Chapter 1: Fundamentals of Financial Accounting Theory

Accounting: production & transmission of info about an enterprise from ppl who have it →
those who need it

GAAP: Broad principles, conventions, rules & procedures of general application &
determine accepted accounting practices

Regulatory Agencies
● International Accounting Standards Board (IASB)
● Accounting Standards Board (AcSB)

Information: evidence that can potentially affect an individual's decision

● Uncertainty in decision making

Information Asymmetry: some people have more info than others

● Supply & demand for financial reporting (FR)
● 2 types: Adverse Selection & Moral Hazard

Adverse Selection: one party has more info
than the other (in a contract)
● Hidden info
● From past & present
● Ex. When buying a used car, the seller
has more info than you
○ Result in you buying worst
possible car bc of the lack of info
you have
Costly Signalling: communication of
information that is otherwise unverifiable
● But action is costly to sender (seller)
● Costless signals are not credible bc
anyone can send a signal
● Ie. Guaranteeing against car defects for a
year → poor quality cars will be costly to
the seller
Cheap Talk: communication of unverifiable
information,
● Can’t be believed (costless)
Moral Hazard: one party in a contact can’t
observe the actions relating to fulfillment of the
contract conditions
● Hidden actions
● What happens in the future
● Ie. Car insurance: insurers can’t see what
kind of driver you are
○ Insurance encourages ↓ care & ↓
effort = ↑ risk (hazard to morals)
○ Costly bc insurance companies
will charge more now
Principal-agent problem: owners (principals)
are not able to monitor management personnel
(the agents) to ensure that management makes
decisions in the best interests of the owners
Reduce Moral Hazard:
● Incentive pay
● Accounting reports about for
performance (indirect indicator of mgmt
performance)
● Stock option pay
 ● Ie. any one can make this claim & can’t be
sued for it

Reduce Adverse Selection

● More information (ie. external audits)
● Costly signalling (payment of dividends)

Desirable Characteristics of Accounting Information and Trade-Offs

● Info asymmetry determines the type of accounting info demanded & decision made
● Variety of user groups + conflicting demands = trade offs & compromises made
● Investors want relevant information (information that can help forecast cash flows)
that can help estimate value of shares
● Lenders want to ensure firm complies with terms of loan agreement & be assured
firms info they provide as proof is reliable

Economic Consequences of Accounting Choice and Earnings Management

Flexibility in Accounting Policy & Estimates
1. General accounting standards are applicable to a variety of businesses
2. Accrual accounting necessitates making estimates for the future → standards can’t
specify what the estimates should be

Positive Accounting Theory: understand managers' motivations, accounting choices, and

reactions to accounting standards (what do managers do and why do they do it?). Given the
incentives a manager faces we can predict the ways they will react to any latitude in
accounting standards

Earnings Management: managers' efforts to bias reported accounting information in one

way or another

Reasons for Earnings Management:

Upward Downward

● Influence investors to make ↑ future ● ↓ additional taxes/regulation

earnings estimates = ↑ share price
● ↓ risk to more lending & ↓ interest
rate
● ↑ likely to meet contractual
obligations
● ↑ likely to meet regulatory
requirements
● ↑ stronger bargaining position in
M&A
↑ compensation thru profit sharing
● ↑ gov subsidies & trade protection
● “Big bath” - in a bad year, record
more expenses than usual so future
yrs are more likely to show rising
profitability
○ Higher future compensation
/ share price
● ↑ bargaining power relative to ee
unions
 agreements/ stock options

What are the consequences of earnings management?

● Most of earnings management issues are timing issues e.g. capitalizing an item that
should have been expensed
● Managements credibility might take a hit, I.e reliability of their statement, I.e after a
review

Accounting and Securities Market

Public company: firms w/ debt, equity or securities traded in public markets

Efficient Securities Market (semi-strong form): security prices traded in that market
reflect all info that is publicly known at all times
● Strong form: reflects all info publically & privately known

Implications
● Prices react quickly to accounting information
● Accounting information competes with other sources of information (ie.
non-accounting info)
○ Consider whether it has already affected prices or not
● New information must be distinguished from already known information
● With only public information, it is difficult to gain significant profits
○ Possible to gain significant profits with non-public insider information
● Accounting reports and standards assume users can understand that information
● Efficient market theory influences laws and legal doctrine
○ Ie. What constitutes fraud in providing public information

Info from securities markets in accounting

● Financing
● Measure value of investments
● If Company have shares in Apple stocks, they report the value of the stocks in
market value based on the current market price of the apple stock
○ I.e the market prices of publicly traded securities are a reliable measure of
value if they are efficiently priced. This allows enterprises that are holders to
use them
 Chapter 2: Conceptual Frameworks for Financial Reporting

Conceptual Frameworks for Financial Accounting & Strategies to Meet Market

Demands for Information
1. Assessing Demand → consider market structure; one product cannot satisfy the
entire market
○ Target market → understand group needs
○ Identify strategic goal or objective
○ Find desirable product characteristics

2. Supply Planning → identify potential product components that will help meet
customers’ needs
○ At this step, a more specific product design can begin
○ Product design must take into account technological and economic feasibility

IFRS Conceptual Framework

1. Users
● Existing and potential investors, lenders, and other creditors
● Standards focus on the needs of these users, other users: employees,
customers' needs are likely to be less well served
2. Objectives of Financial Reporting
● To provide financial information about a reporting entity that is useful to
existing potential investors, leaders, other creditors, etc.
○ Investment and Lending Decisions
○ Amount, timing, and uncertainty of cash flows → investors care about
these factors, and investment and lending decisions are heavily reliant
upon these as well
○ Information one entity’s resources, claims, and performance → users
of an entity’s financial statements require this information
■ Accrual accounting: a basis of accounting that records
economic events when they happen rather than only when
cash exchanged occur

3. Qualitative Characteristics
a) Fundamental qualitative characteristics: characteristics that must be
present for information to be useful for decision making
○ Relevance: ability to influence users economic decisions; information
that is able to provide feedback about past performance or helps
make predictions is more relevant
■ Information is relevant if it has confirmatory value, provides
feedback about past events, predictive value for future
outcomes
■ Materiality: whether the omission or misstatement of a
particular piece of information about a reporting entity would
influence users’ economic decisions

○ Representational faithfulness: extent to which financial information

reflects the underlying transactions, resources, claims of an enterprise
■ Completeness: inclusions of all material items in the financial
statements
● Users of the financial statements must have a
comprehensive picture of the enterprise
■ Neutrality: extent to which information is free from bias
● There can be a lot of subjectivity when it comes to
preparing financial statements, therefore we must find
information free from bias
■ Freedom from error: extent to which information is absent of
errors or omissions
● For example, errors involving addition would undermine
representational faithfulness

b) Enhancing qualitative characteristics: characteristics that affect the

information’s degree of usefulness
 ○ Understandability: ease with which users are able to comprehend
financial reports
○ Comparability: ability to compare one set of financial statements
with another
■ Could be financial statements for same or different enterprise,
same or different year
○ Verifiability: degree to which different people would agree with the
chosen representation in the financial reports
■ For example, cash balances can be verified with banks, but the
value of research requires subjective assessments
○ Timeliness: how soon information becomes available to decision
makers
■ The older the information, the less timely it is

4. Elements of Financial Statements

● Elements relating to financial position → assets, liabilities, equities
● Elements relating to measuring performance → income, revenue, gains,
expenses

*** NEW UPDATE to IFRS: Expectation of future economic benefit does not come
into play for recognition

5. Recognition
● Recognition: process of presenting an item in the financial statements, as
opposed to merely disclosing that item in the notes
● Generally recognize accounting elements (assets, liabilities, equity) if future
inflows/outflows are probable and amounts are reasonably measurable
● Recognition & Measurement
IFRS Conceptual Framework - 4.38 An item that meets the definition of an element
should be recognized if"
● It is probable that any future economic benefit with the item should flow
to or from the entity AND
● The item has a cost of value that can be measured with reliability
Information is reliable when it is complete, neutral and free from error”
 6. Measurement
● Measurement: quantification of items reported in the financial statements
○ Historical cost: actual cost of an asset at the time it was purchases
■ Most commonly used measurement base
● Other measurement bases:
○ Current cost → amount that would be paid currently
○ Realizable value → amount that can be obtained from selling the asset
○ Settlement value → amount needed to settle an obligation
○ Present value → discounted value of free cash flow

7. Constraints
● Cost constraint: a constraint stating that cost of reporting financial
information should not exceed benefits that can be obtained from using that
information
○ Some costs are explicit and quantifiable, some are subjective

8. Assumptions → simplified generalizations about the real world

● Going Concern: assumption that reporting entity will continue operation into
the foreseeable future
○ Basis of accrual accounting

● Financial Capital Maintenance

○ Amount of resources required to ensure economic sustainability of an
entity; determines how to measure profit
○ Assumption that an entity needs to have as much resources in
monetary terms at the end of the period as it did at the beginning to
maintain operating capacity

Financial Information Prepared on Other Basis

“IFRS cannot satisfy the needs of everyone, so enterprises can choose to present
information in a different way that may be deemed more relevant for its users”
● for example “pro forma” measures of income which excludes certain items from
their figure. E.g EBIT, EBITDA, Normalized Earnings; more relevant to some users

● Publicly accountable enterprise: entity, other than not-for-profit organization,

that:
○ has issued, or is in the process of issuing, debt or equity instruments that
are, or will be, outstanding and traded in a public market or,
○ holds assets in a fiduciary capacity for a broad group of outsiders as one of
its primary business

● Private enterprise: ASPE standards, any for-profit entity that is not a publicly
accountable enterprise
CPA Canada: Chartered Professional Accountants of Canada
Book 1- IFRS: Applicable to Canadian Publicly accountable enterprises
Book 2- ASPE: Accounting Standards for Private Enterprises
Book 3 - NFPOs; Not-for-profit enterprises that are not government controlled
Book 4 - Pension Plans
Book 5 - Legacy Standards in effect before January 1, 2011
 Chapter 3: Accrual Accounting

● Cash cycle: set of transactions that converts a cash inflow to a cash outflow and vice
versa
○ Financing cash cycle: receipt of funding from investors, using those funds to
generate returns from investments and operations, and returning the funds
to investors
○ Investing cash cycle: purchase of property that has long-term future
benefits for the enterprise, using that property to obtain economic benefits
that result in cash inflows and disposing of property
○ Operating cash cycle: purchase of items such as inventory; production,
sales, and delivery of goods or provision of services; and receipts from
customers

● Accrual accounting: a basis of accounting that records economic events when they
happen rather than when cash exchanges occur

Accrual vs Cash Accounting

● Accrual: an accounting entry that reflects events or transactions in a period
different from its corresponding cash flow
● Deferral: an accounting entry that reflects events or transactions after the related
cash flow
○ E.g. recognizing sales revenue after the receipt of cash is a deferral of
revenue
 ● Periodic reports are more useful in terms of reflecting the economic conditions of
the enterprise if they use an accrual basis rather than a cash basis

Uncertainty and the Essential Role of Estimates in Accrual Accounting

● Accrual accounting involves reporting an amount before the completion of some or
all cash cycles (estimates must be made)
● Unbiased accounting: a conceptual accounting outcome that would result from
taking an average consensus from a sample of disinterested accountants
○ Trying to find neutrality
● True and fair: an overall evaluation of a set of financial statements as being a fair
representation of the enterprise's economic conditions and performance

Quality of Earnings and Earnings Management

● A measure of true earnings does not exist, therefore we cannot evaluate the
earnings quality relative to true earnings
● Using cash flow to evaluate the quality of earnings implies that cash flow is a better
measure of performance compared with accrual basis earnings
● Quality of earnings: how closely reported earnings correspond to earnings that
would be reported in the absence of management bias
○ Unbiased accruals: reflect economic conditions and accounting standards
with the applications of professional judgement and considering professional
ethics
○ Excessive accruals: results from contractual incentives for the firm or
management as well as any unethical managerial opportunism to over- or
under-accrue

Periodicity, Cut-off, Subsequent events

● Essential to properly define reporting period
● How do we deal with events and information that arise near the cut-off date?
 1. Periodicity
○ Typical reporting period for an enterprise is 12 months
○ Many entities choose year-ends that coincide with times of lower activity

2. Cut-off
○ Defining cut-off point is crucial for financial statements reported periodically
○ Cut-off: point in time at which one reporting period ends and the next begins
○ Subsequent-events period: period between the cut-off date and the date
when the company authorizes its financial statements for issuance
○ We recognize transactions and events occurring within reporting period (i.e
up to cut-off date), but measurement of those transactions can use the best
information available whether info is from subsequent-events or reporting
period

Accounting Changes: Errors, Changes in Accounting Policy, Changes in Estimates

● Accounting is inexact because accruals depend on uncertain future outcomes

1. Correction of Errors
○ An error is the incorrect amount given the information available at the time
○ Correction of an error: accounting change made necessary by the discovery
of an incorrect amount, given the information available at the time the
amount was reported
○ Retrospective adjustment: applying an accounting change to all periods
affected in the past, present, future
i. Retrospective adjustment with restatement: shows any
comparative figures on the same basis as the current figure periods
 ii. Retrospective adjustment without restatement: reflects the
accounting change’s impact on the past periods in the current
accounting period

2. Changes in Estimates
○ Estimates should be based on the best information available at the time of
financial statement preparation
○ Prospective adjustment: applying an accounting charge only to the current
and future reporting periods without any changes to past statements
○ Change in estimate: accounting change made necessary by the arrival of
new information

Structure of Financial Reports and their Relationships

● IFRS asserts that financial reports help users make these assessments by providing
two main types of information
1. Information on entity’s resources and claims against those resources
2. Information on changes in the entity’s resources and claims

● Other considerations of categories of IFRS:

1. Financial performance according to accrual accounting
2. Financial performance according to cash flows
3. Changes in the entity’s resources and claims that are not due to financial
performance

Relationships between information and financial statements

Information Financial Statement

Resources and Claims Balance Sheet

Performance on Accrual Basis Statement of Comprehensive Income

Performance on Cash Basis Cash Flow Statement

Changes in resources and claims not due to Statement of changes in equity

performance
Articulation: the connection of financial statements with each other
Balance Sheet → comprised of assets, liabilities, equity

Statement of Changes in Equity

● 3 Components of Equity:
1. Contributed capital - amount of funds provided by owners, net of any
repayments to the owners or repurchases of shares
2. Retained earnings - amount of cumulative (or losses) recognized through the
statement of comprehensive income less dividends
3. Reserves - amounts accumulated from events or transactions increasing
equity that are not transactions with owners and which have not flowed
through profit or loss

● Potentially 5 classes of transactions that explain change in above components:

1. Profit or loss - income and expenses as recognized on the statement of
comprehensive income
2. Other comprehensive income (OCI)
○ Recycling (of OCI): the process of recognizing amounts through OCI,
accumulating OCI in reserves, later recognizing these amounts
through Net Income and Retained Earnings
3. Dividends
 4. Capital transactions - transactions with owners such as share issuances or
repurchases
5. Effect of changes in accounting policy and correction of errors

Statement of Comprehensive Income

● Measure of return on capital, therefore is a measure of performance
● Analysis of expenses:
○ Nature (of an expense): relates to the source of the expense (depreciation of
equipment, labour costs from employees)
○ Function (of an expense): refers to the use of which has been put (cost of
sales, distribution, administration)

Statement of Cash Flows

● Helps the readers understand the changes in financial position in terms of most
liquid assets available
○ Direct method and indirect method
● Cash equivalents: short-term, highly liquid investments that are readily available to
known amounts of cash and which are subject to an insignificant risk of changes in
value
Note Disclosures
● Very important part of financial statements → reveal certain important facts
regarding the financial statements
● General requirements for note disclosures include:
○ Disclosures required by specific IFRS standards
○ A summary of significant accounting policies, including base measurements
used preparing in the financial statements
○ Disclosures relevant to understanding the items reported on the face of the
four financial statements

Discontinued Operations and Other Non-Current Assets for Sale

● From time to time, companies will decide to discontinue some part of their
operations
● Once management has made the decision to dispose of these groups of assets and
related liabilities, they no longer satisfy the going-concern principle
 Chapter 4: Revenue Recognition

Recognition: Process of presenting an item in the financial statements as opposed to

merely disclosing them in the notes

A. Range of Conceptual Alternatives for Revenue Recognition

● Wide range of alternatives exist along the value creation process
● Revenue recognized earlier reduces the quality of the information (more estimates)
○ Ie. Biotech company recognizes revenue for discovery of new vaccine w/o
considering FDA approval, future price, demand & alternatives
● Criteria established by accounting standards eliminates some alternatives

B. An Overview of Revenue Recognition Criteria

● IFRS 15 (by IASB & FASB): Revenue from contracts w/ customers

Contract: Written, verbal, formal or implied by customary biz practices

● Notable exclusions
○ Lease contracts (IAS 17)
○ Insurance contracts (IFRS 4)
○ Financial Instruments (IFRS 9)
○ Non-monetary exchanges between entities in the same line of biz to facilitate
sales to customers/potential customers
■ Ex. contract between 2 oil companies to fulfill customer demand on
different locations
Five Steps for Revenue Recognition
1. Identify the contract with the customer
2. Identify the performance obligations
3. Determine the transaction price
4. Allocate the transaction price to
performance obligations
5. Recognize revenue in accordance with
performance

C. Revenue Recognition Criteria:

Revenue Recognition Example

1. Identify the contract ● Readily identifiable

2. Identify the Performance Obligation ● PO: delivery of car by dealership to

(PO) buyer

3. Determine Transaction Price ● Contract specifies the price as

$28000 to be settled in cash

4. Allocate the transaction price to ● No allocation bc one PO

Performance Obligations

5. Recognize income in accordance DR. Cash 28000

with performance CR. Sales Revenue 28000
DR. COGS 25000
CR. Inventories 25000

Key Requirements Under IFRS

1. Identify the Contract
● Parties in contract have approved contract & committed to perform
obligations
● Identify each parties rights regarding g/s to be transferred
● Identify payment terms
● Contract has commercial substance (ex. risk, timing, amount of future cash
flows are expected to change as a result)
○ Ie. exchange of coal between 2 companies doesn’t count bc no
change to future cash flows
● Probably entity will collect consideration its entitled
○ Revenue recognition prevented if high enough probability of not
obtaining benefits

2. Identify Performance Obligation

● Good/service (or a bundle) that is distinct
a) Customer can benefit from good/service on its own or together w/ readily
 available resources OR; (is it capable of being distinct)
b) Good/service is separately identifiable from other promises in contract (in
context)
● Ex: Building construction satisfies a, but not b → can’t separate the
wiring, bricks etc.
Use judgement for:
● Significant integration
● Modification or customization
● Highly interdependent or high interrelated

● Series of distinct good/service that are substantially the same & have same
pattern of transfer to customer
○ Ex. 5 tonnes of Aluminum to a customer each month for 2 yrs

Example: Screen Printing

Screen Printing Inc., a publicly traded entity, sells a custom screen printing machine to its
customer for $1,000,000.
● The agreement includes the installation, additional operation training and two
years of service maintenance.
● The machine was delivered and installed at the beginning of the year.
● The training took place in the first several months of the year of delivery.
● Given the custom nature of the product, the machines are never sold without
installation i.e. there are no other providers of this installation service.
● They can be sold without the training and service contract

Selling price of machine & installation: $930,000

Selling price of additional operational training $7,000
Selling price of the two-year service contract $90,000

Identify the “distinct” performance obligation(s)

● Installed Machine: distinct
○ Machine: Not distinct
○ Installation: Not distinct
● Training: Distinct
● 2 yrs Service Contract : Distinct
3. Determine transaction price
● Consideration promised in a contract may include fixed, variable or both amounts

a) Non cash consideration → Estimate the fair value & combine w/ cash
consideration
● Ex. trade in phone for partial consideration + $500
● Estimate FV of phone to be $300 → total TP is $800 (500+300)

b) Significant Financing Component

● Time value of money need to be reflected when it is significant
● When the timing of payment differs substantially from the timing of
delivery of the goods or services
○ Ex. Sell g/s in exchange of $121 000 payment in 2 years → TP is less
than $121 000 bc of TVM
● IFRS 15 allows enterprises to forego the adjustment for financing if, at contract
inception, the enterprise expects to collect the promised payment within one
year of delivering the promised goods or services
○ Ex. trade credit

c) Consideration payable to customer

● Seller provides an incentive for the customers to continue purchasing from seller
● ↓ revenue recognized - don’t overstate revenue @ time of sale
○ Ex. Coupons

d) Variable consideration
● Some uncertainty over the amount of consideration involved
○ Ex. How much of the coupons will actually be redeemed
● Methods for Variable consideration (don’t artificially overstate revenue @
time of sale)
 ○ Expected value (probabilities of a large # of contracts w/ similar
characteristics )
○ Most likely amount (only 2 possible outcomes OR most likely in a
range of series of outcomes) → be prudent in TP so we are sure that
we will not need to reverse a significant amount of revenue in
future

4. Allocate Transaction Price to Performance Obligations

● Allocated on a relative stand-alone selling price
● Stand-alone selling price: price at which an entity would sell a promised
good or service separately to a customer

Three alternative methods:

1. Adjusted market assessment approach: estimate what a customer would be
willing to pay for the g/s or what competitors charge for a similar good/service
2. Expected cost plus margin approach: estimate expected costs to provide the
goods/service + adding a profit margin typical for the good/service
3. Residual Approach: computes stand-alone selling prices as transaction price -
total of observable stand-alone selling prices of other g/s involved
● Ex. 3 PO’s, Total TP $900, PO#1 has an estimated price of 500, PO#2 of
$300
○ So PO#3 has an estimated price of $100

5. Recognize income in accordance w/ performance

● Revenue recognition when entity satisfies PO by transferring a promised
good/service
● Asset transferred when customer obtains control of asset
● Factors to consider regarding if control is transferred if customer @ point
in time:
○ Obligated to pay for asset
○ Has legal title to the asset
○ Taken physical possession
○ Bears significant risk & rewards ownership
○ Accepted the asset
● If PO satisfied over time (input & output method):
○ Customer simultaneously receives & consumes the benefits of
good/service (aka customer consumed)
○ Entity’s performance creates/ enhances asset that the customer
 controls (aka customer controls it)
○ Entity’s performance doesn’t create an asset w/ an alternative use &
the entity has an enforceable right to payment for the performance
completed to date (aka seller has legally sold it but is holding it for a
while)

D. Other Related Issues

1. Expense Recognition
● Limited guidance under IFRS
○ Conceptual framework provides guidance
● The matching principle applies in the recognition of revenue and cost of
sales
● Systematic and rational approach applies for other expenses
○ Ex. depreciation of PPE, accruing interest expense
● Expense applies if asset criteria not met
○ Ex. Biz spends $5 mill but can’t demonstrate future benefits →
expensed

2. Contract costs
● Large contracts, biz incurs significant costs to obtain a contract with a
customer
○ IFRS 15: costs should be recognized as an asset if it can identify the
incremental costs
○ Ex. Costs incurred to prepare bid documents would be incurred
whether the bidder is awarded contract or not → can’t be
capitalized
○ Ex. Legal fees for contract preparation and sales commissions
would be paid only when an enterprise obtains a contract with a
customer
● Asset would be amortized as an expense in consistent w/ satisfaction of
PO

3. Warranties

1. Assurance-type: Ensure that the customer receives the delivered product as

specified in the contract
● Guarantee of quality
● Not a distinct PO bc defect & resulting warranty are inseparable in the
production process
● Biz records estimated cost of fulfilling warranty
 2. Service-type: Provide service beyond the assurance-type warranty
● Distinct PO
○ Ex. offer replacement phone in case of damage → no connection to
quality or time of sale

4. Onerous Contracts
● When unavoidable costs of meeting the obligations under the contract exceeds
the economic benefits expected to be received under it
● Treatment is different from non-onerous (profitable) contracts
● When onerous contract identified → full effect of loss needs to be recorded
○ Ex. Onerous contract might only be 20% completed, but 100% of the
expected loss would be recognized in the period when the contract is
identified as onerous
○ Profitable contracts only record the % completed

E. Specific Revenue Recognition Situations

● Recognizing revenue at a time different from the point of sale

1. Consignment sales: when only party (consignor) provides goods to a second party
(consignee) has the right to return all/portion of the goods if not sold
● Consignor retains control & legal title
○ Bears the significant risks and rewards of ownership,
● Consignee is not obligated to pay for the good until sold
● Revenue recognized when right of return expires
● Ex. Magazine Distribution: give out a 100000 copies, but only 75 000 sold, 25 000
returned, Revenue only recorded for 75000 copies

2. Installment sales
● Buyer makes payments over extended periods of time
● Buyer receives product at beginning of installment period
● Legal title may not transfer to buyer until all payments made
● ↑ Uncertainty over amount that will be ultimately collected

Option
● Recognize revenue in proportion to payments received

● No revenue recorded on initial sale

 3. Bill-and-Hold arrangements
● Seller holds onto the goods on the request of buyers
● Seller is ready to deliver, buyer has paid
● Seller can recognize revenue on the sale of goods even though the goods remain on
the seller’s premises

F. Accounting for Long-Term Contracts

● IFRS 15: Revenue from PO’s recognized over a period of time should be based on
the progress toward completion (percentage of completion method)

Percentage of completion method: Recognizes revenues & expenses on a LT contract in

proportion to the degree of progression the contracted project

Types of Contracts Covered in “Long-term Contracts”

● Fixed price: contractor agrees to prices before performance begins
○ All risk is on the contractor therefore they have an incentive to control costs
● Cost plus: cost spent on project + fixed margin
○ All risk is in the hands of the buyer
○ Only use if little uncertainty

1. Revenue recognition for cost-plus contracts

● Actual costs incurred + margin determine amount of revenue recognized in
each year
2. Revenue recognition for fixed-price contracts: Application of changes in
estimates
● Realistically, there will be changes
○ Similar to accounting for depreciation
○ Ex. 50% of project completed, so 50% revenue recorded
● With no uncertainty → use the % completed within each year to compute
amount of revenue to recognize
3. Revenue recognition for fixed price contracts: cost to cost approach
● Use costs already incurred + estimates of how much additional costs need to be
incurred to finish the project

4. Accounting cycle for LT contracts

5. Onerous contracts
● When LT contract expected to be profitable → recognize profits over duration of
contract
● Expected loss: recognize all at once
 6. Revenue Recognition when outcome of a contract is uncertain: Cost Recovery
Method
Cost recovery method recognizes:
● Contract costs incurred in the period as an expense
● An amount of revenue equal to the costs that are expected to be recoverable
● NOTE: profit deferred to after cost is covered, expected losses recognized
immediately

7. Alternative in ASPE: Completed contract method

Completed contract method
● Deferral of revenue and expenses to end of project
● Performance consists of single act or progress not reasonably estimated
● Losses not deferred

G. Risk of Earnings Overstatement in Long Term Contracts

● LT contract → high risk bc allocate revenue over 2 accounting periods

1. Intentional overstatement: earnings management

● Underestimating costs increases current profit
● Management’s ethical responsibility is to choose the best approach of estimation
○ Ex. Cost-to-cost approach or Engineering estimate
Impacts of underestimating future costs:
● ↓ denominator in % complete ratio
● ↑ estimated gross profit
Therefore: ↑ profit in current periods & ↓ profit in future periods

2. Unintentional overstatement: Winners Curse

● Errors (ex. Incorrect conversions, estimates)
○ Ex. Giving project to lowest price bidders may result in underestimating costs
to get the project → result in ↑ costs in long run
● Winner’s curse: underestimating costs to win a contract → higher likelihood of loss
when input information is different
○ Error: misstatement that is made based on the given info at that time

H. Presentation and Disclosure

1. General presentation and disclosure requirements of Revenue:
● Type of Activity
 ○ Sale of goods, provision of services, royalties, interest & dividends
● Activity from non-monetary exchanges
● Revenue recognition policies in notes
● Method of determining stage of completion
● Others: ST/LT contract, geography, type of customer

2. Presentation and disclosure for long-term contracts

● Amount of contract revenue recognized
● Method of revenue recognition (ex. % of completion)
● Method of estimating the percentage completed (ex. Cost to cost approach)

Measuring Progress towards Completion:

1. Output Method: Percentage of total services that the customer has benefited from
to date
a. % complete = benefit to customer to date / total benefit
b. Revenue to be recognized to date: Percent complete x Contract Price
c. Current period revenue = revenue to be recognized to date - revenue
recognized in prior periods
d. Gross profit to be recognized to date = % complete x most recent estimated
contract gross profit
e. Current period GP = GP to be recognized to date - GP previously recognized
f. Current period COS = current period revenue - current period GP
2. Input Method: the entity’s efforts/inputs to satisfy a performance obligation
a. % complete = costs incurred to date and used / Most recent estimated total
costs
b. Revenue to be Recognized to date: % complete x Contract Price
c. Current period revenue = revenue to be recognized to date - revenue
previously recognized
d. Gross profit to be recognized to date = % complete x most recent estimated
contract GP
 e. Current Period gross profit = GP to be recognized to date - GP previously
recognized
f. Current Period COS = current period revenue - current period gross profit

Chapter 6: Inventory

Inventory Systems
Perpetual System Periodic System

● Directly keeps track of additions to and
withdrawals from inventory.
● Identify expected and actual amounts
of COGS which is better for managing
inventory and can identify shrinkage.
● Inventory count must still be
performed to verify actual inventory
quantities
● Does not keep continual track of
inventories and COGS.
● Inventory count performed to
determine ending inventory quantity
● COGS calculated by: Beginning
inventory + Purchases - Ending
Inventory

Recognition and Measurement

Must determine the costs to be included in inventory. IAS 2 refers to the general criterion
that the cost of inventories shall comprise:
● All costs of purchase
● Costs of conversion
● Other costs incurred in bringing inventories to their present location and condition
(transportation and installation)
Purchased Goods
● Purchase price
● Government taxes not recoverable
● Shipping and handling costs
● Other costs to bring product to location
● Subsequent costs (ex. retail space, sales staff) are not inventory costs

Transportation Costs: Must consider goods in transit, shipping terms will determine legal
possession.
FOB Shipping Point → Buyer takes possession as soon as the goods leave the supplier’s
premises.
FOB Destination → Buyer takes possession when the goods reach the buyer’s premises.

Consignment
A company (the consignee) sells products on behalf of the products’ owners (the consignor)
and a commission is paid for this service.
● Intermediary between consignor and buyer
● Risk and rewards of ownership do not transfer from consignor to consignee.
● Consigned goods not included in inventory

Manufactured Goods
● All product costs
● Capitalized in inventory because they are incurred as part of the production
process.

Period Costs: expensed because not closely related to the production process.
● Ex. SG&A, marketing, accounting, finance

Fixed Overhead Costs

● Variable Costing: Considers fixed manufacturing overhead to be a period cost
because such costs do not vary according to production level.
● Absorption Costing: Considers fixed overhead as a product cost because production
cannot take place without these costs.
○ IFRS only uses Absorption Costing
Example: Fixed Overhead Capitalization When Production Levels Differ
Normal Production ● FOH / Unit

High Production ● Higher production = lower Fixed Overhead / Unit

○ ↓ COGS

Low Production ● Low production = high Fixed Overhead / Unit

○ This overstates inventory
● Allocate FOH / Unit based on normal production FOH / Unit
to avoid earnings management
○ Expense all unallocated overhead
Ex. Normal FOH/ Unit is $15 / unit
Low FOH / Unit is $25 Unit
● Total 120 units produced
● Total FOH: $3000
● Capitalize $15 * 120 = $1800 under inventory costs
● $3000 - 1800 = $12 000 (unallocated FOH expensed)

Costing Allocation Methods for Inventories

Specific Identification
A method of assigning costs to inventories and cost of sales based on actual costs of each
item.
● Most straightforward and costly method
● Usually applied to high value items and items that are not ordinarily
interchangeable
● Prone to earnings management

Cost Flow Assumptions

COGAS = Beg. Inventories + Purchased/Manufactured Goods
COGS = COGAS - Ending Inventories

Cost Flow Options for allocating costs include for IFRS:

● FIFO: Use oldest costs to calculate COGS
○ Same for both Periodic & Perpetual
● Weighted Average
○ Differs between Periodic & Perpetual
Comparison of Cost Flow Assumptions:

Retail Inventory Method

● A method of estimating cost of ending inventory by applying an average sales (gross
profit) margin to retail price of products
● A popular method for retailers, the method relies on an average sales margin to
estimate the cost of each product.
● Accuracy of the sales profit margin is key
● Quantities obtained by an inventory count

Gross Margin Method

● A method for estimating COGS by applying an average gross margin to the amount
of sales recorded in a period
● Estimates ending inventory balance by using the inventory cost flow equation.
● Used for interim reporting to save costs
● Not normally accepted for annual financial statements
Avoiding Overvaluation of Inventories
● Always use Lower of Cost and market (Net Realizable Value) to avoid earnings
management
○ Market:
● Input market view: Replacement cost of inventory
● Output market view: Selling price - Selling costs (NRV)
● Applied to finished goods
○ If finished goods are impaired, check the raw materials that go into the
finished goods for write down & impairment
● Unit of Evaluation: Write down inventories by item
● If market recovers, reverse the writedown
○ Journal entries:
Dr. COGS or Loss on Inventory
Cr. Inventory or Allowance for Inventory Write-Down

Accounting for Inventory Errors

● For periodic systems, inventory is included twice in the COGS calculation (Beginning
Inventory & Ending Inventory)
○ Impacts two periods

Year Ending Inventory Cost of Goods Sold Net Income

1 Overstated Understated Overstated

2 Overstated Overstated Understated

Earnings Management Considerations

1. Overproduction → Mgmt may overproduce as it reduces overall fixed overhead
costs / unit
● COGS ↓ = Net Income ↑
2. Non-production costs in inventory → Mgmt includes expenses in inventory cost to
keep it off the income statement
● Net Income ↑
● Ex. Wages included in inventory cost
3. Ignoring Impaired/Discounted Amounts
● Net Income ↑
● Always ensure inventory is LCNRV
 Chapter 7: Financial Assets

Financial asset: is an asset arising from contractual agreements on future cash flows
○ “A financial asset is any asset that is:
a) Cash
b) An equity instrument of another entity
c) A contractual right:
i) To receive cash or another financial asset from another entity”
○ Ex. investments in stocks & bonds because these investments entitle the holder
to future dividends and interest, even if those payments are uncertain

Grouping of Financial Assets

We can group financial assets based on:
Influence Nature

● Strategic: Based on the degree to ● Equity: Gives contract holders the

which we can influence a
company (management or board
of directors) we invested in
● Non-Strategic (Passive): We have
expectation regarding the ability
to influence operating decisions
right to residual interest in a firm
after deducting its liabilities. (may or
may not have dividends)
● Debt: Has principle and interest
payments requirements
● Derivative: Derives its value from
another variable.
● I.e Option ~ derives its
value from share price

Non-Strategic Investments:

1. Fair Value through Profit or Loss (FVPL)

 ● Use if equity investments are held with the purpose of trading
● Firm buys the entity with the intent of benefitting from changes in the value
● After initial recognition, it is measured at Fair Value
● Transaction costs affects net income
● Holding gains and losses are recognized through net income
● Realized gains and losses are recognized through net income
● Dividends recognized through net income

Sample JE for FVPL:

2. Fair Value through Other Comprehensive Income (FVOCI)

● Includes debt securities
● After initial recognition, measured at Fair Value
● Transaction costs included in the investment cost at acquisition
 ● Holding gains and losses are recognized through OCI

3. Fair Value through OCI Election (FVOCI Election)

● For equity
● After initial recognition, measured at Fair Value
● Transaction costs include the investment costs at acquisition
● Holding gains and losses are recognized through OCI
● Not recycled into net income
● Any dividends recognized in net income

Sample JE for FVOCI through election:

4. Amortized Cost
● For Debt
● Measured at the Present Value for Future Cash Flows
● Premium/discount on acquisition amortized over the term of the investments as
interest income based on the effective interest rate method
● Transaction costs included in the investment cost @ acquisition
● No fair value subsequent measurement
● Gains/losses on derecognition i.e. “realized” gains/losses are recognized in net
income
● Interest income measured based on effective interest rate method and reported
in net income
Impairment:

The value of an investment is determined by both the expected cash flows and the
discount rate that reflects the time value of money. Since a debt instrument specifies the
sequence of contractual cash flows, fluctuations in fair value derive primarily from changes
in the discount rate.

● At each reporting date, assess credit risk of investee and recognize expected credit
losses
● Applies to FVOCI and AC debt instruments only
● Expected PV of all cash shortfalls using estimate of past, present + future forecasts
of losses
● Recognize all impairment losses in income statement
● Losses may be reversed if expected amount and timing of cash flows change
 Chapter 5: Cash & Receivables

Cash and Cash Equivalents

The classification of items as cash and cash equivalents must meet 2 criteria:
1. Readily convertible into cash
2. The amount must have insignificant risk of change in value

Cash: Cash on hand and demand deposits are idle assets as they earn no return. Firms find
it beneficial to minimize the amount of cash and to hold funds in accounts that do earn a
rate of return.

Cash Equivalents: Short term, highly liquid investments that are readily convertible to
known amounts of cash and that are subject to insignificant risks of change in value (ex.
Savings accounts, term deposit with maturity of three months or less).

Excluded from cash and cash equivalents are any funds subject to restrictions that prevent
their use for current purposes, or "appropriated" for specific purposes.
Also excluded are financial investments subject to significant fluctuations in value.

Cash held in foreign currencies is reported in functional currency is reported in functional

currency at balance sheet date
● Functional Currency: Currency used in the entity’s primary economic environment

Negative Balances
Cash management involves having a sufficient amount of cash to satisfy obligations as they
become due, but not having too much cash idle. Existing low levels of idle cash can result in
a negative account balance (account in overdraft).
These balances should be reported as part of cash and cash equivalents (as deductions)
rather than listed as liabilities (unless net balance is negative).

Bank Reconciliations

There are two records of a business's cash:

1. The Cash account in the company's general ledger.
2. The bank statement, which shows the cash receipts and payments transacted
through the bank.
The books and the bank statement usually show different cash balances due to a time lag
in recording transactions, missing items, or recording errors.
*The person who prepares a company's bank reconciliation should have no other cash
duties and be independent of cash activities. Otherwise cash can be stolen or the
reconciliation may be manipulated to conceal theft.

Preparing the Bank Reconciliation

The overall idea in a bank reconciliation is to identify all the items affecting cash that should
have been recorded but were not. A bank reconciliation has 2 sides:
● Bank Side. Reconcile the bank statement balance to the correct balance.
● Book Side. Reconcile the book balance to the correct balance.
The adjusted balances should be the same.

Bank Side
Must reconcile for items recorded by the company but not yet the bank, these include:
● Deposits in Transit (Outstanding Deposits). The company has recorded these
deposits but the bank has not. Add deposits in transit to the bank reconciliation.
● Outstanding Cheques. The company has recorded these cheques but the payees
have not yet cashed them. Subtract outstanding cheques.
● Bank Errors. Correct all bank errors on the bank side.

Book Side
Must reconcile for items recorded by the bank but not yet by the company, these include:
● Bank Collections. Cash receipts that the bank has recorded for the company's
account. The company has not yet recorded the cash receipt yet (ex. Accounts
receivable, direct payments to banks by the customers). Add bank collections on the
bank reconciliation.
● Electronic Funds Transfers (EFT). The bank may receive or pay cash on your behalf
(receipt or payment). Add EFT receipts and subtract EFT payments.
● Service Charge. Subtract service charges.
● Interest Income. Add interest income.
● Nonsufficient Funds (NSF) Cheques. Cash receipts from customers who do not have
sufficient funds in their bank account to cover the amount. Sometimes called bad
cheques. Subtract NSF cheques from the book side.
● The Cost of Printed Cheques. Subtract from the book side.
● Book Errors. Correct all book errors on the book side.
NOTE: All items on the book side of the bank reconciliation require journal entries.

Cash Management, Internal Controls, and Fraud Prevention

Significant risks are associated with cash, thus, preventative measures are necessary.

● Bank Reconciliation: Independent check on bank balance prepared after period

end to identify bank and book errors/omissions
● Segregation of Duties. Separate certain activities surrounding cash. May be the
most important to reduce risk of cash misappropriation. When duties are
segregated, fraud requires collusion which is more difficult to execute.
● Monitoring by Staff and Customers. It is not always possible to segregate duties
due to time or cost. Thus, the entity must rely on staff and customers to monitor the
existence of potential fraud.
● Implications for Internal Controls of Other Areas. Cash is one of many assets
subject to misappropriation. Controls are needed for other non-cash assets as well
as experiments show that people are more willing to lie when dealing with non-cash
items.

Accounting for Non-Cash Assets

Non-cash assets are due to accrual accounting. Must determine:

Does a transaction give rise to an asset or expense?
● To capitalize is to record an expenditure as an asset on the balance sheet.
● The expense is the amount reported on the income statement that reduces the
amount of profit.
 ● Assets and expenses are defined in IFRS.
What is appropriate balance sheet value for an asset or class of assets?
● Need to determine if the asset is appropriately valued; consider if the value is
overstated or understated.
● Valuation adjustments increase representational faithfulness.
When should an asset be removed from the balance sheet?
● Need to determine if asset should be removed (ex. due to selling of inventory or
depreciation of equipment).
● Derecognize asset.

Trade Receivables

A receivable is a cash flow temporarily foregone, and is considered a current asset. Time
value of money is ignored for receivables under a year.

Cash discounts may be offered to customers and there are two ways to account for cash
discounts:
1. Gross Method. Record at face value. (Assumes customers will forfeit the discount;
irrational).
2. Net Method. Record at sales price less cash discount. (Assumes customers will take
the discount; rational).

Accounting for Bad Debts

Companies must adjust the value of the receivables at the balance sheet date to the
amounts they expect to ultimately collect (the net realizable value).
There are two methods to measure bad debt expense:
● The Direct Write-Off Method. A specific customer's uncollectible account (in the
subsidiary ledger) is first identified and then Bad Debt Expense is recognized. Does
not meet the matching principle.
● The Allowance Method. The best way to measure bad debts. Records losses from
failure to collect receivables. Management does not wait to see which customers will
not pay; they estimate it on the basis of the company's collection experience and
their professional judgement. They recognize bad debt expense in the period
incurred. Thus, meets the matching principle.

Allowance Method
● Uses a contra-account to accounts receivable called Allowance for Doubtful
Accounts.
● To measure the expected uncollectibles, can either use the percentage of sale
method or the aging-of-receivables method.
After summing up all the allowance amounts to obtain the desired balance in the ADA at
period end, find the difference between the desired balance and the current balance in the
ADA. This difference is recorded as a bad debt expense via an AJE:

**A/R are reported at net realizable value (NRV) on the balance sheet.**

NRV = Accounts Receivable - Allowance for Doubtful Accounts

Journal Entries
Cash Collections

To Write Off Uncollectible Accounts:

To Recover an Uncollectible Account (One that has already been written off):
*The write-off of bad debts has no effect on total assets, current assets, and net accounts
receivable. There is no effect on net income either because:
● Writing-off bad debts does not affect an expense account.
● Under the allowance method, expenses would have been properly recognized in the
period they were incurred, which is the same period in which the related sales took
place.

Transfer of Receivables

Factoring
A finance company can buy accounts receivable from other companies.

● Transfer without Recourse: The factor takes on the risk of uncollectible accounts
and does not have recourse to go back to the company that transferred the
receivable to seek funding for bad debts. Risks and rewards of ownership have been
transferred, can consider it a sale of receivables and remove the asset off the books.
● Transfer with Recourse: The factor can demand money back from the transferor if
the customers do not pay. Does not constitute a sale.

Long Term Receivables

● Non-trade receivables generally will have written contracts such as a promissory
note.
● Time value of money must be taken into account.
● Recognize the note receivable and the interest income.
 Chapter 8: Property, Plant & Equipment

Initial Recognition & Measurement

● 2 important questions: what to capitalize & how to categorize costs

Impairment: recognize decline in fair market value by writing down asset value
1. What to Capitalize:

Capitalize: record cost on BS as an asset (IAS 16)

● Probable future economic benefits
○ Direct: furniture in a restaurant is directly related to ability to serve ppl
○ Indirect: manu equip that produce’s inventories that are sold in future
○ Can be broad
● Item cost can be reliably measured

Costs to include in PP&E Account

● Capitalize all costs required to acquire/ construct / prepare an asset for use
● Self judgement: self-constructed assets, period of capitalization, repairs,
replacements, dismantlement costs, removal & site restoration

Self-Construction Costs
Ex. Buying land to develop apartment buildings
● Separate land & building accounts to allocate costs
● Professional judgement for DM
● Management salaries, insurance & borrowing costs can be capitalized or expensed -
judgement

Costs potentially related to Land Costs Building Costs

property development

● Land Purchase ● Site decontamination - ● Building materials, labour &

● Building materials, labour & intention for land is to overhead
overhead develop it into residential ● Development app + architerical
● Development app + buildings & design
architercial design deconomination ● Public amenities - could be either
● Site decontamination necessary to do so land or building
● Public amenities ● Mgmt salaries - could be expensed
● Mgmt salaries/ Rental office or included in costs bc large portion
staff of mgmt time spent on project
● Insurance ● Insurance
● Avg borrowing costs during ● Borrowing costs
construction period of 10 yrs
Borrowing Costs on Self-Constructed Assets
● IFRS: capitalize borrowing, acquisition & production costs directly related to
construction of assets
○ Ex. Costs that would have been avoided if construction had not occurred
○ Interest rate - on loan agreement
● Expense other borrowing costs (ie. internal funds)
○ Interest rate (capitalization rate): must be computed
■ Weighted avg of borrowing costs applicable to outstanding
borrowings (other than borrowings for assets)

Period of Capitalization
● Capitalization period ends when item ready for intended use (not necessarily the
same as when the asset starts to be used)
○ Ex. House constructed from Jan 1, 2012 to June 30, 2013, but people moved
in Sept 30, 2013
○ Capitalization period is from Jan 1, 2012 to June 30, 2013

Replacement vs. Repairs

● Replacement: for significant asset components - Capitalize
○ Ex. New car engine
○ Remove old PPE as loss
● Repairs: normal maintenance - Expense
○ Ex. Oil change
○ Reoccuring or insignificant relative to PPE value

Costs of dismantlement, removal & site restoration

● Future costs necessary to obtain regulatory approval sometimes so include in initial
cost related to PPE
○ Depreciate costs alongside
○ PV the future costs to recognize
● Ex. $500,000 to decontaminate land after 20 year period, discount rate 8%
○ PV: $107,274
○ Total Expense (dep + interest) = $500,000

Building site restoration Cost 107,274

Obligation for future site restoration 107,274

Depreciation Expense (107,274 / 20) 5,364

Accumulated Depreciation - Building 5,364

Interest Expense (107,274 * 8%) 8,582

Obligation for future site restoration 8,582
How to categorize Cost
a. Unit of measurement & componentization
● Only componentize significant parts of PPE to accommodate for different use
lifes & depreciation
○ Ex. parts with significant costs in relation to total cost should be
depreciated separately
● Parts of an item with similar useful lives/ depreciation classified as single
asset

b. Bundled Purchases
● Allocate total purchase price to specific asset using estimates of each assets
fair value
● Earnings mgmt issue when determining fair value (Ex. Management could ↑
FV estimate for land & ↓ for building as land is not depreciable)
● Total estimated FV could be ↑ or ↓ than the total purchase price →
proportional allocation

Subsequent Measurement
● After purchase date - IFRS measurement at Historical cost OR Fair Value

Historical Cost: actual cost of asset at purchase - adjusted for depreciation/ impairment
● Calculates depreciation over the useful life

Current Value: entry value, value in use or exit value at date of measurement
● Replacement cost (entry value): $$ required to replace asset’s productive capacity
● Value in Use: based on cash flow expected based on PPE output
○ Usually exceeds entry & exit value
● Net Realizable Value (exist value): $$ obtained from sale of asset net costs of
disposal

Fair Value: price received/ paid to sell an asset or transfer a liability btwn market
participants
 ● Priority: Exit Value, then Value in Use or Entry Value
Revaluing PPE
● Ensure that carrying amount doesn’t materially differ from amount determined
using fair value at end of reporting period
● Not compulsory
● Must be measured reliably for ↑ relevance

Impairment: applies regardless of historical cost or fair value → done for neutrality &
representational faithfulness

Depreciation under historical cost basis

Cost Allocation: apportioning cost of asset over useful life

Depreciation: matches costs to periods over which benefits are obtained

a. Total amount to depreciate:
● Depreciable amount: total amount to be expensed through depreciation:
initial cost - residual value

b. Period of depreciation: useful life of asset

● Period of time OR # of production units entity expects to obtain from use of
asset
● “Useful” specific to entity & technology - there be more efficient methods
● Depreciation calculated for period PPE is available for use , not actually used

c. Pattern of depreciation
● Straight - line method
● Declining- balance method: fixed % of assets carrying value
● Units of Production method: allocates depreciable amount in proportion to
fraction of production capacity used

d. Other considerations
● Partial year depreciation - depends on entity
○ Ex. could be depreciated based on months, or record full year of
depreciation in year regardless of purchase date
● Use PPE to produce other assets: depreciation charges flow into other assets
○ Ex. depreciation on mau equip included part of production cost of
inventories & as an asset
○ Depreciation not expensed on Income Statement
○ Instead included as cost of clases when enterprise sales inventory

e. Impact of changes in estimates on depreciation

● Change in Residual Value, Useful life = change in estimate
● Prospective method (apply in future years)
 Derecognition
● Derecognize when sold/disposed
● Carrying amount DOES NOT equal disposal amount
○ Difference is gain or loss

Monetary Items: assets/liabilities w/ fixed or determinable cash flows (Ex. A/R, bonds)
Non-Monetary: Ex. Trade delivery truck for a used car, shares for PPE

Classification of non-monetary exchanges

General case Exceptions

● Record fair value of asset given or received - 1. No commercial substance of transaction
whichever is more reliable 2. FV of assets exchanged are not reliably
● Equal reliability: use fair value of asset given measured
up
Commercial substance if:
Transactions ● Assets exchanged are significantly different in
● Sale at FV terms of risk, timing or amount of cash flows
● Purchase using proceeds of sale (object)
● Value of entity's operations significantly
changes as a result of transaction (subject)
 1. Recognition of non-monetary exchanges

Example: Trade Sailboat A for Sailboat B

● Same size, same use (rent out for same price of $500/day)
● Sailboat A cost: $200,000, Acc Dep: $70,000

Sailboat B 130,000
Acc Dep - SailBoat A 70,000
Sailboat A 200,000

Example: Trade Sailboat A for Motor Boat A

● Different sizes, uses, gas expenses
● Sailboat A: $200,000, Acc Dep: $70,000
● Motorboat A: $140,000 (based on recent sale of a similar model)
● Commercial Substance

Motor Boat A 140,000

Acc. Dep 70,000
Sailboat A 200,000
Gain 10,000

Potential Earnings Management Using PP&E

Including Operating expenses in PPE Interest Capitalization

● Only capitalize costs directly attributable to ● Biz could ↑ income & ↓ expenses by getting
purchase/ construction of asset extra loans to finance PPE
● Subjectivity: determining which costs are ○ ↓ IR
actually related to purchase/ construction

Depreciation Parameters Opportunistic disposals of PPE

● Useful life & Residual Value - estimates
● Depreciation method also impacts amount of
depreciation expense
● Biz can change pattern of depreciation as a
change in estimate w/o disclosure of change
(prospective)
● Depreciation: cost allocation not a method
of asset valuation
● Carrying values can be different than fair
values
○ Biz can sell them to realize gains or
losses
IFRS vs. APSE
 Chapter 9: Intangible Assets & Goodwill

Asset
● Control
● From past transactions
● Power over future economic benefits
● Restrict others from getting access to the future benefits

Intangible Assets Definition

● Control → from legal right (ie. trademark, legal patent
● Should meet the definition of both an Asset & an Intangible Asset
1. Lack of physical substance
● Patent certificate just represents the patent (considered non physical)
● If software was an integral part of a machine & needed for its operations →
then it’s PPE
○ If not that significant - separate from the hardware of the computer)
2. Non Monetary
● Ex. Bonds & A/R doesn’t count because they are cash flow claims = financial
3. Identifiable
a. Separable
● Different from entity
● Can be sold/transferred/leased
b. Contractual or Legal Right
● Ex. Goodwill is NOT an intangible asset because it’s the residual amount after
all items have been accounted for so it is NOT SPECIFICALLY IDENTIFIABLE

Examples of Intangible Assets

● Patents
● Brands
● Trademarks/tradenames
● Copyrights
● Franchises or licenses

Capitalization of Intangible Assets

1. Probably future economic benefits
2. Reliable Measurement of Cost

Acquired Intangibles Internally Developed Intangibles

Ex. Gov grant, purchase ● Harder to meet reliable measurable

● Easy to measure reliably → use definition b/c no independent check
purchase price (aka FV) involved
 ● Probable future economic benefits ● Have to meet all 6 criteria (below) to
(b/c organization owns it, so they capitalize
will probably get the cashflows b/c
they wouldn’t buy it if it wasn’t going
to provide them with future
benefits)
● Independent transaction (hard for
mgmt to make up values)

Acquisition of Intangible through purchase of another company

● Use relative market price for similar intangible
● Record at FV or nominal value if no other options

Cost of internally developed intangibles

Criteria for internally developed capitalization

1. Technical Feasibility for completing intangible asset for use or sale → can they even
make it?
2. Intention → they plan to complete it to use or to sell
3. Ability to use or sell intangible asset
4. Available Resources → are there enough financial/ human resources to complete it
5. Probability of future economic benefits
● Is there a market
● How useful is it
6. Reliable measure costs incurred in development
→ Capitalization stops when asset is ready for use or sale
● Ex. Development of a new production process → capitalization of costs stop when
the production process is ready to make commercial products for sale
○ Costs prior to this (ex. Test production runs = capitalized)
THINGS YOU CANNOT CAPITALIZE
1. Advertising or Promotion → Expense
2. Branding & Building customer lists → Expense
 Subsequent Measurement
1. Historical Cost Approach
● Use actual cost at purchase - depreciation/ amortization/ impairment
2. Revaluation approach
● Limited applications
● Measure value to the active market
Impairment: writing down value of an asset to recognize decline in FV
Useful life: period of time which the asset is available for use / number of production units
biz is able to obtain from use

Finite useful life Indefinite useful life

● Amortize over useful life ● DOES NOT mean infinite time

● Max amortization period is the legal life ● Uncertainty over the period that the
○ Can be shorter based on market or asset will provide economic benefits
economic life in the foreseeable future
Ex. Patent is legally valid for 10 years, but is expected to ● Impairment test each year
be useful to the business for 6 years → use 6 years to
amortize (always use LOWER time period)
Considerations
● Speed of technological innovation
● Obsolescence
● Market
● trends/ industry/ competition
● Useful life of other assets that this one depends
on

IFRS Assumptions
● Residual Value (RV) is 0
● If not method of depreciation is reliable → use Straight Line method

Derecognition
● Same as PPE
● Proceeds - Carrying Amount = Gain or Loss
○ Remove both Cost & Acc. Amortization (credit)
○ Gain/ Loss → Net Income
Goodwill
● Seperate from intangible assets
● Goodwill = Purchase - FV of Net Assets
○ Aka how much a buyer is willing to pay for a business over the value of the
individual assets alone
○ Portion of the Purchase price that is not accounted for by the identifiable
assets & liabilities
● Similar to intangible assets w/ indefinite life → Test for impairment
 ○ DO NOT Amortize
Examples of Fair Value on Acquisition Date

A/R ● FV is lower than recorded amount due to uncollectible

accounts
● A/R balance doesn’t reflect TVM (Time Value of Money)

Inventories ● Obsolescence = lower value

PPE ● Sometimes depreciation is less than the decline in fair

value sp PPE FV is lower than carrying amount

Intangible Assets ● FV GREATER than actual value b/c maybe organization

did not capitalize

Earnings Management

Capitalization of ● Possible to undercapitalize because grey area around

developmental capitalization definition
costs ○ Easy to show that asset doesn’t meet ⅙ criteria for
capitalization
○ Capitalizing in future after under capitalizing shows
improved performance (not accurate)

Useful life ● Economic live of intangible asset is uncertain, especially for

acquired intangibles
● Mgmt may to increase the useful life to spread out expenses
over a longer period of time
○ Increase Net Earnings in short term
 Chapter 10: Applications of Fair Value to Non-Current Assets

Entities can choose the cost model or the revaluation model as accounting policy to
measure carrying values of non-current assets such as PP&E and intangible assets.

Revaluation Model of Measuring Carrying Values Subsequent to Initial Acquisition

● Revaluation Model: Restates the carrying value of an asset to the asset’s fair value
on the date of revaluation
● Carrying value/Net Book Value: Original Cost - Accumulated Depreciation
● Fair Value: Price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the measurement date

IAS 16 - PPE
● Assets of the same class
● Choice if "FV can be measured reliably…"
● Sufficient regularity
● Not permitted for ASPE - Cost

IAS 38 - Intangibles
● Assets of the same class
● Choice - less likely as requires an active market to measure Fair Value
● Sufficient regularity
● Not permitted for ASPE - Cost

IAS 16
“An entity shall choose either the cost model in paragraph 30 or the revaluation model in
paragraph 31 as its accounting policy and shall apply that policy to an entire class of
property, plant and equipment.”

“After recognition as an asset, an item of property, plant and equipment whose fair value
can be measured reliably shall be carried at a revalued amount...”

Issues:
1. How do we adjust asset values?
2. Increases/Decreases recognized in Net Income or OCI?
3. For depreciable/amortized assets:
1. What is the depreciation/amortization base for the future?
2. What do we do with accumulated depreciation/amortization?

Increases/Decreases Recognized in Net Income or OCI

● A revaluation increase in asset’s carrying amount is recognized in OCI and
accumulated in equity under the heading “revaluation surplus”
 ○ The increase is recognized in NI to reverse a revaluation decrease of the
same asset previously recognized in NI
● A revaluation decrease in asset’s carrying amount due to revaluation is recognized
in NI
○ The decrease is recognized in OCI to reverse a revaluation increase of the
same asset previously recognized in OCI,
○ This decrease reduces the amount accumulated in equity

Revaluation of Non-Depreciable Asset Examples

Land Example 1 Land Example 2
● Cost Year 1 = $100,000 ● Cost Year 1 = $300,000
● Fair Value Year 2 = $90,000 ● Fair Value Year 2 = $350,000
● Fair Value Year 3 = $150,000 ● Fair Value Year 3 = $290,000
● Sale: Year 4 = $160,000
Year 2 JE:
Year 2 JE: Land 50,000
Revaluation Loss (NI) 10,000 Revaluation Surplus (OCI) 50,000
Land 10,000
Year 3 JE:
Year 3 JE: Revaluation Surplus (OCI) 50,000
Land 60,000 Revaluation Loss (NI) 10,000
Revaluation Gain (NI) 10,000 Land 60,000
Revaluation Surplus (OCI) 50,000

Year 4 JE:
Cash 160,000
Land 150,000
Gain on Sale (NI) 10,000
(realized through a transaction, therefore
NI)
Accumulated Revaluation Surplus 50,000
Retained Earnings 50,000

Land T Account:
Purchase = $100,000
Year 2 = $10,000
Ending = $90,000

Revaluation of Depreciable Assets

Proportional vs Elimination
● Proportional maintains the character of the original purchase since the ratio of
accumulated depreciation to cost remains unchanged before and after revaluation
○ Adjusts the gross carrying value and accumulated depreciation (or
amortization) by the same percentage such that the net carrying amount
equals fair value after revaluation.
● Elimination is the number that would result from purchase at the revaluation date
○ A method that removes the balance in accumulated depreciation and
restates the gross carrying amount to fair value
● Both methods result in the same net carrying amount

Revaluation of Depreciable Assets Examples

Proportional Elimination
● Building Cost - beg. of year 1 = ● Building Cost - beg.of year 1 =
$200,000 $600,000
● Residual = $0 ● Residual = $100,000
● Useful Life - Straight Line Method = ● Useful Life - Straight Line Method =
20 years 10 years
● NBV - end of year 5 = $150,000 ● Revalued end of year 2 = $530,000
● FV - end of year 5 = $300,000 ● Revalued end of year 4 = $400,000
● Sold beginning of year 5 = $420,000
Acc. Dep, end of year 5 = $50,000
Building Costs = $200,000 Year 1+2 JE:
NBV = $150,000 Dep. Expense 50,000
FV = $300,000 Acc. Dep 50,000
● There has been a double increase of
NBV to FV Year 2 JE:
Acc. Dep 100,000
JE: Building 100,000
Building 200,000 Building 30,000
Acc. Dep. 50,000 Revaluation Surplus (OCI) 30,000
Revaluation Surplus (OCI) 150,000
Year 3+4 JE:
Updated Depreciation: Dep. Expense 53,750
Dep. = (400,000 - 100,000) / 15 years = Acc. Dep 53,750
 $20,000 (530,000 - 100,000) / 8 years

Year 4 JE:
Acc. Dep 107,500
Building 107,500
Building Surplus (OCI) 22,500
Building 22,500

Year 5 JE:
Cash 420,000
Building 400,000
Gain on Sale (NI) 20 000
AOCI Revaluation Surplus 7,500
Retained Earnings 7,500

Building T-Account
Purchase = $600,000
Year 2 = $100,000
________________________________________
$500,000
Year 2 = $30,000
________________________________________
$530,000
Year 4 = $107,500
________________________________________
$422,500
Year 4 = $22,500
________________________________________
$400,000

Acc. Dep T-Account

Year 1 = $50,000
Year 2 = $50,000
Year 2 = $100,000
__________________________________________
$0
Year 3 = $53,750
Year 4 = $53,750

Investment Property
IAS 40
● Land or building held to earn rental income, or for capital appreciation, or both
● Choice: Cost model of FV model
● Apply to all Investment property
● If choose Cost model - disclose FV in notes
Investment Property: Fair Value Model
IAS 40
● Gains or losses recognized in NI
● No depreciation
● FV should reflect actual market conditions at the Balance Sheet date
● Change-in-use requirements
● Not permitted for ASPE - Cost

Impairment
● Test at the cash generating unit level: smallest identifiable group of assets that
generates cash inflows that are largely independent of those from other assets

Stage 1: Do indicators exist?

Stage 2: Impairment Test

● Depending on the type of Asset, Carrying Value may be based on:
○ Cost Model
○ Revaluation Model
 ● Recoverable Amount (higher of):
○ FV less cost to sell:
■ “Exit price”
■ Market-based
■ FV hierarchy
○ Value in Use
■ PV of future cash flows from use and subsequent disposal

Stage 3: Entries to record impairment

Decision Tree (IFRS)

Reversals of Impairment

● Max. amount of impairment reversal = impairment amount (can't exceed original

impairment)
● Under IFRS, no reversals of goodwill impairment losses

EXAMPLE: Robson Inc.

Depreciation Expense = (3,500,000 - 200,000)/19 = $330,000/year

End of 2015:
● Carrying Amount - Recoverable Amount = Impairment Loss
● $2,840,000 - $2,500,000 = $340,000

JE:
Impairment Loss (NI) 340,000
Accumulated Depreciation 340,000

Depreciation Expense = (350,000 - 660,000 - 340,000 - 200,000) / 8 years = $287,500/year

End of 2017:
Carrying Amount = $1,925,000
Recoverable Amount = $2,200,000
Recoverable Amount > Carrying Amount, therefore, must reverse some impairment

Carrying Amount without impairment = $2,180,000 (original cost minus 4 years of

depreciation)

JE:
Accumulated Depreciation 255,000
Recovery of Impairment Loss 255,000
 Appendix: Statement of Cash Flows

Formatting

Operating Activities → The principal

revenue-producing activities of the
entity and other activities of the entity
and other activities that are not
investing or financing activities.

Investing Activities → The acquisition

and disposal of long-term assets and
other investments not included in cash
equivalents.
Cash flows related to investing
summarizes the net expenditures on assets meant to generate future income. There are
two distinct components of investing activities:
1) The acquisition and disposal
of fixed assets
2) The purchase and resale of
financial assets

Exceptions:
→ The purchase and resale of investments classified as cash equivalents are not reported
as cash flows.
→ transactions involving the purchase and sale of investments at FVPL held for trading
purposes are reported as operating activities as they are similar to inventory held
specifically for resale.

Financing Activities → Activities that

result in changes in the size and
composition of the contributed equity
and borrowings of the entity. These do
not include financing resulting from
ordinary operations.

Cash Flows with Classification Options:

● Interest and Dividends Received. May classify as either operating or investing
activity.
● Interest and Dividends Paid. May classify as either an operating or financing activity.

Non-Cash Transactions:
Activities that do not involve cash. Investing and financing non-cash transactions are not
recorded on the cash flow statement, but significant ones must be disclosed in the notes.

Direct Method vs. Indirect Method

Direct Method: Whereby major classes of gross cash receipts and gross cash payments are
disclosed.
Indirect Method: Whereby profit or loss is adjusted for the effects of transactions of a
non-cash nature, any deferrals or accruals of past or future operating cash receipts or
payments and items of income or expense associated with investing or financing cash
flows.

The operating section is where the differences between the two methods lie. They involve
different line items, but the net amount of operating cash flows remains the same for both.
The investing and financing sections for both methods are the same.
 Indirect Method Direct Method

Cash Flow Statement under ASPE

→ Referred to as Cash Flow Statement rather than a Statement of Cash Flows.

→ Interest and dividend received and the payment of interest are operating activities.
→ Dividends paid are financing activities.
→ Requires that the amount of interest and dividends paid and charged directly to retained
earnings be separately presented as financing activities. Does not require separate
disclosure.
→ The amount of income taxes paid need not be disclosed.

Sources of Information

● Comparative Balance Sheets. The change in cash for the year can be explained by all
the non-cash accounts on the balance sheet.
● Income Statement for the Period. For the indirect method, the net profit or loss is
needed. It also provides information on retained earnings.
● Select Transaction Data.
Steps

1) Determine the change in cash that needs to be explained. (Comparing current year’s
closing cash + equivalents balance to prior year).
2) Adjust net income as necessary to determine net cash from operating activities.
→ Start with profit/loss
→ Adjust net income for all non-cash items, depreciation, gains/losses
→ Add back interest and income tax expense and subtract investment income from
interest and dividends
→ Adjust for the unexplained changes in working capital accounts representing
operating activities.
→ Add dividends and interest received and subtract dividends, interest, and income
taxes paid. (Separately itemize these cash flows)
3) Account for the changes in remaining balance sheet accounts
4) Calculate subtotals for operating, investing, and financing activities and ensure the
net change in cash and cash equivalents thus determined is equal to the actual
change for the period computed in step 1)