Customer retentionShares not included in diluted because if the condition were to end in 20X2, retention target has not been met

Employee retentionShares included in diluted because if the condition were to end at the endof 20X2, the employees are still employed and shares would be issued.

1, 300,000 shares

Diluted EPS:Basic EPS $1,445,000 11,958,333 $0.12Shares backdated 41,667Shares _________ 1,300,000

Diluted EPS $1,445,000 13,300,000 $0.11

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Assignment 19-13



Net earnings $2,500,000Preferred shares (50,000 x $5) (250,000)

$2,250,000

Shares outstanding450,000 x 9/12 337,500550,000 x 3/12 137,500

475,000

Basic EPS $4.74

Individual effect:OptionsShares issued 50,000Shares retired (50,000 x $5) / $20 (12,500)Bond:Interest avoided

$80,000 x (1-.4) 48,000Shares issued 65,000 $0.74

Diluted EPS:Basic EPS $2,250,000 475,000 $4.74Options 50,000

________ (12,500)2,250,000 512,500 4.39

Bond:Interest avoided 48,000Shares issued

65,000Diluted EPS $2,298,000 577,500 $3.98

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Assignment 19-14


common shareholders number of shares ShareCase A

Basic EPS $17,100,000 6,240,000 $2.74Actual conversion:Dividends on converted shares: 200,000 x $.50 x 3 300,000Adjusted shares for 3 quarters 600,000 x 9/12 450,000Preferred shares:Dividends 600,000 x $2 1,200,000Shares 600,000 x 3 (600/200) _________ 1,800,000Diluted EPS $18,600,000 8,490,000 $2.19

Note: Since individual effect of each is identical ($0.67), they are both dilutive and theirorder is irrelevant.

Case B

Basic EPS $17,100,000 6,240,000 $2.74Options:Shares issued 500,000Shares retired (500,000 x $15)/$28 _(267,857)Subtotal 17,100,000 6,472,143 2.64

Actual conversion, backdated After-tax interest

$291,667 x (1-.3) 204,167Shares issued 2,400,000 x 10/12 _________ 2,000,000Diluted EPS $17,304,167 8,472,143 $2.04

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Assignment 19-15Earnings available to Weighted average Earningscommon shareholders number of shares per Share

Basic:Net earnings $602,000Pref dividends

20,000 x $3 (60,000)10,000 x ($3 x ¾) (22,500)

$519,500Weighted average shares

100,000 x 9/12 75,000150,000 x 2/12 25,000190,000 x 1/12 15,833

Basic EPS 115,833 $4.49

Individual effects:Contingent shares – lawsuitShares issued backdated to the beginning of the year40,000 x 11/12 36,667 shares

Contingent shares - earningsContingency met if 20X2 were the end of the agreement 50,000 shares

Preferred shares,Converted = 10,000 x ($3 x ¾) = 22,500 = 0.60

10,000 x 5 x 9/12 37,500Preferred Shares, unconverted = 20,000 x $3 = $60,000 = 0.60

20,000 x 5 100,000

Debentures = $197,000 x (1 - .40) = $118,200 = 2.3650,000 50,000

Diluted Basic, above $519,500 115,833 $4.49Contingent shares 36,667

________ 50,000Subtotal 519,500 202,500 $2.56Pref conversion; backdated __22,500 _37,500

542,000 240,000 2.26Preferred shares _60,000 100,000Diluted EPS $602,000 340,000 $1.77Debentures are now anti-dilutive in the cascade

EPS disclosure:Earnings per shareBasic $4.49Diluted $1.77

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Assignment 19-16

Case Basic EPS Diluted EPSA Net earnings:

(($680,000 – (50,000 x $2))/350,000 = $580,000 / 350,000 = $1.66Net earnings from continuing operations:($815,000 – (50,000 x $2))/350,000 = $715,000 / 350,000 = $2.04

Not applicable – no convertible elements

B Net earnings: ($750,000 – (40,000 x $4))/350,000 = $590,000 / 350,000 = $1.69

($590,000 + $160,000) / 350,000 + (40,000 x 5) = $1.36

C Net earnings: ($675,000 – (50,000 x $7))/400,000 = $325,000 / 400,000 = $0.81

($325,000 + $350,000) / (400,000 + (50,000 x 5) ) = $1.04This is higher than basic and thus the preferred shares are antidilutive.

(or, individual effect of $4/4 = $1 is antidilutive)

Diluted EPS is therefore the same as basic, $0.81

D Net earnings: ($540,000 - $0)/400,000 = $1.35

($540,000 + $0) / (400,000 + (75,000 x 5))= $0.70

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Basic:Net earnings $2,289,000Pref dividends

500,000 x $.25 x 2 (250,000)350,000 x $.25 x 2 (175,000)

$1,864,000Weighted average shares

2,900,000 x 6/12 1,450,0003,500,000 x 6/12 1,750,000

Basic EPS 3,200,000 $0.58

Individual effects:Preferred shares,Converted = 150,000 x $.25 x 2 = 75,000 = 0.25

150,000 x 4 x 6/12 300,000Preferred Shares, unconverted = 350,000 x $1 = $350,000 = 0.25

350,000 x 4 1,400,000

Debentures = $175,000 x (1 - .48) = $91,000 = 0.19$4,000,000 x 1/100 x 12 480,000

$14 Options = Shares issued: 600,000 Shares retired: (600,000 x $14) / $18 = 466,667

$22 Options: The $22 options must be evaluated for the period during which they were outstanding, the first two quarters of the year. They were anti-dilutive during this period and are excluded for this reason.

Diluted Basic, above $1,864,000 3,200,000 $0.58Options 600,000

________ (466,667)Subtotal 1,864,000 3,333,333 0.56Debentures 91,000 480,000

1,955,000 3,813,333 0.51Pref conversion; backdated __75,000 _300,000

2,030,000 4,113,333 0.49Preferred shares _350,000 1,400,000Diluted EPS $2,380,000 5,513,333 $.43

EPS disclosure:Earnings per shareBasic $0.58Diluted $0.43

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Net earnings $366,000Preferred shares (30,000 x $.50) (15,000)

$351,000

Shares outstanding150,000 x 6/12 75,000450,000 x 5/12 187,500516,000 (1) x 1/12 43,000

305,500Basic EPS $1.15

(1) ($600,000/$1,000 x 110) + 450,000

Individual effect:Preferred shares

Dividend avoided 15,000Shares issued 30,000 x 2 60,000 $0.25

Actual conversion:Interest avoided

$47,250 x (1-.3) 33,075Shares issued

($600,000/$1,000) x 110 x 11/12 60,500 $0.55

Diluted EPS:Basic EPS $351,000 305,500 $1.15Preferred shares

Dividend avoided 15,000Shares issued 30,000 x 2 ______ 60,000

366,000 365,500 1.00Actual conversion:Interest avoided 33,075Shares issued

60,500Diluted EPS $399,075 426,000 $0.94

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Assignment 19-19

Item Include Numerator Denominator Indiv.effectA No; individual

effect higher than $2.61 basic and anti-dilutive

$1 x 75,000 shares = $75,000Cumulative dividend included whether declared or not.

75,000 shares x ¼ = 18,750

$4

B No; exercise price of $65 is higher than $42 average price for the year; antidilutive

C Yes None Shares issued: 30,000Shares retired: (30,000 x $35)/ $42 = (25,000)

D No; granted at end of year and weighted to 0/12

E No; individual effect higher than $2.61 basic and anti-dilutive

Interest:$5,000,000 x 12% = $600,000Discount: $43,750Total, after tax = $643,750 (1-.4) = $386,250

Shares:$5,000,000/1000 x 18 = 90,000

$4.29

F Yes Interest:$9,000,000 x 8% = $720,000Discount: $19,200Total, after tax = $739,200 (1-.4) = $443,520

Shares:$9,000,000/1000 x 24 = 216,000

$2.05

G Yes Interest:$9,000,000 x 6% x 3/12 = $135,000Discount: $2,500Total, after tax = $137,500 (1-.4) = $82,500

Shares:$9,000,000/1000 x 20x 3/12 = 45,000

$1.83

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Assignment 19-20


common shareholders number of shares ShareEarnings

Net profit $860,000

Shares outstanding (beginning at the end of the year)300,000 x 7/12 (June – Dec.) 175,000340,000 x 3/12 (March – May) 85,000 60,000 x 1/12 (Feb) 5,000 20,000 x 300% (split) x 1/12 (Jan) 5,000

270,000Basic EPS $3.18

Diluted EPS:Basic EPS $860,000 270,000 $3.18Options Shares issued 50,000 x 3 = 150,000 150,000 Shares retired (150,000 x $8.33) / $20) (62,500) (rounded)Subtotal 357,500 $2.41Bonds (1) 252,000 360,000Diluted EPS $1,112,000 717,500 $1.55

(1) Bonds: $420,000 (1-.4) after-tax interest expense/ ($4,000,000/$1,000) x (30 shares x 300%) $252,000 / 360,000 = $0.70.

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Basic EPSEarnings from continuing. ops. $6,080,000Less: loss on P/S retirement (74,000)Less: preferred dividends 600,000 x $2 (1,200,000)


2,450,000 x 9/12 x 24,900,000 x 3/12

Basic EPS 4,900,000 $0.98

Individual effect for diluted EPS:Preferred shares – not convertible$5,000,000 Bonds:

$290,600 (1-.35) after-tax interest expense/ 120,000$188,890 / 120,000 = $1.57 Anti-dilutive

Options: $10 options – anti-dilutive$5 options – shares issued, 500,000

shares retired, (500,000 x $5)/$7 = 357,143$4 options – shares issued, 200,000

shares retired, (200,000 x $4)/$7 = 114,286

Diluted EPS:Basic EPS $4,806,000 4,900,000 $0.98

Options Shares issued 500,000 Share retired (357,143) Shares issued 200,000 Shares retired _________ (114,286)

4,806,000 5,128,571 0.94Bonds – anti-dilutive -- --Diluted EPS $4,806,000 5,128,571 $0.94

EPS Reporting:Basic EPS Earnings from continuing operations $0.98Discontinued operations (0.15) ($760,000 / 4,900,000)

Net earnings $0.83 ($5,320,000 -$1,274,000 / 4,900,000) Diluted EPS Earnings from continuing operations $0.94Discontinued operations (0.15) ($760,000 / 5,128,571)Net earnings $0.79 ($5,320,000 -$1,274,000 /5 ,128,571)

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Assignment 19-22 WEBEarnings available to Weighted average Earningscommon shareholders number of shares per Share

Basic EPSNet earnings $600,000

Note: preferred dividends are already deducted from net earnings _______

600,000Shares outstanding

48,000* x 3/12 12,00060,000 x 9/12 45,000

57,000Basic EPS $10.53

* Bonds: ($1,500,000 / 1,000) x 8 = 12,000; 60,000 – 12,000 = 48,000

Individual effect:Actual conversion, 12% debenturesBond interest $48,000 x (1-.4) 28,800Shares 12,000 x 3/12 3,000 $9.6012% debentures outstanding

Interest ($624,000 - $48,000) x (1-.4) 345,600Shares: ($4,500,000 / $1,000) x 8 36,000 9.60

12.4% debenturesInterest ($450,000) x (1-.4) $270,000($3,000,000 / $1,000) x 8 24,000 $11.25

The options are anti-dilutive because exercise price is greater than market value. The individual effect of the 12% debenture items are identical and their order is irrelevant.The 12.4% debenture is anti-dilutive.

Diluted EPS:Basic EPS 600,000 57,000 $10.53Actual conversion:Bond interest 28,800Shares 3,00012% debentures

Interest 345,600Shares ______ 36,000

Diluted EPS $974,400 96,000 $10.15

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Assignment 19-23

Requirement 1Earnings Shares

effect issued Individual effecta) Options

Shares issued 400,000Shares retired (400,000 x $17.50) / $40 (175,000)

b) $4 Preferred shares$2 x 7,000 $14,0005 x 7,000 35,000 $0.40

c) 9% Debentures$285,000 x (1 - .35) 185,250$3,000,000 / $100 x 5 150,000 1.24

d) $5 Preferred shares$5 x 4,000 (cumulative) 20,0003 x 4,000 12,000 1.67

e) 11.5% Debentures$660,000 x (1 - .35) 429,000520,000 shares (given) 520,000 0.83

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Requirement 2Earnings available to Weighted average Earningscommon shareholders number of shares per Share

Earnings $1,000,000Less: preferred dividends (given) ( 34,000)

966,000Shares

(given) 750,000Basic EPS $1.29

Diluted EPS:Options:

Shares issued 400,000Shares retired _______ (175,000)

Subtotal 966,000 975,000 $0.99

Preferred Shares (most dilutive)Dividends 14,000Shares ___35,000

Subtotal 980,000 1,010,000 $0.97

11.5% DebenturesInterest 429,000Shares 520,000

Diluted EPS $1,409,000 1,530,000 $0.92

All other elements are higher than $0.92 and are anti-dilutive. Dilutive calculations all use earnings from continuing operations as the reference point in determining whether an item is dilutive.

Presentation on statement of comprehensive income:Basic Diluted

Earnings from continuing operations $1.29 $0.92Discontinued operations 1.00 .49*Net earnings $2.29 $1.41**

* $750,000 / 1,530,000** ($1,750,000 - $34,000 + $14,000 + $429,000) / 1,530,000

Disclosure of the individual effect of the discontinued operation may be included in the disclosure notes.

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Assignment 19-24

Earnings available to Weighted average Earningscommon shareholder number of shares per Share

Basic EPSNet earnings $920,000Less: preferred dividends 20,000 x $1.5 (30,000) 15,000 x $0.5 (7,500)


140,000 x 4/12 x 3 140,000195,000 x 5/12 x 3 243,750220,000 x 2/12 x 3 110,000660,000 x 1/12 55,000

Basic EPS 548,750 $1.61

Individual effects:Preferred shares converted

Dividend 5,000 x $1.50 7,500 Shares 5,000 x 5 x 9/12 x 3 56,250 $0.13

Preferred shares unconvertedDividend 15,000 x $2 30,000Shares 15,000 x 15 225,000 $0.13

Bonds convertedInterest $5,000,000 x 6% x 4/12 100,000

Discount 8,333108,333

After tax (60%) 65,000Shares 55,000 x 3 x 4/12 55,000 $1.18


Preferred shares convertedDividend 7,500Shares 56,250

Preferred shares converted Dividend 30,000Shares 225,000

920,000 830,000 1.11Bonds: excluded as now antidilutive

Diluted EPS 920,000 $830,000 $1.11

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Assignment 19-25

Individual effect:Earnings Shares

effect issued Individual effecta) 8% bond payable

$403,000 x (1 - .4) 241,800$5,000,000/$1,000 x 80 400,000 0.60

b) OptionsShares issued 120,000Shares retired (120,000 x $3)/$15 (24,000)

c) $1.25 Preferred shares$1.25 x 70,000 (cumulative) $87,500

50,000 $1.75d) Contingent shares

Not included because terms would not be met (cumulative earnings) if the contingency agreement were to be ended at the end of 20X5.

e) 6% bonds payable$285,750 x (1 - .40) 171,450$8,000,000/$1,000 x 40 x 9/12 240,000 0.71

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EPS Calculations:Earnings available to Weighted average Earningscommon shareholders number of shares per Share

Earnings $1,300,000Less: preferred dividends (87,500)

1,212,500Shares

(500,000 x 12/12) + (700,000 x 0/12) 500,000Basic EPS $2.43

Diluted EPS:Options:

Shares issued 120,000Shares retired _______ ( 24,000)

Subtotal 1,212,500 596,000 $2.038% bonds payable (most dilutive)

Interest 241,800Shares 400,000

Subtotal $1,454,300 996,000 $1.466% bonds payable (next most dilutive)

Interest 171,450Shares 240,000

Diluted EPS $1,625,750 1,236,000 $1.32

The preferred shares have an individual effect higher than $1.32 and are anti-dilutive. hzzled



Assignment 19-26

The Class B shares are common becase they have voting rights.

Basic EPS:

Net loss per share $350,000 + $150,000* (1) = ($500,000) = ($0.53) loss per share950,000 950,000

*Dividend claim increases the loss

Computations:

1) Cumulative, Class A (preferred) dividend claim on earnings:

Outstanding all year: 15,000 shares x $5 = $75,000Outstanding part of year: 30,000 shares x $5 x 1/2 = 75,000

Total cumulative preferred dividend claim added to net loss $150,000

2) Individual effects of options and convertible debt:

Stock rights:Shares issued = 700,000 sharesShares retired: (($9 x 700,000)/$11) = 572,727

Convertible bonds payable:

$525,000 x (1 - .40) = $0.45 ($10,000,000 1,000) x 70

Including these items in EPS would decrease the loss per share and thus neither should be included in any calculation of diluted EPS. Therefore, diluted EPS is identical to basic, ($0.53).

EPS presentation:

Basic loss per share ($0.53)

Diluted loss per share ($0.53)

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Assignment 19-27Earnings available to Weighted average Earnings

common shareholders number of shares per ShareBasic EPS

Net earnings $790,000Less: preferred dividend

30,000 x $1.25 (one quarter) (37,500)$752,500

Shares outstanding 600,000Basic EPS $1.25

Diluted EPS, individual effect8% Debentures $216,000 (1 - .4) = $129,600 = $0.74

$2,500,000 x 1/100 x 7 175,000

9.5% Debentures $250,000 (1 - .4) = $150,000 = $1.00$2,500,000 x 1/100 x 6 150,000

$11 Options Shares issued: 200,000Shares retired: (200,000 x $11)/$40 = 55,000

$20 Options Most dilutive alternative used. Backdated to date of issue.Shares issued: 50,000 x 8/12 = 33,333Shares retired: (50,000 x $20) /$40 = 25,000 x 8/12 = 16,667

Preferred Shares (30,000 x $5) x 3/12 = $37,500 = $0.56(backdated to 30,000 x 9 x 3/12 67,500date of issuance)


Basic numbers, above $752,500 600,000 $1.25$11 Options

Shares issued 200,000 Shares retired (55,000)

$20 OptionsShares issued 33,333Shares retired _______ (16,667)

Subtotal 752,500 761,666 $0.99Preferreds

Earnings 37,500Shares 67,500

Subtotal 790,000 829,166 $0.958% Debentures

Earnings 129,600Shares _______ _175,000

$919,600 1,004,166 $0.929.5% Debentures

Anti-dilutive; $1.00 is higher than $0.92Diluted EPS $0.92

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Net earnings from continuing ops. $2,022,800Preferred dividends

175,000 x $1.20 (210,000)400,000 x $2 x 6/12 (400,000)

1,412,800Shares outstanding

2,300,000 x 1/12 191,6671,550,000 x 7/12 904,1671,610,000 x 3/12 402,5001,660,000 x 1/12 138,3331,660,000 + (175,000 x 4) x 0/12 0

1,636,667Basic EPS $0.86

Diluted EPS:Individual effects:1. $2 Preferred shares: backdate to date of issue

Dividend: 400,000 x $2 x 6/12 = $ 400,000Shares: 400,000 x 6 x 6/12 = 1,200,000 = $0.33

2. $1.20 Preferred shares: backdate full year:Dividend 175,000 x $1.20 / (175,000 x 4 shares) = $210,000 / 700,000 = $0.30

3. $5 Stock option share issued – backdatingShares issued: 60,000 x 8/12 = 40,000Shares retired (60,000 x $5)/$15 x 8/12 = 13,333 The average for the first eight months is used because it is more relevant to the backdating.

4. $5 Stock option – remainderShares issued: 140,000 Shares retired (140,000 x $5) / $22 = 31,818

5. $24 stock option – No effect because granted at the end of the year.

6. Convertible bonds:Interest: $281,000 (1-.30) = $196,700Shares ($3,000,000 / $1,000) x 30 = 90,000$196,700 / 90,000 = $2.19 (anti-dilutive)

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Diluted EPS:Basic totals $1,412,800 1,636,667 $0.86

$5 Stock option backdating Shares issued 60,000 x 8/12 40,000 Shares retired (60,000 x $5)/$15 x 8/12 (13,333)

$5 Stock option remainderShares issued 140,000

Shares retired (140,000 x $5)/$22 ________ (31,818)Subtotal 1,412,800 1,771,516 0.80$1.20 Preferred shares, backdating

Dividends 210,000Shares 700,000

Subtotal 1,622,800 2,471,516 0.66$2 Preferred shares

Dividends 400,000Shares 1,200,000

Diluted EPS $2,022,800 3,671,516 $0.55

Convertible bonds at $2.19 are anti-dilutive

EPS presentation:Basic Diluted

Earnings from continuing operations $0.86 $0.55Discontinued operations* (.41) (.18)Net earnings** $0.45 $0.37

* $677,800 / 1,636,667; 3,671,516

** $1,345,000 - $210,000 - $400,000 / 1,636,667$1,345,000 - $210,000 - $400,000 + $210,000 + $400,000 / 3,671,516

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Requirement 2

The company has basic EPS from continuing operations of $0.86. This is the predictive number, since discontinued operations will cease. Basic EPS should be compared to past years and to budget for trend analysis.

Diluted EPS is lower, at $0.55. This means that if contingent claims to common share earnings were to be exercised, common shareholders would each have a lower claim to earnings. In fact, the major dilutive claim, that of the preferred shareholders, was exercised at the end of the year and the dilution is real for the next year. Further dilution may occur with the new preferred shares, and options outstanding, where the option price is lower than average fair market value.

Other claims to common shares are anti-dilutive, which means that investors have higher earnings entitlements in their current form (debt). These entitlements are not included in diluted EPS. hzzled




Net earnings $1,140,000Preferred dividendsClass A must already have been recorded as interest expenseClass B

90,000 x $0.90 ( 81,000)$1,059,000

Shares outstandingBoth common share classes are included; Class B are weighted x 2 because of their higher dividend entitlement.Class A:

500,000 x 2/12 x 3 250,000560,000 x 8/12 x 3 1,120,0001,680,000 x 2/12 280,000

1,650,000Class B:

(50,000 x 2) x 10/12 x 3 250,000(150,000 x 2) x 2/12 50,000

300,000

Total common share equivalents 1,950,000

Basic EPS $0.54

Individual effects:1. Stock option i – backdating

Shares issued: 180,000 x 2/12 = 30,000Shares retired (180,000 x $3.33)/$14 x 2/12 = 7,143The adjusted average for January and February is used because it is more relevant to the backdating.

2. Stock option ii Shares issued: 88,000 x 3 = 264,000Shares retired (88,000 x 3 x $3*)/$12 = 66,000*($9/3)

3. Preferred shares, Class B($0.90 x 90,000)/(90,000 x 2 x 3) = $81,000/540,000 = $0.15; dilutive

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Diluted EPS:Basic totals $1,059,000 1,950,000 $0.54Stock option i; backdating

Shares issued 30,000Shares retired (7,143)

Stock option iiShares issued 264,000Shares retired ________ (66,000)

Subtotal $1,059,000 2,170,857 $0.49Preferred shares

Earnings 81,000Shares ________ _540,000

Diluted EPS $1,140,000 2,710,857 $0.42

EPS disclosure:Earnings per share Class A Class B

Common CommonBasic $0.54 $1.08Diluted $0.42 $0.84

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Basic:Net earnings $18,000,000Preferred dividends 600,000 x $.20 ( 120,000)

$17,880,000Average shares3,300,000 x 12/12 3,300,0003,320,000 (1) x 0/12 0Basic EPS $5.42

(1) 10,000 x 2 = 20,000 shares issued on conversion 31 December 20x6

Individual effect of:

1. Preferred shares $.20 x 600,000 = $120,000 = $.20600,000 600,000

2. Options Shares issued: 500,000 Shares retired: ($53 x 500,000)/$75 = 353,333

3. Debentures [($9,000,000 x .10) + ($20,000 x .9)] (1 - .4) = $550,800 = $3.06 (9,000,000 / 100) x 2) 180,000

4. Debentures, converted

[($1,000,000 x .10) + ($20,000 x .1)] (1 - .4) = $61,200 = $3.06(1,000,000 / 100) x 2) 20,000

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Diluted:Basic, above $17,880,000 3,300,000 $5.42Options

Shares issued 500,000Shares retired _________ (353,333)

$17,880,000 3,446,667 $5.19Preferred shares

Dividends/Shares 120,000 _600,000$18,000,000 4,046,667 $4.45

Actual conversion of debenturesEarnings 61,200Shares 20,000Debentures

Interest; Shares ___550,800 _180,000Diluted EPS $18,612,000 4,246,667 $4.38hzzled



Chapter 20: RestatementsSuggested Time

Case 20-1 Mountain Mines Lubrication Ltd.20-2 Regional Airlines20-3 Lalani Couture20-4 MTC

Assignment 20-1 Overview—types of accounting changes......... 1520-2 Overview—types of accounting changes ........ 1520-3 Overview—types of accounting changes......... 2020-4 Rationale for accounting changes .................... 1520-5 Accounting changes ......................................... 2020-6 Accounting changes ......................................... 2520-7 Change in estimated useful life—entries and

reporting (*W) ......................................... 2020-8 Change in estimate........................................... 2520-9 Accounting changes—inventory and revenue.. 2020-10 Accounting changes: depreciable assets .......... 2020-11 Change in resource exploration costs—

entries and reporting (*W) ....................... 4020-12 Error correction ................................................ 1020-13 Error correction ................................................ 1520-14 Error correction ................................................ 2520-15 Error correction ................................................ 3020-16 Accounting change—bad debts ....................... 2520-17 Change from AC to FIFO—entries and

reporting................................................... 3020-18 Retrospective policy changes........................... 4520-19 Policy changes.................................................. 2020-20 Retrospective policy change ............................ 3020-21 Change regarding construction .......................

contracts (*W).......................................... 3520-22 Change in policy, error..................................... 3520-23 Change in accounting for natural resources ..... 3020-24 Accounting changes, comprehensive (*W)...... 3520-25 Multiple accounting changes ........................... 45

*W The solution to this assignment is on the text Web page and in the Study Guide. The solution is marked WEB.

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Questions

1. This is a change of estimate, in the application of a particular accounting policy. The policy is to have an allowance/accrual for bad debts; the method of calculating the amount is the application of the policy. The change has been caused by a change in economic conditions, which now presumably render sales a better indicator of future bad debt losses.

2. Changes in estimates are common because measurements often are based on future expectations, which cannot be predicted with complete accuracy.

3. A change in accounting estimate is accounted for using the prospective basis; the change affects the current and future periods only. Prior years’ results are unchanged.

4. After 6 years, accumulated depreciation (at $9,000 per year) amounts to $54,000, leaving a carrying value of $46,000. Subtracting the new residual value of $2,000 leaves $44,000 depreciable cost. Dividing by the new estimate of remaining life (5 years) yields Year 7 depreciation expense of $8,800.

5. When there is doubt as to the classification of a change as a policy versus estimate change, accounting standards specifies that the change should be classified as a change in estimate. Since estimate changes are so pervasive, they have the balance of doubt; also, prospective treatment is less radical than retrospective treatment in that it doesn’t change previously-reported figures.

6. A mandatory change in policy is caused by a change in an existing standard or the creation of a new standard. A voluntary change is caused internally in order to improve the usefulness of the financial statements.

7. A voluntary accounting policy change must result in reliable and more relevant information. The difficulty arises in attempting to justify exactly how the change increases relevance while maintaining or improving reliability. Normally, there must be a significant change in financial reporting objectives, often driven by significant changes in ownership, such as from private to public ownership, or vice versa.

8. Reporting objectives often determine choice of accounting policy; if objectives change, it seems logical that policies may be changed as well, to provide better information to users.

9. A change in accounting estimate arises from changes in the enterprise’s environment. Previous estimates are replaced by new estimates on the basis of new or changed information. A change in estimate always is applied prospectively, because the basis of the new estimate could not have been known previously.

In contrast, an accounting error is the result of (1) omissions or misstatements, (2) mathematical errors, (3) incorrect decisions based on available or obtainable

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information, (4) oversights, and (5) mistakes in applying policies. Accounting errors are made inadvertently and must be corrected by retrospective restatement.

10. (i) b (ii) b (iii) b* (iv) c(v) b

* the ability to estimate reliably for the first time indicates that the new contracts are substantially different than the old contracts. The key is in prospective, not retrospective, treatment.

11. An accounting error is accounted for retrospectively with restatement. The cumulative effect of the error as of the beginning of the current year (if any) is recorded as an adjustment to opening retained earnings of that year. All comparatives are restated.

12. Retrospective restatement has the advantage of making current and future financial information fully comparable with past periods. Consistency and comparability are enhanced. It is not required for all changes because the information is not always available, or not available on a cost-effective basis.

13. Under the old policy of expensing development costs, there would be an outflow under “operations”, however disclosed (direct or indirect). Now, since the costs will be recognized as an asset, development costs will be classified as investing activities.The capitalized development costs will be amortized to reduce earnings, but the amortization will be added back to net income under “operations” (indirect method) or ignored as an outflow (direct method).

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Cases

Case 20-1 Mountain Mines Lubrication Ltd.

Overview

MMLL’s bank is the primary user of the financial statements. Mr. Mulholland (the company’s owner) is concerned about the company’s cash flow, so he will want to minimize taxes to conserve cash.

The company has implemented a new revenue recognition policy this year for some of its clients. The new policy has the effect of reducing MMLL’s reported earnings and thus may be contrary to the most important reporting objectives of (1) obtaining additional bank financing and (2) conserving cash. As well, the change seems to have been implemented improperly, resulting in misstated draft financial statements.

MMLL is using estimation methods to determine inventory and cost of goods sold. The appropriateness of the estimating methods should be examined, since they have a direct impact on net income (including taxes payable, and thus cash flow). Since this is a review engagement, the audit firm will not be able to verify unbilled inventory that is being held at customer locations; students must examine the calculations made by management todetermine inventory and cost of sales amounts. Students should be able to identify an inventory understatement that requires correction.

Another issue is the strong possibility of inventory theft, since MMLL doesn’t have effective control of most of the inventory that is out in the field.

Revenue recognition

For three of its customer, MML recognizes revenue on the basis of hours of machine use. The mining machines of these customers have been equipped with meters that measure the number of hours that a machine operates. Each week, the customers advise MML of the meter readings, and MML bills the customer based on the number of hours of use. Revenue is recognized on the basis of the meter readings.

However, the cost of the lubricant is fully expensed when MMLL is notified that a new tub of lubricant has been poured into the machines. As a result, a portion of the cost of thelubricant is recognized before the related revenue is recognized. The result is that cost of goods sold is overstated and inventory understated because too much lubricant is expensed at the time a machine is filled. MMLL should expense only that portion of the cost of the lubricant that has been used since that is the basis of revenue recognition. If 20% of a tub of lubricant has been billed to the customer, only 20% of the cost should be expensed.

1. There are three options possible for revenue recognition: Given the new billing arrangement that MMLL now uses for three of its customers, the company is recognizing revenue only when the lubricant is actually used by the machine in operations. That policy should be followed only if the lubricant still “belongs” to MMLL and is part of MMLL’s inventory. Under this approach, cost of sales should

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only be the portion of lubricant used in the machines; the unused portion should be carried as inventory with the billed but unearned revenue reported as a liability.

2. A second option is for MMLL to recognize revenue when the lubricant is shipped (and the shipment accepted) by the customer. The customer has possession. However, the arrangement seems to be for MMLL’s convenience (to save shipping costs) rather than because the customer actually ordered the quantities that are shipped. Under this circumstance, it seems more appropriate to view the inventory held by customers to be on consignment until poured into the machines.

3. Once lubricant is poured into a machine, the customer clearly has accepted the inventory and it presumably becomes un-reclaimable and non-returnable. Thus, a more cogent argument may be made for recognizing revenue (and cost of sales) as soon as a tub is opened and added to a machine. However, the case data doesn’t enable a quantitative analysis of this option because no data on “tubs shipped” is included—only kgs is given.

If a student chooses the first or second option, the cost of sales is in error and must be adjusted. If a student chooses the second option, both revenue and cost of sales must be adjusted. If the third (and less acceptable) option is chosen, cost of sales requires correction.

Error due to mismatch between revenue and cost of sales

The effect of the mismatched revenue and cost recognition can be estimated from the relative gross margins on a per-unit basis as compared with the income statement for 20X9:

Slip Coat Maximum GuardGross margin/unit (16.00–13.50)÷16.00=15.6% (22.50–18.25)÷22.50=18.9%Gross margin on

income statement 18,067÷136,000=13.3% 31,892÷200,250=15.9%

If the gross margin percentage per product is applied to the reported sales, the extent of the reporting error can be estimated as follows:

20X9 Sales GM% Estimated GMSlip Coat $136,000 15.6% $21,216Maximum Guard 200,250 18.9% 37,847Revised GM estimate $59,063Reported GM 49,959Understated GM & NI $ 9,104

Therefore, under option 1 (the new 20X9 revenue recognition policies), cost of sales should be lowered by $9,104 and pre-tax income should be increased by the same amount. The effective tax rate (from the draft 20X9 income statement) seems to be 27.7% (i.e., $3,500÷$12,650), and thus the net income appears to be understated by $9,104 ×72.3% = $6,585, which would increase net income by 72%, a very substantial difference that can have a significant impact on the bank’s appraisal.

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Change in revenue recognition policy

While it clearly is possible to estimate the error in 20X9 earnings due to the mismatch of revenue and cost, it is not possible (with the data provided) to measure what revenue (and net income) would have been had the previous 20X8 policy had been used. Similarly, it is not feasible to restate 20X8 earnings to reflect the new policy because the company does not have data on customers’ prior-year usage as compared to purchases—the practice of usage measurement is new for 20X9. Therefore, the notes to the financial statements will need to explain the change in policy and note that the new policy recognized revenue at a later point than did the 20X8 policy, and therefore the 20X9 earnings (corrected, as above) will be more conservative (i.e., lower) than if the revenue recognition policy had not been changed.

Reliability of measurements

The new revenue recognition policy relies on customer self-reporting. Without investigating the inventory on hand at the different sites, it is impossible to verify that the usage rates are being properly reported. The salesman seldom visits the mine sites to check the meter readings, so MMLL should consider appointing someone (i.e., a solicitor or insurance agent) in the vicinity of each site to verify the meter reading at or near the end of the year and also check on how much of the year’s shipment still remains on-site.

There also is the issue of meter accuracy. In particular, it seems odd that Scorched Earth is reporting low levels of lubricant when their meter readings have been low. Either they are seriously under-reporting the meter readings or the inventory is being stolen.

IFRS compliance

The bank asks for IFRS-compliant reporting, even though MMLL is a private company. MMLL’s financial statements (as drafted) are compliant with ASPE, but they display no apparent shortcoming as compared to IFRS. The income statement can be relabeled as a “statement of comprehensive income”; MMLL has no other comprehensive income, and thus net income and comprehensive income are the same. The retained earnings portion of the draft statement should be reported in a separate “statement of changes in shareholder’s equity”; however, to make MMLL’s statements consistent with those of the bank’s other clients.

Other issues

MMLL’s year-end inventory levels are quite high at 70% of 20X9 sales, as compared to57% for 20X8. Some of this may be due to the new policy of shipping most of the product early in the following years. However, given the company’s cash flow problems, Mr. Mulholland should re-examine the company’s production policy and try to get the inventory down.

The company is highly dependent on just four customers, and three of those are owned directly or indirectly by Broken Wing Properties. While Broken Wing and its subsidiary companies may be in good health at the moment, MMLL is highly vulnerable to any downturn in Broken Wing’s fortunes as well as to the overall state of the mining industry.

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This fact should be reported in a note to the financial statements. Indeed, one customer owned by Broken Wing (i.e., Scorched Earth) is already in some financial difficulty.

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Case 20-2 Regional Airlines

Overview

Regional Airlines is the wholly owned subsidiary of National Commercial Airlines. All airline companies have been under government scrutiny in the light of increased concentration in the industry and reduced profits. The industry is characterized by significant investment in capital assets, and high-margin business. Profits are dependent on volume and price, which is volatile.

The management incentive program is impacted by RA’s reporting objectives; managers receive bonuses based on income before interest and taxes. The ethical responsibility is for fair presentation, not manipulation for the sake of bonus payments. Management may wish to explore alternate bonus formulae, such as one linked to earnings before interest, taxes, depreciation, and amortization (EBITDA).

Issues

1. Accounting for a change in useful life and residual values.

2. Accounting for change from declining balance depreciation to straight-line depreciation.

Analysis and recommendations

The depreciation of separate parts or components of the aircraft is supported by IAS 16.44-.46.

Estimates are inherent in many financial statement elements. Judgments must be based on reliable, up-to-date information. IAS 16.51 requires that the useful life and residual value of depreciable assets be reviewed at least annually. The international survey indicates that variations and changes in amortization estimates are characteristic of the airline industry. RA’s decision to lower the estimated residual value from 52% to 20% of cost is supported by the survey.

According to IAS 8.32(d), changes in accounting estimates include the useful lives of, or expected pattern of consumption of the future economic benefits embodied in, depreciable assets. Both the declining balance and straight-line depreciation methods are “expected pattern of consumption of the future economic benefit of depreciable assets”, in this case, the aircraft fuselage. As such, all items under consideration by RA are changes in accounting estimates, not changes in an accounting policy. These changes in accounting estimates shall be recognized prospectively in profit and loss (IAS 8.36). RA’s auditors are correct in saying that the entire $2.0 million difference will have to be charged to this year’s income statement.

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Case 20-3 Lalani Couture Limited

Overview

LCL is a private company. The company is profitable, but is not as profitable recently has it had been previously. The shareholders have expressed some concern about the declining profitability.

LCL has a modest level of debt financing. Long-term debt (a private placement) is held by a pension plan, while operating financing is via a bank credit line supported by inventory as collateral. There is no indication that either source of debt financing has any concerns about the company. However, declining profitability could raise some concerns if there is a noticable and/or long-term downward trend.

This case deals with a mixture of operational and reporting issues, including some accounting changes that must be identified. The company does have an auditor and ASPE compliance is a constraint.

1. LCL bought one its suppliers and allocated 40% of the purchase price to Goodwill. After the acquisition, many of the supplier’s other clients left the company and the acquired company became unprofitable. The loss of profitability is a clear indication that the goodwill is impaired, since the only point of goodwill is that it represented enhanced profitability. When the customers disappear, so does the ‘excess’ profitability.

It is possible that the goodwill should be written off and charged against earnings for the current year. If LCL manages to sell the subsidiary to another buyer, a gain can be recognized for any proceeds in excess of the book value of the other assets, but goodwill writedown cannot be delayed until the sale occurs.

2. If LCL negotiates significantly longer terms for its leases, it is possible that the new leases will qualify as capital leases. If they do satisfy the criteria for capital leases, reported long-term debt will increase and earnings probably will decrease due to the combination of imputed interest and asset amortization. The differential reporting options do not provide any relief from capital lease accounting.

More likely, however, the longer leases still will not qualify as capital leases. They will permit longer amortization for leasehold improvements, however, which seems to be one of the intentions of management to improve apparent profitability.

3. The expensing of startup costs is a change in accounting policy. The information for restatement is readily available, and therefore retrospective treatment must be used. The policy change will tend to increase expense and decrease profitability, which is not the result that management desires.

4. LCL is contractually obligated to restore the roofs and buildings to their original condition at expiration of the leases. The company has accounted for the asset retirement obligations, except for one that they overlooked. The obligation relating to

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the “missed” lease must be accounted for by retrospective restatement, as a correction of an accounting error.

In contrast, the revaluation of retirement obligations due to interest rate changes is a change in accounting estimate. Revaluation at a lower interest rate will increase the amount of the obligation, which consequently will increase amortization (partially offset by a lower interest accretion) and lower net income.

5. A change to the taxes payable method is permitted under ASPE. This will be a change in accounting policy. The change must be applied retrospectively.

6. The company didn’t anticipate market demand properly, but they used their best judgement at the time. This is a judgement error, not an accounting error. The opening inventory cannot be restated. The loss on the inventory must be recognized in the 20X9 income statement.hzzled



Case 20-4 MTC

Overview

MTC is a large public company, with significant capital assets. While utilities are usually classified as stable entities, MTC is currently very risky, due to de-regulation of domestic telephone service, competition in long-distance telephone service, and the discovery of fraudulent commodities trading in one division. Stewardship reporting to investors, and the analysts that advise them, is a key corporate reporting objective, and ethicallyrequired. MTC is trying to re-establish credibility with investors, on an operational and ethical level. Investors, of course, are trying to evaluate the performance of the company and its management after poor results and a major trading scandal.

Instructors may wish to point out, when discussing this case, that MTC would be required to follow IFRS even if it were privately held. As a regulated enterprise, MTC is publicly accountable.

Issues

1. Capitalization policies/capital asset valuation.

2. Trading losses in copper inventory.

3. Layoffs.

Analysis

Capitalization policies and capital asset valuation.

In the past, MTC has benefited from a regulated local telephone market. The company has been granted rates based on operating costs plus a set return on the asset base. As a result, the company has always tended to capitalize betterments and replacements, and use long amortization periods for capital assets.

In a deregulated environment, the future benefits of these assets will be questionable. Therefore, MTC must reconsider policies in this regard. Betterments may only be capitalized if they make the assets better by increasing cash flow. This improved cash flow must be proven objectively. Furthermore, depreciation rates and methods must be critically reviewed to see if they properly reflect the new reality. In all likelihood, depreciation periods should be shortened to reflect uncertainties. Since capital assets are significant, changing policies in this area will have a material effect on earnings, likely negative.

Since these new policies are caused by changed circumstances and events, the changes in accounting policy are not treated retrospectively. The new policies will apply prospectively, for the current year and future years. Existing balances will be used as opening balances for new depreciation calculations, etc.

Existing asset balances must, however, be critically reviewed to ensure that they represent probable future cash flows. If there is doubt about their validity as an asset, then they

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must be written down. Assets in the long-distance telephone sector and the local telephone sector must be carefully reviewed to see if there are any overstatements.

The resulting one-time write-down would be in the nature of a restructuring charge, and is a current period charge, not any kind of a retrospective adjustment. The old policies were appropriate for the old environment.

Note that MTC must undertake an actuarial revaluation of their pension plan obligation, given changes to retirement programs. Any increased obligation is recorded as part of the restructuring cost, and is not part of ongoing pension expense.

Since analysts and shareholders are aware of the potential for asset overstatement, and MTC must regain credibility in their eyes, this review of existing balances should be undertaken with a view to conservatism. The restructuring charge will send a powerful signal to the market that the company is cleaning up its act. Since there are already losses in the telephone business this year, the charge will be part of a “big bath” in the current year. Future earnings will rebound more strongly, as amortization charges will be reduced as a result. Of course, other asset accounting policies may mitigate this benefit.

Trading losses in copper inventory.

The trading losses in copper inventory, and the subsequent manipulation of the books were a serious ethical breach that must be avoided again at all costs. The audit committee must institute and monitor controls to ensure that such rogue trading is rendered impossible, and that manipulations of the books are not repeated. Internal control has obviously been weak.

From an accounting perspective, the fraudulently stated inventory is an accounting error that must be corrected on a retrospective basis. Inventory values must be restated to their correct amounts. Net income and net assets will change on a retrospective basis. The adjustment is made net of tax, and affects opening retained earnings in each period for which there is a prior year effect.

Complete note disclosure of the adjustment, and the fraud, is important to create an image of “clean up” and full disclosure.

Layoffs

The cost of the layoff program must be accounted for in the period in which the board of directors approved the program. This will lead to a large one-time restructuring charge on the income statement, represented by a liability to employees on the SFP. As employees are laid off and benefits paid, the liability is reduced.

This will further reduce income this year, and contribute to the “big bath.” In future years, the liability will be re-estimated, and the difference between existing balances and new estimates will be taken into income, either as a further expense or as a recovery.

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The extent of the liability for future layoffs will be very difficult to measure. The liability includes cash payments to employees. Another element is any increase to the pension obligation, which must be determined.

MTC would be well-advised to make a conservative (high) estimate to restore credibility in financial markets, and get all the bad news over with at once. In future years, if the liability is reduced, income of that year will be increased by this change in estimate. This will work to MTC’s subsequent advantage.

All adjustments mentioned would be part of interim reports and projections issued to the financial press.

Is the big bath strategy ethical? It probably sends a positive signal to the market that the company is serious about change and is suitably chastised. There should be no blatant writedowns to manage future earnings, but some well-founded pessimism would not be inappropriate. hzzled



Assignments

Assignment 20-1

Case (event or transaction)

TypeP = Policy

E = EstimateAE = Accounting Error

ApproachRFRRPRPNR

a. Changed from DB to SL depreciation E PNR

b. Switched from cost to revaluation method for capital assets; prior years’ amounts cannot be determined P PNR

c. Changed useful life of a machine E PNR

d. Changed from FIFO to AC; no restatement possible

PRPR; change made in

following year to allow data collection

e. Changed residual value of capital asset E PNR

f. Recorded expense, wrong amount AE RFR

g. Changed from percentage-of-completion to completed-contract for long-term contracts; all prior balances can be reconstructed

P RFR

h. Machinery acquisition charged to land account by mistake

AE RFR

i. Changed from HC to NRV for inventory; opening balance cannot be reconstructed

P PNR

j. Changed from undiscounted to PV for asset retirement obligations AE* RFR

* This is an accounting error, not a change in policy, because asset retirement obligations always have been required to be discounted.

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Assignment 20-2

Case (event or transaction)

TypeP = Policy

E = EstimateAE = AccountingError

ApproachRWRRNR

P

a. Change in useful life of capital asset E P

b. Capital asset incorrectly expensed 5 years previously

AE RWR

c. Changed EPS calculation because of new CICA Handbook rules

P RWR(unless P or RNR

specified in section)

d. Changed amortization method because of information about usage pattern.

E P

e. Changed percentage used to accrue bad debts

E P

f. Delayed recognition of impairment for two years after it became known

AE RWR

g. Inventory policy FIFO to AC; only opening balances can be reconstructed

P RNR

h. Used installment sales when facts indicated cost recovery

AE RWR

i. Began capitalizing development costs because criteria for deferral now met

E(policy is unchanged but judgement about

one criteria has shifted)

P

j. Changed inventory cost method to conform with new standard

PRWR

(if prior years’ data is available)

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Assignment 20-3

Type ofchange

Reportingmethod

Effect ofchange

a. Estimate Prospective Use different depreciation expense in current and future periods

b. Error Retrospective w/full restatement (assuming the amounts are material)

Recalculate depreciation using correct salvage; restate prior periods

c. Policy Retrospective w/full restatement Deferred tax amounts are removed from expense and liability in all prior periods

d. Error Retrospective w/ restatement Correct error and restate inventory and CGS amounts in 20x1 and 20x2

e. Policy, but treated as a change in estimate

Prospective; past amounts not obtainable

Changes revenue recognition point to recognize changes in FV

f. Error Retrospective w/full restatement if possible; otherwise apply in current period without restatement

Begin using new method in current period; disclose the change and restate prior periods, if possible

g. Policy Retrospective to the extent feasible

Changes pattern of depreciation in past and current years

h. Estimate Prospective Asset balance written off in current year; future costs will be expensed until criteria for capitalization are attained in the future

i. Not an accounting change

Prospective This is a new policy being adopted for longer-term contracts not previously used.

j. Estimate Prospective Recognize revenue at point of sale to reflect new economic situation

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Assignment 20-4

The company is changing two significant accounting policies. Both changes must be reported retrospectively.

a. The change to a taxes payable reporting method is a change in accounting policy. As such, it must be reported retrospectively. Future income tax amounts must be removed from both the income statement and the balance sheet for all past reporting periods. Retained earnings will be adjusted for the net cumulative effect of the change.

The change will increase net income and retained earnings because tax effect of the CCA-depreciation temporary difference will be eliminated. Any liability for deferred income taxes will be eliminated. As a result, total liabilities will decline while total shareholders’ equity will increase. The change should enhance compliance with the debt covenants.

b. The company is voluntarily changing from declining balance to straight line. Ordinarily, such a change would be accounted for prospectively, as a change in accounting estimate. However, the company wishes to apply the change retrospectively, which makes it a change in accounting policy.

Changing from declining balance to straight-line will reduce prior years’ depreciation (i.e., increase opening retained earnings and future income tax) and increase current and future years’ depreciation (i.e., decrease current and future earnings). The retained earnings balance will increase, improving the debt-to-equity ratio. Capital assets on the balance sheet will increase, with less accumulated depreciation.

The overall impact of both policy changes would be to improve existing working capital and debt/equity ratios. Accounting policies are clearly being chosen to improve the firm’s position regarding key ratios. Both the existing policies and the alternatives are acceptable under GAAP. The company must be able to justify the new policies as reliable and more relevant. Since relevancy is subjective, this should not be especially problematic.

Indeed, it is quite possible that straight-line amortization is more in line with practices in the industry, given that the vast majority of Canadian companies do use straight-line amortization for their capital assets. Also, eliminating deferred income tax liabilities will better reflect the true credit position of the company since future income tax liabilities are notional amounts and not amounts presently owed to the government.

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Assignment 20-5

a. This is a change in estimate. The increase in discount rate will decrease the amount of the accrued pension obligation. The change in obligation also will affect the over- or under-funded status of the pension fund, as disclosed in the notes.

b. The renewal of the lease means that the obligation to restore the roof has been pushed an additional five years into the future. The asset retirement obligation must be remeasured, using the new longer period. Unless the reduction in present value is fully offset by increased estimated costs of restoration, the obligation will decrease; the reduction in the asset retirement liability will be reported as a gain in operating income and disclosed in a note.

c. An amount of $900,000 (i.e., $3 million × 30%) will be reported in the 20X5 income statement as an income tax benefit (recovery), with an offsetting debit to non-current deferred income tax asset. Details will be disclosed in a note.

d. This is an accounting error that must be accounted for retrospectively. For 20X3, pre-tax expenses should be reduced by $10 million and a capital asset recorded. Depreciation expense would be $2.0 for 20X3 and $1.6 million 20X4. Therefore, after-tax opening retained earnings for 20X4 would be increased by $5.6 million, and opening retained earnings for 20X5 would be increased by $4.48 million. Amortization for 20X5 will be $1.28 million. The details for the two years of restatement are as follows:

Amounts in millions—dr./(cr.) 20X3 20X4

Change in earnings:Operating expenses (10.00) —Depreciation expense 2.00 1.60Net change in earnings, pre-tax (8.00) 1.60 Income tax 2.40 (0.48)Net change in earnings after tax (5.60) 1.12

Change in SFP:Capital assets 10.00 10.00 Accumulated depreciation (2.00) (3.60)Income taxes, deferred (2.40) (1.92)Retained earnings (5.60) (4.48)

The full effects of this error should be disclosed in a note.

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Assignment 20-6

Requirement 1

a. This is an error, as the bond should have been recognized as part debt, and part equity. Interest expense is misstated, and liabilities are misstated, for 20x1, 20x2, 20x3, and 20x4. This correction should be made retrospectively, with restatement.

b. This is the correction of an accounting estimate, as the allowance is understated at the end of the current year. It is fixed prospectively; in this case, all in 20x4 with a higher bad debt expense.

c. This is an accounting error, as an exchange of similar assets with no cash changing hands is accounted for at book value. No gain on the transaction is recognized. Error correction will affect only the current year, 20x4, because this is the year of the transaction.

d. This is a change in estimate—the probabilistic estimate has been changed. The change is applied prospectively by recognizing the future tax benefit in 20X4. The benefit is the $400,000 previously unrecognized carryforward multiplied by the 25% tax rate.

Requirement 2

Income before tax, as currently calculated $ 786,000

Revisions:

a. increase interest expense ($84,000 ÷ 15 years) (5,600)

b. tax benefit from loss carryforward ($400,000 × 25%) 100,000

c. increase allowance for doubtful accounts (26,000)

d. eliminates gain on swap transaction ($325,000 – $233,000) (92,000)

Revised income before income tax $ 662,400

Tax on 20X4 pre-tax earnings ($662,400 × 25%) $165,600Recognized benefit of tax loss carryforward (100,000) 65,600

Revised net income, after tax $ 596,800

Requirement 3

Retrospective adjustment:a. increase interest expense ($84,000 ÷ 15 years) × three years $(16,800)b. none 0c. none 0d. none 0

Total retrospective adjustment (16,800)

Income tax (25%) 4,200

Retrospective effect, after tax $(12,600)

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Assignment 20-7 WEB

Requirement 1

This is a change in estimate; therefore, the prospective approach should be used. Revision of accounting estimates is normal and expected; therefore, their effects should be allocated to the current and future periods.

20x1 20x1–20x4 20x5Analysis:

Cost .......................................................... $24,000 $24,000Amortization to date ................................ ($1,800 × 4 yrs.) (7,200)Residual value.......................................... (6,000) (6,000)To be depreciated ..................................... $18,000 $10,800Annual depreciation (SL):

Ten year life, per year ........................ $ 1,800Life (14 – 4 yrs), per year................... $ 1,080

Requirement 2

No correction or adjusting entry is necessary at the date of change because (under the prospective approach) the unamortized balance is amortized over the remaining life.To record amortization at year-end, 20x5

Amortization expense [$10,800 (14 – 4 years)] .................... 1,080Accumulated amortization, equipment ............................... 1,080

Requirement 3

Comparative balance sheet, 31 December:20x5 20x4

Equipment .................................................................................... $24,000 $24,000Accumulated amortization .......................................................... (8,280)* (7,200)

Net book value ....................................................................... $15,720 $16,800*$7,200 + $1,080 = $8,280

Comparative income statement for year:

Income prior to amortization and tax..................................... $52,800 $49,800Amortization expense ............................................................ (1,080) (1,800)Net income before tax............................................................ $51,720 $48,000

No note disclosure is required because the change is rather ordinary. However, if the company wishes to make disclosures:

Note X: Change in accounting estimate—Effective in 20x5, the company revised the estimated life on equipment. In 20x5, this change in estimated useful life caused net income to be higher than under the prior basis by $720.

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Assignment 20-8

Requirement 1

The change is done prospectively, since it is based on experience.

Existing depreciation: 20x3 $560,000 × 20% ............................................$112,00020x4 ($560,000 – $112,000) × 20% ....................... 89,600

Accumulated depreciation, 1 January 20x5 ......................................................... 201,600New depreciation 20x5 ($560,000 – $201,600) × 30% ....................... 107,520

Accumulated depreciation, 31 December 20x5 ...................................................$309,120

Note that residual values are not relevant until accumulated declining balance depreciation mounts up.

20x5 Entry:

Depreciation expense ..................................................................................107,520Accumulated depreciation..................................................................... 107,520

Using the old rate, depreciation would have been ($560,000–$201,600) × 20% = $71,680

Requirement 2Barker Company

Statement of Comprehensive IncomeFor Year Ended 31 December

20x5 20x4Revenue......................................................................................... $2,800,000 $2,240,000Expenses other than depreciation and tax ..................................... (1,680,000) (1,534,400)Depreciation expense .................................................................... (107,520) (89,600)Net income before discontinued operations and tax ..................... 1,012,480 616,000Income tax expense (25%)............................................................ (253,120) (154,000)Net income from continuing operations........................................ 759,360 462,000Discontinued operations loss, net of $10,000 tax ......................... (30,000) —Net income and comprehensive income ....................................... $ 729,360 $ 462,000

Note: During 20x5, the depreciation rate and residual value on a capital asset were changed based on changed expectations regarding the pattern of use. The change decreased net income by $26,880.* In each succeeding year that the asset is owned and depreciated, the effect on each year’s net income arising from the depreciation change will be reduced by 30%.

*[($71,680 – $107,520) × (1.00 – .25)] = $–26,880 after tax

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Assignment 20-9

Requirement 1

Net income for 20X6 will not be affected by the change when the company prepares its 20X6 financial statements because the accounting policy change doesn’t come into effect until 1 January 20X7. The original statements for 20X6 are prepared on the old sales-based revenue recognition policy. When the 20X7 statements are prepared, the new production-basis revenue recognition policy will be used.

For the 20X7 comparative statements, 20X6 must be restated to show the change of inventory to NRV and the change in revenue recognition point:

Opening 20X6 inventory will increase by $16 million, offset by a credit to future income tax liability of $4 million (i.e., $16 million × 25%) and an increase in opening retained earnings of $12 million.

Ending 20X6 inventory will increase by $22 million, offset by credits of $5.5 million to FIT liability and $16.5 million to ending retained earnings.

Revenue will increase by the net change in inventory NRV value: $22 – $16 million = $6 million. Income tax expense (FIT) will increase by $1.5 million; net income will rise by $4.5 million.

Requirement 2

This change can be applied retrospectively only as far back as reliable information is available about the market value (NRV) of the refined minerals. Management has information for the beginning 20X6 inventory, but it may be more difficult to go back further.

On the other hand, there will be a historical record of mineral prices. Richter also should have a historical record of the composition of past mineral inventories. The inventory is easily sold on the world market and thus reasonable past values should be readily obtainable. Even if some estimation is necessary, it would be better to be approximately correct (in restatement) than completely wrong (by failing to restate).

Richter should be able to apply full retrospective restatement.

Requirement 3

The 20X6 ending balances of retained earnings and of inventory must be restated. In millions:

Inventory of refined minerals .................................................................. 22.0Future income tax liability ................................................................. 5.5Retained earnings............................................................................... 16.5

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Assignment 20-10

Requirement 1

Machine 1: This is a change in accounting estimate, and is accounted for prospectively, beginning in the year that the estimate changed.

Machine 2: This is a change in policy but will accounted for as a change in estimate, under IFRS 8.32(f) and 8.38 (i.e., as a change in “expected pattern of consumption of the future economic benefits”). It will be accounted for prospectively.

Machine 3: This is an error correction, and will be accounted for retrospectively.

Requirement 2

Machine 1: Net book value at the beginning of 20x6:$872,000 × 3/6 remaining years = $436,000

20x6 depreciation: ($436,000 – $0) ÷ (8 – 3) = $87,200

Machine 2: Net book value at the beginning of 20x6:$448,500 × .4 = $179,400; ($448,500 – $179,400) = $269,100

20x6 depreciation: ($269,100 – $0) ÷ (350,000 – 75,000) = $0.98$0.98 × 30,000 = $29,400

Machine 3: ($325,000 – $32,500) ÷ 10 = $29,250

Requirement 3

Machine 1 – None............................................................................... —

Machine 2 – None............................................................................... —

Machine 3 – Decrease in 20x3 machine expense ............................... $(325,000)

Increase in depreciation expense, 20x3, 20x4, 20x5

($325,000 – $32,500) ÷ 10 = ($29,250 × 3 years) ... 87,750

Total ..................................................................................................... $(237,250)

Income tax (25%)................................................................................. 59,313

Retrospective adjustment, after income tax (increase net income)...... $(177,937)

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Requirement 1Gunnard Company

Statement of Comprehensive Income—Successful EffortsFor the Years Ended 31 December

20x5 20x4Revenues ................................................................................. $7,100,000 $4,400,000Expenses:

Resource exploration costs ............................................... 4,700,000 3,200,000Amortization ..................................................................... 200,000 40,000Other ................................................................................. 2,050,000 720,000

Total ........................................................................................ 6,950,000 3,960,000NI before tax ........................................................................... 150,000 440,000Income tax expense (30%)...................................................... 45,000 132,000Net income and comprehensive income ................................. $ 105,000 $ 308,000

Requirement 2

Resource exploration costs to be capitalized ............................ $(3,200,000)Additional amortization expense, 20x4 ($240,000 – $40,000). 200,000Net effect on 20x4 income, pre-tax........................................... $(3,000,000)Additional resource exploration costs, asset, 20x4

($3,200,000 – $200,000)..................................................... $ 3,000,000

Journal entry:

Resource exploration costs (see above) .................................... 3,000,000Deferred income tax liability ($3,000,000 × .3) ................. 900,000Retained earnings, ($3,000,000 × .7) .................................. 2,100,000

[Cumulative effect of accounting change]

Amortization expense, 20x5 ..................................................... 850,000Resource exploration costs ................................................. 850,000

Note: This assumes that the $4,700,000 resource development costs incurred in 20x5, which would have been expensed under SE, have been correctly capitalized. If not, the following entry is needed:

Resource exploration costs (asset) .......................................... 4,700,000Resource exploration expense........................................... 4,700,000

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Statement of Comprehensive Income—Full CostingFor the Years Ended 31 December

20x5 20x4Revenues ................................................................................ $7,100,000 $4,400,000Expenses:

Exploration cost amortization.......................................... 850,000 240,000Other ................................................................................ 2,050,000 720,000

Total ....................................................................................... 2,900,000 960,000NI before tax .......................................................................... 4,200,000 3,440,000Income tax expense (30%)..................................................... 1,260,000 1,032,000Net income............................................................................. $2,940,000 $2,408,000

In 20x5, the Company changed from SE to FC for accounting for resource exploration costs. The change increased 20x4 net income by $2,100,000 and 20x5 income by $2,835,000*. The 20x4 comparative statements are restated to reflect the change.

* Reduced resource exploration costs............................................................ $(4,700,000)Increased amortization expense ($850,000 – $200,000)............................. 650,000Net effect on income................................................................................... (4,050,000)After-tax effect (1 – .30) ............................................................................. $(2,835,000)


Statement of Changes in Shareholders’ Equity—Retained EarningsFor the Years Ended 31 December

20x5 20x4Opening retained earnings, as previously reported ................ $ 308,000 $ —Cumulative effect of accounting policy change, net of

income tax of $900,000.................................................... 2,100,000 —Opening retained earnings, as restated................................... 2,408,000 —Net income............................................................................. 2,940,000 2,408,000Closing retained earnings ...................................................... $5,348,000 $2,408,000

Requirement 5

Under successful efforts, expenditures for exploration costs would be an outflow under the operations section. Under FC, such costs would be an investing outflow. Using the indirect method to present the operations section, the amortization would be a non-cash expense add-back.

The change in policy is not disclosed on the CFS.

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Assignment 20-12

Requirement 1

To correct opening balances:

Deferred lease costs (1)............................................................. 103,000 Retained earnings ............................................................ 103,000

(1) Total rent over 40 years:($45,000 + $20,000 + $10,000 + $2,000) × 10 = $770,000

Annual rent expense = $770,000 ÷ 40 = $19,250Amount paid (and expensed) to end of prior year $45,000 × 4 = $180,000 Amount that should have been expensed $19,500 × 4 = 77,000Correction $103,000

To correct current year:

Deferred lease costs ($45,000 – $19,250)................................. 25,750 Lease expense ................................................................. 25,750

(Entries may be combined)

Requirement 2

Each prior year, 20X0 through 20X3, the company charged $45,000 to expense. The correct allocated cost is $19,250, as determined above. Thus, expense was overstated and earnings understated by $25,750 in each year. In the comparative 5-year summary of financial results, net income should be increased by $25,750 for each of the previous fouryears.

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Assignment 20-13

Requirement 1

20x6 entry to correct error:

Accumulated depreciation ($40,000 × 2 years) ................................. 80,000Deferred income tax liability ($80,000 × 30%) ........................... 24,000Retained earnings, error correction .............................................. 56,000

Requirement 2Cathode Company

Retained Earnings StatementFor the Year Ended 31 December

20x6 20x5Beginning retained earnings, as previously reported .........................$265,000 $180,000Error correction, depreciation, net of $28,000 and $12,000 tax,

respectively (calculations below)................................................. 56,000 28,000Beginning balance restated ................................................................ 321,000 208,000Net income (restated for 20X5) ......................................................... 125,000 173,000 Dividends declared............................................................................. (80,000) (60,000)Ending balance...................................................................................$366,000 $321,000

Calculations:After-tax effect of error on 20x4 income: ($40,000 × 70%) = $28,000Income, 20x5: $145,000 + ($40,000 (for 20x5 error) × 70%) = $173,000

Note: In 20x6, the company discovered that depreciation expense was overstated $40,000 in both 20x4 and 20x5. The 20x5 statements are restated to reflect the correct amount of depreciation. Correction of the error increased previously-reported 20x5 net income by $28,000.

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Assignment 20-14

Requirement 1

No entry is needed to record any correction because the error has self-corrected. The error affected 20x5 and 20x6 financial statements but it is now 20x7.


Income statement—cost of goods sold, as originally stated $790,000 $705,200 $676,800

Overstatement of 20X5 closing inventory — — 3,600Restated cost of goods sold $790,000 $705,200 $680,400

Balance sheet—inventory, restated for 20X5 $ 34,500 $ 30,900 $ 16,100

—retained earnings, restated $414,700 $331,000 $257,200

Simpson Ltd.Retained Earnings Statement

For the Year Ended 31 December 20x7

20x7 20x6 20x5Retained earning statement Opening retained earnings $331,000 $260,800 $211,500 Correction of opening inventory error _____--_ (3,600) _____--_ Opening retained earnings as restated $331,000 $257,200 $211,500 Net income, as previously reported 104,700 91,200 70,300

Correction of 20X5 inventory error (1) — 3,600 (3,600)Net income, restated 94,800 66,700

Dividends (21,000) (21,000) (21,000) Closing retained earnings $414,700 $331,000 $257,200

(1) Reported 20X5 ending inventory .............. $19,700Corrected 20X5 ending inventory ............. 16,100Decrease in 20X5 assets and income ........ $ (3,600)

Requirement 3

Disclosure of the error would include all information to help the financial statement reader understand the impact of the error on the financial statements. This would include the change in inventory and cost of goods sold, as well as net income and retained earnings, for the two comparative years affected.

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Assignment 20-15

Requirement 1

Capital assets............................................................................. 200,000 Retained earnings, 1 January 20x9 (1)............................ 90,000 Deferred income tax ($200,000 – $80,000) × 25%......... 30,000

Accumulated depreciation (1).......................................... 80,000

(1) Annual amortization = $200,000 – $40,000 ÷ 8 = $20,000 Amortization to 1 January 20x9 = $20,000 × 4 = $80,000 Adjustment to RE = ($200,000 – $80,000) × (1 – .25) = $90,000

(current year entry; not required)

Depreciation expense, 20X9 .................................................... 20,000Accumulated depreciation................................................ 20,000

Note: Income tax and future income tax would change as a result of this additional depreciation expense.

Requirement 220X9 20X8 20X7

Income StatementDepreciation expense (all assets) (1) $ 120,400 $ 111,600 $ 112,400

Balance SheetCapital assets (net) (2) $1,316,200 $1,267,600 $1,145,400

Retained earnings statementOpening retained earnings $879,200 $ 905,800 $ 655,800 Error correction (3) 90,000 105,000 120,000Opening retained earnings as restated $969,200 $1,010,800 $ 775,800Net income (loss) (4) (150,700) 26,200 302,800Dividends (67,800) (67,800) (67,800)Closing retained earnings $750,700 $969,200 $1,010,800

(1) Increased by $20,000 in all three years

(2) Increased by $100,000 ($200,000 less $100,000) in 20x9;$120,000 ($200,000 less $80,000) in 20x8; and $140,000 ($200,000 less $60,000) in 20x7

(3) Per entry for 20x9: ($200,000 – $60,000) × (1 – .25) = $105,000 in 20x8, and($200,000 – $40,000) × (1 – .25) = $120,000 in 20x7

(4) Decreased/increased by $20,000 × (1 – .25) = $15,000 each year

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Requirement 3

Disclosure of the error would include all information to help the financial statement reader understand the impact of the error on the financial statements. This would include the change in capital assets, future income tax, depreciation, tax expense, as well as netincome and retained earnings, for all years affected.

Assignment 20-16

Requirement 1

The previous method of accounting for uncollectible accounts was inappropriate because it did not properly apply the matching principle. The costs of uncollectible accounts should be expensed in the period of the sale. Corrections of errors are accounted for on a retrospective basis with restatement so that income is comparable from one year to another.

Alternatively, one can argue that this is a change in policy, as the company is moving to an acceptable industry norm. Such a change would also be accounted for retrospectively with restatement.

Thus, the treatment of the change (retrospectively, with restatement) is identical regardless of the classification choice.

Requirement 2

The effect of the change is calculated effective the beginning of the year of the change, 1 January 20x5.

Retained earnings, 1 January 20x5 ........................................... 860Bad debt expense ($2,475 – $1,810) (see below) ..................... 665

Allowance for doubtful accounts ..................................... 1,525

The data for 20x3 and 20x4 will be used to establish an appropriate percentage of credit sales, since the total of all uncollectible accounts for the two years should already be known. Since there may still be some uncollectible accounts resulting from the 20x5 sales, the data for 20x5 will not be considered. The percentage of sales expected to be uncollectible is 1.1%, calculated as follows:

Total credit sales for 20x3 and 20x4......................................... $250,000Total write-offs for 20x3 and 20x4........................................... $2,850*Less: recoveries for 20x3 and 20x4 ......................................... (100)**Net write-offs for 20x3 and 20x4.............................................. $ 2,750Write-offs as percent of credit sales ($2,750 ÷ $250,000)........ 1.1%

* ($550 + $650 + $750 + $900)** ($10 + $30 + $20 + $40)

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Therefore, the following adjustments are needed:

YearCreditSales Bad Debts 1.1%

Net write-offs Previously Recorded Adjustment

20x3 $100,000 $1,100 $ 540 $ 56020x4 150,000 1,650 1,350 30020x5 225,000 2,475 1,810 665

$1,525

(Students may also develop percentages based on individual years. This is an acceptable alternative approach.)

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Assignment 20-17

Requirement 1

This is a change in accounting policy because the method of inventory costing is being changed to conform to industry practice. The retrospective approach with restatementmust be used. This approach means that (a) an entry must be made for the retrospective effect at the beginning of the year of change, (b) the comparative statements must be restated to the new basis to be comparable, and (c) the beginning balance of retained earnings for all years reported must be adjusted for any change effect prior to those years.

Requirement 2

1 January 20x5 (year of change), to record the retrospective effect:

Inventory (adjust to beginning FIFO basis: $70,000–$40,000) 30,000Deferred income tax liability ($30,000 × 30%) .................. 9,000Retained earnings, adjustment due to accounting change [$30,000 × (100% – 30%)] .......................................... 21,000

All the change relates to 20x4, since opening 20x4 FIFO and AC inventories are identical.

Requirement 3FIFO Basis

20x5 20x4Comparative balance sheet:

Inventory, FIFO................................................................... $ 76,000 $ 70,000Retained earnings (below) .................................................. 169,000 157,000

Comparative income statement:Net income:

(20x5, given; 20x4, restated, $80 + $21(Req.1)) .......... $82,000 $101,000Earnings per share (10,000 shares) ..................................... $ 8.20 $10.10

Comparative retained earnings statement:Beginning balance (20x4, given), as previously reported... $136,000* $120,000Cumulative effect of accounting change............................. 21,000 0

Beginning balance restated ........................................... 157,000 120,000Net income (FIFO basis from above).................................. 82,000 101,000Dividends declared and paid (given) .................................. (70,000) (64,000)Ending balance.................................................................... $169,000 $157,000

* 31 December 20x4 RE balance, as previously reported = $120,000 + $80,000 –$64,000 = $136,000.

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Assignment 20-18

Situation 1

The inventory policy change is accounted for retrospectively:

Retained earnings, 1 January 20x7 ........................................... 416,250Deferred income tax ................................................................ 138,750

Inventory (opening) ......................................................... 555,000

* Opening inventory; ($2,655,000 – $2,100,000) = $555,000 RE = $555,000 × 75% = $416,250 FIT = $555,000 × 25% = $138,750

Situation 2Linfei Ltd.

Statement of Changes in Equity—Retained EarningsFor the Year Ended 31 December 20x7

20x7 20x6Opening retained earnings, 1 January, as previously reported ......................................................................................$4,365,000 $4,010,000Cumulative effect of a change in accounting principles (1) ........ (416,250) (300,000)Opening retained earnings, as restated......................................... 3,948,750 3,710,000Net income (2) ............................................................................. 1,375,000 448,750Dividends ..................................................................................... (235,000) (210,000)Closing retained earnings, 31 December .....................................$5,088,750 $3,948,750

(1) 20x7, per entry above: ($2,655,000 – $2,100,000) × 75% = $416,250

20x6: ($2,600,000 – $2,200,000) × 75% = $300,000

(2) 20x7: $1,600,000 – ($145,000* × 75%) = $1,600,000 – $108,750) = $1,491,250

20X6: $565,000 – ($155,000* × 75%) = $565,000 – $116,250 = $448,750

Changes in inventory values and CGS:20x7 20x6

Opening Ending Opening Ending

WA $2,100,000 $2,600,000 $2,200,000 $2,100,000FIFO 2,655,000 3,300,000 2,600,000 2,655,000Incr.(decr.) (555,000) (700,000) (400,000) (555,000)*Change in CGS, pre-tax $145,000 $155,000 Change after 25% tax $108,750 $116,250

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Situation 3Linfei Ltd.

Statement of Changes in Equity—Retained Earnings For the Year Ended 31 December 20x7

20x7 20x6Opening retained earnings, 1 January, as previously reported ......................................................................................$4,365,000 $4,010,000Cumulative effect of a change in accounting principles ............. (416,250) –Opening retained earnings, as restated......................................... 3,948,750 4,010,000Net income .................................................................................. 1,375,000 565,000Dividends ..................................................................................... (235,000) (210,000)Closing retained earnings, 31 December .....................................$5,088,750 $4,365,000

Situation 4

Depreciation expense, 20X7 .................................................... 19,978Accumulated depreciation................................................ 19,978

Change in depreciation method accounted for prospectively because based on usage information (revision of pattern)

Book value, beginning of 20x7:($400,000 × 20%) = $80,000; ($400,000 – $80,000) × 20% = $64,000($400,000 – $144,000) × 20% = $51,200; $400,000 – $195,200 = $204,800

New depreciation: ($204,800 – $25,000) ÷ (12 – 3) = $19,978

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Assignment 20-19

Case A


Investments ($450,000 – $400,000).......................................... 50,000 Unrealized holding gains, 1 January 20x3 .................... 50,000

To record increase in current year:

Investments ($466,000 – $450,000).......................................... 16,000 Unrealized holding gains .............................................. 16,000

Case B


Shareholders’ equity—unrealized holding gains($1,600,000 × 60%) ............................................. 960,000

Unearned revenue ............................................................... 960,000 In the current year, sales on the receivables of $2,355,000 have been recorded and should not have been; sales for the opening accounts receivable have not been recorded and should have been. This affects sales and cost of sales:

Sales ($2,355,000 – $1,600,000) ............................................. 755,000 Cost of sales (40%) ......................................................... 302,000 Unearned revenue ........................................................... 453,000

This brings the unearned revenue account to the balance of $960,000 + $453,000 = $1,413,000. This is the correct balance for the end for the year: ($2,355,000 × 60%) = $1,413,000.

Another approximation is as follows, although it is less desirable as it does not show sales and cost of sales separately:

Gross profit .............................................................................. 453,000 Unearned revenue ($1,413,000 – $960,000)........................ 453,000

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Assignment 20-20

Armstrong LimitedRetained Earnings Statement

For the Year Ended 31 December 20x720x7 20x6

Opening retained earnings, 1 January, as previouslyreported (1) ............................................................................. $563,000 $318,000

Cumulative effect of a change in accounting principles (2) ........ ( 4,900) (2,800)

Opening retained earnings restated .............................................. 558,100 315,200

Net income (3) ............................................................................. 125,000 252,900

Dividends ..................................................................................... (14,000) (10,000)

Closing retained earnings, 31 December ..................................... $669,100 $558,100

(1) 20x7: ($56,000 + $65,000 + $216,000 + $255,000) – ($5,000 + $7,000 + $7,000 + $10,000);

20x6: ($56,000 + $65,000 + $216,000 ) – ($5,000 + $7,000 + $7,000)

(2) 20x7: [($91,000 - $84,000) (1 – 30%)]; inventory and retained earnings are lower20x6: [($56,000 - $52,000) (1 – 30%)]; inventory and retained earnings are lower

(3) 20x7: given. 20x6: $255,000 less $2,100 ($4,900 – $2,800)

Alternatively, 20x6, increase in AC inventory $35,000 ($91,000 versus $56,000) Increase in FIFO inventory, $32,000 ($84,000 – $52,000). After-tax differential between the two methods is $2,100: [($35,000 – $32,000) (1 – 30%)].

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Requirement 1

This is a change in accounting principle to conform with industry practices, from completed-contract to percentage-of-completion. It should be applied retrospectively with restatement.

Requirement 2

Construction in progress inventory ($195 – $180) ............................ 15,000Deferred income tax liability (1) ................................................ 6,000Retained earnings: cumulative effect of change in accounting principles (1)............................................................................. 9,000

(1) CC Income, 20x3-20x6: ($60,000 + $120,000) ......................... $180,000PC Income, 20x3-20x6: ($40,000 + $65,000 + $50,000 + $40,000).................................................................................... 195,000Increase in net income ................................................................ 15,000Tax effect (40%)......................................................................... 6,000Impact on retained earnings........................................................ $ 9,000

Requirement 3KLB Corporation

Retained Earnings StatementFor the Year Ended 31 December 20x7

20x7 20x6Opening retained earnings, 1 January .......................................... $440,000 $320,000Cumulative effect of a change in accounting principle (2) .......... 9,000 57,000Opening retained earnings, as restated......................................... 449,000 377,000Net income (1) ............................................................................. 160,000 92,000Dividends ..................................................................................... (20,000) (20,000)Closing retained earnings, 31 December ..................................... $589,000 $449,000

(1) CC income, 20x6 .................................................. $120,000PC income, 20x6................................................... 40,000Decrease in income ............................................... 80,000Tax effect (40%) ................................................... 32,000Change in 20x6 income ........................................ 48,00020x6 income, as reported ...................................... 140,000Revised 20x6 income............................................ $ 92,000

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(2) Cumulative effect (increase) ................................. $ 9,00020x6 effect (see #1) (decrease) ............................. 48,000

$57,000

Proof: CC income 20x3-20x5 ..................................................................... $ 60,000PC income, 20x3-20x5 ($40,000 + $65,000 + $50,000).................. 155,000Increase in income............................................................................ 95,000After tax (1 – 40%)........................................................................... $ 57,000

Requirement 4KLB Corporation

Retained Earnings StatementFor the Year Ended 31 December 20x7

20x7 20x6Opening retained earnings, 1 January, as previously

reported................................................................................. $440,000 $320,000Cumulative effect of a change in accounting principles .............. 9,000 —Opening retained earnings, as restated......................................... 449,000 320,000Net income................................................................................... 160,000 140,000Dividends ..................................................................................... (20,000) (20,000)Closing retained earnings, 31 December ..................................... $589,000 $440,000

Requirement 5

If it were impossible to restate any opening balances, the change would be made in 20X8. Information could then be gathered to restate closing 20X7 (opening 20X8) balances and the change would be accounted for prospectively in 20X8 with no restatement of opening balances.

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Assignment 20-22

Requirement 1– 20X4 net income

Unadjusted income before taxes ....................................................................... $660,000Change in inventory from FIFO to average cost (1) ......................................... 42,000Change in depreciation expense (2b) ................................................................ 40,000Adjusted income before taxes........................................................................... 742,000Less: income taxes @ 30% .............................................................................. 222,600Net income........................................................................................................ $519,400

Requirement 2 – Retained earnings section with adjustments

TXL CorporationStatement of Changes in Equity—Retained Earnings

For the year ended 31 December 20x4

Balance, beginning of year, as previously stated ..............................................$3,600,000Change in accounting policy, net of tax of $5,400 (3)...................................... (12,600)Correction of error, net of tax of $162,000 (4) ................................................. (336,000)Correction of 20x3 depreciation, net of tax of $12,000 (2a)............................. 28,000Balance, beginning of year, as restated ............................................................. 3,279,400Net income........................................................................................................ 404,600Dividends declared (5) ...................................................................................... (300,000)Balance, end of year ..........................................................................................$3,384,000

Computations:

1. Increase in inventory under FIFO($486,000 – $480,000) ..................................................................... $ 6,000

Increase (decrease) in inventory under AC($510,000 – $462,000) ..................................................................... (48,000)

Increase (decrease) in cost of goods sold under AC.................................. $(42,000)

2a. 20x3 Depreciation was recorded as($3,000,000 – $360,000) ÷ 12 years................................................. $220,000

20x3 Depreciation should have been recorded as($3,000,000 – $360,000 – $480,000) ÷ 12 years.............................. 180,000

Decrease in depreciation expense.............................................................. 40,000Less: tax effect 30% ................................................................................. 12,000After tax adjustment .................................................................................. $ 28,000

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2b. 20x4 Depreciation was recorded as($3,000,000 – $360,000) ÷ 12 years................................................. $220,000

20x4 Depreciation should have been recorded as($3,000,000 – $360,000 – $480,000) ÷ 12 years.............................. 180,000

Decrease in depreciation expense (increase in earnings) .......................... $ 40,000

3. Inventory under FIFO at beginning of 20x4.............................................. $480,000Inventory under average cost at beginning of 20x4................................... 462,000Decrease in inventory and retained earnings ............................................. 18,000Income tax savings @ 30% ....................................................................... 5,400Decrease in retained earnings, net of tax................................................... $ 12,600

4. Government grant included in 20x3 income ............................................. $480,000Less: Tax effect @ 30% ........................................................................... 144,000After-tax adjustment.................................................................................. $336,000

5. $270,000 – $60,000 + $90,000.................................................................. $300,000

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Assignment 20-23

Requirement 1— Entry to record accounting change, 20x6:

Natural resources............................................................................. 69,000Retained earnings, effect of accounting change (1)................. 48,300Deferred income tax liability................................................... 20,700

(1)Total difference in pretax income for the two methods for 20x3-20x5 is $69,000 (FC has higher income). $48,300 = $69,000 × 70%.

Requirement 2 Black Oil Company

Statement of Changes in Equity—Retained EarningsFor Years Ended 31 December

20x6 20x5 20x4Beginning balance, as previously reported ...................... $ 93,000 $ 69,000 $ 54,000Cumulative effect of accounting change, net of $20,700,

$11,700, and $9,000 tax .............................................. 48,300 c 27,300 b 21,000 a

Beginning balance restated .............................................. 141,300 96,300 75,000Net income (after 30% tax).............................................. 126,000 73,500 52,500Dividends ......................................................................... (36,000) (28,500) (31,200)Ending balance.................................................................$231,300 $141,300 $ 96,300

a $21,000 = [$30,000 (1 – 30%)] after tax income difference for 20x3b $27,300 = [$39,000 (1 – 30%)] after tax income difference for 20x3-20x4c $48,300 = [$69,000 (1 – 30%)] amount from entry covering all years affected

Note: The company changed from the successful efforts to the full costing method of accounting for oil exploration costs in 20x6. The after-tax effects of the change on income are as follows:

The natural resources asset increased by $129,000 in 20x6, $69,000 in 20x5, and $39,000 in 20x4. Effect of change on net income:

20x6 20x5 20x4Increase in net income ................................................. $42,000 a $21,000 b $6,300 c

a $42,000.................................... = ($180,000 – $120,000) (1 – 30%)b $21,000.................................... = ($105,000 – $75,000) (1 – 30%)c $6,300...................................... = ($75,000 – $66,000) (1 – 30%)

Requirement 3

Under SE, all development expenses for unsuccessful properties would be reflected inoperations, either directly, listed as a cash outflow under the direct method of presentation, or indirectly, as part of net income under the indirect method of presentation. Under FC, the expenditures would be shown as an outflow under the investing activities section.

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Assignment 20-24

Requirement 1

Revised net income:Income before income tax, as previously calculated.................... $600,0001. Correction to depreciation:

Recorded depreciation:20x6 ($200,000 × 40%) = $80,00020x7 ($120,000 × 40%) = $48,000

Correct depreciation20x6 ($230,000 × 40%) = $92,00020x7 ($138,000 × 40%) = $55,200

20x7 correction ($55,200 – $48,000)............................... (7,200)2. Correction to construction income:

Actual revenue: none in 20x6 or 20x7Correct income................................................................. 2,500,000

20x6: {[$8 ÷ ($8 + $12)] × [$30 – ($8 + $12)]} = $4,000,00020x7: {[$13 ÷ ($13 + 7)] × [$30 – ($13 + $7)]} = $6,500,000

$6,500,000 – $4,000,000 = $2,500,0003. Income from equity-accounted investments:

Income percentage: 19% of $25,000................................ 4,750

Corrected income before income tax ........................................... $3,097,550Income tax – 40% ........................................................................ (1,239,020)Income tax reassessment (recorded in current year) .................... (29,600)Corrected net income after tax ..................................................... $1,828,930

Requirement 2EC Construction Limited

Statement of Changes in Equity—Retained Earnings For the Year Ended 31 December 20x7

20x7Opening retained earnings, 1 January, as previously

reported (1) ........................................................................... $2,400,000Cumulative effect of a change in accounting policies (2)............ 2,392,800 Opening retained earnings, restated ............................................. 4,792,800Net income (3) ............................................................................. 1,828,930Dividends (4) ............................................................................... (300,000)Closing retained earnings, 31 December ..................................... $6,321,730

(1) given(2) depreciation, [($92,000 – $80,000) × (1 – 40%)] (decrease to RE)

plus construction contract, [$4,000,000) × (1 – 40%)] (increase to retained earnings)(3) per requirement 1(4) 100,000 × $3

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Assignment 20-25

Requirement 1

(1) Depreciation estimate change

20x6 depreciation before change in estimate:

($350,000 – $50,000) ÷ 20........................................................... $15,000

20x6 depreciation after change in estimate:

Total depreciation through 31 December 20x5:4 × $15,000 = $60,000

Book value, 1 January 20x6 = $350,000 – $60,000 = $290,00020x6 depreciation = ($290,000 – $200,000) ÷ (14 – 4) ............... 9,000

Effect of estimate change on pretax 20x6 income ............................. $ 6,000

20x6 entry:

Depreciation expense ......................................................................... 9,000Accumulated depreciation............................................................ 9,000

(2) Change from FIFO to weighted average

This was a voluntary change in accounting policy. Preferably, the change should bedelayed until 20X7, as 20X6 closing inventory will then be available under both methods.If the company’s stakeholders would benefit significantly from immediate application, then only the ending inventory would be restated to WA:

Cost of sales ....................................................................................... 10,000Inventory ..................................................................................... 10,000

This adjustment will decrease income tax by $3,000 and 20X6 net income by $7,000.

(3) Staff Training Costs

Costs incurred through 31 December 20x5:($100,000 + $60,000) .................................................................. $160,000

Amortization through 31 December 20x5:($100,000 × 3/3) + ($60,000 × 1/3) ............................................ 120,000

Decrease in retained earnings due to accounting change, before tax. $ 40,000

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20x6 Entry to record accounting policy change:

Deferred income tax liability ($40,000 × 30%) ........................... 12,000Retained earnings [$40,000 × (1 – 30%)] .................................... 28,000

Deferred staff training costs ................................................... 40,000

20x6 Entry to record expenditures:

Staff training costs ....................................................................... 45,000Cash........................................................................................ 45,000

Effect on net income: 20x6 20x5

Expense, old method.................................................................... $35,000 1 $53,333 2

Expense, new method .................................................................. 45,000 60,000Increase (decrease) in income, before income tax ............................. (10,000) (6,667)Increase (decrease) in net income, after income tax (1 – 30%) ......... $(7,000) $(4,667)

1($60,000 × 1/3) + ($45,000 × 1/3)2($100,000 × 1/3) + ($60,000 × 1/3)

(4) Patent amortization error correction

Correct patent amortization through 31 December 20x5 ($510,000 ÷ 5 × 2).... $204,000Amortization erroneously recorded through 31 December 20x5:

($510,000 ÷ 20) × 2 = .................................................................................. 51,000Total error, before income tax............................................................................ $153,000Total error, after income tax (70%) ................................................................... $107,100

Years 20x4 and 20x5 are affected equally by the error, i.e., income in both years was increased $76,500 before tax and $53,550 after tax.

20x6 entry to correct error:

Retained earnings, error correction, patent amortization ................... 107,100Deferred income tax asset ($144,000 × 30%).................................... 45,900

Patent ........................................................................................... 153,000

20x6 entry to record patent amortization:

Patent amortization expense ($510,000 ÷ 5)...................................... 102,000Patent............................................................................................ 102,000

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Requirement 2Zealand Company

Statement of Changes in Equity—Retained Earnings For Years Ended 31 December

20x6 20x5Beginning balance, as previously reported .................................. $489,000 $319,000Error correction, patent amortization, net of income taxes

of $45,900 and $22,950 (i.e., $76,500 × 30%) ...................... (107,100) (53,550)Change in accounting policy for staff training costs, net of

$12,000 and $10,000 tax........................................................ (28,000) (23,333)Beginning balance, as restated ..................................................... 353,900 242,117Net income................................................................................... 335,000(1) 161,783(2)Dividends ..................................................................................... (70,000) (50,000)Ending balance............................................................................. $618,900 $353,900

(1) given; $335,000.(2) $161,783 = $220,000 – $53,550 (effect of error on 20x5 income) – $4,667 (effect of

staff training policy change)

Note: During 20x6, the company changed the estimated useful life and salvage value on a capital asset on the basis of new information. The change increased 20x6 net income by $4,200 ($6,000 × 70%).

Note: During 20x6, the company changed its accounting policy for certain staff training costs from deferral to immediate write off. This change has been made as the result of a change in accounting standards pertaining to internally-generated intangible assets. The accounting change decreased 20x6 net income by $7,000 and decreased 20x5 net income by $4,667.

Note: During 20x6, the company discovered an error which understated patent amortization expense in 20x4 and 20x5. The 20x5 statements are restated to reflect the correct amortization expense. The error decreased 20x5 net income by $53,550[($102,000 – $25,500) × 70%].

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© 2011 McGraw-Hill Ryerson Ltd. All Rights Reserved.Solutions Manual to accompany Intermediate Accounting, Volume 2, 5rd edition 21-1

Chapter 21: Financial Statement Analysis

Suggested TimeCase 21-1 Peterson Products Limited

21-2 Forest Industry

Assignment 21-1 Horizontal and vertical analysis—income statement.... 2021-2 Horizontal and vertical analysis—balance sheet (*W) . 2521-3 Horizontal and vertical analysis—balance sheet........... 3021-4 Ratio interpretation ....................................................... 2521-5 Vertical and horizontal analysis .................................... 3521-6 Ratio interpretation ....................................................... 1521-7 Compute and explain profitability ratios ...................... 2521-8 Ratio analysis ................................................................ 2521-9 Ratio analysis; liquidity and efficiency......................... 2021-10 Compute and summarize significance of ratios (*W)... 3521-11 Selected ratios ............................................................... 1521-12 Profitability and solvency ratios, competing

Companies............................................................. 2021-13 Competing companies, continuation............................. 2021-14 Leverage—sell share capital versus debt, analysis ....... 3021-15 Comparative analysis .................................................... 3021-16 Investment analysis ....................................................... 3021-17 Recasting, selected ratios .............................................. 3021-18 Integrative problem, chapters 17-21 (*W) .................... 35

*W The solution to this exercise/problem is on the text Web site andIn the Study Guide. The solution is marked WEB.

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21-2 Solutions Manual to accompany Intermediate Accounting, Volume 2, 5rd edition

Questions

1. Three users and decisions that may rest on financial statement analysis: An investor, buying or selling shares. A lender, issuing or recalling debt, or pricing debt. A supplier, deciding whether or not to extend trade credit.

A wide range of possible answers are acceptable.

2. A potential investor is deciding whether to invest capital in an enterprise; an existing investor is concerned with comparing his or her investment to its current (exit) value and the results of terminating an existing relationship.

3. Financial analysts and other financial statement users examine the summary of accounting policies because it contains information fundamental to understanding, interpreting, and evaluating the financial data in the financial statements. It explains the accounting policies used by the business, and the objectives implicit in those choices.

4. Disclosure of accounting principles may not be meaningful (e.g., disclose a policy that does not involve choice), vague or lacking numeric values (no detail). Other key policies may not be disclosed at all.

5. To recast financial statements is to revise the statements to reflect different policies or estimates. It is done to improve comparisons, make information more relevant and/or reliable, or otherwise tailor the financial statements to a particular user’s needs.

6. Vertical analysis involves the expression of each item on a financial statement as a percent of the base, which is one specific item on the statement. The emphasis is on their relative importance. The base amount, representing 100 per cent, is divided into each component item to derive the component percentages. The base amount is typically net sales on the income statement and total assets on the balance sheet.Horizontal analysis involves developing percentages indicating the proportionate change in each financial statement item over time. Usually, the earliest period is designated as the base period. Horizontal percentages emphasize trends.

7. Return on assets may be desegregated into two ratios, operating margin and asset turnover:

EBIT × Revenue = EBITRevenue Average assets Average assets

Operating margin is a measure of earnings as a portion of revenue, while asset turnover is a measure of revenue in relation to assets: an activity measure.

Companies can maximize ROA by increasing sales volume (asset turnover) or profitability (operating margin). High volume, low profit-per-dollar-of-sales companies can earn high ROA’s, as can low volume, (relatively) high profit combinations.

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8. Return on assets is the ratio, or percent, of income (plus after-tax interest) to total assets. It is significant because it incorporates the relationship between income and total assets used to earn that income.

9. On average, a receivable is 24 days old before being collected. This reveals the effectiveness with which (a) credit is granted and (b) collections are made. This amount should be evaluated in light of the terms of sale and existing credit conditions. If terms are 30 days, the ratio of 24 days looks satisfactory. The age of receivables of 24 means that credit sales are approximately 15 times the average balance in accounts receivable (365 ÷ 24 = 15.2).

10. An inventory turnover of 9 indicates that average inventory was “turned over” or sold an average of nine times during the period being evaluated (usually a year). In order to interpret these figures, we need to look at the average for the industry and try to determine whether the “average” inventory is indicative of the inventory level throughout the year.

11. a) The leverage factor for a company with debt financing is positive if the rate of return on total assets is higher than the rate of interest paid on debt (net of tax).

b) The leverage factor for a company with debt financing is negative if the rate of return on total assets is less than the rate of interest paid on debt (net of tax).

c) The leverage factor for a company with debt financing is zero if the rate of return on total assets and the rate paid on debt are equal. (leverage is also zero when there is no debt.)

12. The amount of working capital is identical for each company (i.e., $200,000); however, the current ratio for Company X is 3 to 1, whereas for Company Y it is 1.29 to 1. This is a clear-cut example of the importance of the current ratio, since the current ratio reveals a condition which is significant but is not evident from looking at the absolute dollar amount of working capital.

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Cases

Case 21-1 Peterson Products Limited

Dear Investor,

I have just completed my review of PPL’s financial statements, and I am prepared to give you my advice regarding your potential purchase of PPL’s non-voting shares.

Before I begin my analysis, I believe that it is important to remind you what you are getting with non-voting common shares. You will exercise no control over company policy because you will not have voting rights. Since you have the right to have your shares redeemed for cash at net book value per share, PPL would classify this investment as a debt obligation. However, the dividend payments are still at the discretion of the board of directors. You must remember that this is a tightly-held family company, and your investment is subject to the whims and decisions of the management regarding accounting policies that could affect the future net book value. Therefore, your investment in terms of dividends and exit price is risky.

Ratios based on unadjusted financial statements are shown in Exhibit 1, and seem to compare well with industry norms.

In this analysis, deferred income tax is reclassified from debt to equity, because deferred income tax arises due to temporary differences between tax and accounting revenue. The primary difference is due to the development costs which the company expenses entirely in the year of occurrence for tax purposes, but expenses over five years for accounting purposes. Since this company is a going concern, and development costs are constantly taking place, this deferredincome tax will probably never have to be paid. Thus, the reclassification into shareholders’ equity, since these amounts just increase the value to the shareholders.

This reclassification should also be important should the time ever come for you to redeem your shares. This amount is not included in the shareholders’ equity; thus, you will not receive the value when determining the net book value of the shares. If deferred income tax remainssubstantial, you will be missing out on some added value, and there really is nothing you can do about it.

However, several factors make these financial statements and their resulting ratios misleading:

1. LeasesThere is debt missing from the balance sheet. This is attributed to the leases with Imaginative Rental Services. IRS is a company owned and controlled by the president of PPL. They buy the equipment that PPL needs, and then rent it to them. This is known as off-balance sheet financing, and it is a way of eliminating the debt from the books of the parent company. Instead, all PPL shows on its books are the rental payments of $354,000 ($29,500 × 12) per year that are hidden in contract costs. If PPL purchased the assets directly rather than through IRS Ltd., they would have spent $1,433,000 in 20x7. Probably, they would have had to borrow the money (or issue shares). This would have had a drastic

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impact on the debt: equity ratio and they would not have looked as good relative to other companies.

The operating leases also affect their return on asset ratio, which currently does not reflect leased assets. PPL’s asset base was lower than it should be, thus lowering the denominator of the asset turnover ratio, thus increasing the return on assets.

2. RevenuePPL recognizes revenue on subcontracted jobs when the contracts are signed, as operating risks are transferred to the subcontractors. This is aggressive revenue recognition, and may not be an industry norm. This may have an even greater impact on future earnings, as the portion of these contracts grows.

3. Development costsThe company expenses its development costs over 5 years, instead of expensing all of it in the year in which they occur. Even though the statements are audited, the capitalization of these costs is a management decision. If they feel that there is a proven market for developed products, and thus an expected future benefit, then they can decide to capitalize the development costs. Each company can make this decision at their own discretion and can be more or less optimistic. Therefore, we have to be cautious when comparing companies.

This policy has a negligible effect if development expenses are constant, as amortization would be equal to expenditures. When development expenditures grow, however, the expense of amortization understates the cash outlay by the company. This is the case for PPL; the cash flow statement indicates that $778,000 was spent but only $183,000 of amortization was recognized.

Since we are not sure how development costs are treated throughout the industry, we really can not be sure of our comparison of operating margins.

4. Gain on asset salesThe sale of the assets for a gain to a related party which will rent it back to them is artificial and should be excluded when comparing recent performances and performance against other such companies. In fact, the GAAP treatment of such gains is to exclude them from income and amortize them over the life of the lease, if the lease is a capital lease. PPL avoids this requirement by using operating leases, which is slightly misleading, since PPL has a long-term commitment to use these assets.

Recalculations, using various assumptions, are shown in Exhibit 2. Ratios do not look good compared to industry averages when adjusted.

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The cash flow position is not as strong as you have indicated. First, the cash flow from operations is the relevant figure, as most of the remaining cash flow comes from selling capitalassets to the leasing company. Cash flow from operations is only $528. However, PPL spent $778 on development costs during the year, so in fact had negative cash flows from its regular operations.

In conclusion, it is my recommendation to hold off on your purchase of PPL’s non-voting common shares. There are two reasons for this: your lack of control as an investor, and the obvious “window dressing” that has been adopted to manage the appearance of the financial statements. In light of the analysis, the investment is not as good as it seems.

Exhibit 1 Ratio analysis

20x7 20x6 Industry

Debt*: equity 0.17 0.57 0.67Operating margin 17% 19.5% 6%Return on assets, after income tax 12.7% 11.7% 10%

* Deferred income tax liability reclassified from debt to equity.

Exhibit 2 Recalculated Ratio Analysis

20x7 Industry

Debt:equity 1.85 0.67Operating margin negative 6%Return on assets negative 10%

Debt: $487 + $1,433 + $1,385 (capital assets for past two years) = $3,305 (could also capitalize lease payment as a perpetuity)

Equity: $915 + $600 + $1,413 – [$1,512(1–.4) (deferred development)] – [($580 – $179) (1–.4) (revenue)] = $1,780

Income: $435 – [($340(1–.4)] (asset sale gain) – [($778 – $183)(1–.4)] (development cost amortization versus expense) – [($580 – $179) (1–.4)] (revenue policy) = loss of $366.6.

Lease payments are assumed to be roughly equal to interest and amortization if assets were owned, a simplifying assumption.

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Case 21-2 Forest Industry

Both companies have had a significant decrease in income from 20X5 to 20X6. Canamoraearned $147 in 20X5, but only $19 in 20X6. Fallsview earned $325 in 20X5, and only $26 in 20X6. The industry is noted for its volatility, and the industry norms, over a (dissimilar) three-year period, also show wide variations in return. Note that the industry norms are three years out of date, and can be used for general conclusions only.

Ratio information for the two companies follows, in Exhibit 1. Cash flow information is in Exhibit 2.

A potential short-term creditor should be interested in short-term liquidity and cash flow. The current ratio of Canamora, at 2.5 for both years, is higher than the current ratio of Fallsview, at 1.6 (1.7 in the comparatives). The Canamora ratio is also higher than the historical industry norm of 2.1.

Once inventory is factored out, however, the two companies show similar quick ratios, with Canamora at 0.9 and Fallsview at 1.0. Canamora’s quick ratio stayed the same as for theprior year, but Fallsview’s quick ratio improved from 0.8.

Canamora’s higher current ratio is caused by the higher balance in inventory. Fallsviewuses FIFO for inventory valuation, and thus should report a higher inventory valuation during periods of rising prices. We have no information about prices in this industry, but generally, prices have increased in the economy at a modest rate in recent years. However, the FIFO policy difference probably does not explain the entire difference.

Operating efficiency with respect to inventory is higher for Fallsview than Canamora. Inventory turnover for Canamora is 3.64, improved slightly from 3.44 in the comparative year. Fallsview, however, has actually improved its inventory turnover from 4.59 to 5.64; this implies lower inventory levels, perhaps better control over inventory. One would expect, because of FIFO, to have lower numbers in Fallsview but this difference is significant. Thus, Canamora appears to be doing a better job at inventory management.

The operating efficiency ratios may also provide insights into the quality of accounts receivable and inventory. Canamora’s numbers are higher, indicating faster collection. Within that, the trend is negative for both companies. Canamora shows slower collection of accounts receivable, down from 8.82 to 7.74. Fallsview also shows a decline, from 7.06 to 6.53. The overall decline for both companies is consistent with a bad year in the industry. The customer mix, including various foreign customers, may impact on these ratios.

Canamora had lower cash flow from operations, at $90, versus the $105 from Fallsview. Fallsview improved its cash flow from operations by increasing the level of its accounts payable – an increase of $116 from the prior year. This did not hurt its quick ratio, and thus must be supported with higher levels of cash (up from $17 to $208). Likely it is a timing concern, not an indication of payment difficulties.

Both companies carry significant levels of long-term debt, with Canamora more highly levered.

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In conclusion, from the perspective of a short-term creditor, neither company appears to be especially problematic, although Fallsview, because of its lower inventory levels and higher inventory turnover, appears slightly more attractive.

A potential common stock investor should be interested in potential for long-term profitability, and risk profile. As previously mentioned, both companies have reported very low profits this year, compared to last year. This is reinforced by the profitability ratios. Canamora has a 2.23% return on long-term capital, down from 7.19% the prior year. Return on assets is down from 6.3% to 2%. Return on equity is 1.33%, down from 11.13%. Return on equity is lower than the return on assets, the result of negative leverage when assets have not returned the after-tax cost of debt.

Fallsview shows a similar story – return on long-term capital and assets, at 3.49% and 2.8%, are far lower than the prior year, at 18.22% and 15.1%. The notable thing here is that the prior year’s results were much higher —in 20X5, Fallsview was much more profitable than Canamora. Return on common equity is, as for Canamora, less than the return on assets, with a return figure of 2.25%. Again, the prior year was very high, at 27.04%.

Asset turnover is quite similar for the two companies, at .73 for Canamora and .78 for Fallsview. Fallsview, however, managed a much higher turnover figure in the prior year at .93. It seems that the higher profitability of Fallsview in 20X5 was caused by superior asset turnover.

Asset turnover, and indeed profitability in general, will be affected by the inventory and depreciation policies (estimates) chosen by Canamora. The two companies differ in terms of the cost flow assumption, and also the useful lives chosen for capital assets, with Canamorachoosing longer lives. This should increase income and assets, and reduce asset turnover because of the higher asset balances. Canamora has more depreciation on the income statement, which means it must have more assets. It may be more capital intensive, and less efficient. Part of the lower asset turnover problem is caused by this choice of policy.

In terms of solvency, Canamora carries more debt than Fallsview, although they are identical in respect to debt-to-total assets, at .55. However, Canamora has more long-term debt as compared to total equity, at .95 compared to .76. In this ratio, Canamora is higher than the average for the industry, and Fallsview is lower than the average. This implies that Canamora is more risky, and should provide more returns.

Overall, there are a number of strategic questions that should be answered before any firm conclusions. The primary question is the reason for the sales decline in both of these companies. If this decline is likely permanent, and costs cannot be quickly cut, then the 1% or 2% return on equity could easily be matched in the money market with no risk. On the other hand, if sales are expected to rebound, then Fallsview appears to be a more interesting investment than Canamora. It has less debt, has proven to be more profitable when sales were at higher levels, and appears to operate efficiently.

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Exhibit 1

Financial statement analysisCanamora Fallsview Industry

20X6 20X5 20X6 20X5 20X5 20X4 20X3Profitability - base denominator on year-end figuresReturn on long-term capital, after tax * 2.23% 7.19% 3.49% 18.22%Return on total assets, after tax 2.00% 6.30% 2.80% 15.10% 7.6% 6.0% 0.7%Return on common shareholders’ equity 1.33% 11.13% 2.25% 27.04% 17.40% 12.50% 1.50%Operating margin 4.7 % 7.17% 3.36% 20.71% 15.8% 13.4% 7.7%* Include all long-term elements as long-term debt

Efficiency – base denominator on year-end balanceAsset turnover 0.73 0.77 0.78 0.93Accounts receivable turnover * 7.74 8.82 6.53 7.06Inventory turnover 3.64 3.44 5.64 4.59* Assume all sales on account

SolvencyLong-term debt-to-equity * 0.95 0.87 0.76 0.68 0.81 0.68 0.72Long-term debt-to-total capitalization 0.49 0.46 0.43 0.40Debt-to-total assets 0.55 0.53 0.55 0.50Times-interest-earned 1.87 3.83 1.13 7.82

LiquidityCurrent ration 2.5 2.5 1.6 1.7 2.1 2.1 1.9Quick ratio 0.9 1.0 1.0 0.9

Exhibit 2

Cash Flow from Operations 20X6Cash flow from operations Canamora FallsviewNet income $ 19 $ 26Plus/lessNon-cash charges 148 106Changes in working capitalAccounts receivable (25) 17Inventory 8 41Deferred income tax – current 7 15Accounts payable and accrued liabilities 7 116Deferred income tax – non-current (74) (216)Cash flow from operations $90 $105

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Assignments

Assignment 21-1

Requirement 1

Simard Trading CompanyComparative Income Statement

For the Years Ended 31 December 20x4 and 20x5(Vertical Percentage Analysis)

20x4 20x5Amount Percent Amount Percent

Gross sales revenue......................... $550,000 102 $606,000 101Less: sales returns ....................... ( 10,000) ( 2) (6,000) ( 1)

Net sales revenue ............................ 540,000 100 600,000 100Cost of goods sold........................... (270,000) ( 50) (360,000) (60)Gross margin................................... 270,000 50 240,000 40

Less: Selling expenses ................ (120,600) (22) (130,700) (22)Administrative expenses.... (75,600) (14) (66,000) (11)Restructuring ..................... (10,800) (2) (8,000) (1)Interest expense ................. (5,400) (1) (6,000) (1)Income tax expense ........... (14,400) (3) (7,300) (1)

Total other expenses .................... 226,800 (42) 218,000 (36)Net income...................................... $ 43,200 8 $ 22,000 4

Comments Cost of goods sold has risen significantly as a portion of revenue. As a result, gross

margin has declined from 50% to 40%, not a good sign. Operating expenses have declined as a proportion of net revenue. In fact, all expenses

have declined with the exception of selling expense which has remained the same.

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Requirement 2

Simard Trading CompanyComparative Income Statement (Single Step)

For the Years Ended 31 December 20x4 and 20x5(Horizontal Percentage Analysis)

20x4 20x5Revenues:

Gross sales revenue...................... 100% 110%Less: Returns .......................... 100 60

Net sales revenue ....................... 100 111Expenses:

Cost of goods sold........................ 100 133Selling expenses........................... 100 108Administrative expenses .............. 100 87Restructuring................................ 100 74Interest expenses .......................... 100 111Income tax expense...................... 100 51

Net income...................................... 100 (51)

Comments Returns have gone down, which suggests that customers are more satisfied. Cost of goods sold has risen by 33%. The increase could be due to operating

inefficiencies or it could be due to improved operations that have increased product quality.

Selling expense is up, while admin expense is down. Overall, the operating expense pattern hasn’t changed significantly except for restructuring expense, which is a non-recurring cost.

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Assignment 21-2 WEB

Requirement 1Bryant Company

Comparative Statement of Financial Position31 December 20x4 and 20x5

(Vertical Percentage Analysis)

20x4 20x5Amount Percent Amount Percent

AssetsCurrent assets:

Cash.............................................. $ 60,000 7 $ 80,000 8Accounts receivable (net)............. 120,000 14 116,000 12Inventory (FIFO, LCM) ............... 144,000 17 192,000 19Prepaid expenses.......................... 8,000 1 4,000 0

Total current assets .................. 332,000 39 392,000 39Funds and investments (at cost) ...... 60,000 7 88,000 9Tangible capital assets .................... 560,000 65 664,000 65

Accumulated depreciation............ (104,000) (12) (196,000) (19)Intangible assets .............................. 12,000 1 60,000 6

Total assets .............................. $860,000 100 $1,008,000 100

LiabilitiesCurrent liabilities:

Accounts payable ......................... $160,000 19 $ 100,000 10Other current liabilities ................ _40,000 5 40,000 4

Total current liabilities ............ 200,000 24 140,000 14Long-term mortgage payable .......... 200,000 23 172,000 17

Total liabilities......................... 400,000 47 312,000 31

Shareholders’ EquityContributed capital:

Common shares, no-par ............... 340,000 39 520,000 52Retained earnings............................ 120,000 14 176,000 17

Total shareholders’ equity............ 460,000 53 696,000 69Total liabilities and shareholders’ equity............ $860,000 100 $1,008,000 100

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Requirement 2

Bryant CompanyComparative Statement of Financial Position

31 December 20x4 and 20x5(Horizontal Analysis)

20x4 20x5Assets

Current assets:Cash.............................................. 100% 133Accounts receivable (net)............. 100 97Inventory (FIFO, LCM) ............... 100 133Prepaid expenses.......................... 100 50

Funds and investments (at cost) ...... 100 147Tangible capital assets .................... 100 119

Accumulated depreciation............ 100 188Intangible assets .............................. 100 500

Total assets............................. 100 117

LiabilitiesCurrent liabilities

Accounts payable ......................... 100 63Other current liabilities ................ 100 100

Long-term mortgage payable .......... 100 86Total liabilities ....................... 100 78

Shareholders’ EquityContributed capital:

Common shares, no-par ............... 100 153Retained earnings............................ 100 147

Total shareholders’ equity............ 100 151Total liabilities and shareholders’ equity ............... 100 117

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Assignment 21-3

Requirement 1 — vertical analysis

20X5 20X4 20X3

Cash 6% 5% 5%

Marketable securities 5% 8% 11%

Receivables, net 5% 7% 9%

Inventory 19% 21% 16%

Capital assets 83% 75% 69%

Accumulated amortization –21% –20% –17%

Intangible capital assets 4% 6% 6%

100% 100% 100%

Current liabilities 3% 4% 10%

Debentures payable 22% 28% 14%

Common shares 37% 29% 36%

Retained earnings 38% 40% 4%

100% 100% 100%

Note: Totals do not add to 100.0% due to rounding.

Requirement 2 — horizontal analysis

20X5 20X4 20X3

Cash 175% 112% 100.0%Marketable securities 67% 91% 100.0%Receivables, net 82% 93% 100.0%Inventory 185% 160% 100.0%Tangible capital assets 189% 135% 100.0%Accumulated amortization 200% 150% 100.0%Intangible capital assets 108% 116% 100.0%

Total assets 158% 125% 100.0%

Current liabilities 48% 45% 100.0%Debentures payable 247% 253% 100.0%Common shares 164% 100% 100.0%Retained earnings 148% 124% 100.0%

Total liabilities and shareholders’ equity 158% 125% 100.0%

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Requirement 3

In the horizontal analysis, all assets show significant increases except for receivables and marketable securities. The biggest increases are in inventory and both tangible and intangible capital assets, accompanied by a substantial jump in debentures payable. The sharp increases suggest that Heresy Limited may have acquired another business in 20X4. Either Heresy issued debt to finance the purchase, or Heresy assumed the purchased company’s debt as part of the transaction. A business combination also would explain the significant increases in cash in 20X5.

Heresy issued additional shares in 20X5, apparently to finance purchases of additional capital assets, which increased significantly between 20X4 and 20X5. The proceeds of the share issue may also account for the increase in cash in 20X5.

Although Heresy’s assets, liabilities, and shareholders’ equity increased significantly, the vertical analysis suggests that the overall asset structure has changed somewhat less significantly. Overall, capital assets increased while liquid assets decreased.

The composition of financing changed through the increase in debt in 20X4, but the overall proportion of shareholders’ equity in the financial structure is much the same in 20X5 as it was in 20X3.

The analysis suggests that while the company has been an active acquiror and has entered into some major new financing, the stability of its financial structure hasn’t changed much.

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Assignment 21-4

Requirement 1

a. The financial institution is most likely interested is the ratio that indicate the quality of their security: inventory turnover. After that, they might be interested in the profit margin of the enterprise, on the basis that a profitable company is a better credit risk. (The current or quick ratio is another acceptable suggestion.)

b. The supplier is most likely interested in short-term liquidity, the current and quick ratios.

c. An investment banker would be interested in long-term profitability, return on assets and return on equity. The banker would also use the debt-equity ratio to assess solvency and risk.

Other responses, if justified, are acceptable.

Requirement 2

Diluted EPS is less than basic EPS if the company has dilutive elements in its capital structure: preferred shares or bonds convertible to common shares at favourable exchange terms, or stock options, where the exercise price is less than the average market price.

Requirement 3

Wilcox reports an increasing current ratio, which is now higher than industry average. The quick ratio is also increasing, but is less than the industry average. The increase in the current ratio may indicate inventory build up, a cause for concern as inventory is a high-risk asset. Inventory turnover is decreasing, a bad sign, and is still far less than the industry average, which is unfavourable.

Return on assets has increased from 11% to 12%, a healthy return and higher than industry average, indicating efficient use of assets. Profit margin has increased from 5% to 6% over this period, another favourable sign. EPS is trending higher, although the presence of diluted EPS indicates that there are material dilutive stock contracts outstanding. Industry average is meaningless, as the ‘size’ of shares is not consistent from company to company. Return on equity has increased to 16%, indicating use of financial leverage through debt. Again, this is better than the industry norm. The company has more debt (Debt-to-equity is 1.44, and climbing, versus the industry at 0.95.) This is part of the reason for the high return on equity, and it means that the risk profile of Wilcox, with high debt, is higher than the industry norm.

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Assignment 21-5

Requirement 1

Firenza Products Ltd.Statement of Comprehensive Income

Years ended 31 December

20x8 20x7 20x6 20x5Net sales 100.0% 100.0% 100.0% 100.0%Cost of products sold 130.0% 83.6% 75.3% 76.6%Depreciation, depletion and amortization 13.5% 10.0% 6.4% 6.8%Selling and administrative 16.3% 5.1% 3.8% 3.8%Operating earnings (loss) –59.8% 1.3% 14.5% 12.8%Interest expense –0.6% –1.5% –1.2% –1.9%Other income (expense) 11.5% –0.1% –0.4% 1.6%Earnings(loss) before income tax and non-controlling interest –48.9% –0.3% 12.9% 12.5%Income tax (recovery) –16.5% –0.3% 5.7% 5.4%Earnings (loss) before non-controlling interest –32.4% 0% 7.2% 7.1%Earnings (loss) from discontinued operations 137.5% 12.6% 3.9% —Net earnings (loss) 105.1% 12.6% 11.1% 7.1%

Firenza Products Ltd.

Condensed Statement of Financial Position

31 December

Assets 20x8 20x7 20x6 20x5Current assets 41.0% 17.1% 4.6% 7.9%Investments and other 3.9% 1.5% 2.4% 3.9%Fixed assets 55.1% 54.2% 47.5% 88.2%Assets of discontinued operations — 27.2% 45.5% —

Total assets 100.0% 100.0% 100.0% 100.0%

Liabilities and shareholders’ equityCurrent liabilities 31.5% 13.8% 5.7% 5.3%Long-term debt — — 2.7% 9.1%Deferred income tax 6.9% 8.5% 4.9% 7.6%Liabilities of discontinued operations — 7.3% 15.8% —Preferred shares issued by subsidiaries — — — 1.4%Non-controlling interest — — 6.4% 7.0%Shareholders’ equity 61.6% 70.3% 64.5% 69.6%

Total capitalization 100.0% 100.0% 100.0% 100.0%

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Requirement 2

Firenza Products Ltd.Statement of Comprehensive Income

Years ended 31 December

20x8 20x7 20x6 20x5Net sales 13% 44% 64% 100%Cost of products sold 22% 48% 63% 100%Depreciation, depletion and amortization 26% 65% 60% 100%Selling and administrative 56% 59% 65% 100%Operating earnings (loss) -62% 4% 73% 100%Interest expense 4% 37% 40% 100%Other income (expense) 94% -1% -15% 100%Earnings (loss) from continuing operations before income tax -52% -1% 67% 100%Income tax (recovery) -41% -2% 69% 100%Earnings (loss) from continuing operations -60% -0% 65% 100%Earnings (loss) from discontinued operations

(using 20X6 as the base year) 713% 219% 100% —Net earnings (loss) 194% 77% 100% 100%

Firenza Products Ltd.Condensed Statement of Financial Position

31 December

Assets 20x8 20x7 20x6 20x5Current assets 484% 206% 64% 100%Investments and other 93% 37% 67% 100%Fixed assets 59% 58% 60% 100%Total assets 94% 95% 111% 100%

Liabilities and shareholders’ equityCurrent liabilities 561% 251% 120% 100%Long-term debt — — 33% 100%Deferred income tax 85% 107% 72% 100%Preferred shares of subsidiaries — — — 100%Non-controlling interest — — 101% 100%Shareholders’ equity 83% 96% 103% 100%

Total capitalization 94% 95% 111% 100%

Note: Assets and liabilities of discontinued operations are excluded because they no longer contribute to performance and should be included in an analysis of current and future financial performance.

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Requirement 3

FPI has reduced its revenue drastically over the 4-year period, decreasing by 87% while net earnings have increased by 94% over the period. This is highly misleading, however, since the profits have come from non-recurring gains—the disposition of discontinued operations. In contrast, net earnings from continuing operations have decreased by 160% over the same period, from a net profit to a net loss.

CGS is higher than net revenue, indicating that the company is selling product at less than cost, which is not a sustainable situation.

Despite the discontinuance of major divisions, total assets has changed very little. Long term debt has gone to zero, but both current assets and current liabilities have increased drastically.

Asset turnover is only 0.12 times, as compared to a turnover of 0.86 in 20X5.

This company is not in good shape.hzzled



Assignment 21-6

Requirement 1

The increase in the current ratio, accompanied by decrease in the quick ratio, implies that inventory is growing. Inventory is in the numerator of the current ratio but not the quick ratio. Inventory turnover is decreasing, implying that inventory balances are higher.

Requirement 2

The ROA is 8%, while ROE is 13, declining from 14. Therefore, the conclusion is that leverage is present and positive, but declining. That is, ROE is higher than ROA, so debt financing, with a cost of less than 8%, must be present. However, since ROA has been fairly stable, but ROE has slipped 1%, leverage is declining. Note that debt is increasing in the capital structure — up from 52% to 62%. The declining benefit of leverage must mean that the cost of debt has increased over the period. hzzled


Assignment 21-7

Requirement 1

20x4 20x5

a) ROA (before tax) ($180,000 + $18,000 + $90,000)$5,250,000 (average)

= 5.5%

($142,500 + $27,000 + $90,000)$5,475,000 (average)

= 4.7%

b) ROA (after tax) ($180,000 + $11,700*)= $5,250,000 (average)

= 3.7%

($142,500 + $16,200*) 5,475,000 (average)

= 2.9%

c) Return on LT capital, before tax

$180,000 + $18,000 +$90,000$3,487,500 (average)

= 8.3%

$142,500 + $27,000 + $90,000$3,757,500 (average)

= 6.9%

d) Return on LT capital, after tax $180,000 + $11,700 $3,487,500 (average)

= 5.5%

$142,500 + $16,200$3,757,500

= 4.2%

e) ROE (common) $180,000 – $15,000$1,987,500 (average)**

= 8.3%

$142,500 – $18,000$2,032,500 (average)**

= 6.1%

f) Operating margin $180,000 + $18,000 + $90,000$19,500,000

= 1.5%

$142,500 + $27,000 + $90,000$20,250,000

= 1.3%

g) Asset turnover $19,500,0005,250,000 (average)

= 3.7 times

$20,250,0005,475,000 (average)

= 3.7 times

* $18,000 (1 – .35) = $11,700; $27,000 (1 – .4) = $16,200** Common only

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Requirement 2

Return on common equity, after tax, is probably the most important ratio for a common shareholder. Return on total assets and return on owners’ equity (and their difference, leverage) would be important in the evaluation of profitability, since they relate income to investment and indicate the extent of leverage. After-tax numbers are more relevant than pre-tax numbers, as it is the after-tax residual that is actually available to common shareholders.

Requirement 3 — Significant trends

There is an unfavorable trend in all return ratios. The drop-off in ROE exceeds the drop in ROA as preferred dividends have climbed. There is also a higher drop-off in after-tax returns, reflecting higher tax rates.

ROA appears to be earned by high volume (low margin); the only bright note is that volume (asset turnover) has been stable.hzzled


Assignment 21-8

[Partial vertical and horizontal analyses are shown below. These are not required by the question, but they are helpful for developing a response. They are fairly straight-forward to prepare on Excel.]

Horizontal analysis

2009 2008 2007 2006 2005

Gross operating revenue 112.6% 118.2% 111.6% 107.0% 100.0%

Operating expenses 112.9% 118.9% 111.6% 107.5% 100.0%

Depreciation and amortization

134.1% 122.2% 111.9% 103.8% 100.0%

Interest expense 175.0% 146.4% 75.0% 90.5% 100.0%

Income taxes 75.8% 88.4% 105.3% 105.8% 100.0%

Net earnings 101.5% 113.6% 124.8% 107.6% 100.0%

Current assets 172.0% 133.8% 105.5% 85.5% 100.0%

Inventories 138.4% 135.9% 115.4% 98.8% 100.0%

Property and equipment (net)

115.9% 116.6% 119.7% 105.0% 100.0%

Total assets 147.6% 130.7% 113.6% 97.5% 100.0%

Current liabilities 140.8% 109.8% 116.1% 91.4% 100.0%

Long-term debt 94.1% 117.3% 114.6% 99.7% 100.0%

Shareholders’ equity 146.8% 142.0% 123.8% 110.9% 100.0%

LTD + Share equity 130.1% 134.1% 120.9% 107.4% 100.0%

Basic EPS 101.5% 113.9% 125.0% 107.7% 100.0%

Return on equity 9.1% 10.5% 13.3% 12.7% 13.1%Return on assets 3.8% 4.8% 6.1% 6.1% 5.5%

Vertical Analysis—earnings

2009 2008 2007 2006 2005

Gross operating revenue 100.0% 100.0% 100.0% 100.0% 100.0%Operating expenses 89.7% 89.9% 89.4% 89.9% 89.4%Depreciation and amortization 2.9% 2.5% 2.4% 2.3% 2.4%Interest expense 1.7% 1.3% 0.7% 0.9% 1.1%Income taxes 1.7% 1.8% 2.3% 2.4% 2.5%Net earnings 3.9% 4.1% 4.8% 4.3% 4.3%

Asset turnover 0.99 1.17 1.27 1.42 1.30

SHE as % of total assets 42% 46% 46% 48% 42%

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Discussion—profitability

The company’s net earnings are about the same in 2009 as they were in 2005. During that time, the long-term capital employed (i.e., long-term debt plus shareholders’ equity) rose by 30%. Income taxes have declined by about 24% and thus it is obvious that taxes have not been eating up the profits. Asset turnover went down from 1.3 in 2005 to .99 in 2009, indicating significantly reduced revenue per asset invested. In 2009, operating margin dropped to just 7.2%; both asset turnover and operating margin are down from 2005.

Return on assets has declined from 5.5% in 2005 to 3.8% in 2009. Return on equity has dropped from 13.1% to 9.1%. Negative leverage quite clearly exists, driving down the return on equity and probably committing a significant portion of free cash flow to servicing the debt.

Solvency

The company’s debt-equity ratio has declined from about 46% to 30% over the 5-year period. Equity has increased 47%, indicating that the company has been able to issue new debt to offset increased long-term debt (47% higher in 2009 than 2005). On the other hand, interest expense increased 75%, indicating that the debt is more expensive now. Interest expense in 2009 was equal to 12% of average LTD during 2009, a very high rate. For 2009, net earnings plus interest expense and taxes (i.e., EBIT) amounted to $626 million; EBIT+D = $874 million. Times-interest-earned is 4.26 (on EBIT) and 6.0 on EBITD. There seems to be a relatively good cushion, provided that this cash flow is free for debt service and provided there isn’t significant debt coming due that can’t be refinanced through earnings or equity.

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Assignment 21-9

Ratio 20x4 20x5 Significance

a) Current (or working capital) ratio $1,008,000 = 1.5 to 1$672,000

$1,176,000 = 2.0 to 1$588,000

Test of short-term liquidity; ability to pay current liabilities with current assets.

b) Quick ratio $1,008,000 – $588,000 = .625 to 1$672,000

$1,176,000 – $420,000 = 1.29 to 1$588,000

Severe test of immediate liquidity; ability to meet sudden demands for cash.

c) Defensive interval ratio $420,000 = 32 days$13,020

$756,000 = 62 days$12,180

Days of operation with existing liquid assets: severe test of liquidity

d) Asset turnover $4,452,000 = .96$4,620,000 (average)

$4,494,000 = .82$5,460,000

Level of sales generated by investment in assets. Level of activity/volume.

e) Accounts receivable turnover $1,176,000 = 4.5 times$260,400 (average)

$1,050,000 = 4.0 times$262,500 (average)

Velocity of collection of trade receivables; efficiency of collection.

f) Average collection period of accounts receivable

365 = 81 days4.5

365 = 91 days4.0

Average number of days to collect trade receivables.

g) Inventory turnover $2,457,000 = 4.5 times$546,000 (average)

$2,520,000 = 5 times$504,000 (average)

Times the inventory turned over (i.e., sold) on average. May indicate overstocking.

Requirement 2

1) Liquidity is improving gradually (Ratios a, b, and c) 3) Collections on trade accounts getting worse (Ratios e and f)

2) Turnover is decreasing (Ratio d) 4) Inventory position improving (Ratio g)

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(a) Ratios that measure profitability

Return on long-term capital(after tax)

Income + Interest exp. onlong-term capital, net of taxAverage LT Debt + Equity

$28 + ($4(1–.40)) = .18$167 (or 18%)

Return on long-term capital investment, excluding current liabilities.

Return on assets (after tax) Income +Interest exp.,net of taxAverage total assets

$28 + ($4(1–.40)) = .16$185 (or 16%)

Rate of return earned on all assets employed

Return on common owners’ equity

Income – Pref dividendsAverage common owners’

equity

$28 = .23$124 (or 23%)

Rate of return earned on assets provided by owners

Operating margin (before tax) Income + interest + income taxTotal revenue

$28 + $4 + $20 = .33$157 (or 33%)

Profit margin earned on each dollar of sales

Return on gross assets(before tax)

EBIT + DepreciationAverage total assets (net) +

Average accumulated depreciation

$28 + $4 + $20 + $8 = .28(($184 + $29) + (or 28%)($186 + $37)) ÷ 2)

Return on invested capital exclusive of return of capital (depreciation)

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(b) Ratios that measure efficiency:

1. Asset turnover Total revenueTotal assets (average)

$157 = .85 times$185

Efficiency of asset utilization

2. Accounts receivable turnover

Credit salesAverage trade receivables

$51 = 2.4 times$21

Efficiency of collection of accounts receivable

3. Average collection period of accounts receivable

365 (days)Receivable turnover

365 = 152 days2.4

Average number of days to collect receivables

4. Inventory turnover Cost of goods soldAverage inventory

$70 = 2.1 times$34

Number of times average inventory was soldhzzled



(c) Ratios that measure solvency:

1. Debt:equity Total liabilitiesTotal owners’ equity

$57 = .44$129 (or 44%)

Compares resources provided by creditors versus owners

2. Debt: total capitalization Long-term debtLong-term debt + owners’

equity

$45 = .26 $45 + $129 (or 26%)

Proportion of long-term capital financed by debt

3. Debt: capital employed Long-term debt + current liabilitiesLong-term debt + current liabilities –(liquid) current assets + equity

$45 + $12 = .40 $45 + $12 – (or 40%)($20 + $4 + $19)+ $129

Debt burden with liquid current assets netted out.

4. Debt: total assets Total liabilitiesTotal assets

$57 = .31 $186 (or 31%)

Proportion of resources provided by creditors

5. Times-interest-earned Income + interest + taxInterest expense

$28 + $20 + $4 = 13$4

Income available to cover interest

6. Times-debt-service-earned Cash flow fromops + interest + tax

Interest + projected debt service costs ÷ (1 – t)

$22 + $20 + $4 = 11.5$4

Ability to co. to service debt charges

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(d) Ratios that measure liquidity:

1. Current ratio Current assetsCurrent liabilities

$83 = 6.9$12

Ability to pay liabilities with current assets

2. Quick ratio Monetary current assetsMonetary current liabilities

$43 = 3.6$12

Ability to pay liabilities with liquid current assets

3. Defensive interval Monetary current assets *Projected daily operating

expenditures

$43 = 1,427 days11÷365

Average number of days the company can operate with the currently available liquid assets

* Interest + administrative expense – depreciationhzzled



Assignment 21-11

a. Return on assets:

$3,900 [($84,000 + $74,000) 2] 4.9%

b. Asset turnover:

$40,000 [($84,000 + $74,000) 2] 0.51 times

c. Operating margin:

$5,400 $40,000 13.5%

d. Return on shareholders’ equity:

$2,800 [($20,000 + $44,500 + $43,000 + $15,000) 2] 4.6%

e. Inventory turnover:

$22,500 [($8,000 + $6,000) 2] 3.2 times

f. Average collection period:

365 {$40,000 [($13,500 + $14,500) 2]} 128 days

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Assignment 21-12

Requirement 1

Abacus Ltd. Zandi Corporation

Operating margin$80,000 $540,000 14.8% $23,000 $270,000 8.5%

Asset turnover$540,000 $660,000 0.82 times $270,000 $150,000 1.8 times

Return on assets$39,000 + [$24,000 × (1 – .3)]

$660,000 8.5% $16,000 $150,000 10.7%

Return on shareholders’ equity$39,000 $180,000 21.7% $16,000 $90,000 17.8%

Total debt-to-shareholders’ equity$480,000 $180,000 2.67 $60,000 $90,000 0.67

Requirement 2

Abacus has a higher operating margin but a lower asset turnover. The low Abacus turnover is due to the fact that Abacus owns its assets while Zandi uses leases; Zandi’s recorded assets will be lower because the assets are not shown on the books (assuming operating leases).

Zandi achieves higher return on assets (again, without including leased assets in the denominator) but gets a lower return on shareholders’ equity. Abacus is making effective use of financial leverage to increase the shareholders’ return.

Abacus’s debt-equity ratio is much higher than Zandi’s. The higher Abacus debt is due to the secured loans to finance the assets. Zandi’s implicit debt for the leased operating assets does not appear on the balance sheet, and yet Zandi must have these assets in order to maintain operations.

On the surface, it appears that Abacus is riskier because of the high debt. This may be true if Abacus’s debt is floating-rate debt, which would make them vulnerable to interest rate changes. Nevertheless, the effect of financial leverage is very strong, which suggests that there is a substantial margin of safety in Abacus’s operations. Abacus appears to be more profitable and probably is a safer investment.

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Assignment 21-13

Present value of the lease commitments (to be added to long-term debt and to capital assets for ratio analysis):

Year Commitment P/F, 8%, n Present value

20X3 $ 53,000 0.92593 $ 49,07420X4 49,000 0.85734 42,01020X5 45,000 0.79383 35,72220X6 40,000 0.73503 29,40120X7 35,000 0.68058 23,820Total $180,027

For ratio analysis, the total present value can be rounded to $180,000.

Revised ratio analysis:

Including lease

From A21-12

Operating margin: $23,000* $270,000 8.5% 8.5%

Asset turnover: $270,000 ($150,000 + $180,000) 0.82 1.8

Return on assets: $16,000* ($150,000 + $180,000) 4.8% 10.7%

Return on shareholders’ equity: $16,000 * $90,000 17.8% 17.8%

Total debt-to-shareholders’ equity: ($60,000 + $180,000) $90,000 2.67 0.67

* Assumes that operating lease payments are equal to interest plus depreciation

The addition of the PV of operating lease commitments has a drastic effect on asset turnover, return on assets, and debt:equity ratio. The company’s ratios now appear very similar to those of Abacus Ltd. in A21-12, although ROA is significantly worse.

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Assignment 21-14

Requirement 1(a) (b)

Sell Shares Issue Bondsa) Expected net income

Average income expected ($400,000 + $1,050,000*).... $1,450,000 $1,450,000Bond interest expense ($7,600,000 × 10%).................... (760,000)Tax saving ($760,000 × 30%) ........................................ 228,000Net income estimated ..................................................... $1,450,000 $918,000

*$1,500,000 × (100% – 30%)

b) Cash outflows for additional funds:Dividends, 95,000 additional shares × $6 ......................$570,000Interest (net of tax = $760,000 × 70%)........................... $532,000

c) Return on total assets, return on owners’ equity, and financial leverage:

(a) Sell Shares (b) Issue BondsReturn on $1,450,000 = 11.7% $918,000 = 20.4%owners’ equity $4,500,000 + $7,600,000 $4,500,000

Return on $1,450,000 = 10.6% $918,000 + $532,000 = 10.6%total assets $6,100,000 + $7,600,000 $6,100,000 + $7,600,000

There is no financial leverage if shares are used to finance the acquisition. Financial leverage is positive if bonds are used; return on assets is lower than return on equity.

Requirement 2

Arguments against issuing the bonds are: (1) high annual cash interest payments that must be made ($532,000 net of tax) regardless of profits or losses, (2) maturity payment of $7,600,000 in 5 years (a short maturity period), (3) annual estimated net income is lower ($918,000 versus $1,450,000), and (4) the dividends (for the shares in (a)) are not required to be paid each year.

Arguments for the bonds are (1) the cost of capital is less because the interest rate is lower than the dividend rate, (2) the interest cost is deductible for tax purposes, (3) return on owners’ equity increases significantly, and (4) a positive leverage factor is likely. The leverage factor is significant because of the resulting increase in earnings available for dividends in the future.

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Assignment 21-15

Common Size Statements of Income Comprehensive Income:Cuppola Inc. Ling Ltd.

20x1 20x0 20x1 20x0Sales ............................................................ 100 100 100 100Cost of sales ................................................ 72 70 68 70Gross margin............................................... 28 30 32 30Expenses ..................................................... 20.5 25 23 24Net income.................................................. 7.5 5 9 6Increase in sales over 20x0 ................... 30% 20%

Cuppola is 4% below Ling in gross margin; this should be investigated.

Relevant ratios Cuppola Inc. Ling Ltd.20x1 20x0 20x1 20x0

Current ratio .............................................. 2.05 1.80 1.57 2.16Quick ratio ................................................ .87 .53 .43 .70Accounts receivable turnover.................... 20 16.67* 11.61 10.00*Inventory turnover..................................... 4.45 3.68* 2.89 2.87*Long-term debt:equity ratio ...................... .08 .17 .47 .58Return on total assets ................................ 17.7 10.00* 12.6 7.60*Return on equity........................................ 28.9 16.67* 26.2 15.25*

* Data not available for average. Results are based on year-end figures. Note that interest expense was not available and not added back.

(Students may provide a range of ratios, as the required was open-ended.)

Cuppola appears to be quite liquid in 20x1, compared with Ling Ltd. (quick ratio). This is caused by the large cash balance in Cuppola. The company should be re-investing cash balances to generate income. The receivables turnover is significantly better than Ling’s, indicating good management over this area (providing the sales mix between the two companies is comparable). Similarly, inventory turnover is faster than for the larger company.

Debt:equity ratios reflect the higher use of external financing by Ling. It should also be noted that Ling is increasing its fixed assets and long-term debt, while Cuppola is not.

Coppola’s return on total assets is consistently above that of Ling Ltd., however, it is important to realize that Cuppola is not purchasing new fixed assets and thus its asset base is decreasing.

The return on assets and equity is very good, indicating that Cuppola is a well-managed and profitable venture.

Mr. Smythe should investigate the decline of his gross margin, and attempt to reverse this trend. He should also reconsider his capital asset financing policy. The company has the capacity for additional long-term debt, which would provide leverage to further improve return on equity.

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Solutions Manual to accompany Intermediate Accounting, 5th edition 21-35

Assignment 21-16

Selected Ratios Company A Company BCurrent ratio ................................................................... 2.13 2.35Quick ratio ..................................................................... 1.61 1.67Accounts receivable turnover......................................... 11.60 9.36Inventory turnover.......................................................... 20.57 14.49Debt: equity ratio (total debt)........................................ 2.22 .77Return on total assets, after tax ...................................... 10.02 10.61Return on equity............................................................. 21.00 14.67Times interest earned ..................................................... 2.86 4.58

Note: Students will provide a variety of ratios from the four categories, as the required was open-ended. Averages could not be used because comparative financial statements were not provided.

Common Size Statements of Comprehensive Income Company A Company B

Sales ............................................................................... 100.0% 100.0%Cost of goods sold.......................................................... 64.0 65.0Gross margin.................................................................. 36.0 35.0Operating expenses ........................................................ 28.9 27.0Operating income........................................................... 7.1 8.0Interest expense.............................................................. 2.5 1.8Net income before tax .................................................... 4.6 6.2Income tax...................................................................... 1.8 2.5Net income..................................................................... 2.8% 3.7%

Company A appears to be the better investment, although it is certainly a matter of opinion.

The turnover figures for receivables and inventory are significantly higher for Company A than Company B, which, along with the higher gross margin, indicate better management.

The two companies have roughly the same investment in plant assets, however, it seems to have been financed by debt in company A and by equity in company B. With a higher debt load, company A has used leverage to a much larger degree. Consequently, their return on equity is considerably higher. Of course, the risk factor is proportionate to the debt incurred. Fixed charge coverage is much lower for A than B.

Examination of the statement of comprehensive income shows that operating expenses are higher in A than in B. Profits could be significantly improved if these expenses could be reduced.

Mr. Panchaud should obtain more information concerning the future projections for these companies and for the industry as a whole. However, based on the information presented, A appears to be the more profitable investment.

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Assignment 21-17

Requirement 1

The statement of comprehensive income remains the same through “Earnings before income taxes”:

Earnings before income tax $ 120,000Income tax, current (14,400)Net earnings $ 105,600

In the balance sheet, “Future income tax” must be removed and reclassified as retained earnings:

Current assets $ 144,000Capital assets:

Tangible (net) 624,000Identifiable intangible 168,000

Total assets $ 936,000

Accounts payable and accrued liabilities $ 120,000Long-term debt 384,000Total liabilities 504,000Shareholders’ equity:Common shares 60,000Retained earnings ($180,000 + $192,000) 372,000Total shareholders’ equity 432,000Total liabilities and shareholders’ equity $ 936,000

Requirement 2

Before recasting After recasting

Operating margin* $132,000$660,000 = 20% $132,000$660,000 = 20%Return on assets (after tax)

{$84,000+[$12,000(1–.3)]}$936,000 = 9.9%

{$105,600+[$12,000(1–.3)]}$936,000 = 12.2%

Total liabilities:SHE $696,000$240,000 = 2.9 $504,000$432,000 = 1.17

* EBIT: $120,000 + $12,000 = $132,000

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Solutions Manual to accompany Intermediate Accounting, 5th edition 21-37


Requirement 1 (EPS calculations in thousands)

a. Basic EPS: ($898 – $401) ÷ [(380 × 1/12) + (420 × 11/12)] = $2.06

1 Preferred shares are cumulative

b. Diluted EPS: [$898 + $98(1–.30)] ÷ [417* + 401 + 502 + $403] = $1.81

* From basic calculation

Dilution tests:1 Pref. shares $40/40=$1; dilutive2 $98(1–.30) = $68.60; dilutive3 Options: 40K shares issued and (40 × $16) ÷ $20 = 32 retired

c. Debt: equity: ($2,190 + $833 + $619) ÷ ($500 + $166 + $2,150 + $2,461) = 0.69Note: deferred income tax might be classified differently: assumptions must be stated!

d. Inventory turnover : $7,620 ÷ [($2,575 + $2,110) ÷ 2] = 3.25

e. Quick: ($1,720 + $1,150 + $450) ÷ $2,190 = 1.52

f. Return on assets: (after tax) [$898 + $98(1–.30)] ÷ [($8,919 + $7,401)/2] = 11.8%

g. Return on common shareholders’ equity: ($898 – $401) ÷ $4,1802 = 20.5%

1 Preferred shares are cumulative.2 [($2,150 + $2,461 + $166) + ($1,700 + $1,716 + $166)] ÷ 2 = $4,180

h. Accounts receivable turnover: $10,450 ÷ [($1,150 + $1,170) ÷ 2] = 9

i. Asset turnover: $10,450 ÷ [($8,919 + $7,401) ÷ 2] = 1.28

j. Return on long-term capital, after tax:[$898 + $98(1–.30)] ÷ {[($8,919 – $2,190) + ($7,401 – $1,900)] ÷ 2} = 15.8%

k. Operating margin: ($898 + $98 + $385) ÷ $10,450 = 13.2%

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Documents

Chapter 12: Liabilities - Amazon Web Services · 2014-01-03 · Solutions Manualto accompany Intermediate Accounting,Volume 2,5thedition 12-1 Chapter 12: Liabilities Suggested