ACTG 2011 - Midterm Package - 2012-2013

ACTG2011
MIDTERM Exam-AID
Review Package
Tutor: Balpreet Singh ([email protected])
York SOS
1
Preface
This document was created by the York University chapter of Students Offering
Support (York SOS) to accompany our ACTG2011 Exam-AID session. It is
intended for students enrolled in any sections of 2012/2013 INTRODUCTION TO
FINANCIAL ACCOUNTING II-ACTG2011 course who are looking for an
additional resource to assist their studies in preparation for the exam.
References
Friedlan, John (2010). Financial Accounting: A Critical Approach 3rd Ed.
McGraw Hill.
What is Students Offering Support?

Students Offering Support is a national network of student volunteers working
together to raise funds to raise the quality of education and life for those in
developing nations through raising marks of our fellow University students.
This is accomplished through our Exam-AID initiative where student volunteers

run group review sessions prior to a midterm or final exam for a $20 donation.
All of the money raised through SOS Exam-AIDs is funneled directly into
sustainable educational projects in developing nations. Not only does SOS fund
these projects, but SOS volunteers help build the projects on annual volunteer
trips coordinated by each University chapter.
York SOS
2
Introduction to Financial Accounting I
Chapter 1 What is Accounting
Accounting System for producing information about an entity and communicating it to users for
decision making
- The more and better information a person has about a situation the better decisions possible
- Information costs money
- Information is limited and thus decisions must be made on assumptions and predictions
2 Fields of Accounting
- Financial Accounting Provides information to people who are external to the entity. (E.g.
Investors, CRA, Lenders, customers). These stakeholders must rely on entity for info
- Managerial Accounting Field of Accounting that provides information to managers of the
entity. This information assists them in making decisions for entity.
Accounting Environment
- Preparers of accounting information must assess who is using statements and for what reason
- The accounting environment influences whom entities provide information to
Entities
- Corporations Separate Legal entity created. Different shareholders have shares in the corporation.
The shareholders are given limited liability.
Corporations can also be private were on person owns all shares
Public Corporations Corporations whose shares are publicly traded in the stock market
- Proprietorship One owner, Unlimited Liability
- Partnership Owned by 2+ people, Unlimited Liability
- Individuals Also accounting entities as they must file tax returns through CRA
Stakeholders
- After looking at different entities we need to access their stakeholders (anyone who has a interest in
the company) their decisions and how the accounting financial statements are prepared accordingly.
(e.g. Owners, Lenders, Suppliers, Customers, Shareholders, Government, regulators)
Constraints on Managers & Financial Reporting
- IFRS, GAAP for Private Enterprise (ASPE), CRA, Canadian Business Act
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- Stock exchange securities law
- Voluntary contracts to accounting a certain way
- Bank/lender covenants
Preparers of Financial Statements: decide how and when to release company financial statements and
are not neutral
Managers bonus sometimes based on F/S
Tax paid based on F/S
Business selling price based on F/S
- This conflict requires external opinion
External Auditors They examine the companies F/S in an external audit. Employed by
management or CRA to confirm taxes
Chapter 2: Financial Statements

General Purpose Financial Statements GPFS One set of general financial statements for all
stakeholders. As they are general they do not provide complete information for all stakeholders to make
their decisions. For this reason this information usually only tailors certain stakeholders over others.
1) Balance Sheet Provides information about the financial position of an entity at a specific time
Accounting Equation (A = L + OE)
The balance sheet is like a photograph Captures the scene at the moment it is made
Assets Economic recourses that provide future benefits to an entity for carrying out business
o 3 Criteria to be an asset
Asset Must Provide future benefit
Entity has control over asset benefits
Asset must be from a transaction that has already occurred
o Current Assets Assets used, converted to cash or sold with one year (one operating
cycle)
o Non-Current Assets Not converted to cash or used up in a year (Capital Assets)
Liability obligations of an entity to pay back
o Entitys obligation to pay money or provide goods or services to suppliers, lenders and
customers (Unearned revenue, long term debt, A/P)
o Current Liabilities: Liabilities satisfied within a year
o Non-Current Liabilities: Paid/Satisfied in over a year
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Liquidity: Entitys abilities to pay its obligations as they come due
o Working Capital = Current Assets - Current Liabilities
o Current Ratio Current Assets/Current Liabilities
Owners Equity: Owners capital in entity after liabilities
o Owners Investment in the company. The part of the assets they own.
o Indirect Investment: Reinvested Net Income accumulated into retained earnings for
shareholders (if retained earnings negative then deficit)
o Direct Investment: Money given by shareholders for shares in the company. This goes
into capital stock
o Dividends: Payment of the corporations assets usually in cash to shareholders
(Dividends reduce retained earnings)
2) Income Statement: How did we do? Measures Economic performance for an entity over a period of
time
Net Income = Revenue - Cost of Sales - Operating Costs
2 Methods of Accounting
o Cash Basis: Reports Cash in and Cash Out through Cash receipts
o Accrual Basis: Records transactions when they have occurred rather than cash flow
Extended Accounting Equation
o A = L + OE + R V E
Gross Margin = Sales V Costs of Sales
Gross Margin % = Gross Margin/Sales
3) Cash Flow Statement: Shows how cash is obtained and used and used over a period (Cash from
operations, Cash from investing activities)
4) Statement of Retained Earnings: Summarizes changes in retained earnings in period (Bridges the B/S
& I/S)
RE at year end = RE at beginning of year + Net Income - Dividends Declared
Shareholders Equity = RE + Capital Stock
o Dividends is not an expense, it is a reduction in OE
5) Notes in Financial Statements: Expand on Information in F/S, Provide additional information in F/S,
provide additional information and help stakeholders assess entity
Give information on accounting Policies and practices of company
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Chapter 3: Accounting Cycle
Accounting Cycle: Process by which data on economic events are entered into an accounting system,
processed, organized & used to make F/S
1. Economic Event/Transaction
2. Prepare Journal Entry
3. Post Journal Entry to General Ledger
4. Prepare & Post Adjusting Entries
5. Prepare Trial Balance
6. Prepare Financial Statement
7. Prepare & Post Closing Entries
1) Economic Event/Transaction: Not all information captured by the accounting system. Financial
Statements do not give exact picture of entity.
Financial Statements are consolidated to make the information more concise
F/S are made comparing 2 years
F/S are made for a period of time that is constant and continuous
2) Prepare Journal Entry: Identify transactions
Which elements are affected
What specific accounts and how are those accounts affected (DR/CR) and by how much
o Increase in Assets & Expense Debit
o Increase in Liabilities, OE, Revenue Credit
I. A = L + OE + R V E
3) Post Journal Entry to General Ledger
General Ledger is a record of all accounts
Posting V Transferring journal entries to the general ledger
T accounts represent general ledger
4) Prepare & Post Adjusting Entries
Adjusting Entries are not triggered with outside entries
o Must make adjustments for accrual system of accounting to update accounting system,
Generally:
Expense and Revenue recognition can happen at different times
Each entry includes a B/S account and I/S account
Each adjusting entry has other entry before or after it
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General tips on adjusting Entries
o Needed only when F/S prepared
o Never use cash account
o One B/S & one I/S account
4 Types of Adjusting Entries
I. Deferred Expense V Prepaid Expense V Cash Paid before expense
DR Expense, CR Asset
II. Deferred Revenue V Cash received before revenue recognized
DR Liability, CR Revenue
III. Accrued Expense V Expense realized before paid
DR Expense, CR Liability
IV. Accrued Revenue V Revenue realized before cash
DR Asset, CR Revenue
5) Prepare Trial Balance
6) Prepare Financial Statement
7) Prepare & Post Closing Entries
Closing Entry V To Close revenue & expense accounts into retained earnings (CR retained
earnings if net gain)
Chapter 4: Income Measurement & Reporting Objectives

Revenue Recognition
Revenue is a continuous process. Under the accrual basis Revenue is a gain by an economic entity for
providing goods/services.
2 Approaches:
Critical Event approach: Entity chooses an instant in the earning process to recognize revenue.
Gradual Approach: Revenue recognized little by little- Mainly for long term projects (i.e.
construction)
Criteria to Recognize Revenue (RCMP)

These criteria are consecutive to avoid uncertainty. Revenue Recognition should provide fair image of
companys economic activities
R: Revenue can be Measured
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C: Collection of Payment is reasonably assured
M: Costs to Earn Revenue Measurable- Matching
P: Performance has occurred V Transfer of risks and rewards
Critical Event Approach

100% of Revenue Recognized at each event (all or nothing)
Delivery: Uncertainty before delivery
Completion of Production: Production costs are largest
Cash Collection: Payment assured and Revenue Measured
I. Installation Method: Recognize Revenue in parts paid
Completion or Warranty/Right of Return V If there are significant uncertainties after delivery
(expenses not measurable)
Unrealized Gains & Losses: Transaction not triggered by foreign party- Asset evaluation does not
occur in IFRS because it does not follow criteria
Why Managers Have Accounting Choice

Use choice to provide best picture of firms financial position and economic transactions
Can also use their choice to twist the statements to his/her desire instead of giving best picture
to shareholders
Gains/Losses When entity sells one of its own assets at a different value from its books
Depends on Management amortization, estimates of residual value and capitalization methods
o DR Cash, CR Gain, CR Capital Asset
Expense Recognition: Expenses must be matched to revenue. Expenses not matching are recorded in
period they occur
Objectives of Financial Reporting

Managers Self Interest: Bonus, Job security, Performance
Tax Minimization
Stewardship: Follow IFRS and give good accounting info
Management Evaluation: Provide info on management decisions
Performance Evaluation
Cash Flow Prediction
Monitoring Contract Compliance
Earnings Management
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o Influence Stock Price
o Increase Selling Price of Company
o Ability to get loan
o Control Shareholders
o Maintain Loan
o Manager Bonus
Reduce Income: Tax Minimization
o Big Bath: Put more expenses in one year to make next year better
Smooth out income
Constraints
Limit choices available to managers
IFRS, GAAP
Powerful Shareholders
Auditors
Facts: Issues that surround the transactions/economic events
Chapter 5: Cash Flow, Profitability and the Cash Flow Statement

The Cash Cycle:
When analyzing the success of a business, a focus on only profitability is not enough. A business must
have cash on hand in order to keep investing and growing and most importantly, in order to survive.
Cash
collection Cash on Cash from
Cash used to from hand investments or
reinvest in customers loans
business or pay
creditors/ share
profits with
shareholders Purchase of
Sale of inventory,
goods marketing,
etc.
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Cash lag: delay between expenditure and receipt of cash
Inventory conversion period: time between delivery of inventory from supplier and sale to customer
Payables deferral period: time between receiving goods from supplier to time of payment to supplier
Receivables conversion period: time between delivery of goods to customer to time payment is
received from customer
Inventory self-financing period: time between inventory is paid to supplier to time payment is received
from customer
Total cash lag= payables deferral period + inventory self-financing period
OR inventory conversion period + receivables conversion period
Example: Schulich Corp. purchases books from suppliers and has 30 days to pay once they are delivered.
Customers have 60 days to pay their invoices once they purchase the goods. The books are normally
held for 50 days in the warehouse until sold to customers. What is the inventory self-financing period?
Answer: Total cash lag = inventory conversion period (50 days) + receivables conversion period (60 days)
= 110 days
Total cash lag (110 days)= payables deferral period (30 days) + inventory self-financing period
Inventory self-financing period = 80 days
The cash flow statement:

Cash from operations (CFO): use of or collection of cash in day-to-day business activities (e.g. cash and
cash equivalents, payments received from customers, payments to suppliers)
Cash from financing activities: cash raised from and paid to investors and creditors (e.g. mortgages,
bank loans, bonds, long-term debt, dividend payment, repurchase of shares)
Cash from investing activities: cash spent on buying capital assets and raised from selling assets (also
includes investment in equity and debt of other companies)
*IFRS requires disclosure of non-cash transactions in the notes
The cash flow statement does not reflect all activities in the financing and investing section if they do
not involve cash. This is why it is important to disclose the non-cash transactions in the notes.
Cash from operations:

Indirect method:
Step 1: Start with Net Income amount
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Step 2: Remove items included in net income calculation which have no effect on cash flow (e.g.
depreciation expense does not involve a cash outlay). If the item was subtracted to get to net income,
add it back and vice versa.
Step 3: Adjust for changes in non-cash working capital accounts
Accounts receivable increased from previous year subtract
Inventory increased from previous year subtract
Accounts payable increased from previous year add
In general , if an operating asset has increased, you will always subtract it from the CFO and if
decreased, you will add it to the CFO. If an operating liability has increased, you will always add
it to the CFO and if it decreased, you will subtract it from the CFO.
Evaluating the Cash Flow Statement:

The CFO is often used to measure liquidity, an entitys ability to meet short-term obligations. Comparing
the CFO to the current liabilities is a commonly used ratio to evaluate whether the entity is generating
enough cash from operations to meet current liabilities. If there is not enough cash from operations, the
company will have to rely on other sources (e.g. cash from financing and investing activities).
A negative CFO is not necessarily bad as it is common when a business is growing and expanding since
growth requires additional cash outlays.
Free cash flow (CFO capital expenditures) is another way to evaluate cash flows. The cash remaining
after investing in capital expenditures, which are necessary for the continuation of a business, can be
used as management wishes.
Cash flow Patterns:

Cash from Cash from Investing Cash from Financing Analysis
Operations Activities Activities
+ + + -building up cash reserves
-uncommon
-possibly seeking acquisition
+ + - -using CFO and cash from
investing to reduce debt or pay
dividends
+ - + -using CFO and loans and sale of
equity to expand
-successful growing entity
+ - - -likely a mature successful entity
-using CFO to reduce debt and
buy assets
- + + -entity may be shrinking but may
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still be successful
-selling capital assets and raising
equity to cover negative CFO
- + - -downsizing entity
-depending on sale of assets to
cover debt payments and
negative CFO
- - + -growing entity
-debtors and creditors are
providing financing for growth
- - - -not sustainable for entity, will
lead to eventual failure
Manipulating cash flow information:

All of the following methods to manipulate the cash flow statement lead to an increased cash flow in the
short term but there are negative consequences for the business, which are outlined below:
Decrease in spending on equipment Poor maintenance may lead to higher expenditures later
and also reduce efficiency, which increases cost of goods sold and decreases revenues
Decrease in marketing and promotion Low awareness in the future may decrease sales
Delaying payments to suppliers Poor credit rating, harder to obtain financing in the future
Selling capital assets not enough capacity in the future to meet customer demand, which
leads to decreased revenues
Selling the entitys accounts receivable to third party no negative consequence but will have
huge impact on CFO so when analyzing the statement, take this into consideration if this is
something the entity has done
How cash collection relates to cases:

Revenue recognition and cash flow relation- if you have a bank that is a user and is interested in
collection of interest payments, their objective is likely predicting cash flows of the business. Thus, a
viable alternative to consider when discussing revenue recognition is one that delays the recognition of
revenue to the point of cash collection. This may not be the best alternative, depending on other case
facts, but it is one that matches cash collection to revenue recognition and may be preferred by the
bank.
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Chapter 6: Cash, Receivables, and the Time Value of Money
Unit-of-measure assumption:
All economic activity of an entity can be reported in terms of a single unit of measure (e.g. Canadian
dollars)
The Effect of Changes in Purchasing Power

Inflation occurs over time increase in prices and decrease in purchasing power
IFRS requires adjustments for changes in purchasing power on financial statements in countries that
are hyperinflationary only (extremely high changes in prices). This is not a problem for Canada and many
stable economic countries. IFRS requires a decrease in purchasing power to be recorded as a loss on the
income statement.
The Effect of Changing Prices of Foreign Currencies

Exchange rates of currencies are always changing and thus, adjustments must be made for currencies
held by the entity that are not in the nominal reporting currency used on the financial statements.
Cash Management and Controls over Cash

Holding cash in the business is unproductive since its value (purchasing power) declines over time. If an
entity cannot find a productive use of their cash, they should use it to pay off creditors or shareholders.
Management has the responsibility of developing and maintaining internal controls.
Internal controls protect an entitys assets from theft, loss or inappropriate use.
A lack of adequate internal controls means users cannot rely on the accuracy of financial statements.
The management discussion and analysis letter in the financial statements address the assessment of
the entitys internal controls. This is not required under ASPE.
Some examples of internal controls over cash: segregation of duties (ensure that the person in charge of
handling the cash is not the same person who records the cash amount), bank reconciliation (explains
differences between bank account and general ledger amount), physical safeguards, management sign
off requirements, etc.
How to address internal controls on a case:

Step 1: Identify the weakness over controls (usually as simple as stating the case fact)
Example: The purchasing manager is responsible for placing purchase orders that are forwarded
to him from each department as well as ensuring payment to suppliers once the purchase order
is complete.
Step 2: State why this is important, or the implication to the business and the reason it is a weak control
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Example: There is a lack of segregation of duties in the purchasing department since the
purchasing manager has the power to both order and pay for the items ordered. This can lead to
a misappropriation of assets as the purchasing manager can do a number of fraudulent things
such as create a fictitious supplier and pay for goods that were never delivered (and pocket the
money himself).
Step 3: Give a recommendation on how to improve this internal control
Example: Once the purchase order is placed by the purchasing manager, the order should be
forwarded to the warehousing clerk who will be responsible for reconciling that the amount
ordered is the same as the amount received. The warehouse clerk will then forward the invoice
to the accounts payable department, who will pay the suppliers in order to ensure segregation
of duties.
Time Value of Money

Future Value (FV): the amount of money to be received in the future by investing today at a given
interest rate.
FV= (1 + r)n x Amount Invested
Where: r= interest rate n= number of years or periods ended when interest accrues
Higher interest rate means higher future value of amount invested today
Present Value (PV): the value today of money to be received in the future at a given interest rate.
PV= 1/ (1 + r)n x amount to be received or paid
Where: r= discount rate (or interest rate) and n= number of years or periods ended
Higher discount rate means lower present value of amount today
Present Value of an Annuity:

Annuity: a series of equal cash payments (inflows or outflows) made at equally spaced time intervals
e.g. $1,000 received every 6 months for a 3 year period
PV= [ 1/ (1+r)n] x amount to be received or paid in each period
PV= (1/r) x [1 (1/ (1+r)n) ] x amount to be received or paid in each period
Receivables
Sometimes customers will receive a discount if they pay early (e.g. on a $1,000 invoice, 2 percent
discount is given if paid x number of days before it is due so only 980 must be paid)
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Dr. Cash 980
Dr. Discount on A/R 20
Cr. Accounts Receivable 1,000
Uncollectible Receivables:
Direct write-off method: item by item basis, recognized when it becomes apparent that the customer
will not pay poor matching since this is not known until a period of time passes, which could cause
recognition of bad debts in a different period than in which the revenue and receivable arose
Journal Entry: Dr. Bad Debt Expense xx
Cr. Accounts Receivable xx
THE DIRECT WRITE-OFF METHOD IS NOT ACCEPTED UNDER ACCRUAL ACCOUNTING
Percentage of receivables method: estimation at the end of the period of percentage of receivables
that will not be collected better matching since recognized in same period
Balance sheet approach since an aging schedule of receivables is used to estimate the allowance for
uncollectible accounts and the allowance is the main focus whereas the bad debt expense is simply
there to balance the entry
Journal Entry: Dr. Bad Debt Expense xx
Cr. Allowance for uncollectible accounts xx
Percentage of credit sales method: estimation at the end of the period of percentage of credit sales
that will not be collected
Income statement approach since management uses a historical rate of collection of credit sales to
calculate the bad debt expense, which is the focus of this method while the allowance for bad debts is
the balancing amount to the entry
Journal Entry: same as above
Writing off receivables:

For the above estimation methods (percentage of credit sales and percentage of receivables methods),
once it is clear the customer will not pay, the journal entry is as follows:
Dr. Allowance of uncollectible accounts xx
Cr. Accounts receivable xx
These are both balance sheet accounts (allowance for uncollectible accounts is a contra-asset) and thus,
this entry has no effect on the income statement. The effect has already taken place when the estimate
was recorded.
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Long-term receivables:
Receivables due in more than a year or operating cycle
If interest is not being paid on the long-term receivable or the interest is below the market rate, revenue
amounts will be too high
The entry should be recorded at the time of sale at its present value:
Dr. Long-term receivable PV
Cr. Revenue PV
At every period ending, an adjusting entry should be made for the amount of interest accrued. This will
bring the Long-term receivable up to the value that will be received in the future by the time it is due:
Dr. Long-term account receivable xx
Cr. Interest Revenue xx
At the time it is due/paid, the long-term receivable will be equal to the amount of money received from
the customer. First, the long-term account receivable must be reclassified to become current since it is
due in this period:
Dr. Accounts Receivable yy
Cr. Long-term Account receivable yy
Dr. Cash yy
Cr. Accounts receivable yy
Chapter 7 Inventory
What is inventory?
IAS 2 defines inventory as, assets held for sale in the ordinary course of business
(finished goods), assets in the production process for sale in the ordinary course of
business (work in process), and materials and supplies that are consumed in production
(raw materials)
Classification as inventory depends on what an entity does
Manufacturing companies, companies that process inputs into finished goods, can break
inventory down into three subcategories: Raw Materials, Work-in-Process, and Finished
Goods
Where is inventory reported? Which financial numbers are affected by inventory valuation?
Which financial ratios are affected by inventory valuation?
Cost of inventory on hand is reported on the Statement of Financial Position (Balance
Sheet) and cost of inventory sold is reported on the Profit and Loss Statement (Income
Statement)
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Valuation of inventory on hand would affect current assets, as well as total assets, and the
amount for cost of goods sold would affect reported earnings on the Income Statement
Financial accounting measures and ratios are affected by the cost formula used because
cost of inventory and cost of sales is different under each approach
o gross margin, return on assets, return on equity, profit margin, current ratio and
debt-to-equity ratio differ for each of the cost formulas
How is inventory recognized under IFRS (IAS 2)?

Inventories are required to be stated at the lower of cost and net realisable value (NRV)
o NRV is the estimated selling price in the ordinary course of business, less the
estimated cost of completion and the estimated costs necessary to make the sale
o NRV of inventory could decline due to technological change, damaged goods
and/or fluctuation in commodity markets
o Any write-down to NRV should be recognised as an expense in the period in
which the write-down occurs and any subsequent reversal should be recognised in
the income statement in the period in which the reversal occurs
o Keep in mind that inventory could only be written-up to the amount of its initial
cost and inventory reversal only applies to inventory that was previously written
down
Cost of inventory includes all costs incurred to get the inventory ready for sale or use: purchase
price of the inventory, import duties and other taxes, shipping and handling, and any other costs
directly related to the purchase
o For manufacturers, cost of inventory should include all costs incurred to produce
finished goods: cost of materials, cost of labor directly used to produce the product, plus
an allocation of overhead incurred in the production process
o For companies in a service industry, cost of employee and partner time, travel costs,
administration costs, supplies, printing and any other costs incurred to provide services
would be recorded as inventory
Inventory cost should NOT include costs not related to producing the inventory and readying it
for use:
o Abnormal waste
o Storage costs
o Administrative overheads unrelated to production
o Selling costs
o Foreign exchange differences arising directly on the recent acquisition of inventories
invoiced in a foreign currency
o Interest cost when inventories are purchased with deferred settlement terms
Inventory Control Systems: Perpetual Inventory Systems and Periodic Inventory Systems
A perpetual inventory control system keeps an ongoing tally of purchases and sales of inventory,
and the inventory account is adjusted to reflect changes as they occur
o Computerized system of keeping track of inventory
o Can determine cost of sales at any time and is recorded at the time of sale (transactional
entry)
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A periodic inventory control system does not adjust the inventory account after every
transaction and purchases are accumulated in a separate purchase account
o Inventory balance at the end of a period is determined by a physical count of inventory
o Cost of sales is determined indirectly: Cost of sales = Beginning inventory + Purchases
Ending Inventory
o No journal entry is recorded for cost of sale until the end of the period when the
inventory is physically counted
The choice between a periodic and perpetual inventory control system is an internal control
issue, not an accounting issue
How is inventory valued under IFRS (IAS 2)?

For inventory items that are not interchangeable, specific costs are attributed to the specific
individual items of inventory
o Specific identification assigns the actual cost of a particular unit of inventory to that unit
of inventory so that the physical flow of inventory matches the flow of costs in the
accounting system
Inventory cost reported on the balance sheet is the actual cost of the specific
items that are in inventory and cost of sales is the actual cost of the specific
items sold during the period
For interchangeable items, FIFO or weighted average cost formulas is permitted
o First-In, First-Out (FIFO) ensures that cost associated with the inventory first is expensed
to cost of sales account first
Cost of inventory reported on the balance sheet represents the cost of the most
recently purchased or produced inventory
o With the average cost method, the average cost of the inventory on hand is calculated
and is used to determine cost of sales and ending inventory
The LIFO formula, which had been allowed prior to the 2003, is NOT allowed
Consistency is required: the same cost formula should be used for all inventories with similar
characteristics as to their nature and use to the entity
o For groups of inventories that have different characteristics, different cost formulas may
be justified
Keep in mind that the method used for valuing inventory has no effect on the underlying
economic activity of the entity but it may affect the amounts reported on the balance sheet and
income statement, so there may be economic consequences
o Different cost formulas allocate cost between ending inventory and cost of sales
differently but the sum of both accounts is always the same
Which valuation method should be used?

Specific identification can ONLY be used for unique inventory items which are NOT
interchangeable
IFRS does not recommend one method over another in choosing between FIFO or average cost
but they do have economic implications
o FIFO provides a close approximation of the replacement cost of the inventory as is
possible while still valuing the inventory at cost better facilitates prediction of future
cash flows
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o FIFO results in a higher current ratio when prices are rising as compared to the average
cost method
o Stakeholders who base predictions on an income statement based on FIFO might
overestimate future profitability
o Average cost provides a balance sheet measure of inventory which is not as current as
FIFO but cost of sales is more current than with FIFO
Could inventory be valued at other than cost?

Inventory could be measured at market value on the financial statements but this approach is
NOT permitted for public companies under IFRS
o Market value measures that can be used are NRV, what you can sell it for, and
replacement cost what it would cost to replace
o Using market value measures is equivalent to recognizing the revenue and profit from
inventory before it is sold
What are the tax implications of the chosen accounting policy for valuing inventory?
Income Tax Act is not very specific about accounting for inventory, in the calculation of taxable
income ,which means that entities will use the inventory accounting methods selected for
general purpose financial statements for tax purposes as well
Entities are also allowed to use the LCM rule for tax purposes which allows the taxpayer to
reduce income taxes by writing down the value of inventory to NRV
Entities are restricted to change inventory valuation methods for tax purposes from year to year
without justifiable reasons
Inventory management
Inventory turnover ratio provides information on how efficiently inventory is being managed by
measuring how quickly the entity is able to sell its inventory
o Inventory turnover ratio = Cost of sales / Average Inventory
o Average inventory can be calculated by summing the amount of inventory at beginning
and the end of the period and dividing by two
o A higher inventory turnover ratio is better because it indicates that the entity can sell or
turn over the inventory more quickly
The average number of days inventory on hand indicates the number of days it takes an entity
to sell its inventory
o Average number of days inventory on hand = 365/inventory turnover ratio
o A company improves its efficiency by reducing the number of days it holds inventory on
hand and indicates that the inventory is more liquid
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Chapter 8 Capital Assets
What qualifies as an Asset under IFRS?
Characteristics of an asset are as follows:

o It is probable that future economic benefits associated with the item will
flow to the entity; and
o Entity can control access to the benefit
o The cost of the item can be measured reliably
Expenditures such as advertising costs and employee training costs can NOT be
capitalized because they fail to meet the criteria of probable and measurable
future economic benefit
o An entity does not have control over the future benefits associated with
employee training costs because employees are free to leave anytime
What is a Capital Asset?
Resources that contribute to earning revenue over more than one period by
helping an entity produce, supply, support, or make available the goods or
services it offers to its customers
Are not bought and sold in the ordinary course of business, unlike inventory
Categories of capital assets: Property, plant and equipment; intangibles; and
goodwill
o Property, plant and equipment are tangible items that are held for use in
the production or supply of goods or services, for rental to others, or for
administrative purposes are expected to be used during more than one
period
o Intangible assets are capital assets without physical substance
o Goodwill is an intangible asset that arises when one business acquires
another and pays more than the fair value of the net assets purchased
How are Capital Assets measured under IFRS (IAS 16)?
The cost of an item of property, plant and equipment comprises:

o its purchase price, including import duties and non-refundable purchase
taxes, delivery costs, transportation insurance costs, installation costs and
legal costs
o any costs directly attributable to bringing the asset to the location and
condition necessary for it to be capable of operating in the manner
intended by management
After recognition as an asset, an item of property, plant and equipment shall be
carried at its cost less any accumulated depreciation and any accumulated
impairment losses
ACTG 2011 Introduction to Financial Accounting II Winter page 7 of 32

In the case of basket or bundle purchases, the purchase price is allocated in
proportion to the market values of each of the assets
o Different assets may then be accounted for differently and different
allocation will result in different financial statement effects
If an item of property, plant and equipment is made of parts or components for
which different useful lives or depreciation methods are appropriate, IFRS
requires each component to be accounted for separately
o Known as componentization
There are three other alternatives to historical cost accounting for capital assets:
net realizable value (NRV), replacement cost, and value-in-use
o NRV is the amount received from selling an asset after the selling costs
are deducted gives current estimate of the amount that would be
received if the property had to be sold
o Replacement cost is the amount that would have to be spent to replace a
capital asset
o Value-in-use is the net present value of the cash flow the asset will
generate or save over its useful life
Upon sale of a depreciable asset, the cost of asset and its accumulated
depreciation must be removed from the books
o If the amount received is greater than the carrying amount, a gain is
recorded
o If the amount received is less than the carrying amount, there is a loss
According to IFRS, a capital asset is impaired if its recoverable amount is less
than its carrying value
o Recoverable amount is the greater of the net realizable value (NRV) less
cost to sell and value-in-use
o A short-time decline in NRV or a short-term reduction in net cash flows is
not enough to trigger the writedown of a capital asset
o If an asset is impaired, the amount of the write-down equals carrying
amount less recoverable amount
o Write downs can be reversed if the recoverable amount increases in a later
period, except for write downs of goodwill
Which expenditures should be capitalized vs. expensed?
Interest can be capitalized but only until the asset is ready for use, after which it is
expensed
Costs that are not necessary or related to the acquisition, such as repairs or
unnecessary work caused by poor maintenance, should NOT be capitalized
A betterment increases the future benefit associated with a capital asset, perhaps
by increasing the assets useful life or improving its efficiency or effectiveness,
and should be capitalized and depreciated over the remaining life of the asset
Expenditures enabling an asset to do what it is designed to do are considered
repairs or maintenance and should be expensed when incurred

Generally, expenditures on existing capital assets are more likely to be repairs or
maintenance than betterments
Depreciation, Amortization and Depletion
IFRS uses the term depreciation for the process of allocating the cost of property,
plant and equipment to expense and amortization for intangible assets; depletion
is used for natural resources
IAS 16 defines depreciation as the systematic allocation of the depreciable
amount of an asset over its useful life
o Depreciable amount is the cost of an asset, or other amount substituted for
cost, less its residual value
o The depreciation method used shall reflect the pattern in which the assets
future economic benefits are expected to be consumed by the entity
Not all assets are depreciated
o Land is not subject to depreciation because it does not wear out or become
obsolete (an exception is land mined for natural resources)
o Intangibles with indefinite useful life are not amortized
o Internally generated intangible assets not amortized
o Goodwill is also not amortized
Several methods are accepted for deprecation and each of them allocates the cost
of a capital asset to expense in a different way, resulting in different net income
and carrying amount of the asset
o Under straight-line depreciation, the depreciation expense is the same in
each period, implying that the contribution to revenue by the capital asset
is the same each period
Depreciation expense = Cost Estimated residual value
Estimated useful life
o Accelerated depreciation methods allocate more of the cost of a capital
asset to expense in the early years of its life and less in the later years
based on the assumption that the assets revenue-generating ability is
greater in the early part of its life
Appropriate for assets sensitive to obsolescence and assets that
clearly lose efficiency and/or effectiveness over time (e.g. high-
tech equipment)
Depreciation expense = Carrying amount at the beginning of
period * Rate
o If an assets consumption can be readily associated with its use and not to
the passage of time or obsolescence, then a usage-based depreciation
method can be used
Unit-of-production method is the most common one but the
number of units that the asset will produce over an assets useful
life must be measurable
Depreciation expense = No. of units produced in the period * (carrying
Estimated no. of units produced amount)
over the assets life

It should be kept in mind that the various depreciation methods available and
estimates required to record deprecation can result in managers making choices
that serve their reporting objectives
o Depreciation has no impact on cash flow
o Managers choices can have economic consequences as management
bonuses and debt covenants depend on accounting measurements
What other alternatives are available to value Capital Assets other than historical cost,
under IFRS?
IFRS provides the option of valuing certain assets at market value using the
revaluation model
o Property, plant and equipment can be reported at market value if the
market value can be measured reliably
o Intangibles can be valued at market value if there is an active market for
them
o Gross method or the Proportional method can be used to revalue the
capital asset to its market value
o Gains are recorded in other comprehensive income in the statement of
comprehensive income and as accumulated other comprehensive income
revaluation surplus in the equity section of the balance sheet
o Losses due to revaluation are recognized in the income statement
o IFRS requires that revaluations be performed often enough so the
difference between the carrying amount and market value is not significant
based on the volatility in the price of the asset
Which intangibles can be recognized on the financial statements? How are they valued?
Under IFRS
To be recognized as an intangible asset an item must meet the following

conditions:
o It must be separately identifiable
o It must have future benefit
Future benefits must be controlled by an entity
Cost must be reliably measurable
Can also be recognized if it represents a contractual or legal right
Amortized over its useful life unless the life is indefinite
Can be valued at either cost or fair value but fair value can only be used if an
active market exists for the intangible
Costs associated with internally generated intangible assets such as customer lists
and loyalty, brands, information , training , advertising and promotion costs
cannot be recorded as an asset and must be expensed as incurred
o Future benefit is uncertain for these types of intangibles
o Measurability is also an issue most of the times

How is goodwill recognized on the Statement of Financial Position (Balance Sheet),
under IFRS?
Goodwill arises as a result of a company purchasing another company for more

than the fair value of net assets being obtained as part of the acquisition
o Represents the amount paid over and above the fair market value of the
purchased entitys identifiable assets and liabilities on the date of purchase
o Identifiable assets and liabilities are tangible and intangible assets and
liabilities that can be specifically identified
Goodwill is often attributed to things such as management ability, location,
synergies created by the acquisition, customer loyalty, reputation and benefits
associated with the elimination of competition
According to IFRS, goodwill is NOT amortized but must be tested for impairment
at each reporting date
o If fair value is deemed to be less than carrying value, it must be written
down to its fair value with the write-down amount expensed in the income
statement
IFRS prescribes specific guidelines for estimating the fair value of goodwill
Tax implications depreciation of capital assets
Income Tax Act is very specific about how capital assets can be depreciated for
tax purposes
o Uses the term capital cost allowance (CCA) to describe depreciation for
tax purposes
o Very detailed about the method and rate that must be used for each type of
asset
o There is no choice or discretion available to the managers the rules in the
ITA must be followed exactly
o The half-year rule requires an entity to deduct for tax purposes, in the year
the asset is purchased, only one-half of the otherwise allowable amount of
CCA
Prevents entities from getting the full tax benefit from a new
capital asset if the asset is purchased late in the year
Hence, the choice of one depreciation method over another, for financial
accounting purposes, will have NO effect on the income taxes payable because all
entities are required to use the CCA method for tax purposes
o Reducing income tax expense can NOT be a valid motive in the choice of
choosing a depreciation method for accounting purposes

Chapter 9 Liabilities
What qualifies as a liability?
IFRS defines a liability as obligations arising from past transactions or

economic events that require the sacrifice of economic resources to settle
o there must be a past transaction, an identifiable obligating event, which is
an event that creates an obligation where there is no other realistic
alternative but to settle the obligation
Liabilities should be discounted to present values but current liabilities are not
discounted because the impact is immaterial
Types of current liabilities
Current liabilities are obligations that will be settled in one year or one operating
cycle
o Important information for assessing the short-term liquidity of an entity
o Loans are reported as current liabilities if the amount has to be repaid
within the next year or if the loan is a demand loan, in which case it must
be repaid whenever the lender requests payment
o A line of credit allows an entity to borrow up to a specified maximum
amount whenever it requires the money
Is only classified as a current liability if money is actually
borrowed
o Accounts Payable are amounts an entity owes to suppliers for goods and
services
o Collections on behalf of third parties, such as GST or HST, does not
belong to the entity and a liability represents the obligation to remit the
amount
o Incomes taxes payable represents the amount of income taxes accrued
o Dividends payable is an obligation to pay the corporations shareholders a
dividend that has been declared
Is only recorded when a dividend is declared
o Accrued liabilities are recorded when an entity incurs an expense which
will be paid in the future (e.g. rent payable, wages payable)
o Provision is a non-financial liability of uncertain timing or amount
A non-financial liability is one which has no offsetting financial
asset on the books of another party
Payment is probable but amount is uncertain
Managements best estimate, expected value or the most likely
outcome should be used to record the provision
o Unearned revenue is recognized as a liability when an entity receives cash
in advance of providing goods or services (e.g. advance rent payment, gift
card purchases, points or rewards as part of a loyalty program)
Past transaction is the payment received in advance and agreement
on the services
Represents a future obligation to provide good or services

Will entail sacrifice of economic resources to provide the goods or
service
What is a bond? What are the characteristics of a bond? How is it recognized in the
financial statements?
A bond is a formal borrowing arrangement in which a borrower(also known as

issuer) agrees to make periodic interest payments to lenders as well as repay the
principal at a specified time in the future
o Interest and principal repayment has to made as specified in the loan
agreement regardless of how well the entity is doing
Essential characteristics of a bond include its face value, maturity date, coupon
rate, proceeds and effective interest rate
o Face value is the amount the borrower has to repay at maturity
Specified in the terms of the bond and cannot change
o Maturity date is the date on which the borrower has to pay back the
principal (face value of the bond) to the lender
Also identified in the terms of the bond
o Coupon rate represents the amount of periodic interest payments the
borrower has to pay
Stated in the terms of the bond as a percentage of the face value of
the bond and cannot be changed
o Proceeds (price) of a bond are the amount the borrower receives at the
issuance of the bond
Is not necessarily the same as the face value of the bond
Is dictated by the effective interest rate at the time the bond is
issued
Is determined by calculating the present value of periodic interest
payments and principal repayment using the effective interest rate
o Effective interest rate is the prevailing market interest rate required by
investors to invest in the bond
When the coupon rate offered by a bond is different than the effective interest
rate, the bonds sell at either a premium or a discount because the proceeds are not
equal to the face value of the bond
o Effective interest rate = Coupon rate bond sells at par proceeds =
face value
o Effective interest rate > Coupon rate bond sells at discount proceeds
< face value
Discount compensates the investor for investing in a bond offering
lower than market interest rate
o Effective interest rate < Coupon rate bond sells at premium proceeds
> face value
Premium compensates the borrower for borrowing at a higher than
market interest rate
Proceeds or price of a bond is equal to the present value of the cash flows that will
be paid to the investor, discounted at the effective interest rate

o Price = PV of interest payments + PV of Principal
o PV of interest payments = (1/r) *[1- (1/(1 + r )n)]*(coupon rate *face
value)
o PV of principal = face value / (1+ r)n
When bonds are sold for less than their face value, they are said to be selling at a
discount
o The discount is the difference between the face value and the proceeds of
the bond
o The carrying amount of the bonds, the face value of the bonds less the
bond discount, is the net present value of bonds discounted using the
effective interest rate
o The discount is amortized over the life of the bond and becomes part of
the interest expense in addition to the interest payments required by the
coupon rate
Interest expense is greater than interest payments made on the
bond
o Represents a contra-liability and is a debit balance which is credited each
period by the amount of amortization
When bonds are sold for more than their face value, they are said to be selling at a
premium
o The premium is the difference between the face value and the proceeds of
the bond
o The carrying amount of the bonds, the face value plus premium, is the net
present value of bonds discounted using the effective interest rate
o Bond premium amount carries a credit balance and the amortization of the
premium decreases interest expense
Interest expense is less than the interest payment
There are two methods for amortizing the discount or premium on a bond:
straight-line method and effective interest method
o IFRS requires the use of effective interest method to account for bond
discount of premium amortization
o Private companies following GAAP can use either straight-line method or
effective interest method
o With the straight line method, the discount is spread evenly over the life of
the bond
Amortization per period = Amount of discount / No. of periods
If bond interest payment dates do not coincide with the companys year end, it is
necessary to accrue the interest expense at the end of the period so the cost of
borrowing is recognized in the appropriate period, even though the interest is not
paid until later
In the case of a callable bond, entities have the option of retiring debt before it
matures which may be ideal is the market interest rates decrease in subsequent
period after bond issuance
o Accounting for early retirement of debt requires that any unamortized
discount or premium be removed from the books

A gain arises if the cost of retiring the debt is less than its carrying
amount and a loss occurs if the cost of retiring the debt is greater
than its carrying amount
As mentioned earlier, under IFRS, bonds and other forms of long-term debt are
measured at the present value of the cash outflow to the investors, discounted
using the effective interest date at the time of issuance
o It should be kept in mind that interest rate changes over the life of the
bond, which changes the market value of the bond, are not reflected in the
financial statements
o Gains and losses arising from subsequent market interest rate changes are
NOT recognized in the financial statements under IFRS, but disclosure of
the market value of the debt must be made in the notes to the financial
statements
What is a lease? What are the different types of leases and how are they accounted for
differently for financial reporting purposes?
A lease is a contract in which one entity, the lessee, agrees to pay another entity,
the lessor, a fee for the use of an asset
o An entity does not have to obtain separate financing for the purchase
which can be important when there is already a lot of debt and lenders
There are two categories of leases: capital or finance leases and operating leases
and each have different accounting implications
o A financing or capital lease transfers the risks and rewards of ownership to
the lessee and the leased asset and liability are recorded on the lessees
balance sheet at the present value of the lease payments to be made over
the life of the lease
A capital lease is considered to be similar to a purchase of an asset,
in substance, thus recognized on the financial statements in a
similar manner
o An operating lease does not transfer the risks and rewards of ownership to
the lessee but are retained by the lessor and the lessee recognizes an
expense when the payment to the lessor is paid or payable and the lessor
recognizes revenue from the lease when payments are received or
receivable
The lessee does NOT record the leased asset or the associated
liability on its balance sheet
Lessee has off-balance-sheet financing which may be preferable in
terms of decreasing debt-to-equity ratio
A lease should be classified as a capital lease if ANY of the following three
criteria are met:
o It is likely that the lessee will get ownership of the asset by the end of the
lease
o The lease term is long enough that the lessee receives most of the
economic benefits of the asset

o The present value of the lease payments is equal to most of the fair value
of the leased asset
Classifying a lease as either a capital or an operating lease requires the application
of the accounting standard substance over form in order to prevent managers
from off-balance-sheet financing
Leased capital assets are accounted for in much the same way as any capital asset
depreciated over their useful lives
o If the term of the capital lease is shorter than the useful life of the asset
and the lessee is not likely to take title of the asset at the end of the lease,
the asset should be depreciated over the term of the lease
IFRS requires extensive disclosure about an entitys lease transactions
What are contingencies? When and how are they recognized in the financial statements?
IFRS identifies economic events called contingent liabilities, which have the
following characteristics:
o A possible obligation whose existence has to be confirmed by a future
event beyond the control of the entity (e.g. lawsuit)
o An obligation with uncertainties about the probability that payment will be
made or about the amount of payment
A contingent liability is not recognized in the financial statements but is disclosed
in the notes unless payment is probable (>50%), in which case it is classified as a
provision and recorded
A contingent asset is an asset whose existence is uncertain
o Are NOT recognized in the financial statements, but are disclosed in the
notes if realization is probable
IFRS defines probable as more like than not
o The asset is only realized if the realization of the asset becomes virtually
certain (>95%)
What are commitments? Should they be recognized in the financial statements?
A commitment is a contractual agreement to enter into a future transaction

o According to IFRS, agreements committing an entity to future purchases
of goods or services are not reported as liabilities
o These agreements are called executory contracts
o When neither party has performed its part of the bargain, then neither the
liability to pay nor the asset representing the good or service to be
received in recorded
o Disclosure of such executory contracts may be appropriate for users of
financial statements
What are subsequent events? When and how are they accounted for?
A subsequent event is an economic event that occurs after an entitys year-end but
before the financial statements are released to stakeholders

There are two types of subsequent events:
o Events that provide information about circumstances that existed at the
year-end (e.g. settle of a lawsuit resulting in a liability or customer
bankruptcy resulting in uncollectible accounts)
Financial statements are adjusted to reflect the new information
o Events that happened after the year-end of the period
Only appear in the notes to the financial statements
IFRS says that events that will have a significant or material effect
on the entity should be disclosed
Financial Statement Analysis
Debt-to-equity ratio is a measure of the amount of debt relative to equity an entity

uses for financing
o Gives an indication of an entitys risk and ability to carry more debt
o Debt-to-equity ratio = Total liabilities / Total shareholders equity
Interest coverage ratio is one of the coverage ratios that measure an entitys
ability to meet its fixed financing charges
o Indicates how easily an entity can meet its interest payments from its
current income
o Interest coverage ratio = (Net income + Interest expense + Income tax
expense) \ Interest expense
What gives rise to future income taxes? How are they accrued on the financial
statements?
Future income taxes appear as assets and liabilities on the balance sheet and they
are reported on the income statement as part of the income tax expense
Future income tax assets and liabilities and future income tax expense arises
because the accounting methods used to prepare general purpose financial
statements are sometimes different from the methods used to calculate the income
tax an entity must pay
o Differences arising due to revenues and expenses being recognized at
different times for accounting and tax purposes are called temporary
differences
o Permanent differences are revenues and expenses recognized for tax
purposes but not for financial reporting purposes, or recognized for
financial reporting purposes but not for tax purposes
The amount of future income tax associated with an asset or liability at a point in
time is calculated using the following formula:
o [Tax basis of an asset or liability Accounting basis of an asset or
liability] * tax rate
The tax basis of an asset or liability is its carrying amount for tax
purposes
The amount of future income tax expense for a period related to an asset or
liability is calculated as follows:

o Future income tax (end of period) Future income tax (beg. of period)
Future income tax liability means that more expenses are recognized for tax
purposes than for financial reporting purposes

Practice Questions (with solution)
Possible technical questions on the exam: 1) Inventory cost formulas (Chapter 7)
2) Depreciation methods (Chapter 8)
3) Bonds and long-term debt (Chapter 9)
Tips for studying for the exam:
* Practice all assigned lab questions AGAIN so that you are well-prepared to do
them under a time constraint during exam
* Solved review problems at the end of each chapter are also good practice for the
technical part of the exam
* Practice a few cases by WRITING out the solution as opposed to orally going
over them
1 - Hammer Ltd had 1,000 units of inventory on hand at the beginning of the year worth
$4,000. During the year they purchased 15,000 units at $4.25 and 10,000 units at $4.40.
They sold 24,500 units during the year at an average price of $7.50 and pay taxes at 25%.
(20 minutes)
a) If Hammer uses the average cost assumption for inventory valuation:

i- What would be the ending inventory value at year-end?
Avg. cost per unit = [(1000 units @ $4) + (15,000 units @ $4.25) +
(10,000 units @ $4.40] / (1000 + 15,000 + 10,000) = $4.30 / unit
Ending inventory = (Beginning inventory + purchases sales) *Avg. cost
per unit
= (1000 + 15,000 + 10,000 24,500) * $4.30
= $6,450
* The sales price of inventory is irrelevant in determining the value of inventory to be
recognized in the Statement of Financial position because inventory is valued at lower of
cost or market value.
ii- What is their gross profit for the year?
Sales Revenue = 24,500 units * $7.50 = $183,750

Cost of sales = 24,500 units * $4.30 = $105,350
Gross Profit = $183,750 - $105,350 = $78,400
* Note: based on the assumption that 25% implies income taxes, they are not accounted
for in the calculation of gross profit
b) Hammer has a bank loan outstanding, the size of which is related to the
company's inventory. If prices are rising which cost flow assumption would
management most likely prefer?
FIFO values the most recent inventory as ending inventory on the Statement of
Financial Position as cost of the earliest inventory is transferred to the income

statement. If prices are rising, most recent inventory will be valued at a higher
price and will thus result in a higher valuation of inventory on the balance sheet.
Average cost averages the cost of inventory over all the acquired units and thus
results in a lower valuation of ending inventory on the Statement on Financial
Position as opposed to FIFO.
Therefore, management would prefer to use FIFO to value inventory as it
will result in a higher ending inventory balance and will be beneficial with
respect to the bank loan.
c) For its next fiscal year end (not the current year end) Hammer Ltd is
considering changing to the FIFO cost flow assumption. How will this impact
financial reporting?
Changing to the FIFO cost flow assumption could possibly have a significant
impact on the financial statement numbers but the magnitude of the impact would
depend upon the difference in the change in prices. Changing to FIFO from
Average cost would result in a higher ending inventory, higher current
assets, higher total assets, a higher current ratio, lower cost of sales and a
higher net income.
2 - Noisy Kitchens Inc has a new showroom that cost $400,000. During the construction
phase Noisy Kitchens Inc incurred interest expense of $10,000 (not included in the
$400,000). It took six months to build. It will be amortized using the declining balance
method at a rate of 5%. The estimated residual value of the building is $50,000, and it has
an expected useful life of 20 years. Noisy Kitchens Inc records a full year amortization in
the first year of purchase or use. Assuming the first year's amortization expense was
recorded properly. Answer the following questions as they relate to Noisy Kitchens Inc
and its new showroom. (25 minutes)
* Note: all of the following answers are based on the assumption that we are referring to
Year 2 as the current year.
a) What would be the amount of amortization expense for the second year?
Amortization expense (year 1) = ($400,000 + $10,000) * 5% = $20,500

Amortization expense (year 2) = ($400,000 + $10,000 - $20,500) * 5% = $19,475
b) What would be the amount of accumulated amortization at the end of the

second year (after adjusting entries)?
Accumulated amortization (year 2) = $20,500 + $19,475 = $39,975
c) What would be the net book value of the showroom at the end of the second
year (after adjusting entries)?
Net book value = $410,000 - $39,975 = $370,025
d) What would be the impact on the Statement of Cash flows for the current year?

Depreciation expense is a non-cash expense deducted in the calculation of net
income and should be added back in cash flow from operations. During the
current year, depreciation expense of $19,475 will be added back to net income
in the calculation of cash flow from operations.
e) How should the interest expense be recorded?
Interest expense of $10,000 incurred during the construction phase should be dealt
with as part of the acquisition cost of the asset and is thus capitalized with the
asset. Each year, using the declining balance method, a portion of the capitalized
interest is transferred to the income statement along with the depreciation expense
on the asset as a whole.
3- The following items pertain to the liabilities of ABC Corporation. You may assume
that ABC Corporation began business on January 1, 2010. (10 minutes)
*On January 1, 2010, ABC Corporation issued bonds with a face value of $
50,000. The bonds are due in five years and have a face interest rate of 10%. The
market rate on January 1 for similar bonds was 12%. The bonds pay interest
annually each December 31. Brent has chosen to use the effective interest method
of amortization for any premium or discount on the bonds.
* On December 31, 2010, ABC Corporation signed a lease agreement with York
Leasing. The agreement requires ABC to make annual lease payments of $ 3,000
per year for four years, with the first payment due on December 31, 2011. The
agreement stipulates that ownership of the property is transferred to Brent at the
end of the four year lease. Assume that an interest of 8% is used for the leasing
transaction.
(a) Make the accounting entries necessary on December 31, 2010 for the
above 2 transactions.
Carrying value of the bond = [$50,000 * (P/F, 12%, 5)] + [($50,000*10%)

* (P/A, 12%, 5)]
= $28,371.50 + $18,024 = $46,395.5
Interest payment on bonds:
Interest expense ($46,395.5 * 12%)5,567.5-
Discount Amortization (5,567.5 5,000).567.5-
Cash ($50,000 * 10%) ..5,000-
The lease agreement classifies as a capital lease because ABC Corporation will get
ownership of the asset by the end of the lease term, as per the terms of the contract.
Present value of lease payments = $3,000 * (P/A, 8%, 4) = $9,936.40
Lease Agreement:
Asset under capital lease....9,936.40-
Lease liability..9,936.40-

*Note: Interest expense exceeds the actual interest payment because the bond is issued at
a discount as the effective interest rate is more than the coupon rate offered by the bond.
(b) Explain if the entry for year 2 will be the same as (a) above (You do
not need to do the journal entries)
The same account will be debited and credited for the bond in year 2 but
the numbers will differ. Discount amortization will increase each year
and so will the interest expense because effective interest method is
being used by ABC Corporation.
After the initial recording of the leased asset and lease liability, the asset
and liability are accounted for separately. Leased capital asset is
accounted for much the same way as any capital asset depreciated
over the useful life of the asset because ABC will be getting ownership at
the end of the lease term. Interest expense will also be recognized in
subsequent years by multiplying the liability outstanding at the beginning
of the year by the interest rate.
(c) Is the structure of the lease the best for ABC Corporation? Why?
Generally companies who have debt, such as ABC Corporation, prefer to

reduce the amount of liability in order to lower their debt-to-equity ratio.
Although there is no mention of any such covenant with respect to the
amount of liability, most companies prefer to structure a lease such that it
could be classified as an operating lease in order to benefit from off-
balance-sheet financing. If a lease is classified as an operating lease, no
liability is recorded and expense is recognized whenever a lease payment
is paid or comes due. Hence, the structure of the lease may not be the
best for financial reporting purposes for ABC Corporation as it
increases liability and the debt-to-equity ratio.

Case Writing TIPS
General
Always good to read the required first
Identify your role and who you are addressing (To, From and RE)
If your role is not stated in the required, then refer to the last paragraph of the case
Underline/highlight any important information
Reading the case
Identify whether it is a public or private company
Underline any constraints (IFRS/GAAP)
Underline all the stated users and their objectives
Identify issues
Optional- Use a timeline
Re-read your required to clarify what you really need to do
Rank your issues based on materiality/importance
Writing the case
Start off with TO, FROM and RE
Brief overview of the case
Users and objectives, clearly explain each users motive
Make sure you identify the most important user
Try to limit yourself to the three or four most important users
Introduce your issue with a header (Capitalizing vs. Expensing)
Briefly describe the issue in one line or so
State at least two different alternatives
Talk about alternative keeping in mind your constraints
Make sure you talk about the impact each of your alternatives will have on the primary users
State your recommendation based on the constraints and then consider the objectives of your
primary users
Page 19 of 28
EXAMPLE CASE SOLUTION TO BBEAN COFFEE INC.
Page 20 of 28
To: BBean Coffee Inc.
From: Accounting Advisor
RE: Accounting Options and Recommendation for the BBeanss franchise sale transaction
Introduction: BBean Coffee Inc. can recognize revenue from its sales of franchises in a few ways.
However, management needs to pick a revenue recognition policy which meets their and the
stakeholders objectives. The fact that BBean Coffee Inc is a public company, we have to adhere to IFRS
principles. We have to ensure that all criteria for recognizing revenue are met.
Users and Objectives
BBeans Management (primary): The main objective of the Management is to maximize earnings so that
they can attract more clients and increase the number of franchises. Furthermore, they need to make
sure that they adhere to IFRS principles, since, potential franchise holders would want to see
transparency and accuracy in their financial statements.
Auditor: The auditors main objective is using the right revenue recognition policy to ensure BBean is
adhering to IFRS.
Franchise Owners: The main objective of the franchise owners is to see that BBeans is not involved in
any fraudulent activities. In another words they want to ensure that BBean receives and unqualified
opinion from Audit (Clean). If BBeans were involved in any accounting scandal, it would have a negative
impact the value of their investment, which is the franchise. Hence, the current franchise owners would
want to see and make sure that the reputation of BBeans Coffee Inc. is not hampered in any way.
Potential Franchise Owners: Their main objective would be to make sure that the company in which
they are investing their money, has a good reputation, and also has fair accounting principles. For
potential franchise holders, their most important concern is that the company does not go bankrupt,
which usually happens when the management manipulates their financial statements to make them
look more appealing. Hence, the potential franchise owners would want to make sure that BBeans
Coffee Inc. has transparent and fair accounting practices.
Canada Revenue Agency (CRA): The main objective of the CRA is to make sure that BBeans Coffee Inc. is
reporting accurate net income, which conversely would affect the amount of taxes they pay.
Shareholders: Since, shareholders are a major stakeholders of almost every public company. The
primary objective of shareholders would be to maximize yield on their investment.
Page 21 of 28
Issue: Revenue recognition
The issue at hand is whether BBean should continue using their current revenue recognition policy or
change it?
Revenue from sales can be recognized in the following ways:
Alternative 1: Cash collection - Revenue can be collected when cash is received from the customer in
instalments. This approach to recognizing revenue removes all uncertainties regarding BBean Incs
revenue which is very important in this case because we have to abide by IFRS. The revenue recognition
criteria is met, performance, revenue amount, cost amount and cash collection have already happened.
The cost and revenue are measureable, performance has occurred because the franchise has been sold
and assurance of collection is met because we are recognizing revenue after the cash payment is made.
This takes care of the Auditors concern about earnings being overstated because revenue is not
recorded immediately after the sale; it is recorded once the payment is received. The first payment of
$100,000 will be recognized immediately and the remaining $200,000 will be recognized in annual
instalments of $50,000. The company will also pay a lower tax rate because this alternative will
recognize revenues in instalments which will reduce the Net Income. This approach also provides steady
cash flow which can be very beneficial to BBean Inc, because potential buyers will be impressed by the
steady growth of the company.
Alternative 2: Record immediately with providing collateral- Revenue can also be recognized
immediately as long as the franchise owners can provide collateral for the remaining payment. If we
have collateral against the remaining $200,000 that is to be paid in instalments, we have assurance of
collection. Performance has already occurred because we have already sold the franchise and revenue
and costs are measurable. Revenue recognition criteria is met which is the most important concern
because BBean is a public company. This meets managements objective to record the full amount
($300,000) immediately. This increases the Net Income which the management wants so they can
attract potential buyers. This increases the Net Income in the period the sale is made which also means
that higher taxes will have to be paid. The auditors concern is that earnings are overstated, however as
long as we have collateral against the pending amount of $200,000; the auditor should not be
concerned because we are adhering to IFRS principles. There will however remain a deviation in
earnings from one accounting period to another. Lets say in one accounting period we sell two
franchises ($600,000) and in the next accounting period we sell only one franchise ($300,000), this will
create a lot of deviation in the earnings in one accounting period relative to the other.
Page 22 of 28
Alternative 3: Recognize the revenue when all the instalments have been received- the third alternative
would be to recognize revenue after all the instalments have been made by the franchise owner. By
using this alternative, all the criterions of revenue recognition are met. The first criterion is that
performance has occurred: in this case, since the franchise has already been sold, performance has
occurred. The second criteria is that the amount of revenue can be reasonably measured: in this case,
since the franchise has already been sold for a monetary value, there is no need to estimate the
revenue, as it can be easily calculated, since it has already been collected by BBeans Coffee. The third
criterion of revenue recognition requires costs to be measurable. In this case, the cost incurred can be
easily estimated, as BBeans Coffee has been in this business for a few years, and also has a lot of
experience in selling the franchises. Hence, they can easily measure the costs that are associated with
revenue collection, which comes from selling franchises. The last criterion is that the collection of the
revenue should be reasonably assured. In this case, we recognize the revenue only when all the
instalments are received by BBeans Coffee Inc. Hence, we have complete assurance that revenue will be
collected. Therefore, all the four criterions of the revenue recognition are met. Moreover, by using this
method of revenue recognition, we are not overstating the net income which is a major issue for BBeans
Coffee. Another benefit of using this method is that, BBeans would be showing transparency in their
accounting practices, as nowadays, shareholders are willing to invest in the companies that adhere to
IFRS principles, especially after the accounting scandals of WorldCom, and Enron. This method
recognizes revenues the latest which can be of concern to management because they are looking to
inflate earnings to attract potential buyers.
Recommendation: As an accounting advisor, I believe recognizing revenue upon cash collection in
instalments would be the most appropriate course of action. This method of accounting for revenue
meets the revenue recognition criteria keeping BBean Coffee Inc. away from fraudulent accounting
practices. The cost price is measurable considering BBean Inc. has been in business for quite a significant
time. As mentioned in the company profile BBean Coffee Inc. first sold large franchises and have now
moved on to selling relatively small franchises. Revenues are measurable because the selling price is
already determined ($300,000) and performance has already occurred because we have sold the
franchise and lastly assurance of collection is also met because we are recording revenue after cash has
been collected. That being said, I concur with the auditors concern that recognizing revenue
immediately overstates earnings and fails to reflect the substance of the transaction stream.
Recognizing revenue upon cash collection takes care of that concern because we are only recording
$100,000 as revenue immediately deferring the rest till we receive the payments. The remainder
Page 23 of 28
$200,000 is recorded as recognized when the yearly instalments are made. Managements objective is
to record the full amount so that earnings seem significant. Although this policy fails to meet the
managements objective, the management is still able to recognize $100,000 as immediate revenue,
which is still a significant amount. This accounting policy also provides them with steady cash flow
because revenue is recorded upon cash collection, which is essential in a business operation.
Furthermore, earnings will grow at a steady pace because revenue will be recognized when cash is
collected; steady growth in earnings can fulfill managements purpose of attracting potential franchise
buyers. Steady growth adds to a companys goodwill which attracts potential buyers. Public companies
are taxed on earnings; there is a direction correlation between the two variables. If this accounting
policy is implemented, BBean Inc. will pay a lower tax rate because earnings will be relatively lower. This
will leave the company with a higher disposable income, which can benefit management who are
seeking to make Net Income seem as high as possible. Franchise owners also benefit from this
accounting policy. The fact that this accounting policy results in growth at a steady pace, it increases the
market value of BBean Coffee Incs franchise.
Why not the other alternatives? The third alternative recognizes revenue at the very end when all
payments are made. This accounting policy fails to meet the managements objective. The second
alternative, fails to meet the auditors concern who feels that recording revenue immediately does not
reflect the substance of the transaction stream and overstates earnings. Even though this accounting
policy meets the management's objective, it fails to bring about growth at a steady pace. The third
alternative fails to meet the management's objective who is the most important stakeholder in this case.
Whereas the second alternative ignores the auditors concern about earnings being overstated. The first
alternative recognizes the auditors concern and also recognizes the management's objectives and offers
concrete evidence that all IFRS principles will be adhered to.
2) The course of action that BBean is taking would have the following impact on balance sheet and
income statement accounts. Under assets, the account that is affected is accounts receivable. The
current accounting policy recognizes the full payment ($300,000) immediately. The journal entry is as
follows:
Dr. Cash 100,000
Dr. Acc. Receivable 200,000
Cr. Sales Revenue 300,000
Page 24 of 28
The recommended accounting policy would reduce assets because revenue is recognized when cash is
collected. Hence, the full amount will not be recognized which will reduce the assets for the fiscal year.
The entry would look like the follows:
Dr. Cash 100,000
Cr. Revenue 100,000
The recommended change in the accounting policy will not have any impact on BBean Incs liabilities.
This is because we are not recording cash payments as unearned revenue. Hence, BBean Incs liabilities
would remain the same. Revenues will be impacted by the recommended change in accounting policy.
The current accounting policy recognizes the total franchise selling price immediately when it is sold.
The recommended accounting policy recognizes only $100,000 immediately which significantly lowers
BBean Incs revenues. Expenses on the other hand will remain unchanged. As a result Earnings would
have the same impact as revenue because only $100,000 is recorded immediately after the sale of the
franchise whereas the rest is recognized when instalments are received.
I hope that I have answered all your questions, and please feel free to contact me if you have any
queries.
Yours Sincerely,
Accounting Advisor
Page 25 of 28
Case Taken up during session:
Page 26 of 28
Page 27 of 28

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ACTG2011

What is Students Offering Support?

This is accomplished through our Exam-AID initiative where student volunteers

Chapter 2: Financial Statements

Chapter 4: Income Measurement & Reporting Objectives

Criteria to Recognize Revenue (RCMP)

Critical Event Approach

Why Managers Have Accounting Choice

Objectives of Financial Reporting

Chapter 5: Cash Flow, Profitability and the Cash Flow Statement

The cash flow statement:

Cash from operations:

Evaluating the Cash Flow Statement:

Cash flow Patterns:

Manipulating cash flow information:

How cash collection relates to cases:

The Effect of Changes in Purchasing Power

The Effect of Changing Prices of Foreign Currencies

Cash Management and Controls over Cash

How to address internal controls on a case:

Time Value of Money

Present Value of an Annuity:

Writing off receivables:

How is inventory recognized under IFRS (IAS 2)?

How is inventory valued under IFRS (IAS 2)?

Which valuation method should be used?

Could inventory be valued at other than cost?

Characteristics of an asset are as follows:

What is a Capital Asset?

How are Capital Assets measured under IFRS (IAS 16)?

The cost of an item of property, plant and equipment comprises:

ACTG 2011 Introduction to Financial Accounting II Winter page 7 of 32

Which expenditures should be capitalized vs. expensed?

ACTG 2011 Introduction to Financial Accounting II Winter page 8 of 32

Depreciation, Amortization and Depletion

ACTG 2011 Introduction to Financial Accounting II Winter page 9 of 32

To be recognized as an intangible asset an item must meet the following

ACTG 2011 Introduction to Financial Accounting II Winter page 10 of 32

Goodwill arises as a result of a company purchasing another company for more

Tax implications depreciation of capital assets

ACTG 2011 Introduction to Financial Accounting II Winter page 11 of 32

IFRS defines a liability as obligations arising from past transactions or

Types of current liabilities

ACTG 2011 Introduction to Financial Accounting II Winter page 12 of 32

A bond is a formal borrowing arrangement in which a borrower(also known as

ACTG 2011 Introduction to Financial Accounting II Winter page 13 of 32

ACTG 2011 Introduction to Financial Accounting II Winter page 14 of 32

ACTG 2011 Introduction to Financial Accounting II Winter page 15 of 32

What are commitments? Should they be recognized in the financial statements?

A commitment is a contractual agreement to enter into a future transaction

ACTG 2011 Introduction to Financial Accounting II Winter page 16 of 32

Financial Statement Analysis

Debt-to-equity ratio is a measure of the amount of debt relative to equity an entity

ACTG 2011 Introduction to Financial Accounting II Winter page 17 of 32

ACTG 2011 Introduction to Financial Accounting II Winter page 18 of 32

a) If Hammer uses the average cost assumption for inventory valuation:

ii- What is their gross profit for the year?

Sales Revenue = 24,500 units * $7.50 = $183,750

ACTG 2011 Introduction to Financial Accounting II Winter page 19 of 32