JIMMAUNIVERSITY

COLLEGE OF BUSINESS & ECONOMICS

DEPARTMENT OF ACCOUNTING & FINANCE

ADVANCED FINANCIAL ACCOUNTING I

[ACFN 4101]

A DISTANCE EDUCATION MODULE

PREPARED BY:
1. MOHAMMED ABDUSELAM(MSc.)
REVIEWED BY:
2. TESFAYE GINBARE ([Link])
JIMMA UNIVERSITY
CONTINUING AND DISTANCE EDUCATION
ACCOUNTING & FINANCE DEPARTMENT

MAY, 2023
JIMMA, ETHIOPIA
MODULE INTRODUCTION

Dear learners! First of all, I would like to say welcome to the module of course ―Advanced
Financial Accounting I.‖ This module is prepared for introducing students with the course Advanced
Financial Accounting I which designed based on international financial reporting standards (IFRS) and
expected to boost their knowledge, skills and practice on the area of income tax accounting, shared based
compensation, agricultural accounting, insurance contracts, statement of cash flows and fair value
[Link] this, module students examine several advanced topics and their effect on financial
reporting and disclosure. The principles and guidelines of IFRS taught in the courses like Fundamentals
of Accounting I & II, Intermediate Financial Accounting I & II will be helpful for warm understandings
of this course. The course is designed to cover a selected group of advanced financial accounting topics
under IFRS. Upon successful completion of this course the student will be able to:

Understand the recognition of deferred tax liabilities and assets

Acquaint with the recognition of current and deferred tax
Record the Accounting for net operating losses
Know how Income tax presentation and disclosures on financial statements
Understand the concepts of share based settlements
Apply the recognition requirements of share-based payment transactions, including the
requirements when there are vesting conditions;
Account for equity-settled share-based payment transactions, including shares and share
options;
Account for cash-settled share-based payment transactions, including share-based
payment transactions with cash-settled alternatives;
Disclose share-based payment in financial statements;
Understand The Nature of Biological Assets
Recognition and Measurement of Biological Assets
Presentation and Disclosure Issues related to Biological assets, Agricultural produces,
and bearer plant
Understand the concept of insurance contracts, cash flow statements & Asset valuation
approaches

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MODULE CONTENTS

CHAPTERS PAGE NO

CHAPTER ONE: INCOME TAXES 6

CHAPTER TWO: SHARE- BASED COMPENSATIONS 31

CHAPTER THREE: ACCOUNTING FOR AGRICULTURE 47

CHAPTER FOUR: INSURANCE CONTRACTS 68

CHAPTER FIVE: REVISITING THE STATEMENTS OF CASH FLOWS 82

CHAPTER SIX: ASSET VALUATION FOR FINANCIAL REPORTING 95

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Table of Contents
MODULE INTRODUCTION ...................................................................................................................... 1
MODULE CONTENTS................................................................................................................................ 3
CHAPTER ONE ........................................................................................................................................... 6
1. INTRODUCTION ................................................................................................................................ 6
1.1. Overview of Income Tax .................................................................................................................. 6
1.2. The Tax base concept .................................................................................................................... 7
1.3. Fundamentals of Accounting for Income Taxes ........................................................................... 8
1.3.1. Future Taxable Amounts and Deferred Taxes ...................................................................... 9
1.4. Accounting for Net Operating Losses ......................................................................................... 17
1.4.1. Loss carryforward ............................................................................................................... 17
1.5. Financial statement presentation ................................................................................................. 21
1.5.1. Statement of Financial Position .......................................................................................... 21
1.5.2. Income Statement ................................................................................................................ 22
Glossary items ......................................................................................................................................... 25
CHAPTER END REVIEW QUESTIONS ............................................................................................. 26
CHAPTER TWO ........................................................................................................................................ 31
2.1. Overview of Share-based Payments ........................................................................................... 31
2.2. Types of Share-based Payment ................................................................................................... 34
2.3. Recognition & Measurement of Share Based Compensation ................................................. 34
2.3.1. Equity-settled Share-based Payments ................................................................................. 35
2.3.2. Share-based Payments Settled with Cash ........................................................................... 38
2.3.3. Share-based Payments with Cash Alternatives ................................................................... 40
2.4. Share-based Payment Disclosures .............................................................................................. 41
Glossary Items ........................................................................................................................................ 41
CHAPTER END REVIEW QUESTIONS ............................................................................................. 42
CHAPTER THREE .................................................................................................................................... 47
3. INTRODUCTION .......................................................................................................................... 47
3.1. Overview of Agricultural activities & basic Terminologies ....................................................... 49
3.1.1. Nature of Biological Assets ................................................................................................ 51
[Link]. Types of Biological Assets ............................................................................................. 54
[Link]. Identifying Biological assets, Agricultural produce and inventories .............................. 56
3.2. Accounting for Agriculture ......................................................................................................... 57
3.2.1. Measurement & Recognition of Biological assets and Agricultural Produces ................... 57
3.3. Presentation & Disclosures of Biological assets on Financial statements .................................. 63

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 3.3.1. Presentation & Classifications ............................................................................................ 63
3.3.2. Disclosures required ............................................................................................................ 63
Glossary items ......................................................................................................................................... 64
CHAPTER END REVIEW QUESTIONS ............................................................................................. 66
CHAPTER FOUR ....................................................................................................................................... 68
4.1. INTRODUCTION .......................................................................................................................... 68
4.2. Accounting for insurance contracts ............................................................................................. 70
4.2.1. Initial Recognition & Measurement of Insurance Contracts ................................................... 74
[Link]. DE recognition of Insurance contract ............................................................................. 76
4.2.2. Initial Measurements of Insurance contracts ........................................................................... 76
4.3. Presentation & Disclosures of Insurance contract on financial statements ................................. 79
CHAPTER END REVIEW QUESTIONS ............................................................................................. 79
CHAPTER FIVE ........................................................................................................................................ 82
5. INTRODUCTION .............................................................................................................................. 82
5.1. Importance of cash flow statement ............................................................................................. 83
5.2. Classification of Cash Flows....................................................................................................... 85
5.3. Overview of the Preparation of the Statement of Cash Flows .................................................... 87
1. Determine the Starting Balance .................................................................................................. 87
2. Calculate Cash Flow from Operating Activities ......................................................................... 88
3. Calculate Cash Flow from Investing Activities .......................................................................... 89
4. Calculate Cash Flow from Financing Activity............................................................................ 89
5. Determine the Ending Balance ................................................................................................... 90
CHAPTER END REVIEW QUESTIONS ............................................................................................. 92
CHAPTER SIX ........................................................................................................................................... 95
6. INTRODUCTION .............................................................................................................................. 95
6.1. International Valuation Standards ............................................................................................... 96
6.1.1. Valuation Approaches ......................................................................................................... 96
6.2. Fair value Measurement .............................................................................................................. 97
6.2.2. Fair value hierarchy ............................................................................................................ 98
6.3. Impairment Measurement ........................................................................................................... 99
CHAPTER END REVIEW QUESTIONS ........................................................................................... 101

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 CHAPTER ONE

ACCOUNTING FOR INCOME TAX

1. INTRODUCTION
Companies spend aconsiderable amount of time and effort to minimize their income
taxpayments. And with good reason, as income taxes are major costs ofdoing business for most
companies. Yet, at the same time, companiesmust present financial information to the investment
community thatprovides a clear picture of present and potential tax obligations and
[Link]‘s competitive markets, managers are expected to look for loopholesin the tax
law that a company can exploit to pay less tax to various taxauthorities. After completing this
chapter, Students will be able to understand;

The tax base concept

Recognition of deferred tax liabilities and assets
Future taxable temporary differences
Future deductible temporary differences
Recognition of current and deferred tax
Accounting for net operating losses
Income tax presentation and disclosures

1.1. Overview of Income Tax

Dear students before reading the following paragraphs think for a moment about income tax
and standards?
In April 2001 the International Accounting Standards Board adopted IAS 12 Income
Taxes, which had originally been issued by the International Accounting Standards Committee in
October 1996. IAS 12 Income Taxes replaced parts of IAS 12 Accounting for Income
Taxes (issued in July 1979). In December 2010 the Board amended IAS 12 to address an issue
that arises when entities apply the measurement principle in IAS 12 to temporary differences
relating to investment properties that are measured at fair value.

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The objective of this Standard is to prescribe the accounting treatment for income taxes. The
principal issue in accounting for income taxes is how to account for the current and future tax
consequences of:

(a) The future recovery (settlement) of the carrying amount of assets (liabilities) that
are recognized in an entity’s statement of financial position; and

(b) Transactions and other events of the current period that are recognized in an
entity’s financial statements.

It is inherent in the recognition of an asset or liability that the reporting entity expects to recover
or settle the carrying amount of that asset or liability. If it is probable that recovery or settlement
of that carrying amount will make future tax payments larger (smaller) than they would be if
such recovery or settlement were to have no tax consequences, this Standard requires an entity to
recognize a deferred tax liability(deferred tax asset), with certain limited exceptions.

1.2. The Tax base concept

Tax base is the amount attributable to that asset or liability for tax purpose. It is calculated based
on the application of tax rule.

The tax base of an asset is the amount that will be deductible for tax purposes against any taxable
economic benefits that will flow to an entity when it recovers the carrying amount of the asset. If
those economic benefits will not be taxable, the tax base of the asset is equal to its carrying
amount.

Example

1 A machine cost 100. For tax purposes, depreciation of 30 has already been deducted in the
current and prior periods and the remaining cost will be deductible in future periods, either as
depreciation or through a deduction on disposal. Revenue generated by using the machine is
taxable, any gain on disposal of the machine will be taxable and any loss on disposal will be
deductible for tax purposes. The tax base of the machine is 70.

2 Interest receivable has a carrying amount of 100. The related interest revenue will be taxed
on a cash basis. The tax base of the interest receivable is nil.

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3 Trade receivables have a carrying amount of 100. The related revenue has already been
included in taxable profit (tax loss). The tax base of the trade receivables is 100.

1.3. Fundamentals of Accounting for Income Taxes

Dear students, can you differentiate pretax financial income from income tax?

Companies must fileincome tax returns following the guidelines developed by the appropriatetax
authority. Because IFRS and tax regulations differ in a number of ways,so frequently do pretax
financial income and taxable [Link], the amount that a company reports as tax
expense will differfrom the amount of taxes payable to the tax authority.

 Pretax financial income is a financial reporting term. It also is often referred to as

income before taxes, income for financial reporting purposes, or income for book
purposes. Companies determine pretax financial income according to IFRS. They
measure it with the objective of providing useful information to investors and creditors.
 Taxable income (income for tax purposes) is a tax accounting term. It indicates the
amount used to compute income taxes payable. Companies determine taxable income
according to the tax regulations. Income taxes provide money to support government
operations.

To illustrate how differences in IFRS and tax rules affect financialreporting and taxable income,
assume that Chelsea Inc. reported revenuesof $130,000 and expenses of $60,000 in each of its
first three years ofoperations. The following is the financial reporting incomeof the company.

Tax reporting income

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Income tax expense and income taxes payable differed over the three yearsbut were equal in
total. The differences between income tax expense and income taxes payable inthis example
arise for a simple reason. For financial reporting, companiesuse the full accrual method to
report revenues. For tax purposes, theygenerally use a modified cash basis. As a result, Chelsea
reports pretaxfinancial income of $70,000 and income tax expense of $28,000 for eachof the
three years. However, taxable income fluctuates. For example, in2022 taxable income is only
$40,000, so Chelsea owes just $16,000 to thetax authority that year. Chelsea classifies the
income taxes payable as acurrent liability on the statement of financial position.

For Chelsea the $12,000 ($28,000 − $16,000)difference between income tax expense and income
taxes payable in 2022reflects taxes that it will pay in future periods. This $12,000 difference
isoften referred to as a deferred tax amount. In this case, it is a deferredtax liability. In cases
where taxes will be lower in the future, Chelsearecords a deferred tax asset.

1.3.1. Future Taxable Amounts and Deferred Taxes

Income taxespayable can differ from income tax expense. This can happen when thereare
temporary differences between the amounts reported for tax purposesand those reported for book
purposes. A temporary difference is thedifference between the tax basis of an asset or liability
and its reported(carrying or book) amount in the financial statements, which will result intaxable
amounts or deductible amounts in future years. Taxableamounts increase taxable income in
future years. Deductible amountsdecrease taxable income in future years.

In Chelsea‘s situation, the only difference between the book basis and taxbasis of the assets and
liabilities relates to accounts receivable that arosefrom revenue recognized for book purposes.
Chelsea reports accounts receivable at $30,000 in the December 31,2022, IFRS-basis statement
of financial position. However, the receivableshave a zero-tax basis.

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Assuming that Chelsea expects to collect $20,000 of thereceivables in 2023 and $10,000 in 2024,
this collection results in futuretaxable amounts of $20,000 in 2023 and $10,000 in 2024. These
futuretaxable amounts will cause taxable income to exceed pretax financialincome in both 2023
and 2024.

An assumption inherent in a company‘s IFRS statement of financialposition is that companies

recover and settle the assets and liabilities attheir reported amounts (carrying amounts). This
assumption creates arequirement under accrual accounting to recognize currently the deferredtax
consequences of temporary differences. That is, companies recognizethe amount of income taxes
that are payable (or refundable) when theyrecover and settle the reported amounts of the assets
and liabilities,respectively. Below shows the reversal of the temporarydifference described above
and the resulting taxable amountsin future periods.

[Link]. Deferred tax liability

It is the deferred tax consequences attributable totaxable temporary differences. In other words, a
deferred tax liabilityrepresents the increase in taxes payable in future years as a resultof taxable
temporary differences existing at the end of the currentyear.

Recall from the Chelsea example that income taxes payable is $16,000($40,000 × .40) in 2022.
In addition, a temporarydifference exists at year-end because Chelsea reports the revenue
andrelated accounts receivable differently for book and tax purposes. The bookbasis of accounts
receivable is $30,000, and the tax basis is zero. Thus, thetotal deferred tax liability at the end of
2022 is $12,000, computed bellow.

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Chelseamakes the following entry at the end of 2022.

Income tax expense 28,000

Income tax payable 16,000

Deferred tax liability 12,000

At the end of 2023 (the second year), the difference between the book basisand the tax basis of
the accounts receivable is $10,000. Chelsea multipliesthis difference by the applicable tax rate to
arrive at the deferred taxliability of $4,000 ($10,000 × .40), which it reports at the end of
[Link] taxes payable for 2023 is $36,000 and theincome tax expense for 2023 is as shown
below.

Deferred tax liability at end of 2023 $ 4,000

Deferred tax liability at beginning of 2023 12,000

Deferred tax expense (benefit) for 2023 (8,000)

Current tax expense for 2023 (income taxes payable) 36,000

Income tax expense (total) for 2023 $28,000

Chelsea records the income tax expense, the change in deferred taxliability, and income taxes
payable for 2023 as follows.

Income Tax Expense 28,000

Deferred Tax Liability 8,000

Income Taxes Payable 36,000

At the end of 2024 (the third and final year), the difference between thebook basis and the tax
basis of the receivable is zero. Income taxes payablefor 2024 is $32,000, and the income tax
expense for2024 is $28,000 as shown below.

Deferred tax liability at end of 2024 $0

Deferred tax liability at beginning of 2024 (4,000)

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Deferred tax expense (benefit) for 2024 (4,000)

Current tax expense for 2024 (income taxes payable) 32,000

Income tax expense (total) for 2024 $28,000

Chelsea records the income tax expense, the change in deferred taxliability, and income taxes
payable for 2024 as follows.

Income Tax Expense 28,000

Deferred Tax Liability 4,000

Income Taxes Payable 32,000

The Deferred Tax Liability account at the end of 2024 is shown below and it has a balance of
zero:

Deferred tax liability

2023 8000 2022 12000

2024 4000

Financial statement effects

Chelsea reports the information on its statements of financial position for2022–2024 as shown
below:

Income taxes payable is reported as a current liability, and the deferred taxliability is reported as
a non-current [Link] its income statement, Chelsea reports the information as shown below:

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Companies also are required to show the components of income taxexpense either in the income
statement or in the notes to the financialstatements. For example, if Chelsea reported this
information in theincome statement for 2022, the presentation is as shown below:

[Link]. Deferred tax asset

A deferred tax asset is the deferred tax consequence attributable todeductible temporary
differences. In other words, a deferred tax assetrepresents the increase in taxes refundable (or
saved) in futureyears as a result of deductible temporary differences existing atthe end of the
current year.

To illustrate, assume that Hunt Company has revenues of $900,000 forboth 2022 and 2023. It
also has operating expenses of $400,000 for each ofthese years. In addition, Hunt accrues a loss
and related liability of$50,000 for financial reporting purposes in 2022 because of
pendinglitigation. Hunt cannot deduct this amount for tax purposes until it paysthe liability,
expected in 2023. As a result, a deductible amount will occurin 2023 when Hunt settles the
liability, causing taxable income to be lowerthan pretax financial information. Below financial
statement shows both theIFRS and tax reporting over the two years.

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In this case, Hunt records a deferred tax asset of $20,000 at the end of2022 because it represents
taxes that will be saved in future periods as aresult of a deductible temporary difference existing
at the end of [Link] shows the computation of the deferred tax asset at theend of 2022
(assuming a 40 percent tax rate).

Hunt can also compute the deferred tax asset by preparing a schedule thatindicates the future
deductible amounts due to deductible temporarydifferences. Below shows this schedule.

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Assuming that 2022 is Hunt‘s first year of operations and that incometaxes payable is $200,000,
Hunt computes its income tax expense asshown below.

The deferred tax benefit results from the increase in the deferred taxasset from the beginning to
the end of the accounting period (similar to theChelsea example earlier). The deferred tax benefit
is a negative componentof income tax expense. The total income tax expense of $180,000 on
theincome statement for 2022 thus consists of two elements—current taxexpense of $200,000
and a deferred tax benefit of $20,000. Hunt makesthe following journal entry at the end of 2022
to record income taxexpense, deferred income taxes, and income taxes payable.

Income Tax Expense 180,000

Deferred Tax Asset 20,000

Income Taxes Payable 200,000

At the end of 2023 (the second year), the difference between the bookvalue and the tax basis of
the litigation liability is zero. Therefore, there isno deferred tax asset at this date. Assuming that
income taxes payable for2023 is $180,000, Hunt computes income tax expense for 2023 as
shown below.

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Income Tax Expense 200,000

Deferred Tax Asset 20,000

Income Taxes Payable 180,000

Financial Statement Effects

Hunt Company reports the following information on its statements offinancial position for 2022
and 2023 as shown below.

Income taxes payable is reported as a current liability, and the deferred taxasset is reported as a
non-current asset. On its income statement, HuntCompany reports the information as shown
below.

As illustrated, Hunt reports both the current portion (the amount ofincome taxes payable for the
period) and the deferred portion of theincome tax expense. In this case, the deferred amount is
subtracted fromthe current portion to arrive at the proper income tax expense. Below shows the
Deferred Tax Asset account at the end of2023.

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 Deferred Tax Asset

2022 20,000 2023 20,000

1.4. Accounting for Net Operating Losses

Dear learners, before reading the following paragraphs, would you clearly define the Net
operating losses and its Accounting treatment?

Every management hopes its company will be profitable. But hopes andprofits may not
materialize. For a start-up company, it is common toaccumulate operating losses while it
expands its customer base but beforeit realizes economies of scale. For an established company,
major eventssuch as a labor strike, rapidly changing regulatory and competitive forces, atsunami,
or a general economic recession such as that experienced in thewake of the COVID-19 pandemic
can cause expenses to exceed revenues—anet operating loss.

A net operating loss (NOL) occurs for tax purposes in a year when taxdeductibleexpenses exceed
taxable revenues. An inequitable tax burdenwould result if companies were taxed during
profitable periods withoutreceiving any tax relief during periods of net operating losses.
Undercertain circumstances, therefore, tax laws permit taxpayers to use thelosses of one year to
offset the profits of other years.

Companies accomplish this income-averaging provision through thecarryforward of net

operating losses. Under this provision, a companypays no income taxes for a year in which it
incurs a net operating loss. Inaddition, it can reduce future taxes payable as discussed below.

1.4.1. Loss carryforward

Through the use of a loss carryforward, a company may carry the netoperating loss forward to
offset future taxable income and reduce taxespayable in future years. Operating losses can be
substantial. For example, VW Group (DEU) had€2.5 billion in tax loss carryforwards at the end
of 2018. At VW‘s effectivetax rate, that would imply over €500 million in reduced taxes if it is
able togenerate taxable income.

Because companies use carryforwards to offset future taxable income, thetax effect of a loss
carryforward represents future tax [Link], realization of the future tax benefit depends
on future earnings,an uncertain prospect.

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The key accounting issue is whether there should be differentrequirements for recognition of a
deferred tax asset for (a) deductibletemporary differences, and (b) operating loss carryforwards.
The IASB‘sposition is that in substance these items are the same—both are
taxdeductibleamounts in future years. As a result, the Board concluded thatthere should not be
different requirements for recognition of adeferred tax asset from deductible temporary
differences and operatingloss carryforwards.

Carryforward (Recognition)

To illustrate the accounting procedures for a net operating losscarryforward, assume that Groh
Inc. has no temporary or permanentdifferences. Groh experiences a net operating loss of
$200,000 in 2022 andtakes advantage of the carryforward provision. In 2022, the
companyrecords the tax effect of the $200,000 loss carryforward as a deferred taxasset of
$40,000 ($200,000 × .20), assuming that the enacted future taxrate is 20 percent. Groh records
the benefit of the carryforward in 2022 asfollows.

Deferred Tax Asset 40,000

Income Tax Expense (Loss Carryforward) 40,000

Groh establishes a Deferred Tax Asset account for the benefits of future taxsavings. The account
credited [Income Tax Expense (Loss Carryforward)]is a contra income tax expense item, which
Groh presents on the 2022income statement shown below. The $40,000 is thedeferred tax benefit
for 2022, which results from an increase in thedeferred tax asset.

For 2023, assume that Groh returns to profitable operations and hastaxable income of $250,000
(prior to adjustment for the NOLcarryforward), subject to a 20 percent tax rate. Groh then
realizes thebenefits of the carryforward for tax purposes in 2023, which it recognizedfor
accounting purposes in 2022. Groh computes the income taxes payablefor 2023 as shown below.

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Groh records income taxes in 2023 as follows.

Income tax expense 50,000

Deferred tax asset 40,000

Income taxes payable 10,000

The benefits of the NOL carryforward, realized in 2023, reduce theDeferred Tax Asset account
tozero.
Groh Inc.

Income Statement (partial) for 2023

Income before income taxes $250,000

Income tax expense:

Current $10,000

Deferred 40,000 50,000

Net income $200,000

Carryforward (Non-Recognition)
Let us return to the Groh example. Assume that it is more likely than notthat Groh will not
realize the entire NOL carryforward in future years. Inthis situation, Groh does not recognize a
deferred tax asset for the losscarryforward because it is probable that it will not realize the
[Link] a result, there is no journal entry in 2022 for income taxes by [Link]
shows Groh‘s 2022 income statement presentation.

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In 2023, assuming that Groh has taxable income of $250,000 (beforeconsidering the
carryforward) subject to a tax rate of 20 percent, it realizesthe deferred tax asset. Groh records
the following entries.

Groh reports the $40,000 Income Tax Expense (Loss Carryforward) on the2023 income
statement. The company did not recognize it in 2022 becauseit was probable that it would not be
realized. Assuming that Groh derivesthe income for 2023 from continuing operations, it prepares
the incomestatement as shown below.

Non-Recognition Revisited
Whether the company will realize a deferred tax asset depends on whethersufficient taxable
income exists or will exist within the carryforward periodavailable under tax law. Below shows
possible sources oftaxable income and related factors that companies can consider inassessing
the probability that taxable income will be available againstwhich the unused tax losses or
unused tax credits can be utilized.
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To the extent that it is not probable that taxable profit will be availableagainst which the unused
tax losses or unused tax credits can be utilized,the deferred tax asset is not [Link] a
conclusion that recognition of a loss carryforward is probable isdifficult when there is negative
evidence (such as cumulative losses inrecent years). However, companies often cite positive
evidence indicatingthat recognition of the carryforward is warranted.

Unfortunately, the subjective nature of determining impairment for adeferred tax asset provides a
company with an opportunity to manage itsearnings. As one accounting expert notes, ―The
‗probable‘ provision isperhaps the most judgmental clause in accounting.‖ Some companies
mayrecognize the loss carryforward immediately and then use it to increaseincome as needed.
Others may take the income immediately to increasecapital or to offset large negative charges to
income.

1.5. Financial statement presentation

1.5.1. Statement of Financial Position

Companies classify taxes receivable or payable as current assets or currentliabilities. Although
current tax assets and liabilities are separatelyrecognized and measured, they are often offset in
the statement offinancial position. The offset occurs because companies normally have alegally
enforceable right to set off a current tax asset (Income TaxesReceivable) against a current tax
liability (Income Taxes Payable) whenthey relate to income taxes levied by the same taxation
authority.

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Deferred tax assets and deferred tax liabilities are also separatelyrecognized and measured but
may be offset in the statement of financialposition. The net deferred tax asset or net deferred tax
liability is reportedin the non-current section of the statement of financial [Link] illustrate,
assume that K. Scott Company has four deferred tax items atDecember 31, 2022, as shown
below.

Temporary Difference Resulting DeferredTax

(Asset) Liability

1. Rent collected in advance: recognized whenperformance

obligation satisfied for accountingpurposes and when received for
tax purposes.
$(42,000)

2. Use of straight-line depreciation for accountingpurposes and

accelerated depreciation for taxpurposes.
$214,000

3. Recognition of profits on installment salesduring period of sale

for accounting purposesand during period of collection for tax
45,000
purposes.

[Link] liabilities: recognized for accountingpurposes at time of

sale; for tax purposes attime paid.
(12,000)

Totals $(54,000) $259,000

As indicated, K. Scott has a total deferred tax asset of $54,000 and a totaldeferred tax liability of
$259,000. Assuming these two items can be offset,K. Scott reports a deferred tax liability of
$205,000 ($259,000 − $54,000)in the non-current liability section of its statement of financial
position.

1.5.2. Income Statement

Companies allocate income tax expense (or benefit) to continuingoperations, discontinued
operations, other comprehensive income, andprior period adjustments. This approach is referred

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to as intra-period taxallocation. In addition, the components of income tax expense (benefit)may
include:
1. Current tax expense (benefit).
2. Any adjustments recognized in the period for current tax of priorperiods.
3. The amount of deferred tax expense (benefit) relating to theorigination and reversal of
temporary differences.
4. The amount of deferred tax expense (benefit) relating to changes intax rates or the imposition
of new taxes.
5. The amount of the benefit arising from a previously unrecognized taxloss, tax credit, or
temporary difference of a prior period that is used toreduce current and deferred tax expense.

To illustrate, the relevant portion of the consolidated statement ofcomprehensive income of

Morrison Supermarkets is presented below.

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The following presents Note 2.2, which is the explanation of thecomposition of the taxes charged
to Morrison Supermarkets.

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Glossary items
Accounting profit: It is profit or loss for a period determined in accordance with IFRS

Current tax-tax consequences that are legal assets or liabilities at the reporting date.

Deferred tax- tax consequences, which are expected to become, or (more strictly) form
part of, legal assets or liabilities in a future period.

Income tax: all domestic and foreign taxes, based on taxable profits.

Taxable profit (tax loss): It is the profit (loss) for a period, determined in accordance
with income tax law.

Tax base of an asset is the amount that will be deductible for tax purposes when it
recovers the carrying value of the asset.

Tax base of a liability is its carrying amount, less any amount that will be deducted for
tax purposes.

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CHAPTER END REVIEW QUESTIONS
I. MULTPLE CHOICE QUESTIONS

Instruction:After reading each of the following question Attentively choose the best answer
from a given Alternatives.

1. Which of the following is a temporary difference that creates a deferred tax liability?
A. Accelerated depreciation for tax purposes
B. Straight-line depreciation for financial statement purposes
C. Capitalizing interest for financial statement purposes
2. Which method of accounting for income taxes is required by generally accepted accounting
principles (GAAP) in the United States?
A. Income Statement Method
B. Balance sheet method
C. Both A and B
3. What is the purpose of accounting for income taxes?
A. To estimate future tax liabilities and assets.
B. To reduce current tax liabilities.
C. To increase current tax liabilities.
4. Which of the following is not an example of a temporary difference?
A. Prepaid rent expense for financial statement purposes
B. Unearned revenue for tax purposes
C. Interest income accrued for financial statement purposes
5. What is the difference between a deferred tax asset and a deferred tax liability?
A. A deferred tax asset results in a tax refund, while a deferred tax liability results in
additional taxes due.
B. A deferred tax asset is a source of taxable income, while a deferred tax liability is a use of
taxable income.
C. A deferred tax asset is created when tax expense exceeds tax payable, while a deferred tax
liability is created when tax payable exceeds tax expense.
6. Which of the following is a permanent difference that does not create a deferred tax liability
or asset?

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 A. Interest income accrued for financial statement purposes
B. Fines and penalties for tax purposes
C. Tax-exempt income for financial statement purposes
7. Which method of accounting for income taxes is allowed under International Financial
Reporting Standards (IFRS)?
A. Income Statement Method
B. Balance sheet method
C. Both A and B
8. What is the primary factor that determines the tax rate used to compute the deferred tax
liability or asset?
A. Current tax law
B. Historical tax rates
C. Estimated future tax rates
9. Which of the following is an example of a valuation allowance?
A. A reduction in the deferred tax liability.
B. A reduction in the deferred tax asset.
C. A reduction in the current tax payable.
10. What is the journal entry to recognize income tax expense?
A. Debit income tax expense, credit income tax payable.
B. Debit income tax payable, credit income tax expense.
C. There is no journal entry to recognize income tax expense as it is a non-cash item.
11. Which of the following is an example of a tax carryforward?
A. A net operating loss carryforward
B. A deferred tax asset
C. A deferred tax liability
12. Which of the following is true about the overall tax rate used to calculate the deferred tax
liability or asset?
A. It is always equal to the current tax rate.
B. It is always higher than the current tax rate.
C. It may be higher or lower than the current tax rate.

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13. How does a change in tax law affect the deferred tax liability or asset?
A. It has no effect.
B. It results in an adjustment to the deferred tax liability or asset.
C. It results in the elimination of the deferred tax liability or asset.
14. What is the difference between a deferred tax asset and a current tax asset?
A. A deferred tax asset is recognized for financial statement purposes, while a current tax
asset is recognized for tax purposes.
B. A deferred tax asset is a result of temporary differences, while a current tax asset is a
result of carrybacks or carryforwards.
C. A deferred tax asset is a reduction in future tax liabilities, while a current tax asset is a
reduction in current tax liabilities.
15. Which of the following is an example of an uncertain tax position?
A. A tax liability for which the amount and timing are certain.
B. A tax asset that is almost certain to be realized.
C. A tax liability for which the amount and timing are uncertain.
16. Which of the following is not a source of taxable income?
A. Net operating loss carryforward
B. Recovery of a previously written off bad debt
C. Tax-exempt income
17. What is the journal entry to recognize a change in estimate related to income taxes?
A. Debit income tax expense, credit income tax payable.
B. Debit income tax payable, credit income tax expense.
C. Debit deferred tax asset, credit income tax expense.
18. What is the difference between a deferred tax asset and a tax credit?
A. A deferred tax asset reduces future tax liabilities, while a tax credit reduces current tax
liabilities.
B. A deferred tax asset is recognized for financial statement purposes, while a tax credit is
recognized for tax purposes.
C. A deferred tax asset is a result of temporary differences, while a tax credit is a result of
special tax provisions.

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19. How is a change in tax rates accounted for in the computation of the deferred tax liability or
asset?
A. It has no effect.
B. It results in a revaluation of the deferred tax liability or asset.
C. It results in the elimination of the deferred tax liability or asset.
20. Which of the following is an example of a deferred tax liability?
A. Accrued vacation expense for financial statement purposes
B. Unearned revenue for financial statement purposes
C. Income recognized for tax purposes but not yet recognized for financial statement purpose
21. Which of the following statements regarding loss carryforward is CORRECT?
a) Loss carryforward allows companies to reduce their taxable income in future years.
b) The carryforward loss must be used in the year it is generated.
c) Loss carryforward cannot be claimed by companies.
d) Loss carryforward only applies to individuals.
22. What is the maximum number of years for which a loss can be carried forward?
a) 5 years
b) 10 years
c) 15 years
d) 20 years
23. If a company reports a loss of $50,000 in Year 1 and a profit of $100,000 in Year 2, how
much of the Year 1 loss can be carried forward to Year 2 for tax purposes?
a) $0
b) $20,000
c) $30,000
d) $50,000
24. Can a company carry forward a loss if it goes bankrupt?
a) Yes
b) No
25. If a company carries forward a loss, what happens to the tax paid on the profits of the year in
which the loss was originally incurred?
a) The company can claim a refund on the tax paid.

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 b) The tax paid cannot be recovered under any circumstances.
c) The company can only offset the tax paid against future profits in the year the loss is
carried forward.
d) The company can offset the tax paid against future profits in any year.
26. Which one of the following types of losses cannot be carried forward?
a) Operating losses
b) Capital losses
c) Depreciation losses
d) Interest expense losses
27. Can a company carry forward losses for tax purposes if it has changed ownership?
a) Yes, if there is a continuity of ownership.
b) No, if there is a change of ownership.
II. WORD PROBLEM

1. The following transactions were related to Allman Company during the year of 2016. During
2016, the product warranty liability accrued for book purposes was $200,000, and the actual
paid for warranty liability was $44,000. Allman expects to settle the remaining $156,000 by
expenditures of $56,000 in 2017 and $100,000 in 2018. In 2016, nontaxable municipal bond
interest revenue was $28,000. Again, In 2016, nondeductible fines and penalties of $26,000
were paid. Pretax financial income for 2016 amounts to $412,000 and Tax rates enacted up to
2016 were 50% and for 2017 and later years 40%.
Required
a) Identify temporary and permanent differences?
b) Determine taxable income of 2016?
c) Computes income taxes payable for 2016?
d) Compute future taxable amount (DTL) at the end of 2016?
e) Compute future deductible amount (DTA) at the end of 2016?
f) Compute net deferred tax expense (DTL - DTA) for 2016?
g) Compute total income tax expense (deferred + current) of 2016?
h) Records income taxes payable, deferred income taxes, and income tax expense of 2016?
i) Show the financial presentation.

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 CHAPTER TWO
ACCOUNTING FOR SHARED BASED COMPENSATIONS

After completing this chapter students will be able to;

Understand the meaning of Share based settlements

Apply the recognition requirements of share-based payment transactions, including the
requirements when there are vesting conditions;
Account for equity-settled share-based payment transactions, including shares and share
options;
Account for cash-settled share-based payment transactions, including share-based
payment transactions with cash-settled alternatives; ( (Counterparty Has Choice of
Settlement & Issuer Has Choice of Settlement)
Disclose share-based payment in financial statements;

2.1. Overview of Share-based Payments

Dear learners, would you please define share based payments in your own terms before
proceeding to the following paragraphs?

A major objective of the accounting for shareholders‘ equity is the adequate disclosure of the
sources from which the capital was derived. A share-based payment is a transaction in which the
entity receives goods or services as consideration for its equity instruments or Acquires goods or
services by incurring liabilities for amounts that are based on the price (or value) of the entity‘s
shares (or other equity instruments of the entity).

The concept of share-based payments includes not only employee share options but also

 share appreciation rights,

 Employee share ownership plans,
 Employee share purchase plans,
 Share option plans and other share arrangements.

Share-based compensation also called Stock-based compensation or share-based payments

(SBP). It refers to the rewards given by the company to its employees by way of giving them the

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equity ownership rights in the company with the motive of aligning the interest of the
management, shareholders, and the employees of the company. A ‗share-based payment‘ is
either a payment in equity instruments or A paymentin cash or other [Link] agreement
between the entity and another party (including an employee) that entitles the other party to
receive : (a) equity instruments (including shares or share options) of the entity or another group
entity, provided the specified vesting conditions, if any, are met. (b) cash or other assets of the
entity or by incurring liabilities for amounts that are based on the price (or value) of equity
instruments of the entity.

In February 2004 the International Accounting Standards Board (Board) issued IFRS 2
Sharebased Payment. The Board amended IFRS 2 to clarify its scope in January 2008 and to
incorporate the guidance contained in two related Interpretations (IFRIC 8 Scope of IFRS 2 and
IFRIC 11 IFRS 2—Group and Treasury Share Transactions) in June 2009. International
Financial Reporting Standard (IFRS®) 2, Share-based Payment, applies when a company
acquires or receives goods and services for equity-based payment. These goods can include
inventories, property, plant and equipment, intangible assets, and other non-financial assets. The
objective of this IFRS is to specify the financial reporting by an entity when it undertakes a
share-based payment transaction. In particular, it requires an entity to reflect in its profit or loss
and financial position the effects of share-based payment transactions, including expenses
associated with transactions in which share options are granted to employees.

There are two notable exceptions: shares issued in a business combination, which are dealt with
under IFRS 3, Business Combinations; and contracts for the purchase of goods that are within
the scope of International Accounting Standard (IAS®) 32 and IAS 39. In addition, a purchase of
treasury shares would not fall within the scope of IFRS 2, nor would a rights issue where some
of the employees are shareholders. Examples of some of the arrangements that would be
accounted for under IFRS 2 include call options, share appreciation rights, share ownership
schemes, and payments for services made to external consultants based on the company‘s equity
capital. Stock Based Compensation (also called Share-Based Compensation or Equity
Compensation) is a way of paying employees, executives, and directors of a company with
equity in the business. It is typically used to motivate employees beyond their regular cash-based

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compensation (salary and bonus) and to align their interests with those of the company‘s
shareholders.

 It is typically used to motivate employees beyond their regular cash-based

compensation (salary and bonus) and to align their interests with those of the company‘s
shareholders.

 IFRS® 2, Share-based Payment, applies when a company acquires or receives goods

and services for equity-based payment. some of the arrangements accounted for under
IFRS 2 include call options, share appreciation rights, share ownership schemes, and
payments for services made to external consultants based on the company‘s equity
capital.

 A payment for goods or service in either

 Share

 Share options

 Cash payments based on share price

 Agreement b/n the entity and another party that entitles the other party to receive
cash/other assets based on the price or value of company equity instruments.

 Common ways of awarding employee performance

Generally, SBP is a transaction in which the entity receives goods or services as consideration
for its equity instruments or acquires goods or services by incurring liabilities for amounts that
are based on the price (or value) of the entity‘s shares (or other equity instruments of the entity)

2.1.1. Advantages of Share Based Compensation

 Creates an incentive for employees to stay with the company (they have to wait for shares
to vest)

 Aligns the interests of employees and shareholders – both want to see the company
prosper and the share price rise

 Doesn‘t require cash

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 2.1.2. Disadvantages of Share Based Compensation

 Dilutes the ownership of existing shareholders (by increasing the number of shares
outstanding)

 May not be useful for recruiting or retaining employees if the share price is decreasing

2.1.3. Why share based payment?

 To motivate employees to higher levels of performance

 To build a sense of shared ownership in the entity.

 To help retain executives and recruit new talent

 To maximize employee‘s after-tax benefit

2.2. Types of Share-based Payment

 Share-based Payments Settled with Equity

 Share-based Payments Settled with Cash

 Share-based Payments with Cash Alternatives

Equity-settled share based payment transactions where a company receives goods or services
in exchange for company equity instruments (e.g. shares/share options).

Cash-settled share based payment transactions, where a company receives goods and services
in exchange for a cash amount paid based on its share [Link] is liability award.

Share-based Payments with Cash Alternatives, where a either the entity or the counterparty
has choice of the entity settling the transaction in cash, other assets, or by issuing equity
instruments

2.3. Recognition & Measurement of Share Based Compensation

Recognition of share-based payment IFRS 2 requires an asset or expense to be recognized for the
goods or services received by a company. The corresponding entry in the accounting records will
either be a liability or an increase in the equity of the company, depending on whether the
transaction is to be settled in cash or in equity shares.

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  If the share options vest immediately, the employee is not required to complete a
specified period of services before unconditionally entitled to the share options. The
entity shall recognize the services received in full, with a corresponding increase in
equity.

 If the share options do not vest immediately until the employee completes a specified
period of services, the entity shall recognize for those as they are rendered by the
counterparty during the vesting period, with a corresponding increase in equity.

 If the share based payment is equity settled, the compensation is equal to the fair value
(FV) of the share/ share options on the grant date.

 If the entity cannot estimate reliably the fair value of the goods or services received, the
entity shall measure their value, and the corresponding increase in equity, indirectly, by
reference to the fair value of the equity instruments granted.

 If the share based payment is cash settled, the compensation is equal to the fair value of
the share at each reporting date.

2.3.1. Equity-settled Share-based Payments

Equity-settled Share-based Payments is where the entity receives goods/services that are settled
by issuing equity instruments (that is, shares or share options). For equity-settled share-based
payment transactions, the entity shall measure the goods or services received, and the
corresponding increase in equity, directly, at the fair value of the goods or services received,
unless that fair value cannot be estimated reliably. If the entity cannot estimate reliably the fair
value of the goods or services received, the entity shall measure their value, and the
corresponding increase in equity, indirectly, by reference to the fair value of the equity
instruments granted.

To apply the requirements of the transactions with employees and others providing similar
services, the entity shall measure the fair value of the services received by reference to the fair
value of the equity instruments granted, because typically it is not possible to estimate reliably
the fair value of the services received, as explained above. The fair value of those equity
instruments shall be measured at grant date. Typically, shares, share options or other equity
instruments are granted to employees as part of their remuneration package, in addition to a cash

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salary and other employment benefits. Usually, it is not possible to measure directly the services
received for particular components of the employee‘s remuneration package. It might also not be
possible to measure the fair value of the total remuneration package independently, without
measuring directly the fair value of the equity instruments granted. Furthermore, shares or share
options are sometimes granted as part of a bonus arrangement, rather than as a part of basic
remuneration, eg as an incentive to the employees to remain in the entity‘s employ or to reward
them for their efforts in improving the entity‘s performance. By granting shares or share options,
in addition to other remuneration, the entity is paying additional remuneration to obtain
additional benefits. Estimating the fair value of those additional benefits is likely to be difficult.
Because of the difficulty of measuring directly the fair value of the services received, the entity
shall measure the fair value of the employee services received by reference to the fair value of
the equity instruments granted.

Transactions in which goods are received

EXAMPLE 1: Assume ABC Company issued share options on 1 June 2006 to pay for the
purchase of inventory. The inventory is eventually sold on 31 December 2008. The value of the
inventory on 1 June 2006 was $6m and this value was unchanged up to the date of sale. The sale
proceeds were $8m. The shares issued have a market value of $6 m.

How will this transaction be dealt with in the financial statements?

Answer IFRS 2 states that the fair value of the goods and services received should be used to
value theshare options unless the fair value of the goods cannot be measured reliably. Thus
equity would be increased by $6m and inventory increased by $6m. The inventory value will be
expensed on sale.

Inventory …………………………………….. 6,000,000

Equity …………………………………….. 6,000,000

Transactions in which services are received

If the equity instruments granted vest immediately, the counterparty is not required to complete a
specified period of service before becoming unconditionally entitled to those equity instruments.
In the absence of evidence to the contrary, the entity shall presume that services rendered by the

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counterparty as consideration for the equity instruments have been received. In this case, on
grant date the entity shall recognize the services received in full, with a corresponding increase in
equity. If the equity instruments granted do not vest until the counterparty completes a specified
period of service, the entity shall presume that the services to be rendered by the counterparty as
consideration for those equity instruments will be received in the future, during the vesting
period. The entity shall account for those services as they are rendered by the counterparty
during the vesting period, with a corresponding increase in equity. For example: if an employee
is granted share options conditional upon completing three years‘ service, then the entity shall
presume that the services to be rendered by the employee as consideration for the share options
will be received in the future, over that three-year vesting period.

Grant Date means the date on which an Option is granted under the Plan. Date of Grant
means the date on which the granting of an Award is authorized by the Committee
Vesting date is the date that employees entitled to the share based payment
Exercise date is the date in which employees receive the share based payments.
Vesting Conditions means any term, condition or restriction, including without
limitation any performance-based condition or criteria, described in the award
documents applicable to an award that a Participant must satisfy in order to receive a
payment, distribution or otherwise realize monetary value from an Award
A vesting period is the time an employee must work for an employer in order to own
outright employee stock options, shares of company stock or employer contributions to a
taxadvantaged retirement plan. Vesting periods come in a variety of durations
Share vesting is the process by which an employee, investor, or co-founder is rewarded
with shares or stock options but receives the full rights to them over a set period of time
or, in some cases, after a specific milestone is hit – usually one that's established in an
employment contract or a shareholders' agreement

EXAMPLE 2

ABC Company grants 2,000 share options to each of its three directors on 1 January 2006,
subject to the directors being employed on 31 December 2008. The options vest on 31 December
2008. The fair value of each option on 1 January 2006 is $10, and it is anticipated that on 1
January 2006 all of the share options will vest on 30 December 2008. The share price at 31

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December 2006 is $8 and it is anticipated that it will rise over the next two years. It is anticipated
that on 31 December 2006 only two directors will be employed on 31 December 2008. How will
the share options be treated in the financial statements for the year ended 31 December 2006?
Answer The market-based condition (i.e. the increase in the share price) can be ignored for the
purpose of the calculation. However the employment condition must be taken into account.

The options will be treated as follows: =2,000 options x 2 directors x $10 x 1 year / 3 years =
$13,333 Expense …………………………………….. $13,333

Equity …………………………………….. $13,333

*** Equity will be increased by this amount and an expense shown in profit or loss for the year
ended 31 December 2006. During 31 December 2007 assume the share price went to 13 and no
director left his work. The options will be treated as follows:

the movement will be recorded the profit or loss and financial position statements. =2,000
options x 2 directors x $10 x 2 year / 3 years = $26,667

Expense …………………………………….. $13,33

Equity …………………………………….. $13,333

*** Assume during 31 December 2008 no assumptions have been changed. The options will be
treated as follows: =2,000 options x 2 directors x $10 x 3year / 3 years = $40,000

Expense …………………………………….. $13,333

Equity …………………………………….. $13,333

2.3.2. Share-based Payments Settled with Cash

Cash settled share-based payment transactions occur where goods or services are paid for at
amounts that are based on the price of the company‘s equity instruments. The expense for cash
settled transactions is the cash paid by the company. For cash-settled share-based payment
transactions, the entity shall measure the goods or services acquired and the liability incurred at
the fair value of the liability, Until the liability is settled, the entity shall re measure the fair value
of the liability at the end of each reporting period and at the date of settlement, with any changes
in fair value recognized in profit or loss for the period. For example, an entity might grant share

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appreciation rights to employees as part of their remuneration package, whereby the employees
will become entitled to a future cash payment (rather than an equity instrument), based on the
increase in the entity‘s share price from a specified level over a specified period of time.

Alternatively, an entity might grant to its employees a right to receive a future cash payment by
granting to them a right to shares (including shares to be issued upon the exercise of share
options) that are redeemable, either mandatorily (for example, upon cessation of employment) or
at the employee‘s option. These arrangements are examples of cash-settled sharebased payment
transactions. This creates a liability, and the recognized cost is based on the fair value of the
instrument at the reporting date. The fair value of the liability is re-measured at each reporting
date until settlement.

JOY a public limited company, has granted 300 share appreciation rights to each of its 500
employees on 1 July 2005. The management feel that 80% of employees will stay and the awards
will vest on 31July 2007. The fair value of each share appreciation right on 31 July 2006 is $15.
What is the fair value of the liability to be recorded in the financial statements for the year ended
31 July 2006?

Answer

= 300 rights x 500 employees x 80% x $15 x 1 year / 2 years = $900,000

Expense ……………………………………. 900,000

Liability ……………………………………. 900,000

Assume fair value at the end of July 2007 is $16. What is the fair value of the liability to be
recorded in the financial statements for the year ended 31 July 2007?

= 300 rights x 500 employees x 80% x $16 x 2 year / 2 years = $1,920,000

Expense ……………………………………. 1,020,000

Liability ……………………………………. 1,020,000

At the exercise date the company will record the cash payment as

Liability ……………………………………. 1,920,000

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Cash ……………………………………. 1,920,000

2.3.3. Share-based Payments with Cash Alternatives

For share-based payment transactions in which the terms of the arrangement provide either the
entity or the counterparty with the choice of whether the entity settles the transaction in cash (or
other assets) or by issuing equity instruments, the entity shall account for that transaction, or the
components of that transaction, as a cash-settled share-based payment transaction if, and to the
extent that, the entity has incurred a liability to settle in cash or other assets, or as an
equitysettled share-based payment transaction if, and to the extent that, no such liability has been
incurred.

Counterparty Has Choice of Settlement: If an entity has granted the counterparty the right to
choose whether a share-based payment transaction is settled in cash or by issuing equity
instruments, the entity has granted a compound financial instrument, which includes a debt
component (i.e. the counterparty‘s right to demand payment in cash) and an equity component
(i.e. the counterparty‘s right to demand settlement in equity instruments rather than in cash).

For transactions with parties other than employees, in which the fair value of the goods or
services received is measured directly, the entity shall measure the equity component of the
compound financial instrument as the difference between the fair value of the goods or services
received and the fair value of the debt component, at the date when the goods or services are
received. For other transactions, including transactions with employees, the entity shall measure
the fair value of the compound financial instrument at the measurement date, taking into account
the terms and conditions on which the rights to cash or equity instruments were granted.

The entity shall first measure the fair value of the debt component, and then measure the fair
value of the equity component—taking into account that the counterparty must forfeit the right to
receive cash in order to receive the equity instrument. The entity shall account separately for the
goods or services received or acquired in respect of each component of the compound financial
instrument. For the debt component, the entity shall recognize the goods or services acquired,
and a liability to pay for those goods or services, as the counterparty supplies goods or renders
service, in accordance with the requirements applying to cash-settled share-based payment
transactions For the equity component (if any), the entity shall recognize the goods or services

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received, and an increase in equity, as the counterparty supplies goods or renders service, in
accordance with the requirements applying to equity-settled share-based payment transactions.

Issuer Has Choice of Settlement: For a share-based payment transaction in which the terms of
the arrangement provide an entity with the choice of whether to settle in cash or by issuing
equity instruments, the entity shall determine whether it has a present obligation to settle in cash
and account for the share-based payment transaction accordingly. The entity has a present
obligation to settle in cash if the choice of settlement in equity instruments has no commercial
substance (eg because the entity is legally prohibited from issuing shares), or the entity has a past
practice or a stated policy of settling in cash, or generally settles in cash whenever the
counterparty asks for cash settlement. If the entity has a present obligation tosettle in cash, it
shall account for the transaction in accordance with the requirements applying to cash-settled
share-based payment transactions. If no such obligation exists, the entity shall account for the
transaction in accordance with the requirements applying to equity-settled sharebased payment
transactions.

2.4. Share-based Payment Disclosures

IFRS 2 requires extensive disclosures under three main headings:

Information that enables users of financial statements to understand the nature and extent
of the share-based payment transactions that existed during the period.
Information that allows users of financial statements to understand how the fair value of
the goods or services received, or the fair value of the equity instruments which have
been granted during the period, was determined.
Information that allows users of financial statements to understand the effect of
expenses, which have arisen from share-based payment transactions, on the entity‘s
profit or loss in the period

Glossary Items
Grant date: the date a share-based payment transaction is entered into.
Vesting date: is the date when the counter party becomes entitled to share based payment
Exercise date: is the date in which employees receive the share based payments.

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 Vesting conditions- refers to the conditions that must be satisfied for the counter party to
become entitled to receive the payment. 2 types: service and performance conditions
Vesting period: refers to the period b/n the grant date and the vesting date.
Fair value: refers to the amount at which the asset will be exchanged or liability settled
b/n willing party.

CHAPTER END REVIEW QUESTIONS

I. MULTIPLE CHOICE QUESTIONS

Instructions: After reading each of the following question attentively choose the best answer
from a given Alternatives.

1. It is the difference between the fair value of the shares to which the counterparty has the right
to subscribe and the price the counterparty is required to pay for those shares.
A. Fair Value C. Market Value
B. Intrinsic Value D. Book Value
2. What is the date on which the entity and another party agree to a share- based payment
arrangement, being when the entity and the counterparty have a shared understanding of the
terms and conditions of the arrangement?
A. Grant date C. Exercise date
B. Vest date D. End of reporting period
3. What is the date on which the fair value of the equity instrument granted is measured?
A. Vest date C. End of reporting period
B. Grant date D. Exercise date
4. It is the contract that gives the holder the right, but not the obligation, to subscribe to the
entity‘s shares at a fixed or determinable price for a specified period of time.
A. Share option C. Share appreciation right
B. Share warrant D. Share split
5. If the entity has the choice of settlement in a ―cash and share alternative‖, the entity shall
account for the instrument initially as
A. Equity only D. Either equity or liability but not
B. Liability only both
C. Partly equity and partly liability

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6. Cash settled share-based payment transaction increases which of the following?
A. A current asset C. Equity
B. A non-current asset D. A liability
7. What is the measurement date for a share-based payment to employees that is classified as a
liability?
A. The service inception date C. The settlement date
B. The grant date D. The end of the reporting period
8. These are transactions in which the entity receives goods or services as consideration for
equity instruments of the entity, including shares and share options.
A. Equity settled share-based payment transactions
B. Cash settled share-based payment transactions
C. Equity payment transactions
D. Cash payment transactions
9. If the share options do not vest until the employee completes a specified service period, the
compensation is
A. Not recognized as expense
B. Recognized as expense immediately
C. Recognized as expense over the service or vesting period
D. Recognized expense over a reasonable period not exceeding 10 years
10. The entity has issued a range of share options to employees. What type of share-based
payment transaction does this represent?
A. Asset settled share-based payment transactions
B. Equity settled share-based payment transactions
C. Cash settled share-based payment transactions
D. Liability settled share-based payment transactions
11. Which of the following is not a type of share-based settlement alternative?
A) Restricted stock units
B) Stock options
C) Stock appreciation rights
D) Income bonds

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12. What is a characteristic of a stock option?
A) The employee is given a certain number of shares outright
B) The employee is given the right to purchase shares at a certain price
C) The employee is given shares that vest over a certain period of time
D) None of the above
13. Which of the following is not a requirement for a stock option to be considered an incentive
stock option?
A) The option cannot have a term longer than 10 years
B) The option price cannot be less than the fair market value of the stock on the date of grant
C) The options may only be granted to employees
D) None of the above
14. Which of the following is not a characteristic of a restricted stock unit (RSU)?
A) The employee is given a certain number of shares outright
B) The employee is given a right to the value of the stock at a future date
C) The value of the RSU is tied to the fair market value of the stock on the date of grant
D) None of the above
15. Which of the following is a disadvantage of using stock options as a share-based settlement
alternative?
A) The company has no expense to record
B) The company may not receive tax deductions
C) The company may be diluted if too many options are granted
D) None of the above
16. What is a characteristic of a stock appreciation right (SAR)?
A) The employee is given the right to purchase shares at a certain price
B) The employee is given shares that vest over a certain period of time
C) The employee is given a right to the increase in the value of the company's stock over a
certain period of time
D) None of the above
17. Which of the following is not an example of a share-based payment arrangement?
A) Stock options
B) Bonus payments

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 C) RSUs
D) SARs
18. Which of the following is not a factor that companies should consider when selecting a
share-based settlement alternative?
A) The company's accounting and tax considerations
B) The company's cash flow and financing considerations
C) The preferences of the company's employees
D) None of the above
19. Which of the following types of share-based payment arrangements involves the issuance of
units that are settled in cash or stock?
A) RSUs
B) Stock options
C) SARs
D) None of the above
20. Irish Company granted 10,000 share options to each of its five directors on January 1, 2016.
The options vest on January 1, 2020. The fair value of each option on January 1. 2016 is 50
and it is anticipated that all of the share options will vest on January 1, 2020. What amount
should be reported as increase in expense and equity for the year ended December 31, 2016?

A. 750,000 C. 625,000
B. 500,000 D. 125,000

21. Esmeralda Company issued fully paid shares to 200 employees on December 31, 2016.
Normally, shares issued to employees vest over a two-year period but these shares have been
given as a bonus to the employees because of their exceptional performance during the year.
The shares have a market value of 500,000 on December 31, 2016 and an average fair value
of 600,00 for the year. What amount should be expensed for this share-based payment
transaction?

A. 600,000 C. 300,000
B. 500,000 D. 250,000

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WORD PROBLEM

1. ABC granted 10,000 cash settled share based payments to its 20 directors on January 1, 2015.
The options vest on 31 December 2017. it is anticipated that none of the directors will leave
over the next 3 years period. Fair value of options were given below;
1 January 2015 12
31 December 2015 13.50
31 December 2016 13.80
31 December 2017 14.20

Required: Compute the amount of compensation expense at the end of each year?

2. An entity grants 100 shares options to each of its 300 employees. Each grant is conditional
that the employees should be working in the entity for not less than 3 years. Fair value of
each share option is $25(estimated). In addition the company estimates that 20% of the
employees will leave during the 3 years period. Hence, there share are forfeited.

Required: Calculate each year expense and Journal entry on each of the 3 years ended
31 December

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 CHAPTER THREE

ACCOUNTING FOR AGRICULTURE

3. INTRODUCTION

Agriculture is the largest sector in the Ethiopian economy, accounting for over 50% of GDP and
employing over 85% of the labour force (MEDaC, 1999). Hence,Agriculture is the backbone of
the Ethiopian economy. This particular sector determines the growth of all other sectors and
consequently, the whole national economy. On average, crop production makes up 60 percent of
the sector‘s outputs, whereas livestock accounts for 27 percent and other areas contribute 13
percent of the total agricultural value added. The sector is dominated by small-scale farmers who
practice rain-fed mixed farming by employing traditional technology, adopting a low input and
low output production system. The land tilled by the Ethiopian small-scale farmer accounts for
95 percent of the total area under agricultural use and these farmers are responsible for more than
90 percent of the total agricultural output. As result, the accounting information system
application is very crucial in measuring,recording, & reporting the agricultural activities of those
sectors in the development of modern economy of this country.

Agricultural accounting, as noted earlier, is among the specialty accounting types since
enterprises in agricultural activities tend to acquire specific branches and objectives of activity.

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They all utilize the data provided by financial, cost and managerial accounting. Within this
framework, while recording of financial transactions in agricultural production process
necessitates the use of financial accounting; estimation of production costs incurred during the
cultivation of agricultural goods necessitates the use of cost accounting and provision of new
data, either obtained from financial or cost accounting, for decision-making practices of
enterprise managers necessitates the use of managerial accounting. Agricultural accounting can
be explained as a specialty accounting which primarily records financial and monetary
transactions throughout agricultural activities, classifies financial transaction in respect of types,
estimates production costs incurred during the cultivation of agricultural goods and then reports
those financial according to their purposes. In this chapter, you will be introduced with the basic
concepts of agricultural activities, biological assets and its accounting and reporting standards in
the practice.

After completing this chapter student will be able to;

Identify Basic Terms and Agricultural activities

Identify Standards applied to Agricultural accounting

Define biological assets, bearer plants, and Agricultural produce

Describe the Accounting for Biological assets

Account for Recognition and Measurement of Biological Assets

Presentation and Disclosure Issues related with Biological Assets

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3.1. Overview of Agricultural activities & basic Terminologies

Dear Learners, Can you define the Agricultural activities by your own terms and explain their
purposes for human population?

Figure 3.1: hypothetical example of Agricultural Activities

Agricultural activities encompass the various processes we use to grow crops and raise livestock
for food for human populations. Crops are also used for industrial processes, for example, palm
oil is used in many products from frying oil to cosmetics, sugar cane waste is used for biofuel,
and cotton is used for textiles. Livestock are used for meat, eggs, milk, as well as for leather and
wool. Livestock are also used for labor. Humans have altered Earth‘s land for thousands of years
through agricultural activities. Industrialization of many agricultural activities over the last 300
years, and especially over the last 70 years, has allowed us to greatly expand our land use. This
has also fragmented habitats and ecosystems, affecting species
populations and ranges and biodiversity.

Agricultural activities impact the Earth system in a variety of ways, including:

 Increasing greenhouse gases into the atmosphere, for example, from farm animals (for
example, methane from the digestion of plant material by cows), from the cultivation of
rice (for example, methane is produced by bacteria that thrive in rice fields), and from
the burning of fossil fuels to power farming equipment, and from the mining of minerals
and the burning of fossil fuels to make fertilizer.

 Deforestation and other forms of habitat loss to make land available for crops and grazing
livestock. Habitat loss often alters populations, species ranges, and the biodiversity in

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 ecosystems. Fire is often used in deforestation, which releases greenhouse gases into the
atmosphere. Deforestation can also decrease soil quality by increasing erosion,
necessitating the use of fertilizers that can also disrupt ecosystem biomass and
productivity.

 Diverting freshwater for crops and livestock, which in turn decreases the amount of water
available for other organisms and for other human needs and activities.

 Increasing food availability. Industrial and technological innovations increased the

reliability of food supplies, especially the last 70 years, which in turn has played a role in
global human population

 Increasing the amount of nutrients in soil or water, especially nitrogen and phosphorous.
These nutrients increase plant and algae growth, but also have negative impacts on other
species. For, example, in aquatic environments, nutrient-rich runoff can cause large
amounts of algae grow – when the algae die, they are consumed by bacteria which can
reduce oxygen levels in the water, killing fish and other species. This process is known as
eutrophication.

 Releasing pollutants and waste from fertilizers and pesticides into ecosystems that can
harm the health of native species populations. Pollutants and waste also decrease
the quality of freshwater

 Removing trees and plants, plowing fields, and overgrazing by livestock disrupt roots that
stabilize sediment and decrease soil quality. These human activities can
increase erosion rates 10 to 100 times. In turn, increasing erosion decreases water
quality by increasing sediment and pollutants in rivers and streams.

Q. Can you think of additional cause and effect relationships between agricultural activities
and other parts of the Earth system?

The following are relevant terminologies related to agricultural activities;

Agricultural activity is the management by an enterprise of the biological

transformation of biological assets for sale, into agricultural produce or into additional

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 biological [Link] activity is the management of biological transformation
(such as biological growth) of a biological asset for the purpose of sales of that asset.

Agricultural activity is the management of biological transformation (reproduction) of a

biological asset for the purpose of creating additional biological asset.

Agricultural activity is the management of biological transformation of a biological asset

for the purpose of harvesting agricultural produce from that asset.

Examples of agricultural activity include: Raising livestock, fish or poultry,

Cultivating Mango yards, Stud farms (for example, breeding horses or cattle) , Forestry,
Floriculture

Biological assets:areLiving plants and animals.

Agricultural produce: The product of the entity‘s biological assets, for example, milk
and coffee [Link] produce is the harvested produce from biological
[Link] is the detachment of produce from a biological asset or the cessations of a
biological assets life.

Biological transformation: Relates to the processes of growth, degeneration, and

production that can cause changes of quantitative or qualitative nature in a biological
asset.

Biological transformation leads to either;

 Asset changes can be:

Growth: increase in quantity and/or quality

Degeneration: decrease in quantity and/or quality

 Creation of new assets:

Production: producing separable non-living products

Procreation: producing separable living animals

3.1.1. Nature of Biological Assets

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Biological assets are living plant or animal owned by a business entity for the purpose
agricultural activity. But, not all living plant or animals are biological asset.
For example, livestock such as goats, cows, sheep, pigs, and fish are all considered biological
assets. Biological assets also include crops grown by farmers – e.g., corn, tomatoes – as well as
grapevines, cannabis, trees, and any produce coming from trees, such as [Link] following
are excluded from biological assets for reporting purposes;
Land related to agricultural activity
Biological assets held for provision or supply of services( E.g. Public sector can have lots
of examples of biological asset held for the provision of services. Examples include:
Police / customs dogs, Police horses, Trees / flowers in public parks.)
Bearer plant related to agricultural activity( E.g. A living plant that is used in the
production or supply of agricultural produce. Mango trees held for the provision of
mango fruit)

Figure 3.2: Examples of biological assets & agricultural produces

The International Accounting Standard 41 (IAS 41) states that a biological asset is any living
plant or animal owned by the business, and they are typically measured at fair value minus
selling costs.

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Biological assets can be held and accounted for by any business owner. However, because of
their nature, they are, typically, of the utmost importance to farmers or any individuals whose
primary source of profit comes from growing, selling, and shipping such goods.
Biological assets, because they are living or have an active component that makes them difficult
to maintain, are constantly under the threat of change, both qualitatively and quantitatively. It
simply means that plants, animals, and the living things they produce (such as hens producing
eggs or cows producing milk) have a period of time where they must grow or be produced, a
useful period during which they can be harvested, and a limited amount of time during which
they can be moved and sold before they rot, decay, or otherwise become useless to consumers.
Biological assets generate substantial revenue or income for businesses in industries such as
silviculture, cannabis, vineyards, and livestock, so this asset type is typically seen in the balance
sheet of companies in these industries. They are the same as the goods produced by other
companies that manufacture items made of plastic, paper, or other materials in terms of
generating revenue for the seller and accounting for loss if the goods are damaged or stolen. The
only qualitative difference is that the asset is living. Biological assets change and depreciate
naturally and more rapidly than other types of goods. Different types of biological assets, much
like other goods, can be in high or low demand, depending on the season. Recently there has
been a surge in the demand for cannabis. They can also be lost or damaged, with the loss or
damage usually due to things like unexpected periods of rain or drought, cold weather, or the
spread of a disease that wipes out crops and/or livestock.

It‘s important to note that the term ―biological asset‖ is unique to the field of accounting for the
purpose of clearly categorizing and identifying assets owned by businesses, such as farms and
vineyards, or produce that is a primary source of the company‘s income. Businesses in various
industries and sectors can raise plants and animals for a variety of reasons; classifying them as
biological assets denote their nature and their value to the business owner.
Cannabis Stocks have gained increased awareness due to the listing of cannabis companies in
public stock exchanges. With shares in the public market, they are required by regulation to
periodically release their financial statements. This has given the general public access to their
Income Statements, Statements of Financial Position, and Cash Flow Statements.A significant
portion of the current assets owned by these companies is biological assets (cannabis), which is

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typically their primary resource for profit-generating operations. Below is an example of Canopy
Growth Corporation‘s balance sheet, and highlighted is their Biological Asset holdings.

Figure 3.3: Statement of Financial Position of Canopy growth Corporation

Other Industries that are known for large amounts of biological assets are:

 Paper and Forest Products (Trees)

 Dairy (Cows)

 Agriculture (Crops)

 Meat (Grazing)

 BioFuel (Energy Crops – such as Soybean)

[Link]. Types of Biological Assets

The biological assets are categorized based on nature of their natural existence, durability and
purposes. International Accounting Standards ( IAS 41) Grouped biological assets as follows;

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 Biological assets

Bearer biological Consumable

assets/Bearer Plants biological assets

IAS 16, except

produce IAS 41
growing thereon
Produce

1. Bearer Plant

Bearer plant is a living plant that is used in the production or supply of agricultural [Link]
has the following main features;

The plant is expected to bear produce for more than one year, and

It is unlikely that the entity will harvest the plant as agricultural produce

Produce growing on bearer plant is a biological asset.

o Example Mangos on a mango tree.

o The following are not bearer plants;

Plants cultivated to be harvested as agricultural produce (eg trees grown for use
as a lumber)

Plants cultivated for agricultural produce but there is a likelihood that the entity
will also harvest and sell the plant as agricultural produce. Other than as
incidental sales (eg trees are cultivated both for their fruit and also their lumber)

Annual crops ( for example, wheat)

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 2. Consumable Biological assets

o Consumable biological assets are those biological assets that are to be harvested as
agricultural produce or sold as biological asset.
o Biological assets which do not meet all of the above requirements (For bearer plant)
o E.g. All animals

[Link]. Identifying Biological assets, Agricultural produce and inventories

Practical Examples

Example 1: Assume Entity A raises cattle, slaughters them at its abattoirs and sells the carcasses
to the local meat market.

Required: Identify these activities as Biological asset (Bearer/Consumable, Agricultural

produce, or Inventories?

Answer

The cattle are biological assets while they are living. When they are slaughtered,
biological transformation ceases and the carcasses meet the definition of agricultural
produce. Hence, Entity A should account for the live cattle in accordance with IAS41 and
the carcasses as inventory in accordance with IAS 2 Inventories.

Example 2. Assume ABC grows vines, harvests the grapes and produces wine.

Required: Which of these activities are in the scope of IAS 41?

Answer
The vines are biological assets that continually generate crops of grapes. When the entity
harvests the grapes, their biological transformation ceases and they become agricultural
produce. The vines continue to be living plants and should be recognised as biological
assets.
Assets such as wine that are subject to a lengthy maturation period are not biological
assets. These processes are analogous to the conversion of raw materials to a finished
product rather than biological transformation. Therefore, the entity should account for the

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 grapevines in accordance with IAS 41 and the harvested grapes and the production of
wine, as inventory in accordance with IAS 2.
Example 3: An entity on adoption of IAS 41 has reclassified forest as biological assets. The total
value of the group‘s forest assets is $2 million comprising
Freestanding trees …………$1,700
Land under trees………………... 200
Roads in forests …………………..100
Required
Show how the forests would be classified in the financial statements.
Answer

The forests would be classified on the statement of financial position as follows;

 Biological assets ……………….…………….….$1,700

 Noncurrent asset-land …………….………....….….200

 Noncurrent assets—other tangible assets…..……....100

3.2. Accounting for Agriculture

International Accounting Standard (IAS 41) sets out accounting for agricultural activity – the
transformation of biological assets (living plants and animals) into agricultural produce
(harvested product of the entity's biological assets).

The objective of IAS 41 is to establish standards of accounting for agricultural activity .This
Standard shall be applied to account for the following when they relate to agricultural activity:

Biological assets, except for bearer plants;

Agricultural produce at the point of harvest; and
Government grants

3.2.1. Measurement & Recognition of Biological assets and Agricultural Produces

A) Recognition Criteria

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IAS 41 suggests the recognition of biological asset or agricultural produce when the following
criteria met;

Entity controls asset as result of past event

Probable future economic benefits/service potential will flow to entity

Fair value or cost can be measured reliably

B) Measurement of biological assets & Agricultural Produce

Any biological asset should be measured initially and at each balance sheet date, at its fair value
less estimated point-of-sale costs. The only exception to this is where the fair value cannot be
measured reliably.
Agricultural produce should be measured at fair value less estimated point-of-sale costs at the
point of harvest.
According to IAS 41, agricultural produce can always be measured reliably. Point-of-sale costs
include brokers‘ and dealers‘ commissions, any levies by regulatory authorities and commodity
exchanges, and any transfer taxes and duties. They exclude transport and other costs necessary
to get the assets to a market.
If an active market does not exist, then fair value is determined as per fair value [Link]
hierarchy may be summarized as follows:
Price for the asset in an active market.
Recent transaction price for the asset if there is no active market.
Market prices for similar assets, adjusted for the points of difference.
Sector benchmarks.
Present value of the future cash flows expected to be generated from the asset.
EXAMPLE: Assume Agaro Livestock Farm purchased a cow for $1,000. It paid $20 carriage in
cost. It estimated that if they wish to sell the cow then they will have to pay another $20 carriage
out cost and $30 sales commission per cow.
Required
How the cow is measured initially?
Is carriage in is capitalized or expensed?
Is there any gain or loss on initial recognition?

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 How to journalize the transaction?
Answer
How the cow is measured initially?
Cost = FV – cost to sale $1,000-$30-$20 =$950
Is carriage in is capitalized or expensed?
It is Expensed, b/s carriage in is considered period cost not cost of biological asset. Thus, it
should be expensed in that period.
Is there any gain or loss on initial recognition?
There is a loss b/s FV of the asset is $1000, but, recorded initially as $950. Thus a loss of $50
recognized initially.
How to journalize the transaction?
Cow ----------------------------$950
Freight in-------------------------$20
Loss on initial recognition---$50
Cash----------------------------------------------$10200
C) Measurement of Bearer Plant
A bearer plants should be treated as property, plant and equipment (IPSAS 16). A bearer plant
is measured at cost for the initial [Link] cost based measurement is continued till the
plant grows to maturity.
Subsequently it is measured using:
Cost less depreciation and impairment model Or
Revaluation Model

Summary of Measurement of Biological assets, Agricultural Produces & Bearer Plant

The following table summarizes the measurement recognition criteria of biological assets,
agricultural produces & bearer Plant at different stages of production;

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Page 60 of 112
Subsequent expenses relating to agriculturalActivity
Various expenditures may be incurred after the initial acquisition or production of biological
assets. The following are some of activities and related costs with measurement criteria;
Such costs may include feeding, veterinary services, planting, weeding, irrigation,
fertilizer, and harvesting and slaughtering costs.
IAS 41 does not prescribe the treatment of such costs.
Prior to adoption of IAS 41, many agricultural businesses had policy of capitalizing some
of these costs.
Many entities now adopt a policy of treating all such expenditure as a cost of production.
Measurement & Recognition of Gain or Loss on Biological assets
The change in the fair value of biological assets is twofold. There can be physical change
through growth, and there can be a price [Link] gain on the initial recognition of
biological assets at fair value less estimated point-of sale costs and any changes in the fair value
less estimated point-of-sale costs of biological assets during the reporting period are included in
profit or loss for the period.
Common Accounting entries related to Biological assets
A) Bearer Biological assets related entries
1) Before maturity
Equivalent to Construction - in – progress
Measured at Accumulated costs (IAS 16)
Entry to record costs incurred:
Dr. Bearer Immature Biological assets… xxx
Cr. Cash/Materials etc.. xxx
2) On maturity
Accumulated cost transferred to depreciable PPE (IAS 16)
Entry to record the transfer:
Dr. Bearer Matured BA… xxx
Cr. Bearer Immature BA..xxx
3) Aftermaturity
a) Depreciation on matured BA (IAS 16)
Use acceptable depreciation method as per IAS 16

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Entry to record depreciation:
Dr. Work in Progress Biological assets (WIP-BA)… xxx
Cr. Accumulated Depreciation - BA..xxx
b) Current costs on matured Biological Assets(IAS 16)
Standard silent on these costs
Options: Capitalize or charge to Cost of Production
Entry to record current costs:

Treatment Entry

Current cost capitalized Dr. Bearer Matured BA …. xxx

Cr. Cash/Materials etc …. xxx

Current cost charged to production Dr. WIP – BA…….xxx

Cr. Cr. Cash/Materials etc …. xxx

c) Agricultural produces (IAS 41)

Measured at fair value less costs to sell, with changes recognised in profit or loss as the
produce grows.
B) Consumable Biological Assets related Entries

1) Beforematurity
Measured at fair value less costs to sell, with changes recognised in profit or loss as the
produce grows.
Entry to record costs incurred:
Dr. Consumable Biological Assets xxx
Cr. Cash/Materials etc xxx
2) On Maturity
Measured at fair value less cost to sell (IAS 41)
Entry to record change in fair value:
Dr. Consumable Biological Assets xxx
Cr. Gain on R-measurement xxx

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 3) Aftermaturity - Harvesting
 Measured at (IAS 2)
Entry to record costs incurred:
Dr. Inventory (e.g. Corn) xxx
Cr. Consumable BA xxx
Cr. Gain on Re-measurement xxx

3.3. Presentation & Disclosures of Biological assets on Financial statements

3.3.1. Presentation & Classifications

It‘s important to note that the term ―biological asset‖ is unique to the field of accounting for the
purpose of clearly categorizing and identifying assets owned by businesses, such as farms and
vineyards, or produce that is a primary source of the company‘s income. Businesses in various
industries and sectors can raise plants and animals for a variety of reasons; classifying them as
biological assets denotes their nature and their value to the business [Link] the statement of
financial position biological assets should be classified as a separate class of assets falling under
neither current nor non-current classifications. Biological assets should also be sub-classified
(either on the face of the statement of financial position or as a note to the accounts).

Class of animal or plant

Nature of activities (consumable or bearer)
Maturity or immaturity for intended purpose

3.3.2. Disclosures required

An entity shall disclose the aggregate gain or loss that arises on the initial recognition of
biological assets and agricultural produce and from the change in value less estimated
point-of sale costs of the biological assets.
A description of each group of biological assets is also required.
The methods and assumptions applied in determining fair value should also be disclosed.

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 The fair value less estimated point-of-sale costs of agricultural produce harvested during
the period shall be disclosed at the point of harvest
The existence and carrying amounts of biological assets whose title is restricted and any
biological assets placed as security should be disclosed.
The amount of any commitments for the development or acquisition of biological assets
and management‘s financial risk strategies should also be disclosed.
A reconciliation of the changes in the carrying amount of biological assets showing
separately changes in value, purchases, sales, harvesting, business combinations, and
exchange differences should be disclosed.

Glossary items
Agricultural activity is the management by an enterprise of the biological
transformation of biological assets for sale, into agricultural produce or into additional
biological assets.
Agricultural produce: The product of the entity‘s biological assets, for example, milk
and coffee beans.
Bearer plant: is a living plant that is used in the production or supply of agricultural
produce.
Biological assets:are Living plants and animals.
Biological transformation: Relates to the processes of growth, degeneration, and
production that can cause changes of quantitative or qualitative nature in a biological
asset.
Consumable biological assets: are biological assets that are to be harvested as
agricultural produce or sold as biological asset.

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Page 65 of 112
CHAPTER END REVIEW QUESTIONS
I. MULTIPLE CHOICE QUESTIONS

Instructions: After reading each of the following question attentively choose the best answer
from a given Alternatives.

1. What are biological assets?

A. Non-living assets used in agriculture
B. Living assets used in agriculture
C. Physical assets used in agriculture
D. Financial assets used in agriculture
2. Which of the following is not an example of a biological asset?
A. Livestock
B. Crops
C. Land
D. Trees
3. What should be the initial measurement of biological assets?
A. Cost
B. Fair value
C. Net realizable value
D. Net present value
4. Which of the following statements is true about fair value changes of biological assets?
A. Increases in fair value can be recognized in profit or loss
B. Decreases in fair value can be recognized in profit or loss
C. Both A and B
D. None of the above
5. How should agricultural produce be measured?
A. Fair value less cost to sell
B. Cost
C. Fair value
D. Net realizable value

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6. Which of the following is required for a gain on a biological asset to be recognized in profit
or loss?
A. The change in fair value must be reliable and measurable
B. The asset must have reached maturity
C. The asset must have been sold
D. None of the above
7. Which of the following should be included in the cost of a biological asset?
A. Purchase price
B. Direct costs of acquisition
C. Costs necessary to bring the asset to use
D. All of the above
8. How should the cost of a group of biological assets be allocated to the individual assets?
A. Proportionally to their fair values
B. Proportionally to their net present values
C. Proportionally to their net realizable values
D. Proportionally to their purchase prices
9. What is meant by the term "carrying amount" of a biological asset?
A. Its initial cost
B. Its fair value adjusted for any accumulated changes in fair value
C. Its net realizable value
D. None of the above
10. Which of the following is not a requirement for a biological asset to be recognized in the
financial statements?
A. It must be probable that the future economic benefits will flow to the entity
B. Its cost can be reliably measured
C. It must have a physical existence
D. It must be controlled by the entity

II. Short Answer Questions

1. Identify whether each of the following biological assets is bearer or consumable

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Biological Asset Agricultural Produce Bearer or consumable?

Sheep Wool

Trees in a plantation forest Logs

Cotton Cotton

Sugarcane Harvested cane

Dairy cattle Milk

Pigs Carcass

Bushes Leaf

Vines Grapes

Fruit trees Picked fruit

III) Discussion Questions

1. Briefly describe Agricultural activities using practical examples in Ethiopian context

2. Lists and briefly explain the types of biological assets with practical examples in
Ethiopian context

CHAPTER FOUR

INSURANCE CONTRACTS

4.1. INTRODUCTION

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After studying this portion you are expected to understand;

The meaning of insurance contract,

Accounting for measurement and recognition of insurance contracts, &
Presentation & disclosures of insurance contracts on financial statements

An insurance contract is a document representing the agreement between an insurance

company and the insured. Central to any insurance contract is the insuring agreement, which
specifies the risks covered, the limits of the policy, and the term of the policy. Additionally, all
insurance contracts specify:

Conditions: which are requirements of the insured, such as paying the premium or
reporting a loss;
Limitations: which specify policy limits, such as the maximum amount the insurance
company will pay;
Exclusions: which specify what is not covered by the policy.

An insurance contract is a contract under which one party (the issuer) accepts significant
insurance risk from another party (the policyholder) by agreeing to compensate the policyholder
if a specified uncertain future event (the insured event) adversely affects the policyholder‖.In
insurance, the insurance policy is a contract( generally a standard form contract) between the
insurer and the policyholder, which determines the claims which the insurer is legally required to
pay in exchange for an initial payment, known as the premium, the insurer promises to pay for
loss caused by peril covered under the policy The insurance policy is generally integrated
contract, meaning that it includes all forms associated with the agreement between the insured
and insurer. In some cases, however, supplementary writings such as letters sent after the final
agreement can make the insurance policy a non-integrated [Link] both parties consent, are
part of the written policy

Itis a legally binding agreement between an insurance company and the policyholder. The
contract outlines the terms and conditions of the insurance coverage being provided in exchange
for payment of premiums by the policyholder. The purpose of an insurance contract is to transfer
the financial risk of loss from the policyholder to the insurance company. In the event of an
insured event, the insurance company is obligated to provide financial benefits to the

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policyholders that are stipulated in the insurance policy. It is important for policyholders to
understand the terms of their insurance contract and their obligations under the policy to ensure
they are adequately protected in the event of a loss.

An insurance contract is a legal agreement between an insurer and a policyholder, where the
insurer promises to provide financial protection against specific risks in exchange for the
payment of premiums. The contract outlines the terms and conditions of the insurance policy,
including the coverage provided, the duration of the policy, and the obligations of both parties.
Insurance contracts can vary widely depending on the type of insurance being offered, such as
life insurance, health insurance, or property and casualty insurance. The purpose of an insurance
contract is to provide peace of mind and financial security to individuals and businesses by
transferring the risk of potential losses to an insurance company. Understanding the terms and
conditions of an insurance contract is essential for making informed decisions about coverage
and ensuring that policyholders are adequately protected.

Reinsurance contract is an insurance contract issued by one entity (the reinsurer) to compensate
another entity (the ‖cedant‖) for claims arising from one or more insurance contracts issued by
the cedent‖

4.2. Accounting for insurance contracts

Accounting for insurance contracts is a complex process that requires careful consideration of
various factors. The accounting treatment for insurance contracts can vary depending on the type
of contract, the nature of the risks covered, and the accounting standards applicable to the
insurer.
One of the key considerations in accounting for insurance contracts is the recognition of
premiums and claims. Premiums received from policyholders are recognized as revenue over the
period of the policy, while claims are recognized as expenses when they are incurred.
Another important aspect of accounting for insurance contracts is the measurement of liabilities.
Insurance companies are required to estimate the amount of future claims based on actuarial
assumptions and discount them to their present value. This process is known as the provision for
unearned premiums and claims reserves.

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The accounting treatment for insurance contracts also involves the recognition of investment
income. Insurers typically invest premiums received from policyholders in various assets, such
as stocks, bonds, and real estate. The income earned from these investments is recognized as
revenue in the insurer's financial statements.
Finally, accounting for insurance contracts also involves disclosure requirements. Insurers are
required to provide detailed information about their insurance contracts in their financial
statements, including the nature of the risks covered, the terms and conditions of the policies, and
the assumptions used in estimating liabilities.
In conclusion, accounting for insurance contracts is a complex process that requires careful
consideration of various factors. Insurers must follow specific accounting standards and
regulations to ensure that their financial statements accurately reflect their financial position and
performance. By providing transparency and accountability, accounting for insurance contracts
helps to build trust and confidence in the insurance industry.
Accounting for insurance contracts involves the recording, measurement, and reporting of
financial information related to the insurance coverage provided by an insurance company.
Insurance companies have unique accounting requirements because they must account for the
risks associated with potential future losses, as well as the premiums they collect from
policyholders.
The accounting for insurance contracts typically begins with the initial recognition of an
insurance policy, upon which the insurer writes a liability to reflect the expected payout to the
policyholder in the future. This liability is recorded on the balance sheet and is known as the
unearned premium reserve. The insurer earns a portion of the premium for each period of
coverage over the life of the policy, and the unearned premium reserve is reduced accordingly.
As policyholders make claims against their insurance policies, the insurer records a
corresponding liability for the loss on the balance sheet. This is known as the loss reserve. The
loss reserve represents the amount of money that the insurer expects to pay out for the claims
that have been reported but not yet settled.
To ensure accuracy and transparency in their financial reporting, insurers must follow specific
accounting standards, such as the International Financial Reporting Standards (IFRS) or the
Generally Accepted Accounting Principles (GAAP) in the United States. These standards

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provide guidelines for recognizing insurance revenue, estimating losses, and measuring financial
performance.
In conclusion, accounting for insurance contracts is a complex process that requires careful
consideration of the many risks and uncertainties associated with the insurance industry. It is a
critical component of an insurance company's overall financial management strategy and is
closely monitored by regulators and investors [Link]! Let me give you a simplified
example of accounting for insurance contracts.
Example Let's say a company, ABC Insurance, issues a policy for $10,000 with coverage for one
year against fire damage for a customer's building. The policy is issued on January 1 and expires
on December 31 of the same year.
On January 1, ABC Insurance would recognize the premium as revenue of $10,000. This is
because they have earned the right to keep the premium as the customer is now covered against
any fire damage during the year.
Throughout the year, ABC Insurance would make an estimate of the expected claims based on
historical data plus any possible future changes. Let's assume that at the end of the year, the
estimate of expected claims is $3,000.
To account for this, ABC Insurance would create a liability for claims of $3,000. This is because
they have incurred an obligation to pay for any claims any time during the policy term.
The net revenue for ABC Insurance for the year would, therefore, be $10,000 - $3,000 = $7,000.
This represents the earnings made by ABC Insurance for providing insurance coverage for the
year.
Journal entries of the above example is recorded as follows
1. To record the premium received at the beginning of the coverage period on January 1:
Debit Cash (or Accounts Receivable, if the customer paid later) $10,000
Credit Unearned Premium Revenue $10,000
2. To recognize the revenue earned for the coverage period at the end of the year:
Debit Unearned Premium Revenue $7,000
Credit Premium Revenue (or Insurance Revenue) $7,000
3. To record the liability for claims at the end of the year based on estimated claims:
Debit Claims Expense (or Loss Expense) $3,000
Credit Reserve for Claims (or Claims Liability) $3,000

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Another example assume XYZ Insurance Company is providing coverage under a property
insurance contract for a business client for a one-year term starting from January 1, 20X1, for a
total premium of $10,000. The expected loss ratio for this type of policy is 60%, and the insurer
uses the gross premium method to recognize premium revenue.
1. on January 1, 20X1:
Cash $10,000
Unearned Premium Revenue $10,000
To record receipt of premium)
2. On December 31, 20X1:
Estimated Claims Expense $6,000
Claims Payable $6,000
(To recognize expected claims for the year)
3. on December 31, 20X1:
Unearned Premium Revenue $6,000
Premium Revenue $6,000
(To recognize earned premium revenue based on the expected loss ratio)
4. on January 1, 20X2:
Claims Payable $6,000
Cash $6,000
(To record payment for the claims)
5. on December 31, 20X2:
Estimated Claims Expense $2,000
Claims Payable $2,000
(To recognize additional claims)
6. on December 31, 20X2:
Unearned Premium Revenue $4,000
Premium Revenue $4,000
(To recognize additional earned premium revenue based on the expected loss ratio)
7. On January 1, 20X3:
Claims Payable $2,000
Cash $2,000

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 (To record payment for the remaining claims)

4.2.1. Initial Recognition & Measurement of Insurance Contracts

 Under IFRS 17 insurance contracts are to be initially recognized at the earliest of

 the beginning of coverage period or when the first payment becomes due; or

 the date when facts/circumstances indicate the contract is onerous

The initial recognition of an insurance contract occurs when the insurer agrees to provide
insurance coverage to a policyholder. At this point, the insurer writes a liability on its balance
sheet to reflect the expected payout to the policyholder in the future. This liability is known as
the unearned premium reserve.

The unearned premium reserve is calculated by taking the total premium paid by the
policyholder and dividing it by the total number of days in the insurance coverage period. This
gives the daily rate of premium that the insurer has earned, and the unearned premium reserve is
the amount of premium that has not yet been earned by the insurer.

For example, if a policyholder paid an annual premium of $1000 for insurance coverage over the
course of a year, the daily rate of premium is $2.74 ($1000 divided by 365 days). If the insurer
writes the insurance policy on January 1st, the unearned premium reserve on that date is $1000,
representing the full value of the premium paid by the policyholder.

Over time, as the insurer provides coverage to the policyholder, the unearned premium reserve is
reduced, and the earned premium is recorded as revenue on the insurer's income statement. This
reflects the insurer's obligation to provide insurance coverage to the policyholder over the period
of the insurance contract.

The initial recognition of an insurance contract involves the identification of the policyholder,
the nature of the risks covered, and the terms and conditions of the policy. The insurer must also
determine the premium to be charged based on the perceived risk associated with the policy.

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Once the policy is issued, the insurer recognizes the premiums received as revenue over the
period of the policy. At the same time, the insurer recognizes a liability for unearned premiums,
which represents the portion of the premiums that have not yet been earned.

The insurer must also estimate the amount of future claims that will be incurred and recognize a
liability for claims reserves. This involves using actuarial assumptions to estimate the likelihood
and magnitude of future claims, and discounting them to their present value.

Overall, the initial recognition of an insurance contract involves a careful assessment of the risks
involved and the financial implications of those risks. By accurately recognizing premiums and
liabilities, insurers can ensure that their financial statements provide a true and fair view of their
financial position and performance.

Example let‘s say a company signs a contract with a policyholder for a one-year car insurance
policy. The policy covers the policyholder for up to $50,000 in damages and costs $1,000 per
year in premiums.

To record the initial recognition of this insurance contract, the company would make the
following journal entries:

1. The company would record the $1,000 premium received as an asset on their balance sheet,
with the following entry:

Debit - Cash: $1,000

Credit - Unearned Revenue: $1,000

2. The company would record the estimated liability for the expected future payouts, based on
the terms of the policy and the level of risk. For example, let's say that the company estimates
that there is a 10% chance of a $50,000 loss, resulting in an estimated payout of $5,000. The
company would record the liability with the following entry:

Debit - Insurance Expense: $5,000

Credit - Loss Reserve Liability: $5,000

The Unearned Revenue account represents the premium payments received by the company, but
which have not yet been earned due to the term of the policy. The Loss Reserve Liability account

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represents the estimated future payouts that the company expects to make as a result of the
policy, while the Insurance Expense account represents the cost of providing the insurance
coverage. These accounts would be adjusted over time as the policy matures and the level of risk
changes.

[Link]. DE recognition of Insurance contract

Insurance contracts are to be derecognized when;

The insurance contract is extinguished - when the obligation is discharged or cancelled

or expired. OR
when specified modifications of the terms of the contract are met, e.g. the modified
contract does no longer meet the criteria for simplified accounting

4.2.2. Initial Measurements of Insurance contracts

IFRS 17 Insurance Contracts establishes specific principles for grouping contracts together
(LoA). This grouping is particularly relevant for the determination of the contractual service
margin (CSM) and the limitation of offsetting effects for subsequent measurement. An entity
shall identify portfolios of insurance contracts. A portfolio comprises contracts subject to similar
risks and managed together.

An entity shall divide a portfolio of insurance contracts issued into a minimum of

1. a group of contracts that are onerous at initial recognition, if any;

2. a group of contracts that at initial recognition have no significant possibility of

becoming onerous subsequently, if any;

3. a group of the remaining contracts in the portfolio, if any.

 Expected gains and losses are treated differently under IFRS 17

o Contracts that at inception have no significant possibility of becoming onerous

subsequently, if any and Other profitable contracts, if any

Thus, unearned profit is recognised as liability and is released as insurance services are provided

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 o Contracts that are onerous at inception, if any

Thus, a loss is recognised in P/L

o Three different ways to measure insurance contracts under IFRS 17:

1. general measurement model (GMM / BBA);

2. premium allocation approach (PAA); and

3. Variable fee approach (VFA).

1. General Measurement Model

o Default model to measure insurance contract liabilities under IFRS 17

o Also known as building blocks approach (BBA)

o Losses recognized in P&L at inception and gains capitalized

o Total carrying amount = liability for the remaining coverage (LRC) + liability for
incurred claims (LIC)

o Liability for remaining coverage (LRC) is relating to coverage that will be provided to
the policyholder for insured events that have not yet occurred

o Liability for incurred claims (LIC) is relating to claims and expenses for insured events
that have already occurred.

2. Premium Allocation Approach

Option to apply PAA, if and only if

 Coverage period one year or less

 Or measurement differs not materially from BBA

 May be applied to liability for the remaining coverage (LRC) only

 BBA to be applied to liability for incurred claims (LIC)

3. Variable Fee Approach

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  Modification of BBA

 for contracts with direct participation features

 Not admitted for reinsurance held

 Only valid for some insurance contracts

The initial measurement of an insurance contract is a crucial step in accounting for insurance
transactions. It involves determining the expected present value of future cash flows associated
with the insurance obligation.

The initial measurement of insurance contracts typically involves estimating the expected future
cash flows from premiums, claims, and associated costs, and determining the appropriate
discount rate to calculate the present value of these cash flows. The measurement also considers
the probability of various scenarios that may impact the future cash flows, such as changes in
interest rates or market conditions. The result of this initial measurement determines the amount
of revenue that can be recognized for the insurance contract, which is typically spread over the
contract period.

Insurance contracts typically involve the potential for future losses, which can be difficult to
estimate. Therefore, the initial measurement of an insurance contract requires the use of actuarial
techniques to estimate the expected future cash flows. This includes estimating the probability
and severity of potential losses, as well as the timing and frequency of insurance claims.

The Fair Value estimate of an insurance contract reflects the entity's estimate of the amount it is
required to pay to fulfill the insurance obligation. The fair value takes into account both the
expected cash outflows (the amount the insurance company expects to pay out to cover claims)
and the expected cash inflows (the estimated future premiums to be paid by the policyholder).

The fair value of an insurance contract may be measured as the present value of the expected
cash flows associated with the insurance obligation. This can be done using the insurer's
expected cash flow projections, which take into account the probability and timing of future
claims payments and premium receipts, as well as the discount rate used to reflect the time value
of money.

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The fair value estimate is critical for assessing the insurer's liability for insurance claims and
determining the amount of premiums to be earned over the life of the contract. Insurance
companies typically report the fair value of their insurance contracts on their financial
statements, providing transparency to investors and regulators regarding the company's insurance
obligations.

The initial measurement of an insurance contract involves determining the fair value of the
consideration received or payable for the contract. This includes any upfront fees or commissions
paid or received, as well as the expected future cash flows associated with the contract.

The insurer must also consider any financial guarantees or options included in the contract, and
estimate their fair value. This may involve complex modeling and analysis to determine the
likelihood and magnitude of potential future events.

The initial measurement also involves assessing the risk of non-performance by the policyholder
or insurer, and recognizing any provisions or contingencies related to this risk.

Overall, the initial measurement of an insurance contract is a critical step in ensuring that the
financial statements accurately reflect the value and risks associated with the contract. By
carefully estimating future cash flows and assessing the risks involved, insurers can make
informed decisions about pricing and underwriting policies, and ensure that they are adequately
capitalized to meet their obligations.

4.3. Presentation & Disclosures of Insurance contract on financial statements

END OF CHAPTER REVIEW QUESTIONS

I. MULTIPLE CHOICE QUESTIONS

Instructions: After reading each of the following question attentively choose the best answer
from a given Alternatives.

1. What is the primary accounting standard for insurance contracts?

(A) IFRS 9
(B) IFRS 15
(C) IFRS 17
(D) IFRS 7

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2. Which of the following is an insurance contract according to IFRS 17?
(A) A warranty on a product
(B) A service contract
(C) A life insurance policy
(D) A lease agreement
3. What is a liability for remaining coverage according to IFRS 17?
(A) The amount of premiums paid by the policyholder
(B) The expected future claims and expenses related to the policy
(C) The fair value of the policy
(D) The amount of cash surrender value of the policy
4. Which of the following is NOT a component of the insurance liability according to IFRS 17?
(A) Premiums received
(B) Liability for remaining coverage
(C) Liability for incurred claims
(D) Liability for risk adjustment
5. How are insurance contracts classified under IFRS 17?
(A) As level 1 or level 2 contracts
(B) As investment contracts or insurance contracts
(C) As non-financial or financial contracts
(D) As direct insurance contracts or reinsurance contracts
6. How should an insurance company account for changes in the estimate of future claims under
IFRS 17?
(A) Record the change in the income statement
(B) Record the change in the statement of comprehensive income
(C) Adjust the liability for incurred claims
(D) Adjust the liability for remaining coverage
7. What is the purpose of the risk adjustment according to IFRS 17?
(A) To measure the insurer's credit risk
(B) To adjust the insurance liability for uncertainty
(C) To adjust the insurance liability for inflation
(D) To measure the insurer's liquidity risk

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8. Which of the following is an example of a reinsurance contract?
(A) A life insurance policy
(B) A property insurance policy
(C) A health insurance policy
(D) A retrocession agreement
9. What is the impact of using the general measurement model under IFRS 17?
(A) More volatility in the income statement
(B) More stable results over time
(C) More complex accounting treatment
(D) More uncertainty in the financial statements
10. How does IFRS 17 affect the accounting for investment components in insurance contracts?
(A) Investment components are accounted for separately from insurance components
(B) Investment components are not recognized as assets or liabilities
(C) Investment components are recorded at fair value through profit or loss
(D) Investment components are recorded at amortized cost

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 CHAPTER FIVE

REVISITING THE STATEMENT OF CASH FLOWS

5. INTRODUCTION
In addition to the income statement and the balance sheet, a statement of cash flows (SCF) is an
essential component within the set of basic financial statements. Specifically, when a balance
sheet and an income statement are presented, a statement of cash flows is required for each
income statement period. The purpose of the SCF is to provide information about the cash
receipts and cash disbursements of an enterprise that occurred during a period. Similar to the
income statement, it is a change statement, summarizing the transactions that caused cash to
change during a reporting period.
Cash Flow Statements is that it measures the cash inflows or cash outflows during the given
period. Such details of the cash position of the company can not only help the company or the
financial analyst to plan for the short term or long term and also analyze the optimum level of
cash and working capital needed in the company. There are three categories under which the
cash sources and the uses of the cash are divided, which include:

 The Cash flow Statement from operating activities is crucial as it focuses on cash
flows from the business‘s main activities like selling and buying the merchandise,
provisioning the services, etc.
 The Cash flows Statement from investing is important because it provides details of the
company‘s purchase and sale of the capital assets, i.e., the assets having a useful life of
more than one year as per the company‘s balance sheet.
 Cash flows Statement from finance is crucial as it considers the stock purchase or sale
by the company and any other proceeds or payments concerning the debt financing. Thus

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 they are the section in the company‘s cash flow, which reflects the company‘s net cash
flows, which is used for the funding.

5.1. Importance of cash flow statement

1. Short Term Planning

The Cash Flow Statement is considered a useful and vital tool for the company‘s management
for short-term planning and keeping control of cash. To meet the various obligations, every
business entity must keep a sufficient amount of liquid funds so that as and when the requirement
arises, it can pay the same. Thus the cash flow statement helps the financial manager in
projecting the cash flow shortly by using the past data of the cash inflows and outflows.

For Example, The Company needs the cash to meet the various obligations that could arise
shortly, like paying debts, various operating expenses, etc.
2. Provides the Details where the Money is spent

Another importance of the Cash Flow statement is that there is additional payments that the
company makes and is not reflected in the profit and loss statement. In contrast, the same is
present in the cash flow statement. Thus the cash flow statement provides the detailed areas
where the company spends the money.

For Example, If the company has the loan and it is paying off the principal amount back to the
bank, then, in that case, the payment will not get reflected in the Profit and loss statement of the
company. In contrast, the same will be available in the cash flow statement. There might be a
situation where the company has the profits, but after paying the principal amount, it has no
funds to pay off its obligations. Such situations can be identified using the cash flow statement.

3. Creating Excess Cash

Every business enterprise runs with the motive of earning profits. The profit helps create the
cash, but other ways also help create the cash in the company. These ways can be identified and

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implemented by focusing on the cash flow statement. On the other hand, concentrating only on
the P & L account makes it hard to focus on creating cash.

For Example, excess cash can be created if the company can collect the receivables from its
customers faster, if it efficiently uses the inventory, etc.

4. Revealing the Cash Planning Results

Another importance of the cash flow statement is that it helps companies analyze the extent to
which the cash planning of the company became successful as the actual results can be compared
with the projected statement of the Cash Flow Statement or the Cash budget. The results will
then help the company to take the measures accordingly. Thus it helps the company compare the
past assessments‘ cash budget with that of the current budget to assess the cash requirement of
the company in the future.
For Example, the company expected that the expenditure on the capital asset for the particular
month would be $10,000, but the actual was $20,000. So such a variance between expected and
actual should be identified by the company, and the action should be taken accordingly.

5. Long Term Planning

This is another importance of the cash flow statement because it helps the management make the
long-term planning of the cash. The company must make long-term financial planning as the
growth of the company is dependent on that. Thus it reveals vital changes that are required for a
company‘s financial positioning and helps the management prioritize the business‘s crucial
activities.

For Example, projected cash flow helps the company‘s management identify the possibility
of long term debt repayment as the same depends on the availability of the cash.

6. Knowing the Optimum Level of Cash Balance

The importance of the Cash Flow Statement is that it helps the company ascertain the Optimum
level of Cash Balance. The company must determine the optimum level of Cash Balance because

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this firm can know whether the funds are lying idle, there is a shortage of cash, or the funds are
excess. After knowing the actual cash position, the company‘s management can make the
decisions accordingly.

For Example, suppose there is a surplus of cash and funds are lying idle. In that case, the
company can invest surplus cash, or if there are deficit funds, it can decide to borrow the funds
from outside to overcome the deficit situation.

7. Helps in Analyzing the Working Capital

Working capital is the component of the cash flow from the operations that can influence the
companies‘ cash flow. Thus, the investors should be aware of the company‘s working capital
movement.
For Example, the company can preserve its cash by increasing the time for paying the bills. It
can increase cash inflow by reducing the time taken to collect the amount from debtors and delay
buying inventory to preserve cash, etc.

5.2. Classification of Cash Flows

As list of cash flows is more meaningful to investors and creditors if they can determine the type
of transaction that give rise to each cash flow. Toward this end, the statement of cash flows
classifies all transactions affecting cash into one of three categories:
Operating activities
Investing activities
Financing activities
A) Cash from Operating Activities
Operating activities are the activities that comprise of the primary / main activities of an
enterprise during an accounting period. For example, for a garment manufacturing company,
operating activities include procurement of raw material, sale of garments, incurrence of
manufacturing expenses, etc. These are the principal revenue generating activities of the
[Link] before tax as presented in the income statement could be used as a starting point
to calculate the cash flows from operating activities.

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Cash Inflows from operating activities:
Cash receipts from sale of goods and rendering services.
Cash receipts from fees, royalties, commissions and other revenues.
Cash Outflows from operating activities:
Cash payments to suppliers for goods and services.
Cash payments of income taxes unless they can be specifically identified with financing
and investing activities.
Following adjustments are required to be made to the profit before tax to arrive at the cash flow
from operations:
 Elimination of non cash expenses (e.g. depreciation, amortization, impairment losses, bad
debts written off, etc)
 Removal of expenses to be classified elsewhere in the cash flow statement (e.g. interest
expense should be classified under financing activities)
 Removal of income to be presented elsewhere in the cash flow statement (e.g. dividend
income and interest income should be classified under investing activities unless in case
of for example an investment bank)
 Elimination of non cash income (e.g. gain on revaluation of investments)
The amount of cash from operations indicates the internal solvency level of the company. It is a
key indicator of the extent to which the operations of the enterprise have generated sufficient
cash flows to maintain its operating potential.
B) Cash from Investing Activities
Cash flow from investing activities includes the movement in cash flows owing to the purchase
and sale of assets. It relates to purchase and sale of long-term assets or fixed assets such as
machinery, furniture, land and building, etc.
Cash Outflows from investing activities
Cash payments to acquire fixed assets including intangibles and capitalized R&D.
Cash advances and loans made to third party (other than advances and loans made by a
financial enterprise wherein it is operating activities).
Cash payments to acquire shares, warrants or debt instruments of other enterprises other
than the instruments those held for trading purposes.
Cash Inflows from investing activities

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 Cash receipt from disposal of fixed assets including intangibles.
Cash receipt from the repayment of advances or loans made to third parties (except in
case of financial enterprise).
Dividend received from investments in other enterprises.
Cash receipt from disposal of shares, warrants or debt instruments of other enterprises
except those held for trading purposes.
C) Cash from Financing Activities
It includes financing activities related to long-term funds or capital of an enterprise. Financing
activities are activities that result in changes in the size and composition of the owners‘ capital
and borrowings of the enterprise. e.g., cash proceeds from issue of equity shares, debentures,
raising long-term loans, repayment of bank loans, etc.
Cash Inflows from financing activities
Cash proceeds from issuing shares (equity / preference).
Cash proceeds from issuing debentures, loans, bonds and other short/ long-term
borrowings.
Cash Outflows from financing activities:
Cash repayments of amounts borrowed.
Interest paid on debentures and long-term loans and advances.
Dividends paid on equity and preference capital.

5.3. Overview of the Preparation of the Statement of Cash Flows

1. Determine the Starting Balance

The first step in preparing a cash flow statement is determining the starting balance of cash and
cash equivalents at the beginning of the reporting period. This value can be found on the income
statement of the same accounting [Link] starting cash balance is necessary when leveraging
the indirect method of calculating cash flow from operating activities. However, the direct
method doesn‘t require this information.

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 2. Calculate Cash Flow from Operating Activities

One you have your starting balance, you need to calculate cash flow from operating activities.
This step is crucial because it reveals how much cash a company generated from its
[Link] flow from operations are calculated using either the direct or indirect method.

Direct Method

The direct method of calculating cash flow from operating activities is a straightforward process
that involves taking all the cash collections from operations and subtracting all the cash
disbursements from operations. This approach lists all the transactions that resulted in cash paid
or received during the reporting [Link] operating cash flows section of the statement of cash
flows under the direct method would appear something like this:
Cash receipts from customers xx,xxx
Cash paid to suppliers xx,xxx
Cash paid to employees xx,xxx
Cash paid for other operating expenses xx,xxx
Interest paid xx,xxx
Income taxes paid xx,xxx
Net cash from operating activities xx,xxx
Indirect Method

The indirect method of calculating cash flow from operating activities requires you to start with
net income from the income statement (see step one above) and make adjustments to ―undo‖ the
impact of the accruals made during the reporting period. Some of the most common and
consistent adjustments include depreciation and [Link] operating cash flows section of
the statement of cash flows under the indirect method would appear something like this:

Profit before interest and income taxes xx,xxx

Add back depreciation xx,xxx
Add back impairment of assets xx,xxx
Increase in receivables xx,xxx
Decrease in inventories xx,xxx

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Increase in trade payables xx,xxx
Interest expense xx,xxx
Less Interest accrued but not yet paid xx,xxx
Interest paid xx,xxx
Income taxes paid xx,xxx
Net cash from operating activities xx,xxx
Both the direct and indirect methods will result in the same number, but the process of
calculating cash flow from operations differs.

While the direct method is easier to understand, it‘s more time-consuming because it requires
accounting for every transaction that took place during the reporting period. Most companies
prefer the indirect method because it's faster and closely linked to the balance sheet. However,
both methods are accepted by Generally Accepted Accounting Principles (GAAP) and
International Financial Reporting Standards (IFRS).

3. Calculate Cash Flow from Investing Activities

After calculating cash flows from operating activities, you need to calculate cash flows from
investing activities. This section of the cash flow statement details cash flows related to the
buying and selling of long-term assets like property, facilities, and equipment. Keep in mind that
this section only includes investing activities involving free cash, not debt.

4. Calculate Cash Flow from Financing Activity

The third section of the cash flow statement examines cash inflows and outflows related to
financing activities. This includes cash flows from both debt and equity financing—cash flows
associated with raising cash and paying back debts to investors and creditors. When using
GAAP, this section also includes dividends paid, which may be included in the operating section
when using IFRS standards. Interest paid is included in the operating section under GAAP, but
sometimes in the financing section under IFRS as well.

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 5. Determine the Ending Balance

Once cash flows generated from the three main types of business activities are accounted for,
you can determine the ending balance of cash and cash equivalents at the close of the reporting
period. The change in net cash for the period is equal to the sum of cash flows from operating,
investing, and financing activities. This value shows the total amount of cash a company gained
or lost during the reporting period. A positive net cash flow indicates a company had more cash
flowing into it than out of it, while a negative net cash flow indicates it spent more than it earned.

Sources of Information
Companies obtain the information to prepare the statement of cash flows from
several sources: (1) comparative balance sheets, (2) the current income statement,
and (3) selected transaction data.
Preparing the statement of cash flows from these sources involves four steps:
1. Determine the net cash provided by (or used in) operating activities.
2. Determine the net cash provided by (or used in) investing and financing activities.
3. Determine the change (increase or decrease) in cash during the period.
4. Reconcile the change in cash with the beginning and the ending cash balances.
Illustration The following are summary transactions that occurred during Year 9 for the
DEGITU Corporation:

Customers Received from

Customers 577,500
Interest on note receivable 10,500
Sale of investments 17,500
Proceeds from note payable 87,500
Sale of equipment 35,000
Issuance of common stock 175,000
Cash paid for:
Purchase of investments (not cash equivalents) 87,500

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 Interest on note payable 15,750
Purchase of equipment 105,000
Operating expenses 385,000
Principal on note payable 131,250
Payment of dividends to shareholders 26,250
The balance of cash and cash equivalents is Birr 113,750 at the beginning of Year 9 and Birr
266,000 at the end of Year 9.
A statement of cash flows prepared for Year 9 for DEGITU Corporation using the direct method
for reporting operating activities can be presented below.

Illustration Statement of Cash Flows (Direct Method)

DEGITU Corporation
Statement of Cash Flows
For the Year Ended December 31. Year 9
Cash Flows from Operating Activities
Collections from customers 577,500
Interest on note receivable 10,500
Interest on note payable 15,750
Payment of operating expenses (385,000)
Net cash inflows from operating activities 187,250
Cash Flows from Investing Activities
Purchase of investments (87,500)
Sale of investments 17,500
Purchase of equipment (105,000)
Sale of equipment 35,000
Net cash outflows from investing activities (140,000)
Cash Flows from Financing Activities
Proceeds from note payable 87,500
Payment of note payable (131,250)
Issuance of common stock 175,000

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Payment of dividends (26,250)
Net cash inflows from financing activities 105,000
Net increase in cash 152,250
Cash and cash equivalents, January 1 113,750
Cash and cash equivalents, December 31 266,000

Significant Noncash Activities

Not all of a company‘s significant activities involve cash. Examples of significant noncash
activities are:
 Issuance of common stock to purchase assets.
 Conversion of bonds into common stock.
 Issuance of debt to purchase assets.
 Exchanges of long-lived assets.
Significant financing and investing activities that do not affect cash are not reported in the body
of the statement of cash flows. Rather, these activities are reported in either a separate schedule
at the bottom of the statement of cash flows or in separate notes to the financial statements. Such
reporting of these noncash activities satisfies the full disclosure principle.

CHAPTER ENDS REVIEW QUESTIONS

I. MULTIPLE CHOICE QUESTIONS

Instructions: After reading each of the following question attentively choose the best answer
from a given Alternatives.

1. What is the purpose of the cash flow statement?

A. To show the profit or loss of a business
B. To show the changes in the cash balance of a business
C. To show the changes in the equity of a business
D. To show the changes in the assets of a business
2. Which of the following is an example of an operating cash flow?
A. Sale of long-term investment

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B. Purchase of equipment
C. Collection of accounts receivable
D. Repayment of long-term debt
3. Which of the following is an example of a financing cash flow?
A. Payment of accounts payable
B. Payment of interest on a loan
C. Issuance of bonds
D. Purchase of inventory
4. Which cash flow statement section reports the cash inflows and outflows from investing
activities?
A. Operating activities C. Investing activities
B. Financing activities D. None of the above
5. Which of the following is considered a non-cash transaction?
A. Purchase of equipment with cash
B. Sale of inventory for cash
C. Sale of equipment for notes payable
D. Payment of interest on a loan with cash
6. Which of the following is not an example of a cash equivalent?
A. Short-term investments C. Certificates of deposit
B. Treasury bills D. Accounts receivable
7. Which of the following is a direct method of preparing the cash flow statement?
A. Starting with net income and adjusting for non-cash items
B. Starting with the change in cash balance and adding and subtracting cash inflows and
outflows
C. Starting with the end-of-period cash balance and working backward to determine the sources
and uses of cash
D. None of the above
8. A positive cash flow from operating activities indicates:
A. The company is generating more cash than it is spending on operations
B. The company has a cash surplus
C. The company needs to borrow money to finance its operations

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D. The company is not profitable
9. Which financial statement is the cash flow statement most closely related to?
A. Balance sheet C. Statement of retained earnings
B. Income statement D. None of the above
10. What is the purpose of the statement of cash flows?
A. To provide information about a company's sources and uses of cash during a specific period
B. To provide information about a company's financial position at a specific point in time
C. To provide information about a company's profitability during a specific period
D. To provide information about a company's investments in other companies
11. What are the three sections of the statement of cash flows?
A. Operating activities, investing activities, and financing activities
B. Income statement, balance sheet, and statement of changes in equity
C. Revenue, expenses, and net income
D. Assets, liabilities, and equity
12. How are operating cash flows calculated?
A. By adjusting net income for non-cash items and changes in working capital accounts
B. By adding net income to changes in working capital accounts
C. By subtracting net income from changes in working capital accounts
D. By adding net income to non-cash items
13. What is the difference between direct and indirect methods of preparing the operating activities
section of the statement of cash flows?
A. Direct method shows actual cash inflows and outflows, while indirect method adjusts net income
for non-cash items and changes in working capital accounts
B. Indirect method shows actual cash inflows and outflows, while direct method adjusts net income
for non-cash items and changes in working capital accounts
C. Direct method only includes cash inflows, while indirect method only includes cash outflows
D. Direct method only includes cash outflows, while indirect method only includes cash inflows
14. What is the purpose of the statement of changes in equity?
A. To provide information about a company's sources and uses of cash during a specific period
B. To provide information about a company's financial position at a specific point in time
C. To provide information about a company's profitability during a specific period

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D. To provide information about changes in a company's equity accounts during a specific period

CHAPTER SIX

ASSET VALUATION FOR FINANCIAL REPORTING

6. INTRODUCTION

After completing this chapter students are expected to;

Understand the International valuation standards
Acquaint the fair value measurement and approaches
Understand the measurement and recognition of impairment loss

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 6.1. International Valuation Standards

International Valuation Standards (IVS) are a set of globally recognized standards that provide
guidance on how to undertake and report valuations. IVS is developed by the International Valuation
Standards Council (IVSC), which is an independent, not-for-profit organization that sets the
standards for the valuation profession worldwide.

The purpose of IVS is to promote consistency and transparency in valuation practices across
different countries and markets. It covers a wide range of valuation areas, including real estate,
business, financial instruments, and intangible assets.

IVS is used by valuation professionals, regulators, investors, and other stakeholders to ensure that
valuations are conducted in a consistent and transparent manner. It helps to provide confidence in the
valuation process and the results that are produced.

Overall, IVS plays an important role in promoting trust and confidence in the global financial
markets by ensuring that valuations are conducted in a professional and Business valuation is the
process of estimating the value of a company or business entity. The purpose of a business valuation
can vary, from determining the value of a business for sale or purchase, to determining the value for
tax, legal, or accounting purposes.

6.1.1. Valuation Approaches

There are three main approaches to business valuation: the income approach, the market approach,
and the asset-based approach.

1. Income approach: This approach is based on the income that the business generates. The
appraiser will estimate the potential income that the business could generate, and then apply a
capitalization rate or discount rate to arrive at an estimated value. The capitalization rate or
discount rate is based on the risk associated with the business, and is typically based on market
data from similar businesses in the industry.
2. Market approach: This approach involves comparing the subject business to similar businesses
that have recently sold in the same industry. The appraiser will make adjustments for any

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 differences between the subject business and the comparable businesses, such as size, revenue,
profitability, and market share, to arrive at an estimated value.
3. Asset-based approach: This approach involves estimating the value of the assets and liabilities
of the business. The appraiser will estimate the value of the assets, including tangible assets such
as property and equipment, and intangible assets such as patents and trademarks. The appraiser
will also estimate the value of the liabilities, such as loans and other debts. The difference
between the value of the assets and the value of the liabilities is the estimated value of the
business.

6.2. Fair value Measurement

Fair value is defined as ―the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the
measurement date.‖ ‖ Fair value is therefore a market-based measure. Recently,
IFRS has increasingly called for use of fair value measurements in the financial
statements. This is often referred to as the fair value principle.

6.2.1. Market participants

The market participants are the buyers and sellers in the principal market who are:

a. Independent or unrelated parties

b. Knowledgeable or having a reasonable understanding of the transaction
c. Willing or motivated but not forced and compelled to enter into the transaction
Principal or most advantageous market

An active market is a market in which transactions for the asset or liability take place with sufficient
regularity and volume to provide pricing information on an on-going basis. A principal market is the
market with the greatest volume and level of activity for the asset or liability.

In the absence of a principal market, the entity should consider the most advantageous market. The
most advantageous market is the market that maximizes the amount that would be received to sell
the asset or minimizes the amount that could be paid to transfer the liability. Generally, the market

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that an entity enters when it sells an asset or transfers a liability is the principal market or the most
advantageous market.

Valuation premise

In determining the fair value of an asset or a liability, an entity may refer to information that is
directly observable or readily available. The entity can also estimate the fair value by using a
valuation method. The fair value shall not be adjusted for transaction cost. If location is a
characteristic of an asset, the fair value shall be adjusted for transport cost that would be incurred to
transport the asset from its current location to the principal] or most advantageous market.

Highest and best use

In measuring the fair value of nonfinancial asset, an entity must take into consideration the highest
and best use of the asset. Highest and best use is defined as the use of nonfinancial asset by market
participants that would maximize the value of asset. The highest and best use of the asset should
possess the following:
a. Physically possible, meaning, it reflects the physical characteristics of an asset.
b. Legally permissible, meaning, it reflects any legal restrictions on the use of the asset.
c. Financially feasible, meaning, it reflects whether the use would generate sufficient income or
cash flows. The highest and best use of the asset might provide maximum value either on a
stand-alone basis, or as a group in combination with other asset and liability.
Valuation method
Three valuation techniques can be used to measure fair value:
a. Market approach - uses prices and relevant information for market transactions for identical
and comparable asset and liability.
b. Income approach - Focuses on converting future amounts into discounted cash flows.
c. Cost approach - relies on the current replacement cost to replace the asset with a comparable
asset.

6.2.2. Fair value hierarchy

The fair value hierarchy or best evidence of fair value is enumerated as follows:
1. Level 1 input is the quoted prices in an active market for identical asset or liability. A
quoted price in an active market provides the most reliable evidence of fair value and shall be
used without adjustment.

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 2. Level 2 inputs are inputs that are observable either directly or indirectly. Level 2 inputs
include quoted prices for similar/related/comparable asset or liability in an active market and
quoted prices for identical/equal/the same asset or liability in an inactive market.
3. Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs are
usually developed by the entity using the best available information from the entity's own
data. Level 3 inputs include the present value of estimated cash flows.

6.3. Impairment Measurement

Impairment is a fall in the market value of an asset so that the recoverable amount is now less than
the carrying amount in the statement of financial position. The carrying amount is the amount at
which an asset is recognized in the statement of financial position after deducting accumulated
depreciation and accumulated impairment loss.
Core principle of impairment
The basic principle underlying impairment of asset is relatively straightforward. There is an
established principle that an asset shall not be carried at above the recoverable amount. An entity
shall write down the carrying amount of an asset to the recoverable amount if the carrying amount is
not recoverable in full. If the carrying amount is higher than the recoverable amount, the asset is
judged to have suffered an impairment loss.
6.3.1. Accounting for impairment
In this regard, there are three main accounting issues to consider, namely:
a. Indication of possible impairment
b. Measurement of the recoverable amount
c. Recognition of impairment loss
[Link]. Indication of impairment
An entity shall assess at each reporting date whether there is any indication that an asset maybe
impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset.
However, irrespective of whether there is any indication of impairment, an entity shall test an
intangible asset with indefinite useful life or an intangible asset not yet available for use for
impairment annually by comparing the carrying amount with the recoverable amount. The events
and changes in circumstances that lead to an impairment of assets may be classified as external and
internal sources of information.
External sources

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a. Significant decrease or decline in the market value of the asset as a result of passage of time or
normal use or new competitor entering the market.
b. Significant change in the technological market, legal or economic environment of the business in
which the asset is employed. This could be as simple as a change in customer taste.
c. An increase in the interest rate or market rate of return on investment which will like affect the
discount rate used in calculating the value in use.
d. The carrying amount of net asset of the entity is more than the market capitalization. In other
words, the carrying amount exceeds the fair value of the net assets. The market capitalization simply
means the fair value of the net assets of the entity.
Internal Sources
a. Evidence of obsolescence or physical damage of an asset.
b. Significant change in the manner or extent in which asset is used with an adverse effect on the
entity. For example, the asset is part of restructuring or held for sale or the asset is idle.
c. Evidence that the economic performance of an asset will be worse than expected.
For example, the undiscounted net cash flows from the asset are significantly worse than those
budgets. The external and internal sources of information are not exhaustive. An entity may identify
other indications that an asset may be impaired.
[Link]. Measurement of recoverable amount.
After establishing evidence that an asset has been impaired, the next step is to determine the
recoverable amount preparatory to the recognition of an impairment loss. The recoverable amount of
an asset is the fair value less cost of disposal or value in use, whichever is higher.
Fair value less of cost of disposal
Fair value is the price that would be received to sell an asset in an orderly transaction between
market participants at the measurement date. Cost of disposal is an incremental cost directly
attributable to the disposal of an asset, excluding finance cost and income tax expense.
Examples of cost of disposal include legal cost, stamp duty and similar transaction tax, cost of
removing the asset, and direct cost in bringing the asset into condition for sale. In simple terms, fair
value less cost of disposal is equal to the exit price or selling price of an asset minus cost of
disposal.
Value in use

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Value in use is measured as the present value or discounted value of future net cash flows expected
to be derived from an asset. The cash flows are pretax cash flow and pretax discount rate is applied
in determining the present value.
Calculation of value in use
Calculating a value in use calls for estimates of future cash flows and there is the possibility that an
entity might come up with overoptimistic estimates of cash flows.
a. Cash flow projections shall be based on reasonable and supportable assumptions
b. Cash flow projections shall be based on the most recent budgets on financial forecasts, usually
up to a maximum period of 5 years, unless a longer period can be justified.
c. The discount rate used in estimating future cash flows is the current pretax rate.
Composition of estimates of future cash flows
Estimates of future cash flows include:
a. Projections of cash inflows from the continuing use of the asset.
b. Projections of cash outflows necessarily incurred to generate cash inflows from the continuing use
of the asset.
c. Net cash flows received or paid on the disposal of the asset at the end of its useful life in an arm‘s
length transaction.
Estimates of future cash flows do not include:
a. Future cash flows relating to restructuring to which the entity is not yet committed.
b. Future costs of improving or enhancing the asset‘s performance.
c. Cash inflows or outflows from financing activities.
d. Income tax receipts or payments.
[Link]. Recognition of impairment loss
If the recoverable amount of an asset is less than that carrying amount, an impairment loss has
occurred. The impairment loss shall be recognized immediately by reducing the asset‘s carrying
amount to its recoverable amount. The impairment loss is recognized in profit or loss and
presented separately in the income statement.

CHAPTER END REVIEW QUESTIONS

I. MULTIPLE CHOICE QUESTIONS

Instructions: After reading each of the following question attentively choose the best answer from a
given Alternatives;
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1. What is the definition of fair value?
A. The amount a company paid for an asset
B. The amount an asset could be sold for in an arm's length transaction between willing parties
C. The amount of depreciation taken on an asset over its useful life
D. The amount of revenue generated by an asset during a specific period
2. What is the purpose of impairment testing?
A. To determine the fair value of an asset
B. To determine if an asset's carrying value is greater than its recoverable amount
C. To determine the useful life of an asset
D. To determine the amount of depreciation to be taken on an asset during a specific period
3. What is the difference between historical cost and fair value accounting?
A. Historical cost accounting records assets at their original purchase price, while fair value
accounting records assets at their current market value
B. Historical cost accounting records assets at their current market value, while fair value
accounting records assets at their original purchase price
C. Historical cost accounting records assets at their net book value, while fair value accounting
records assets at their gross book value
D. Historical cost accounting records assets at their gross book value, while fair value accounting
records assets at their net book value
4. How are intangible assets valued?
A. At their original purchase price
B. At their current market value
C. At their net present value of expected future cash flows
D. At their replacement cost
5. What is the difference between tangible and intangible assets?
A. Tangible assets are physical assets, while intangible assets are non-physical assets
B. Tangible assets have a finite useful life, while intangible assets have an indefinite useful life
C. Tangible assets can be easily valued, while intangible assets are difficult to value
D. Tangible assets are recorded at their net book value, while intangible assets are recorded at their
gross book value
6. Which accounting standard requires fair value measurement of certain assets and liabilities?
A. IFRS 9
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B. IAS 16
C. FASB ASC 820
D. GAAP
7. What is the fair value hierarchy?
A. A system used to classify fair value measurements based on the reliability of inputs used
B. A system used to classify assets based on their useful life
C. A system used to determine the replacement cost of an asset
D. A system used to determine the net book value of an asset
8. What are Level 3 inputs in the fair value hierarchy?
A. Unobservable inputs based on management's own assumptions
B. Observable inputs based on market data
C. Inputs based on quoted prices in active markets for identical assets or liabilities
D. Inputs based on quoted prices in inactive markets for similar assets or liabilities
9. How is fair value measurement impacted by liquidity concerns?
A. Assets become more valuable when they are less liquid
B. Assets become less valuable when they are more liquid
C. Liabilities become more valuable when they are less liquid
D. Liabilities become less valuable when they are more liquid
10. What is the role of a valuation specialist in fair value measurement?
A. To provide an independent estimate of fair value for certain assets or liabilities
B. To determine the useful life of an asset
C. To record assets at their original purchase price
D. To determine the amount of depreciation to be taken on an asset during a specific period

11. Which accounting standard requires companies to disclose their accounting policies and
estimates?
A. IFRS 15
B. IAS 1
C. FASB ASC 606
D. GAAP
12. What is the purpose of the statement of cash flows?
A. To report a company's net income or loss
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B. To report a company's financial position at a specific point in time
C. To report a company's cash inflows and outflows during a specific period
D. To report a company's equity transactions during a specific period
13. What is the difference between a current asset and a non-current asset?
A. Current assets are expected to be converted to cash within one year, while non-current assets are
expected to be held for more than one year
B. Current assets are tangible assets, while non-current assets are intangible assets
C. Current assets are reported at their original cost, while non-current assets are reported at fair value
D. Current assets are used in the production of goods and services, while non-current assets are used
for administrative purposes
14. What is the purpose of the notes to the financial statements?
A. To provide additional information about the company's financial position, performance, and cash
flows
B. To provide a summary of the company's financial statements
C. To provide detailed information about the company's equity transactions
D. To provide information about the company's tax liabilities and payments
15. What is the difference between revenue and profit?
A. Revenue is the amount of money a company earns from its operations, while profit is the amount
of money a company earns after deducting expenses
B. Revenue is the amount of money a company earns from its investments, while profit is the
amount of money a company earns from its operations
C. Revenue is the amount of money a company earns from its equity transactions, while profit is the
amount of money a company earns from its debt transactions
D. Revenue is the amount of money a company earns from its financing activities, while profit is the
amount of money a company earns from its investing activities

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 JIMMA UNIVERSITY CONTINUING &
DISTANCE STUDIES

DEPARTMENT OF ACCOUNTING & FINANCE

ADVANCED FINANCIAL ACCOUNTING I (ACFN 4101)

ASSIGNMENT FOR DISTANCE LEARNERS

INSTRUCTIONS:

This booklet has three parts. Part I consists of 16 multiple-choice questions Part II consists of 1
Essay Questions and Part III 1 Workout questions. All the questions are compulsory and will be
marked. It is obligatory for you to strictly observe and follow the following instructions while
doing your assignment; otherwise you will loss the total mark for the Assignment:

 Only hand written answers are acceptable. Computer written answers or any
photocopied answers will not be accepted (will not be marked)
 Do not send back the question paper for the assignment to us. Send only your answer.
 Try to Work out all the questions by yourself. Any form of copying from friends will result
in complete disqualification of your assignment.

GIVE YOUR COMPLETE PERSONAL INFORMATION IN THE BLACK SPACE BELOW:

NAME:

ID. NO.:

COLLEGE:

DEPARTMENT:

COURSE TITLE AND NUMBER

CENTRE:

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 TELEPHONE:

Page 1 of 5

Page 106 of 112

Part One: Multiple Choice [15%]

Instruction: After reading each of the following questions attentively; choose the best
answer and write it only on the Answer sheet (1 point each).
1. Which of the following transactions have effect on the reciprocal ledger account?
A. Branch acquired land for br.500,000
B. Home office paid salaries for its employee amounted Br. 50,000
C. Branch remitted cash of Br.90,000 to the bank account belong to home office
D. Branch transfers inventory of Br. 40,000 at home office cost to another branch
under command of Home office.
E. All except ‘D’ F. All except ‘B’
2. At the end of an accounting period, the balance of the Investment in Branch ledger
account may not agree with the balance of the Home Office account because one of the
following reasons:
A. Branch sent check to home office on the last day of accounting period
B. Home office acquired equipment for its usage on the last day of accounting period
C. Branch collects trade account receivable from its customers on the last day of
accounting period
D. A home office plant asset is depreciated based on straight line method.
E. All of the Above
3. The tax base is;
A. The total amount of taxes collected by the government
B. The amount of taxable income or assets subject to taxation
C. The maximum allowable deductions from taxable income
D. The percentage of income tax owed based on the tax bracket
E. All of the above
4. Which of the following is an example of a temporary difference that creates a
deferred tax asset?
A. Depreciation expense is greater for tax purposes than accounting purpose
B. Depreciation expense is greater for accounting purposes than tax purpose
C. A business incurred a loss for tax purposes, but not for accounting purposes
D. A business incurred a profit for accounting purposes, but not for tax purposes
2
5. What is a characteristic of a stock appreciation right (SAR)?

3
 A. The employee is given the right to purchase shares at a certain price
B. The employee is given shares that vest over a certain period of time
C. The employee is given a right to the increase in the value of the company's stock
over a certain period of time
D. None of the above
6. Which of the following statement(s) is incorrect regarding the Accounting for share
based payments?
A. If the share based payment is cash settled, the compensation is equal to the fair
value of the share at grant date.
B. If the share based payment is equity settled, the compensation is equal to the
fair value of the share/ share options on the reporting date.
C. If the share options vest immediately, the employee is required to complete a
specified period of services before unconditionally entitled to the share
options.
D. All of the above
7. Which of the following is not an example of a biological asset?
A. Livestock C. Forestry Trees
B. Crops D. Land related to agricultural activity
8. Which of the following is not a requirement for a biological asset to be recognized in
the financial statements?
A. It must be probable that the future economic benefits will flow to the entity
B. Its fair value can be reliably measured
C. It must have a physical existence
D. It must be controlled by the entity
E. None of the above
9. Which of the following item is not agricultural produce?
A. Egg B. Cheese C. Banana D. Milk
10. One of the following statement is wrong about bearer plant;
A. A living plant that is used in the production or supply of agricultural produce.
B. The bearer plant is expected to bear a produce for more than one year.
C. Are accounted for under IPSAS 17, Property, Plant, and Equipment.
D. Are cultivated to be harvested as agricultural produce.
11. Biological assets are initially measured at fair value less estimated Point of sales costs.
The fair value of assets can be measured using active market. If an active market does
not exist, and then fair value is determined as per fair value hierarchy. All of the
following are among fair value hierarchy EXCEPT?
A. Recent transaction price for the asset if there is no active market.
B. Market prices for similar assets, adjusted for the points of difference.
4
C. Sector benchmarks.
D. Future value of the cash flows expected to be generated from the asset.

5
12. Which of the following is an example of a deferred tax liability?
A. Accrued vacation expense for financial statement purposes
B. Unearned revenue for financial statement purposes
C. Income recognized for tax purposes but not yet recognized for financial
statement purposes
D. None of the above
13. What is the difference between a deferred tax asset and a deferred tax liability?
A. A deferred tax asset reduces taxable income in the future, and a deferred tax
liability increases taxable income in the future
B. A deferred tax asset increases taxable income in the future, and a deferred
tax liability reduces taxable income in the future
C. A deferred tax asset is a tax credit, and a deferred tax liability is a tax deduction
D. A deferred tax asset and a deferred tax liability have the same effect on
taxable income in the future.
14. An entity on adoption of IAS 41 has reclassified forest as biological assets. The total
value of the group’s forest assets is $2 million comprising; Freestanding trees $1.7
million; Land under trees……200,000 & Roads in forests…….100,000. How this forest
would be classified in the financial statements?
A. Land under trees and free standing trees are presented under non-current asset
section of balance sheet
B. Freestanding trees & road in the forest are presented under the non-current asset
section as biological assets
C. Freestanding trees are presented as biological assets in the balance sheet while land
under trees and road in the forest are classified as non-current asset on the balance
sheet
D. All items will be reported on the balance sheet of entity as bearer pant.
15. is the difference between the tax basis of an asset or liability and its
reported (carrying or book) amount in the financial statements that will result in taxable
amounts or deductible amounts in future years.
A. Permanent difference C. Taxable income difference
B. Temporary difference D. Pre-tax financial income difference
PART II: ESSAY QUESTIONS

1. Assume Jimma Dairy cattle farm started raising, fattening and processing cattle in
the year 2020. It has currently more than 500 cows and 300 lambs. Some of its cattle
were slaughtered at the end of year 2020 and the raw meet were packed and sent to
manufacturing firms in Addis for processing to other end products.
Required
6
 a) Clearly define how those activities will be categorized in the financial
statement of the company considering the scope of IAS 41 (3 marks)
b) Define biological assets, agricultural produce & bearer plant considering
their examples from the above illustration (2 marks)

PART III: WORKOUT QUESTIONS

1. Assume On January 1, 2020, an awash insurance company granted 500 share options
each to 50 employees, conditional up on the employees remaining in the entity
during the vesting period. The share options vest at the end of a three year period.
On grant date, each share option has a fair value of Br.500. By December 31, 2020,
10 employees have left and it is expected that on the basis of a weighted average
probability a further 5 employees will leave during the vesting period. By December
31, 2021, 15 employees have left and it is expected that a further 3 employees will
leave during year. By December 31, 2022, 5 employees have left the company.
Required
a) Calculate the amount of yearly compensation expense & prepare necessary
journal entry for three year period ( 5 Marks)