Valuation of Inventories:

1 A Cost-Basis Approach

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Identify major classifications of 4. Understand the items to include as

inventory. inventory cost.

2. Determine the goods included in 5. Describe and compare the methods

inventory and the effects of inventory used to price inventories.
errors on the financial statements.

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 INVENTORY ISSUES

Classification
Inventories are assets:
◆ items held for sale in the ordinary course of business, or
◆ goods to be used in the production of goods to be sold.

Businesses with Inventory

Merchandising or Manufacturing
Company Company

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 INVENTORY ISSUES
ILLUSTRATION 8-1
Classification
◆ One inventory
account.

◆ Purchase
merchandise in
a form ready
for sale.

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 INVENTORY ISSUES
ILLUSTRATION 8-1
Classification
Three accounts
◆ Raw Materials

◆ Work in Process

◆ Finished Goods

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 INVENTORY ISSUES ILLUSTRATION 8-2
Flow of Costs through
Manufacturing and
Merchandising Companies

Classification

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 INVENTORY ISSUES

Inventory Control
All companies need periodic verification of the inventory records
◆ by actual count, weight, or measurement, with
◆ counts compared with detailed inventory records.

Companies should take the physical inventory

◆ near the end of their fiscal year,
◆ to properly report inventory quantities in their annual
accounting reports.

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 INVENTORY ISSUES

Basic Issues in Inventory Valuation

Companies must allocate the cost of all the goods available for
sale (or use) between the goods that were sold or used and
those that are still on hand.

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 Basic Issues in Inventory Valuation

Valuing inventories requires determining

1. The physical goods to include in inventory (who owns
the goods?—goods in transit, consigned goods, special
sales agreements).

2. The costs to include in inventory (product vs. period

costs).

3. The cost flow assumption to adopt (specific

identification, average-cost, FIFO, retail, etc.).

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 PHYSICAL GOODS INCLUDED IN
INVENTORY

A company should record inventory when it obtains legal title

to the goods.

ILLUSTRATION 8-6
Guidelines for Determining Ownership
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 GOODS INCLUDED IN INVENTORY

Goods in Transit
Example: LG (KOR) determines ownership by applying the
“passage of title” rule.
◆ If a supplier ships goods to LG f.o.b. shipping point, title
passes to LG when the supplier delivers the goods to the
common carrier, who acts as an agent for LG.
◆ If the supplier ships the goods f.o.b. destination, title
passes to LG only when it receives the goods from the
common carrier.
“Shipping point” and “destination” are often designated by a
particular location, for example, f.o.b. Seoul.

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 GOODS INCLUDED IN INVENTORY

Consigned Goods
Example: Williams Art Gallery (the consignor) ships various art
merchandise to Sotheby’s Holdings (USA) (the consignee), who
acts as Williams’ agent in selling the consigned goods.
◆ Sotheby’s agrees to accept the goods without any liability,
except to exercise due care and reasonable protection from
loss or damage, until it sells the goods to a third party.
◆ When Sotheby’s sells the goods, it remits the revenue, less a
selling commission and expenses incurred, to Williams.
Goods out on consignment remain the property of the consignor
(Williams).

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 GOODS INCLUDED IN INVENTORY

Sales with Repurchase Agreements

Example: Hill Enterprises transfers (“sells”) inventory to Chase,
Inc. and simultaneously agrees to repurchase this merchandise at
a specified price over a specified period of time. Chase then uses
the inventory as collateral and borrows against it.
◆ Essence of transaction is that Hill Enterprises is financing its
inventory—and retains control of the inventory—even though it
transferred to Chase technical legal title to the merchandise.
◆ Often described in practice as a “parking transaction.”
◆ Hill should report the inventory and related liability on its books.

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 GOODS INCLUDED IN INVENTORY

Sales with Rights of Return

Example: Quality Publishing Company sells textbooks to Campus
Bookstores with an agreement that Campus may return for full
credit any books not sold. Quality Publishing should recognize
a) Revenue from the textbooks sold that it expects will not be
returned.
b) A refund liability for the estimated books to be returned.
c) An asset for the books estimated to be returned which reduces
the cost of goods sold.
If Quality Publishing is unable to estimate the level of returns, it
should not report any revenue until the returns become predictive.
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 COSTS INCLUDED IN INVENTORY

Product Costs
Costs directly connected with bringing the goods to the buyer’s
place of business and converting such goods to a salable condition.

Cost of purchase includes all of:

1. The purchase price.

2. Import duties and other taxes.

3. Transportation costs.

4. Handling costs directly related to the acquisition of the goods.

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 COSTS INCLUDED IN INVENTORY

Period Costs
Costs that are indirectly related to the acquisition or production
of goods.

Period costs such as

◆ selling expenses and,

◆ general and administrative expenses

are not included as part of inventory cost.

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 COSTS INCLUDED IN INVENTORY

Treatment of Purchase Discounts

Purchase or trade discounts are reductions in the selling prices
granted to customers.

IASB requires these discounts to be recorded as a reduction

from the cost of inventories.

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 WHICH COST FLOW ASSUMPTIONS TO
ADOPT?

Cost Flow Methods

◆ Specific Identification

or

◆ Two cost flow assumptions

► First-in, First-out (FIFO) or

► Average Cost

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 Cost Flow Methods
To illustrate the cost flow methods, assume that Call-Mart Inc.
had the following transactions in its first month of operations.

Calculate Goods Available for Sale

Beginning inventory (2,000 x €4) € 8,000
Purchases:
6,000 x €4.40 26,400
2,000 x €4.75 9,500
Goods available for sale €43,900
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 Cost Flow Methods

Specific Identification
◆ IASB requires in cases where inventories are not ordinarily
interchangeable or for goods and services produced or
segregated for specific projects.

◆ Cost of goods sold includes costs of the specific items sold.

◆ Used when handling a relatively small number of costly,

easily distinguishable items.

◆ Matches actual costs against actual revenue.

◆ Cost flow matches the physical flow of the goods.

◆ May allow a company to manipulate net income.

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 Specific Identification
Illustration: Call-Mart Inc.’s 6,000 units of inventory consists of 1,000
units from the March 2 purchase, 3,000 from the March 15 purchase, and
2,000 from the March 30 purchase. Compute the amount of ending
inventory and cost of goods sold.

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 Cost Flow Assumptions

Average-Cost
◆ Prices items in the inventory on the basis of the average
cost of all similar goods available during the period.

◆ Not as subject to income manipulation.

◆ Measuring a specific physical flow of inventory is often

impossible.

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 Average-Cost

Weighted-Average Method

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 Average-Cost

Moving-Average Method

In this method, Call-Mart computes a new average unit cost each

time it makes a purchase.

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 Cost Flow Assumptions

First-In, First-Out (FIFO)

◆ Assumes goods are used in the order in which they are
purchased.

◆ Approximates the physical flow of goods.

◆ Ending inventory is close to current cost.

◆ Fails to match current costs against current revenues on

the income statement.

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 First-In, First-Out (FIFO)

Periodic Inventory System

Determine cost of ending inventory by taking the cost of the most

recent purchase and working back until it accounts for all units in the
inventory.
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 First-In, First-Out (FIFO)

Perpetual Inventory System

In all cases where FIFO is used, the inventory and cost of goods
sold would be the same at the end of the month whether a perpetual
or periodic system is used.

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 Inventory Valuation Methods—Summary

Comparison assumes periodic inventory procedures and the

following selected data.

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 Inventory Valuation Methods—Summary

ILLUSTRATION 8-17
Comparative Results of
Average-Cost and FIFO
Methods

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 Inventory Valuation Methods—Summary

When prices are rising, average-cost results in the higher cash

balance at year-end (because taxes are lower).

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 Inventories: Additional
1 Valuation Issues

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe and apply the lower-of- 5. Determine ending inventory by applying

cost-or-net realizable value rule. the gross profit method.

2. Explain when companies value 6. Determine ending inventory by applying

inventories at net realizable value. the retail inventory method.

3. Explain when companies use the 7. Explain how to report and analyze
relative standalone sales value method inventory.
to value inventories.
4. Discuss accounting issues related to
purchase commitments.
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 LOWER-OF-COST-OR-NET REALIZABLE
VALUE (LCNRV)

A company abandons the historical cost principle when

the future utility (revenue-producing ability) of the asset
drops below its original cost.

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 LCNRV

Net Realizable Value

Estimated selling price in the normal course of business less
◆ estimated costs to complete and

◆ estimated costs to make a sale.

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 LCNRV

Illustration of LCNRV: Jinn-Feng Foods computes its

inventory at LCNRV (amounts in thousands).

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 LCNRV

Methods of Applying LCNRV

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 LCNRV

Methods of Applying LCNRV

◆ In most situations, companies price inventory on an item-
by-item basis.

◆ Tax rules in some countries require that companies use an

individual-item basis.

◆ Individual-item approach gives the lowest valuation for

statement of financial position purposes.

◆ Method should be applied consistently from one period to

another.

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 Recording Net Realizable Value

Illustration: Data for Ricardo Company

Cost of goods sold (before adj. to NRV) €108,000
Ending inventory (cost) 82,000
Ending inventory (at NRV) 70,000

Loss Loss Due to Decline to NRV 12,000

Method Inventory (€82,000 - €70,000) 12,000

COGS Cost of Goods Sold 12,000

Method
Inventory 12,000

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 Recording Net Realizable Value

Partial Statement of Financial Position

Loss COGS
Method Method
Current assets:
Inventory € 70,000 € 70,000
Prepaids 20,000 20,000
Accounts receivable 350,000 350,000
Cash 100,000 100,000
Total current assets 540,000 540,000

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 Recording Net Realizable Value
Loss COGS
Income Statement Method Method
Sales € 200,000 € 200,000
Cost of goods sold 108,000 120,000
Gross profit 92,000 80,000
Operating expenses:
Selling 45,000 45,000
General and administrative 20,000 20,000
Total operating expenses 65,000 65,000
Other income and expense:
Loss due to decline of inventory to NRV 12,000 -
Interest income 5,000 5,000
Total other (7,000) 5,000
Income from operations 20,000 20,000
Income tax expense 6,000 6,000
Net income € 14,000 € 14,000
9-9
 LCNRV

Use of an Allowance
Instead of crediting the Inventory account for net realizable
value adjustments, companies generally use an allowance
account.

Loss Method

Loss Due to Decline to NRV 12,000

Allowance to Reduce Inventory to NRV 12,000

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 Use of an Allowance

Partial Statement of Financial Position

No
Allowance Allowance
Current assets:
Inventory € 70,000 € 82,000
Allowance to reduce inventory (12,000)
Inventory at NRV 70,000
Prepaids 20,000 20,000
Accounts receivable 350,000 350,000
Cash 100,000 100,000
Total current assets 540,000 540,000

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 LCNRV

Recovery of Inventory Loss

◆ Amount of write-down is reversed.

◆ Reversal limited to amount of original write-down.

Continuing the Ricardo example, assume the net realizable

value increases to €74,000 (an increase of €4,000). Ricardo
makes the following entry, using the loss method.

Allowance to Reduce Inventory to NRV 4,000

Recovery of Inventory Loss 4,000

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 Recovery of Inventory Loss

Allowance account is adjusted in subsequent periods, such

that inventory is reported at the LCNRV.
Illustration shows net realizable value evaluation for Vuko Company
and the effect of net realizable value adjustments on income.

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 Evaluation of LCM Rule

LCNRV rule suffers some conceptual deficiencies:

1. A company recognizes decreases in the value of the asset
and the charge to expense in the period in which the loss in
utility occurs—not in the period of sale.
2. Application of the rule results in inconsistency because a
company may value the inventory at cost in one year and at
net realizable value in the next year.
3. LCNRV values the inventory in the statement of financial
position conservatively, but its effect on the income statement
may or may not be conservative. Net income for the year in
which a company takes the loss is definitely lower. Net
income of the subsequent period may be higher than normal if
the expected reductions in sales price do not materialize.
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 LCNRV
P9-1: Remmers Company manufactures desks. Most of the
company’s desks are standard models and are sold on the basis of
catalog prices. At December 31, 2015, the following finished desks
appear in the company’s inventory.

Finished Desks A B C D
Catalog selling price € 500 € 540 € 900 € 1,200
FIFO cost per inventory list 12/31/15 470 450 830 960
Estimated cost to complete and sell 50 110 260 200

Instructions: At what amount should the desks appear in the

company’s December 31, 2015, inventory, assuming that the company
has adopted a lower-of-FIFO-cost-or-net realizable value approach for
valuation of inventories on an individual-item basis?

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 LCNRV
P9-1: Remmers Company manufactures desks. Most of the
company’s desks are standard models and are sold on the basis of
catalog prices. At December 31, 2015, the following finished desks
appear in the company’s inventory.

Finished Desks A B C D
Catalog selling price € 500 € 540 € 900 € 1,200
FIFO cost per inventory list 12/31/15 470 450 830 960
Estimated cost to complete and sell 50 110 260 200
Net realizable value 450 430 640 1,000
Lower-of-cost-or-NRV 450 430 640 960

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 VALUATION BASES

Special Valuation Situations

Departure from LCNRV rule may be justified in situations when

◆ cost is difficult to determine,

◆ items are readily marketable at quoted market prices, and

◆ units of product are interchangeable.

Two common situations in which NRV is the general rule:

◆ Agricultural assets

◆ Commodities held by broker-traders.

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 VALUATION BASES

Valuation Using Relative Standalone Sales

Value
Used when buying varying units in a single lump-sum purchase.

Illustration: Woodland Developers purchases land for $1 million

that it will subdivide into 400 lots. These lots are of different sizes
and shapes but can be roughly sorted into three groups graded A,
B, and C. As Woodland sells the lots, it apportions the purchase
cost of $1 million among the lots sold and the lots remaining on
hand. Calculate the cost of lots sold and gross profit.

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 VALUATION BASES

ILLUSTRATION 9-11
Determination of Gross Profit,
Using Relative Standalone Sales Value

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 GROSS PROFIT METHOD OF
ESTIMATING INVENTORY

Substitute Measure to Approximate Inventory

Relies on three assumptions:

1. Beginning inventory plus purchases equal total goods to be
accounted for.

2. Goods not sold must be on hand.

3. The sales, reduced to cost, deducted from the sum of the

opening inventory plus purchases, equal ending inventory.

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 GROSS PROFIT METHOD

Illustration: Cetus Corp. has a beginning inventory of €60,000

and purchases of €200,000, both at cost. Sales at selling price
amount to €280,000. The gross profit on selling price is 30
percent. Cetus applies the gross margin method as follows.

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 GROSS PROFIT METHOD

Computation of Gross Profit Percentage

Illustration: In Illustration 9-13, the gross profit was a given. But
how did Cetus derive that figure? To see how to compute a gross
profit percentage, assume that an article cost €15 and sells for
€20, a gross profit of €5.

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 GROSS PROFIT METHOD

9-23
 GROSS PROFIT METHOD

Illustration: Astaire Company uses the gross profit method to

estimate inventory for monthly reporting purposes. Presented below is
information for the month of May.
Inventory, May 1 € 160,000 Sales € 1,000,000
Purchases (gross) 640,000 Sales returns 70,000
Freight-in 30,000 Purchases discounts 12,000

Instructions:
(a) Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of sales.
(b) Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of cost.

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 GROSS PROFIT METHOD
(a) Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of sales.

Inventory, May 1 (at cost) € 160,000

Purchases (gross) (at cost) 640,000
Purchase discounts (12,000)
Freight-in 30,000
Goods available (at cost) 818,000
Sales (at selling price) € 1,000,000
Sales returns (at selling price) (70,000)
Net sales (at selling price) 930,000
Less: Gross profit (25% of €930,000) 232,500
Sales (at cost) 697,500
Approximate inventory, May 31 (at cost) € 120,500

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 GROSS PROFIT METHOD
(b) Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of cost.

Inventory, May 1 (at cost) € 160,000

Purchases (gross) (at cost) 640,000
25%
Purchase discounts = 20% of sales (12,000)
100% + 25%
Freight-in 30,000
Goods available (at cost) 818,000
Sales (at selling price) € 1,000,000
Sales returns (at selling price) (70,000)
Net sales (at selling price) 930,000
Less: Gross profit (20% of €930,000) 186,000
Sales (at cost) 744,000
Approximate inventory, May 31 (at cost) € 74,000

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 GROSS PROFIT METHOD

Evaluation of Gross Profit Method

Disadvantages
1) Provides an estimate of ending inventory.

2) Uses past percentages in calculation.

3) A blanket gross profit rate may not be representative.

4) Normally unacceptable for financial reporting purposes

because it provides only an estimate.

IFRS requires a physical inventory as additional verification of

the inventory indicated in the records.

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 RETAIL INVENTORY METHOD

Method used by retailers to compile inventories at retail prices.

Retailer can use a formula to convert retail prices to cost.
Requires retailers to keep a record of:
1) Total cost and retail value of goods purchased.

2) Total cost and retail value of the goods available for sale.

3) Sales for the period.

Methods
◆ Conventional Method (or LCNRV)
◆ Cost Method

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 ⚫ For retailers, the term markup means an additional markup of the
original retail price.
⚫ Markup cancellations are decreases in prices of merchandise that
the retailer had marked up above the original retail price.
⚫ In a competitive market, retailers often need to use markdowns,
which are decreases in the original sales prices.
⚫ Markdown cancellations occur when the markdowns are later
offset by increases in the prices of goods that the retailer had
marked down—such as after a one-day sale.
⚫ Neither a markup cancellation nor a markdown cancellation can
exceed the original markup or markdown.

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⚫ To illustrate these concepts, assume that Designer Clothing
Store recently purchased 100 dress shirts from Marroway,
Inc. The cost for these shirts was €1,500, or €15 a shirt.
Designer Clothing established the selling price on these
shirts at €30 a shirt. The shirts were selling quickly, so the
manager added a markup of €5 per shirt. This markup
made the price too high for customers, and sales slowed.
The manager then reduced the price to €32. At this point,
we would say that the shirts at Designer Clothing have had
a markup of €5 and a markup cancellation of €3.
⚫ A month later, the manager marked down the remaining
shirts to a sales price of €23. At this point, an additional
markup cancellation of €2 has taken place, and a €7
markdown has occurred. If the manager later increases the
price of the shirts to €24, a markdown cancellation of €1
would occur.
9-30
 ⚫ Freight costs are part of the purchase cost.
⚫ Purchase returns are ordinarily considered as
a reduction of the price at both cost and retail.
⚫ Purchase discounts and allowances usually
are considered as a reduction of the cost of
purchases.

9-31
 ⚫ Transfers-in from another department are reported in the same
way as purchases from an outside enterprise.
⚫ Normal shortages (breakage, damage, theft, shrinkage) should
reduce the retail column because these goods are no longer
available for sale. Such costs are reflected in the selling price
because a certain amount of shortage is considered normal in a
retail enterprise. As a result, companies do not consider this amount
in computing the cost-to-retail percentage. Rather, to arrive at
ending inventory at retail, they show normal shortages as a
deduction similar to sales.
⚫ Abnormal shortages, on the other hand, are deducted from both
the cost and retail columns and reported as a special inventory
amount or as a loss. To do otherwise distorts the cost-to-retail ratio
and overstates ending inventory.
⚫ Employee discounts (given to employees to encourage loyalty,
better performance, and so on) are deducted from the retail column
in the same way as sales. These discounts should not be
considered in the cost-to-retail percentage because they do not
reflect an overall change in the selling price.
9-32
 ⚫ The cost/retail ratio makes up one of the main
components used to calculate the retail inventory
method. Two methods exist for calculating the cost/retail
ratio.
⚫ The first method, called the conventional retail method
includes markups but excludes markdowns. This method
results in a lower ending inventory value.
⚫ To approach the lower of cost or NRV consider
markdown as a current loss and not included in
calculating the cost to retail ratio, omitting the
markdown makes the cost to retail ratio lower
which lead to the lower of cost or NRV.
⚫ The second method, simply called the retail method,
uses both markups and markdowns to calculate the
ratio. This method results in a higher-ending inventory
value.
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9-34
 RETAIL INVENTORY METHOD
Illustration: The following data pertain to a single department for
the month of October for Fuque Inc. Prepare a schedule computing
retail inventory using the Conventional and Cost methods.

COST RETAIL
Beg. inventory, Oct. 1 £ 52,000 £ 78,000
Purchases 272,000 423,000
Freight in 16,600
Purchase returns 5,600 8,000
Additional markups 9,000
Markup cancellations 2,000
Markdowns (net) 3,600
Normal spoilage and breakage 10,000
Sales 390,000
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 RETAIL INVENTORY METHOD

CONVENTIONAL Method: Cost to

COST RETAIL Retail %
Beginning inventory £ 52,000 £ 78,000
Purchases 272,000 423,000
Purchase returns (5,600) (8,000)
Freight in 16,600
Markups, net 7,000
Current year additions 283,000 422,000
Goods available for sale 335,000 500,000 67.0%
Markdowns, net (3,600)
Normal spoilage and breakage (10,000)
Sales (390,000)
Ending inventory at retail £ 96,400

Ending inventory at Cost:

£ 96,400 x 67.0% = £ 64,588

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 RETAIL INVENTORY METHOD

COST Method: Cost to

COST RETAIL Retail %
Beginning inventory £ 52,000 £ 78,000
Purchases 272,000 423,000
Purchase returns (5,600) (8,000)
Freight in 16,600
Markdowns, net (3,600)
Markups, net 7,000
Current year additions 283,000 418,400
Goods available for sale 335,000 496,400 67.49%
Normal spoilage and breakage (10,000)
Sales (390,000)
Ending inventory at retail £ 96,400

Ending inventory at Cost:

£ 96,400 x 67.49% = £ 65,060

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 RETAIL INVENTORY METHOD

Special Items Relating to Retail Method

◆ Freight costs
◆ Purchase returns
◆ Purchase discounts and allowances
◆ Transfers-in
When sales are recorded
◆ Normal shortages
gross, companies do not
◆ Abnormal shortages recognize sales discounts.

◆ Employee discounts

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 RETAIL INVENTORY METHOD

Special
Items

ILLUSTRATION 9-22
Conventional Retail
Inventory Method—
Special Items Included

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 RETAIL INVENTORY METHOD

Evaluation of Retail Inventory Method

Used for the following reasons:
1) To permit the computation of net income without a physical
count of inventory.

2) Control measure in determining inventory shortages.

3) Regulating quantities of merchandise on hand.

4) Insurance information.

Some companies refine the retail method by computing inventory separately by

departments or class of merchandise with similar gross profits.

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 PRESENTATION AND ANALYSIS

Presentation of Inventories
Accounting standards require disclosure of:
1) Accounting policies adopted in measuring inventories,
including the cost formula used (weighted-average, FIFO).

2) Total carrying amount of inventories and the carrying

amount in classifications (merchandise, production supplies,
raw materials, work in progress, and finished goods).

3) Carrying amount of inventories carried at fair value less

costs to sell.

4) Amount of inventories recognized as an expense during the

period.
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 PRESENTATION AND ANALYSIS

Presentation of Inventories
Accounting standards require disclosure of:
5) Amount of any write-down of inventories recognized as
an expense in the period and the amount of any reversal
of write-downs recognized as a reduction of expense in
the period.

6) Circumstances or events that led to the reversal of a

write-down of inventories.

7) Carrying amount of inventories pledged as security for

liabilities, if any.

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 PREVIEW OF CHAPTER 2

Topics/Learning Objectives (L.O.)

1. Nature of plant assets
2. Cost of plant assets/Valuation
3. Costs after acquisition
4. Depreciation & depletion of plant assets
5. Disposition of plant assets
6. Nature, cost, & amortization of intangible assets

10-1
 1. NATURE OF PROPERTY, PLANT, AND EQUIPMENT

Property, plant, and equipment are assets of a durable nature.

Other terms commonly used are plant assets, fixed assets, and
capital assets.
 Includes:
 Major characteristics:
▪Land,
▪ “Used in operations” and not for resale/investment.
▪Building
▪ Include standby assets (in non-continuous use)
structures
▪ Exclude idle assets (land or building)-investment (offices,
▪ Revenue producing assets-productive purpose factories,

▪ Long-term/long-lived in nature and usually depreciated. warehouses),

and
▪ Long-term prepayments
▪Equipment
▪ Bundle of future services (machinery,
▪ Possess physical substance. furniture,
▪ Tangible in nature-fixed in nature tools).

▪ Conversion (indirect) cost to a product

10-2
▪ Not directly incorporated/become part of a product
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

Guideline for Initial Valuation

▪ Historical cost [Cost principle] measures the cash or cash

equivalent price of obtaining the asset and bringing it to the
location and condition necessary for its intended use.

▪ Cost consists of all expenditures necessary & reasonable

to acquire an asset and make it ready for its intended use.

▪ Companies value property, plant, and equipment in

subsequent periods using either the
◆ cost method or
◆ fair value (revaluation) method.

10-3
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

Cost Components/Elements [Subject to Mode of Acquisition]

❖ Cost of Land
All expenditures made to acquire land and ready it for use.
Costs typically include:
(1) purchase price;
(2) closing costs, such as title (fees) to the land, attorney’s fees,
recording fees, sales taxes, broker’s commission
(3) costs of surveying, grading, filling, leveling, draining, and clearing;
(4) Razing or removing unwanted buildings, less the salvage
(5) assumption of any liens (delinquent real estate taxes),
mortgages, or encumbrances on the property; and
(6) additional land improvements that have an indefinite life (Paving a
public street bordering the land)
10-4
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

❖ Cost of Land
◆ Improvements with limited lives, such as private
driveways, walks, fences, and parking lots, are recorded
as Land Improvements and depreciated.

◆ Land acquired and held for speculation is classified as an

investment.

◆ Land held by a real estate concern for resale should be

classified as inventory.

10-5
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

Illustration: Sunrise Company acquires real estate at a cash

cost of Br.100,000. The property contains an old warehouse
that is razed at a net cost of Br.6,000 (Br.7,500 in costs less
Br.1,500 proceeds from salvaged materials). Additional
expenditures are the attorney’s fee, Br.1,000, and the real
estate broker’s commission, Br.8,000.

Required: Determine the amount to be reported as the cost of

the land.

10-6
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

Required: Determine amount to be reported as the cost of the

land.
Land
Cash price of property (Br.100,000) Br.100,000
Net removal cost of warehouse (Br.7,500-Br.1,500) 6,000
Attorney's fees (Br.1,000) 1,000
Real estate broker’s commission (Br.8,000) 8,000
Cost of Land Br.115,000
Illustration 10-2
Computation of cost of land

10-7
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

❖ Cost of Land Improvements

Structural additions made to land. Cost includes all
expenditures necessary to make the improvements ready
for their intended use.

◆ Examples: driveways, parking lots, fences, landscaping,

and underground sprinklers, trees and shrubs, outdoor
lighting, concrete sewers and drainage.
◆ Limited useful lives.

◆ Expense (depreciate) the cost of land improvements over

their useful lives.

10-8
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

❖COST OF BUILDINGS
Includes all costs related directly to purchase or construction.
Purchase costs:
◆ Purchase price, closing costs (attorney’s fees, title insurance, etc.)
and real estate broker’s commission.
◆ Remodeling, and replacing or repairing the roof, floors, electrical
wiring, and plumbing. Reconditioning (purchase of an existing
building)
Construction costs:
◆ materials, labor, and overhead costs incurred during construction
and professional fees and building permits.
◆ Contract price plus payments for architects’ fees, Engineers’ fees,
building permits, and excavation costs.
◆ Companies consider all costs incurred, from excavation to
completion, as part of the building costs.
◆ Insurance & interest costs incurred during construction
10-9
◆ Walkways to and around the building
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

Illustration: The expenditures and receipts below are related to land,

land improvements, and buildings acquired for use in a business
enterprise. Determine how the following should be classified:

a. Money borrowed to pay building contractor a. Notes Payable

(signed a note)
b. Payment for construction from note proceeds b. Buildings
c. Cost of land fill and clearing c. Land
d. Delinquent real estate taxes on property d. Land
assumed by purchaser
e. Premium on 6-month insurance policy during e. Buildings
construction

10-10
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

Illustration: Determine how the following should be classified:

f. Refund of 1-month insurance premium f. (Buildings)

because construction completed early
g. Architect’s fee on building g. Buildings
h. Cost of real estate purchased as a plant site h. Land
(land Br.200,000 and building Br.50,000)
i. Commission fee paid to real estate agency i. Land
j. Cost of razing and removing building j. Land
k. Installation of fences around property k. Land
Improvements

10-11
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

Illustration: Determine how the following should be classified:

l. Proceeds from residual value of demolished l. (Land)

building
m. Interest paid during construction on money m. Buildings
borrowed for construction
n. Land
n. Cost of parking lots and driveways
Improvements
o. Cost of trees and shrubbery planted o. Land
(permanent in nature)
p. Excavation costs for new building p. Buildings

10-12
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

❖ Cost of Equipment
Include all expenditures incurred in acquiring the equipment
and preparing it for use. Costs include:
◆ Cash purchase price,
◆ freight and handling charges,
◆ insurance on the equipment while in transit,
◆ cost of special foundations if required,
◆ assembling and installation costs, and
◆ costs of conducting trial runs.
◆ Sales taxes
◆ Repairs (purchase of used equipment)
◆ Reconditioning (purchase of used equipment)
◆ Modifying for use

10-13
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

Illustration: Lenard Company purchases a delivery truck at a

cash price of Br.22,000. Related expenditures are sales taxes
Br.1,320, painting and lettering Br.500, motor vehicle license $80,
and a three-year accident insurance policy Br.1,600. Compute the
cost of the delivery truck.
Truck
Cash price Br.22,000
Sales taxes 1,320
Painting and lettering 500

Cost of Delivery Truck Br.23,820

10-14
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

Illustration: Lenard Company purchases a delivery truck at a

cash price of Br.22,000. Related expenditures are sales taxes
Br.1,320, painting and lettering Br.500, motor vehicle license
Br.80, and a three-year accident insurance policy Br.1,600.
Prepare the journal entry to record these costs.

Equipment 23,820
License Expense 80
Prepaid Insurance 1,600
Cash 25,500

10-15
 2. ACQUISITION COST OF PP&E [INITIAL VALUATION]

❖ Cost of Acquiring Fixed Assets Excludes:

▪Vandalism (deliberate destruction of property)
▪Mistakes in installation
▪Uninsured theft
▪Damage during unpacking and installing
▪Fines for not obtaining proper permits from
government agencies

10-16
2. Special Issues
a) Self-Construction
Factory Overhead [FOH]
Interest cost [Debt Financing]
b) Savings or loss on self-construction
c) Cash discounts
c) Deferred payment contracts
d) Issuance of shares
e) Group/Basket/Lump sum purchases (vs.
individual/separate)
f) Donations/Grants/Gifts
g) Exchanges of non-monetary assets
10-17
 Valuation of PPE-Interest Capitalization
Self-Constructed assets: These are assets constructed by the
business for use in operations.
Costs include:
◆ Materials and direct labor
◆ Direct/Variable manufacturing overhead
◆ Interest during construction [b/c of HC & Matching principles]
◆ Pro rata portion of indirect manufacturing overhead, i.e. Full
costing approach.
➢ Full costing is the most commonly used and is the generally
accepted method used to allocate the indirect MOH between
the normal operation (inventories) and self-construction. That
is all overhead costs are allocated both to production and to
self-constructed assets based on the relative amount of a
chosen cost driver (for example, labor hours) incurred.

10-18
 Valuation of PPE-Interest Capitalization

Interest Costs During Construction

Three approaches have been suggested to account for the
interest incurred in financing the construction.

$0
Increase to Cost of Asset $?

Capitalize no Capitalize
interest during Capitalize actual all costs of
construction costs incurred during funds
construction

ILLUSTRATION 10-1
Capitalization of Interest
Costs IFRS

10-19
 Valuation of PPE-Interest Capitalization

◆ IFRS requires — capitalizing actual interest (with

modification).

◆ Interest should be capitalized on all “pre-

earning” assets
◆ Consistent with historical cost.

◆ Capitalization considers three items:

1. Qualifying assets.

2. Capitalization period.

3. Amount to capitalize.

10-20
 Valuation of PPE-Interest Capitalization

Qualifying Assets
Require a substantial period of time to get them ready for their
intended use or sale.
Two types of assets:
 Assets under construction for a company’s own use.
 Assets intended for sale or lease that are constructed or
produced as discrete projects.
Non-qualifying assets include:
Inventories that are routinely manufactured.
Assets that are in use or ready for their intended use.
Assets that are not being used in the earning activities of the
company and are not undergoing the activities necessary to
get them ready for use.
10-21
 Valuation of PPE-Interest Capitalization
Capitalization Period
Begins when:
1. Expenditures for the assets are being incurred.
2. Activities for readying the asset for use or sale are in progress .
3. Interest costs are being incurred.
➢ Capitalization continues for as long as these three conditions exist or
ceases when any one of the three conditions is not met or when the
asset is substantially completed.
➢ If the first condition is not met, the conceptual basis for interest
capitalization is absent.
➢ If the second condition is not met, construction activities are not the
cause of the opportunity cost.
➢ If the third condition is not met, there is no interest to capitalize.
Ends when:
The asset is substantially complete and ready for use

10-22
 Valuation of PPE-Interest Capitalization
Interrupted when:
➢ Brief & inherent in normal construction work (e.g. labor disputes)-
Capitalization continues
➢ Intentional delays (e.g. customer choice of fixtures)-Capitalization
discontinued.

❖ Capitalization period: time between the expenditure date and the

date interest capitalization stops or year-end (whichever comes first)

❖ If the construction period covers more than one fiscal period,

accumulated expenditures include prior years’ capitalized
interest. (See comprehensive illus #2)

10-23
 Valuation of PPE-Interest Capitalization

Amount to Capitalize
Capitalize the lesser of:
1. Actual interest cost incurred [both on the specific & general
or other loans].
2. Avoidable interest (Interest Potentially Capitalizable =IPC):
the amount of interest cost during the period that a
company could theoretically avoid if it had not made
expenditures for the asset. Or Avoidable interest is the
amount that could have been avoided, if expenditures for
the asset had not been made. It is a function of AAE.
➢ Average Accumulated Expenditures [AAE]-is a measure of
the debt that could have been retired and is the average
cash investment during the construction period.
10-24
 Valuation of PPE-Interest Capitalization

Illustration: Assume a company borrowed $200,000 at 12% interest

from State Bank on Jan. 1, 2015, for specific purposes of constructing
special-purpose equipment to be used in its operations. Construction on
the equipment began on Jan. 1, 2015, and the following expenditures
were made prior to the project’s completion on Dec. 31, 2015:

Actual Expenditures during 2015: Other general debt existing on

January 1 $ 100,000 Jan. 1, 2015:
April 30 150,000
$500,000, 14%, 10-year
November 1 300,000 bonds payable
December 31 100,000
Total expenditures $ 650,000 $300,000, 10%, 5-year
note payable

10-25
 Valuation of PPE-Interest Capitalization

Step 1 - Determine which assets qualify for capitalization of

interest.
Special purpose equipment qualifies because it requires a period of
time to get ready and it will be used in the company’s operations.

Step 2 - Determine the capitalization period.

The capitalization period is from Jan. 1, 2015 through Dec. 31, 2015,
because expenditures are being made and interest costs are being
incurred during this period while construction is taking place.

10-26
 Valuation of PPE-Interest Capitalization

Step 3 - Compute weighted-average accumulated

expenditures (WAAE).
Weighted
Average
Actual Capitalization Accumulated
Date Expenditures Period Expenditures
Jan. 1 $ 100,000 12/12 $ 100,000
Apr. 30 150,000 8/12 100,000
Nov. 1 300,000 2/12 50,000
Dec. 31 100,000 0/12 -
$ 650,000 $ 250,000

A company weights the construction expenditures by the amount of time

(fraction of a year or accounting period) that it can incur interest cost on the
expenditure.
10-27
 Valuation of PPE-Interest Capitalization

Step 4 - Compute the Actual and Avoidable Interest.

Selecting Appropriate Interest Rate:

1. For the portion of weighted-average accumulated expenditures
that is less than or equal to any amounts borrowed specifically to
finance construction of the assets, use the interest rate incurred
on the specific borrowings.

2. For the portion of weighted-average accumulated expenditures

that is greater than any debt incurred specifically to finance
construction of the assets, use a weighted average of interest
rates incurred on all other outstanding debt during the
period.

10-28
 Valuation of PPE-Interest Capitalization

Step 4 - Compute the Actual and Avoidable Interest.

Actual Interest
Interest Actual
Debt Rate Interest Weighted-average
Specific Debt $ 200,000 12% $ 24,000 interest rate on
general debt
General Debt 500,000 14% 70,000 $100,000
= 12.5%
300,000 10% 30,000 $800,000
$ 1,000,000 $ 124,000

Accumulated Interest Avoidable

Avoidable Interest Expenditures Rate Interest
$ 200,000 12% $ 24,000
50,000 12.5% 6,250
$ 250,000 $ 30,250
10-29
 Valuation of PPE-Interest Capitalization

Step 5 – Capitalize the lesser of Avoidable interest or Actual

interest.

Avoidable interest $ 30,250

Actual interest 124,000

Journal entry to Capitalize Interest:

Equipment 30,250
Interest Expense 30,250

10-30
 Valuation of PPE-Interest Capitalization

Comprehensive Illustration 1: On November 1, 2014, ABC

Company contracted Pfeifer Construction Co. to construct a building
for $1,400,000 on land costing $100,000 (purchased from the
contractor and included in the first payment). ABC made the
following payments to the construction company during 2015.

10-31
 Valuation of PPE-Interest Capitalization

ABC Construction completed the building, ready for occupancy, on

December 31, 2015. ABC had the following debt outstanding at
December 31, 2015.
Specific Construction Debt
1. 15%, 3-year note to finance purchase of land and
construction of the building, dated December 31, 2014, with
interest payable annually on December 31 $750,000
Other Debt
2. 10%, 5-year note payable, dated December 31, 2011, with
interest payable annually on December 31 $550,000
3. 12%, 10-year bonds issued December 31, 2010, with
interest payable annually on December 31 $600,000

Compute weighted-average accumulated expenditures for 2015.

10-32
 Valuation of PPE-Interest Capitalization

Compute weighted-average accumulated expenditures for 2015.

10-33
 Valuation of PPE-Interest Capitalization

Compute the avoidable interest.

10-34
 Valuation of PPE-Interest Capitalization

Compute the actual interest cost, which represents the maximum

amount of interest that it may capitalize during 2015.

The interest cost that Shalla capitalizes is the

lesser of $120,228 (avoidable interest) and
$239,500 (actual interest), or $120,228.

10-35
 Valuation of PPE-Interest Capitalization

ABC records the following journal entries during 2015:

January 1 Land 100,000

Buildings (or CIP) 110,000
Cash 210,000
March 1 Buildings 300,000
Cash 300,000
May 1 Buildings 540,000
Cash 540,000
December 31 Buildings 450,000
Cash 450,000
Buildings (Capitalized Interest) 120,228
Interest Expense 119,272
Cash 239,500

10-36
 Valuation of PPE-Interest Capitalization

At December 31, 2015, ABC discloses the amount of interest

capitalized either as part of the income statement or in the notes
accompanying the financial statements.

10-37
 Valuation of PPE-Interest Capitalization

Special Issues Related to Interest Capitalization

1. Expenditures for Land
◆ If land is purchased as a site for a structure, interest
costs capitalized during the period of construction are
part of the cost of the plant, not the land.

◆ Conversely, if the company develops land for lot sales,

it includes any capitalized interest cost as part of the
acquisition cost of the developed land.

2. Interest Revenue
◆ In general, companies should not offset interest revenue
against interest cost unless earned on specific borrowings.
10-38
 Valuation of PPE- Savings or Loss on Self-Construction

⚫ When the cost of self-construction of an asset is less

than the cost to acquire it through purchase or
construction from outsiders, the difference is not a
profit, but a savings.
• When the cost is greater than the cost to acquire it
through purchase or construction from outsiders, the
asset should be recorded at cost.

10-39
 Valuation of PPE- Savings or Loss on Self-Construction
Illustration: Kaplan Limited completed the construction of equipment on
November 10, 20X1. The following itemizes total construction costs:
Material $200,000
Labor 500,000
Incremental overhead 100,000
Capitalized interest 100,000
Total $900,000
Kaplan recorded all construction costs in equipment under construction.
1. If the asset’s market value at completion equals or exceeds
$900,000, the following entry would be made on November 10,
20X1:
Equipment…………………………..900,000
Equipment under construction…………….900, 000
2. If the asset’s market value is only $880,000, the following entry
would be made on November 10, 20X1:
Equipment……………………………….880, 000
Loss on Construction of Equipment…….20,000
Equipment under construction…………….900, 000
10-40
 Valuation of PPE- Cash Discounts
Cash Discounts — whether taken or not — generally considered a
reduction in the cost of the asset. The Net-of-Discount Method is
the preferred method
Example: ABC Co purchased equipment for Br 60,000 on account
under the term 2/10, n/30. Record the purchase:
Equipment ………………………………… 58,800
Accounts Payable…………………………………… 58,800

10-41
 Valuation of PPE: Lump-sum (Basket) Purchases
Lump-Sum Purchases — Allocate the total cost among the various
assets on the basis of their relative fair market values.
Example: A company pays $120,000 for equipment and a building.
The land and building are appraised at $50,000 and $75,000,
respectively.
Appraisal Relative Total Allocated
Assets Value Fair Value Cost Cost
Equipment 50,000 50,000/125,000 120,000 48,000
Building 75,000 75,000/125,000 120,000 72,000
Total 125,000 120,000

Equipment 48,000
Building 72,000
Cash 120,000
10-42
 Valuation of PPE: Issuance of Shares

Issuance of Shares — The market price of the shares issued is a

fair indication of the cost of the property acquired.
Example: North Co. decides to purchase building located adjacent to
it for expansion of its operation. The building is owned by Sky Co. In
lieu of paying cash for the building, North issues to Sky Co. 5,000
shares of common stock (par value $10) that have a fair value of $12
per share. Make the journal entry

Building (5,000 x $12)…………………….. 60,000

Common Stock………………………………………………….. 50,000
Paid-In Capital in Excess of Par—Common Stock.. 10,000

10-43
 Valuation of PPE- Deferred-Payment Contracts
Deferred-Payment Contracts — Assets purchased on long-term credit
contracts are valued at the present value of the consideration exchanged.
Example 1: On January 2, 2013, purchased equipment with a cash price of
$50,000 for $15,000 down plus seven annual payments of $7,189 each.

Equipment 50,000
Discount on Notes Payable 15,323
Notes Payable 50,323
Cash 15,000
Example 2: Greathouse Company purchases equipment today in exchange
for a $10,000 zero-interest-bearing note payable four years from now. The
market interest rate is 9%. Record the purchase
Equipment …………………………… 7,084.30
Discount on Notes Payable………… 2,915.70
Notes Payable ………………..…………………. 10,000
10-44
 Valuation of PPE: Exchanges
Exchanges of Non-Monetary Assets
Ordinarily accounted for on the basis of:
◆ the fair value of the asset given up or
◆ the fair value of the asset received,
whichever is clearly more evident.
Companies should recognize immediately any gains or losses on
the exchange when the transaction has commercial substance
(future cash flows change as a result of the transaction).
For example, ABC Co. exchanges some of its equipment for Building
held by XYZ Co. It is likely that the timing and amount of the cash
flows arising for the building will differ significantly from the cash
flows arising from the equipment. As a result, both ABC Co. and XYZ
Co. are in different economic positions. Therefore, the exchange has
commercial substance, and the companies recognize a gain or loss on
the exchange.
10-45
 Valuation of PPE: Exchanges

• In some cases, an enterprise acquires a new asset

by exchanging or trading existing nonmonetary
assets.

• Monetary assets are those assets whose amounts

are fixed in terms of currency, by contract, or
otherwise (cash, accounts receivable).

• Nonmonetary assets include all the other assets

(inventories, land).

10-46
 Valuation of PPE: Exchanges

Accounting for Exchanges

* If cash is 25% or more of the fair value of the exchange,

recognize entire gain because earnings process is complete.

10-47
 Valuation of PPE: Exchanges

Summary of Gain and Loss Recognition on Exchanges of

Nonmonetary Assets Lacks Commercial Substance

10-48
 Valuation of PPE: Exchanges

Exchanges - Loss Situation

Companies recognize a loss immediately whether the exchange

has commercial substance or not.
Rationale: Companies should not value assets at more than their
cash equivalent price; if the loss were deferred, assets would be
overstated.

10-49
 Valuation of PPE: Exchanges

Exchange – Gain Situation Illustration: ABC Company exchanged

equipment used in its manufacturing operations for similar equipment used
in the operations of XYZ Company plus $3,000 in cash . The following
information pertains to the exchange.

ABC XYZ
Equipment (cost) $28,000 $28,000
Accumulated Depreciation 19,000 10,000

Fair value of equipment 15,500 12,500

Cash given up 3,000

Instructions: Prepare the journal entries to record the exchange on the books
of both companies.

10-50
 Valuation of PPE: Exchanges

Calculation of Gain or Loss

ABC XYZ
Fair value of equipment received $12,500 $15,500
Cash received / paid 3,000 (3,000)
Less: Bookvalue of equipment
($28,000-19,000) (9,000)
($28,000-10,000) (18,000)
Gain or (Loss) on Exchange $6,500 ($5,500)

When a company receives cash (sometimes referred to as “boot”)

in an exchange that lacks commercial substance, it may
immediately recognize a portion of the gain.

10-51
 Valuation of PPE: Exchanges
Has Commercial Substance

ABC:
Equipment 12,500
Cash 3,000
Accumulated depreciation 19,000
Equipment 28,000
Gain on exchange 6,500

XYZ:
Equipment 15,500
Accumulated depreciation 10,000
Loss on exchange 5,500
Equipment 28,000
Cash 3,000

10-52
 Valuation of PPE: Exchanges
Lacks Commercial Substance

ABC:
Equipment (12,500 – 5,242) 7,258
Cash 3,000
Accumulated depreciation 19,000
Equipment 28,000
Gain on exchange 1,258

Cash Received Total Recognized

x =
Cash Received + FMV of Assets Received Gain Gain

$3,000
x $6,500 = $1,258
$3,000 + $12,500
Deferred gain = $6,500 – 1,258 = $5,242
10-53
 Valuation of PPE: Exchanges
Lacks Commercial Substance

XYZ (no change):

Equipment 15,500
Accumulated depreciation 10,000
Loss on exchange 5,500
Equipment 28,000
Cash 3,000

Companies recognize a loss immediately whether the

exchange has commercial substance or not.

10-54
 Valuation of PPE: Contributions
Contributions: Nonreciprocal transfers: transfer of assets
where nothing is given up in exchange (e.g. donations, gift, grants)
Companies should use:
▪ the fair value of the asset to establish its value on the books and
▪ should recognize contributions received as revenues in the period
received.
▪ When a company contributes a non-monetary asset, it should
record the amount of the donation as an expense at the fair value
of the donated asset.
▪ Two approaches to valuing and recording such transfer:
1. Capital Approach: credit contributed surplus account (donated
capital)
2. Income Approach: credit represents income and the gain is
deferred over the life of the asset (exception being land)
a) Cost Reduction Method: credit the respective asset account
b) Deferral Method: credit Deferred Revenue
10-55
 Valuation of PPE: Contributions/Grants
Illustration: Kline Industries donates land to the city of Los Angeles
for a city park. The land cost $80,000 and has a fair value of $110,000.
Kline Industries records this donation as follows.

Donor’s Book:

Contribution Expense 110,000

Land 80,000
Gain on Disposal of Land 30,000
Donee’s Book:
Land 110,000
Contribution Revenue 110,000

10-56
 Valuation of PPE: Contributions/Grants

Government Grants are assistance received from

a government in the form of transfers of resources
to a company in return for past or future compliance
with certain conditions relating to the operating
activities of the company.
IFRS requires grants to be recognized in income
(income approach) on a systematic basis that
matches them with the related costs that they are
intended to compensate.
10-57
 Valuation of PPE: Contributions/Grants

Example 1: Grant for Lab Equipment. AG Company received a

€500,000 subsidy from the government to purchase lab
equipment on January 2, 2015. The lab equipment cost is
€2,000,000, has a useful life of five years, and is depreciated on
the straight-line basis.

IFRS allows AG to record this grant in one of two ways:

1. Credit Deferred Grant Revenue for the subsidy and amortize

the deferred grant revenue over the five-year period.

2. Credit the lab equipment for the subsidy and depreciate this
amount over the five-year period.

10-58
 Valuation of PPE: Contributions/Grants

Example 1: Grant for Lab Equipment. If AG chooses to record

deferred revenue of €500,000, it amortizes this amount over the
five-year period to income (€100,000 per year). The effects on the
financial statements at December 31, 2015, are:

ILLUSTRATION 10-17
Government Grant
Recorded as Deferred
Revenue

10-59
 Valuation of PPE: Contributions/Grants

Example 1: Grant for Lab Equipment. If AG chooses to reduce

the cost of the lab equipment, AG reports the equipment at
€1,500,000 (€2,000,000 - €500,000) and depreciates this amount
over the five-year period. The effects on the financial statements
at December 31, 2015, are: ILLUSTRATION 10-18
Government Grant Adjusted to Asset

10-60
 Post Acquisition Costs
• In general:
1. If costs incurred increase future benefits, capitalize
costs (Capital Expenditure)
2. If costs maintain a given level of services, expense
costs (Revenue Expenditure)
• Evidence of future economic benefit would include
increases in
1. useful life,
2. quantity of product produced, and
3. quality of product produced.

10-61
 Post Acquisition Costs

• Costs incurred after acquisition can be:

1. Additions: increase or extension of existing assets &
capitalize the cost of addition to asset account.
2. Improvements and replacements: substitution of an
existing asset for an improved or equivalent one
3. Rearrangement and reinstallation[ Relocation/
Reorganization]: moving asset from one location to
another
4. Repairs: costs that maintain assets in operating
condition

10-62
 Post acquisition Costs

➢Improvements and Replacements

Capitalize costs, if

They increase future service potential

Improvements or Replacements

Substitution of Substitution of
a better asset a similar asset
for present for present
asset asset
10-63
 Post acquisition Costs
➢ Capitalization Approaches
a. Carrying value of asset is known
Substitution approach: Remove cost of and accumulated
depreciation on old asset, recognizing any gain or loss. Capitalize
cost of improvement/ replacement.
b. Carrying value of the asset is unknown
➢ Capitalize the new asset (without removing the old asset from
the pool), [If the quantity or quality of the asset’s productivity is
increased capitalize cost of improvement/replacement to asset
account] OR
➢ Debit accumulated depreciation (when expenditures extend
useful life of asset)

10-64
 Post acquisition Costs

➢ Rearrangement and reinstallation

a) If original installation cost is known, account for cost of

rearrangement/ reinstallation as a replacement (carrying value
known).
b) If original installation cost is unknown and rearrangement/
reinstallation cost is material in amount and benefits future
periods, capitalize as an asset.
c) If original installation cost is unknown and rearrangement/
reinstallation cost is not material or future benefit is
questionable, expense the cost when incurred.

10-65
Post acquisition Costs
➢ Repairs
a. Ordinary: Expense cost of repairs when incurred.
b. Major/Extraordinary: As appropriate, treat as an
addition, improvement, or replacement.
Example: Improvements
Instinct Enterprises decides to replace the pipes in its
plumbing system. A plumber suggests that the company
use plastic tubing in place of the cast iron pipes and
copper tubing. The old pipe and tubing have a book value
of $15,000 (cost of $150,000 less accumulated
depreciation of $135,000), and a scrap value of $1,000.
The plastic tubing costs $125,000.
10-66
Post acquisition Costs

If Instinct pays $124,000 for the new tubing after

exchanging the old tubing, it makes the following entry:
Plant Assets (plumbing system)….. 125,000
Acc. Dep.—Plant Assets……………… 135,000
Loss on Disposal of Plant Assets…… 14,000
Plant Assets………………………….………… 150,000
Cash ($125,000 - $1,000)………………… 124,000

10-67
 Disposition of PPE

A company may retire plant assets voluntarily or dispose of

them by
◆ Sale,

◆ Exchange,

◆ Involuntary conversion, or

◆ Abandonment.

Depreciation must be taken up to the date of disposition.

10-68
 Disposition of PPE: Sale
When fixed assets are sold, the owner may break
even, sustain a loss, or realize a gain.

1. If the sale price is equal to book value, there will

be no gain or loss.
2. If the sale price is less than book value, there will
be a loss equal to the difference.
3. If the sale price is more than book value, there will
be a gain equal to the difference.

Gain or loss will be reported in the income statement

as Other Income or Other Loss.

10-69
 Disposition of PPE: Sale
Illustration: City Company owns machinery that cost $20,000 when
purchased on January 1, 2004. Depreciation has been recorded at a
rate of $3,000 per year, resulting in a balance in accumulated
depreciation of $9,000 at December 31, 2006. The machinery is sold
on September 1, 2007, for $10,500. Prepare journal entries to (a)
update depreciation for 2007 and (b) record the sale.
(a) update depreciation for 2007
Depreciation expense ($3,000 x 8/12) 2,000
Accumulated depreciation 2,000
(b) record the sale
Cash 10,500
Accumulated depreciation 11,000
Machinery 20,000
Gain on sale 1,500
10-70
 Disposition of PPE: Discarding/ Abandonment
Illustration 1: A piece of equipment acquired at a cost of $25,000 is
fully depreciated. On February 14, the equipment is discarded.
Accumulated Depr.—Equipment 25,000
Equipment 25,000
Illustration 2: costing $6,000 is depreciated at an annual straight-line
rate of 10%. After the adjusting entry, Accumulated Depreciation—
Equipment had a $4,750 balance. The equipment was discarded on
March 24.
a. Update the Depreciation
Depreciation Expense.—Equipment 150
Accum. Depreciation—Equipment[=600 × 3/12] 150
b. Write-off Equipment Discarded
Accumulated Depr.—Equipment 4900
Loss on Disposal of Fixed Asset 1100
Equipment 6000
10-71
 Disposition of PPE: Involuntary Conversion

Involuntary Conversion: Sometimes an asset’s service is

terminated through some type of involuntary conversion such as
fire, flood, theft, or condemnation.

Companies report the difference between the amount recovered

(e.g., from a condemnation award or insurance recovery), if any,
and the asset’s book value as a gain or loss.

They treat these gains or losses like any other type of disposition.

10-72
 Disposition of PPE: Involuntary Conversion

Illustration 1: Camel Transport Corp. had to sell a plant located on

company property that stood directly in the path of an interstate
highway. Camel received $500,000, which substantially exceeded the
book value of the land of $150,000 and the book value of the building
of $100,000 (cost of $300,000 less accumulated depreciation of
$200,000). Camel made the following entry.

Cash 500,000
Accumulated Depreciation—Buildings 200,000
Buildings 300,000
Land 150,000
Gain on Disposal of Plant Assets 250,000

10-73
 Disposition of PPE: Involuntary Conversion

Illustration 2: A company’s building with cost Br900,000 and

accumulated depreciation of br580,000, is condemned by the
government for the construction of a highway. The government sets a
price of br200,000 as the condemnation award.

Cash 200,000
Accumulated Depreciation—Buildings 580,000
Loss on condemnation of property 120,000
Buildings 900,000

10-74
 Supplementary: Natural Resources & Intangible Assets

Natural resources consist of standing timber and

underground deposits of oil, gas, and minerals.

Distinguishing characteristics:

◆ Physically extracted in operations.

◆ Replaceable only by an act of nature.

Cost is the price needed to acquire the resource and prepare

it for its intended use.

10-75
 Depletion

The allocation of the cost to expense in a rational and

systematic manner over the resource’s useful life.
◆ Companies generally use units-of-activity method.
◆ Depletion generally is a function of the units extracted.

10-76
 Depletion

Illustration: Lane Coal Company invests $5 million in a mine

estimated to have 1 million tons of coal and no salvage value.

10-77
 Depletion

Illustration: Lane Coal Company invests $5 million in a mine

estimated to have 1 million tons of coal and no salvage value. In
the first year, Lane extracts and sells 250,000 tons of coal. Lane
computes the depletion expense as follows:

$5,000,000 ÷ 1,000,000 = $5.00 depletion cost per ton

$5.00 x 250,000 = $1,250,000 annual depletion expense

Journal entry:
Depletion Expense/Inventory (coal)1,250,000
Accumulated Depletion 1,250,000

10-78
 Depreciation, Impairments, and
Revaluation

11-1
 Depreciation—Method of Cost Allocation

Depreciation is the accounting process of allocating the cost

of tangible assets to expense in a systematic and rational
manner to those periods expected to benefit from the use of
the asset.

Allocating costs of long-lived assets:

◆ Fixed assets = Depreciation expense
◆ Intangibles = Amortization expense
◆ Mineral resources = Depletion expense

11-2
 Depreciation—Cost Allocation

Factors Involved in the Depreciation Process

Three basic questions:
1. What depreciable base is to be used?
➢Depreciable Base=Cost-Residual Value
1. What is the asset’s useful life?
2. What method of cost apportionment is best?

11-3
 Factors Involved in Depreciation Process

Estimation of Service Lives

◆ Service life often differs from physical life.
◆ Companies retire assets for two reasons:
1. Physical factors (casualty or expiration of physical life).

2. Economic factors

✓ inadequacy: results when an asset ceases to be useful

to a company because the demands of the firm have
changed,

✓ Supersession: is the replacement of one asset with

another more efficient and economical asset, and

✓ Obsolescence: is the catchall for situations not involving

11-4
inadequacy and supersession.
 Depreciation—Cost Allocation

Methods of Depreciation
The profession requires the method employed be “systematic
and rational.” Methods used include:

1. Activity method (units of use or production).

2. Straight-line method.

3. Diminishing (accelerated)-charge methods:

a) Sum-of-the-years’-digits.

b) Declining-balance method.

11-5
 Methods of Depreciation

Activity Method ILLUSTRATION 11-2

Data Used to Illustrate
Depreciation Methods

Data for
Stanley Coal
Mines

Illustration: If Stanley uses the crane for 4,000 hours the first
year, the depreciation charge is:

ILLUSTRATION 11-3
Depreciation Calculation,
Activity Method—Crane
Example

11-6
 Methods of Depreciation

Straight-Line Method ILLUSTRATION 11-2

Data Used to Illustrate
Depreciation Methods

Data for
Stanley Coal
Mines

Illustration: Stanley computes depreciation as follows:

ILLUSTRATION 11-4
Depreciation Calculation,
Straight-Line Method—
Crane Example

11-7
 Methods of Depreciation

Diminishing-Charge Methods ILLUSTRATION 11-2

Data Used to Illustrate
Depreciation Methods

Data for
Stanley Coal
Mines

Sum-of-the-Years’-Digits. Each fraction uses the sum of the

years as a denominator (5 + 4 + 3 + 2 + 1 = 15). The numerator
is the number of years of estimated life remaining as of the
beginning of the year.

Alternate sum-of-the- n(n+1) 5(5+1)

= = 15
years’ calculation 2 2
11-8
 Methods of Depreciation

Sum-of-the-Years’-Digits

ILLUSTRATION 11-6
Sum-of-the-Years’-Digits
Depreciation Schedule—
Crane Example

11-9
 Methods of Depreciation

Diminishing-Charge Methods ILLUSTRATION 11-2

Data Used to Illustrate
Depreciation Methods

Data for
Stanley Coal
Mines

Declining-Balance Method.
◆ Utilizes a depreciation rate (percentage) that is some multiple
of the straight-line method.

◆ Does not deduct the salvage value in computing the

depreciation base.

11-10
 Methods of Depreciation

Declining-Balance Method

ILLUSTRATION 11-7
Double-Declining
Depreciation Schedule—
Crane Example

11-11
 Component Depreciation

IFRS requires that each part of an item of property, plant,

and equipment that is significant to the total cost of the
asset must be depreciated separately.
Illustration: EuroAsia Airlines purchases an airplane for
€100,000,000 on January 1, 2016. The airplane has a useful life
of 20 years and a residual value of €0. EuroAsia uses the straight-
line method of depreciation for all its airplanes. EuroAsia identifies
the following components, amounts, and useful lives.

ILLUSTRATION 11-8
Airplane Components
11-12
 Component Depreciation

Computation of depreciation expense for

ILLUSTRATION 11-9
EuroAsia for 2016. Computation of
Component Depreciation

Depreciation journal entry for 2016.

Depreciation Expense 8,600,000
Accumulated Depreciation—Airplane 8,600,000

11-13
 Component Depreciation

On the statement of financial position at the end of 2016,

EuroAsia reports the airplane as a single amount.

ILLUSTRATION 11-10
Presentation of Carrying
Amount of Airplane

11-14
 Depreciation—Cost Allocation

Special Depreciation Issues

1. How should companies compute depreciation for
partial periods?

◆ Companies determine the depreciation expense for

the full year and then

◆ prorate this depreciation expense between the two

periods involved.

This process should continue throughout the useful life of

the asset.

11-15
 Depreciation and Partial Periods

Illustration—(Four Methods): Maserati Corporation purchased a

new machine for its assembly process on August 1, 2015. The cost
of this machine was €150,000. The company estimated that the
machine would have a salvage value of €24,000 at the end of its
service life. Its life is estimated at 5 years and its working hours are
estimated at 21,000 hours. Year-end is December 31.

Instructions: Compute the depreciation expense under the

following methods.
(a) Straight-line depreciation. (c) Sum-of-the-years’-digits.
(b) Activity method (d) Double-declining balance.

11-16
 Depreciation and Partial Periods

Straight-line Method
Current
Depreciable Annual Partial Year Accum.
Year Base Years Expense Year Expense Deprec.
2015 € 126,000 / 5 = $ 25,200 x 5/12 = € 10,500 $ 10,500
2016 126,000 / 5 = 25,200 25,200 35,700
2017 126,000 / 5 = 25,200 25,200 60,900
2018 126,000 / 5 = 25,200 25,200 86,100
2019 126,000 / 5 = 25,200 25,200 111,300
2020 126,000 / 5 = 25,200 x 7/12 = 14,700 126,000
€ 126,000
Journal entry:

2015 Depreciation expense 10,500

Accumultated depreciation 10,500

11-17
 Depreciation and Partial Periods

Activity Method (Assume 800 hours used in 2015)

(€126,000 / 21,000 hours = €6 per hour)
(Given) Current
Hours Rate per Annual Partial Year Accum.
Year Used Hours Expense Year Expense Deprec.
2015 800 x $6 = € 4,800 € 4,800 € 4,800
2016 x =
2017 x =
2018 x =
2019 x =
800 € 4,800

Journal entry:
2015 Depreciation expense 4,800
Accumultated depreciation 4,800

11-18 Advance slide in presentation mode to reveal answer.

 Depreciation and Partial Periods

5/12 = .416667
Sum-of-the-Years’-Digits Method 7/12 = .583333
Current
Depreciable Annual Partial Year Accum.
Year Base Years Expense Year Expense Deprec.

2015 € 126,000 x 5/15 = 42,000 x 5/12 € 17,500 € 17,500

2016 126,000 x 4.58/15 = 38,500 38,500 56,000

2017 126,000 x 3.58/15 = 30,100 30,100 86,100

2018 126,000 x 2.58/15 = 21,700 21,700 107,800

2019 126,000 x 1.58/15 = 13,300 13,300 121,100

2020 126,000 x .58/15 = 4,900 4,900 126,000

€ 126,000
Journal entry:
2015 Depreciation expense 17,500
Accumultated depreciation 17,500
11-19
Advance slide in presentation mode to reveal answer.
 Depreciation and Partial Periods

Double-Declining Balance Method

Current
Depreciable Rate Annual Partial Year
Year Base per Year Expense Year Expense

2015 € 150,000 x 40% = € 60,000 x 5/12 = € 25,000

2016 125,000 x 40% = 50,000 50,000

2017 75,000 x 40% = 30,000 30,000

2018 45,000 x 40% = 18,000 18,000

2019 27,000 x 40% = 10,800 Plug 3,000

€ 126,000
Journal entry:
2015 Depreciation expense 25,000
Accumultated depreciation 25,000
11-20 Advance slide in presentation mode to reveal answer.
 Depreciation—Cost Allocation

Special Depreciation Issues

2. Does depreciation provide for the replacement of assets?
◆ Does not involve a current cash outflow.
◆ Funds for the replacement of the assets come from the
revenues.
3. How should companies handle revisions in
depreciation rates?
◆ Accounted for in the current and prospective periods
◆ Not handled retrospectively
◆ Not considered errors or extraordinary items

11-21
 Revision of Depreciation Rates

Arcadia HS, purchased equipment for $510,000 which was estimated to

have a useful life of 10 years with a residual value of $10,000 at the end
of that time. Depreciation has been recorded for 7 years on a straight-
line basis. In 2015 (year 8), it is determined that the total estimated life
should be 15 years with a residual value of $5,000 at the end of that
time.

Questions:
⚫ What is the journal entry to correct No Entry
the prior years’ depreciation? Required

⚫ Calculate the depreciation expense

for 2015.
11-22
 After 7
Revision of Depreciation Rates years

Equipment cost $510,000 First, establish NBV

Salvage value - 10,000 at date of change in
Depreciable base 500,000 estimate.
Useful life (original) 10 years
Annual depreciation $ 50,000 x 7 years = $350,000

Balance Sheet (Dec. 31, 2014)

Equipment $510,000
Accumulated depreciation 350,000
Net book value (NBV) $160,000

11-23
 After 7
Revision of Depreciation Rates years

Net book value $160,000 Depreciation

Salvage value (new) 5,000 Expense calculation
Depreciable base 155,000 for 2015.
Useful life remaining 8 years
Annual depreciation $ 19,375

Journal entry for 2015

Depreciation Expense 19,375

Accumulated Depreciation 19,375

11-24
 Impairments

A long-lived tangible asset is impaired when a company is not able

to recover the asset’s carrying amount either through using it or by
selling it. A company records a write-off referred to as an impairment
On an annual basis, companies review the asset for indicators
of impairments—that is, a decline in the asset’s cash-generating
ability through use or sale.
Events leading to an impairment:
a. Decrease in the market value of an asset.
b. Change in the manner in which an asset is used.
c. Adverse change in legal factors or in the business climate.
d. An accumulation of costs in excess of the amount originally
expected to acquire or construct an asset.
e. A projection or forecast that demonstrates continuing losses
associated with an asset.
11-25
 Impairments

Measuring Impairments/ Impairment test

1. Review events for possible impairment.
2. If the review indicates impairment, apply the recoverability
test. If the sum of the expected future net cash flows from
the long-lived asset is less than the carrying amount of the
asset, an impairment has occurred.
3. Assuming an impairment, the impairment loss is the
amount by which the carrying amount of the asset exceeds
the fair value of the asset. The fair value is the market value
or the present value of expected future net cash flows.

11-26
 IMPAIRMENTS

ILLUSTRATION 11-18
Graphic of Accounting for
Impairments

11-27 LO 5
 Recognizing Impairments

If impairment indicators are present, then an impairment test

must be conducted.

ILLUSTRATION 11-15
Impairment Test

11-28
 Recognizing Impairments

Example: Assume that Cruz Company performs an impairment

test for its equipment. The carrying amount of Cruz’s equipment is
€200,000, its fair value less costs to sell is €180,000, and its
value-in-use is €205,000.
ILLUSTRATION 11-15

€200,000 €205,000
No
Impairment

€180,000 €205,000
11-29
 Recognizing Impairments

Example: Assume the same information for Cruz Company

except that the value-in-use of Cruz’s equipment is €175,000
rather than €205,000.
€20,000 Impairment Loss
ILLUSTRATION 11-15

€200,000 €180,000

€180,000 €175,000
11-30
 Recognizing Impairments

Example: Assume the same information for Cruz Company

except that the value-in-use of Cruz’s equipment is €175,000
rather than €205,000.
€20,000 Impairment Loss
ILLUSTRATION 11-15

€200,000 €180,000

Cruz makes the following entry to record the impairment loss.

Loss on Impairment 20,000

Accumulated Depreciation—Equipment 20,000

11-31
 Impairment Illustrations
Case 1
At December 31, 2016, Hanoi Company has equipment with a cost of
VND26,000,000, and accumulated depreciation of VND12,000,000. The
equipment has a total useful life of four years with a residual value of
VND2,000,000. The following information relates to this equipment.
1. The equipment’s carrying amount at December 31, 2016, is
VND14,000,000 (VND26,000,000 - VND12,000,000).
2. Hanoi uses straight-line depreciation. Hanoi’s depreciation was
VND6,000,000 [(VND26,000,000 - VND2,000,000) ÷ 4] for 2016
and is recorded.
3. Hanoi has determined that the recoverable amount for this asset at
December 31, 2016, is VND11,000,000.
4. The remaining useful life of the equipment after December 31,
2016, is two years.
11-32 LO 5
 Impairment Illustrations

Case 1: Hanoi records the impairment on its equipment at

December 31, 2016, as follows.

VND3,000,000 Impairment Loss

ILLUSTRATION 11-15
VND14,000,000 VND11,000,000

Loss on Impairment 3,000,000

Accumulated Depreciation—Equipment 3,000,000

11-33 LO 5
 Impairment Illustrations

Equipment VND 26,000,000

Less: Accumulated Depreciation-Equipment 15,000,000
Carrying value (Dec. 31, 2016) VND 11,000,000

Hanoi Company determines that the equipment’s total useful life

has not changed (remaining useful life is still two years). However,
the estimated residual value of the equipment is now zero. Hanoi
continues to use straight-line depreciation and makes the
following journal entry to record depreciation for 2017.

Depreciation Expense 5,500,000

Accumulated Depreciation—Equipment 5,500,000

11-34 LO 5
 Impairment Illustrations
Case 2
At the end of 2015, Verma Company tests a machine for impairment. The
machine has a carrying amount of $200,000. It has an estimated
remaining useful life of five years. Because there is little market-related
information on which to base a recoverable amount based on fair value,
Verma determines the machine’s recoverable amount should be based on
value-in-use. Verma uses a discount rate of 8 percent. Verma’s analysis
indicates that its future cash flows will be $40,000 each year for five
years, and it will receive a residual value of $10,000 at the end of the five
years. It is assumed that all cash flows occur at the end of the year.

ILLUSTRATION 11-16
Value-in-Use Computation
11-35 LO 5
 Impairment Illustrations
Case 2: Computation of the impairment loss on the machine at
the end of 2015.
$33,486 Impairment Loss
ILLUSTRATION 11-15

$200,000 $166,514

Unknown $166,514
11-36 LO 5
 Impairment Illustrations
Case 2: Computation of the impairment loss on the machine at
the end of 2015.
$33,486 Impairment Loss

$200,000 $166,514

Loss on Impairment 33,486

Accumulated Depreciation—Machinery 33,486

Unknown $166,514
11-37 LO 5
 Reversal of Impairment Loss

Illustration: Tan Company purchases equipment on January 1,

2015, for HK$300,000, useful life of three years, and no residual
value.

At December 31, 2015, Tan records an impairment loss of

HK$20,000.
Loss on Impairment 20,000
Accumulated Depreciation—Equipment 20,000
11-38 LO 5
 Reversal of Impairment Loss

Depreciation expense and related carrying amount after the

impairment.

At the end of 2016, Tan determines that the recoverable amount of

the equipment is HK$96,000. Tan reverses the impairment loss.

Accumulated Depreciation—Equipment 6,000

Recovery of Impairment Loss 6,000

11-39 LO 5
 Impairment Illustrations
Example 1 : Presented below is information related to equipment
owned by Suzan Company at December 31, 2007. Assume that
Suzan will sell the asset in the future. As of December 31, 2007,
the equipment has a remaining useful life of 4 years.
Cost $ 9,000,000
Accumulated depreciation to date 1,000,000
Expected future net cash flows 7,000,000
Fair value 4,800,000

Instructions:
(a) Prepare the journal entry (if any) to record the impairment of the
asset at December 31, 2007.
(b) Prepare the journal entry to record depreciation expense for 2008.

11-40
 Impairment Illustrations

(a). Cost $9,000,000

Accumulated depreciation 1,000,000
Carrying amount 8,000,000
Fair value 4,800,000
Loss on impairment $3,200,000

12/31/07

Loss on impairment 3,200,000

Accumulated depreciation 3,200,000

11-41
 Impairment Illustrations

(b). Net carrying amount $4,800,000

Useful life 4 years
Depreciation per year $1,200,000

12/31/08

Depreciation expense 1,200,000

Accumulated depreciation 1,200,000

11-42
 IMPAIRMENTS

Cash-Generating Units
When it is not possible to assess a single asset for impairment
because the single asset generates cash flows only in
combination with other assets, companies identify the
smallest group of assets that can be identified that generate
cash flows independently of the cash flows from other assets.

11-43 LO 5
 IMPAIRMENTS

Impairment of Assets to Be Disposed Of

◆ Report the impaired asset at the lower-of-cost-or-net
realizable value (fair value less costs to sell).

◆ No depreciation or amortization is taken on assets held

for disposal during the period they are held.

◆ Can write up or down an asset held for disposal in future

periods, as long as the carrying amount after the write up
never exceeds the carrying amount of the asset before
the impairment.

11-44 LO 5
 Presentation of PPE & Natural Resources

Presentation of Property, Plant, Equipment, and

Mineral Resources

Depreciating assets, use Accumulated Depreciation.

Depleting assets may include use of Accumulated Depletion

account, or the direct reduction of asset.

Disclosures Basis of valuation (usually cost)

Pledges, liens, and other commitments

11-45
 REVALUATION OF PROPERTY, PLANT, AND EQUIPMENT

As indicated in previous part, companies can use

revaluation accounting subsequent to acquisition.
When companies choose to fair value their long-
lived tangible assets subsequent to acquisition,
they account for the change in the fair value by
adjusting the appropriate asset account and
recording an unrealized gain on the revalued
long-lived tangible asset. This unrealized gain is
often referred to as revaluation surplus.

11-46
 The general rules for revaluation accounting are as follows.

1. When a company revalues its long-lived tangible

assets above historical cost, it reports an unrealized
gain that increases other comprehensive income.
Thus, the unrealized gain bypasses net income,
increases other comprehensive income, and
increases accumulated other comprehensive income.
2. If a company experiences a loss on impairment
(decrease of value below historical cost), the loss
reduces income and retained earnings. Thus, gains
on revaluation increase equity but not net income,
whereas losses decrease income and retained
earnings (and therefore equity).

11-47
 The general rules for revaluation accounting are as follows.

3. If a revaluation increase reverses a decrease that

was previously reported as an impairment loss, a
company credits the revaluation increase to income
using the account Recovery of Impairment Loss up to
the amount of the prior loss. Any additional valuation
increase above historical cost increases other
comprehensive income and is credited to Unrealized
Gain on Revaluation.
4. If a revaluation decrease reverses an increase that
was reported as an unrealized gain, a company first
reduces other comprehensive income by eliminating
the unrealized gain. Any additional valuation decrease
reduces net income and is reported as a loss on
11-48 impairment.
 Recognizing Revaluation

Revaluation—Land
Illustration: Siemens Group (DEU) purchased land for
€1,000,000 on January 5, 2015. The company elects to use
revaluation accounting for the land in subsequent periods. At
December 31, 2015, the land’s fair value is €1,200,000. The entry
to record the land at fair value is as follows.

Land 200,000
Unrealized Gain on Revaluation - Land 200,000

Unrealized Gain on Revaluation—Land increases other comprehensive

income in the statement of comprehensive income.

11-49 LO 7
 Recognizing Revaluation

Revaluation—Depreciable Assets
Illustration: Lenovo Group (CHN) purchases equipment for
¥500,000 on January 2, 2015. The equipment has a useful life of
five years, is depreciated using the straight-line method of
depreciation, and its residual value is zero. Lenovo chooses to
revalue its equipment to fair value over the life of the equipment.
Lenovo records depreciation expense of ¥100,000 (¥500,000 ÷ 5)
at December 31, 2015, as follows.

Depreciation Expense 100,000

Accumulated Depreciation—Equipment 100,000

11-50
 Recognizing Revaluation

Revaluation—Depreciable Assets
After this entry, Lenovo’s equipment has a carrying amount of
¥400,000 (¥500,000 - ¥100,000). Lenovo receives an independent
appraisal for the fair value of equipment at December 31, 2015,
which is ¥460,000.

Accumulated Depreciation—Equipment 100,000

Equipment 40,000
Unrealized Gain on Revaluation—Equipment 60,000

11-51
 Recognizing Revaluation

Revaluation—Depreciable Assets

Under no circumstances can the Accumulated Other Comprehensive Income

account related to revaluations have a negative balance.

11-52
 Recognizing Revaluation

Revaluation—Land
Illustration: Unilever Group (GBR and NLD) purchased land on January
1, 2015, that cost €400,000. Unilever decides to report the land at fair value
in subsequent periods. At December 31, 2015, an appraisal of the land
indicates that its fair value is €520,000. Unilever makes the following entry
to record the increase in fair value.

Land 120,000
Unrealized Gain on Revaluation - Land 120,000

Unrealized Gain on Revaluation—Land increases other comprehensive

income in the statement of comprehensive income.

11-53
 Recognizing Revaluation
Summary of the revaluation adjustments for Unilever in 2015.

The land is now reported at its fair value of €520,000. The increase in the fair
value of €120,000 is reported on the statement of comprehensive income as other
comprehensive income. In addition, the ending balance in Unrealized Gain on
Revaluation—Land is reported as accumulated other comprehensive income in
the statement of financial position in the equity section.
11-54
 Revaluation–2016: Decrease below Historical Cost

What happens if the land's fair value at

December 31, 2016, is €380,000, a decrease of
€140,000 (€520,000 − €380,000)? In this case,
the land's fair value is below its historical cost.
Therefore, Unilever debits Unrealized Gain on
Revaluation—Land for €120,000 to eliminate its
balance. In addition, Unilever reports a Loss on
Impairment of €20,000 (€400,000 − €380,000),
reducing net income. Unilever makes the
following entry to record the decrease in fair
value of the land.
11-55
 I

summary of the revaluation adjustments for

Unilever in 2016.

11-56
 The decrease to Unrealized Gain on
Revaluation—Land of €120,000 reduces other
comprehensive income, which then reduces the
balance in accumulated other comprehensive
income. The Loss on Impairment of €20,000
reduces net income and retained earnings. In this
case, Unilever had a revaluation decrease which
first reverses any increases that Unilever
reported in prior periods as an unrealized gain.
Any additional amount is reported as an
impairment loss. Under no circumstances can the
revaluation decrease reduce accumulated other
11-57 comprehensive income below zero.
 Revaluation–2017: Recovery of Impairment Loss

At December 31, 2017, Unilever's land value

increases to €415,000, an increase of €35,000
(€415,000 − €380,000). In this case, the Loss on
Impairment of €20,000 is reversed and the
remaining increase of €15,000 is reported in
other comprehensive income. Unilever makes
the following entry to record this transaction.

11-58
 I

summary of the revaluation adjustments for

Unilever in 2017.

11-59
 The recovery of the impairment loss of
€20,000 increases income (and retained
earnings) only to the extent that it reverses
previously recorded impairment losses.
On January 2, 2018, Unilever sells the
land for €415,000. Unilever makes the
following entry to record this
transaction.

11-60
 In this case, Unilever does not record a gain or
loss because the carrying amount of the land is
the same as its fair value. At this time, since the
land is sold, Unilever has the option to transfer
Accumulated Other Comprehensive Income
(AOCI) to Retained Earnings. The entry to record
the transfer is as follows.

11-61
 The purpose of this transfer is to eliminate
the unrealized gain on the land that was
sold. It should be noted that transfers from
Accumulated Other Comprehensive
Income cannot increase net income.
This last entry illustrates why revaluation
accounting is not popular. Even though the
land has appreciated in value by €15,000,
Unilever is not able to recognize this gain
in net income over the periods that it held
11-62 the land.
 REVALUATION OF DEPRECIABLE ASSETS

To illustrate the accounting for revaluations using

depreciable assets, assume that Nokia (FIN)
purchases equipment for €1,000,000 on January
2, 2015. The equipment has a useful life of five
years, is depreciated using the straight-line
method of depreciation, and its residual value is
zero.
Revaluation–2015: Valuation Increase
Nokia chooses to revalue its equipment to fair
value over the life of equipment. Nokia records
depreciation expense of €200,000 (€1,000,000 ÷
11-63
5) as follows.
 I

After this entry, Nokia's equipment has a carrying amount of

€800,000 (€1,000,000 − €200,000). Nokia employs an
independent appraiser, who determines that the fair value of
equipment at December 31, 2015, is €950,000. To report the
equipment at fair value, Nokia does the following.
Reduces the Accumulated Depreciation—Equipment account
to zero.
Reduces the Equipment account by €50,000—it then is
reported at its fair value of €950,000.
Records an Unrealized Gain on Revaluation—Equipment for
the difference between the fair value and carrying amount of
the equipment, or €150,000 (€950,000 − €800,000). The entry
to record this revaluation at December 31, 2015, is as follows.
11-64
 I

summary of the revaluation adjustments for

Nokia in 2015.

11-65
 Following these revaluation adjustments, the
carrying amount of the asset is now €950,000.
Nokia reports depreciation expense of €200,000
in the income statement and Unrealized Gain on
Revaluation—Equipment of €150,000 in other
comprehensive income. This unrealized gain
increases accumulated other comprehensive
income (reported on the statement of financial
position in the equity section).

11-66
 Revaluation–2016: Decrease below Historical Cost

Assuming no change in the useful life of the

equipment, depreciation expense for Nokia in
2016 is €237,500 (€950,000 ÷ 4), and the entry
to record depreciation expense is as follows.

11-67
 Under IFRS, Nokia may transfer from AOCI the
difference between depreciation based on the
revalued carrying amount of the equipment and
depreciation based on the asset's original cost to
retained earnings. Depreciation based on the
original cost was €200,000 (€1,000,000 ÷ 5) and
on fair value is €237,500, or a difference of
€37,500 (€237,500 − €200,000). The entry to
record this transfer is as follows.

11-68
 At this point, before revaluation in 2016,
Nokia has the following amounts related to its
equipment.

11-69
 Nokia determines through appraisal that the equipment now
has a fair value of €570,000. To report the equipment at fair
value, Nokia does the following.
Reduces the Accumulated Depreciation—Equipment account
of €237,500 to zero.
Reduces the Equipment account by €380,000 (€950,000 −
€570,000)—it then is reported at its fair value of €570,000.
Reduces Unrealized Gain on Revaluation—Equipment by
€112,500, to offset the balance in the unrealized gain account
(related to the revaluation in 2015).
Records a loss on impairment of €30,000.

11-70
 The entry to record this transaction is as follows.

11-71
 summary of the revaluation adjustments for Nokia in 2016.

11-72
 Following the revaluation entry, the carrying
amount of the equipment is now €570,000. Nokia
reports depreciation expense of €237,500 and an
impairment loss of €30,000 in the income
statement (which reduces retained earnings).
Nokia reports the reversal of the previously
recorded unrealized gain by recording the
transfer to retained earnings of €37,500 and the
entry to Unrealized Gain on Revaluation—
Equipment of €112,500. These two entries
reduce the balance in AOCI to zero.
11-73
 Revaluation–2017: Recovery of Impairment Loss

Assuming no change in the useful life of the

equipment, depreciation expense for Nokia in
2017 is €190,000 (€570,000 ÷ 3), and the entry
to record depreciation expense is as follows.

11-74
 Nokia transfers the difference between
depreciation based on the revalued carrying
amount of the equipment and depreciation based
on the asset's original cost from AOCI to retained
earnings. Depreciation based on the original cost
was €200,000 (€1,000,000 ÷ 5) and on fair value
is €190,000, or a difference of €10,000 (€200,000
− €190,000). The entry to record this transfer is
as follows.

11-75
 At this point, before revaluation in 2017,
Nokia has the following amounts related to its
equipment.

11-76
 Nokia determines through appraisal that the equipment
now has a fair value of €450,000. To report the
equipment at fair value, Nokia does the following.
Reduces the Accumulated Depreciation—Equipment
account of €190,000 to zero.
Reduces the Equipment account by €120,000 (€570,000
− €450,000)—it then is reported at its fair value of
€450,000.
Records an Unrealized Gain on Revaluation—Equipment
for €40,000.
Records a Recovery of Loss on Impairment for €30,000.
11-77
 The entry to record this transaction is as
follows.

11-78
 summary of the revaluation adjustments for Nokia in 2017.

11-79
 Following the revaluation entry, the carrying amount of the
equipment is now €450,000. Nokia reports depreciation
expense of €190,000 and an impairment loss recovery of
€30,000 in the income statement. Nokia records €40,000 to
Unrealized Gain on Revaluation—Equipment, which
increases AOCI to €50,000.
On January 2, 2018, Nokia sells the equipment for €450,000.
Nokia makes the following entry to record this transaction.

11-80
 Nokia does not record a gain or loss because the carrying
amount of the equipment is the same as its fair value. Nokia
transfers the remaining balance in Accumulated Other
Comprehensive Income to Retained Earnings because the
equipment has been sold. The entry to record this transaction
is as follows.

The transfer from Accumulated Other Comprehensive Income

does not increase net income. Even though the equipment has
appreciated in value by €50,000, the company does not
recognize this gain in net income over the periods that Nokia
held the equipment.
11-81
 Intangible Assets

12-1
 INTANGIBLE ASSET ISSUES

Characteristics Coca-Cola Company’s

(USA) success comes
1. Identifiable. from its secret formula
for making Coca-Cola,
2. Lack physical existence. not its plant facilities.

3. Not monetary assets.

Normally classified as non-current asset.

Common types of intangibles:

◆ Patent ◆ Trademark or trade name

◆ Copyright ◆ Customer list
◆ Franchise or license ◆ Goodwill
12-2 LO 1
 INTANGIBLE ASSET ISSUES

Valuation
Purchased Intangibles
◆ Recorded at cost.

◆ Includes all acquisition costs plus expenditures to make the

intangible asset ready for its intended use.

◆ Typical costs include:

► Purchase price.

► Legal fees.

► Other incidental expenses.

12-3 LO 2
 INTANGIBLE ASSET ISSUES

Valuation
Internally Created Intangibles
◆ Companies expense all research phase costs and some
development phase costs.

◆ Certain development costs are capitalized once economic

viability criteria are met.

◆ IFRS identifies several specific

criteria that must be met before
development costs are capitalized.

12-4 LO 2
 INTANGIBLE ASSET ISSUES

Internally Created Intangibles ILLUSTRATION 12-1

Research and
Development Stages

12-5 LO 2
 INTANGIBLE ASSET ISSUES

Amortization of Intangibles
Limited-Life Intangibles
◆ Amortize by systematic charge to expense over useful life.

◆ Credit asset account or accumulated amortization.

◆ Useful life should reflect the periods over which the asset
will contribute to cash flows.

◆ Amortization should be cost less residual value.

◆ Companies must evaluate the limited-life intangibles

annually for impairment.

12-6 LO 3
 INTANGIBLE ASSET ISSUES

Amortization of Intangibles
Indefinite-Life Intangibles
◆ No foreseeable limit on time the asset is expected to provide
cash flows.

◆ Must test indefinite-life intangibles for impairment at least

annually.

◆ No amortization.

12-7 LO 3
 INTANGIBLE ASSET ISSUES

Amortization of Intangibles ILLUSTRATION 12-2

Accounting Treatment
for Intangibles

12-8 LO 3
 TYPES OF INTANGIBLE ASSETS

Six Major Categories:

(1) Marketing-related. (4) Contract-related.

(2) Customer-related. (5) Technology-related.

(3) Artistic-related. (6) Goodwill.

12-9 LO 4
 TYPES OF INTANGIBLE ASSETS

Marketing-Related Intangible Assets

◆ Examples:
► Trademarks or trade names, newspaper
mastheads, Internet domain names, and non-
competition agreements.

◆ In Ethiopia trademark or trade name has legal protection

for indefinite number of 7 year renewal periods
(Trademark Registration and Protection Proclamation
No.501/2006)..

◆ Capitalize purchase price.

◆ No amortization.
12-10 LO 4
 TYPES OF INTANGIBLE ASSETS

Customer-Related Intangible Assets

◆ Examples:

► Customer lists, order or production backlogs,

and both contractual and non-contractual
customer relationships.

◆ Capitalize acquisition costs.

◆ Amortized to expense over useful life.

12-11 LO 4
 TYPES OF INTANGIBLE ASSETS
Illustration: Green Market Inc. acquires the customer list of a large
newspaper for €6,000,000 on January 1, 2015. Green Market
expects to benefit from the information evenly over a three-year
period. Record the purchase of the customer list and the
amortization of the customer list at the end of each year.

Jan. 1 Customer List 6,000,000

2015
Cash 6,000,000

Dec. 31 Amortization Expense 2,000,000

2015
Customer List * 2,000,000
2016
2017

12-12 * or Accumulated Amortization LO 4

 TYPES OF INTANGIBLE ASSETS

Artistic-Related Intangible Assets

◆ Examples:
► Plays, literary works, musical works, pictures,
photographs, and video and audiovisual material.

◆ Copyright granted for the life of the creator plus 70 years.

◆ In Ethiopia copyright is granted for the life of the creator plus
50 years (Copyright and Neighboring Rights Protection
Proclamation No. 410/2004). Mickey
and Mouse
◆ Capitalize costs of acquiring and defending.

◆ Amortized to expense over useful life if less than the legal

life.
12-13 LO 4
 TYPES OF INTANGIBLE ASSETS

Contract-Related Intangible Assets

◆ Examples:
► Franchise and licensing agreements, construction permits,
broadcast rights, and service or supply contracts.

◆ Franchise (or license) with a limited life should be amortized

as operating expense over the life of the franchise.

◆ Franchise with an indefinite life should be carried at cost and

not amortized.

12-14 LO 4
 TYPES OF INTANGIBLE ASSETS

Technology-Related Intangible Assets

◆ Examples:
► Patented technology and trade secrets granted by a
government body.
◆ Patent gives holder exclusive use for a period of 20 years.
◆ In Ethiopia patent gives the holder exclusive use for a period of
15 years (Inventions, Minor Inventions and Industrial Designs
Proclamation No. 123/1995).
◆ Capitalize costs of purchasing a patent.
◆ Expense any R&D costs in developing a patent.
◆ Amortize over legal life or useful life, whichever is shorter.

12-15 LO 4
 TYPES OF INTANGIBLE ASSETS
Illustration: Harcott Co. incurs $180,000 in legal costs on January
1, 2015, to successfully defend a patent. The patent’s useful life is
20 years, amortized on a straight-line basis. Harcott records the
legal fees and the amortization at the end of 2015 as follows.

Jan. 1 Patents 180,000

Cash 180,000

Dec. 31 Patent Amortization Expense 9,000

Patents (or Accumulated Amortization) 9,000

Patent Amortization Expense = ($180,000 ÷ 20) = $9,000

12-16 LO 4
 TYPES OF INTANGIBLE ASSETS

Goodwill
Conceptually, represents the future economic benefits arising from
the other assets acquired in a business combination that are not
individually identified and separately recognized.

Only recorded when an entire business is purchased.

Goodwill is measured as the excess of ...

cost of the purchase over the fair value of the identifiable net
assets (assets less liabilities) purchased.

Internally created goodwill should not be capitalized.

12-17 LO 5
 RECORDING GOODWILL

Illustration: Feng, Inc. decides that it needs a parts division to

supplement its existing tractor distributorship. The president of Feng is
interested in buying Tractorling Company. The illustration presents the
statement of financial position of Tractorling Company.

ILLUSTRATION 12-4

12-18 LO 5
 RECORDING GOODWILL

Illustration: Feng investigates Tractorling’s underlying assets to

determine their fair values.
ILLUSTRATION 12-5

Tractorling Company decides to accept Feng’s offer of $400,000. What

is the value of the goodwill, if any?

12-19 LO 5
 RECORDING GOODWILL

Illustration: Determination of Goodwill.

ILLUSTRATION 12-6

12-20 LO 5
 Book Value = $200,000
Revaluation
$150,000
Fair Value = $350,000
Goodwill
$50,000
Purchase Price = $400,000

12-21
 RECORDING GOODWILL

Illustration: Feng records this transaction as follows.

Property, Plant, and Equipment 205,000

Patents 18,000
Inventory 122,000
Accounts Receivables 35,000
Cash 25,000
Goodwill 50,000
Liabilities 55,000
Cash 400,000

12-22 LO 5
 RECORDING GOODWILL

Goodwill Write-Off
◆ Goodwill considered to have an indefinite life.

◆ Should not be amortized.

◆ Only adjust carrying value when goodwill is impaired.

Bargain Purchase
◆ Purchase price less than the fair value of net assets
acquired.

◆ Amount is recorded as a gain by the purchaser.

12-23 LO 5
 IMPAIRMENT OF INTANGIBLE ASSETS
Impairment of Limited-Life Intangibles
A long-lived tangible and intangible asset are impaired when a company
is not able to recover the asset’s carrying amount either through using it
or by selling it.

The impairment loss is the carrying amount of the asset less the
recoverable amount of the impaired asset.

12-24 LO 6
 IMPAIRMENT OF INTANGIBLE ASSETS
Illustration: Lerch, Inc. has a patent on how to extract oil from shale
rock, with a carrying value of €5,000,000 at the end of 2014.
Unfortunately, several recent non-shale-oil discoveries adversely
affected the demand for shale-oil technology, indicating that the patent
is impaired. Lerch determines the recoverable amount for the patent,
based on value-in-use (because there is no active market for the
patent). Lerch estimates the patent’s value-in-use at €2,000,000,
based on the discounted expected net future cash flows at its market
rate of interest.
.

12-25 LO 6
 IMPAIRMENT OF INTANGIBLE ASSETS

Calculate the impairment loss (based on value-in-use).

€3,000,000 Impairment Loss

ILLUSTRATION 11-15
€5,000,000 €2,000,000

Unknown €2,000,000

12-26 LO 6
 IMPAIRMENT OF INTANGIBLE ASSETS

Calculate the impairment loss (based on value-in-use).

€3,000,000 Impairment Loss

ILLUSTRATION 11-15
€5,000,000 €2,000,000

Lerch makes the following entry to record the impairment.

Loss on Impairment 3,000,000
Unknown $2,000,000
Patents 3,000,000
12-27 LO 6
 IMPAIRMENT OF INTANGIBLE ASSETS

Reversal of Impairment Loss

Illustration: The carrying value of the patent after impairment is
€2,000,000. Lerch’s amortization is €400,000 (€2000,000 ÷ 5) over
the remaining five years of the patent’s life. The amortization expense
and related carrying amount after the impairment is shown below:
ILLUSTRATION 12-8

12-28 LO 6
 IMPAIRMENT OF INTANGIBLE ASSETS

Reversal of Impairment Loss

Early in 2016, based on improving conditions in the market for
shale-oil technology, Lerch remeasures the recoverable amount of
the patent to be €1,750,000. In this case, Lerch reverses a portion
of the recognized impairment loss.

Patents (€1,750,000 - €1,600,000) 150,000

Recovery of Impairment Loss 150,000

12-29 LO 6
 IMPAIRMENT OF INTANGIBLE ASSETS

Impairment of Indefinite-Life Intangibles

Other than Goodwill
◆ Should be tested for impairment at least annually.

◆ Impairment test is the same as that for limited-life

intangibles. That is,

► compare the recoverable amount of the intangible

asset with the asset’s carrying value.

► If the recoverable amount is less than the carrying

amount, the company recognizes an impairment.

12-30 LO 6
 IMPAIRMENT OF INTANGIBLE ASSETS

Illustration: Arcon Radio purchased a broadcast license for

€2,000,000. The license is renewable every 10 years. Arcon Radio
has renewed the license with the GCC twice, at a minimal cost.
Because it expects cash flows to last indefinitely, Arcon reports the
license as an indefinite-life intangible asset. Recently, the GCC
decided to auction these licenses to the highest bidder instead of
renewing them. Based on recent auctions of similar licenses, Arcon
Radio estimates the fair value less costs to sell (the recoverable
amount) of its license to be €1,500,000.
ILLUSTRATION 12-9
Computation of Loss on
Impairment of Broadcast License

12-31 LO 6
 IMPAIRMENT OF INTANGIBLE ASSETS

Impairment of Goodwill
◆ Companies must test goodwill at least annually.

◆ Impairment test is conducted based on the cash-generating

unit to which the goodwill is assigned.

► Cash-generating unit = smallest identifiable group of

assets that generate cash flow.

◆ Because there is rarely a market for cash-generating units,

estimation of the recoverable amount for goodwill
impairments is usually based on value-in-use estimates.

12-32 LO 6
 IMPAIRMENT OF INTANGIBLE ASSETS

Illustration: Kohlbuy Corporation has three divisions. It purchased

one division, Pritt Products, four years ago for €2 million.
Unfortunately, Pritt experienced operating losses over the last three
quarters. Kohlbuy management is now reviewing the division (the
cash-generating unit), for purposes of its annual impairment testing.
Illustration 12-10 lists the Pritt Division’s net assets, including the
associated goodwill of €900,000 from the purchase.
ILLUSTRATION 12-10

12-33 LO 6
 IMPAIRMENT OF INTANGIBLE ASSETS
Kohlbuy determines the recoverable amount for the Pritt Division to
be €2,800,000, based on a value-in-use estimate.

ILLUSTRATION 11-15
$2,400,000 $2,800,000

No
Impairment

Unknown $2,800,000
12-34 LO 6
 IMPAIRMENT OF INTANGIBLE ASSETS
Assume that the recoverable amount for the Pritt Division is
€1,900,000 instead of €2,800,000.

$500,000 Impairment Loss

ILLUSTRATION 11-15
$2,400,000 $1,900,000

Unknown $1,900,000
12-35 LO 7
6
 IMPAIRMENT OF INTANGIBLE ASSETS
Assume that the recoverable amount for the Pritt Division is
€1,900,000 instead of €2,800,000.

$500,000 Impairment Loss

ILLUSTRATION 11-15
$2,400,000 $1,900,000

Kohlbuy makes the following entry to record the impairment.

Loss on Impairment 500,000

Goodwill Unknown 500,000

$1,900,000
12-36 LO 7
6
 RESEARCH AND DEVELOPMENT COSTS

Research and development (R&D) costs are not in

themselves intangible assets.

Frequently results in the development of patents or

copyrights such as new

◆ product, ◆ formula,

◆ process, ◆ composition, or

◆ idea, ◆ literary work.

12-37 LO 7
 RESEARCH AND DEVELOPMENT COSTS

Companies spend considerable sums on research and

development. ILLUSTRATION 12-12
R&D Outlays, as a
Percentage of Sales

12-38 LO 7
 RESEARCH AND DEVELOPMENT COSTS

◆ Research costs must be expensed as incurred.

◆ Development costs may or may not be expensed as

incurred.

◆ Capitalization begins when the project is far enough along

in the process such that the economic benefits of the R&D
project will flow to the company (the project is
economically viable).

12-39 LO 7
 RESEARCH AND DEVELOPMENT COSTS

Identifying R & D Activities ILLUSTRATION 12-13

Research Activities versus
Development Activities

Research Activities Examples

Original and planned investigation Laboratory research aimed at discovery of
undertaken with the prospect of gaining new knowledge; searching for applications of
new scientific or technical knowledge new research findings.
and understanding.

Development Activities Examples

Application of research findings or other Conceptual formulation and design of
knowledge to a plan or design for the possible product or process alternatives;
production of new or substantially construction of prototypes and
improved materials, devices, products, operation of pilot plants.
processes, systems, or services before
the start of commercial production or
use.

12-40 LO 7
 RESEARCH AND DEVELOPMENT COSTS

Accounting for R & D Activities

Costs Associated with R&D Activities:
◆ Materials, equipment, and facilities.

◆ Personnel.

◆ Purchased intangibles.

◆ Contract Services.

◆ Indirect Costs.

12-41 LO 8
 RESEARCH AND DEVELOPMENT COSTS
E12-1: Indicate how items on the list below would generally be reported in
the financial statements.

Item Classification

1. Investment in a subsidiary company. 1. Long-term investments

2. Timberland. 2. PP&E
3. Cost of engineering activity required to 3. R&D expense
advance the design of a product to the
manufacturing stage.
4. Lease prepayment (6 months’ rent). 4. Prepaid rent
5. Cost of equipment obtained. 5. PP&E
6. Cost of searching for applications of 6. R&D expense
new research findings.
12-42 LO 8
 RESEARCH AND DEVELOPMENT COSTS

Item Classification

7. Cost incurred in the formation of a 7. Expense

corporation.
8. Operating losses incurred in the 8. Operating loss
start-up of a business.
9. Training costs incurred in start-up of 9. Expense
new operation.
10. Purchase cost of a franchise. 10. Intangible
11. Goodwill generated internally. 11. Not recorded
12. Cost of testing in search of product 12. R&D expense
alternatives.

12-43 LO 8
 RESEARCH AND DEVELOPMENT COSTS

Item Classification

13. Goodwill acquired in the purchase 13. Intangible

of a business.
14. Cost of developing a patent (before 14. R&D expense
achieving economic viability).
15. Cost of purchasing a patent from 15. Intangible
an inventor.
16. Legal costs incurred in securing a 16. Intangible
patent.
17. Unrecovered costs of a successful legal 17. Intangible
suit to protect the patent.

12-44 LO 8
 RESEARCH AND DEVELOPMENT COSTS

Item Classification

18. Cost of conceptual formulation of 18. R&D expense

possible product alternatives.
19. Cost of purchasing a copyright. 19. Intangible
20. Development costs incurred after 20. Intangible
achieving economic viability.
21. Long-term receivables. 21. Long-term investment
22. Cost of developing a trademark. 22. Expense
23. Cost of purchasing a trademark. 23. Intangible

12-45 LO 8
 RESEARCH AND DEVELOPMENT COSTS

Costs Similar to R & D Costs

◆ Start-up costs for a new operation.

◆ Initial operating losses.

◆ Advertising costs.

These costs are expensed as incurred, similar to the accounting

for R&D costs.

12-46 LO 8
 RESEARCH AND DEVELOPMENT COSTS
E12-17: Compute the amount to be reported as research and
development expense.
$330,000 / 5 = $66,000 R&D
Expense
Cost of equipment acquired that will have alternative
uses in future R&D projects over the next 5 years. $330,000 $66,000
Materials consumed in R&D projects 59,000 59,000

Consulting fees paid to outsiders for R&D projects 100,000 100,000

Personnel costs of persons involved in R&D projects 128,000 128,000

Indirect costs reasonably allocable to R&D projects 50,000 50,000
Materials purchased for future R&D projects 34,000 0

$403,000

12-47 LO 8
 PRESENTATION OF INTANGIBLES

Presentation of Intangible Assets

Statement of Financial Position
◆ Companies should report as a separate item all intangible
assets other than goodwill.

◆ Reporting is similar to the reporting of property, plant, and

equipment.

◆ Contra accounts may not normally shown for intangibles.

12-48 LO 9
 PRESENTATION OF INTANGIBLES

Presentation of Intangible Assets

Income Statement

Companies should report

◆ amortization expense and

◆ impairment losses and reversals

for intangible assets other than goodwill separately in net income

(usually in the operating section).

Notes to the financial statements should include the amortization

expense for each type of asset.
12-49 LO 9
 PRESENTATION OF INTANGIBLES

Presentation of Intangible Assets

ILLUSTRATION 12-15
Nestlé’s Intangible Asset
Disclosures

12-50 LO 9
 PRESENTATION OF INTANGIBLES

Presentation of Research and Development

Costs
Companies should disclose the total R&D costs charged to
expense each period.
ILLUSTRATION 12-16
R&D Reporting

12-51 LO 9
 CHAPTER 1
CURRENT LIABILITIES, PROVISIONS, AND
CONTINGENCIES

13-1
 CURRENT LIABILITIES
“What is a Liability?”

Liability is defined as present obligation of the company

arising from past events, the settlement of which is expected
to result in an outflow from the company of resources,
embodying economic benefits.

Three essential characteristics:

1. Present obligation.

2. Arises from past events.

3. Results in an outflow of resources

(cash, goods, services).
13-2
 CURRENT LIABILITIES
Recall: Current assets are cash or other assets that companies
reasonably expect to convert into cash, sell, or consume in operations
within a single operating cycle or within a year.
Current liabilities are “obligations whose liquidation is reasonably
expected to require use of existing resources properly classified as
current assets, or the creation of other current liabilities.”

A current liability is reported if one of two conditions exists:

1. Liability is expected to be settled within its normal operating cycle; or

2. Liability is expected to be settled within 12 months after the reporting

date.

The operating cycle is the period of time elapsing between the acquisition
of goods and services and the final cash realization resulting from sales and
subsequent collections.
13-3
 CURRENT LIABILITIES

Typical Current Liabilities:

1. Accounts payable. 6. Customer advances and
deposits.
2. Notes payable.
7. Unearned revenues.
3. Current maturities of long-
term debt. 8. Sales and value-added
taxes payable.
4. Short-term obligations
expected to be refinanced. 9. Income taxes payable.

5. Dividends payable. 10. Employee-related liabilities.

13-4
 CURRENT LIABILITIES

Accounts Payable (trade accounts payable)

Balances owed to others for goods, supplies, or services
purchased on open account.

◆ Arises because of time lag between the receipt of services

or acquisition of title to assets and the payment for them.

◆ Terms of the sale (e.g., 2/10, n/30 or 1/10, E.O.M.) usually

state period of extended credit, commonly 30 to 60 days.

◆ These liabilities typically are noninterest-bearing and are

reported at their face amounts.
13-5
 CURRENT LIABILITIES

Notes Payable
Written promises to pay a certain sum of money on a
specified future date.
◆ Arise from purchases, financing, or other transactions.

◆ Notes classified as short-term or long-term.

◆ Notes may be interest-bearing or zero-interest-bearing.

13-6
 CURRENT LIABILITIES

Interest-Bearing Note Issued

Illustration: Castle National Bank agrees to lend €100,000 on
March 1, 2015, to Landscape Co. if Landscape signs a
€100,000, 6 percent, four-month note. Landscape records the
cash received on March 1 as follows:

Cash 100,000
Notes Payable 100,000

13-7
 Interest-Bearing Note Issued

If Landscape prepares financial statements semiannually, it

makes the following adjusting entry to recognize interest
expense and interest payable at June 30, 2015:

Interest calculation = (€100,000 x 6% x 4/12) = €2,000

Interest Expense 2,000

Interest Payable 2,000

13-8
 Interest-Bearing Note Issued

At maturity (July 1, 2016), Landscape records payment of the

note and accrued interest as follows.

Notes Payable 100,000

Interest Payable 2,000
Cash 102,000

13-9
 CURRENT LIABILITIES
Zero-Interest-Bearing Note Issued
This note does not explicitly state an interest rate on the
face of a note. Interest is still charged, however. At
maturity, the borrower must pay back an amount greater
than the cash received at issuance date.
Illustration: On March 1, Landscape issues a €102,000, four-
month, zero-interest-bearing note to Castle National Bank. The
present value of the note is €100,000. Landscape records this
transaction as follows.
Cash 100,000
Notes Payable 100,000
OR
Cash 100,000
Discount on Notes Payable 2,000
13-10
Notes Payable 102,000
 Zero-Interest-Bearing Note Issued

If Landscape prepares financial statements semiannually, it

makes the following adjusting entry to recognize interest
expense and the increase in the note payable of €2,000 at
June 30.
Interest Expense 2,000
Notes Payable/Discount on N/P 2,000

At maturity (July 1), Landscape must pay the note, as follows.

Notes Payable 102,000

Cash 102,000

13-11
 CURRENT LIABILITIES

E13-2: (Accounts and Notes Payable) The following are selected

2015 transactions of Darby Corporation.

Sept. 1 - Purchased inventory from Orion Company on

account for $50,000. Darby records purchases gross and uses
a periodic inventory system.

Oct. 1 - Issued a $50,000, 12-month, 8% note to Orion in

payment of account.

Oct. 1 - Borrowed $75,000 from the Shore Bank by signing a

12-month, zero-interest-bearing $81,000 note.

Prepare journal entries for the selected transactions.

13-12 LO 1
 CURRENT LIABILITIES

Sept. 1 - Purchased inventory from Orion Company on

account for $50,000. Darby records purchases gross and
uses a periodic inventory system.

Sept. 1 Purchases 50,000

Accounts Payable 50,000

13-13
 CURRENT LIABILITIES

Oct. 1 - Issued a $50,000, 12-month, 8% note to Orion in

payment of account.

Oct. 1 Accounts Payable 50,000

Notes Payable 50,000

Interest calculation = ($50,000 x 8% x 3/12) = $1,000

Dec. 31 Interest Expense 1,000

Interest Payable 1,000

13-14
 CURRENT LIABILITIES

Oct. 1 - Borrowed $75,000 from the Shore Bank by signing a

12-month, zero-interest-bearing $81,000 note.

Oct. 1 Cash 75,000

Notes Payable 75,000

Interest calculation = ($6,000 x 3/12) = $1,500

Dec. 31 Interest Expense 1,500

Notes Payable 1,500

13-15
 CURRENT LIABILITIES

Current Maturities of Long-Term Debt

Portion of bonds, mortgage notes, and other long-term
indebtedness that matures within the next fiscal year. It
categorizes this amount as current maturities of long-term
debt

Exclude long-term debts maturing currently if they are to be:

1. Retired by assets accumulated that have not been shown as
current assets,

2. Refinanced, or retired from the proceeds of a new debt issue, or

3. Converted into ordinary shares.

13-16
 CURRENT LIABILITIES

Short-Term Obligations Expected to Be Refinanced

Refinancing a short term obligation on a long term basis
means either replacing it with a long term obligation or equity
securities or renewing, extending or replacing it with short
term obligations for an uninterrupted period extending beyond
one year (or the normal operating cycle) from the date of the
company’s statement of financial position.
Exclude from current liabilities if both of the following conditions are
met:
1. Must intend to refinance the obligation on a long-term basis.

2. Must have an unconditional right to defer settlement of the liability

13-17 for at least 12 months after the reporting date.
 CURRENT LIABILITIES

E13-4 (Refinancing of Short-Term Debt): The CFO for Yong

Corporation is discussing with the company’s chief executive
officer issues related to the company’s short-term obligations.
Presently, both the current ratio and the acid-test ratio for the
company are quite low, and the chief executive officer is
wondering if any of these short-term obligations could be
reclassified as long-term. The financial reporting date is
December 31, 2014. Two short-term obligations were discussed,
and the following action was taken by the CFO.

Instructions: Indicate how these transactions should be reported

at Dec. 31, 2014, on Yongs’ statement of financial position.

13-18
 CURRENT LIABILITIES

Short-Term Obligation A: Yong has a $50,000 short-term

obligation due on March 1, 2015. The CFO discussed with its
lender whether the payment could be extended to March 1, 2017,
provided Yong agrees to provide additional collateral. An
agreement is reached on February 1, 2015, to change the loan
terms to extend the obligation’s maturity to March 1, 2017. The
financial statements are authorized for issuance on April 1, 2015.

Liability of Refinance Liability due Statement

$50,000 completed for payment Issuance

Dec. 31, 2014 Feb. 1, 2015 Mar. 1, 2015 Apr. 1, 2015

13-19
 CURRENT LIABILITIES

Short-Term Obligation A: Yong has a $50,000 short-term

obligation due on March 1, 2015. The CFO discussed with its
lender whether the payment could be extended to March 1, 2017,
provided Yong agrees to provide additional collateral. An
agreement is reached on February 1, 2015, to change the loan
terms to extend the obligation’s maturity to March 1, 2017. The
financial statements are authorized for issuance on April 1, 2015.

Current Liability
of $50,000 Since the agreement was not in place as of the reporting
date (December 31, 2015), the obligation should be
Dec. 31, 2015 reported as a current liability.

13-20
 CURRENT LIABILITIES

Short-Term Obligation B: Yong also has another short-term

obligation of $120,000 due on February 15, 2015. In its discussion
with the lender, the lender agrees to extend the maturity date to
February 1, 2016. The agreement is signed on December 18,
2014. The financial statements are authorized for issuance on
March 31, 2015.

Refinance Liability of Liability due Statement

completed $120,000 for payment Issuance

Dec. 18, 2014 Dec. 31, 2014 Feb. 15, 2015 Mar. 31, 2015

13-21
 CURRENT LIABILITIES

Short-Term Obligation B: Yong also has another short-term

obligation of $120,000 due on February 15, 2015. In its discussion
with the lender, the lender agrees to extend the maturity date to
February 1, 2016. The agreement is signed on December 18,
2014. The financial statements are authorized for issuance on
March 31, 2015.
Non-Current
Refinance Liability of Since the agreement was in place as of
completed $120,000
the reporting date (December 31, 2014),
the obligation is reported as a non-
Dec. 18, 2014 Dec. 31, 2014
current liability.

13-22
 Current Liabilities

Illustration: On December 31, 2014, Alexander Company had

$1,200,000 of short-term debt in the form of notes payable due
February 2, 2015. On January 21, 2015, the company issued 25,000
shares of its common stock for $36 per share, receiving $900,000
proceeds after brokerage fees and other costs of issuance. On
February 2, 2015, the proceeds from the stock sale, supplemented by
an additional $300,000 cash, are used to liquidate the $1,200,000
debt. The December 31, 2014, balance sheet is issued on February
23, 2015.
Instructions:
Show how the $1,200,000 of short-term debt should be presented on
the December 31, 2014, balance sheet, including note disclosure

13-23
 CURRENT LIABILITIES: Dividends Payable
Amount owed by a corporation to its stockholders as a result of board
of directors’ authorization.
◆ Because companies always pay cash dividends within one year
of declaration (generally within three months), they classify
them as current liabilities.
◆ Undeclared dividends on cumulative preference shares not
recognized as a liability. Why? Because preferred dividends in
arrears are not an obligation until the board of directors
a u t h o r i z e s the payment.
◆ Dividends payable in the form of additional shares are not
recognized as a liability because such stock dividends do not
require future outlays of assets or services.
► Reported in equity because they represent retained
earnings in the process of transfer to paid-in capital.
13-24
 CURRENT LIABILITIES

Customer Advances and Deposits

Returnable cash deposits received from customers and
employees.

◆ To guarantee performance of a contract or service or

◆ As guarantees to cover payment of expected future

obligations.
Note: May be classified as current or non-current liabilities.
The classification of these items as current or noncurrent liabilities
depends on the time between the date of the deposit and the
termination of the relationship that required the deposit.
13-25
 CURRENT LIABILITIES: Unearned Revenues
Payment received before providing goods or performing
services.
How do these companies account for unearned revenues ?
1. When a company receives an advance payment, it debits Cash, and
credits a current liability account identifying the source of the
unearned revenue.
2. When a company recognizes revenue, it debits the unearned revenue
account, and credits a revenue account.

13-26
 CURRENT LIABILITIES

BE13-6: Sports Pro Magazine sold 12,000 annual subscriptions

on August 1, 2015, for €18 each. Prepare Sports Pro’s August 1,
2015, journal entry and the December 31, 2015, annual adjusting
entry.

Aug. 1 Cash 216,000

Unearned Revenue 216,000
(12,000 x €18)

Dec. 31 Unearned Revenue 90,000

Subscription Revenue 90,000
(€216,000 x 5/12 = €90,000)

13-27 LO 2
 CURRENT LIABILITIES

Sales and Value-Added Taxes Payable

Consumption taxes are generally either

◆ a sales tax or

◆ a value-added tax (VAT).

Purpose is to generate revenue for the government.

The two systems use different methods to accomplish this

objective.

13-28
 Sales Taxes Payable

Illustration: Halo Supermarket sells loaves of bread to

consumers on a given day for €2,400. Assuming a sales tax
rate of 10 percent, Halo Supermarket makes the following entry
to record the sale.
Cash 2,640
Sales Revenue 2,400
Sales Taxes Payable 240

13-29
 Value-Added Taxes Payable

Illustration: The VAT is collected every time a business

purchases products from another business in the product’s
supply chain. To illustrate,

1. Hill Farms Wheat Company grows wheat and sells it to

Sunshine Baking for €1,000. Hill Farms Wheat makes the
following entry to record the sale, assuming the VAT is 10
percent.

Cash 1,100
Sales Revenue 1,000
Value-Added Taxes Payable 100

13-30
 Value-Added Taxes Payable

2. Sunshine Baking makes loaves of bread from this wheat and

sells it to Halo Supermarket for €2,000. Sunshine Baking
makes the following entry to record the sale, assuming the
VAT is 10 percent.

Cash 2,200
Sales Revenue 2,000
Value-Added Taxes Payable 200

Sunshine Baking then remits €100 to the government, not €200. The
reason: Sunshine Baking has already paid €100 to Hill Farms Wheat.

13-31
 Value-Added Taxes Payable

3. Halo Supermarket sells the loaves of bread to consumers for

€2,400. Halo Supermarket makes the following entry to
record the sale, assuming the VAT is 10 percent.

Cash 2,640
Sales Revenue 2,400
Value-Added Taxes Payable 240

Halo Supermarket then sends only €40 to the tax authority as it

deducts the €200 VAT already paid to Sunshine Baking.

13-32
 CURRENT LIABILITIES

Income Tax Payable

Businesses must prepare an income tax return and compute the
income tax payable.

◆ Taxes payable are a current liability.

◆ Corporations must make periodic tax payments.

◆ Differences between taxable income and accounting income

sometimes occur. Because of these differences, the amount of
income taxes payable to the government in any given year may differ
substantially from income tax expense as reported on the financial
statements.
13-33
 CURRENT LIABILITIES

Employee-Related Liabilities
Amounts owed to employees for salaries or wages are
reported as a current liability.

Current liabilities may include:

◆ Payroll deductions.

◆ Compensated absences.

◆ Bonuses.

13-34
 Employee-Related Liabilities
Payroll Deductions
To the extent that a company has not remitted the amounts
deducted to the proper authority at the end of the accounting
period, it should recognize them as current liabilities.
Taxes:
► Social Security Taxes

► Income Tax Withholding

13-35
 Employee-Related Liabilities

Illustration: Assume a weekly payroll of $10,000 entirely subject to

Social Security taxes (8%), with income tax withholding of $1,320 and
union dues of $88 deducted. The company records the wages and
salaries paid and the employee payroll deductions as follows.

Wages and Salaries Expense 10,000

Withholding Taxes Payable 1,320
Social Security Taxes Payable 800
Union Dues Payable 88
Cash 7,792

13-36
 Employee-Related Liabilities

Illustration: Assume a weekly payroll of $10,000 entirely

subject to Social Security taxes (8%), with income tax
withholding of $1,320 and union dues of $88 deducted.
The company records the employer payroll taxes as
follows.
Payroll Tax Expense 800
Social Security Taxes Payable 800

The employer must remit to the government its share of

Social Security tax along with the amount of Social
Security tax deducted from each employee’s gross
compensation.
13-37
 Employee-Related Liabilities

Compensated Absences
Paid absences for vacation, illness and maternity, paternity,
and jury leaves.
Companies should accrue a liability for the cost of
compensation for future absences if all of the following
conditions exist.
(a) The employer’s obligation relating to employees’ rights to
receive compensation for future absences is attributable to
employees’ services already rendered.
(b) The obligation relates to the rights that vest or accumulate.
(c) Payment of the compensation is probable.
(d) The amount can be reasonably estimated.
13-38
 Employee-Related Liabilities
Compensated Absences
The following considerations are relevant to the accounting for
compensated absences.
Vested rights - employer has an obligation to make payment to an
employee even after terminating his or her employment. Thus,
vested rights are not contingent on an employee’s future service.

Accumulated rights - employees can carry forward to future periods

if not used in the period in which earned.

Non-accumulating rights - do not carry forward; they lapse if not

used.
Companies should recognize the expense and related liability
for compensated absences in the year earned by employees.
13-39
 Employee-Related Liabilities

Illustration: Amutron Inc. began operations on January 1, 2015. The

company employs 10 individuals and pays each €480 per week.
Employees earned 20 unused vacation weeks in 2015. In 2016, the
employees used the vacation weeks, but now they each earn €540
per week. Amutron accrues the accumulated vacation pay on
December 31, 2015, as follows.

Salaries and Wages Expense 9,600

Salaries and Wages Payable 9,600

In 2016, it records the payment of vacation pay as follows.

Salaries and Wages Payable 9,600

Salaries and Wages Expense 1,200
Cash 10,800
13-40
 Employee-Related Liabilities

Profit-Sharing and Bonus Plans

Payments to certain or all employees in addition to their regular
salaries or wages.
Frequently the bonus amount depends on the company’s
yearly profit.
A company may consider bonus payments to employees as
additional wages and should include them as a deduction in
determining the net income for the year.
◆ Bonuses paid are an operating expense.
◆ Unpaid bonuses should be reported as a current liability.

13-41
 PROVISIONS

Provision is a liability of uncertain timing or amount.

Reported either as current or non-current liability.

Common types are

► Obligations related to litigation (lawsuit).

Uncertainty about the
► Warrantees or product guarantees. timing or amount of
the future expenditure
► Business restructurings. required to settle the
obligation.
► Environmental damage.

13-42
 Recognition of a Provision

Companies accrue an expense and related liability for a

provision only if the following three conditions are met:

1. Company has a present obligation (legal or constructive) as

a result of a past event;

2. Probable that an outflow of resources will be required to

settle the obligation; and

3. A reliable estimate can be made.

13-43
 Recognition of a Provision
Recognition Examples
A reliable estimate of the amount of the obligation can be determined.

ILLUSTRATION 13-5
Recognition of a Provision—Warranty
13-44
 Recognition Examples

Constructive obligation is an obligation that derives from a

company’s actions where:

1. By an established pattern of past practice, published

policies, or a sufficiently specific current statement, the
company has indicated to other parties that it will accept
certain responsibilities; and

2. As a result, the company has created a valid expectation

on the part of those other parties that it will discharge those
responsibilities.

13-45
 Recognition Examples

A reliable estimate of the amount of the obligation can be determined.

ILLUSTRATION 13-6
Recognition of a Provision—Refunds
13-46
 Recognition Examples
A reliable estimate of the amount of the obligation can be determined.

ILLUSTRATION 13-7
13-47 Recognition of a Provision—Lawsuit
 Measurement of Provisions

How does a company determine the amount to report

for a provision?

IFRS:
Amount recognized should be the best estimate of the
expenditure required to settle the present obligation.

Best estimate represents the amount that a company would pay

to settle the obligation at the statement of financial position date.

13-48
 Measurement of Provisions

Measurement Examples
Management must use judgment, based on past or similar
transactions, discussions with experts, and any other pertinent
information.

Toyota warranties. Toyota might determine that 80

percent of its cars will not have any warranty cost, 12
percent will have substantial costs, and 8 percent will have a much
smaller cost. In this case, by weighting all the possible outcomes by
their associated probabilities, Toyota arrives at an expected value
for its warranty liability.

13-49
 Measurement of Provisions

Measurement Examples
Management must use judgment, based on past or similar
transactions, discussions with experts, and any other pertinent
information.

Carrefour refunds. Carrefour sells many items at

varying selling prices. Refunds to customers for products
sold may be viewed as a continuous range of refunds, with each
point in the range having the same probability of occurrence. In this
case, the midpoint in the range can be used as the basis for
measuring the amount of the refunds.

13-50
 Measurement of Provisions

Measurement Examples

Novartis lawsuit. Large companies like Novartis are

involved in numerous litigation issues related to their
products. Where a single obligation such as a lawsuit is being
measured, the most likely outcome of the lawsuit may be the best
estimate of the liability.

Measurement of the liability should consider the time value of money,

if material. Future events that may have an impact on the
measurement of the costs should be considered.

13-51
 Common Types of Provisions

Common Types:
1. Lawsuits 4. Environmental

2. Warranties 5. Onerous contracts

3. Consideration payable 6. Restructuring

IFRS requires extensive disclosure related to provisions in the notes to

the financial statements. Companies do not record or report in the
notes general risk contingencies inherent in business operations (e.g.,
the possibility of war, strike, uninsurable catastrophes, or a business
recession).

13-52
 Common Types of Provisions

Litigation Provisions
Companies must consider the following in determining
whether to record a liability with respect to pending or
threatened litigation and actual or possible claims and
assessments.

1. The time period in which the underlying cause of action

occurred.

2. The probability of an unfavorable outcome.

3. Ability to make a reasonable estimate of the amount of

13-53
loss.
 Litigation Provisions

With respect to unfiled suits and unasserted claims

and assessments, a company must determine

1. the degree of probability that a suit may be filed or

a claim or assessment may be asserted, and

2. the probability of an unfavorable outcome.

If both are probable, if the loss is reasonably estimable,

and if the cause for action is dated on or before the date
of the financial statements, then the company should
accrue the liability.
13-54
 Litigation Provisions

BE13-12: Scorcese Inc. is involved in a lawsuit at December 31,

2015. (a) Prepare the December 31 entry assuming it is probable
that Scorcese will be liable for 900,000 as a result of this suit. (b)
Prepare the December 31 entry, if any, assuming it is not probable
that Scorcese will be liable for any payment as a result of this suit.

(a) Lawsuit Loss 900,000

Lawsuit Liability 900,000

(b) No entry is necessary. The loss is not accrued because it

is not probable that a liability has been incurred at
12/31/15.
13-55
 Common Types of Provisions

Warranty Provisions
Promise made by a seller to a buyer to make good on a
deficiency of quantity, quality, or performance in a product.

If it is probable that customers will make warranty claims and a

company can reasonably estimate the costs involved, the
company must record an expense.

13-56
 Warranty Provisions

Companies often provide one of two types of warranties to

customers:

Assurance-Type Warranty
A quality guarantee that the good or service is free from
defects at the point of sale.

◆ Obligations should be expensed in the period the

goods are provided or services performed (in other
words, at the point of sale).

◆ Company should record a warranty liability.

13-57
 Assurance-Type Warranty

Facts: Denson Machinery Company begins production of a new

machine in July 2015 and sells 100 of these machines for $5,000
cash by year-end. Each machine is under warranty for one year.
Denson estimates, based on past experience with similar
machines, that the warranty cost will average $200 per unit.
Further, as a result of parts replacements and services performed
in compliance with machinery warranties, it incurs $4,000 in
warranty costs in 2015 and $16,000 in 2016.

Question: What are the journal entries for the sale and the
related warranty costs for 2015 and 2016?

13-58
 Assurance-Type Warranty

Solution: For the sale of the machines and related warranty

costs in 2015 the entry is as follows.

1. To recognize sales of machines and accrual of warranty

liability:

July–December 2015

Cash 500,000
Warranty Expense 20,000
Warranty Liability 20,000
Sales Revenue 500,000

13-59
 Assurance-Type Warranty

Solution: For the sale of the machines and related warranty

costs in 2015 the entry is as follows.

2. To record payment for warranties incurred:

July–December 2015

Warranty Liability 4,000

Cash, Inventory, Accrued Payroll 4,000

The December 31, 2015, statement of financial position reports

Warranty Liability as a current liability of $16,000. The income statement
for 2015 reports Warranty Expense of $20,000.

13-60
 Assurance-Type Warranty

Solution: For the sale of the machines and related warranty

costs in 2015 the entry is as follows.

3. To record payment for warranty costs incurred in 2016

related to 2015 machinery sales:

January 1–December 31, 2016

Warranty Liability 16,000

Cash, Inventory, Accrued Payroll 16,000

At the end of 2016, no warranty liability is reported for the machinery

sold in 2015.

13-61
 Warranty Provisions

Companies often provide one of two types of warranties to

customers:

Service-Type Warranty
An extended warranty on the product at an additional cost.

◆ Usually recorded in an Unearned Warranty Revenue

account.

◆ Recognize revenue on a straight-line basis over the period

the service-type warranty is in effect.

13-62
 Service-Type Warranty

Facts: You purchase an automobile from Hamlin Auto for €30,000

on January 2, 2014. Hamlin estimates the assurance-type
warranty costs on the automobile to be €700 (Hamlin will pay for
repairs for the first 36,000 miles or three years, whichever comes
first). You also purchase for €900 a service-type warranty for an
additional three years or 36,000 miles. Hamlin incurs warranty
costs related to the assurance-type warranty of €500 in 2014 and
€200 in 2015. Hamlin records revenue on the service-type
warranty on a straight-line basis.

Question: What entries should Hamlin make in 2014 and 2017?

13-63
 Service-Type Warranty

Solution:

1. To record the sale of the automobile and related

warranties:

January 2, 2014

Cash (€30,000 + €900) 30,900

Warranty Expense 700
Warranty Liability 700
Unearned Warranty Revenue 900
Sales Revenue 30,000

13-64
 Service-Type Warranty

Solution:

2. To record warranty costs incurred in 2014:

January 2–December 31, 2014

Warranty Liability 500

Cash, Inventory, Accrued Payroll 500

13-65
 Service-Type Warranty

Solution:

3. To record revenue recognized in 2017 on the service-

type warranty:

January 1–December 31, 2017

Unearned Warranty Revenue (€900 ÷ 3) 300

Warranty Revenue 300

13-66
 Common Types of Provisions

Consideration Payable
Companies often make payments (provide consideration) to
their customers as part of a revenue arrangement.

Companies offer premiums, coupon offers, and rebates to

stimulate sales.
◆ Companies should charge the costs of premiums and
coupons to expense in the period of the sale that
benefits from the plan.

13-67
 Consideration Payable

Facts: Fluffy Cake Mix Company sells boxes of cake mix for £3
per box. In addition, Fluffy Cake Mix offers its customers a large
durable mixing bowl in exchange for £1 and 10 box tops. The
mixing bowl costs Fluffy Cake Mix £2, and the company estimates
that customers will redeem 60 percent of the box tops. The
premium offer began in June 2015. During 2015, Fluffy Cake Mix
purchased 20,000 mixing bowls at £2, sold 300,000 boxes of cake
mix for £3 per box, and redeemed 60,000 box tops.

Question: What entries should Fluffy Cake Mix record in 2015?

13-68
 Consideration Payable

Solution:

1. To record purchase of 20,000 mixing bowls at £2 per

bowl:

Premium Inventory (20,000 bowls x £2) 40,000

Cash 40,000

13-69
 Consideration Payable

Solution:

2. Before Fluffy Cake Mix makes the entry to record the

sale of the cake mix boxes, it determines its premium
expense and related premium liability. This
computation is as follows.

13-70
 Consideration Payable

Solution:

2. The entry to record the sale of the cake mix boxes and
premium expense and premium liability is as follows.

Cash (300,000 boxes x £3) 900,000

Premium Expense 18,000
Sales Revenue 900,000
Premium Liability 18,000

13-71
 Consideration Payable

Solution:

3. To record the actual redemption of 60,000 box tops, the

receipt of £1 per 10 box tops, and the delivery of the
mixing bowls:

Cash [(60,000 ÷ 10) x £1] 6,000

Premium Liability 6,000
Premium Inventory [(60,000 ÷ 10) x £2] 12,000

13-72
 Common Types of Provisions

Environmental Provisions
Estimates to clean up existing toxic wastes sites are substantial.
In addition, cost estimates of cleaning up our air and preventing
future deterioration of the environment run even higher.
A company must recognize an environmental liability when it
has an existing legal obligation associated with the retirement of a
long-lived asset and when it can reasonably estimate the amount
of the liability.

13-73
 Environmental Provisions

Obligating Events. Examples of existing legal obligations,

which require recognition of a liability include, but are not
limited to:
► Decommissioning nuclear facilities,
► Dismantling, restoring, and reclamation of oil and gas
properties,
► Certain closure, reclamation, and removal costs of mining
facilities,
► Closure and post-closure costs of landfills.

13-74
 Environmental Provisions

Measurement. A company initially measures an

environmental liability at the best estimate of its future costs.

Recognition and Allocation. To record an environmental

liability a company includes

► the cost associated with the environmental liability in the

carrying amount of the related long-lived asset, and

► records a liability for the same amount.

13-75
 Environmental Provisions

Illustration: On January 1, 2015, Wildcat Oil Company erected an

oil platform in the Gulf of Mexico. Wildcat is legally required to
dismantle and remove the platform at the end of its useful life,
estimated to be five years. Wildcat estimates that dismantling and
removal will cost $1,000,000. Based on a 10 percent discount rate,
the fair value of the environmental liability is estimated to be
$620,920 ($1,000,000 x .62092). Wildcat records this liability on Jan.
1, 2015 as follows.

Drilling Platform 620,920

Environmental Liability 620,920

13-76
 Environmental Provisions

Illustration: During the life of the asset, Wildcat allocates the asset
retirement cost to expense. Using the straight-line method, Wildcat
makes the following entries to record this expense.

December 31, 2015, 2016, 2017, 2018

Depreciation Expense ($620,920 ÷ 5) 124,184

Accumulated Depreciation—Plant Assets 124,184

13-77
 Environmental Provisions

Illustration: In addition, Wildcat must accrue interest expense each

period. Wildcat records interest expense and the related increase in
the environmental liability on December 31, 2015, as follows.

December 31, 2015

Interest Expense ($620,920 x 10%) 62,092

Environmental Liability 62,092

13-78
 Environmental Provisions

Illustration: On January 10, 2020, Wildcat contracts with Rig

Reclaimers, Inc. to dismantle the platform at a contract price of
$995,000. Wildcat makes the following journal entry to
record settlement of the liability.

January 10, 2020

Environmental Liability 1,000,000

Gain on Settlement of Environmental Liability 5,000
Cash 995,000

13-79
 Common Types of Provisions
Onerous Contract Provisions
“The unavoidable costs of meeting the obligations exceed the
economic benefits expected to be received.”
An example of an onerous contract is a loss recognized on
unfavorable non cancelable commitments relate to inventory items.

The expected costs should reflect the least net cost of exiting from
the contract, which is the lower of

1. the cost of fulfilling the contract, or

2. the compensation or penalties arising from failure to fulfill the

contract.

13-80
 Onerous Contract Provisions

Illustration: Sumart Sports operates profitably in a factory that

it has leased and on which it pays monthly rentals. Sumart
decides to relocate its operations to another facility. However,
the lease on the old facility continues for the next three years.
Unfortunately, Sumart cannot cancel the lease nor will it be able
to sublet the factory to another party. The expected costs to
satisfy this onerous contract are €200,000. In this case, Sumart
makes the following entry.

Loss on Lease Contract 200,000

Lease Contract Liability 200,000

13-81
 Onerous Contract Provisions

Assume the same facts as above for the Sumart example and
the expected costs to fulfill the contract are €200,000. However,
Sumart can cancel the lease by paying a penalty of €175,000. In
this case, Sumart should record the liability as follows.

Loss on Lease Contract 175,000

Lease Contract Liability 175,000

13-82
 Common Types of Provisions

Self-Insurance
Self-insurance is not insurance, but risk assumption.
There is little theoretical justification for the establishment of
a liability based on a hypothetical charge to insurance
expense.

Conditions for accrual stated in IFRS are not satisfied prior to

the occurrence of the event.

13-83
 Disclosure Related to Provisions

A company must provide a reconciliation of its beginning to

ending balance for each major class of provisions, identifying
what caused the change during the period.

In addition,

► Provision must be described and the expected timing of

any outflows disclosed.

► Disclosure about uncertainties related to expected

outflows as well as expected reimbursements should be
provided.

13-84
 CONTINGENCIES
“An existing condition, situation, or set of circumstances
involving uncertainty as to possible gain (gain contingency)
or loss (loss contingency) to an enterprise that will
ultimately be resolved when one or more future events occur
or fail to occur.”
Contingent Liabilities/Loss Contingencies
Contingent liabilities are not recognized in the financial
statements because they are
1. A possible obligation (not yet confirmed),
2. A present obligation for which it is not probable that
payment will be made, or
3. A present obligation for which a reliable estimate of the
obligation cannot be made.
13-85
 Loss Contingencies

Probability Accounting
and reasonably estimable
Probable Accrue

Reasonably
Footnote
Possible

Remote Ignore

13-86
 Contingent Liabilities

Illustration 13-16 presents the general guidelines for the

accounting and reporting of contingent liabilities.

ILLUSTRATION 13-16
Contingent Liability
Guidelines

13-87
 CONTINGENCIES

Contingent Assets/Gain Contingencies

A contingent asset is a possible asset that arises from past
events and whose existence will be confirmed by the
occurrence or non-occurrence of uncertain future events not
wholly within the control of the company. Typical contingent
assets are:

1. Possible receipts of monies from gifts, donations, bonuses.

2. Possible refunds from the government in tax disputes.
3. Pending court cases with a probable favorable outcome.

Contingent assets are not recognized on the statement of financial position.

13-88
 Contingent Assets

The general rules related to contingent assets are presented

in Illustration 13-18.

ILLUSTRATION 13-18
Contingent Asset Guidelines

Contingent assets are disclosed when an inflow of economic benefits

is considered more likely than not to occur (greater than 50 percent).

13-89
 PRESENTATION AND ANALYSIS

Presentation of Current Liabilities

◆ Usually reported at their full maturity value.
◆ Difference between present value and the maturity
value is considered immaterial.

13-90
 GLOBAL ACCOUNTING INSIGHTS

LIABILITIES
U.S. GAAP and IFRS have similar definitions for liabilities. In
addition, the accounting for current liabilities is essentially the
same under both IFRS and U.S. GAAP.

13-91
 GLOBAL ACCOUNTING INSIGHTS
Relevant Facts
Similarities

• U.S. GAAP and IFRS have similar liability definitions. Both also
classify liabilities as current and non-current.
• Both U.S. GAAP and IFRS require the best estimate of a probable
loss. In U.S. GAAP, the minimum amount in a range is used.
Under IFRS, if a range of estimates is predicted and no amount in
the range is more likely than any other amount in the range, the
midpoint of the range is used to measure the liability.
• Both U.S. GAAP and IFRS prohibit the recognition of liabilities for
future losses.

13-92
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Differences
• Under U.S. GAAP, companies must classify a refinancing as current only if
it is completed before the financial statements are issued. IFRS requires
that the current portion of long-term debt be classified as current unless an
agreement to refinance on a long-term basis is completed before the
reporting date.
• U.S. GAAP uses the term contingency in a different way than IFRS. A
contingency under U.S. GAAP may be reported as a liability under certain
situations. IFRS does not permit a contingency to be recorded as a liability.
• U.S. GAAP uses the term estimated liabilities to discuss various liability
items that have some uncertainty related to timing or amount. IFRS
generally uses the term provisions.
13-93
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Differences

• U.S. GAAP and IFRS are similar in the treatment of

environmental liabilities. However, the recognition criteria for
environmental liabilities are more stringent under U.S. GAAP:
Environmental liabilities are not recognized unless there is a
present legal obligation and the fair value of the obligation can
be reasonably estimated.
• U.S. GAAP uses the term troubled debt restructurings and
develops recognition rules related to this category. IFRS
generally assumes that all restructurings should be
13-94 considered extinguishments of debt.
 04 Investments

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe the accounting framework 4. Understand the accounting for equity

for financial assets. investments at fair value.

2. Understand the accounting for debt 5. Explain the equity method of

investments at amortized cost. accounting and compare it to the fair
value method for equity investments.
3. Understand the accounting for debt
investments at fair value.

17-1
 ACCOUNTING FOR FINANCIAL ASSETS

Financial Asset
◆ Cash.

◆ Equity investment of another company (e.g., ordinary or

preference shares).

◆ Contractual right to receive cash from another party

(e.g., loans, receivables, and bonds).

IASB requires that companies classify financial assets into two

measurement categories—amortized cost and fair value—
depending on the circumstances.

17-2
 ACCOUNTING FOR FINANCIAL ASSETS

Measurement Basis—A Closer Look

IFRS requires that companies measure their financial
assets based on two criteria:

◆ Company’s business model for managing its financial

assets; and

◆ Contractual cash flow characteristics of the financial

asset.

Only debt investments such as receivables, loans, and bond

investments that meet the two criteria above are recorded at amortized
cost. All other debt investments are recorded and reported at fair value.

17-3
 ACCOUNTING FOR FINANCIAL ASSETS

Measurement Basis—A Closer Look

Equity investments are generally recorded and reported at
fair value.

17-4
 Equity Investments—Trading (Income)

At December 31, 2015, Republic’s equity investment portfolio has

the carrying value and fair value shown.

17-5
 Equity Investments—Trading (Income)

Unrealized Holding Gain or Loss—Income 35,550

Fair Value Adjustment 35,550
17-6
 Equity Investments—Trading (Income)

On January 23, 2016, Republic sold all of its Burberry ordinary

shares, receiving €287,220.

Cash 287,220
Equity Investments 259,700
Gain on Sale of Equity Investment 27,520

17-7
 Equity Investments—Trading (Income)

In addition, assume that on February 10, 2016, Republic purchased

€255,000 of Continental Trucking ordinary shares (20,000 shares
€12.75 per share), plus brokerage commissions of €1,850.
Republic’s equity investment portfolio as of December 31, 2016.

17-8
 Republic records this adjustment as follows.

Fair Value Adjustment 101,650

Unrealized Holding Gain or Loss—Income 101,650

17-9
 Equity Investments—Non-Trading (OCI)

The accounting entries to record non-trading equity

investments are the same as for trading equity investments,
except for recording the unrealized holding gain or loss.

Report the unrealized holding gain or loss as other

comprehensive income (OCI).

17-10
 Equity Investments—Non-Trading (OCI)

Illustration: On December 10, 2015, Republic Corporation

purchased 1,000 ordinary shares of Hawthorne Company for
€20.75 per share (total cost €20,750). The investment represents
less than a 20 percent interest. Hawthorne is a distributor for
Republic products in certain locales, the laws of which require a
minimum level of share ownership of a company in that region.
The investment in Hawthorne meets this regulatory requirement.
Republic accounts for this investment at fair value.

Equity Investments 20,750

Cash 20,750

17-11
 Equity Investments—Non-Trading (OCI)

On December 27, 2015, Republic receives a cash dividend of

€450 on its investment in the ordinary shares of Hawthorne
Company. It records the cash dividend as follows.

Cash 450
Dividend Revenue 450

17-12
 Equity Investments—Non-Trading (OCI)

At December 31, 2015, Republic’s investment

in Hawthorne has the carrying value and fair
value shown.

Republic records this adjustment as follows.

Fair Value Adjustment 3,250

Unrealized Holding Gain or Loss—Equity 3,250
17-13
 Equity Investments—Non-Trading (OCI)

17-14
 Equity Investments—Non-Trading (OCI)

On December 20, 2016, Republic sold all of its Hawthorne

Company ordinary shares receiving net proceeds of €22,500.

Entry to adjust the carrying value of the non-trading investment.

Unrealized Holding Gain or Loss—Equity 1,500

Fair Value Adjustment 1,500

17-15
 Equity Investments—Non-Trading (OCI)

On December 20, 2016, Republic sold all of its Hawthorne

Company ordinary shares receiving net proceeds of €22,500.

Entry to record the sale of the investment.

Cash 22,500
Equity Investments 20,750
Fair Value Adjustment 1,750
17-16
 Holdings Between 20% and 50%

An investment (direct or indirect) of 20 percent or more of the

voting shares of an investee should lead to a presumption that
in the absence of evidence to the contrary, an investor has the
ability to exercise significant influence over an investee.

In instances of “significant influence,” the investor must

account for the investment using the equity method.

17-17
 Holdings Between 20% and 50%

Equity Method
Record the investment at cost and subsequently adjust
the amount each period for
◆ the investor’s proportionate share of the earnings
(losses) and

◆ dividends received by the investor.

If investor’s share of investee’s losses exceeds the carrying amount

of the investment, the investor ordinarily should discontinue
applying the equity method.

17-18
17-19
 Holdings of More Than 50%

Controlling Interest - When one corporation acquires a

voting interest of more than 50 percent in another
corporation.
◆ Investor is referred to as the parent.

◆ Investee is referred to as the subsidiary.

◆ Investment in the subsidiary is reported on the parent’s

books as a long-term investment.

◆ Parent generally prepares consolidated financial

statements.

17-20
 DEBT INVESTMENTS

Debt investments are characterized by contractual

payments on specified dates of
◆ principal and
◆ interest on the principal amount outstanding.

Companies measure debt investments at

◆ amortized cost or
◆ fair value.

17-21
 Debt Investments—Amortized Cost

Illustration: Robinson Company purchased €100,000 of 8%

bonds of Evermaster Corporation on January 1, 2015, at a
discount, paying €92,278. The bonds mature January 1, 2020
and yield 10%; interest is payable each July 1 and January 1.
Robinson records the investment as follows:

January 1, 2015

Debt Investments 92,278

Cash 92,278

17-22
 Debt Investments—Amortized Cost

17-23
 Debt Investments—Amortized Cost

Robinson Company records the receipt of the first semiannual

interest payment on July 1, 2015, as follows:

Cash 4,000
Debt Investments 614
Interest Revenue 4,614

17-24
 Debt Investments—Amortized Cost

Because Robinson is on a calendar-year basis, it accrues

interest and amortizes the discount at December 31, 2015, as
follows:
Interest Receivable 4,000
Debt Investments 645
Interest Revenue 4,645
17-25
 Debt Investments—Amortized Cost

Reporting of Bond Investment at Amortized Cost

17-26
 Assume that Robinson Company sells its investment on
November 1, 2017, at 99¾ plus accrued interest. Robinson
records this discount amortization as follows:

Debt Investments 522

Interest Revenue 522
(€783 x 4/6 = €522)
17-27
 Debt Investments—Amortized Cost

Computation Gain on Sale of Bonds

Cash 102,417
Interest Revenue (4/6 x €4,000) 2,667
Debt Investments 96,193
Gain on Sale of Debt Investments 3,557

17-28
 Debt Investments—Fair Value

Debt investments at fair value follow the same

accounting entries as debt investments held-for-collection
during the reporting period. That is, they are recorded at
amortized cost.

However, at each reporting date, companies

◆ Adjust the amortized cost to fair value.

◆ Any unrealized holding gain or loss reported as part of

net income (fair value method).

17-29
 Debt Investments—Fair Value

Illustration: Robinson Company purchased €100,000 of 8

percent bonds of Evermaster Corporation on January 1, 2015,
at a discount, paying €92,278. The bonds mature January 1,
2020, and yield 10 percent; interest is payable each July 1 and
January 1.

The journal entries in 2015 are exactly the same as those for
amortized cost.

17-30
 Debt Investments—Fair Value

Entries are the same as those for amortized cost.

17-31
 Debt Investments—Fair Value

To apply the fair value approach, Robinson determines that,

due to a decrease in interest rates, the fair value of the debt
investment increased to €95,000 at December 31, 2015.

Fair Value Adjustment 1,463

Unrealized Holding Gain or Loss—Income 1,463

17-32
 Debt Investments—Fair Value

17-33
 Debt Investments—Fair Value

At December 31, 2016, assume that the fair value

of the Evermaster debt investment is €94,000.

Unrealized Holding Gain or Loss—Income 2,388

Fair Value Adjustment 2,388

17-34
 Debt Investments—Fair Value

17-35
 Debt Investments—Fair Value

Assume now that Robinson sells its investment in Evermaster

bonds on November 1, 2017, at 99 ¾ plus accrued interest. The
only difference occurs on December 31, 2017. Since the bonds
are no longer owned by Robinson, the Fair Value Adjustment
account should now be reported at zero. Robinson makes the
following entry to record the elimination of the valuation account.

Fair Value Adjustment 925

Unrealized Holding Gain or Loss—Income 925

17-36
 Debt Investments—Fair Value
Income
Effects on
Debt
Investment
(2015-2017)

17-37
 Debt Investments—Fair Value (portfolio)

Illustration (Portfolio): Wang Corporation has two debt

investments accounted for at fair value. The following illustration
identifies the amortized cost, fair value, and the amount of the
unrealized gain or loss.

17-38
 Debt Investments—Fair Value

Illustration (Portfolio): Wang makes an adjusting entry at

December 31, 2015 to record the decrease in value and to
record the loss as follows.

Unrealized Holding Gain or Loss—Income 9,537

Fair Value Adjustment 9,537

17-39
 Debt Investments—Fair Value

Illustration (Sale of Debt Investments): Wang Corporation

sold the Watson bonds (from Illustration 17-10) on July 1, 2016,
for ¥90,000, at which time it had an amortized cost of ¥94,214.

Cash 90,000
Loss on Sale of Debt Investments 4,214
Debt Investments 94,214

17-40
 Debt Investments—Fair Value

Wang reports this realized loss in the “Other income and

expense” section of the income statement. Assuming no other
purchases and sales of bonds in 2016, Wang on December 31,
2016, prepares the information:

17-41
 Debt Investments—Fair Value

Wang records the following at December 31, 2016.

Fair Value Adjustment 4,537

Unrealized Holding Gain or Loss—Income 4,537

17-42
 Debt Investments—Fair Value

Financial Statement Presentation

17-43
 EQUITY INVESTMENTS

Equity investment represents ownership of ordinary,

preference, or other capital shares.

◆ Cost includes price of the security.

◆ Broker’s commissions and fees are recorded as

expense.

The degree to which one corporation (investor) acquires an

interest in the common stock of another corporation
(investee) generally determines the accounting treatment for
the investment subsequent to acquisition.

17-44
 EQUITY INVESTMENTS

17-45
 EQUITY INVESTMENTS

17-46
 EQUITY INVESTMENTS

Holdings of Less Than 20%

Under IFRS, the presumption is that equity investments are
held-for-trading.

General accounting and reporting rule:

◆ Investments valued at fair value.

◆ Record unrealized gains and losses in net income.

17-47
 EQUITY INVESTMENTS

Holdings of Less Than 20%

IFRS allows companies to classify some equity investments
as non-trading.

General accounting and reporting rule:

◆ Investments valued at fair value.

◆ Record unrealized gains and losses in other

comprehensive income.

17-48
 Equity Investments—Trading (Income)

Illustration: November 3, 2015, Republic Corporation

purchased ordinary shares of three companies, each
investment representing less than a 20 percent interest. These
shares are held-for-trading.

Republic records these investments as follows:

17-49
 Equity
Investments
—Trading

Republic records these investments as follows:

Equity Investments 718,550
Cash 718,550

On December 6, 2015, Republic receives a cash dividend of

€4,200 on its investment in the ordinary shares of Nestlé.

Cash 4,200
Dividend Revenue 4,200

17-50
 Reporting Treatment of Investments

17-51
 EQUITY INVESTMENTS

Equity investment represents ownership of ordinary,

preference, or other capital shares.

◆ Cost includes price of the security.

◆ Broker’s commissions and fees are recorded as

expense.

The degree to which one corporation (investor) acquires an

interest in the common stock of another corporation
(investee) generally determines the accounting treatment for
the investment subsequent to acquisition.

17-1
 EQUITY INVESTMENTS

17-2
 EQUITY INVESTMENTS

17-3
 EQUITY INVESTMENTS

Holdings of Less Than 20%

Under IFRS, the presumption is that equity investments are
held-for-trading.

General accounting and reporting rule:

◆ Investments valued at fair value.

◆ Record unrealized gains and losses in net income.

17-4
 EQUITY INVESTMENTS

Holdings of Less Than 20%

IFRS allows companies to classify some equity investments
as non-trading.

General accounting and reporting rule:

◆ Investments valued at fair value.

◆ Record unrealized gains and losses in other

comprehensive income.

17-5
 Holdings Between 20% and 50%

An investment (direct or indirect) of 20 percent or more of the

voting shares of an investee should lead to a presumption that
in the absence of evidence to the contrary, an investor has the
ability to exercise significant influence over an investee.

In instances of “significant influence,” the investor must

account for the investment using the equity method.

17-6
 Holdings Between 20% and 50%

Equity Method
Record the investment at cost and subsequently adjust
the amount each period for
◆ the investor’s proportionate share of the earnings
(losses) and

◆ dividends received by the investor.

If investor’s share of investee’s losses exceeds the carrying amount

of the investment, the investor ordinarily should discontinue
applying the equity method.

17-7
17-8
 Holdings of More Than 50%

Controlling Interest - When one corporation acquires a

voting interest of more than 50 percent in another
corporation.
◆ Investor is referred to as the parent.

◆ Investee is referred to as the subsidiary.

◆ Investment in the subsidiary is reported on the parent’s

books as a long-term investment.

◆ Parent generally prepares consolidated financial

statements.

17-9
 Reporting Treatment of Investments

17-10
 05 Non-Current Liabilities

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe the formal procedures 5. Explain the accounting for long-term

associated with issuing long- notes payable.
term debt. 6. Describe the accounting for the
extinguishment of non-current liabilities.
2. Identify various types of bond issues.
7. Indicate how to present and analyze
3. Describe the accounting valuation for
non-current liabilities.
bonds at date of issuance.
4. Apply the methods of bond discount
and premium amortization.

14-1
 Characteristics of Bonds
⚫ Debenture bonds. Debenture bonds are bonds that are not secured by
specific property. Their marketability is based on the general credit
rating of the company. Generally, a company must have a long-period
of earnings and continued favorable predictions of future earnings and
liquidity to sell debenture bonds. Debenture bondholders are
considered to be general creditors, with the same rights as other
creditors if the issuer fails to pay the interest or principal and declares
bankruptcy.
⚫ Mortgage Bonds. Mortgage bonds are bonds that are secured by a
lien against specific property of the company. If the company becomes
bankrupt and is liquidated, the holders of these bonds have first claim
against the proceeds of the sale of the assets that secured their debt.
If the proceeds from the sale of pledged assets are not sufficient to
repay the debt, mortgage bondholders become general creditors for
the balance of the unpaid debt.
14-2
 Characteristics of Bonds
⚫ Registered Bonds. Registered bonds are bonds whose ownership
is registered with the company. That is, the company maintains a
record of the holder of each bond. Therefore, on each interest
payment date, interest is paid to the individuals listed on the
corporate records as owners of the bonds. When an owner sells
registered bonds, the issuer or transfer agent must be notified
so that interest will be paid to the proper person.

⚫ Coupon Bonds. Coupon bonds are unregistered bonds on which

interest is claimed by the holder presenting a coupon to the
company. These bonds can be transferred between individuals
without the company or its agent being notified.

14-3
 Characteristics of Bonds
⚫ Zero-Coupon Bonds. Zero-coupon bonds (also called deep-
discount bonds) are bonds on which the interest is not paid until
the maturity date. That is, the bonds are sold at a price
considerably below their face value, interest accrues until
maturity, and then the bondholders are paid the interest along
with the principal at maturity.

⚫ Callable Bonds. Callable bonds are bonds that are callable by the
company at a predetermined price for a specified period. That is,
the company has the right to require the bondholders to return
the bonds before the maturity date, with the company paying
the predetermined price and interest to date.

14-4
 Characteristics of Bonds
⚫ Convertible Bonds. Convertible bonds are bonds that are
convertible into a predetermined number of shares. That is, the
owner of each bond has the right to exchange it for a
predetermined number of shares of the company. Thus, upon
conversion, the bondholder becomes a stockholder of the
company.
⚫ Serial Bonds. Serial bonds are bonds issued at one time, but
portions of the total face value mature in periodic installments
at different future dates. Bonds with several maturities.
⚫ Term Bonds. Term bonds are bonds that pay the entire principal
on one date, i.e. at the maturity date. Bonds with single
maturity.
⚫ Income (Revenue) Bonds. These are bonds whose payment of
interest is conditional on income.
14-5
 Reasons for Issuance of Long-term Debt
Borrowing, which results in a long-term liability, is one of the choices
available to companies seeking to obtain financial resources. There are five
basic reasons why a company might issue long-term debt rather than offer
other types of securities.
1. Debt financing may be the only available source of funds. Many small-
and medium sized companies may appear too risky to investors to attract
equity (i.e., capital stock) investments. Debt securities issued by a company
may be a less risky investment because by law interest is required to be
paid on each interest payment date. Also, some types of debt are secured
by a lien against specific company assets.
2.Debt financing may have a lower cost. Historically, since debt has a lesser
investment risk than stock, it usually has offered a relatively lower rate of
return. In general, investors in equity securities have earned a higher
return. However, because market conditions change, the cost of debt
financing varies, so this advantage depends on the particular market
14-6
conditions.
 Reasons for Issuance of Long-term Debt
3. Debt financing offers an income tax advantage. Interest payments to
debt holders are deductible by a corporation as interest expense for
income tax purposes, whereas dividend payments on equity securities are
not.
4. The voting privilege is not shared. Corporate stockholders may not wish
to share ownership. Thus, by issuing debt, which does not provide voting
rights, ownership interests are not diluted.
5. Debt financing offers the opportunity for leverage. The term leverage (or
trading on the equity) refers to a company’s use of borrowed funds. By
investing these funds, the company expects to earn a return greater than
the interest it will pay for their use and thereby benefit the stockholders.
Earnings in excess of interest charges (net of the applicable income tax
reduction) increase earnings per share. However, if the return falls below
the effective interest rate, earnings per share will decline. Expectations of
current and future earnings, inflation, and the debt/equity relationship
influence the rate of interest needed to issue debt.
14-7
 I. Bonds Payable

Non-current liabilities (long-term debt) consist of an

expected outflow of resources arising from present obligations
that are not payable within a year or the operating cycle of
the company, whichever is longer.

Examples:
► Bonds payable ► Pension liabilities
► Long-term notes payable ► Lease liabilities
► Mortgages payable
Long-term debt has various
covenants or restrictions.

14-8
 Issuing Bonds

◆ Bond contract known as a bond indenture.

◆ Represents a promise to pay:
(1) sum of money at designated maturity date, plus
(2) periodic interest at a specified rate on the maturity
amount (face value).
◆ Paper certificate, typically a €1,000 face value.
◆ Interest payments usually made semiannually.
◆ Used when the amount of capital needed is too large for
one lender to supply.

14-9
 II. Types and Ratings of Bonds

Common types found in practice:

◆ Secured and Unsecured (debenture) bonds.

◆ Term, Serial, and Callable bonds.

◆ Convertible, Commodity-Backed, Deep-Discount bonds.

◆ Registered and Bearer (Coupon) bonds.

◆ Income and Revenue bonds.

14-10
 Types and Ratings of Bonds

Corporate bond listing.

Company Price as a % of par

Name
Interest rate based on price
Interest rate paid as Creditworthiness
a % of par value

14-11
III. Valuation of Bonds Payable @ Issuance

Issuance and marketing of bonds to the public:

◆ Usually takes weeks or months.

◆ Issuing company must

► Arrange for underwriters.

► Obtain regulatory approval of the bond issue, undergo

audits, and issue a prospectus.

► Have bond certificates printed.

14-12
 Valuation of Bonds Payable

Selling price of a bond issue is set by the

◆ supply and demand of buyers and sellers,

◆ relative risk,

◆ market conditions, and

◆ state of the economy.

Investment community values a bond at the present value of

its expected future cash flows, which consist of (1) interest and
(2) principal.

14-13
 Valuation of Bonds Payable

Interest Rate
◆ Stated, coupon, or nominal rate = Rate written in the
terms of the bond indenture.

► Bond issuer sets this rate.

► Stated as a percentage of bond face value (par).

◆ Market rate or effective yield = Rate that provides an

acceptable return commensurate with the issuer’s risk.

► Rate of interest actually earned by the bondholders.

14-14
 Valuation of Bonds Payable

How do you calculate the amount of interest that is actually

paid to the bondholder each period?

(Stated rate x Face Value of the bond)

How do you calculate the amount of interest that is actually

recorded as interest expense by the issuer of the bonds?

(Market rate x Carrying Value of the bond)

14-15
 Valuation of Bonds Payable
Assume Stated Rate of 8%

Market Interest Bonds Sold At

6% Premium

8% Par Value

10% Discount

14-16
 Bonds Issued at Par

Illustration: Santos Company issues R$100,000 in bonds

dated January 1, 2015, due in five years with 9 percent interest
payable annually on January 1. At the time of issue, the market
rate for such bonds is 9 percent.

ILLUSTRATION 3-1
Time Diagram for Bonds
Issued at Par

14-17
 Bonds Issued at Par ILLUSTRATION 14-1
Time Diagram for Bonds
Issued at Par

ILLUSTRATION 14-2
Present Value
Computation of
Bond Selling at Par

14-18
 Bonds Issued at Par

Journal entry on date of issue, Jan. 1, 2015.

Cash 100,000
Bonds payable 100,000

Journal entry to record accrued interest at Dec. 31, 2015.

Interest expense 9,000

Interest payable 9,000

Journal entry to record first payment on Jan. 1, 2016.

Interest payable 9,000

Cash 9,000
14-19
 Bonds Issued at a Discount

Illustration: Assuming now that Santos issues R$100,000

in bonds, due in five years with 9 percent interest payable
annually at year-end. At the time of issue, the market rate for
such bonds is 11 percent.

ILLUSTRATION 14-3
Time Diagram for Bonds
Issued at a Discount

14-20
 Bonds Issued at a Discount ILLUSTRATION 14-3
Time Diagram for Bonds
Issued at a Discount

ILLUSTRATION 14-4
Present Value
Computation of
Bond Selling at
Discount

14-21
 Bonds Issued at a Discount
Journal entry on date of issue, Jan. 1, 2015.
Cash 92,608
Bonds payable 92,608

Journal entry to record accrued interest at Dec. 31, 2015.

Interest expense ($92,608 x 11%) 10,187
Interest payable 9,000
Bonds payable 1,187

Journal entry to record first payment on Jan. 1, 2016.

Interest payable 9,000
Cash 9,000
14-22
 Bonds Issued at a Discount

When bonds sell at less than face value:

► Investors demand a rate of interest higher than stated rate.

► Usually occurs because investors can earn a higher rate

on alternative investments of equal risk.

► Cannot change stated rate so investors refuse to pay face

value for the bonds.

► Investors receive interest at the stated rate computed on

the face value, but they actually earn at an effective rate
because they paid less than face value for the bonds.

14-23
IV. Bond Discount & Premium Amortization

Bond issued at a discount - amount paid at maturity is more

than the issue amount.

Bonds issued at a premium - company pays less at maturity

relative to the issue price.

Adjustment to the cost is recorded as bond interest expense over

the life of the bonds through a process called amortization.

Required procedure for amortization is the effective-interest

method (also called present value amortization).

14-24
 Effective-Interest Method

Effective-interest method produces a periodic interest

expense equal to a constant percentage of the carrying value
of the bonds.

ILLUSTRATION 14-5
Bond Discount and Premium
Amortization Computation

14-25
 Effective-Interest Method

Bonds Issued at a Discount [Term Bonds]

Illustration: Evermaster Corporation issued €100,000 of 8%
term bonds on January 1, 2015, due on January 1, 2020, with
interest payable each July 1 and January 1. Investors require an
effective-interest rate of 10%. Calculate the bond proceeds.

ILLUSTRATION 14-6
Computation of Discount on Bonds Payable

14-26
ILLUSTRATION 14-7
Bond Discount
Amortization Schedule

14-27
 Effective-Interest Method ILLUSTRATION 14-7
Bond Discount
Amortization Schedule

Journal entry on date of issue, Jan. 1, 2015.

Cash 92,278
Bonds Payable 92,278

14-28
 Effective-Interest Method ILLUSTRATION 14-7
Bond Discount
Amortization Schedule

Journal entry to record first payment and amortization of the

discount on July 1, 2015.

Interest expense 4,614

Bonds payable 614
Cash 4,000
14-29
 Effective-Interest Method ILLUSTRATION 14-7
Bond Discount
Amortization Schedule

Journal entry to record accrued interest and amortization of the

discount on Dec. 31, 2015.

Interest expense 4,645

Interest payable 4,000
Bonds payable 645
14-30
 Effective-Interest Method

Bonds Issued at a Premium [Term Bonds]

Illustration: Evermaster Corporation issued €100,000 of 8%
term bonds on January 1, 2015, due on January 1, 2020, with
interest payable each July 1 and January 1. Investors require an
effective-interest rate of 6%. Calculate the bond proceeds.

ILLUSTRATION 14-8
Computation of Premium on Bonds Payable

14-31
ILLUSTRATION 14-9
Bond Premium
Amortization Schedule

14-32
 Effective-Interest Method ILLUSTRATION 14-9
Bond Premium
Amortization Schedule

Journal entry on date of issue, Jan. 1, 2015.

Cash 108,530
Bonds payable 108,530

14-33
 Effective-Interest Method ILLUSTRATION 14-9
Bond Premium
Amortization Schedule

Journal entry to record first payment and amortization of the

premium on July 1, 2015.

Interest expense 3,256

Bonds payable 744
Cash 4,000
14-34
 Effective-Interest Method

Accrued Interest
What happens if Evermaster prepares financial statements at the
end of February 2015? In this case, the company prorates the
premium by the appropriate number of months to arrive at the
proper interest expense, as follows.

ILLUSTRATION 14-10
Computation of Interest
Expense

14-35
 Effective-Interest Method
ILLUSTRATION 14-10
Accrued Interest Computation of Interest
Expense

Evermaster records this accrual as follows.

Interest expense 1,085.33

Bonds payable 248.00
Interest payable 1,333.33

14-36
 Effective-Interest Method

Bonds Issued between Interest Dates

Bond investors will pay the seller the interest accrued from the
last interest payment date to the date of issue.

On the next semiannual interest payment date, bond investors

will receive the full six months’ interest payment.

14-37
 ⚫ When companies issue bonds on other than the
interest payment dates, buyers of the bonds will
pay the seller the interest accrued from the
last interest payment date to the date of issue.
⚫ The purchasers of the bonds, in effect, pay the
bond issuer in advance for that portion of the full
six-months’ interest payment to which they are not
entitled because they have not held the bonds for
that period.
⚫ Then, on the next semiannual interest payment
date, purchasers will receive the full six-
months’ interest payment.

14-38
 Effective-Interest Method

14-39
 Effective-Interest Method

Bonds Issued at Par

Illustration: Assume Evermaster issued its five-year bonds,
dated January 1, 2015, on May 1, 2015, at par (€100,000).
Evermaster records the issuance of the bonds between interest
dates as follows.
(€100,000 x .08 x 4/12) = €2,667

Cash 100,000
Bonds payable 100,000
Cash 2,667
Interest expense 2,667

14-40
 Effective-Interest Method

Bonds Issued at Par

On July 1, 2015, two months after the date of purchase,
Evermaster pays the investors six months’ interest, by making
the following entry. ($100,000 x .08 x 1/2) = $4,000

Interest expense 4,000

Cash 4,000

14-41
 Effective-Interest Method

Bonds Issued at Discount or Premium

Illustration: Assume that the Evermaster 8% bonds were issued
on May 1, 2015, to yield 6%. Thus, the bonds are issued at a
premium price of €108,039. Evermaster records the issuance of
the bonds between interest dates as follows.

Cash 108,039
Bonds payable 108,039
Cash 2,667
Interest expense 2,667

14-42
 Effective-Interest Method

Bonds Issued at Discount or Premium

Evermaster then determines interest expense from the date of
sale (May 1, 2015), not from the date of the bonds (January 1,
2015).

ILLUSTRATION 14-12
Partial Period Interest
Amortization

14-43
 Effective-Interest Method

Bonds Issued at Discount or Premium

The premium amortization of the bonds is also for only two
months.

ILLUSTRATION 14-13
Partial Period Interest
Amortization

14-44
 Effective-Interest Method

Bonds Issued at Discount or Premium

Evermaster therefore makes the following entries on July 1,
2015, to record the interest payment and the premium
amortization.

Interest expense 4,000

Cash 4,000
Bonds payable 253
Interest expense 253

14-45
 V. Long-term Notes Payable

Accounting is Similar to Bonds

◆ A note is valued at the present value of its future interest

and principal cash flows.

◆ Company amortizes any discount or premium over the

life of the note.

14-46
 Notes Issued at Face Value

BE14-9: Coldwell, Inc. issued a €100,000, 4-year, 10% note at

face value to Flint Hills Bank on January 1, 2015, and received
€100,000 cash. The note requires annual interest payments each
December 31. Prepare Coldwell’s journal entries to record (a) the
issuance of the note and (b) the December 31 interest payment.

(a) Cash 100,000

Notes payable 100,000

(b) Interest expense 10,000

Cash 10,000
(€100,000 x 10% = €10,000)

14-47
 Notes Not Issued at Face Value

Zero-Interest-Bearing Notes
Issuing company records the difference between the face
amount and the present value (cash received) as
◆ a discount and
◆ amortizes that amount to interest expense over the life
of the note.

14-48
 Zero-Interest-Bearing Notes

Illustration: Turtle Cove Company issued the three-year,

$10,000, zero-interest-bearing note to Jeremiah Company. The
implicit rate that equated the total cash to be paid ($10,000 at
maturity) to the present value of the future cash flows ($7,721.80
cash proceeds at date of issuance) was 9 percent.

ILLUSTRATION 14-14
Time Diagram for Zero-Interest Note

14-49
 Zero-Interest-Bearing Notes

Illustration: Turtle Cove Company issued the three-year,

$10,000, zero-interest-bearing note to Jeremiah Company. The
implicit rate that equated the total cash to be paid ($10,000 at
maturity) to the present value of the future cash flows ($7,721.80
cash proceeds at date of issuance) was 9 percent.

Turtle Cove records issuance of the note as follows.

Cash 7,721.80
Notes Payable 7,721.80

14-50
 Zero-Interest-Bearing Notes

ILLUSTRATION 14-15
Schedule of Note
Discount Amortization

14-51
 Zero-Interest-Bearing Notes
ILLUSTRATION 14-15
Schedule of Note
Discount Amortization

Turtle Cove records interest expense for year 1 as follows.

Interest Expense ($7,721.80 x 9%) 694.96

Notes Payable 694.96
14-52
 Interest-Bearing Notes

Illustration: Marie Co. issued for cash a €10,000, three-year

note bearing interest at 10 percent to Morgan Corp. The market
rate of interest for a note of similar risk is 12 percent. In this case,
because the effective rate of interest (12%) is greater than the
stated rate (10%), the present value of the note is less than the
face value. That is, the note is exchanged at a discount.

ILLUSTRATION 7-16
Computation of
Present Value—
Effective Rate
Different from
Stated Rate

14-53
 Interest-Bearing Notes

Illustration: Marie Co. issued for cash a €10,000, three-year

note bearing interest at 10 percent to Morgan Corp. The market
rate of interest for a note of similar risk is 12 percent. In this case,
because the effective rate of interest (12%) is greater than the
stated rate (10%), the present value of the note is less than the
face value. That is, the note is exchanged at a discount.

Marie Co. records the issuance of the note as follows.

Cash 9,520
Notes Payable 9,520

14-54
 Interest-Bearing Notes

ILLUSTRATION 14-16
Schedule of Note
Discount Amortization

14-55
 Interest-Bearing Notes
ILLUSTRATION 14-16
Schedule of Note
Discount Amortization

Marie Co. records the following entry at the end of year 1.

Interest Expense 1,142

Notes Payable 142
Cash 1,000
14-56
 Special Notes Payable Situations

Notes Issued for Property, Goods, or Services

When exchanging the debt instrument for property, goods, or
services in a bargained transaction, the stated interest rate is
presumed to be fair unless:

1. No interest rate is stated, or

2. The stated interest rate is unreasonable, or

3. The stated face amount is materially different from the

current cash price for the same or similar items or from the
current fair value of the debt instrument.

14-57
 Special Notes Payable Situations

Choice of Interest Rates

If a company cannot determine the fair value of the property,
goods, services, or other rights, and if the note has no ready
market, the present value of the note must be determined by the
company to approximate an applicable interest rate
(imputation).

Choice of rate is affected by:

► Prevailing rates for similar instruments.

► Factors such as restrictive covenants, collateral, payment

schedule, and the existing prime interest rate.
14-58
 Special Notes Payable Situations

Illustration: On December 31, 2015, Wunderlich Company issued a

promissory note to Brown Interiors Company for architectural
services. The note has a face value of £550,000, a due date of
December 31, 2020, and bears a stated interest rate of 2 percent,
payable at the end of each year. Wunderlich cannot readily
determine the fair value of the architectural services, nor is the note
readily marketable. On the basis of Wunderlich’s credit rating, the
absence of collateral, the prime interest rate at that date, and the
prevailing interest on Wunderlich’s other outstanding debt, the
company imputes an 8 percent interest rate as appropriate in this
circumstance.

14-59
 Special Notes Payable Situations ILLUSTRATION 14-18
Time Diagram for
Interest-Bearing Note

ILLUSTRATION 14-19
Computation of Imputed Fair Value and Note Discount

14-60
 Special Notes Payable Situations

ILLUSTRATION 14-19
Computation of Imputed Fair Value and Note Discount

On December 31, 2015, Wunderlich records issuance of the

note in payment for the architectural services as follows.

Building (or Construction in Process) 418,239

Notes Payable 418,239

14-61
 Special Notes Payable Situations
ILLUSTRATION 14-20
Schedule of Discount
Amortization Using
Imputed Interest Rate

14-62
 Special Notes Payable Situations
ILLUSTRATION 14-20
Schedule of Discount
Amortization Using
Imputed Interest Rate

Payment of first year’s interest and amortization of the discount.

Interest Expense 33,459

Notes Payable 22,459
Cash 11,000
14-63
 Mortgage Notes Payable

A promissory note secured by a document called a mortgage

that pledges title to property as security for the loan.
◆ Common form of long-term notes payable.

◆ Payable in full at maturity or in installments.

◆ Fixed-rate mortgage.

◆ Variable-rate mortgages.

14-64
 Accounting for Serial Bonds

At the beginning of 2006; a company issued $500,000 of

ten-year, 10% serial bonds, to be repaid in the amount of
$50,000 each year. The bond issue costs were $25,000.
Assume that interest payments are made annually and
that the bonds are issued to yield:
Case 1 9% p.a.
Case 2 11% p.a.

14-65
 Accounting for Serial Bonds
Case 1: Bonds are issued to yield 9%
a. Proceeds of bond issue = PV (I) + PV (P)
A B A+B A+B (1+i)-n
Interest Principal Total Discount Present
End of Due Due Amount Due Factor (9%) value
2006 50,000 50,000 100,000 0.917 91,700
2007 45,000 50,000 95,000 0.842 79,990
2008 40,000 50,000 90,000 0.772 69,480
2009 35,000 50,000 85,000 0.708 60,180
2010 30,000 50,000 80,000 0.650 52,000
2011 25,000 50,000 75,000 0.596 44,700
2012 20,000 50,000 70,000 0.547 38,290
2013 15,000 50,000 65,000 0.502 32,630
2014 10,000 50,000 60,000 0.460 27,600
2015 5,000 50,000 55,000 0.422 23,210
Totals 275,000 500,000 775,000 519,780
Proceeds of Serial Bond issue @ 9% yield 519,780
14-66
 Accounting for Serial Bonds
b. Premium on bond issue
Total proceeds……………………………………$519,780
Face value……………………………………………500,000
Premium…………………………………………......19,780

c. Journal entry for the issuance of the serial bonds

Cash……………………………………519,780
Bonds payable…………………………………….519,780

d. Premium amortization table for the serial bonds using the

interest method

14-67
 Accounting for Serial Bonds
d. Premium amortization table for the serial bonds using the interest method
A B C D
Year Carrying Interest Interest Premium Bond Cumulative
Amount Expense Payment Amortization Premium Bal. Principal
(9%*CV) (10%*FV) (C-B) (BB-D) Payment
Issue 519,780 - - - 19,780 -
2006 466,560 46,780 50,000 3,220 16,560 50,000
2007 413,550 41,990 45,000 3,010 13,550 100,000
2008 360,770 37,220 40,000 2,780 10,770 150,000
2009 308,239 32,469 35,000 2,531 8,239 200,000
2010 255,981 27,742 25,000 2,258 5,981 250,000
2011 204,019 23,038 20,000 1,962 4,019 300,000
2012 152,381 18,362 15,000 1,638 2,381 350,000
2013 101,095 13,714 10,000 1,286 1,095 400,000
2014 50,194 9,099 5,000 901 194* 450,000
2015 - 4,517 483* - 500,000
*Rounding up difference

14-68
 Accounting for Serial Bonds
Journal entry to record the retirement of the first serial bond and
the payment of the first interest for 1996:
Bonds payable……………………….53, 220
Bond Interest Expense…………….46,780
Cash 100,000
Case 2: Bonds are issued to Yield 11%
a. Proceeds of bond issue = PV (I) + PV (P)

14-69
 Accounting for Serial Bonds
A B A+B (1+i)-n A+B (1+i)-n
Interest Principal Total Amount Discount Present
End of Due Due Due factor (11%) value
1996 50,000 50,000 100,000 0.901 90,100
1997 45,000 50,000 95,000 0.812 77,140
1998 40,000 50,000 90,000 0.731 65,790
1999 35,000 50,000 85,000 0.659 56,015
2000 30,000 50,000 80,000 0.593 47,440
2001 25,000 50,000 75,000 0.535 40,125
2002 20,000 50,000 70,000 0.482 33,740
2003 15,000 50,000 65,000 0.434 28,210
2004 10,000 50,000 60,000 0.391 23,460
2005 5,000 50,000 55,000 0.352 19,360
Totals 275,000 500,000 775,000 481,380
Proceeds of Serial Bond issue @ 11% yield 481,380

14-70
 Accounting for Serial Bonds

b. Discount on bond issue

Face value……………………………………………500,000
Total proceeds……………………………………$481,380
Discount ………………………………………….......18,620
c. Journal entry to record the issuance of the bonds
Cash ………………………………………….481,380
Bonds Payable…………………………………..481,380

d. Discount amortization table using the interest method

14-71
 Accounting for Serial Bonds
Year Carrying Interest Interest Discount Bond Cumulative
Amount Expense Payment Amortization Discount Principal
(11%) (10%) Balance Payment
Issue 481,380 - - - 18,620 -
1996 434,332 52,952 50,000 2,952 15,668 50,000
1997 387,109 47,777 45,000 2,777 12,891 100,000
1998 339,691 42,582 40,000 2,582 10,309 150,000
1999 292,057 37,366 35,000 2,366 7,943 200,000
2000 244,183 32,126 25,000 2,126 5,817 250,000
2001 196,043 26,860 20,000 1,860 3,957 300,000
2002 147,608 21,565 15,000 1,565 2,392 350,000
2003 98,845 16,237 10,000 1,237 1,155 400,000
2004 49,718 10,873 5,000 873 282* 450,000
2005 - 5,469 496* - 500,000
*Rounding up difference
e. Journal entry to record the retirement of the first serial bond and
the payment of the first interest for 1996:
Bonds payable [50000-2952]……47048
Bond Interest Expense…………..52,952
Cash………………………………… 100,000
14-72
 Accounting for Serial Bonds
The following diagram shows how the book values of bonds are different between the
straight-line and effective interest methods for both a premium and a discount:

14-73
 VI. Special Issues Related To
Non-current Liabilities

Extinguishment of Non-Current Liabilities

(repurchase or retirement of its outstanding bonds)

1. Extinguishment with cash before maturity,

2. Extinguishment by transferring assets or securities, and

3. Extinguishment with modification of terms.

Retirement of bonds at maturity. There is no recognition
of any gain or loss on retirement, as the carrying value is
equal to the maturity value, which is also equal to the
market value of the bonds at that point.
14-74
 Extinguishment of Non-Current Liabilities

Extinguishment with Cash before Maturity

When debt is retired prior to maturity, a gain or loss must
be recognized for the difference between the carrying
value of the debt and the amount paid to satisfy the
obligation.
◆ Net carrying amount > Reacquisition price = Gain
◆ Reacquisition price > Net carrying amount = Loss
◆ At time of reacquisition, unamortized premium or discount
must be amortized up to the reacquisition date.
If the redemption occurs between interest payment dates, adjusting
entries must be made to recognize the accrued interest and to amortize
the bond discount or premium.
14-75
 Extinguishment with Cash before Maturity

Illustration: Evermaster bonds issued at a discount on January 1,

2015. These bonds are due in five years. The bonds have a par value
of €100,000, a coupon rate of 8% paid semiannually, and were sold to
yield 10%.

14-76
 Extinguishment with Cash before Maturity

Two years after the issue date on January 1, 2017, Evermaster

calls the entire issue at 101 and cancels it.

Evermaster records the reacquisition and cancellation of the

bonds as follows.
Bonds Payable 94,925
Loss on Extinguishment of Bonds 6,075
Cash 101,000
14-77
 Extinguishment of Non-Current Liabilities

Extinguishment by Exchanging Assets or

Securities
◆ Creditor should account for the non-cash assets or equity
interest received at their fair value.

◆ Debtor recognizes a gain equal to the excess of the

carrying amount of the payable over the fair value of the
assets or equity transferred (gain).

14-78
 Exchanging Assets

Illustration: Hamburg Bank loaned €20,000,000 to Bonn Mortgage

Company. Bonn, in turn, invested these monies in residential apartment
buildings. However, because of low occupancy rates, it cannot meet its
loan obligations. Hamburg Bank agrees to accept from Bonn Mortgage
real estate with a fair value of €16,000,000 in full settlement of the
€20,000,000 loan obligation. The real estate has a carrying value of
€21,000,000 on the books of Bonn Mortgage. Bonn (debtor) records this
transaction as follows.

Note Payable (to Hamburg Bank) 20,000,000

Loss on Disposal of Real Estate 5,000,000
Real Estate 21,000,000
14-79 Gain on Extinguishment of Debt 4,000,000
 Exchanging Securities

Illustration: Now assume that Hamburg Bank agrees to

accept from Bonn Mortgage 320,000 ordinary shares
(€10 par) that have a fair value of €16,000,000, in full
settlement of the €20,000,000 loan obligation. Bonn
Mortgage (debtor) records this transaction as follows.

Notes Payable (to Hamburg Bank) 20,000,000

Share Capital—Ordinary 3,200,000
Share Premium—Ordinary 12,800,000
Gain on Extinguishment of Debt 4,000,000

14-80
 Extinguishment with Modification of Terms

Creditor may offer one or a combination of the following

modifications:
1. Reduction of the stated interest rate.
2. Extension of the maturity date of the face amount of the
debt.
3. Reduction of the face amount of the debt.
4. Reduction or deferral of any accrued interest.

14-81
 Modification of Terms
Illustration: On December 31, 2015, Morgan National Bank enters
into a debt modification agreement with Resorts Development
Company. The bank restructures a ¥10,500,000 loan receivable
issued at par (interest paid to date) by:
► Reducing the principal obligation from ¥10,500,000 to
¥9,000,000;
► Extending the maturity date from December 31, 2015, to
December 31, 2019; and
► Reducing the interest rate from the historical effective rate of
12 percent to 8 percent. Given Resorts Development’s
financial distress, its market-based borrowing rate is 15
14-82 percent.
 Modification of Terms

IFRS requires the modification to be accounted for as an

extinguishment of the old note and issuance of the new
note, measured at fair value.

14-83
 Modification of Terms

The gain on the modification is ¥3,298,664, which is the

difference between the prior carrying value (¥10,500,000) and
the fair value of the restructured note, as computed in
Illustration 14-23 (¥7,201,336). Given this information, Resorts
Development makes the following entry to record the
modification.

Note Payable (old) 10,500,000

Gain on Extinguishment of Debt 3,298,664
Note Payable (new) 7,201,336

14-84
 Modification of Terms

Amortization schedule for the new note.

14-85
 VII. Presentation and Analysis

Presentation of Non-Current Liabilities

Note disclosures generally indicate the nature of the liabilities,
maturity dates, interest rates, call provisions, conversion
privileges, restrictions imposed by the creditors, and assets
designated or pledged as security.

Fair value of the debt should be disclosed.

Must disclose future payments for sinking fund requirements

and maturity amounts of long-term debt during each of the
next five years.

14-86
 Financial Instrument
(Long Term Debt and Investment)

1
 Basic Concepts and Terminologies

▪Financial instrument
➢Any contract that gives rise to:
• A financial asset of one entity; and
• A financial liability or equity instrument of another entity

2
 Basic Concepts and Terminologies

▪Financial asset
• Cash
• A contractual right to receive cash or another financial asset
• A contractual right to exchange financial assets or liabilities with another
entity on potentially favourable terms
• An equity instrument (e.g. Ordinary shares of another entity).
• Example: Cash, A/c Receivable, Notes Receivable, derivatives, investments

3
 Basic Concepts and Terminologies

▪ Financial liability
• A contractual obligation to deliver cash or another financial asset
• A contractual obligation to exchange financial assets or liabilities with
another entity on potentially unfavourable terms.
• Example: a/c payable, notes payable, bank overdraft, loans payable, certain
preference shares, derivatives
▪ Equity instrument
• A contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities.
• Example: Ordinary shares, certain preference shares
4
BASIC CONCEPTS AND TERMINOLOGIES

5
 Initial Recognition

➢An entity shall recognise a financial asset/liability in its statement of financial

position [SOFP] when, and only when, the entity becomes party to the

contractual provisions of the instrument as a consequence, has a legal right to

receive/pay cash or another financial instrument.

Contract Period

Beginning of contract End of contract

➢Compare this with the recognition criteria for non-financial assets.

6
INITIAL RECOGNITION

7
 Classification of Financial Assets

➢The initial as well as subsequent measurement of financial assets is subject to their

classification.
➢Classification category
1. Financial assets measured at FVTPL
2. Financial assets measured at fair value through other comprehensive income
(FVTOCI)
▪ with gains and losses remaining in other comprehensive income (OCI) without
subsequent reclassification to profit or loss.
▪ with cumulative gains and losses reclassified to profit or loss upon
derecognition.
3. Financial assets measured at amortised cost

8
 Classification/Measurement Bases
of Financial Assets

Criteria I. Business Model Test

Hold to collect Other business

Hold to collect
and Sell model
Cash flows are solely
II.Cash payments of principal
Flows and interest (SPPI)
Amortised cost FVOCI FVTPL
Test

Other types of cash

FVTPL FVTPL FVTPL
flows

9
 Initial Measurement 10

➢ Transaction costs: fees and commission paid to agents, advisers, brokers and
dealers, levies by regulatory agencies and security exchanges, and transfer
taxes and duties
Adjusted for
transaction costs

Initial Initial
Initial =
carrying carrying
carrying Fair value
amount amount
amount

Asset or Liability Asset Liability

Measured Measured
Measured at
at other at other
FVTPL
than FVTPL than FVTPL 10
 Measurement at Initial Recognition

❑ Initial recognition = fair value + transaction costs

❑ Transaction costs include:
▪ Fees and commissions
▪ Levies by regulatory agencies and securities exchanges
▪ taxes and duties
❑ Transaction costs do not include:
▪ Debt premiums or discounts
▪ Financing costs
▪ Internal administrative costs
11
 Initial Measurement

➢ Fair value versus transaction price

◼ Best evidence of the fair value of a financial instrument at initial recognition is
normally the transaction price.
◼ If fair value at initial recognition differs from transaction price recognise (day 1) the
difference between the fair value at initial recognition and the transaction price as a
gain or loss if fair value is evidenced by:
i. a quoted price in an active market for an identical asset or liability (i.e. Level 1); or
ii.based on valuation technique that uses only data from observable markets (i.e.
some Level 2)
12
 Subsequent Measurement of Financial Asset
Amortised Cost (Debt Instruments)

Other
Statement of
Profit or loss Comprehensive
financial position
Income
Interest revenue using
effective interest method

Impairment
Amortised cost Nil
Foreign exchange gains &
losses
Gain or loss on
derecognition

13
 Debt Instruments

Non-current liabilities (long-term debt) consist of an

expected outflow of resources arising from present
obligations that are not payable within a year or the
operating cycle of the company, whichever is longer.
Examples: ► Pension liabilities
► Bonds payable ► Lease liabilities
► Long-term notes payable
Long-term debt has various covenants
► Mortgages payable or restrictions.
 Issuing Bonds

◆ Bond contract known as a bond indenture.

◆ Represents a promise to pay:
(1) sum of money at designated maturity date, plus
(2) periodic interest at a specified rate on the maturity
amount (face value).
◆ Paper certificate, typically a €1,000 face value.
◆ Interest payments usually made semiannually.
◆ Used when the amount of capital needed is too large for one
 Valuation of Bonds Payable @ Issuance

Issuance and marketing of bonds to the public:

◆ Usually takes weeks or months.
◆ Issuing company must
► Arrange for underwriters.
► Obtain regulatory approval of the bond issue, undergo
audits, and issue a prospectus.
► Have bond certificates printed.
 Valuation of Bonds Payable

Selling price of a bond issue is set by the

◆ supply and demand of buyers and sellers,
◆ relative risk,
◆ market conditions, and
◆ state of the economy.

Investment community values a bond at the present value of its

expected future cash flows, which consist of (1) interest and (2)
principal.
 Valuation of Bonds Payable

Interest Rate
◆ Stated, coupon, or nominal rate = Rate written in the terms
of the bond indenture.

► Bond issuer sets this rate.

► Stated as a percentage of bond face value (par).

◆ Market rate or effective yield = Rate that provides an

acceptable return commensurate with the issuer’s risk.
 Valuation of Bonds Payable

How do you calculate the amount of interest that is actually paid to

the bondholder each period?
(Stated rate x Face Value of the bond)

How do you calculate the amount of interest that is actually

recorded as interest expense by the issuer of the bonds?
(Market rate x Carrying Value of the bond)
 Valuation of Bonds Payable

Assume Stated Rate of 8%

Market Interest Bonds Sold At

6% Premium

8% Par Value

10% Discount
 Types of Bonds

◼ Debenture bonds. Debenture bonds are bonds that are not secured by specific property.
Their marketability is based on the general credit rating of the company. Generally, a
company must have a long-period of earnings and continued favorable predictions of
future earnings and liquidity to sell debenture bonds. Debenture bondholders are
considered to be general creditors, with the same rights as other creditors if the issuer
fails to pay the interest or principal and declares bankruptcy.
◼ Mortgage Bonds. Mortgage bonds are bonds that are secured by a lien against specific
property of the company. If the company becomes bankrupt and is liquidated, the
holders of these bonds have first claim against the proceeds of the sale of the assets that
secured their debt. If the proceeds from the sale of pledged assets are not sufficient to
repay the debt, mortgage bondholders become general creditors for the balance of the
unpaid debt.
◼ Registered Bonds. Registered bonds are bonds whose ownership is
registered with the company. That is, the company maintains a record of the
holder of each bond. Therefore, on each interest payment date, interest is
paid to the individuals listed on the corporate records as owners of the
bonds. When an owner sells registered bonds, the issuer or transfer agent
must be notified so that interest will be paid to the proper person.

◼ Coupon Bonds. Coupon bonds are unregistered bonds on which interest is

claimed by the holder presenting a coupon to the company. These bonds
can be transferred between individuals without the company or its agent
being notified.
◼ Zero-Coupon Bonds. Zero-coupon bonds (also called deep-discount bonds) are bonds on
which the interest is not paid until the maturity date. That is, the bonds are sold at a price
considerably below their face value, interest accrues until maturity, and then the
bondholders are paid the interest along with the principal at maturity.

◼ Callable Bonds. Callable bonds are bonds that are callable by the company at a
predetermined price for a specified period. That is, the company has the right to require
the bondholders to return the bonds before the maturity date, with the company paying
the predetermined price and interest to date.
◼ Convertible Bonds. Convertible bonds are bonds that are convertible into a
predetermined number of shares. That is, the owner of each bond has the right to
exchange it for a
predetermined number of shares of the company. Thus, upon conversion, the
bondholder becomes a stockholder of the company.
◼ Serial Bonds. Serial bonds are bonds issued at one time, but portions of the total face
value mature in periodic installments at different future dates. Bonds with several
maturities.
◼ Term Bonds. Term bonds are bonds that pay the entire principal on one date, i.e. at the
maturity date. Bonds with single maturity.
◼ Income (Revenue) Bonds. These are bonds whose payment of interest is conditional on income.
 Subsequent Measurement of Financial Asset
Fair Value Through OCI (FVOCI Debt Instruments)

Statement of
Other Comprehensive
financial Profit or loss
Income
position
Interest revenue using Fair value change other
effective interest method than those recognised in
profit or loss

Fair value Impairment

(amounts accumulated
Foreign exchange gains are recycled to P&L
& losses upon derecognition)

25
 Subsequent Measurement of Investments in
Equity Instruments
Determining the accounting for interests in other entities
(Interaction of IFRS 10, 11, 12 and IAS 28)
Outright control?
Yes No

Consolidation (IFRS 10) Joint control?

Yes No

Determine type of joint arrangement Significant influence?

(IFRS 11)
Yes No

Joint Operation Joint Venture

Financial asset
Account for assets, liabilities, revenues and Equity accounting accounting (IAS
expenses (IFRS 11) (IAS 28) 39/IFRS 9)

IFRS 12 IFRS 7 26
 Subsequent Measurement of Investments in
Equity Instruments

➢Fair value through OCI (investments in equity instruments)

Statement of
Profit or loss Other Comprehensive Income
financial position

Changes in fair value and

foreign exchange component

Fair value Dividends

(amounts accumulated never
recycled to P&L → may be
transferred within equity)

27
 Subsequent Measurement of Investments in
Equity Instruments

➢Fair value through profit or loss

Statement of financial Other comprehensive

Profit or loss
position income (OCI)

Changes in Fair
value
Fair value Nil
Gain or loss on
derecognition

28
 Derecognition of Financial Assets

▪Removal of a previously recognised financial asset from an entity’s statement of financial position.
▪A financial asset is derecognized when and only when:
1. The contractual rights to the cash flows from the financial asset expire; or
2. The financial asset is transferred and the transfer qualifies for derecognition.
➢A financial asset is transferred when:
▪An entity transfers the contractual rights to receive the cash flows of the financial asset, or
▪An entity retains the contractual rights to receive the cash flows of the financial asset, but assumes a
contractual obligation to pay the cash flows to one or more recipients (pass through of cash flows);
➢Transfer of financial asset qualifies for derecognition:
▪if the entity transfers substantially all the risks and rewards of ownership of the financial asset, or
▪if the entity has not retained control
29
 Derecognition of Financial Assets 30

Continuing
Continued recognition involvement

No Yes
Yes
Have Have rights Obligatio Transferred Retained
rights to No to cash No n to ‘pass Yes substantiall No substantiall No Retained
cash flows been through’ y all risks y all risks control of
flows transferred of cash and and the asset?
expired? ? flows rewards? rewards?

Yes Yes Yes No

Derecognition

30
 Derecognition of Financial Assets
Cases
1. A company sells an investment in shares, but retains the right to repurchase the
shares at any time at a price equal to their current fair value.
(Derecognise the asset. )
2. If the company sells an investment in shares and enters into an agreement whereby
the buyer will return any increases in value to the company and the company will
pay the buyer interest plus compensation for any decrease in the value of the
investment.
( Do not derecognise the asset as it has retained substantially all the risks and
rewards.)
31
 Disclosure

❑ The purpose of disclosures prescribed by IFRS 7 is to assist users in assessing the

nature and extent of risks related to financial instruments: Qualitative &

Quantitative Disclosures about:

◼ Market risk

◼ Credit risk

◼ Liquidity risk

32
 Accounting for Serial Bonds

At the beginning of 2006; a company issued $500,000 of

ten-year, 10% serial bonds, to be repaid in the amount of
$50,000 each year. Assume that interest payments are
made annually and that the bonds are issued to yield:
Case 1 9% p.a.
Case 2 11% p.a.

14-1
 Accounting for Serial Bonds
Case 1: Bonds are issued to yield 9%
a. Proceeds of bond issue = PV (I) + PV (P)
A B A+B A+B (1+i)-n
Interest Principal Total Discount Present
End of Due Due Amount Due Factor (9%) value
2006 50,000 50,000 100,000 0.917 91,700
2007 45,000 50,000 95,000 0.842 79,990
2008 40,000 50,000 90,000 0.772 69,480
2009 35,000 50,000 85,000 0.708 60,180
2010 30,000 50,000 80,000 0.650 52,000
2011 25,000 50,000 75,000 0.596 44,700
2012 20,000 50,000 70,000 0.547 38,290
2013 15,000 50,000 65,000 0.502 32,630
2014 10,000 50,000 60,000 0.460 27,600
2015 5,000 50,000 55,000 0.422 23,210
Totals 275,000 500,000 775,000 519,780
Proceeds of Serial Bond issue @ 9% yield 519,780
14-2
 Accounting for Serial Bonds
b. Premium on bond issue
Total proceeds……………………………………$519,780
Face value……………………………………………500,000
Premium…………………………………………......19,780

c. Journal entry for the issuance of the serial bonds

Cash……………………………………519,780
Bonds payable…………………………………….519,780

d. Premium amortization table for the serial bonds using the

interest method

14-3
 Accounting for Serial Bonds
d. Premium amortization table for the serial bonds using the interest method
A B C D
Year Carrying Interest Interest Premium Bond Cumulative
Amount Expense Payment Amortization Premium Bal. Principal
(9%*CV) (10%*FV) (C-B) (BB-D) Payment
Issue 519,780 - - - 19,780 -
2006 466,560 46,780 50,000 3,220 16,560 50,000
2007 413,550 41,990 45,000 3,010 13,550 100,000
2008 360,770 37,220 40,000 2,780 10,770 150,000
2009 308,239 32,469 35,000 2,531 8,239 200,000
2010 255,981 27,742 25,000 2,258 5,981 250,000
2011 204,019 23,038 20,000 1,962 4,019 300,000
2012 152,381 18,362 15,000 1,638 2,381 350,000
2013 101,095 13,714 10,000 1,286 1,095 400,000
2014 50,194 9,099 5,000 901 194* 450,000
2015 - 4,517 483* - 500,000
*Rounding up difference

14-4
 Accounting for Serial Bonds
Journal entry to record the retirement of the first serial bond and
the payment of the first interest for 1996:
Bonds payable……………………….53, 220
Bond Interest Expense…………….46,780
Cash 100,000
Case 2: Bonds are issued to Yield 11%
a. Proceeds of bond issue = PV (I) + PV (P)

14-5
 Accounting for Serial Bonds
A B A+B (1+i)-n A+B (1+i)-n
Interest Principal Total Amount Discount Present
End of Due Due Due factor (11%) value
1996 50,000 50,000 100,000 0.901 90,100
1997 45,000 50,000 95,000 0.812 77,140
1998 40,000 50,000 90,000 0.731 65,790
1999 35,000 50,000 85,000 0.659 56,015
2000 30,000 50,000 80,000 0.593 47,440
2001 25,000 50,000 75,000 0.535 40,125
2002 20,000 50,000 70,000 0.482 33,740
2003 15,000 50,000 65,000 0.434 28,210
2004 10,000 50,000 60,000 0.391 23,460
2005 5,000 50,000 55,000 0.352 19,360
Totals 275,000 500,000 775,000 481,380
Proceeds of Serial Bond issue @ 11% yield 481,380

14-6
 Accounting for Serial Bonds

b. Discount on bond issue

Face value……………………………………………500,000
Total proceeds……………………………………$481,380
Discount ………………………………………….......18,620
c. Journal entry to record the issuance of the bonds
Cash ………………………………………….481,380
Bonds Payable…………………………………..481,380

d. Discount amortization table using the interest method

14-7
 Accounting for Serial Bonds
Year Carrying Interest Interest Discount Bond Cumulative
Amount Expense Payment Amortization Discount Principal
(11%) (10%) Balance Payment
Issue 481,380 - - - 18,620 -
1996 434,332 52,952 50,000 2,952 15,668 50,000
1997 387,109 47,777 45,000 2,777 12,891 100,000
1998 339,691 42,582 40,000 2,582 10,309 150,000
1999 292,057 37,366 35,000 2,366 7,943 200,000
2000 244,183 32,126 25,000 2,126 5,817 250,000
2001 196,043 26,860 20,000 1,860 3,957 300,000
2002 147,608 21,565 15,000 1,565 2,392 350,000
2003 98,845 16,237 10,000 1,237 1,155 400,000
2004 49,718 10,873 5,000 873 282* 450,000
2005 - 5,469 496* - 500,000
*Rounding up difference
e. Journal entry to record the retirement of the first serial bond and
the payment of the first interest for 1996:
Bonds payable [50000-2952]……47048
Bond Interest Expense…………..52,952
Cash………………………………… 100,000
14-8
 VI. Special Issues Related To
Non-current Liabilities

Extinguishment of Non-Current Liabilities

(repurchase or retirement of its outstanding bonds)

1. Extinguishment with cash before maturity,

2. Extinguishment by transferring assets or securities, and

3. Extinguishment with modification of terms.

Retirement of bonds at maturity. There is no recognition
of any gain or loss on retirement, as the carrying value is
equal to the maturity value, which is also equal to the
market value of the bonds at that point.
14-9
 Extinguishment of Non-Current Liabilities

Extinguishment with Cash before Maturity

When debt is retired prior to maturity, a gain or loss must
be recognized for the difference between the carrying
value of the debt and the amount paid to satisfy the
obligation.
◆ Net carrying amount > Reacquisition price = Gain
◆ Reacquisition price > Net carrying amount = Loss
◆ At time of reacquisition, unamortized premium or discount
must be amortized up to the reacquisition date.
If the redemption occurs between interest payment dates, adjusting
entries must be made to recognize the accrued interest and to amortize
the bond discount or premium.
14-10
 Extinguishment with Cash before Maturity

Illustration: Evermaster bonds issued at a discount on January 1,

2015. These bonds are due in five years. The bonds have a par value
of €100,000, a coupon rate of 8% paid semiannually, and were sold to
yield 10%.

14-11
 Extinguishment with Cash before Maturity

Two years after the issue date on January 1, 2017, Evermaster

calls the entire issue at 101 and cancels it.

Evermaster records the reacquisition and cancellation of the

bonds as follows.
Bonds Payable 94,925
Loss on Extinguishment of Bonds 6,075
Cash 101,000
14-12
 Extinguishment of Non-Current Liabilities

Extinguishment by Exchanging Assets or

Securities
◆ Creditor should account for the non-cash assets or equity
interest received at their fair value.

◆ Debtor recognizes a gain equal to the excess of the

carrying amount of the payable over the fair value of the
assets or equity transferred (gain).

14-13
 Exchanging Assets

Illustration: Hamburg Bank loaned €20,000,000 to Bonn Mortgage

Company. Bonn, in turn, invested these monies in residential apartment
buildings. However, because of low occupancy rates, it cannot meet its
loan obligations. Hamburg Bank agrees to accept from Bonn Mortgage
real estate with a fair value of €16,000,000 in full settlement of the
€20,000,000 loan obligation. The real estate has a carrying value of
€21,000,000 on the books of Bonn Mortgage. Bonn (debtor) records this
transaction as follows.

Note Payable (to Hamburg Bank) 20,000,000

Loss on Disposal of Real Estate 5,000,000
Real Estate 21,000,000
14-14 Gain on Extinguishment of Debt 4,000,000
 Exchanging Securities

Illustration: Now assume that Hamburg Bank agrees to

accept from Bonn Mortgage 320,000 ordinary shares
(€10 par) that have a fair value of €16,000,000, in full
settlement of the €20,000,000 loan obligation. Bonn
Mortgage (debtor) records this transaction as follows.

Notes Payable (to Hamburg Bank) 20,000,000

Share Capital—Ordinary 3,200,000
Share Premium—Ordinary 12,800,000
Gain on Extinguishment of Debt 4,000,000

14-15
 Extinguishment with Modification of Terms

Creditor may offer one or a combination of the following

modifications:
1. Reduction of the stated interest rate.
2. Extension of the maturity date of the face amount of the
debt.
3. Reduction of the face amount of the debt.
4. Reduction or deferral of any accrued interest.

14-16
 Modification of Terms
Illustration: On December 31, 2015, Morgan National Bank enters
into a debt modification agreement with Resorts Development
Company. The bank restructures a ¥10,500,000 loan receivable
issued at par (interest paid to date) by:
► Reducing the principal obligation from ¥10,500,000 to
¥9,000,000;
► Extending the maturity date from December 31, 2015, to
December 31, 2019; and
► Reducing the interest rate from the historical effective rate of
12 percent to 8 percent. Given Resorts Development’s
financial distress, its market-based borrowing rate is 15
14-17 percent.
 Modification of Terms

IFRS requires the modification to be accounted for as an

extinguishment of the old note and issuance of the new
note, measured at fair value.

14-18
 Modification of Terms

The gain on the modification is ¥3,298,664, which is the

difference between the prior carrying value (¥10,500,000) and
the fair value of the restructured note, as computed in
Illustration 14-23 (¥7,201,336). Given this information, Resorts
Development makes the following entry to record the
modification.

Note Payable (old) 10,500,000

Gain on Extinguishment of Debt 3,298,664
Note Payable (new) 7,201,336

14-19
 Modification of Terms

Amortization schedule for the new note.

14-20
 VII. Presentation and Analysis

Presentation of Non-Current Liabilities

Note disclosures generally indicate the nature of the liabilities,
maturity dates, interest rates, call provisions, conversion
privileges, restrictions imposed by the creditors, and assets
designated or pledged as security.

Fair value of the debt should be disclosed.

Must disclose future payments for sinking fund requirements

and maturity amounts of long-term debt during each of the
next five years.

14-21
 06 Accounting for Leases

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Explain the nature, economic substance, 5. Describe the lessor’s accounting for
and advantages of lease transactions. direct-financing leases.
2. Describe the accounting criteria and 6. Identify special features of lease
procedures for capitalizing leases by the arrangements that cause unique
lessee. accounting problems.
3. Contrast the operating and capitalization 7. Describe the effect of residual values,
methods of recording leases. guaranteed and unguaranteed, on lease
4. Explain the advantages and economics accounting.
of leasing to lessors and identify the 8. Describe the lessor’s accounting for
classifications of leases for the lessor. sales-type leases.
9. List the disclosure requirements for
21-1 leases.
21-2
 ACCOUNTING BY THE LESSEE

Executory Costs: If the lessor pays

⚫ Insurance this costs exclude
⚫ Maintenance from PV of Minimum
Lease Payment
⚫ Taxes
Calculation
21-3
 ACCOUNTING BY THE LESSEE
Illustration: CNH Capital (NLD) (a subsidiary of CNH Global) and Ivanhoe Mines Ltd.
(CAN) sign a lease agreement dated January 1, 2015, that calls for CNH to lease a front-
end loader to Ivanhoe beginning January 1, 2015. The a front-end loader is explicitly
specified in the contract, and the owner does not have substitution rights. The terms and
provisions of the lease agreement and other pertinent data are as follows.
• The term of the lease is five years. The lease agreement is non-cancelable, requiring
equal rental payments of $25,981.62 at the beginning of each year (annuity-due
basis).
• The loader has a fair value at the inception of the lease of $100,000, an estimated
economic life of five years, and no residual value.
• Ivanhoe pays all of the executory costs directly to third parties except for the property
taxes of $2,000 per year, which is included as part of its annual payments to CNH.
• The lease contains no renewal options. The loader reverts to CNH at the termination
of the lease.
• Ivanhoe’s incremental borrowing rate is 11 percent per year.
• Ivanhoe depreciates similar equipment that it owns on a straight-line basis.
• CNH sets the annual rental to earn a rate of return on its investment of 10 percent
per year; Ivanhoe knows this fact.
21-4
 ACCOUNTING BY THE LESSEE

Computation of Capitalized Lease Payments

Payment $ 25,981.62
Property taxes (executory cost) - 2,000.00
Minimum lease payment 23,981.62
Present value factor (i=10%,n=5) x 4.16986 *

PV of minimum lease payments $100.000.00

Ivanhoe uses CNH’s implicit interest rate of 10 percent instead of its

incremental borrowing rate of 11 percent because (1) it is lower and (2) it
knows about it.

* Present value of an annuity due of 1 for 5 periods at 10% (Table 6-5)

21-5
 ACCOUNTING BY THE LESSEE

Ivanhoe records the finance lease on its books on January 1, 2015,

as:

Leased Equipment 100,000.00

Lease Liability 100,000.00

Ivanhoe records the first lease payment on January 1, 2015, as

follows.

Property Tax Expense 2,000.00

Lease Liability 23,981.62
Cash 25,981.62

21-6
 ACCOUNTING BY THE LESSEE

21-7
 ACCOUNTING BY THE LESSEE

Prepare the entry to record accrued interest at December 31, 2015.

Ivanhoe records accrued interest on December 31, 2014
Interest Expense 7,601.84
Interest Payable 7,601.84
21-8
 ACCOUNTING BY THE LESSEE

Prepare the required on December 31, 2015, to record depreciation

for the year using the straight-line method ($100,000 ÷ 5 years).

Depreciation Expense 20,000

Accumulated Depreciation—Leased Equipment 20,000

The liabilities section as it relates to lease transactions at

December 31, 2015.

21-9
 ACCOUNTING BY THE LESSEE

Ivanhoe
records the
lease
payment of
January 1,
2015, as
follows.

Property Tax Expense 2,000.00

Interest Payable 7,601.84
Lease Liability 16,379.78
Cash 25,981.62
21-10
 ACCOUNTING BY THE LESSEE

What if the contract is no a lease (Lessee)

The lessee assigns rent to the periods benefiting from the use of
the asset and ignores, in the accounting, any commitments to
make future payments.

Illustration: Assume Ivanhoe accounts for the lease as an

operating lease. Ivanhoe records the payment on January 1,
2015, as follows.

Rent Expense 25,981.62

Cash 25,981.62

21-11
 ACCOUNTING BY THE LESSOR

Benefits to the Lessor

1. Interest revenue.

2. Tax incentives.

3. Residual value profits: Another advantage

to the lessor is the return of the
property at the end of the lease term.
Residual values can produce very large
profits.

21-12
 ACCOUNTING BY THE LESSOR

Classification of Leases by the Lessor

a. Operating leases.

b. Finance leases

◆ Direct-financing leases

◆ Sales-type leases

21-13
 ACCOUNTING BY THE LESSOR

Classification of Leases by the Lessor

21-14
 ACCOUNTING BY THE LESSOR

Direct-Financing Method (Lessor)

In substance the financing of an asset purchase by the lessee.

Lessor records:

◆ A lease receivable instead of a leased asset.

◆ Receivable is the present value of the minimum lease

payments plus the present value of the unguaranteed
residual value.

21-15
 ACCOUNTING BY THE LESSOR
Illustration: Using the data from the preceding CNH/Ivanhoe example
we illustrate the accounting treatment for a direct-financing lease. We
repeat here the information relevant to CNH in accounting for this
lease transaction.
1. The term of the lease is five years beginning January 1, 2015,
non-cancelable, and requires equal rental payments of $25,981.62
at the beginning of each year. Payments include $2,000 of
executory costs (property taxes).
2. The equipment (front-end loader) has a cost of $100,000 to CNH,
a fair value at the inception of the lease of $100,000, an estimated
economic life of five years, and no residual value.
3. CNH incurred no initial direct costs in negotiating and closing the
lease transaction.
21-16 (continued)
 ACCOUNTING BY THE LESSOR
We repeat here the information relevant to CNH in accounting for this
lease transaction.
4. The lease contains no renewal options. The equipment reverts to
CNH at the termination of the lease.
5. CNH sets the annual lease payments to ensure a rate of return of
10 percent (implicit rate) on its investment as shown.

Fair market value of leased equipment $ 100,000.00

Present value of residual value (calculation below) -
Amount to be recovered through lease payment 100,000.00
PV factor of annunity due (i=10%, n=5) 4.16986
Annual payment required $ 23,981.62

21-17
 ACCOUNTING BY THE LESSOR

The lease meets the criteria for classification as a direct-

financing lease for two reasons:
1. the lease term equals the equipment’s estimated economic
life, and

2. the present value of the minimum lease payments equals the

equipment's fair value.

It is not a sales-type lease because there is no difference

between the fair value ($100,000) of the loader and CNH’s cost
($100,000).

21-18
 ACCOUNTING BY THE LESSOR

CNH records the lease of the asset and the resulting receivable
on January 1, 2015 (the inception of the lease), as follows.
Lease Receivable 76,018.38
Cash 25,981.62

Property Taxes Payable 2,000.00

Equipment 100,000
Companies often report the lease receivable in the statement of
financial position as “Net investment in finance leases.
21-19
 ACCOUNTING BY THE LESSOR

21-20
 ACCOUNTING BY THE LESSOR

On December 31, 2015, CNH recognizes the interest revenue earned

during the first year through the following entry.

Interest Receivable 7,601.84

Ivanhoe records accrued interest on December 31, 2014
Interest Revenue 7,601.84

21-21
 ACCOUNTING BY THE LESSOR

At December 31, 2015, CNH reports the lease receivable in its

statement of financial position among current assets or non-current
assets, or both. It classifies the portion due within one year or the
operating cycle, whichever is longer, as a current asset, and the rest
with non-current assets.

21-22
 ACCOUNTING BY THE LESSOR

The following entry records the receipt of the second year's lease
payment on January 1, 2016.
Cash 25,981.62
Ivanhoe records accrued interest on December 31, 2014
Lease Receivable 16,379.78
Interest Receivable 7,601.84
Property Taxes Payable 2,000.00
21-23
 ACCOUNTING BY THE LESSOR

The following entry records the recognition of interest earned on

December 31, 2016.

Interest
IvanhoeReceivable 5,963.86
records accrued interest on December 31, 2014
Interest Revenue 5,963.86

21-24
 ACCOUNTING BY THE LESSOR

Operating Method (Lessor)

◆ Records each rental receipt as rental revenue.

◆ Depreciates leased asset in the normal manner.

21-25
 ACCOUNTING BY THE LESSOR

Assuming that the direct-financing lease illustrated for CNH does not
qualify as a finance lease, CNH accounts for it as an operating lease
and records the cash rental receipt as follows.

Cash 25,981.62
Rental Revenue 25,981.62

Depreciation is recorded as follows: ($100,000 ÷ 5 years = $20,000)

Depreciation Expense 20,000

Accumulated Depreciation 20,000

21-26
 SPECIAL ACCOUNTING PROBLEMS

1. Residual values.

2. Sales-type leases (lessor).

3. Bargain-purchase options.

4. Initial direct costs.

5. Current versus non-current classification.

6. Disclosure.

21-27
 SPECIAL ACCOUNTING PROBLEMS

Residual Values
Meaning of Residual Value - Estimated fair value of the
leased asset at the end of the lease term.

Guaranteed versus Unguaranteed – A guaranteed residual

value is when the lessee agrees to make up any deficiency
below a stated amount that the lessor realizes in residual value
at the end of the lease term.

21-28
 SPECIAL ACCOUNTING PROBLEMS

Residual Values
Lease Payments - Lessor may adjust lease payments
because of the increased certainty of recovery of a guaranteed
residual value.

Lessee Accounting for Residual Value - The minimum

lease payment includes a guaranteed residual value but
excludes an unguaranteed residual value.

21-29
 Lease Payments
Illustration: Assume the same data as in the CNH/Ivanhoe illustrations except
that CNH estimates a residual value of $5,000 at the end of the five-year lease
term. In addition, CNH assumes a 10 percent return on investment (ROI), whether
the residual value is guaranteed or unguaranteed. The terms and provisions of the
lease agreement and other pertinent data are as follows.
• The term of the lease is five years. The lease agreement is non-cancelable,
requiring equal rental payments of $25,981.62 at the beginning of each year
(annuity-due basis).
• The loader has a fair value at the inception of the lease of $100,000, an
estimated economic life of five years.
• Ivanhoe pays all of the executory costs directly to third parties except for the
property taxes of $2,000 per year, which is included as part of its annual
payments to CNH.
• The lease contains no renewal options. The loader reverts to CNH at the
termination of the lease.
• Ivanhoe’s incremental borrowing rate is 11 percent per year.
• Ivanhoe depreciates similar equipment that it owns on a straight-line basis.
• CNH sets the annual rental to earn a rate of return on its investment of 10
21-30 percent per year; Ivanhoe knows this fact.
 Lease Payments

CNH assumes a 10 percent return on investment (ROI), whether

the residual value is guaranteed or unguaranteed. CNH would
compute the amount of the lease payments as follows.

21-31
 Lease Accounting for Residual Value

Guaranteed Residual Value (Lessee Accounting)

An additional lease payment that the lessee will pay in property or
cash, or both, at the end of the lease term.

21-32
 Guaranteed Residual Value (Lessee)

21-33
 Guaranteed Residual Value (Lessee)

At the end of the lease term, before the lessee transfers the asset
to CNH, the lease asset and liability accounts have the following
balances. ILLUSTRATION 21-18
Account Balances on Lessee’s Books at End
of Lease Term—Guaranteed Residual Value

Assume that Ivanhoe depreciated the leased asset down to its

residual value of $5,000 but that the fair market value of the
residual value at December 31, 2019, was $3,000. Ivanhoe would
make the following journal entry.

21-34
 Guaranteed Residual Value (Lessee)
ILLUSTRATION 21-18

Loss on Disposal of Equipment 2,000.00

Interest Expense (or Interest Payable) 454.76
Lease Liability 4,545.24
Accumulated Depreciation—Leased Equipment 95,000.00
Leased Equipment 100,000.00
Cash 2,000.00

21-35
 Lease Accounting for Residual Value

Unguaranteed Residual Value (Lessee Accounting)

Assume the same facts as those above except that the $5,000
residual value is unguaranteed instead of guaranteed. CNH will
recover the same amount through lease rentals—that is,
$96,895.40. Ivanhoe would capitalize the amount as follows:

ILLUSTRATION 21-19
Computation of Lessee’s Capitalized
21-36 Amount—Unguaranteed Residual Value
 Unguaranteed Residual Value (Lessee)

21-37
 Unguaranteed Residual Value (Lessee)

At the end of the lease term, before Ivanhoe transfers the asset to
CNH, the lease asset and liability accounts have the following
balances.

21-38
 Lessee Entries Involving Residual Values

21-39
 SPECIAL ACCOUNTING PROBLEMS

Lessor Accounting for Residual Value

The lessor works on the assumption that it will realize the residual
value at the end of the lease term whether guaranteed or
unguaranteed.

Illustration: Assume a direct-financing lease with a residual value

(either guaranteed or unguaranteed) of $5,000. CNH determines the
payments as follows.

21-40
 Lessor Accounting for Residual Value

21-41
 Lessor Accounting for Residual Value

CNH would
make the
following
entry for this
direct-
financing
lease on
1/1/15.

Lease Receivable 76,762.91

Cash 25,237.09
Property Taxes Payable 2,000.00

21-42
Equipment 100,000.00
 Lessor Accounting for Residual Value

CNH would
make the
following
entry for this
direct-
financing
lease on
12/31/15.

Interest Receivable 7,676.29

Interest Revenue 7,676.29

21-43
 SPECIAL ACCOUNTING PROBLEMS

Sales-Type Leases (Lessor)

◆ Primary difference between a direct-financing lease and
a sales-type lease is the manufacturer’s or dealer’s
gross profit (or loss).

◆ Lessor records the sale price of the asset, the cost of

goods sold and related inventory reduction, and the
lease receivable.

◆ There is a difference in accounting for guaranteed and

unguaranteed residual values.

21-44
 Sales-Type Leases (Lessor)

Direct-Financing versus Sales-Type Leases

21-45
 Sales-Type Leases (Lessor)

LEASE RECEIVABLE (also referred to as NET INVESTMENT). The

present value of the minimum lease payments plus the present value of
any unguaranteed residual value. The lease receivable therefore includes
the present value of the residual value, whether guaranteed or not.

SALES PRICE OF THE ASSET. The present value of the minimum lease
payments.

COST OF GOODS SOLD. The cost of the asset to the lessor, less the
present value of any unguaranteed residual value.

21-46
 Sales-Type Leases (Lessor)

Illustration: To illustrate a sales-type lease with a guaranteed

residual value and with an unguaranteed residual value, assume
the same facts as in the preceding direct-financing lease
situation. The estimated residual value is $5,000 (the present
value of which is $3,104.60), and the leased equipment has an
$85,000 cost to the dealer, CNH. Assume that the fair market
value of the residual value is $3,000 at the end of the lease term.

21-47
 Sales-Type Leases (Lessor)

Computation of Lease Amounts by CNH

Financial—Sales-Type Lease

21-48
 Comparative
Sales-Type Leases (Lessor) Entries

21-49
 SPECIAL ACCOUNTING PROBLEMS

Bargain Purchase Option (Lessee)

◆ Lessee must increase the present value of the minimum
lease payments by the present value of the option.

◆ Only difference between the accounting treatment for a

bargain-purchase option and a guaranteed residual value
of identical amounts is in the computation of the
annual depreciation.

21-50
 SPECIAL ACCOUNTING PROBLEMS
Initial Direct Costs (Lessor)
Accounting for initial direct costs:
◆ Operating leases, the lessor should defer initial direct
costs.
◆ Sales-type leases, the lessor expenses the initial direct
costs.
◆ Direct-financing lease, the lessor adds initial direct
costs to the net investment.
Current versus Noncurrent
Both the annuity-due and the ordinary-annuity situations report
the reduction of principal for the next period as a current
liability/current asset.
21-51
 Current versus Noncurrent

The current portion of the lease liability/receivable as of December

31, 2015, would be $18,017.70.

21-52
 SPECIAL ACCOUNTING PROBLEMS

Disclosing Lease Data

For lessees:
◆ A general description of material leasing arrangements.

◆ A reconciliation between the total of future minimum lease

payments at the end of the reporting period and their present
value.

◆ The total of future minimum lease payments at the end of the

reporting period, and their present value for periods (1) not later
than one year, (2) later than one year and not later than five
years, and (3) later than five years.

21-53
 SPECIAL ACCOUNTING PROBLEMS

Disclosing Lease Data

For lessors:
◆ A general description of material leasing arrangements.

◆ A reconciliation between the gross investment in the lease at the

end of the reporting period, and the present value of minimum
lease payments receivable at the end of the reporting period.

◆ Unearned finance income.

◆ The gross investment in the lease and the present value of

minimum lease payments receivable at the end of the reporting
period for periods (1) not later than one year, (2) later than one
year and not later than five years, and (3) later than five years.
21-54
LEASES

1
 Definition and Identification of Leases

IFRS 16 defines Lease as a contract that conveys to the customer

(‘lessee’) the right to use an identified asset in exchange for
consideration for agreed period of time.
Period of time can also be expressed in terms of use of the
asset.

2
 By way of illustration:

◼ an entity might want to transport a specified cargo by ship

from location A to location B, in accordance with a stated
timetable, for a period of five years. To achieve this, it
could either charter a ship over this period or it could
contract to buy the transport service from a freight
carrier/operator (for example, through a contract of
affreightment). In both cases, the goods will arrive at
location B — but the accounting might be quite different.

3
 Identifying Leases
IFRS 16 provides more guidance for the identification of
Leases
Criteria
I. There is an identifiable asset- can be portion of an asset
II. Lessee obtains economic benefits- including benefit from

sub lease.
III. Lessee directs the use – how to use and for what purpose

The guidance helps to assesses whether the lease conveys the

right to control the use of an identified asset to the customer.
4
 Identification of lease
Is there an Identified asset? No
- Yes
-Does the lessee have the right to obtain substantially all of the economic No
benefits from the use of the asset through out the period of use?
Yes
Does the lessee have the right to Direct the use of the asset? i.e. how and for
what purpose the asset is used given the scope of lease contract
Yes No
Does the Lessee have the right to operate the No
asset, without the lessor having the right to
change those operating instruction?

Yes Yes Did the Lessee design the asset in a way that
No
It is a Lease predetermines how and for what purpose It is not
the asset will be used? 5
Lease
 Cont...
◼ An asset is typically identified by being explicitly specified in a contract.
However, an asset can also be identified by being implicitly specified in a
contract.
◼ If an arrangement identifies the asset to be used, but the supplier has a
substantive contractual right to substitute that asset, the arrangement does not
contain an identified asset.
◼ A substitution right is substantive if (a) the supplier can practically use another
asset to fulfil the arrangement throughout the term of the arrangement, and (b)
it is economically beneficial for the supplier to do so.
◼ The supplier’s right or obligation to substitute an asset for repairs, maintenance,
malfunction, or technical upgrade does not preclude the customer from having
the right to use an identified asset.
6
 Cont...
◼ An identified asset must be physically distinct. A physically distinct asset might
be an entire asset or a portion of an asset.
◼ For example, a building is generally considered physically distinct, but one

floor within the building could also be considered physically distinct if it can
be used independently of the other floors (for example, point of entry or exit,
access to lavatories, etc).
◼ A capacity portion of an asset is not an identified asset if (a) the asset is not
physically distinct (for example, the arrangement permits use of a portion of the
capacity of an oil tanker), and (b) a customer does not have the right to
substantially all of the economic benefits from the use of the asset (for example,
several customers share an oil tanker, and no single customer uses substantially
all of the capacity).
7
 Cont...
◼ A customer controls the use of the identified asset by possessing
the right to:
◼ (a) obtain substantially all of the economic benefits from the use of

such asset (‘economics’ criterion); and

◼ (b) direct the use of the identified asset throughout the period of

use (‘power’ criterion).

◼ A customer meets the ‘power’ criterion if it holds the right to

make decisions that have the most significant impact on the

economic benefits derived from the use of the asset.

8
 Cont...
◼ The standard gives several examples of relevant decision-making rights. The
following questions need to be considered when evaluating which party holds
the relevant decision-making rights in the shipping industry:
◼ Which party decides …
◼ which goods are transported?
◼ how often goods are transported?
◼ where goods are transported?
◼ how often the asset is used?
◼ the minimum capacity at which the asset operates?
◼ which route is taken?
◼ If the leasee makes the above decisions, the contract will meet the definition of a
lease.
9
 Cont...
◼ In some cases, the above decisions are pre-determined in the
contract. If the use of the asset is pre-determined, the contract
contains a lease if the charterer has the right to direct the operations of
the asset without the owner having the right to change those operating
instructions, or if the charterer has designed the asset in a way that
pre-determines how and for what purpose the asset will be used
throughout the period of use.

10
 Cont...
◼ There can be terms in the contract that are protective in nature.
Such terms might be included to protect the supplier’s asset, the
supplier’s personnel and to comply with regulations.
◼ For example, a charterer is normally prevented from sailing a ship
into waters with a high risk of piracy or from transporting
dangerous materials/cargo.
◼ The existence of such protective rights alone does not prevent a
customer from having the right to direct the use of an asset.

11
 Facts 1:
◼ Charterer enters into a contract with ship owner for the transportation of cargo
from Rotterdam to Sydney. The ship is explicitly specified in the contract, and
ship owner does not have substitution rights. Charterer has not specified any
modifications to the ship. The cargo will occupy substantially all of the
capacity of the ship. The contract specifies the cargo to be transported on the
ship and the dates of loading and discharging. Ship owner operates and
maintains the ship and is responsible for the safe passage of the cargo on board
the ship. Charterer is prohibited from hiring another operator for the ship or
operating the ship itself during the term of the contract. Also, charterer cannot
alter the routes or the dates for the transportation.

12
 Cont...
◼ Discussion: The contract does not contain a lease.
◼ There is an identified asset. The ship is explicitly specified in the
contract, and ship owner does not have the right to substitute that
specified ship.
◼ Charterer has the right to obtain substantially all of the economic
benefits from use of the ship over the period of use. Its cargo will
occupy substantially all of the capacity of the ship, thereby
preventing other parties from obtaining economic benefits from use
of the ship.

13
 Cont...
◼ However, charterer does not have the right to control the use of the
ship, because it does not have the right to direct its use. Charterer
does not have the right to direct how and for what purpose the ship is
used. How and for what purpose the ship will be used is pre-
determined in the contract (that is, the transportation of specified
cargo from Rotterdam to Sydney within a specified time frame), and
charterer did not design the ship. Charterer has no right to change
how and for what purpose the ship is used during the period of use.

14
 Fact 2:
◼ Charterer enters into a contract with ship owner for the use of a specified ship
for a five-year period. The ship is explicitly specified in the contract, and ship
owner does not have substitution rights. Charterer decides what cargo will be
transported, and whether, when and to which ports the ship will sail,
throughout the five-year period of use, subject to restrictions specified in the
contract. Those restrictions prevent charterer from sailing the ship into waters
at a high risk of piracy or carrying hazardous materials as cargo. Ship owner
operates and maintains the ship and is responsible for the safe passage of the
cargo on board the ship. Charterer is prohibited from hiring another operator
for the ship or operating the ship itself during the term of the contract.

15
 Cont...
◼ Discussion: The contract contains a lease. Charterer has the right to use the
ship for five years.
◼ There is an identified asset. The ship is explicitly specified in the
contract, and ship owner does not have the right to substitute that
specified ship.
◼ Charterer has the right to control the use of the ship throughout the
five-year period of use, because:
◼ a) Charterer has the right to obtain substantially all of the economic
benefits from use of the ship over the five-year period of use.
Charterer has exclusive use of the ship throughout the period of use.
16
 Cont...
◼ b) Charterer has the right to direct the use of the ship, because the conditions in paragraph
B24(a) of IFRS 16 exist. The contractual restrictions about where the ship can sail, and the
cargo to be transported by the ship, limit the scope of charterer’s right to use the ship.
However, they are protective rights that protect ship owner’s investment in the ship and ship
owner’s personnel. Within the scope of its right of use, charterer makes the relevant
decisions about how and for what purpose the ship is used throughout the five-year period
of use, because it decides whether, where and when the ship sails, as well as the cargo that it
will transport. Charterer has the right to change these decisions throughout the five-year
period of use.

◼ Although the operation and maintenance of the ship are essential to its efficient use, ship
owner’s decisions in this regard do not give it the right to direct how and for what purpose
the ship is used. Instead, ship owner’s decisions are dependent on charterer’s decisions about
how and for what purpose the ship is used.
17
 Components, contract consideration and
allocation
◼ An arrangement might contain lease and non-lease components
that are subject to different accounting models. Non-lease
components are those items or activities that transfer a good or
service to the lessee.
◼ Arrangements might also contain multiple lease components.
IFRS 16 requires each separate lease component to be identified
and accounted for separately.

18
 Fact 3
◼ Charterer enters into a time charter with ship owner in which ship owner will
provide transportation services to charterer for a five-year period, using a ship
that is explicitly specified in the contract. Ship owner does not have substitution
rights in relation to the ship that is specified in the contract. Ship owner is
responsible for operating the ship using its own crew, maintaining the ship and
insuring it. Also, ship owner is responsible for providing cleaning services
(‘holds cleaning’) throughout the contract period. Charterer will provide the
dates of travel and the arrival and departure locations. Ship owner cannot use
the ship for any other purpose when it is not being used by charterer. Charterer
will pay to ship owner: (a) a fixed amount per day for chartering the ship; (b) a
fixed amount per month for CVE (communication/victuals/entertainment);
and (c) a fixed amount for each holds cleaning.
◼ Question: What are the components in this arrangement? 19
 Cont...
◼ Discussion: The contract contains one lease component, which is the lease of the ship, and
two non-lease components, which are the services to operate the ship and cleaning services.
◼ Insurance does not represent a separate good or service. Therefore, the element of
the fixed payment per day for chartering the ship, which covers the ship’s
insurance, is not considered a separate component, and it instead forms part of the
overall contract consideration to be allocated to the lease and non-lease
components.
◼ Charterer can either:
◼ a) separate the lease from the non-lease components and allocate consideration to
each component or;
◼ b) apply the practical expedient and account for both the lease and the associated
non-lease components as a single combined lease component.
20
 Then, how lessee account for leases?

◼ In the book of Lessee , IFRS 16 requires that :

✓ all leases are treated as if lessee acquired “the right of use asset.”

and
✓ Lessee recognizes and reports lease asset (Right of use) and lease

liability (if payment made over time) on the balance sheet.

 Cont..
◼ Should all Leases reported on B/sheet as an asset (right-of-use) and liability?
◼ Exemptions: Optional to exclude from B/Sheet. i.e. lessee can elect not to recognize assets and liabilities(rules). Both
of the following qualify for exemption

Short term leases Leases of low value

• of Less than 12 months Leased assets in order of magnitude of

• But consider the likelihood of <$5,000 (<+ETB100,000),
renewal option assessed independently
Eg. Tablet, PC, Small office furniture

✓ Lease payments are reported as an operating expenses in P/L, on either

straight line basis or other systematic basis.
 Recognition & Measurement of Leases-Lessee
◼ Lessees will recognize almost all leases on the balance sheet (as a
“right of-use asset "and “lease liability”)-Single model
◼ The lessee recognizes:
✓ a lease liability at the present value of future lease payments;
✓ a right-of-use asset at an amount prepaid plus lease liability plus initial
direct costs
◼ Subsequently: Recognize depreciation on ROU-Asset and Interest expense
on Lease liability. Apply IAS 36 for impairment of ROU asset.
◼ Practical expedient: for Short term lease and lease of low value assets

23
 Initial measurement and recognitions of leases
I. LESSEE
◼ Initial measurement and recognition
✓ The lessee recognizes, at commencement date, the right to use as ‘an asset’ at cost and a
lease liability at present value.
How much is the cost?
Right-of use asset = Lease Liability…………………………………………………………….XX
+ Initial Direct cost………………………………………………………XX
+ Prepaid lease payment …………………………………………….XX
- lease incentives………………………………………………………(XX)
+ Estimated cost to dismantle, remove or restore………..XX
Right of use asset…………………………………………………………………XXX

Lease Liability = Present Value of rental payments + Present value of guaranteed Residual value
24
 Initial measurement and recognitions of leases -
Lessee
✓ Discount rate to compute the PV of lease liability:
▪ Implicit rate or Incremental borrowing rate (if the lessee cannot determine the former)
✓ Lease term (discounting period):
▪ non-cancellable period of lease contract plus any additional period of renewal option (if
extension is certain).

✓ Once cost is determined, initial recognition:

Debit: Right-of-use asset(lease)……..XX
Credit: Cash/Lease Liability………………………………XX

25
 Subsequent measurement and recognition -Lessee
◼ A lessee measures right of use asset and leases liability as follows:
Subsequent measurement
Right-of-use
Lease liability
• Apply cost model or
• Elect to apply Revaluation model Determine the carrying value
• Accumulated Depreciation applying applying amortized cost
IAS 16 and Accumulated approach
impairment loss applying IAS 36 Increase lease liability by amount
• Depreciation period: of interest and decrease by
• Useful life if ownership transfers or principal payment(rent)
exercisable purchase option or Use the rate used for
• The earlier of lease term or UL determination of PV of liability
• Report depreciation expense in p/L Report Interest expense(finance
charge) in P/L 26
 Examples on measurement and recognition of leases -
Lessee

Example 1: Initial measurement and recognition

ESC enters in to a 10 year non cancellable lease of a building, with expected UL of 20 years.
Lease payment is 50,000 ETB per year payable at the beginning of every year. To obtain a lease
ESC incurred initial direct cost of 20,000 Birr, of which 15,000 ETB is related to payment for the
former tenant occupying that the building and 5,000 ETB relates to the commission for broker
that arranged the lease. As an incentive the lessor reimburse to the ESC, the broker’s
commission of 5000 ETB and ESC’s leasehold improvement of 7000 ETB. The interest rate
implicit in the lease is not readily determinable. The incremental borrowing rate is 5% per
annum. PVOA of 1 for 9 rents at 5%=7.1078
How does the ESC initially measures and recognizes the asset and liability in relation to this
lease?

27
 Examples on measurement and recognition of leases -
Lessee
Example 1: Solution
At the commencement date, ESC makes lease payment for the first year, incurs initial direct costs,
receives lease incentive(note that reimbursement for leasehold improvement is not an incentive)
and measure lease liability as the present value of the remaining nine payments of 50,000 ETB,
discounted at 5% equal to ETB 355,391.

❑ Lease liability = 50,000*7.1078 = ETB 355,391

❑ Right of use asset = 355,391 + 50,000 + 20,000 – 5000 = 420,391 ETB

Initial Recognition shown as follows:

Dr. Right-of-use asset(lease)……..405,391
Cr. Lease liability………………….355,391
Cr. Cash………………………………..50,000

28
 Examples on measurement and recognition of leases -
Lessee

Dr. Right of use assets…20,000

Cr. Cash………………………..20,000
(initial direct cost)
Dr. Cash………5000
Cr. Right-of-use asset……..5000
(lease incentives received by lessee)
Note: ESC accounts for the reimbursement of leasehold improvements from lessor applying other
standards and not as lease incentive. Because the costs incurred on leasehold improvements are
not included within the cost of the right-of-use asset.

29
 Examples on measurement and recognition of leases -Lessee
Example : Subsequent measurement-for Lease liability and Right of use-Schedule for 1st 5 years
Lease liability Right-of-use asset(leased
building)

Beginni periodic payt. Principal Beg. Liability Interest Bal. with Beg. Bal. Depreciati End Bal.
ng of at the payment balance after expense(5 accrued on
year beginning principal %) at the interest at
payment end of the end of

1 - - 355,391 17,770 373,161 420,391 (42,039) 378,352

2 50,000 32,230 323,161 16,158 339,319 378,352 (42,039) 336.313

3 50,000 33,842 289,319 14,466 303,785 336,313 (42,039) 294,274

4 50,000 35,534 253,785 12,689 266,474 294,274 (42,039) 252,232

5 50,000 37,311 216,474 10,823 227,297 252,232 (42,039) 210,196

10 50,000 0 0 0 42,039 (42,039) 0 30

 Examples on measurement and recognition of leases -
Lessee
Example : Subsequent recognition and reporting assuming that the firm recognizes finance
charge on the date of payment
End of first year/Beginning of 2nd year:
Dr. Lease liability………………….32,230
Dr. Finance charge(interest)……. 17,770
Cr. Cash…………….50,000
Dr. Depreciation expense….42,039
Cr. Accumulated depreciation…..42,039
End of 2nd year/Beginning of 3rd year:
Dr. Lease liability………………..33,842
Dr. Finance charge(interest)..16,158
Cr. Cash………………………50,000
31
Examples on measurement and recognition of leases -Lessee
Example : Subsequent reporting
For First year:
In the statement of P/L:
Interest Expense………………. ETB 17,770
Depreciation Expense………………42,039
In the statement of F/P:
Assets
Non-current(PPE)
Right-of-use asset(leased building)…..ETB 420,391
Accumulated depreciation…………………… .(42,039)
Carrying Value(Book Value)…………………… 378,352
Liability
Current-Lease liability(50,000-16,158)……………….33,842
Non-current- Lease liability(323,161-33,842)………289,319
Total…………………………………………………………………. ETB 323,161
32
 Exercise
CNH Capital and Ivanhoe Mines Ltd. sign a lease agreement dated January 1,
2015, that calls for CNH to lease a front-end loader to Ivanhoe beginning January
1, 2015. The terms and provisions of the lease agreement and other pertinent
data are as follows.
• The term of the lease is five years. The lease agreement is non-cancelable,
requiring equal rental payments of $23,981.62 at the beginning of each year
(annuity-due basis).
• The loader has a fair value at the inception of the lease of $100,000, an
estimated economic life of five years, and no residual value.
• The lease contains no renewal options. The loader reverts to CNH at the
termination of the lease.
• Ivanhoe’s incremental borrowing rate is 11 percent per year.
 Lessor Accounting - No significant change

◼ IFRS 16 requires that Lessor classifies leases in to two : Financing Lease

and an Operating Lease
₋ A lease is classified as a finance lease if it transfers substantially all

the risks and rewards incidental to ownership of an underlying asset.

◼ Other wise, Operating Lease.
◼ Finance leases- de-recognize the asset and recognize a lease receivable
◼ Operating leases- continue to recognize the underlying asset and rent
income

34
 Finance Lease-If any of the following indicators exist

Is the lease
term for the Is the present value of
Is there an major part of the lease payment
exercisable economic life equal to substantially
bargain of an asset? all of the fair value of
Purchase the asset?
option?

Is an asset has a
specialized nature that
Is there a
transfer of Finance only the lessee can use
it?
ownership? Lease

35
IFRS 13 - Fair Value Measurement

• Definition of fair value

• Fair value hierarchy
• Valuation techniques
• Application to non financial assets
• Application to liabilities and an entity’s own
equity instruments
• Disclosures
IFRS 13 Fair Value Measurement

The unit of account (IFRS 13.13-14)

When measuring fair value under IFRS 13, the item to
be measured is based on the unit of account specified
by the IFRS or IAS that requires/permits fair value e.g.
a:
• stand-alone asset or liability (e.g. financial asset or
liability)
• group of assets or liabilities (e.g. cash generating
unit)
• group of assets and liabilities (e.g. business)

The unit of account is the level at which an asset or a

liability is aggregated or disaggregated in an IFRS for
recognition purposes.
The unit of account Examples

Example The unit of account

100 shares in a large quoted company

classified as available-for-sale in Each share (stand-alone asset)
accordance with IFRS 9

A non-controlling interest of 10%,

comprising 100 shares, in an acquired Generally considered to be the
entity to be measured at fair value entire non-controlling interest
under IFRS 3

A 100% holding in a subsidiary,

comprising 100 shares, to be Generally considered to be the
measured at fair value in the parent's total 100% of the shares
separate financial statements
IFRS 13 Fair Value Measurement
Definition of fair value (IFRS 13.9)

Fair value is defined as:

• the price that would be received to

sell an asset or paid to transfer a
liability (exit price)

• in an orderly transaction

• between market participants

IFRS 13 Fair Value Measurement
Definition of fair value- characteristics

Exit
price

Not a Definition Market-

liquidation of Fair based
price or
Value approach
forced sale

Current
price
IFRS 13 Fair Value Measurement
Exit price

Fair value is defined as:

• the price that would be received to sell

an asset or paid to transfer a liability
(exit price)…..
The characteristics of the asset or
liability are taken into account in
measuring the fair value if:
– the characteristics are specific
to the asset or liability (rather
than to the entity), and
– they would influence market
participants’ pricing decisions.
Restrictions on use, sale or transfer of assets
Example
Would the following restrictions impact fair value?
Impacts
Scenario
fair value
1. entity holds an equity instrument (financial asset) for which
sale is legally restricted for a specified period and Yes
restriction is embedded in the terms of the instrument

2. entity holds an equity instrument (financial asset) and has

No
agreed with another entity not to sell for at least 12 months

3. charity holds land donated for use only as a playground but

which could be sold to raise funds and the restriction No
would not transfer to the buyer
4. entity holds a piece of land that is subject to an enduring
legal right of the utility company to run power cables across Yes
the land
IFRS 13 Fair Value Measurement
Orderly transaction

Fair value is defined as:

• the…(exit price) Not a liquidation price
or forced sale
• in an orderly transaction….

The transaction to sell the asset or transfer the liability takes

place in the principal market for the asset or liability

In the absence of a principal market, the transaction takes

place in the most advantageous market for the asset or
liability.
Principal or most advantageous market (IFRS 13.16)

assume the transaction the market with the greatest

takes place in the volume and level of activity for
principal market asset or liability

In the
absence of
a principal
market
the market that:
• maximises the amount that would
assume that the be received to sell the asset or
transaction takes place in • minimises the amount that would
the most advantageous be paid to transfer the liability
market after considering transaction costs
and transport costs.
IFRS 13 Fair Value Measurement
Transaction and transport costs (IFRS 13.25-26)

include in
cost type description explanation
fair value
cost to sell the no, but
asset/transfer the consider in characteristic of
transaction liability that are assessment of the transaction,
cost directly attributable which market is not of the
to the disposal or most asset/liability
transfer and would advantageous
not otherwise have
been incurred

cost that would be yes, if location characteristic of

transport cost incurred to transport is a characteristic
an asset from its the asset
current location to its of the asset
exit market
IFRS 13 Fair Value Measurement
Example 1

Price less
Transport Transaction
Market Price transport Net
costs costs
costs
A 27 3 24 3 21

B 25 2 23 1 22

Scenario Fair value

market A is the principal market 24
market B is the principal market 23
neither market is the principal market 23
IFRS 13 Fair Value Measurement
Example 2

Market 1 2
Daily trade volume 100,000 20,000
Price 100 108
Price less transport
95 101
costs
Transaction costs 4 4
Net 91 97

Entity A has an access to the two markets.

Entity A sells in Market 2.
Which Market will determine the fair value in accordance with IFRS 13?
IFRS 13 Fair Value Measurement
Solution
The principal market is market 1 since it has the greatest
volume and level of activity.
The most advantageous market is market 2 since it has
the highest net proceeds.

The fair value will be determined in accordance to market 1

since:
• market 1 is the market with the greatest volume and
level of activity
• Entity A has an access to that market

Therefore, the fair value will be 95.

IFRS 13 Fair Value Measurement
Market participants at the measurement date

Fair value is defined as:

• the…(exit price)
• in an orderly transaction

• between market participants

• at the measurement date.

An entity should measure the fair value of an asset or a

liability using the assumptions that market participants
would use when pricing the asset or liability, assuming that
market participants act in their economic best interest.
Fair value hierarchy (IFRS 13.72-75)

IFRS 13 establishes a three level fair value hierarchy for

inputs to measure fair value:

unadjusted quoted prices in active markets

for identical assets or liabilities
Level 1
inputs other than quoted prices
included in Level 1 that are
observable, either directly or
indirectly
Level 2
unobservable inputs
Level 3
Fair value hierarchy
Level 1 (IFRS 13.76-80)

Level 1
unadjusted quoted prices in active markets for identical assets or
liabilities that the entity can access at the measurement date

A quoted price in an active market provides the

most reliable evidence of fair value and should
be used without adjustment to measure fair
value subject to some exceptions.

Examples for Level 1 inputs:

• share prices in a stock exchange
• some traded derivatives
• some commodities.
Level 1 adjustments
Example
• Entity A holds 5% of the shares of Bank B
• Bank B shares' are traded in New York stock exchange
(NYSE)
• after the closing time of the NYSE on 30 June 20X3, the
Bank has announced that it is in financial difficulties and has
received a bail out package from its government which will
dilute the existing shareholders interests'
• Entity A needs to measure the fair value of shares in its
interim reporting report on 30 June 20X3
In rare case such as this one, it might be appropriate to adjust the
price of the share in order to measure the fair value at 30 June 20X3.
If the adjustment includes observable inputs, it will probably result in
a fair value measurement categorised within Level 2 of the fair value
hierarchy.
otherwise, it will be categorised within Level 3.
Active market (IFRS 13.A)
Fair value hierarchy
Level 2 (IFRS 13.81-85)

Level 2
inputs, other than quoted prices included in Level 1,
that are observable for the asset or liability, either
directly or indirectly

Examples for Level 2 inputs:

• quoted prices for similar assets or
liabilities in active markets
• quoted prices for identical or
similar assets or liabilities in
markets that are not active.
Fair value hierarchy
Level 3 (IFRS 13.86-90)
Level 3
unobservable inputs for the asset or liability
unobservable inputs should be used to measure fair value
to the extent that relevant observable inputs are not
available.

Unobservable inputs should reflect the assumptions that

market participants would use when pricing the asset or
liability, including assumptions about risk.

Unobservable inputs are inputs used in fair value accounting

for which there is no market information available, which
instead use the best information available for pricing assets or
liabilities (may include the reporting company's own data,
adjusted for other reasonably available information).
Fair value hierarchy
Examples
Hierarchy
Example
input level

Ordinary shares of a
The shares are regularly traded on
blue-chip company
an active market and so a quoted
1 regularly traded on Level 1
price from that market is available
the London Stock
Exchange (LSE)

The more significant the adjustment

Equity shares in a
to the listed share price needed to
private entity that has
Level 2/ reflect larger differences in profile,
2 a similar profile to a
Level 3 the more likely the assessment will
competitor listed
become Level 3
company
Fair value hierarchy
Examples

Hierarchy
Example
input level
The price at the reporting date is the
most objective and directly
Bonds traded on a
observable indicator of fair value.
market that has few
Where transactions in the market
transactions, the most Level 2/
3 are less frequent, some adjustment
recent occurring two Level 3
to the most recent price will be
weeks before the
needed. The more significant the
reporting date
adjustment, the more likely the
assessment will become Level 3.
Fair value hierarchy
Example
• Entity A measures the fair value of its investment property using
the price per square metre derived from market transactions for
similar buildings in similar locations. The assets in the observed
transactions are sufficiently comparable so that no
significant adjustments to the inputs are required
• Entity B measures the fair value of its investment property using
the price per square metre derived from market transactions for
similar buildings. The assets and the location in the observed
transactions are not sufficiently comparable so a significant
adjustments to the inputs are required.

What is the fair value hierarchy for both entities?

Fair value hierarchy
Solution

Entity A
Since the assets in the observed transactions are sufficiently comparable,
the inputs used for fair value measurement are observable inputs, and
therefore the classification will fall probably within Level 2 category

Entity B
Since the assets in the observed transactions are not sufficiently
comparable, significant adjustments to the inputs were required resulting the
using unobservable inputs for fair value measurement, and therefore the
classification is within Level 3 category.
Fair value hierarchy
Flowchart

Are there a quoted prices in active Yes Is the price No Level

markets for identical items? adjusted? 1

No Yes (*)

No Level
Are there any significant unobservable inputs?
2
Yes

Level
(*) extremely rare. 3
Valuation techniques (IFRS 13.61-68)

When a price for an identical asset or liability is not observable,

an entity measures fair value using another valuation technique
that:
• maximises the use of relevant observable inputs and
• minimises the use of unobservable inputs
IFRS 13 provides guidance on the use of valuation techniques
when measuring fair value and states that there are three widely
used valuation techniques:
– the market approach
– the cost approach
– the income approach

An entity should use valuation techniques consistent with one

or more of those approaches to measure fair value.
✓ Market approaches base valuation on market
information. For example, the value of a share of a
company’s stock that’s not traded actively could be
estimated by multiplying the earnings of that company by
the P/E (price of shares/ earnings) multiples of similar
companies.
✓ Income approaches estimate fair value by first estimating
future amounts (for example, earnings or cash flows) and
then mathematically converting those amounts to a single
present value.
✓ Cost approaches determine value by estimating the
amount that would be required to buy or construct an
asset of similar quality and condition.
Application to non financial assets (IFRS 13.27-33)
The fair value of non financial asset should reflect the
highest and best use from market participant
perspective.

highest and best use:

the use of a non-financial asset by market participants
that would maximise the value of the asset or the
group of assets and liabilities (eg a business)
within which the asset would be used.

is presumed to be the

unless market or other factors suggest otherwise

Application to non financial assets (IFRS 13.27-33)
Highest and best use should take into account a use
that is:
– physically possible
– legally permissible and
– financially feasible

is presumed to be the

unless market or other factors suggest

otherwise
Non financial assets
Example

• Entity A acquired a factory which includes:

plant and equipment, a building and land
• Entity A is not allowed to change the use of the
land and the building for a period of 5 years
• other entities have recently received planning
consent to redevelop industrial sites in the same
region for residential purposes
• Entity A legal consultants' advice is that Entity A
could sell the land and the building to a third
party and the restriction will not apply on the
buyers.

What is the highest and best use of the property?

Non financial assets
Solution

The fair value of the land and building should take into
account the possibility of the change of usage since the
restriction is a characteristic of Entity A and not a
characteristic of the asset.

Therefore, the fair value of the property will be the higher of:
• its current use or
• its use for residential development.
 Application to liabilities and an entity’s own
equity instruments (IFRS 13.34-35)
• the measurement of fair value of financial liability, non-
financial liability or an entity’s own equity instrument:
– should assume that they are transferred to a market
participant at the measurement date
– should not take into account the existence of a
restriction that prevents the transfer of the item.

The basic measurement principle of these items:

quoted prices in active market for identical items.
 Liabilities and equity instruments held by other
parties as assets (IFRS 13.37-39)
• the fair value of the liability or equity instrument held by other
parties as an asset should be measured from:
– the perspective of a market participant
– that holds an identical item as an asset at the measurement
date

• the measurement of these items in the absence of quoted

prices:
quoted prices in active market for identical items that are held
as an assets.
If that price is not available- other observable inputs, such as the
quoted price in an inactive market for the identical item held as an
asset.
If the above two are not available- valuation technique.
 Liabilities and equity instruments not held by
other parties as assets (IFRS 13.40-41)
• the fair value of the liability or equity instrument not held
by other parties as an asset should be measured from:
– the perspective of a market participant
– that owes the liability or has issued the claim on
equity

• the measurement of these items in the absence of quoted

prices:
Valuation technique.
Liabilities and an entity’s own equity instruments
Flowchart

Is there a quoted price for the transfer of an identical Yes the fair value is
or a similar liability or entity’s own equity instrument? the quoted price
No

Are identical items held by other parties as an asset?

Yes
No
Are there other Is there a quoted price in an
No observable
No active market for the identical
inputs? item that held as an asset?
Yes Yes

use that price as fair value use that quoted price as fair
use valuation
(with the relevant value (with the relevant
technique
adjustments) adjustments)
IFRS 13 Fair Value Measurement
The disclosure objectives

Disclose information that helps users assess both of the following:

• for assets and liabilities measured at fair value on a recurring or non-
recurring basis after initial recognition:
– the valuation techniques
– the inputs used

• for recurring fair value measurements using significant unobservable

inputs (Level 3), the effect of the measurements on:
– profit or loss
– other comprehensive income
• fair values that are required or permitted only on initial recognition
are exempted from IFRS 13’s disclosures.
IFRS 13 Fair Value Measurement
Disclosures - summary
Recurring fair value measurement

1. the fair value measurement at the end of the period

and the Level in the hierarchy (IFRS 13.93 (a-b))
2. transfers between Level 1 and Level 2 of the
hierarchy and reasons for these transfers (IFRS 13.93
(c))
3. a description of the valuation techniques, the
inputs used in Levels 2 and/or Level 3, any
changes to the valuation techniques and reasons
for that change (IFRS 13.93(d))
4. a narrative description of sensitivity analysis for
Level 3 measurements and the effect of changing an
unobservable input where such a change would
affect the fair value significantly (IFRS 13.93 (g-h)).
IFRS 13 Fair Value Measurement
Disclosures - summary
Non recurring fair value measurement

1. the fair value measurement at the end of the period

and the Level in the hierarchy (IFRS 13.93 (a-b))
2. the policy for determining when transfers between
levels of the hierarchy are deemed to have occurred
3. a description of the valuation techniques, the
inputs used in Levels 2 and/or Level 3, any
changes to the valuation techniques and reasons
for that change (IFRS 13.93(d))
 AGRICULTURE
(IAS 41 and IAS 16)

AGRICULTURE

This material is the property of Department of Accounting and Finance, CoBE, AAU.
1

Permission must be obtained from the Department prior to reproduction

 Learning Objectives

At the completion of studying this chapter, you will

be able to:
• Explain key terms in IAS 41 & IAS 16 agriculture activities
• Indicate measurement and recognition of agricultural
activities
• Show the subsequent accounting treatment of agricultural
activities
• Identify the disclosure requirements for agricultural
activity
• Distinguish between the accounting treatment of
2
agricultural activity under US GAAP and IFRS
3
Outline
⚫ Overview
⚫ Applicable standards
⚫ Objectives of the standards
⚫ Definition of key terms
⚫ Types of biological assets
⚫ Exclusions
⚫ Recognition
⚫ Measurements
⚫ Presentations
⚫ Disclosures
⚫ US GAAP VS IFRS 4
1. Overview

• IAS 41 and IAS 16 Agriculture 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).
2. Applicable Standards
⚫ IAS 41 – Biological Assets
⚫ IAS 16 – Property, Plant and Equipment
⚫ IAS 20 – Government grants

6
3. Objective
The objective of IAS 41 & IAS 16 is to
establish standards of accounting for
agricultural activity .
3. Definitions of Key Terms (in
accordance with IAS 41)
⚫ 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.
⚫ Biological assets. Living plants and animals.
⚫ Agricultural produce. The product of the entity’s
biological assets, for example, milk and coffee beans.
⚫ Biological transformation. Relates to the processes of
growth, degeneration, and production that can cause
changes of quantitative or qualitative nature in a biological
asset.
Definitions Con’td….
⚫ Biological transformation leads to various different
outcomes.
✓ Asset changes:
⚫ 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

 Examples of Biological Assets
Products that are the
result of processing
Biological Asset Agricultural Produce after harvest
Sheep Wool Yarn, carpet
Trees in a plantation
forest Logs Lumber
Plants Cotton, harvested cane Thread, clothing, sugar
Dairy cattle Milk Cheese
Pigs Carcass Sausages, cured hams
Bushes Leaf Tea, cured tobacco
Vines Grapes Wine
Fruit trees Picked fruit Processed fruit
4. Types of Biological Assets

Biological assets

Bearer biological Consumable

assets biological assets

IAS 16, except

produce IAS 41
Produce
growing
thereon 11
Types of Biological Assets
(cont’d)
⚫ Bearer biological assets:
Bearer plants are defined in IAS 41as a plant
that meets all the following criteria:
❑ It is used in the production or supply of agricultural
produce
❑ It is expected to bear produce for more than one
period
❑ It is not intended to be sold as a living plant or
harvested as agricultural produce, except for
incidental scrap sales (i.e. for firewood at the end of
the plants productive life). 12
Types of Biological Assets
(cont’d)
⚫ Consumable biological assets:
⚫ Biological assets which do not meet all
of the above requirements.
⚫ All animals

13
 Identify whether each of the following
biological assets is bearer or consumable

Agricultural Bearer or
Biological Asset Produce 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
5. Exclusions
IAS 41does not apply to:
✓ Land related to agricultural activity (see IAS
16 Property, Plant and Equipment and IAS 40
Investment Property).
✓ Bearer plants related to agricultural activity
(see IAS 16). However, IAS 41 applies to the
produce on those bearer plants.
✓ Government grants related to bearer plants
(see IAS 20 Accounting for Government
Grants and Disclosure of Government
Assistance).
Exclusions (cont’d)
✓ Intangible assets related to agricultural
activity (see IAS 38 Intangible Assets).
✓ Harvested agricultural produce (IAS 2,
Inventory). However, it does apply to produce
growing on bearer plants.
Exercise
1. Entity A raises cattle, slaughters them at its abattoirs and
sells the carcasses to the local meat market. Which of
these activities are in the scope of IAS 41?

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 IAS 41 and the carcasses as inventory in
accordance with IAS 2 Inventories.
2. Entity B grows vines, harvests the grapes and produces
wine. Which of these activities are in the scope of IAS 41?

The grapevines 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 grapevines 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 grapevines in accordance with
IAS 41 and the harvested grapes and the production of
wine, as inventory in accordance with IAS 2.
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.
Solution

The forests would be classified as

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

⚫ Noncurrent asset-land …………….………....….….200
⚫ Noncurrent assets—other tangible assets…..…....100
6. Recognition

An entity should recognize a biological asset or

agricultural produce when :
(a) the enterprise controls the asset as a result of past
events;
(b) it is probable that the future economic benefits will
flow to the enterprise; and
(c) the fair value or cost can be measured reliably.
7. Measurement
• 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.
7. Recognition & Measurement:
Biological Assets
Consumable Biological Bearer Biological assets
Assets
At initial • Measured together with any • Measured separately from any
recognition agricultural produce agricultural produce attached
attached (i.e., one unit of (i.e., two units of account)
account) • Measured at cost
• Measured at fair value less accumulated until maturity
costs to sell
Subsequent • Measured together with the Measured at:
measurement agricultural produce until a) Cost, less any subsequent
requirements the point of harvest (i.e., accumulated depreciation
one unit of account until the and impairment.
point of harvest) b) Fair value at each
• Measured at the end of revaluation date, less any
each reporting period at fair subsequent accumulated
value less costs to sell, with depreciation and
changes recognised in impairment.
profit or loss
7. Recognition & Measurement:
Agricultural Produce
Consumable Bearer Biological
Biological Assets assets
At the end of •Measured together Measured separately
each with the bearer plant from the bearer plant at
reporting •Measured at fair fair value less costs to
period prior value less costs to sell
to harvest sell, with changes
recognised in profit or
loss as the produce
grows

At the point Measured separately Measured separately

of harvest from the bearer plant from the bearer plant at
at fair value less costs fair value less costs to
Recognition and Measurements:
Bearer Biological Assets
1. Before maturity
⚫ Equivalent to Construction - in - progress
⚫ Measured at Accumulated costs (IAS 16)
⚫ Entry to record costs incurred:
Dr. Bearer Immature BA… xxx
Cr. Cash/Materials etc.. xxx

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Bearer Biological Assets
(cont’d)
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

26
Bearer Biological Assets
(cont’d)
3. After maturity
a) Depreciation on matured BA (IAS 16)
⚫ Use acceptable depreciation method as per
IAS 16
⚫ Entry to record depreciation:
Dr. WIP-BA… xxx
Cr. Accumulated Depreciation - BA.. xxx

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Bearer Biological Assets (cont’d)
3. After maturity
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 Dr. WIP – BA…….xxx
production Cr. Cr. Cash/Materials etc …. xxx
28
Bearer Biological Assets (cont’d)
3. After maturity
c) Agricultural produce (IAS 41)
⚫ Measured at fair value less costs to sell, with
changes recognised in profit or loss as the
produce grows.
⚫ Entry to record agricultural produce:
Treatment Entry
End of year before Dr. Standing Inventory - BA …. xxx
harvest Cr. WIP - BA…. ……….. xxx
Cr. Gain on Re-measurement …. xxx
Date of harvesting Dr. Inventory (e.g. Sugarcane)…….xxx
Cr. Standing Inventory……………. xxx

29
Bearer Biological Assets (cont’d)
3. After maturity
d) Subsequent measurement of BA (IAS 16)
⚫ Measured using either cost model or fair
value model

30
Consumable Biological Assets (IAS 41)
1. Before maturity
⚫ 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
31
Consumable Biological Assets (IAS 41)
3. After maturity - Harvesting
⚫ Measured at fair value (IAS 41)
⚫ Entry to record costs incurred:
Dr. Inventory (e.g. Corn) xxx
Cr. Consumable BA xxx
Cr. Gain on Re-measurement xxx

32
8. Presentation

⚫ In the statement of financial position biological assets

should be classified as a separate class of assets falling
under neither current nor non-current classifications.
⚫ This reflects the view of such assets as having an
unlimited life on a collective basis; it is the total exposure
of the entity to this type of asset that is important.
⚫ 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
9. Disclosures

⚫ 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.
Disclosure…
⚫ 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.
Disclosure…
⚫ Regarding government grants, disclosures should be
made as to the nature and extent of the grants, any
conditions that have not been fulfilled, and any
significant decreases in the expected level of the grants.
 10. Difference between IFRS and US
GAAP
Topic IFRS US GAAP

Classification Classified in to bearer and Classification in to bearer and

non-bearer ((consumable) consumable not common and same
and governed by different standard applied to both categories
standards

Measurement basis of Fair value with value Historical cost is generally used.
agricultural crops, livestock, changes recognized in net However, fair value less costs to sell
orchards, forests profit or loss is used for harvested crops and
livestock held for sale.

subsequent expenses As IAS 41 does had a

relating to agricultural activity not prescribe the treatment policy of capitalizing some of these
of subsequent expenditure, costs, particularly those relating to
such a treatment would still the development
be permissible under IAS 41 of immature plants or livestock up to
the point they were productive
38