Section A.

External Financial Reporting Decisions (15% - Levels A, B, and C)

Section A.1. Financial Statements
a. Identify the users of these financial statements and their needs
Financial Statements

Financial statements are the primary means of communicating financial information to

external parties. To be useful, information presented in the financial statements must be
relevant and faithfully represented.

A full set of financial statements includes the following statements:

1) Statement of financial position (also called a balance sheet)
2) Income statement
3) Statement of changes in equity
4) Statement of cash flows
5) Notes to Financial Statements

Users of Financial Statements

Financial statements prepared by the Companies are used by different categories of

individuals and corporates in a sense relevant to them. The most common users of the
financial statements are listed below:
Management of the Company
Management needs financial statements to assess financial strengths and deficiencies, to
evaluate performance results and past decisions, and to plan for future financial goals and
steps toward accomplishing them.

Investors
Investors need information to decide whether to increase, decrease, or obtain an investment
in a firm.

Employees
Employees want financial information to negotiate wages and fringe benefits based on the
increased productivity and value they provide to a profitable firm.

Creditors
Creditors need information to determine whether to extend credit and under what terms.

Financial Advisors and Analysts

Financial advisors and analysts need financial statements to help investors evaluate
investments.

Stock Exchanges Need Financial Statements.

Stock exchanges need financial statements to evaluate whether to accept a firm’s stock for
listing or whether to suspend the stock’s trading.

Regulatory Agencies
Regulatory agencies may need financial statements to evaluate the firm’s conformity with
regulations and to determine price levels in regulated industries.

b. Demonstrating an understanding of the purposes and uses of each statement.

Purposes and Uses of the Income Statement

• The income statement is useful in determining profitability and value for investment
purposes, as well as creditworthiness for prospective lenders.
• Evaluating profitability provides insight into the utilization of company assets in the creation
of wealth for shareholders.
• The evaluation of the income statement allows users to determine/estimate the value of the
company as well as make decisions regarding the long-term solvency.
• The multistep income statement categorizes and lists the components of net income for
users to determine profit (loss) from operations and from ancillary activities.

Purposes and Uses of Statement of Changes in Equity

• This primary purpose of Statement of Changes in Equity is to provide details about all the
movements in the equity account during an accounting period, which is otherwise not
zavailable anywhere else in the financial statements.
• It helps the shareholders and investors make more informed decisions about their
investments.
• Further, it also allows the analysts and other readers of the financial statements to
understand what factors resulted in the change in the equity capital.

Purposes and Uses of the Balance Sheet

• The statement of financial position, also called the balance sheet, reports the amounts of
assets (items of value), liabilities (debt), and equity (net worth) and their relationships at a
moment in time, such as at the end of the fiscal year.
• It helps users assess liquidity, financial flexibility, the efficiency with which assets are used,
capital structure, and risk.

• Classification of items on the balance sheet allows users of the financial statements to
determine not only the composition of assets and liabilities, but also to evaluate the liquidity
and long-term solvency

Purposes and Uses of Statement of Cash Flows

• The primary purpose of the statement of cash flows is to provide relevant information about
the cash receipts and cash payments of an entity during the period.
• The statement of cash flows should help users assess the entity’s ability to generate positive
future net cash flows (liquidity), its ability to meet obligations (solvency), and its financial
flexibility.
• The statement of cash flows explains the change in cash and cash equivalents during the
period. It reconciles the period’s beginning balance of cash and cash equivalents with the
ending balance.

c. Identifying the major components and classifications of each statement

Components of the Income Statement

The multistep income statement consists of two categories: operating items and nonoperating
items. Operating revenues and expenses are directly related to the primary revenue
generating activities of the company.

Nonoperating revenues, expenses, gains, and losses (interest expense, interest revenue,
etc.) are associated with the company's peripheral or incidental activities and included in
income from continuing operations.

Classifying items as either operating or nonoperating allows users to differentiate between

recurring earnings and nonrecurring earnings. Recurring items are likely to occur on a regular
basis and have a more consistent effect on earnings. Nonrecurring items are not likely to
recur and can have an irregular effect on earnings.

Income tax expense is reported separately on an income statement as a major subtotal.

Statement of Changes in Equity Components

Shareholders' equity consists of four main classifications:
1. Paid-in capital.
2. Retained earnings.
3. Accumulated other comprehensive income and
4. Treasury stock.

Capital Stock
Legal capital or capital stock is the amount of capital that must be retained by the corporation
for the protection of creditors.

Common Stock
The common shareholders are the owners of the firm. They have voting rights, and they
select the firm’s board of directors and vote on resolutions. Common shareholders are not
entitled to dividends unless so declared by the board of directors. A firm may choose not to
declare any.
Common shareholders are entitled to receive liquidating distributions only after all other
claims have been satisfied, including those of preferred shareholders.

Preferred Stock
Preferred stock has features of debt and equity. It is classified as an equity instrument and
presented in the equity section of the firm’s balance sheet.

Preferred stock has a fixed charge, but payment of dividends is not an obligation. The
payment of dividends is at the firm’s discretion. Preferred shareholders tend not to have
voting rights.

Par Value
Generally, preferred stock is issued with a par value, but common stock may be issued with or
without a par value.

No-par common stock may be issued as either true no-par stock or as no par stock with a
stated value. Any excess of the actual amount received over the par or stated value of the
stock is accounted for as additional paid-in capital.

Authorized, Issued, and Outstanding

A corporation's charter contains the amounts of each class of stock that it may legally issue,
and this is called authorized capital stock.

When part or all the authorized capital stock is issued, it is called issued capital stock.
Because a corporation may own issued capital stock in the form of treasury stock, the amount
of issued capital stock in the hands of shareholders is called outstanding capital stock.

In summary, capital stock may be:

1. Authorized (in the corporate charter);
2. Authorized and issued (previously issued to shareholders but no longer owned by a
shareholder); or
3. Authorized, issued, and outstanding (previously issued to shareholders and still outstanding
in the market).

Additional Paid-in Capital

Additional paid-in capital is generally contributed capital in excess of par or stated value. It
can also arise from other types of transactions. Additional paid-in capital may be aggregated
and shown as one amount on the balance sheet

Example
Facts:
On January 1, Year 1, Harris Enterprises issued 1 million shares of its $10 par common stock
for $25 per share.
Required:
Prepare the journal entry for the issuance of shares.
Solution:
January 1 journal entry:
Dr. Cash $25,000,000
Cr. Common stock $10,000,000
Cr. Additional paid-in capital—common stock 15,000,000
Retained Earnings.
Accumulated profit generated by the company during its lifetime that has not been distributed
to the shareholders.

The amount of accumulated retained earnings is reduced by distributions to stockholders and

transfers to additional paid-in capital for stock dividends.

Retained earnings do not include treasury stock or accumulated other comprehensive

income. If the retained earnings account has a negative balance, it is called a deficit.

Accumulated Other Comprehensive Income

These components of other comprehensive income are not included in determining net
income and, therefore, are not included in retained earnings. Rather, these components are
recognized in the period in which they occur and are combined with net income to determine
comprehensive income.

Total accumulated other comprehensive income must be shown in the shareholders' equity
section separate from capital stock, additional paid-in capital, and retained earnings.

Treasury Stock
Own shares which have been repurchased by the company and have not been canceled. It is
important to note that, unlike common stock, treasury shares do not represent the ownership
right and do not entitle to any dividends.

Components of the Balance Sheet

Assets
Assets are resources controlled by the entity because of past events. They represent
probable future economic benefits to the entity. Generally, assets are what a company "owns."
Examples include inventory; accounts receivable; investments; and property, plant, and
equipment.

Assets can be sub categorized into Current and non-current assets.

Current Assets

An asset is classified as current on the statement of financial position if it is expected to be

realized in cash or sold or consumed within the entity’s operating cycle or 1 year, whichever is
longer.

The following are the major categories of current assets:

(1) Cash and cash equivalents.
(2) Certain individual trading, available-for-sale, and held-to-maturity debt securities.
(3) Receivables.
(4) Inventories; and
(5) Prepaid expenses, etc.

Prepaid expenses are valued on the balance sheet at the cost less the expired or used
portion.

Noncurrent Assets

Noncurrent assets are those not qualifying as current. The following are the major categories
of noncurrent assets:

Investments and Funds

Investments and funds include non-operating items intended to be held beyond the longer of
1 year or the operating cycle. The following assets are typically included:
a) Investments in securities made to control or influence another entity and other noncurrent
securities.
b) Certain available-for-sale and held-to-maturity debt securities may be noncurrent.
c) Funds restricted as to withdrawal or use for other than current operations.
d) A lessor’s net investment in a sales-type lease
Property, Plant, and Equipment (PPE)

Assets that are tangible, long-lived, and used in business operations. Reported at historical
cost less accumulated depreciation to date (except land, which is not depreciated). Examples:
land, land improvements, buildings, equipment, machinery, furniture, and natural resources.

Intangible Assets:
Assets that have no physical substance, are long-lived, and used in the operations of the
business. These assets typically represent exclusive rights that a company can use to
generate future revenues.
Reported at historical cost net of accumulated amortization (usually shown net). Examples:
patents, copyrights, trademarks, trade names, and franchises.

Other Assets:
A catch-all category of noncurrent assets. This category is reserved for assets that will not fit
into one of the first four categories discussed above.

Examples: long-term prepayments (sometimes called deferred charges) and deferred income
taxes.

Liabilities

Liabilities are present obligations of the entity arising from past events. Their settlement is
expected to result in an outflow of economic benefits from the entity. Examples include loans
payable, bonds issued by the entity, and accounts payable.

Current Liabilities
Current liabilities are expected to be settled or liquidated in the ordinary course of business
during the longer of the next year or the operating cycle. Current liabilities are expected to be
settled or liquidated within 1 year from the balance sheet date.
Examples: accounts payable, notes payable, unearned (or deferred) revenues, accrued
liabilities, and current maturities of long-term debt.

Current liabilities do not include short-term debt if an entity. Intends to refinance them on a
noncurrent basis. The ability to refinance may be demonstrated by entering into a refinancing
agreement before the balance sheet is issued.

Long-Term Liabilities
Represent obligations that will not be satisfied within the next year or within the company's
operating cycle, whichever is longer.
Examples: long-term notes, bonds, lease obligations, and pension obligations.
Equity
Equity (or Net Assets) Equity represents the shareholders' residual claim in the entity's assets
after deducting liabilities. That is, the difference between what the company "owns" and what
the company "owes."
Categories of equity include paid-in capital, retained earnings, accumulated other
comprehensive income, and treasury stock. Equity is presented in order of preference upon
liquidation.

Components of Statement of Cash Flow

Statement of cash flow include the following three sections.
1. Operating activities
2. Investing activities
3. Financing activities

Operating Activities
Operating activities section relates to transactions involved in the production of goods and the
delivery of services to customers.

Cash flows from operating activities are primarily derived from the principal revenue producing
activities of the entity. They generally result from transactions and other events that enter the
determination of net income.

The following are examples of cash inflows from operating activities:

1) Cash receipts from the sale of goods and services (including collections of accounts
receivable)
2) Cash receipts from royalties, fees, commissions, and other revenue
3) Cash received in the form of interest or dividends.

The following are examples of cash outflows from operating activities:

1) Cash payments to suppliers for goods and services
2) Cash payments to employees
3) Cash payments to government for taxes, duties, fines, and other fees or penalties
4) Payments of interest on debt

Investing Activities
This section includes cash flows from the purchase or sale of non-current assets. Some
examples are:
The following are examples of cash outflows (and inflows) from investing activities:

1) Cash payments to acquire (cash receipts from sale of) property, plant, and equipment;
intangible assets; and other long-lived assets.
2) Cash payments to acquire (cash receipts from sale and maturity of) equity and debt
instruments of other entities for investing purposes.
3) Cash advances and loans made to other parties (cash receipts from repayment of
advances and loans made to other parties)

Financing Activities
Financing activities include cash flows from non-current liability (creditor-oriented) and equity
(owner-oriented) transactions. Examples include non-current liability and equity.
The following are examples of cash inflows from financing activities:
1) Cash proceeds from issuing shares and other equity instruments (obtaining resources from
owners).
2) Cash proceeds from issuing loans, notes, bonds, and other short-term or long-term
borrowings.

The following are examples of cash outflows from financing activities:

1) Cash repayments of amounts borrowed.
2) Payments of cash dividends
3) Cash payments to acquire or redeem the entity’s own shares.
4) Cash payments by a lessee for a reduction of the outstanding liability relating to a finance
or operating lease
d. Identifying the limitations of each financial statement.
Limitations of the Income Statement
• The income statement does not always show all items of income and expense. Some of the
items are reported on a statement of other comprehensive income and not included in the
calculation of net income.
• The financial statements report accrual-basis results for the period. The company may
recognize revenue and report net income before any cash was received. For example, the
data from the income statement itself is not sufficient for assessing liquidity. This statement
must be viewed in conjunction with other financial statements, such as the balance sheet and
statement of cash flows.
• The preparation of the income statement requires estimates and management judgment.

Limitations of the Statement of Changes in Equity

• The statement of changes in equity is a straightforward concept. This statement represents
the residual interest of assets minus creditors' claims to those assets. Differences within state
laws affect the account of shareholders' equity transactions and can cause variations in the
accounting and reporting of equity, making the statement of shareholders' equity difficult to
compare between companies.
• The financial statements report accrual-basis results for the period. The company may
recognize revenue and/or expense and report net income before any cash was received
and/or paid. Hence, the data for retained earnings is not sufficient for assessing the amount
available to be reinvested in the company or to pay debt.
• The statement of changes in equity illustrates a company’s equity based on a specific time;
equity may vary significantly a few days before or after publication of the statement.

Limitations of the Balance Sheet

• The key limitation of the balance sheet is that the net assets (assets minus liabilities) does
not equal the market value of the entity.
• The reasons for the difference in value include the use of historical cost for many assets
reported on the balance sheet, the subjective nature of asset recognition, and the use of
estimates within the financial statements.
• Even though the balance sheet does not directly measure the market value of the company,
it provides valuable information on which users of the balance sheet can base decisions
regarding market valuation.

Limitations of the Statement of Cash Flows

• A cash flow statement is not sufficient for forecasting the profitability of a firm as non-cash
items are not included in the calculation of cash flow from operating activities.
• A cash flow statement may not represent the true liquid position of an entity. Hence,
decisions regarding large expenditures could be based on misconceived information when
decisions are based only on the statement of cash flows.
• Information can be manipulated in the statement of cash flows. For instance, management
can schedule vendor payments to occur after year end to increase net cash flows reported on
the statement of cash flows.

d. Identifying how various financial transactions affect the elements of each of the
financial statements and determine the proper classification of a given transaction

Income Statement
Example
Facts:
Dawson Corp.'s adjusted trial balances consist of the following income statement items:

Debit Credit
Service revenue $5,000,000

Interest income 150,000

Gain on the sale of 25,000

investments

Cost of sales $2,700,000

Selling expenses 340,000

General and administrative 660,000

expenses

Interest expense 15,000

Research and 78,000

development expense
Service revenue 5,000,000
Cost of sales (2,700,000) Required:

Selling expenses (340,000) Classify costs as operating and nonoperating.

Calculate the company's operating income for
General and (660,000) the year.
administrative
expenses Classification
Service
Research revenue
and Operating
(78,000)
development
Interest income Non-Operating
expense
Gain on the sale of Non-Operating
Operating income 1,222,000
investments
Cost of sales Operating
Selling expenses Operating
General and Operating
administrative
expenses
Interest expense Non-Operating Operating Income:

Research and Operating

development
expense

Statement of Cash flow

Information about material noncash investing and financing activities (those that do not result
in cash receipts or payments) is provided separately in a supplemental disclosure. Any part of
the transaction that involves cash would be included in the SCF. Examples of noncash
activities include:
1) Issuance of stock to purchase fixed assets.
2) Conversion of bonds to equity instruments, which generally does not involve cash.
3) Acquisition of assets through the incurrence of a finance lease obligation; and
4) Exchange of one noncash asset for another noncash asset.

Example
Facts:
Diana Corp. is preparing its statement of cash flows and is classifying several transactions for
the current year.

1. Issued 500,000 shares of common stock at par value.

2. Sold land at cost for $475,000.
3. Accounts receivable increased by $120,000 during the year.
4. Purchased a machine for $750,000.
5. Sold $2,000,000 in bonds at face value.
6. Accounts payable decreased by $85,000 during the year.
7. Paid a short-term note payable of $325,000.
8. Purchased 50,000 shares of treasury stock.
9. Issued $500,000 in bonds at face value in exchange for a machine.
10. Declared a cash dividend of 25 cents per share.

Required:
Classify the following ten transactions into the appropriate categories on the statement of
cash flows. If the transaction will not appear on the statement, indicate that fact.
Solution:
e. Demonstrates an understanding of the relationship among the financial statements.
Articulation of the Financial Statements

Each financial statement demonstrates a relationship with the balance sheet. The beginning
balances of the balance sheet from the previous period increase and decrease because of the
company's business transactions.

These transactions are recorded and reported by the accounting system and result in the
recognition of assets, liabilities, owners' equity, revenues and/or expenses. The board of
directors will analyze reported income and assess whether any dividends will be declared and
paid by the company.

Reported income less dividends result in increase to retained earnings, which is reflected on
the balance sheet. The statement of cash flows reconciles the change in cash during the year
and reverses the effects of accrual accounting, which allows users of the financial statements
to analyze the sources and uses of cash.
f. Demonstrating an understanding of how a balance sheet, an income statement, a
statement of changes in equity, and a statement of cash flows (indirect method) are
prepared
Income Statement Presentation
The income statement reports operating revenues and expenses separately from
nonoperating revenues and expenses and other gains and losses. The multiple-step income
statement presents major subtotals such as gross profit, operating income, and income before
taxes.

The benefit of the multiple-step income statement is enhanced user information; line items
presented often provide the user with readily available data with which to calculate analytical
ratios
Single-Step Income Statement
In the single-step income statement, presentation of income from continuing operations and
total expenses (including income tax expense) are subtracted from total revenues in a single
step.
The benefits of a single-step income statement are its simple design, and the various types of
revenues or expenses do not appear to be more important than any other type.
Balance Sheet
The balance sheet reflects the financial position of a company at a specific date. To prepare
the balance sheet, the ending balance of retained earnings must be calculated on the
statement of stockholders' equity.
Statement of Changes in Stockholders' Equity
The statement of changes in stockholders' equity follows the preparation of the income
statement and explains the changes in ownership for an entity by providing a reconciliation of
beginning of the year balances within equity and detailing changes within each ownership
category resulting in updated year-end balances.
The income statement must be prepared first because net income from the income statement
is added to retained earnings shown on the statement of stockholders' equity.
Statement of Cash Flows
The statement of cash flows, which is covered in detail in the next module, explains the
change in cash during the period. The cash flow statement is comprised of three main
sections: operating, investing, and financing.
The statement of cash flows is prepared after the balance sheet to reconcile the beginning
and ending cash balance for the period.
h. Defining consolidated financial statements
Control and Business Combination:
Control: The power to govern the financial and operating policies of another entity to benefit
from its activities, typically through ownership of more than 50% of shares / voting interests.
Business Combination: A transaction where an acquirer gains control over another
business, obtaining a controlling financial interest to direct the management and policies of
the acquired entity.
Subsidiary Company: A company controlled by the parent company.
Purpose and Presentation:
Consolidated Financial Statements: These are issued by the parent company and present
the financial information of both the parent and its subsidiaries as a single economic entity.
This reflects the combined financial position, results of operations, and cash flows of the
parent and subsidiaries as if they were one entity.
Requirement: The parent company must issue consolidated financial statements regardless
of the percentage of ownership, as long as it has control over the subsidiary.
These statements provide a comprehensive view of the financial health and performance of
the combined entities, ensuring clarity and transparency for stakeholders.
i. Defining the two types of consolidation models: variable interest entity model and
voting interest model
Models for Assessing Controlling Financial Interest
The primary consolidation models are the Voting Interest Entity (VOE) model and the Variable
Interest Entity (VIE) model.
VOE Model (The voting interest model): The usual condition for a controlling financial
interest is ownership by one reporting entity (directly or indirectly) of more than 50% of the
outstanding voting shares of another entity. Although a controlling financial interest normally
means ownership of more than 50% of the voting stock of a company, it is possible for an
owner to have control with a smaller ownership percentage or to have no control with a higher
ownership percentage.
VIE Model (The variable interest entity model): A VIE is a legal entity financially controlled
by companies that do not hold a majority voting interest. Control exists when the reporting
entity has the power to direct activities significantly impacting the VIE’s economic
performance and the obligation to absorb losses or receive benefits from the VIE. The primary
beneficiary is the entity with this controlling financial interest, which can be an equity investor,
loan provider, or guarantor of the VIE’s debt. Control is often arranged through contracts
rather than direct ownership, and the controlled entity typically lacks sufficient financial
resources to support its ongoing operating needs independently.
Consolidated financial statements are required for VIEs with a primary beneficiary, regardless
of ownership percentage, as per ASC 810-10. Although a parent and subsidiary may exist
separately, consolidated financial statements present them as a single economic entity,
aligning with the principle of substance over form. This approach provides more meaningful
information to users by reflecting the effects of control and ensuring clarity and transparency
about the financial health and performance of the combined entities.

Consolidation Process
After the close of the fiscal year in which the combination occurred, the consolidated entity
prepares its first full set of consolidated financial statements.
The following steps must be performed when preparing consolidated financial
statements:
● All line items of assets, liabilities, revenues, expenses, gains, losses, and other
comprehensive income (OCI) of a subsidiary are added item-by-item to those of the parent.
These items are reported at the consolidated amounts.
● No investment in the subsidiary account is presented in the consolidated financial
statements. Consolidated statements report the assets and liabilities of the subsidiary and the
parent as if they are a single economic entity.
● All the equity accounts of the subsidiary are eliminated (not presented in the consolidated
financial statements). Retained earnings of the consolidated entity at the acquisition date
consist solely of the retained earnings of the parent.
● Goodwill from the acquisition of a subsidiary is presented separately in the noncurrent
assets section of the consolidated balance sheet.
● Intra-entity balances, transactions, income, and expenses must be eliminated in full.
● NCI is reported separately in one line item in the equity section.

Noncontrolling Interests
Noncontrolling interests (NCI) arise when the parent does not own 100% of the subsidiary. In
the consolidated financial statements, the subsidiary's balance sheet is fully included, and NCI
is reported in the equity section, representing the claims of other investors. This ensures that
the consolidated balance sheet shows the assets and liabilities of the subsidiary accurately,
and the income statement includes the revenues and expenses of both entities, adjusted for
intra-entity transactions.
Subsequent Reporting
After the fiscal year in which the combination occurred, the first full set of consolidated
financial statements is prepared. All assets, liabilities, revenues, expenses, gains, and losses
of the subsidiary are added to the parent’s and reported at consolidated amounts. Goodwill
from the acquisition is presented separately, and intra-entity transactions are eliminated to
present a single economic entity. Consolidated net income includes total net income, NCI’s
share, and the parent shareholders’ share, ensuring that the financial statements accurately
reflect the combined operations and financial position of the parent and subsidiary as one
entity.

j. Demonstrating an understanding of the three types of consolidation accounting: full

consolidation, proportionate consolidation, and equity consolidation.
Types of Consolidations
Consolidations can be categorized into three primary methods: Full Consolidation, Equity
Method, and Proportionate Consolidation.
Full Consolidation Method
Full consolidation is applied when the parent company owns more than 50% of the subsidiary.
This method involves combining the financial statements of both the parent and subsidiary,
eliminating intercompany transactions to present a single economic entity. The parent’s
investment in the subsidiary is eliminated to avoid double counting, and the subsidiary’s
equity accounts are adjusted accordingly.

Equity Method
The equity method is used when the investor holds significant influence over the investee,
typically with an ownership interest of 20% to 50% of the voting stock. Under this method, the
investor does not prepare consolidated financial statements. Instead, the investor records its
share of the investee’s net income as a single line item on its income statement, reflecting the
net result of the investee’s operations. This method is sometimes called "one-line
consolidation" because it aggregates the investor’s share of the investee’s results into a single
entry.

Proportionate Consolidation Method

Proportionate consolidation is used for joint ventures, where an entity records its share of the
assets, liabilities, revenues, and expenses of the venture in proportion to its ownership
interest. This method is applicable under specific circumstances, such as when the investor
has an undivided ownership interest in assets and is proportionately liable for related
liabilities, commonly seen in the oil and gas industry. Additionally, it can be used when the
investor has a noncontrolling interest in an unincorporated entity in the construction or
extractive industries, provided it qualifies for the equity method of accounting. Under IFRS,
proportionate consolidation is not permitted, limiting its use primarily to certain industry-
specific situations.
By understanding these three methods, companies can choose the appropriate consolidation
approach based on their level of control and ownership in the investee, ensuring accurate and
meaningful financial reporting.

k. Demonstrating an understanding of intracompany balances and transactions that

should be eliminated in consolidation
Intra-company balances refer to financial transactions between entities within the same
corporate group. These balances arise from various intra-company activities such as sales,
loans, dividends, and other transactions. For consolidated financial reporting, eliminating
these balances is crucial to present the financial statements as if the group operates as a
single economic entity.

Consolidated Financial Reporting: Intra-group Eliminations

Year-End Consolidated Financial Statements
Consolidated entities frequently engage in intra-entity transactions, which must be entirely
eliminated during the preparation of consolidated financial statements. These statements
present the financial position, results of operations, and cash flows as if the entities were a
single economic entity. All line items must reflect amounts as though intra-entity transactions
never occurred. This requires eliminating journal entries to accurately combine the assets,
liabilities, and income statement items of the parent and subsidiary.

Reciprocal Balances
In the consolidated balance sheet, reciprocal balances such as receivables and payables
between the parent and subsidiary are eliminated in full, regardless of the parent’s ownership
percentage in the subsidiary.

Intra-Entity Inventory Transactions – Gross Profit

Intra-entity inventory transactions involving gross profit necessitate complex adjustments. The
selling entity recognizes profit on inventory sales, but the consolidated entity only recognizes
this profit in proportion to inventory sold to non-affiliated parties. Therefore, gross profit
included in inventory remaining with the purchaser must be eliminated from consolidated net
income. A year-end journal entry is required to remove the gross profit and adjust the
inventory account to the balance it would have had absent the intra-entity transactions.

Intra-entity Noncurrent Assets Transactions:

Transfers of noncurrent assets between entities require elimination of any recognized gain or
loss from the sale. All related accounts must be reported at amounts that would have been
recognized if the intra-entity transactions had not occurred. Depreciation expense in the
consolidated financial statements must reflect the expense that would have been recognized
in the seller’s separate financial statements.

Debt:
When one entity holds the debt securities of another consolidated entity, the elimination is
treated as an extinguishment of debt, with recognition of any resulting gain or loss. All related
accounts, including maturity amount, interest receivable/payable, and interest
income/expense, must be eliminated. The premium or discount on the debtor’s and creditor’s
books, along with any related amortization, is eliminated and recognized as a gain or loss on
extinguishment in the purchase period.
Reciprocal Dividends:
When consolidated entities hold reciprocal equity stakes, the portion of dividends paid to each
other must be eliminated from the consolidated financial statements. Dividends paid by the
parent to external parties reduce consolidated retained earnings, while dividends paid by the
subsidiary to external parties reduce any noncontrolling interest.

l. Defining integrated reporting (IR), integrated thinking, and the integrated report and
demonstrate an understanding of the relationship among them

Integrated Reporting is being used by entities around the world; the number of users has
grown each year since 2013. An integrated Report contains information about six different
capitals which an organization uses and generates as it goes about its business. The
Integrated Reporting framework lists eight Content Elements which, ideally, are included in an
Integrated Report. While complete inclusion of all eight Content Elements may not occur for
all users, there has been a trend toward dissemination of more nonfinancial information to
stakeholders. Adoption of Integrated Reporting is typically a multiyear process, and many
organizations will use a phased approach to implementation. Collection, coordination, and
reporting of both financial and nonfinancial information as it relates to an organization’s value
chain has long been the domain of management accountants. Integrated Reporting is an
important development within the accounting profession and wise management accountants
should be conversant on this topic.

m. Identify the primary purpose of IR

According to the International Integrated Reporting Committee's (IIRC) International
Integrated Reporting Framework, integrated reporting:
•Promotes a more cohesive and efficient approach to corporate reporting
•Improves the quality of information available to providers of financial capital
•Enables a more efficient and productive allocation of capital
•Provides a concise communication about how an organization's strategy, governance,
performance, and prospects lead to creation of value over the short, medium, and long term
•Creates value for all stakeholders, including owners, creditors, employees, suppliers,
customers, governments, and society

n. Explain the fundamental concepts of value creation, the six capitals, and the value
creation process
Value Creation
•The process of transforming inputs into outputs with higher value
•Creates value for owners/financial providers in general
•Creates value for community/society
•Leverages the six capitals

The Six Capitals

•Financial Capital: funds available for an organization to use
•Manufactured Capital: available to use in producing goods or providing services
•Intellectual Capital: intellectual property created by organization employees
•Human Capital: capabilities, skills, and experience of the workforce
•Social and Relationship Capital: organization and connection to communities, shareholder
groups, and other networks
•Natural Capital: renewable and nonrenewable environmental resources

Value Creation Process Considerations

•External environment
•Mission and vision
•Governance
•Outputs and outcomes
•Business activities
•Continuous monitoring
•Information collection
•Outlook
o. Identifying elements of an integrated report; (i.e., organizational overview and
external environment, governance, business model, risks and opportunities, strategy
and resource allocation, performance, outlook, and basis of preparation and
presentation)

Elements of the Integrated Report

•Organizational overview and external environment: what an organization does and
circumstances under which it operates
•Governance: governance structure and how that structure supports value creation
•Business model: inputs transformed into outputs transformed into internal and external
outcomes
•Risks and opportunities: ability to create value and the ability to respond
•Strategy and resource allocation: including objectives and measures to evaluate
achievements
•Performance: achievement of objectives and impact on the six capitals
•Outlook: challenges and uncertainties

•Basis of preparation and presentation defines materiality

Key Principles for Preparation
•Strategic focus and future orientation
•Connectivity of information
•Stakeholder relationship
•Materiality
•Conciseness
•Reliability and completeness
•Consistency and comparability

p. Identify and explain the benefits and challenges of adopting IR

Benefits
•Provides reporting discipline
•Enhances communication of nonfinancial performance
•Managers consider performance trade-offs and interdependencies
•Improves internal measurement and control
•Mandates increased information systems quality
•Narrows gap between reality and expectations for external stakeholders
•Provides platform for improved stakeholder dialogue/engagement/relationships
•Promotes commitment by customers who value sustainability
•Enhances employee engagement
•Attracts new long-term investors

Costs and Challenges

•Collecting/analyzing structured and unstructured data
•Infrastructure investments
•New processes, control systems, and resources
•Requires support of chief executive officer and board of directors
•Invest in expertise to interpret, explain, and report data
•Competition gains more/better information
•Lack of guidance for this area
•Understanding reportable (material) issues
•Assuring reliance and comparable reports
•Ensuring quality data

Section A.2. Recognition, Measurement, Valuation, and Disclosure.

Asset Valuation
a. Identifying issues related to the valuation of accounts receivable, including timing
of recognition and estimation of the allowance for credit losses.
Receivables
Accounts receivable are oral promises to pay debts that represent the right to the receipt of
cash in the future by an organization. Generally, receivables are classified as current assets,
but can be non-current depending upon the terms of agreement.

Current accounts receivable is reported in the balance sheet at net realizable value (NRV),
i.e., net of allowance for credit losses (uncollectible accounts), allowance for sales returns,
and billing adjustments.

NRV of account receivable=Gross account receivable−Allowance for uncollectable accounts

Noncurrent receivables are measured at net present value of future cash flows expected to be
collected.

Accounts Receivable and Analysis Format

The preparation of an account analysis may increase your ability to "squeeze" or otherwise
derive various answers to CMA Exam questions regarding accounts receivable, allowance for
doubtful accounts, and many other accounts.

Example
Evelyn Enterprises has an accounts receivable balance of $85,000 as of January 1, Year 1.
On December 31, Year 1, the balance in accounts receivable was $50,000. During the year,
Evelyn collected $805,000 from credit sales during the year. Credit sales during the year were
$795,000. Bad debts written off during the year can be calculated using this information.

If the balance before write-offs is $75,000 based on analysis of the T-account and the ending
balance is $50,000, the write-offs for the year must be $25,000.

Receivable Recognition and Valuation

Accounts receivables are initially valued at the original transaction amount, adjusted for any
sales discounts or sales returns and allowances.

Sales or Cash Discounts

Sales discounts are generally based on a percentage of the sales price. For example, a
discount of 2/10, n/30 offers the purchaser a discount of 2 percent of the sales price if the
payment is made within 10 days. If the discount is not taken, the entire (gross) amount is due
in 30 days.

Gross Method
The gross method records a sale without adjustment for the available discount. If payment is
received within the discount period, a sales discount (contra-revenue) account is debited to
reflect the sales discount with a corresponding credit to accounts receivable to reduce the
value to the amount collected.
Net Method
The net method records sales and accounts receivable net of the available discount, taking
the discount into consideration at the date of sale. An adjustment is not needed if payment is
received within the discount period.
If payment is received after the discount period, a sales discount forfeited (not taken) account,
which serves as a revenue account, must be credited with an offsetting debit for the additional
cash received.

Trade Discounts
Trade discounts (quantity discounts) are offered to customers usually as a percentage
reduction in the list price of the item. These discounts are known and do not represent
uncertainty in future amounts to be collected from customers and, therefore, sales
transactions are recorded net of any trade discounts offered.

Example
Facts:
Caitlyn & Brown sells coats with a list price of $1,000. They are sold to stores for list price
minus trade discounts of 40 percent and 10 percent.
Required:
Calculate the Caitlyn & Brown accounts receivable balance if 100 coats are sold on credit.
Solution:
List price $100,000
Less: 40% discount (40,000)
List price after 40% 60,000
discount
Less: 10% discount (6,000)
Accounts receivable $ 54,000
balance

Estimating Uncollectible Accounts

Accounts receivable should be presented on the balance sheet at net realizable value. The
amount recorded at the initial transaction should be reduced by an estimate of any
uncollectible receivables.
The allowance method recognizes not every customer will pay its bill and includes an
estimate of the bad debts associated with accounts receivables held by the company.
Companies estimate the necessary balance in the allowance for uncollectible accounts using
the current expected credit losses (CECL) model.
Under the CECL model, the balance in the allowance for uncollectible accounts should be
based on current conditions, experience, and future expectations. The allowance should
consider the possibility of credit losses over the entire life of each receivable.
A company can apply any method that reasonably captures its expectation of credit losses,
including estimates based on the following:
1. Individual accounts
2. A percentage of the entire account receivable balance
3. Aging of accounts receivable and estimating bad debts based on aging categories

The allowance for uncollectible accounts is a contra-asset account used to reduce the
carrying value of accounts receivables to reflect the amounts the company expects to collect
from customers. Transactions affecting the allowance for uncollectible accounts can be
summarized in the T-account below.

The normal balance for the allowance account is a credit because it is a contra-asset.
Increases to the allowance account include current bad debts estimates and reversals of
previously written-off receivables where subsequent cash collections have occurred.
Decreases to the account occur when specific accounts deemed uncollectible are identified
and written off.
Percentage of Accounts Receivable Method
Uncollectible accounts may be estimated as a percentage of accounts receivable at year-end.
The percentage is based on the company's experience and is used to calculate the ending
balance of the allowance for doubtful accounts on the balance sheet.
The difference between the unadjusted balance and the desired ending balance is debited (or
credited) to arrive at the balance in the allowance for uncollectible accounts. The offset (debit
or credit, depending on the calculation) goes to bad debt expense.
Example
Facts:
DEF Co. uses a percentage for uncollectible accounts based on the year-end balance in
accounts receivable. DEF Co. estimates that the balance in the allowance account must be 2
percent of year-end accounts receivable of $80,000. The balance in the allowance account is
a $1,000 credit before adjustment.
Required:
Prepare the journal entry to record the adjustment to the allowance account at year-end.
Solution:
The ending balance in the allowance account should be $1,600 ($80,000 × 2%).

To achieve the desired balance in the allowance account of $1,600, an entry in the amount of
$600 is necessary. Journal entry to record increase in allowance account:
Dr. Bad debt Expense $600
Cr. Allowance for uncollectable accounts $600
Aging of Accounts Receivable
Another method used to estimate uncollectible accounts is aging of accounts receivable. A
schedule is prepared categorizing accounts by the number of days or months outstanding.
Each category's total dollar amount is then multiplied by the percentage estimated to be
uncollectable based on the entity's experience. The sum from each aging category is added
together to find the ending balance in the allowance account.
Example
Facts:
DEF Co. uses an aging of accounts receivable to estimate uncollectible accounts. The
balance in the allowance account is a $1,000 credit before adjustment. Below is the aging
schedule prepared by DEF Co. at year-end.

Aging Category Balance in Each Estimated % Estimated

Category Uncollectible Uncollectible

Current $10,000 0.01 $ 100

31–60 days 6,667 0.03 200

 61–90 days 5,000 0.10 500

Over 90 days 4,000 0.20 800

$25,667 $1,600

Required:
Prepare the journal entry to record the adjustment to the allowance account at year-end.

To achieve the desired balance in the allowance account of $1,600, an entry in the amount of
$600 is necessary. Journal entry to record increase in allowance account:
Dr. Bad debt Expense $600
Cr. Allowance for uncollectable accounts $600
Bad Debt Expense
The amount charged to earnings for the bad debt expense of the period includes:
1. The provision made each period throughout the year; and
2. An adjustment made at year-end to increase/decrease the balance in the allowance for
uncollectible accounts, if needed.
Write-off of a Specific Accounts Receivable
Although the entity records uncollectible amounts at the time the estimate is made, the
company does not know which customers will eventually end up not paying their account.
When a receivable is formally determined to be uncollectible, the following entry is made:
Dr. Allowance for uncollectable accounts
Cr. Account receivable

Subsequent Collection of Accounts Receivable Written Off

If a collection is made on a receivable that was previously written off, the following entries are
made:
Step 1: To restore the account previously written off:
Dr. Account receivable
Cr. Allowance for uncollectable accounts
Step 2: To record the cash collection on the account:
Dr. Cash
Cr. Account receivable
b. Distinguishing between receivables sold (factoring) on a with-recourse basis and
those sold on a without-recourse basis, and determine the effect on the balance
sheet
Factoring of Accounts Receivable
Factoring is a transfer of receivables to a third party (a factor) who assumes the responsibility
of collection.

Under factoring arrangements, the customer may or may not be notified. Factors include
finance companies or banks that purchase receivables from a company for a fee and collect
the remittances from customers.

In these types of transactions, receivables are sold according to the terms of the arrangement
as either with or without recourse.
With Recourse
When receivables are sold with recourse, a recourse obligation/ liability must be recorded.
Recourse in a factoring arrangement represents the right of the factor to receive payment
from the transferor (seller) even if some of the receivables in the sale prove to be
uncollectible.

This right creates a recourse obligation/liability for the transferor (seller). When this
requirement is present, the seller must estimate and record the fair value of its recourse
obligation/liability and record the contingency.
Journal entry to factor accounts receivable without recourse:

The entry to the asset account "Due from factor" reflects the proceeds retained by the factor.
This amount protects the factor against sales returns, sales discounts, allowances, and
customer disputes. If the returns, discounts, and allowances are less than the retained
amount, the balance will be returned to the seller.
Example
Facts:
Emmons Corp. needs some money for operations. In September Year 1, the company elected
to sell $5,500,000 to a factor without recourse. The factor charges a 5 percent fee and retains
another 10 percent as security to cover returns, allowances, and discounts taken by the
customer. The factor will collect the accounts receivable.
Required:
Record the sale of the accounts receivable.
Solution:

* $5,500,000 × 10% = $550,000 (protection of factor against returns, allowances, and

discounts taken by the customer)
** $5,500,000 × 5% = $275,000 (fee charge by factor for purchase of receivables)
Example
Facts:
Emmons Corp. needs some money for operations. In September Year 1, the company elected
to sell $5,500,000 to a factor with recourse. The factor charges a 5 percent fee and retains
another 10 percent as security to cover returns, allowances, and discounts taken by the
customer. The fair value of the estimated recourse liability is $100,000.
Required:
Record the sale of the accounts receivable.
Solution:

*$5,500,000 × 10% = $550,000 (protection of factor against returns, allowances, and

discounts taken by the customer)
**$5,500,000 × 5% = $275,000 (fee charge by factor for purchase of receivables) + $100,000
estimated recourse liability
c. Identifying issues in inventory valuation, including which goods to include, what
costs to include, and which cost assumption to use.
Inventory Systems

There are two types of inventory systems used to track and count inventory: the periodic
inventory system and the perpetual inventory system. Both systems are allowed in financial
reporting; however, because of technological advances, perpetual inventory is now the most
common system for many companies.
Perpetual Inventory System
A perpetual inventory system updates inventory accounts after each purchase or sale. This
system is generally more suitable for entities that sell relatively expensive and heterogeneous
items and requires continuous monitoring of inventory and cost of goods sold accounts.
An advantage of the perpetual inventory system is that the amount of inventory on hand and
the cost of goods sold can be determined at any time. A disadvantage of the perpetual
inventory system is that the bookkeeping is more complex and expensive.
Ending inventory under the perpetual inventory system is still physically counted and costed
and then compared to the perpetual inventory balance. If the amount of ending inventory
determined from the physical count is less than the ending inventory amount shown in the
ledger, the difference is adjusted to an inventory shrinkage/spoilage account.
Example
Facts:
ABC Company sold 20,000 units of inventory for $7 per unit. The inventory had originally cost
$5 per unit.
Required:
Prepare the journal entries to record the sale using the periodic and perpetual methods.
Solution:
Journal entry to record sale under periodic method (cost of goods sold will be recorded after
the periodic inventory count):

Example
Facts:
ABC Company purchased 50,000 units of merchandise for $6 a unit to be held as inventory.
Required:
Prepare the journal entries to record the purchase of inventory under the periodic and the
perpetual methods.
Solution:
The periodic method debits purchases; the perpetual method debits inventory. Journal entry
to record purchase under periodic method:

Goods and Materials to Be Included in Inventory

At the end of each accounting period, inventory should include all goods and materials in
which the company has legal title, even if the company does not have physical possession of
the goods.
Goods in Transit
Items in transit are inventories that on the physical count date are not on the entity’s premises
and are on the way to the desired location and whose legal title is held by the entity, i.e., the
entity bears the risk of loss on inventory in transit.
The following are the most common shipping terms:
FOB Shipping Point
Legal title and risk of loss pass to the buyer when the seller delivers the goods to the carrier.
The buyer must include the goods in inventory during shipping.
FOB Destination
Legal title and risk of loss pass to the buyer when the seller delivers the goods to a specified
destination. The seller must include the goods in inventory during shipping.
Example
Facts:
Harris Co. has several inventory shipments in process at year-end.
1. $55,000 of goods in transit from Emmons Corp., a supplier. The goods are shipped
FOB destination.
2. $38,000 of goods in transit from Jones Co., a supplier. The goods are shipped FOB
shipping point.
3. $15,800 of goods in transit to Dawson Inc., a customer. The goods are shipped FOB
shipping point.
4. $25,680 of goods in transit to Mongeau Co., a customer. The goods are shipped FOB
destination.
Required:
Determine which inventory purchases should be included by Harris Co. in the
determination of ending inventory.
Solution:

1. Harris does not include the inventory purchased FOB destination until Harris
receives the goods and does not reject them as being the wrong goods.
2. The goods purchased from Jones should be included in inventory because title
passed at when the goods were picked up by the shipper.
3. Harris does not include the goods sold to Dawson in inventory because title
transferred to Dawson when the carrier received the goods.
4. Harris should include the goods sold to Mongeau in inventory while the goods are in
transit because title does not pass until the goods are delivered to the customer.

Goods Out on Consignment

A consignment sale is an arrangement between the owner of goods (consignor) and
the sales agent (consignee). Consigned goods are not sold but rather transferred to an
agent for possible sale. The consignor records sales only when the goods are sold to
third parties by the consignee.

Goods out on consignment are included in the consignor’s inventory at cost. Costs of
transporting the goods to the consignee are inventoriable costs, not selling expenses.
The consignee never records the consigned goods as an asset.

Example

Facts:
Harris Corp. has an ending inventory balance of $500,000 and had the following
consignment arrangements at year-end: 1. Goods with a cost of $78,500 out on
consignment to Dawson Corp. The inventory is currently excluded from Harris' year-
 end inventory balance. 2. Goods with a cost of $123,000 held on consignment for
Emmons Corp. This amount is currently included in Harris' year-end inventory balance.

Required:
Determine the correct year-end inventory balance.

Inventory balance before $500,000

adjustment
Inventory out on consignment 78,500
with Dawson
Inventory held on consignment (123,000)
for Emmons
Adjusted inventory balance $455,500

The goods held on consignment by Harris and owned by Emmons Corp. should be excluded
from Harris' inventory records. Although Harris has physical possession of the goods, the
legal title to the goods remains with Emmons Corp. until the goods are sold to a third-party
buyer (and then title transfers to that third-party buyer).
The goods out on consignment from Harris to Dawson Corp. should be included in Harris'
year-end inventory balance. Legal title to the goods remains with Harris even though the
goods are out on consignment to Dawson. No transfer of title will take place until the goods
are sold to a third-party buyer (and then title transfers to that third-party buyer).
d. identifying and comparing cost flow assumptions used in accounting for
inventories.
Primary Inventory Cost Flow Assumptions
Inventory valuation is dependent on the cost flow assumption underlying the computation.
Under U.S. GAAP, the cost flow assumption used by a company is not required to have a
rational relationship with the physical inventory flows; however, the primary objective is the
selection of the method that will most clearly reflect periodic income.

Specific Identification Method

Under the specific identification method, the cost of each item in inventory is uniquely
identified to that item. The cost follows the physical flow of the item in and out of inventory to
cost of goods sold.

Specific identification is usually used for physically large or high-value items and allows for
greater opportunity for manipulation of income. Because the company often can use lower
cost inventory items that are identical to higher-priced items to match against current period
sales, thereby increasing profits.
First-In, First-Out (FIFO)
This method assumes that the first goods purchased are the first sold. Thus, ending inventory
consists of the latest purchases. Hence cost of goods sold includes the earliest goods
purchased.
Under the FIFO method, year-end inventory and cost of goods sold for the period are the
same regardless of whether the perpetual or the periodic inventory accounting system is
used.

Weighted Average Method (AVCO)

Under the weighted average method, at the end of the period, the average cost of each item
in inventory would be the weighted average of the costs of all items in inventory.
The weighted average is determined by dividing the total costs of inventory available by the
total number of units of inventory available, remembering that beginning inventory is included
in both totals. This method is particularly suitable for homogeneous products and a periodic
inventory system.

Moving Average Method

The moving average method computes the weighted average cost after each purchase by
dividing the total cost of inventory available after each purchase (inventory plus current
purchase) by the total units available after each purchase.
The moving average is more current than the weighted average. A perpetual inventory system
is necessary to use the moving average method.

Last In, First Out (LIFO) Method (Not Permitted Under IFRS)
The LIFO (last-in, first-out) method assumes the newest items of inventory are sold first.
Thus, the items remaining in inventory are the oldest.
Under the LIFO method, the perpetual and the periodic inventory accounting systems may
result in different values for year-end inventory and cost of goods sold.
Under the periodic inventory accounting system, the calculation of inventory and cost of
goods sold are made at the end of the period.

e. demonstrating an understanding of the lower of cost or market rule for LIFO and the
retail inventory method and the lower of cost and net realizable value rule for all
other inventory methods.

Retail Inventory Method

The retail inventory method is a very effective means of estimating inventory value. It is used
for
1) Interim and annual financial reporting in accordance with GAAP,
2) Federal income tax purposes, and
3) Verifying year-end inventory and cost of goods sold data, e.g., as an analytical procedure
by an independent auditor.
Measurement of Inventory Subsequent to Initial Recognition
The subsequent measurement of inventory depends on the cost method used.
1) Inventory accounted for using LIFO or the retail inventory method is measured at the lower
of cost or market (LCM).
2) Inventory accounted for using any other cost method (e.g., FIFO or average cost) is
measured at the lower of cost or net realizable value.

The loss on write-down of inventory to market or net realizable value (NRV) generally is
presented as a component of cost of goods sold. However, if the amount of loss is material, it
should be presented as a separate line item in the current-period income statement.
A write-down of inventory below its cost may result from damage, deterioration, obsolescence,
changes in price levels, changes in demand, etc.
A reversal of a write-down of inventory recognized in the annual financial statements is
prohibited in subsequent periods. Once inventory is written down below cost, the reduced
amount is the new cost basis.
Measurement of Inventory at the Lower of Cost or Market (LCM)
Inventory accounted for using the LIFO or retail inventory method must be written down to
market if its utility is no longer as great as its cost. The excess of cost over market is
recognized as a loss on write-down in the income statement.
NRV is the estimated selling price in the ordinary course of business minus reasonably
predictable costs of completion, disposal, and transportation. Thus, current replacement cost
(CRC) is not to be greater than NRV or less than NRV minus a normal profit.
Measurement of Inventory at the Lower of Cost or NRV
Inventory measured using any method other than LIFO or retail (e.g., FIFO or average cost),
must be measured at the lower of cost or net realizable value.
Net realizable value (NRV) is the estimated selling price in the ordinary course of business
minus reasonably predictable costs of completion, disposal, and transportation. The excess of
cost over NRV is recognized as a loss on write-down in the income statement.
f. Calculating the effect on income and on assets of using different inventory methods
FIFO Method
Example
Facts:
During its first year of operations, Helix Corporation has purchased all of its inventory in three
batches. Batch 1 was for 4,000 units at $4.25 per unit. Batch 2 was for 2,000 units at $4.50
per unit. Batch 3 was for 3,000 units at $4.75 per unit. In total, 4,000 units were sold, 3,000
units after the first purchase and 1,000 units after the second purchase.
Required:
Determine the amounts of ending inventory and cost of goods sold using the FIFO method
and the periodic and perpetual systems.

Solution:
FIFO: Periodic Inventory System

Units Bought Cost/Unit Ending Inventory Goods Available

for Sale

4,000 $4.25 $17,000

2,000 4.50 $ 9,000 9,000

3,000 4.75 14,250 14,250

$23,250 40,250

Ending inventory 23,250

Cost of goods sold $17,000

FIFO: Perpetual Inventory System

Units Units Sold Cost/Unit Inventory Change in COGS

Bought Inventory
Balance
4,000 $4.25 $17,000
 3,000 4.25 (12,750) 4,250 $12,750

2,000 4.50 9,000 13,250

1,000 4.25 (4,250) 9,000 4,250

3,000 4.75 14,250 23,250

Ending $23,250
inventory

Cost of $17,000
goods sold

Note that the ending inventory under both methods is $23,250 and the amount of cost of
goods sold under both methods is $17,000.
Weighted Average Method
Example
Facts:
Assume the same information for Helix Corporation as in the previous example for FIFO.
Requirement:
Determine the amounts of ending inventory and cost of goods sold under the weighted
average method.
Solution:

Unit Cost Units Purchased Total

$4.25 4,000 $17,000

4.50 2,000 9,000

4.75 3,000 14,250

TOTAL 9000 40,250

Weighted average cost per unit = $4.4722 ($40,250/9,000)

Cost of goods sold = $17,889 (4,000 units × $4.4722)
Ending inventory = $22,361 (5,000 units × $4.4722)

Moving Average Method

Example
Facts:
Assume the same information for Helix Corporation as in the previous example for FIFO.
Required:
Determine the amounts of ending inventory and cost of goods sold under the moving average
method.
Solution:

*Weighted average cost per unit = ($4,250 + $9,000) / 3,000 = $4.4167

**Weighted average cost per unit = ($8,833 + $14,250) / 5,000 = $4.6166
Cost of goods sold is $17,167 ($12,750 + $4,417)
Ending inventory is $23,083

LIFO method
Example
Facts:
Assume the same facts for Helix Corporation as in previous examples.
Required:
Determine the amounts of ending inventory and cost of goods sold using the LIFO method
and periodic and the perpetual systems.
Solution:
LIFO: Periodic Inventory System

Units Bought Cost/Unit Ending Inventory Goods Available

for Sale

4,000 $4.25 $17,000

2,000 4.50 $ 9,000 9,000

 3,000 4.75 14,250 14,250
$23,250 40,250

Ending inventory (21,500)

Cost of goods sold $18750

FIFO: Perpetual Inventory System

Units Bought Units Sold Cost/Unit Inventory COGS

balance

4,000 $4.25 $17,000

3,000 4.25 (12,750) $12,750

2,000 4.50 9,000

1,000 4.25 (4,500) 4,500

3,000 4.75 14,250

Ending $23,000
inventory

Cost of goods $17,250

sold

Under the periodic inventory system, ending inventory is $21,500 and cost of goods sold is
$18,750. Under the perpetual inventory system, ending inventory is $23,000 and cost of
goods sold is $17,250
g. Analyzing the effects of inventory errors
Inventory Errors
These errors may have a material effect on current assets, working capital (current assets
minus current liabilities), cost of goods sold, net income, and equity. A common error is
inappropriate timing of the recognition of transactions.

If a purchase on account is not recorded and the goods are not included in ending inventory,
cost of goods sold and net income are unaffected. But current assets and current liabilities are
understated.

If purchases and beginning inventory are properly recorded but items are excluded from
ending inventory, cost of goods sold is overstated. Net income, inventory, retained earnings,
working capital, and the current ratio are understated.
Errors arising from recording transactions in the wrong period may reverse in the subsequent
period. If ending inventory is overstated, the overstatement of net income will be offset by the
understatement in the following year that results from the overstatement of beginning
inventory.
Example
The following table shows the effect on cost of goods sold, net income, and retained earnings
for four independent inventory errors. Note that the effects of taxes on net income and
retained earnings have been ignored.
Scenario A: Beginning inventory is understated by $20,000
Scenario B: Ending inventory is understated by $15,000
Scenario C: Beginning inventory is overstated by $25,000
Scenario D: Ending inventory is overstated by $30,000

h. Identifying advantages and disadvantages of the different inventory methods

Methods Advantages Disadvantages

Specific identification Company can manipulate

 • Results in a true net income by selection of
matching of actual cost item sold67
and revenue

Average cost
• Simple to apply, objective

• Difficult to manipulate net

income

First-in, first-out Current costs not matched

• This method to current revenue
approximates the physical
flow of goods
• Cannot manipulate
income
• Inventory value
approximates current cost

Last-in, first-out
Matches current costs to Financial net income is
current revenue lower

Results in lower taxes with LIFO liquidations can

rising prices (lower taxes distort net income
mean better cash flow)

Inventory is understated
Low inventory value because old costs remain
means a write-down is less in ending inventory
likely to be needed

i. Recommend the inventory method and cost flow assumption that should be used
for a company given a set of facts
Example
Follows are Entity A’s varying results under each of the five cost flow methods:

Ending Inventory Cost of Goods Sold

Moving average $760 $2,300

Weighted average 816 2,244

FIFO 740 2,320

LIFO periodic 800 2,260

LIFO perpetual 800 2,260

An advantage of FIFO is that ending inventory approximates current replacement cost. A
disadvantage is that current revenues are matched with older costs.
Under LIFO, management can affect net income with an end-of-period purchase that
immediately alters cost of goods sold. A last-minute FIFO purchase included in the ending
inventory has no such effect.
Under LIFO, if fewer units are purchased than sold,
1) The beginning inventory is partially or fully liquidated and
2) Old costs are matched against current revenues in the year’s income statement.

In a time of rising prices (inflation), use of the LIFO method results in the lowest year-end
inventory, the highest cost of goods sold, and the lowest gross profit. LIFO assumes that the
oldest (and therefore the lowest-priced) goods purchased are in year-end inventory, and that
cost of goods sold consists of the latest (and therefore the highest-priced) goods purchased.
The results for the FIFO method are the opposite of those for the LIFO method.
j. Demonstrating an understanding of the following debt security types: trading,
available-for-sale, and held-to-maturity
Debt Securities
A debt security represents a creditor relationship with the issuer. Organizations often hold
marketable securities to invest idle cash before it is needed for business operations.

These securities allow the organization to maintain sufficient cash liquidity while still allowing
the opportunity to earn additional income. Organizations must classify these securities in one
of three ways. The classification is based on the organization's intent related to the debt
securities at the time of purchase.
Trading Securities
Trading securities are bought and held primarily for sale in the near term. They are purchased
and sold frequently.
Debt securities classified as trading securities are generally reported as current assets,
although they can be reported as non-current, if appropriate.
Available-for-Sale Debt Securities
Available-for-sale debt securities are those not meeting the definitions of the other two
classifications (trading or held-to-maturity).
Debt securities classified as available-for-sale securities are reported as either current assets
or non-current assets, depending on the intent of the corporation.
Held-to-Maturity Debt Securities
Investments in debt securities are classified as held-to-maturity only if the corporation has the
positive intent and ability to hold these securities to maturity. If the intent is to hold the security
for an indefinite period of time, but not necessarily to maturity, then the security is classified as
available-for-sale.
If a security can be paid or otherwise settled in a manner that the holder may not recover
substantially all its investment, the held-to-maturity classification may not be used. Securities
classified as held-to-maturity are reported as current or non-current assets, based on their
time to maturity.
k. Demonstrating an understanding of the valuation of debt and equity securities
Trading Securities -- Fair Value through Net Income
Trading securities are bought and held primarily for sale in the near term. They are purchased
and sold frequently. Each trading security is initially recorded at cost
Dr. Trading securities xxx
Cr. Cash xxx
Trading securities are re-measured at fair value at each balance sheet date.
Unrealized holding gains and losses on debt securities classified as trading securities are
included in earnings. Therefore, the unrealized gain or loss on trading securities is recognized
in net income.
Dr. Unrealized loss on trading securities xxx
Cr. Valuation account (fair value adjustment) xxx
Available-for-Sale Securities -- Fair Value through OCI
Securities that are not classified as held-to-maturity or trading are considered available-for
sale. The initial acquisition is recorded at cost by a debit to available-for-sale securities and a
credit to cash.
Dr. Available-for-sale securities xxx
Cr. Cash xxx

Available-for-sale securities are re-measured at fair value at each balance sheet date.
Unrealized holding gains and losses resulting from the re-measurement to fair value are
reported in other comprehensive income (OCI).
Dr. Unrealized loss on available-for-sale securities xxx
Cr. Valuation account (fair value adjustment) xxx

Tax effects are debited or credited directly to OCI. Amortization of any discount (premium) is
reported by a debit (credit) to available-for sale securities or an allowance and a credit (debit)
to interest income and receipt of cash dividends is recorded by a debit to cash and a credit to
dividend income.
Realized gains or losses are recognized when a debt security is sold and when an available-
for-sale debt security is deemed to be impaired. All realized gains or losses are recognized in
net income.

Held-to-Maturity Securities -- Amortized Cost

An investment in a debt security is classified as held-to-maturity when the holder has both the
positive intent and the ability to hold the security until its maturity date.
Held-to-maturity debt securities are reported at amortized cost. The purchase of held-to-
maturity securities is recorded as follows:
Dr. Held-to-maturity securities xxx
Cr. Cash xxx
Unrealized gains and losses on held-to-maturity securities are not recognized in the financial
statements, as held-to-maturity securities are not marked-to-market at period end.

Reclassification
Transfers between categories should occur only when justified. Transfers between categories
are accounted for at transfer-date fair value. The following describes the treatment of
unrealized holding gains and losses at that date:
From Trading Category
The unrealized holding gains or loss at the date of transfer is already recognized in earnings
and shall not be reversed.
To Trading Category
The unrealized holding gains or loss at the date of transfer shall be recognized in earnings
immediately.
Held-to-Maturity Transferred to Available-for-Sale
The unrealized holding gains or loss at the date of transfer shall be reported in other
comprehensive income.
Available-for-Sale Transferred to Held-to-Maturity
The unrealized holding gains or loss at the date of transfer is already reported in other
comprehensive income. The unrealized holding gain or loss shall be amortized over the
remaining life of the security as an adjustment of yield in a manner consistent with the
amortization of any premium or discount.

Income from Investments in Debt Securities

Interest income from an investment in debt securities classified as trading or available-for-sale
is recorded on the income statement.
Dr. Cash xxx
Cr. Interest income xxx
Impairment of Debt Securities
Under the current expected credit losses (CECL) model, available-for-sale debt securities and
held-to-maturity debt securities should be reported at the net amount expected to be collected
using an allowance for expected credit losses.
Expected credit losses are determined based on current conditions, experience, and future
expectations. A credit loss is recognized as a current period expense on the income statement
and as an offsetting allowance on the balance sheet. Increases and decreases in expected
credit losses are reflected on the income statement in the period incurred when the estimate
of expected credit losses changes.
Impairment of Held-to-Maturity Securities
If it is determined that all amounts due (principal and interest) will not be collected on a debt
investment reported at amortized cost, the investment should be reported at the present value
of the principal and interest that is expected to be collected. The credit loss is the difference
between the present value and the amortized cost.
Example
Facts:
On January 2, Year 3, TGPO Co. purchased a $500,000, four-year bond at par with annual
interest at 4.25 percent paid on December 31 each year. TGPO classified the investment as
held-to-maturity. At the end of Year 3, TGPO received the full interest payment of $21,250, but
determined that it would only collect $11,500 each year in interest for the remaining three
years (along with the face value of $500,000 at maturity).
Present value of $1 at 4.25 percent for three periods = 0.88262
Present value of an ordinary annuity of 1 at 4.25 percent for three periods = 2.76198
Required:
Prepare the entry that TGPO will record at the end of Year 3 to recognize the impairment.
Solution:
The first step is to calculate the present value as of December 31, Year 3.
Present value:
Interest payments: $11,500 × 2.76198 = $31,763
Principal payment: $500,000 × 0.88262 = $441,310
Total present value = $473,073
The credit loss is calculated as:
Present value − Amortized cost = $473,073 − $500,000 = ($26,927)
The journal entry will be as follows:
Dr. Credit loss $26,927
Cr. Allowance for credit losses $26,927

Impairment of Available-for-Sale Debt Securities

Impairment on available-for-sale securities is accounted for differently from impairment on
held-to-maturity securities, because the investor has the option to sell an available-for-sale
security if the loss on the sale will be less than the expected credit loss.
As a result, the credit loss reported in net income on an available-for-sale security is limited to
the amount by which fair value is below amortized cost. Any additional loss is reported as an
unrealized loss in other comprehensive income.
Example
Facts:
The same facts as in Example 1, except the investment is an available-for-sale debt security.
Required:
Determine the expected credit loss and/or unrealized holding gain/loss to be recognized on
December 31, Year 3, for each of the following fair-value scenarios, and prepare the journal
entry for each scenario.
Scenario 1: $510,000 fair value
Scenario 2: $480,000 fair value
Scenario 3: $450,000 fair value
Solution:

Scenario 1 Scenario 2 Scenario 3

Amortized cost, $500,000 $500,000 $500,000

1/2/Year 3

Fair value, $510,000 $480,000 $450,000

12/31/Year 3

Expected credit $26,927 $26,927 $26,927

loss*

Expected credit $20,000 $26,927

loss (net income)

Unrealized gain $10,000 0 0

(OCI)

Unrealized loss 0 0 $23,073

(OCI)

* The expected credit loss is the difference between present value and amortized cost,
calculated as shown in Example 1 for the held-to-maturity debt security.

For Scenario 1, the journal entry would be:

Dr. Valuation account (fair value adjustment) $10,000
Cr. Unrealized gain on available-for-sale security $10,000

For Scenario 2, the journal entry would be:

Dr. Credit loss $20,000
Cr. Allowance for credit losses $20,000

For Scenario 3, the journal entry would be:

Dr. Credit loss $26,927
Dr. Unrealized loss on available-for-sale security 23,073
 Cr. Allowance for credit losses $26,927
Cr. Valuation account (fair value adjustment) 23,073

Equity Securities
An equity security is a security that represents an ownership interest in an enterprise or the
right to acquire or dispose of an ownership interest in an enterprise at fixed or determinable
prices.
Equity securities include:
• Ownership shares (common, preferred, and other forms of capital stock);
• Rights to acquire ownership shares (stock warrants, rights, and call options); and
• Rights to dispose of ownership shares (put options).

Equity securities do not include:

• Preferred stock redeemable at the option of the investor or stock that must be redeemed by
the issuer.
• Treasury stock (the company's own stock repurchased and held); and
• Convertible bonds.

Equity securities are generally reported at fair value through net income (FVTNI). Unrealized
holding gains and losses on equity securities are included in earnings as they occur.

Dr. Unrealized loss on equity security $XXX

Cr. Valuation account (fair value adjustment) $XXX

Income from Investments in Equity Securities

Dividend income from an equity security investment is recognized on the income statement as
non-operating income, unless the dividend is a liquidating dividend.
Normal (Non-liquidating) Dividend
Dr. Cash $XXX
Cr. Dividend income $XXX
Liquidating Dividend
A liquidating dividend is a distribution that exceeds the investor's share of the investee's
retained earnings. A liquidating dividend is a return of capital that decreases the investor's
basis in the investment.
Dr. Cash $XXX
Cr. Investment in investee $XXX
Example
Facts:
ABC Corporation owns a 10 percent interest in XYZ Corporation. During the current year, XYZ
Corp. paid a dividend of $10,000,000. XYZ had retained earnings of $8,000,000 when the
dividend was declared. ABC
will receive a dividend of $1,000,000 ($10,000,000 × 10%) from XYZ and will record dividend
income of $800,000 for its share of XYZ's retained earnings ($8,000,000 × 10%). The
$200,000 difference reduces ABC's investment in XYZ.
Required:
Prepare the journal entry that ABC will record for this liquidating dividend.
Solution:
Journal entry to record $1,000,000 ($10,000,000 × 10%) dividends received from XYZ
Corporation:

DR Cash $1,000,000
CR Dividend income ($8,000,000 × 10%) $800,000
CR Investment in XYZ Corporation 200,000

Impairment
Equity investments that do not have readily determinable fair values are measured at cost
minus impairment (the practicability exception). An entity should consider the following
qualitative indicators in order to determine whether an equity investment with no readily
determinable fair value is impaired:
• Heightened concerns regarding the ability of an investee to continue as a going concern due
to factors such as noncompliance with capital or debt requirements, deficiencies in working
capital, or negative operating cash flows.
• Significant and adverse changes in the industry, geographic area, technology, or regulatory
or economic environment of the investee.
• A significant decline in earnings, business prospects, asset quality, or credit rating of the
investee.
• Offers to buy from the investee (and willingness to sell on the part of the investee) the same
or a similar investment for less than the investor's carrying value.

When a qualitative assessment indicates that impairment exists, the cost basis of the security
is written down to fair value and the amount of the write-down is accounted for as a realized
loss and included in earnings.
l. Determining the effect on the financial statements of using different depreciation
methods
Property, Plant, and Equipment
Property, plant, and equipment (PPE), also called fixed assets, are tangible property expected
to benefit the entity for more than 1 year. They are held for the production or supply of goods
or services, rental to others, or administrative purposes.
PPE -- Initial Measurement
PPE are initially measured at historical cost, which consists of all the costs necessarily
incurred to bring the asset to the condition and location necessary for its intended use. The
historical (initial) cost includes
1) The net purchase price (minus trade discounts and rebates, plus purchase taxes and
import duties).
2) The directly attributable costs of bringing the asset to the location and condition needed for
its intended operation, such as architects’ and engineers’ fees, site preparation, delivery and
handling, installation, assembly, and testing.
3) The interest (borrowing costs) attributable to the acquisition, construction, or production of
PPE.

In the case of a constructed building, historical cost does not include site preparation costs
(e.g., the costs of clearing, draining, filling, and leveling the land). Instead, such costs are
costs of the attached land, not of the building to be constructed on the land.

PPE – Subsequent measurement

The carrying amount of an item of PPE is the amount at which it is presented in the balance
sheet. This amount is equal to the historical cost minus accumulated depreciation and
impairment losses.
Historical or initial cost
Minus: Accumulated depreciation
Minus: Impairment losses
Asset’s carrying amount
The accounting issue related to expenditures for PPE after initial recognition is to determine
whether they should be
1) Capitalized at cost and depreciated in future periods (a capital expenditure) or
2) Recognized as an expense as incurred (a revenue expenditure).

Depreciation
Depreciation is the process of systematically and rationally allocating the depreciable base of
a tangible capital asset over its expected useful life. The periodic depreciation expense is
recognized in the income statement. Accumulated depreciation is a contra asset account.
The debit is to depreciation expense, and the credit is to accumulated depreciation.
The journal entry is
Depreciation expense $XXX
Accumulated depreciation $XXX

Depreciable Base
The asset’s depreciable base (the amount to be allocated) is calculated as follows:
Depreciable base = Historical cost – Salvage value – Recognized impairment loss
Estimated useful life is an estimated period over which services or economic benefits are
expected to be obtained from the use of the asset.
Salvage value (residual value) is the amount that the entity expects to obtain from disposal of
the asset at the end of the asset’s useful life.
Land has an indefinite useful life and therefore must not be depreciated. Thus, the
depreciable base of property that consists of land or a building is the depreciable base of the
building only.

Depreciation Methods
Straight-Line (S-L) Depreciation
Straight-line (S-L) depreciation is the simplest method because an equal amount of
depreciation is charged to each period of the asset’s useful life.
The easiest way to calculate straight-line depreciation is to divide the depreciable base by the
estimated useful life.
Example
Assume that an asset cost $11,000, has a salvage value of $1,000, and has an estimated
useful life of five years. $11,000 − $1,0005 years=$2,000 depreciation per year
If the asset was acquired within the year instead of at the beginning of the year, partial
depreciation expense is taken in the first year.
Sum-of-the-Years'-Digits Depreciation
The sum-of-the-years'-digits method is one of the accelerated methods of depreciation that
provides higher depreciation expense in the early years and lower charges in the later years.
To find the sum-of-the-years'-digits, each year is progressively numbered and then added. For
example, the sum-of-the-years'-digits for a five-year life would be:
1 + 2 + 3 + 4 + 5 = 15
For four years: 1 + 2 + 3 + 4 = 10
For three years: 1 + 2 + 3 = 6
The sum-of-the-years'-digits becomes the denominator. The numerator is the remaining life of
the asset at the beginning of the current year. For example, the first year's depreciation for a
five-year life would be 5/15 of the depreciable base of the asset.

When dealing with an asset with a long life, use the general formula for finding the sum-of-
the-years'-digits:

Example
Facts:
Assume that an asset cost $11,000, has a salvage value of $1,000, and has an estimated
useful life of four years.
Required:
Calculate the amount of depreciation expense for each of the four years of the asset's useful
life.
Solution: The first step is to determine the depreciable base:
Cost of asset $11,000
Less: salvage value (1,000)
Depreciable base $10,000
The sum-of-the-years'-digits for four years is: 1 + 2 + 3 + 4 = 10
The first year's depreciation is 4/10, the second year's is 3/10, the third year's is 2/10, and the
fourth year's is 1/10, as follows:

Units-of-Production (Productive Output) Depreciation

The units-of-production method relates depreciation to the estimated production capability of
an asset and is expressed in a rate per unit or hour.

Declining Balance Depreciation

The most common of these accelerated methods is the double-declining-balance method,
although other alternative (less than double) methods are acceptable.
Under double-declining balance, each year's depreciation rate is double the straight-line rate.
In the final year, the asset is depreciated to its salvage value, if any.
Double-declining-balance depreciation is calculated using the following formula, where n is
the number of years of the asset's useful life:
Example
Facts:
An asset costing $10,000 with a salvage value of $2,000 has an estimated useful life of 10
years.
Required:
Using the double-declining-balance (200%) method, calculate the depreciation expense for
each year of the useful life of the asset.
Solution:
First, the regular straight-line method percentage is determined, which in this case is 10
percent (10-year life). The amount is multiplied by two resulting in 20 percent and applied
each year to the remaining book value, as follows:

Note: Had the preceding illustration been 1½ times declining balance (150 percent), the rate
would have been 15 percent of the remaining book value (10% × 1.5).
If the asset had been placed in service halfway through the year, the first year's depreciation
would have been $1,000 (one-half of $2,000), and the second year's depreciation would have
been 20 percent of $9,000 (remaining value after the first year), or $1,800. In Year 8, only $
Partial-Year Depreciation
When an asset is placed in service during the year, the depreciation expense is taken only for
the portion of the year that the asset is used. For example, if an asset (of a company on a
calendar year basis) is placed in service on July 1, only six months' depreciation is taken.
Effects of Depreciation on Net Income
The method of deprecation elected impacts the reported income on the income statement.
Straight-line depreciation results in a uniform amount of depreciation expense each year of
the asset's useful life. Straight-line is the easiest to calculate and has a consistent effect on
income from period to period.
Double-declining-balance depreciation results in higher depreciation expense in the early
years of the life of an asset. Net income will be lower in the earlier years due to the higher
depreciation expense and higher in the later years as depreciation expense decreases.
Sum-of-the-years' digits depreciation results in higher depreciation earlier in the life of an
asset. Depreciation expense will decrease each year. This method is rarely used in practice,
but it has the same effect as other accelerated methods like declining balance.
Units-of-production depreciation measures depreciation based on the usage of an asset
during the period. The effect on net income is variable, as more depreciation expense is taken
when the asset is used more heavily. Greater usage implies greater production, which
hopefully aligns with an increase in sales, matching the higher expense against the periods of
higher revenues.

m. Recommend a depreciation method for a given set of data

Example
Dawson Diggers Inc. purchased several new assets during the current fiscal year.
Management has been discussing depreciation alternatives for assets purchased and
determined the following:
Assets Purchased:
• Building: The building has an estimated useful life of 25 years and will provide a uniform
benefit over its useful life. There is no measurable output for the building.
• Equipment: The equipment has an estimated useful life of 5 years. The equipment will be
used in the construction process and is estimated to have 100,000 hours of run time at the
time of acquisition. Usage of the equipment will vary each year based on the number of jobs
contracted with customers.
The company determines the straight-line method of depreciation is appropriate for the
building because benefit is received uniformly over the life of the asset. The equipment will be
depreciated using units of production based on management's assessment of the life of the
machine in terms of hours utilized. Each year, the amount of depreciation determined will be
based on hours used for the equipment.
n. Demonstrate an understanding of the accounting for impairment of long-term
assets and intangible assets, including goodwill
Impairment of Assets
Long-Term Assets and Intangible Assets
PP&E and intangible assets are tested for impairment when events or circumstances indicate
the book value may not be recoverable. Intangible assets include finite life intangible assets,
such as patents, copyrights, and trademarks, and indefinite life intangible assets such as
goodwill.
Property, Plant, and Equipment
The carrying amounts of fixed assets held for use and to be disposed of need to be reviewed
at least annually or whenever events or changes in circumstances indicate that the carrying
amount may not be recoverable.

Calculation of the Impairment Loss

The impairment loss is calculated as the amount by which the carrying amount exceeds the
fair value of the asset.

Reporting the Impairment Loss: General

The impairment loss is reported as a component of income from continuing operations before
income taxes or in a statement of activities (related to not-for-profit entities). The impairment
loss is recognized by reducing the carrying value of the asset to its lower fair value.
Restoration of previously recognized impairment losses is prohibited under U.S. GAAP unless
the asset is held for disposal. A fixed asset impairment loss under IFRS is calculated using a
one-step model in which the carrying value of the fixed asset is compared with the fixed
asset's recoverable amount.
IFRSs define the recoverable amount as the greater of the asset's fair value less costs to sell
and the asset's value in use. Value in use is the present value of the future cash flows
expected from the fixed asset. IFRSs allow the reversal of impairment losses.

Impairment of Intangible Assets Other Than Goodwill

Intangible assets with indefinite useful life (including goodwill) are tested for impairment at
least annually, and intangible assets with finite useful life are tested whenever events or
changes in circumstances indicate that the carrying amount may not be recoverable.
Under U.S. GAAP, the impairment test applied to an intangible asset other than goodwill is
determined by the asset's life. An intangible asset has a finite life when it is possible to
estimate the useful life of the asset.
If it is not possible to determine the useful life of an intangible asset, then the asset has an
indefinite (not infinite) life. If an intangible asset has a finite life, it is amortized over that life. If
it has an indefinite life, it is not amortized
The test for impairment is a two-step test:
1) Recoverability test. The carrying amount of a long-lived asset to be held and used is not
recoverable if it exceeds the sum of the undiscounted future cash flows expected from the use
and disposition of the asset.
2) If the carrying amount is not recoverable, an impairment loss is recognized. It equals the
excess of the carrying amount of the asset over its fair value

The journal entry to recognize the impairment loss is

Dr. Impairment loss $XXX
Cr. Accumulated depreciation $XXX
The carrying amount of a long-lived asset adjusted for an impairment loss is its new cost
basis. A previously recognized impairment loss must not be reversed.

Intangible Assets with Indefinite Lives (One-Step Impairment Test)

When testing an intangible asset with an indefinite life (including goodwill) for impairment, it is
generally not possible to estimate total future cash flows expected to result from the use of the
assets and its disposition.
As a result, an intangible asset with an indefinite life is tested for impairment by comparing the
fair value of the intangible asset to it carrying amount. If the asset's fair value is less than it is
carrying amount, an impairment loss is recognized in an amount equal to the difference.

Reporting an Impairment Loss

An impairment loss is reported as a component of income from continuing operations before
income taxes unless the impairment loss is related to discontinued operations.
The carrying amount of the asset is reduced by the amount of the impairment loss.
Restoration of previously recognized impairment losses is prohibited unless the asset is held
for disposal.

Goodwill Impairment
Goodwill is tested for impairment at the reporting-unit level. All goodwill is assigned to the
reporting units that will benefit from the business combination. It is tested for impairment each
year at the same time.
As in the case of an intangible asset with an indefinite useful life, an entity may elect to
perform a qualitative assessment to determine whether the quantitative impairment test is
needed.

Qualitative Evaluation of Goodwill Impairment

Under U.S. GAAP, the goodwill impairment test has been simplified by allowing companies to
test qualitative factors to determine whether it is necessary to perform the quantitative
goodwill impairment test. Examples of qualitative factors include:

• Macroeconomic conditions
• Overall financial performance
• Entity-specific events such as bankruptcy, litigation, or changes in management, strategy, or
customers Industry and market conditions
• Sustained decrease in share-price
• Cost factors that could have a negative effect on earnings and cash flows85
The quantitative impairment test is not necessary if, after assessing the relevant qualitative
factors, an entity determines that it is not more likely than not that the fair value of the
reporting unit is less than it is carrying amount.
If the qualitative assessment indicates that there is a greater than 50 percent chance that the
fair value of the reporting unit is less than it is carrying amount, then the entity must perform
the quantitative impairment test.
Valuation of Liabilities
o. Identifying the classification issues of short-term debt expected to be refinanced
Liabilities
abilities are probable future sacrifices of economic benefits arising from present obligations of
an entity to transfer assets or provide services to other entities in the future because of past
transactions or events. Liabilities must be identified as current or non-current for financial
reporting purposes.

Current liabilities are obligations whose liquidation is reasonably expected to require the use
of current assets, the creation of other current liabilities, or the provision of services within the
next year or operating cycle, whichever is longer.

Trade Accounts Payable

Trade accounts payable are amounts owed for goods, raw materials, and supplies that are not
evidenced by a promissory note. Purchases of goods and services on credit are usually
determinable as to amounts due and the due date.
Cash discounts associated with accounts payable can be anticipated and journalized. The
purchase may be recorded gross or net.

Gross Method
The gross method records the purchase without regard to the discount. If invoices are paid
within the discount period, a purchase discount is credited

Net Method
Under the net method, purchases, and accounts payable are recorded net of the discount. If
payment is made within the discount period, no adjustment is necessary. If payment is made
after the discount period, a purchase discount lost account is debited.

Current Portions of Long-Term Debt

Debt instruments may be set up such that periodic principal payments are made during the
life of the borrowing. In this case the principal due within the next year (or operating cycle) will
be classified as a current liability
Current Obligations Expected to Be Refinanced
Under U.S. GAAP, a short-term obligation may be excluded from current liabilities and
included in non-current debt if the company intends to refinance it on a long-term basis and
the intent is supported by the ability to do so as evidenced either by:
The actual refinancing prior to the issuance of the financial statements; or
The existence of a non-cancelable financing agreement from a lender having the financial
resources to accomplish the refinancing.
The amount excluded from current liabilities and a full description of the financing agreement
shall be fully disclosed in the financial statements or notes. The following journal entry would
be used to record the reclassification:
Dr. Short-term liability $XXX
Cr. Long-term liability $XXX

Example
Facts:
Timber Corp. has $5,000,000 of long-term debt that will mature on April 1, Year 2. On
December 1, Year 1, based on its expected available cash, Timber decides to refinance
$4,000,000 of the debt. The bank issues Timber a six-year, 12 percent note on December 15,
Year 1. The entire proceeds of this loan will be used on April 1, Year 2, to pay the long-term
debt due on that date. Timber prepares financial statements on December 31.
Required:
Describe the classification of the $5,000,000 long-term debt, maturing April 1, Year 2, on
Timber Corp.'s balance sheet on December 31, Year 1.
Solution:
Only $1,000,000 of the long-term debt is classified as a current liability; the remaining
$4,000,000 is reclassified as long-term because by the end of Year 1, Timber had initiated,
and in this case completed, actual refinancing using long-term debt.

p. Comparing the effect on financial statements when using either the assurance
warranty approach or the service warranty approach for accounting for warranties
Warranties
Warranties are a seller's promise to "correct" any product defects or to compensate the buyer
for any issues. Sellers offering warranties create a liability account at the time of sale if the
cost of the warranty can be reasonably estimated.

The accounting for warranties depends on whether the warranty represents an assurance
warranty or a service warranty.

Assurance Warranty Approach

An assurance warranty provides the customer a guarantee that the product/service will work
properly for the period covered.
An assurance warranty does not represent a separate performance obligation; therefore, no
sales revenue is recorded related to assurance warranties.
If the product/service does not work properly within this time frame, the seller will correct the
situation by repairing the product, substituting a new product/service, or reimbursing the
customer.
The liability and the related expense are recognized in the year of sale to match the cost with
the corresponding revenue from selling the product. The accrual is recorded even if a portion,
or all, of the warranty expenditure will be incurred in later years.
The classification of the liability as current or long-term depends on the timing of the expected
costs related to satisfying the warranty. As repair work is completed, the liability is reduced.

Example
Facts:
ABC Corp. has a three-year warranty against defects in the machinery it sells. When a
warranty claim is made, ABC Corp. satisfies the claim by replacing the machinery. Warranty
costs are estimated at 2 percent of sales in the year of sale, and 4 and 6 percent in the
succeeding years. ABC sales and actual warranty expenses for Year 1–Year 3 were as
follows:

Required:
Prepare the journal entries to account for the warranty in Years 1-3 and determine the balance
in the warranty liability account at the end of Year 3.
Solution:
ABC's total liability should be accrued in the year of sale even though it will not be incurred in
that year.
The following journal entries will be recorded in Years 1–3.
Year 1:
Dr. Warranty expense ($250,000 × 12%) $30,000
Cr. Warranty liability $30,000
Dr. Warranty liability (actual costs) 10,000
Cr. Inventory 10,000

Year 2:
Dr. Warranty expense ($500,000 × 12%) $60,000
Cr. Warranty liability $60,000
Dr. Warranty liability 20,000
Cr. Inventory 20,000

Year 3:
Dr. Warranty expense ($750,000 × 12%) $90,000
Cr. Warranty liability $90,000

Dr. Warranty liability 30,000

Cr. Inventory 30,000
The balance in the account at the end of Year 3 is total liability fewer actual expenditures and
is calculated as follows:
Total liability = Sales × Total estimated expense
= $1,500,000 × 12% [2% + 4% + 6%]
= $180,000
Balance, liability account, 12/31/Year 3 = Total liability − Actual expenditures
= $180,000 − $60,000
= $120,000

Service Warranty Approach

Service warranties, sometimes referred to as extended warranties, represent a separate
performance obligation, and therefore result in the recognition of revenue.
Service warranties require the recognition of a liability for the warranty obligation and
determination of when to recognize revenue from the sale of the warranty.
Extended warranties are often offered by sellers of products such as electronic devices,
automobiles, and household appliances. Because the warranty is viewed as a separate
performance obligation, the revenue from sales of a service warranty is recorded as unearned
revenue, a liability.
Unearned revenue is recognized as earned revenue as time passes, usually on a straight-line
basis. The unearned revenue is classified as current or long-term based on the time covered.
Costs incurred related to the warranty are expensed in the period in which they occur.
Example
Facts:
Evelyn Electronics offers an extended three-year warranty on all Blu-ray players the company
sells. At the beginning of Year 1, the company sold, for cash, a total of $6,000 in extended
warranties. The company spent $250 related to these warranties in Year 1.
Required:
Prepare the service warranty journal entries for Year 1.
Solution:
Each year $2,000 ($6,000 ÷ 3 years) of unearned revenue is converted to earned revenue;
the cost of the repair work each will be recorded as an expense for that year.
January 1, Year 1: Journal entry to record extended warranty sales at the beginning of the
year that create a performance obligation over the next three years:
Dr. Cash $6,000
Cr. Unearned revenue—extended warranty $6,000

December 31, Year 1: Journal entry to recognize warranty revenue earned during the first
year of coverage, $6,000 ÷ 3 years = $2,000:
Dr. Unearned revenue—extended warranty $2,000
Cr. Revenue—extended warranty $2,000

During Year 1: Journal entry to recognize warranty costs to satisfy customer claims in the
period incurred and match against current period warranty revenues:
Dr. Warranty expense $250
Cr. Cash $250

Income Taxes (Applies to Assets and Liabilities Subtopics)

q. Demonstrate an understanding of inter period tax allocation/deferred income taxes
Accounting for Income Taxes
Accounting for income taxes involves both intraperiod and interperiod tax allocation.
Intraperiod allocation matches a portion of the provision for income tax to the applicable
components of net income and retained earnings.
Interperiod allocation is accounting for the temporary differences between financial accounting
frameworks such as GAAP or IFRS, and governing tax policies.
The objective of interperiod tax allocation is to recognize through the matching principle the
amount of current and future tax related to events that have been recognized in financial
accounting income.
Current Year Taxes: Payable (liability) or refundable (asset)
Or:
Future Year Taxes: Deferred tax asset or deferred tax liability

Accounting for Interperiod Tax Allocation

Total income tax expense (GAAP income tax expense) or benefit for the year is the sum of:
• Current income tax expense/benefit, and
• Deferred income tax expense/benefit.

Current income tax expense/benefit is equal to the income taxes payable or refundable for the
current year, as determined on the corporate tax return (Form 1120) for the current year.
Deferred income tax expense/benefit is equal to the change in deferred tax liability or asset
account on the balance sheet from the beginning of the current year to the end of the current
year (called the "balance sheet approach").
Thus, total income tax expense/benefit can be depicted as follows:

r. Distinguishing between deferred tax liabilities and deferred tax assets

Deferred Tax Liabilities
Deferred tax liabilities are anticipated future tax liabilities derived from situations in which
future taxable income will be greater than future financial accounting income due to temporary
differences. All deferred tax liabilities are recognized on the balance sheet.
DTLs arise when revenues or gains are recognized under GAAP before they are included in
taxable income. An example is income recognized under the equity method for financial
statement purposes and at the time of distribution in taxable income.

DTLs also result when expenses or losses are deductible for tax purposes before they are
recognized under GAAP. An example is accelerated tax depreciation of property.
DTL = Future taxable amount × Tax rate
Example
Facts:
Stone Co. began operations in Year 1 and reported $225,000 in financial income for the year.
Stone Co.'s Year 1 tax depreciation exceeded its book depreciation by $25,000. Stone's tax
rate for Year 1 and years thereafter was 21 percent. In Year 2, book depreciation exceeded
tax depreciation by $25,000. This is a reversal of the temporary difference between GAAP
and tax accounting and results in the reversal of the deferred tax liability in Year 2.
Required:
Prepare the tax journal entries for Year 1 and Year 2.
Solution:

The excess depreciation on the tax return results in a future liability, a financial accounting
expense in future years that will not be deductible in future years because it was deducted in
Year 1. The deferred tax liability reflects the fact that less depreciation will be deducted on the
tax return in future years, compared with the financial statements. This yields a future taxable
income which will be greater than the future financial accounting income.
Journal entry to record the taxes in Year 1:
Dr. Income tax expense—current $42,000
Dr. Income tax expense—deferred 5,250
Cr. Deferred tax liability $ 5,250
Cr. Income tax payable 42,000

Journal entry to record the Year 2 reversal of the deferred tax liability:
Dr. Deferred tax liability $5,250
Cr. Income tax benefit—deferred $5,250
Deferred Tax Assets
Deferred tax assets arise when the amount of taxes paid in the current period exceeds the
amount of income tax expense in the current period. They are anticipated future benefits
derived from situations in which future taxable income will be less than future financial
accounting income due to temporary differences.
DTAs result when revenues or gains are included in taxable income before they are
recognized under GAAP. Examples are unearned revenues such as rent, and subscriptions
received in advance.
DTAs also result when expenses or losses are recognized under GAAP before they are
deductible for tax purposes. Examples are bad debt expense recognized under the allowance
method and warranty costs.
DTA = Future deductible amount × Tax rate
Example
Facts:
Black Co., organized on January 2, Year 1, had pretax accounting income of $500,000 and
taxable income of $800,000 for the year ended December 31, Year 1. The enacted tax rate for
all years is 21 percent. The only temporary difference is accrued product warranty costs,
which are expenses to be paid as follows: Year 2, $100,000; Year 3, $100,000; Year 4,
$100,000
Required:
Prepare the tax journal entries for Year 1 and Year 2.
Solution:

Journal entry to record the Year 1 taxes:

Dr. Deferred tax asset $ 63,000
Dr. Income tax expense—current 168,000
Cr. Income tax payable $168,000
Cr. Income tax benefit—deferred 63,000
When the company pays the warranty costs of $100,000 in Year 2, the company will take a
$21,000 ($100,000 × 21%) tax deduction related to the warranty costs and will reverse out the
related deferred tax asset.
Journal entry to record reversal of a portion of the deferred tax asset for warranty costs paid
and deducted in Year 2:
Dr. Income tax expense—deferred $21,000
Cr. Deferred tax asset $21,000
s. Differentiating between temporary differences and permanent differences and
identify examples of each
Net income under U.S. generally accepted accounting principles (GAAP) or International
Financial Reporting Standards (IFRS) can differ from taxable income reported to government
taxing authorities such as the United States Internal Revenue Service (IRS)
Differences are defined as either temporary or permanent depending on the reasons why the
GAAP to Tax accounting differences occur.
Permanent Differences
Permanent differences occur when GAAP revenues are not taxable, or GAAP expenses are
not deductible under the tax law. These differences will never reconcile because the
underlying definition of what constitutes income and deductions for tax differ from the
definition of what constitutes GAAP revenue and expense
Permanent differences do not result in deferred tax assets or liabilities, because the book to
tax differences will never be reconciled in future periods.
Permanent differences are either (a) nontaxable, (b) nondeductible, or (c) special tax
allowances.
Examples are:
• Tax-exempt interest (municipal, state)
• Life insurance proceeds on officer's key man policy
• Life insurance premiums when corporation is beneficiary
• Certain penalties, fines, bribes, kickbacks, etc.
• Nondeductible portion of meal and entertainment expense
• Dividends-received deduction for corporations
• Excess percentage depletion over cost depletion

Temporary Differences
Temporary differences occur when revenue or expenses are recorded in different periods for
book purposes compared to tax purposes
There are four basic causes of temporary differences, which reverse in future periods.
1. Revenues or gains that are included in taxable income, after they have been included in
financial accounting income, which results in a deferred tax liability.
2. Revenues or gains that are included in taxable income, before they are included in financial
accounting income, which results in a deferred tax asset.
3. Expenses or losses deducted from taxable income, after they have been deducted from
financial accounting income, which results in a deferred tax asset.
4. Expenses or losses deducted for taxable income, before they are deducted from financial
accounting purposes, which results in a deferred tax liability.

Example
Facts:
Foxy Inc.'s financial statement and taxable income for Year 1 follows (income before the effect
of tax-related differences was $140,000):
Financial statement pretax income $115,000
Differences: municipal interest income (12,000)
Penalty expense 7,000
Tax depreciation $40,000
Book depreciation (30,000)
Excess tax depreciation (10,000)

Income tax return $100,000

The enacted tax rate is 21 percent for this year and future years.
Required:
Prepare the tax journal entry for Year 1.
Solution:
Journal entry:
Dr. Income tax expense—current $ 21,000
Dr. Income tax expense—deferred 2,100
Cr. Income taxes currently payable $21,000
Cr. Deferred tax liability 2,100

Leases (applies to Assets and Liabilities subtopics)

s. Distinguish between operating and finance leases
Leases
A lease is a long-term contract in which the owner of property (the lessor) allows another party
(the lessee) to use the property for a stated period in exchange for a stated payment. The
primary issue is whether the lease agreement transfers substantially all the benefits and risks
of ownership of the asset to the lessee.
Lease Classification as Operating or Finance
Leases transfer substantially all of the benefits and risks inherent in ownership of property to
the lessee.
• This is an accounting transaction, which is in substance an installment purchase in the form
of a leasing arrangement.
• The lessee accounts for a lease as either an operating or a finance lease, reflective of the
acquisition of both an asset and a related liability.
• The lessor accounts for the lease as either an operating lease, sales-type lease, or direct
financing lease.
Based on the lease criteria, a lease will be considered either an operating or a finance lease.
Within the finance lease category, two types, and sales-type and direct financing, are
applicable to lessors.

Finance Lease Criteria

The criteria below are applicable to lessors and lessees. If any one of the five criteria is met,
the lease will be classified as a sales-type lease by the lessor and a finance lease by the
lessee.
• Ownership of the underlying asset transfers from the lessor to the lessee by the end of the
lease term.
• The lessee has the written option to purchase the underlying asset; the option is one that the
lessee is "reasonably certain" to exercise.
• The net present value of all lease payments and any guaranteed residual value is equal to or
substantially exceeds the underlying asset's fair value.
• The term of the lease represents a major part of the economic life remaining for the
underlying asset.
• The asset is specialized such that it will not have an expected, alternative use to the lessor
when the lease term ends.
If none of the above criteria are met, or if the lease is considered short term (less than 12
months), it should be treated as an operating lease by the lessee. For the lessor, if none of
the criteria above are met, the classification will depend on whether both of the following
criteria are met:
• Present value of the sum of the lease payments, lessee guaranteed residual value not
included in the lease payments, and any third-party guaranteed residual value is equal to or
substantially exceeds the underlying asset's fair value.
• Collection of the lease payments and any amounts necessary to satisfy residual value
guarantees is probable.

When both criteria above are met, the lessor will classify the lease as a direct financing lease.
If only one or neither are met, the lessor will classify the lease as operating.

Lessee Accounting for Operating Leases

If the lease is an operating lease, the balance sheet will reflect a right-of-use (ROU) asset and
lease liability, and both will be amortized over the life of the lease using the effective interest
method.
The ROU asset and lease liability amounts are calculated using the present value of the lease
payments, using the appropriate discount rate.
On the income statement, lease expense will be recognized each year over the lease term
using the straight-line method for expense measurement. Instead of reporting interest
expense on the income statement, the lessee will report the interest as part of lease expense.

Initial entry:
Dr. ROU asset $XXX
Cr. Lease liability $XXX
Subsequent entries:
Dr. Lease expense $XXX
Cr. Cash/lease liability $XXX

Dr. Lease liability $XXX

Cr. Accumulated amortization—ROU asset $XXX

Example
Facts:
On January 1, Year 2, a lessee enters a three-year asset operating (capital) lease with annual
payments of $18,000 per year. The first payment will be made December 31 and the interest
rate implicit in the lease is 5.75 percent. (The present value of an ordinary annuity for three
years at 5.75% = 2.685424.)
Required:
Prepare the journal entries for the lessee at the commencement date, the end of Year 2, the
end of Year 3, and the end of Year 4.
Solution:
January 1, Year 2, journal entry: The present value of $18,000 for three years (first payment
made at the end of Year 1) at a rate of 5.75 percent per year is equal to $48,338.
Dr. ROU asset $48,338
Cr. Lease liability $48,338
December 31, Year 2, journal entry: The lease payment of $18,000 comprises interest
expense and the amortization of the ROU asset, as calculated in the table above.
Dr. Lease expense $18,000
Dr. Lease liability 15,221
Cr. Cash $18,000
Cr. Accumulated amortization—ROU asset 15,221

December 31, Year 3, journal entry:

Dr. Lease expense $18,000
Dr. Lease liability 16,096
Cr Cash $18,000
Cr Accumulated amortization—ROU asset 16,096

December 31, Year 4, journal entry:

Dr. Lease expense $18,000
Dr. Lease liability 17,021
Cr Cash $18,000
Cr Accumulated amortization—ROU asset 17,021
Once the final entry has been recorded, the ROU asset is fully amortized

Finance Leases
If the lease is a finance lease, the lessee will recognize both an ROU asset and a
corresponding liability on its balance sheet. The liability will equal the present value of lease
payments owed.
The ROU asset will include initial direct costs (such as commissions paid, legal and consulting
fees, etc.) that were incurred because of the lease execution, as well as any lease payments
made by the lessee to the lessor at or before lease commencement.
Any incentives received by the lessee from the lessor will reduce the value of the asset.
Initial entry:
Dr. ROU asset $XXX
Cr. Lease liability $XXX
Subsequent entries:
Dr. Interest expense $XXX
Dr. Lease liability XXX
Cr. Cash/lease payable $XXX

Dr. Amortization expense $XXX

Cr. Accumulated amortization—ROU asset $XXX

Unlike with operating (capital) leases, the amortization of the ROU asset for a finance lease
will be expensed based on how the entity recognizes amortization expense on similar assets.

Facts:
On January 1, Year 2, a lessee enters a three-year asset lease with annual payments of
$18,000 per year. The first payment will be made December 31 and the interest rate implicit in
the lease is 5.75 percent. The lease qualifies as a finance lease.
Required:
Assuming straight-line amortization, prepare the journal entries for the lessee at the
commencement date, the end of Year 2, the end of Year 3, and the end of Year 4.
Solution:
January 1, Year 2, journal entry:
The present value of $18,000 for three years (first payment made at the end of Year 1) at a
rate of 5.75 percent per year is equal to $48,338.
Dr. ROU asset $48,338
Cr. Lease liability $48,338

December 31, Year 2, journal entries:

The lease payment of $18,000 comprises interest expense and the reduction of the lease
liability as calculated in the table above. The ROU asset will be amortized at $48,338 over
three years, or $16,113 per year.
Dr. Interest expense $ 2,779
Dr. Lease liability 15,221
Cr. Cash $18,000

Dr. Amortization expense 16,113

Cr. Accumulated amortization—ROU asset 16,113

December 31, Year 3, journal Entries:

Dr. Interest expense $ 1,904
Dr. Lease liability 16,096
Cr. Cash $18,000

Dr. Amortization expense 16,113

Cr. Accumulated amortization—ROU asset 16,113

December 31, Year 4, journal entries:

Dr. Interest expense $ 979
Dr. Lease liability 17,021
Cr. Cash $18,000

Dr. Amortization expense 16,112

Cr. Accumulated amortization—ROU asset 16,112
Once the final entry has been recorded, the ROU asset is fully amortized.

t. Recognizing the correct financial statement presentation of operating and

finance leases
Financial Statement Presentation of Operating and Finance Leases
Balance Sheet
ROU assets and associated lease liabilities may either be recognized as separate line items
on the balance sheet (in their respective sections) or included with other assets/liabilities and
disclosed separately in the notes to the financial statements (indicating which line items in the
balance sheet include them).

The portion of lease liabilities due within a year or the operating cycle, whichever is longer,
should be reported in the current section and the remainder in the long-term section.
Finance and operating lease ROU assets and lease liabilities cannot be presented together.
The ROU asset will be amortized, and the lease liability will be paid down over the life of the
lease.

The ROU asset will be amortized beginning on the commencement date using a straight-line
basis (unless another methodology better reflects usage and consumption).
Criteria for determining amortization:
• Amortize over the underlying asset's useful life if ownership or written option criteria are met.
• Amortize over shorter of the lease term or the useful life of the asset if net present value,
economic life, or specialized asset criteria are met.

Income Statement
For operating leases, lease expense will be included in income from continuing operations on
the lessee's income statement.
For finance leases, the income statement will include the amortization of the ROU asset and
the portion of the lease expense related to interest on the lease liability.

Cash Flow Statement

For operating leases, lease payments (which include all variable lease payments) are
classified as cash flow from operations. Payments for short-term leases are also included in
cash flow from operations. Any payments needed to bring the asset to a condition and
location in preparation for its intended use are considered investing activities.
For finance leases, the principal portion of the lease payment is a cash flow from financing,
the interest portion of the lease payment is a cash flow from operations, and any variable
lease payments and short-term lease payments not included in the lease liability are classified
as cash flows from operations.

Equity Transactions

v. Identifying transactions that affect paid-in capital and those that affect retained
earnings
Additional Paid-in Capital
Additional paid-in capital is generally contributed capital more than par value or stated value.
It can also arise from many different types of transactions. Additional paid-in capital may be
aggregated and shown as one amount on the balance sheet.
Examples of transactions involving additional paid-in capital include the following:
• Issuance of capital stock in amounts more than par or stated value
• Sale of treasury stock at a gain
• Liquidating dividends
• Conversion of bonds
• Small stock dividends

w. Determining the effect on shareholders’ equity of large and small stock dividends,
and stock splits

Treatment of a Small Stock Dividend (< 20–25%)

Stock dividends distribute additional shares of a company's own stock to its shareholders.
When less than 20 to 25 percent of the shares previously outstanding are declared as a stock
dividend, the dividend is treated as a small stock dividend because the issuance is not
expected to affect the market price of the stock.
The fair market value of the stock dividend at the date of declaration is transferred from
retained earnings to capital stock and additional paid-in capital.
There is no effect on total shareholders' equity, as paid-in capital is substituted for retained
earnings (i.e., retained earnings are "capitalized" and made part of paid-in capital).

Example
Facts:
Capital Corporation has 100,000 shares of $10 par value common stock outstanding. The
company declares a stock dividend of 5,000 shares when the fair market value is $15 (on the
date of declaration). 5,000 shares/100,000 shares = 5%, which is considered a small stock
dividend.
Required:
Prepare the journal entry to record the dividend.

Solution:
Journal entry:
Dr. Retained earnings (5,000 × $15 FV) $75,000
Cr. Common stock (5,000 × $10 par value) $50,000
Cr. Paid-in capital (difference = $75,000 − 50,000) 25,000

Treatment of a Large Stock Dividend (> 20–25 Percent)

When more than 20 to 25 percent of the previously issued shares, outstanding are distributed,
the dividend is treated as a large stock dividend, as it may be expected to reduce the market
price of the stock (similar to a stock split).
The par (or stated) value of the stock dividend is normally transferred from retained earnings
to capital stock to meet legal requirements. The amount transferred is the number of shares
issued multiplied by the par (or stated) value of the stock.
However, if state law does not require capitalization of retained earnings for stock dividends
(which is rare because it requires amendment to the articles of incorporation), record the
stock dividend distribution (like a stock split) by changing the number of shares outstanding
and the par (or stated) value per share.

Example
Facts:
LMT Corp. declares a 40 percent stock dividend on its 1,000,000 shares of outstanding $10
par common stock (5,000,000 authorized). On the date of declaration, LMT stock is selling for
$20 per share. Total stock dividend (0.40 × 1,000,000) 400,000 shares Value of 400,000
shares @ $10 per share (par) $4,000,000
Required:
Prepare the journal entries to record the declaration and distribution of the stock dividend.
Solution:
Journal entry to record the declaration of the stock dividend at par:
Dr. Retained earnings $4,000,000
Cr. Common stock distributable $4,000,000

Journal entry to record the distribution of the stock dividend at par:

Dr. Common stock distributable $4,000,000
Cr. Capital stock, $10 par common $4,000,000

Revenue Recognition
x. Applying revenue recognition principles to various types of transactions
Example
Facts:
On March 1, Year 1, Bulldog Inc. entered a contract to transfer a product to Kitty Inc. on
September 1, Year 1. Kitty will pay the full contract price of $15,000 to Bulldog by August 1,
Year 1. Bulldog transferred the product to Kitty on September 1, Year 1. The cost of the
product totaled $9,000.
Required:
Determine the journal entries that Bulldog will book to account for this transaction.
Solution:
March 1, Year 1, Journal Entry: No entry is required because neither party has performed
according to the contract.
August 1, Year 1, Journal Entry: A contract liability (e.g., unearned sales revenue) is
recognized when the cash is received in advance.
Dr. Cash $15,000
Cr. Unearned sales revenue $15,000
September 1, Year 1, Journal Entry: Revenue is recorded when the product is transferred
from the seller to the buyer.
Dr. Unearned sales revenue $15,000
Cr. Sales revenue $15,000
Dr. Cost of goods sold 9,000
Cr Inventory 9,000

Example
Facts:
A software developer enters a contract with a customer to transfer a software license, perform
installation, and provide software updates and technical support for five years. The developer
sells the license, installation, updates, and technical support separately. The entity determines
that each good or service is separately identifiable because the installation does not modify
the software and the software is functional without the updates and technical support.

Required:
Identify the performance obligation(s) in this contract.
Solution:
The software is delivered before the installation, updates, and technical support and is
functional without the updates and technical support, so the customer can benefit from each
good or service on its own. The developer has also determined that the software license,
installation, updates, and technical support are separately identifiable. On this basis, there are
four performance obligations in this contract:
1. Software license
2. Installation service
3. Software updates
4. Technical support
Example
Facts:
On January 1, Year 5, SDF sold furniture to a customer for $4,000 with three years' interest-
free credit. The customer took delivery of the furniture on that day. The $4,000 is payable to
SDF on December 31, Year 7. The applicable discount rate based on the customer's credit
profile is 8 percent.
Required:
Determine the transaction price for the sale of furniture.
Solution:
The transaction price is $3,175 ($4,000 × 1/ (1.08)3) because the time value of money must
be considered when determining the transaction price.
Note that interest income will also be recognized each year as follows:
Year 5: $3,175 × 8% = $254
Year 6: ($3,175 + $254) × 8% = $274
Year 7: ($3,175 + $254 + $274) × 8% = $296107
Example:
Facts:
A software company enters into a $250,000 contract with a customer to transfer a software
license, perform installation service, and provide technical support for a three-year period.
The entity sells the license, installation service, and technical support separately. The
installation service and technical support could be performed by other entities and the
software remains functional in the absence of these services. The contract price must be paid
on installation of the software, which is planned for March 1, Year 1.

Required:
Determine how the software company should recognize the revenue for these transactions.
Solution: The entity identifies three performance obligations in the contract for the following
goods and services:
• Software license
• Installation service
• Technical support
The stand-alone selling price can be determined for each performance obligation. The license
is usually sold for $160,000; the installation service is $20,000, and technical support runs
$30,000 per [Link] fair value of the contract is determined to be $270,000.
Based on the relative fair values, the allocation of revenue is as follows:
• Software license [($160,000/$270,000) × $250,000] = $148,148
• Installation service [($20,000/$270,000) × $250,000] = $18,519
• Technical support [($90,000/$270,000) × $250,000] = $83,333

The journal entry to record the $250,000 payment made on March 1 appears below.
March 1, Year 1:
Dr. Cash $250,000
Cr. License revenue $148,148
Cr. Service revenue 18,519
Cr. Unearned service revenue 83,333
Revenue is recorded for the sale of the license and the installation at the time of sale. The
technical support will be recognized monthly as the support is provided.
December 31, Year 1:
Dr. Unearned service revenue $23,148
Cr. Service revenue $23,148
At year-end, an adjusting entry is made to record 10 months of technical support ($83,333/36
= $2,314.80; $2,314.80 × 10 months = $23,148) through the end of Year 1. The remaining
technical support will be recorded in Years 2 and 3.

Example
Facts:
Tanner Co. is building a multi-unit residential complex. The entity enters into a contract with a
customer for a specific unit that is under construction. The contract has the following terms:
• The customer pays a nonrefundable security deposit upon entering the contract.
• The customer agrees to make progress payments during construction.
• If the customer fails to make the progress payments, the entity has the right to all of the
consideration in the contract if it completes the unit.
• The terms of the contract prevent the entity from directing the unit to another customer.

Required:
Determine whether this performance obligation is satisfied over time or at a point in time.

Solution:
This performance obligation is satisfied over time because:
• The unit does not have an alternative future use to the entity because it cannot be directed
to another customer.
• The entity has a right to payment for performance to date because the entity has a right to all
the consideration in the contract if it completes the unit.108

Example
Facts:
Tanner Co. is building a multi-unit residential complex. The entity enters a contract with a
customer for a specific unit that is under construction. The contract has the following terms:
• The customer pays a deposit upon entering the contract that is refundable if the entity fails to
complete the unit in accordance with the contract.
• The remainder of the purchase price is due on completion of the unit.
• If the customer defaults on the contract before completion, the entity only has the right to
retain the deposit.

Required:
Determine whether this performance obligation is satisfied over time or at a point in time.
Solution:
This is a performance obligation satisfied at a point in time because it is not a service
contract, the customer does not control the unit as it is created, and the entity does not have
an enforceable right to payment for performance completed to date (i.e., the entity only has a
right to the deposit until the unit is completed).