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COO – FORM 12

SUBJECT TITLE: INTERMEDIATE ACCOUNTING 2

INSTRUCTOR: JUVEN P. LAMERA, CPA
SUBJECT CODE: FA4

MODULE 1

Topic 1: LIABILITIES

Objectives:

At the end of this topic, students are expected to:

1. Understand the concept of liabilities.

2. Describe the nature and type of current and noncurrent liabilities.
3. Know the measurement of current and noncurrent liabilities.
4. Explain the issue of long-term debt falling due within one year.
5. Explain the issue of breach of covenants attached to a long-term debt.
6. Describe formulas in computing bonus to officers and employees.

NOTES:

1. Definition

Liabilities are present obligations of an entity to transfer an economic resource as a result of past
events.

Essential Characteristics of Liabilities:

a. Present Obligation of an entity. “debtor”

b. Resulting from Past Event/Transaction – “legal” or “voluntary”
c. Future outflow of economic resources to settle

2. Current Liabilities

PAS 1, paragraph 69, provides that an entity shall classify a liability as current when:

a. The entity expects to settle the liability within the entity’s operating cycle.
b. The entity holds the liability primarily for the purpose of trading.
c. The liability is due to be settled within twelve months after the reporting period.
d. The entity does not have an unconditional right to defer settlement of the liability for at least
twelve months after the reporting period.

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3. Noncurrent Liabilities

All liabilities not classified as current are classified as noncurrent liabilities.

4. Measurement of Current Liabilities

Current liabilities or short-term obligations are not discounted anymore but measured, recorded and
reported at their face amount.

5. Measurement of Noncurrent Liabilities

Noncurrent liabilities are initially measured at present value and subsequently measured at
amortized cost.

A liability which is due to be settled within twelve months after the reporting period is classified as
current, even if:

a. The original term was for a period longer than twelve months.
b. An agreement to refinance or to reschedule payment on a long-term basis is completed after
the reporting period and before the financial statements are authorized for issue.

However, if the refinancing on a long-term basis is completed on or before the end of the reporting
period, the refinancing is an adjusting event and therefore the obligation is classified as noncurrent.

6. Covenants

Covenants are restrictions on the borrower as to undertaking further borrowings, paying dividends
and so forth, often attached to borrowing agreements which represent undertakings by the borrower.

7. Breach of Covenants

Under these covenants, if certain conditions relating to the borrower’s financial situation are
breached, the liability becomes payable on demand.

8. Estimated Liabilities

Estimated liabilities are obligations which exist at the end of the reporting period although their
amount is not definite.

9. Deferred Revenue

Deferred revenue or unearned revenue is income already received but not yet earned.

10. Bonus Computation

Large entities often compensate key officers and employees by way of bonus for superior income
realized during the year.

The bonus computation usually has four variations. Bonus is expressed as a certain percentage of:

a. Income before bonus and before tax

b. Income after bonus and before tax
c. Income after bonus and after tax
d. Income before bonus and after tax

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Topic 2: PREMIUM LIABILITY

Objectives:

At the end of this topic, students are expected to:

1. Know the recognition of a premium liability.

2. Know the recognition of a cash rebate program.
3. Know the recognition of a cash discount offer program.
4. Understand the recognition and measurement of a customer loyalty program.

NOTES:

1. Premiums

Premiums are articles of value such as toys, dishes, silverware and other goods given to customers
as result of past sales or sales promotion activities.

Accordingly, when the merchandise is sold, an accounting liability for the future distribution of the
premium arises and should be given accounting recognition.
Other variations of premiums:

a. Cash Rebate Program

b. Cash Discount Coupon

ENTRIES:

Purchase of Premiums: Premiums xxx

Cash xxx

Distribution of Premiums: Premium Exp xxx

Premiums xxx

Estimation of Outstanding
Premiums Liability: Premium Exp xxx
Estimated Premium Liability xxx

Solution:
Total Estimate xxx
(Distributed) (xxx)
Estimated Liability xxx

2. Customer Loyalty Program

The customer loyalty program is generally designed to reward customers for past purchases and to
provide them with incentives to make further purchases.
If a customer buys goods or services, the entity grants the customer award credits often described
as “points” which can be redeemed by the entity by distributing to the customer free or discounted
goods or services.

3. Measurement

An entity shall account for the award credits as “separately component of initial sale transaction.”

IFRS 15, paragraph 74, provides that an entity shall allocate the transaction price to each
performance obligation identified in a contract on a relative stand-alone selling price basis.

4. Recognition

The consideration allocated to the award credits is initially recognized as deferred revenue and is
subsequently recognized as revenue when the award credits are redeemed.

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5. Third Party Operates Loyalty Program

A third party operates a loyalty program is when a separate entity, participating in a customer loyalty
program operated by another entity, grants program members points for every certain amount of
purchase from its business.

END OF TOPIC 2

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Topic 3: WARRANTY LIABILITY

Objectives:

At the end of this topic, students are expected to:

1. Understand the nature and purpose of warranty.

2. Ascertain the recognition of an estimated warranty liability.
3. Know the measurement of an estimated liability.
4. Test the reasonable accuracy of an estimated warranty liability.

NOTES:

1. Warranty

Home appliances are often sold under guarantee or warranty to provided free repair service or
replacement during a specified period if the products are defective.

2. Recognition of Warranty Provision

PAS 37, paragraph 14, provides that a provision shall be recognized as a liability in the financial
statements under the following conditions:

a. The entity has a present obligation, legal or constructive, as a result of a past event.
b. It is probable that an outflow of resources embodying economic benefits would be required to settle
the obligation.
c. The amount of obligation can be measured reliably.

3. Accounting for Warranty

There are two approaches in recording the warranty expense, namely:

a. Accrual approach
b. Expense as incurred approach

4. Accrual Approach

The accrual approach has the soundest theoretical support because it properly matches cost with
revenue.

Estimated warranty cost is recorded:

Warranty expense xx
Estimated warranty liability xx

Actual warranty cost is subsequently incurred and paid:

Estimated warranty liability xx
Cash xx

5. Expense as Incurred Approach

The expense as incurred approach is the approach of expensing warranty cost only when actually
incurred.

No estimated warranty liability:

NO ENTRY

Actual warranty cost is subsequently incurred and paid:

Warranty expense xx
Cash xx

END OF TOPIC 3

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Topic 4: PROVISION – CONTINGENT LIABILITY

Objectives:

At the end of this topic, students are expected to:

1. Understand the nature of a provision.

2. Know the conditions for the recognition of a provision.
3. Know the measurement of a provision.
4. Identify measurement considerations for a provision.
5. Know the requirements for the recognition of contingent liability and contingent asset.

NOTES:

1. Provision

A provision is an existing liability of uncertain timing or uncertain amount.

2. Recognition of Provision

PAS 37, paragraph 14, provides that a provision shall be recognized as a liability in the financial
statements under the following conditions:

a. The entity has a present obligation, legal or constructive, as a result of a past event.
b. It is probable that an outflow of resources embodying economic benefits would be required to
settle the obligation.
c. The amount of the obligation can be measured reliably.

3. Measurement of Provision

The amount recognized as a provision should be the best estimate of the expenditure required to
settle the present obligation at the end of reporting period.

Where there is a continuous range of possible outcomes and each point in that range is as likely as
any other, the midpoint of the range is used.

Where the provision being measured involves a large population of items, the obligation is estimated
by “weighting” or “expected value” of all possible outcomes by their associated possibilities.

4. Other Measurement Considerations

The following items are taken into consideration in recognizing and measuring a provision:

a. Risks and uncertainties

b. Present value of obligation
c. Future events
d. Expected disposal of assets
e. Reimbursements
f. Changes in provision
g. Use of provision
h. Future operating losses
i. Onerous contract

5. Examples of Provision

These are some examples of provisions:

a. Warranties
b. Environmental contamination
c. Decommissioning or abandonment cost

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 d. Court case
e. Guarantee

6. Contingent Liability

PAS 37, paragraph 10, defines a contingent liability in two ways:

A contingent liability is a possible obligation that arises from past event and whose existence will be
confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not
wholly within the control of the entity.

A contingent liability is a present obligation that arises from a past event but is not recognized
because it is not probable that an outflow of resources embodying economic benefits will be required
to settle the obligation or the amount of the obligation cannot be measured reliably.

7. Treatment of Contingent Liability

A contingent liability shall not be recognized in the financial statements but shall be disclosed only.

8. Contingent Asset

A contingent asset is a possible asset that arises from past event and whose existence will be
confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not
wholly within the control of the entity.

A contingent asset shall not be recognized. However when the realization of income is virtually
certain, the related asset is no longer contingent therefore its recognition is appropriate.

A contingent asset is disclosed only when it is probable.

END OF TOPIC 4

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Topic 5: FINANCE LEASE - LESSEE

Objectives:

At the end of this topic, students are expected to:

7. Define lease under the new lease standard.

8. Know the optional applications of operating lease on the part of lessee.
9. Recognize right of use asset in a finance lease.
10. Understand the measurement of a right of use asset.
11. Recognize lease liability in a finance lease.
12. Understand the measurement of a lease liability in a finance lease.

NOTES:
1. LEASE

Under Appendix A of IFRS 16, a lease is defined as a contract or part of a contract that conveys the right
to use the underlying asset for a period of time in exchange for consideration.

2. The right to control the use of an asset

A contract conveys the right to se of an asset if throughout the period of use, the customer has the right
to:

a. Obtains substantially all of the economic benefits from the use of the identified asset.
b. Direct use of the identified asset.

3. Finance lease model for lease

IFRS 16, paragraph 22, provides that at the commencement date, a lessee shall recognize a right of use
asset and a lease liability.

All leases shall be accounted for by the lessee as a finance lease under the new lease standard.

4. Operating lease model for lease

IFRS 16, paragraph 5, provides that a lessee is permitted to make an accounting policy election to apply
the operating lease accounting and not recognize an asset and lease liability in two optional exemptions.

a. Short-term lease. A short-term lease is a lease that has a term of 12 months or less at the
commencement date of the lease.

b. Low value lease. Low vale less is a matter of professional judgement. Stated differently, a lessee may
or may not apply the operating lease accounting if the lease is short term or if the underlying asset is
of low value.

5. Finance lease – Lessee

A finance lease is defined as a lease that transfers substantially all of the risks and rewards incidental to
ownership of an underlying asset.

At the commencement date, the lessee shall recognize a right of use asset and lease liability.

6. Initial measurement of right of use asset

A right of use asset is defined as an asset that represents the right of a lessee to use of an underlying
asset over the lease term in a finance lease.

The right of use asset is measured at cost at the commencement date.

The cost of right of use asset comprises:

a. The present value of lease payments or the initial measurement of the lease liability.
b. Lease payments made to lessor at or before commencement date, such as lease bonus, less any
lease incentives received.
c. Initial direct costs incurred by the lessee.
d. Estimate of cost of dismantling, removing and restoring the underlying asset for which the lessee has
a present obligation.
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 The lessee shall measure the right of use asset at cost less any accumulated depreciation and impairment
loss.

The lessee shall present the right of use asset as a separate line item in the statement of financial position.

7. Depreciation of right of use asset

The lessee shall apply normal depreciation policy for right of use asset.

The lessee shall depreciate the right of use asset over the useful life of the underlying asset under the
following conditions:

a. The lease transfers ownership of the underlying asset to the lessee at the end of lease term.
b. The lessee is reasonably curtain to exercise a purchase option.

If there is no transfer of ownership to the lessee or if the purchase option is not reasonable certain to be
exercised, the lessee shall depreciate the right of use asset over the shorter between the useful life of the
asset and the lease term.

8. Measurement of lease liability

Provides that at the commencement date, the lessee shall measure the lease liability at the present value
of lease payments.

The lease payments shall be discounted using the interest rate implicit in the lease.

If the implicit rate cannot be readily determined, the incremental borrowing rate of the lessee is used.

9. Components of lease payments

The lease payments comprise the following payments for the right of use asset during the lease term:

a. Fixed lease payments

b. Variable lease payments
c. Exercise price of a purchase option if the lessee is reasonable certain to exercise the option.
d. Amount expected to be payable by the lessee under a residual value guarantee.
e. Termination penalties if the lease term reflects the exercise of a termination option.

10. Definitions

a. Residual value guarantee is the guarantee made to the lessor by a party unrelated to the lessor that
the value of an underlying asset at the end of the lease term will be at least a specified amount.
b. Unguaranteed residual value is that portion of the residual value of the underlying asset, the realization
of which by the lessor is not assured or is guaranteed solely by a party related to the lessor.
c. Executory cost are ownership expenses such as maintenance, taxes and insurance for the underlying
asset. Executory cost are expensed immediately when incurred.

END OF TOPIC 5

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Topic 6: OPERATING LEASE - LESSOR

Objectives:

At the end of this topic, students are expected to:

5. Understand lessor accounting in contrast to lessee accounting under the new lease standard.
6. Define an operating lease and a finance lease.
7. Identify the criteria in determining a finance lease on the part of the lessor.
8. Know the recognition of an operating lease on the part of the lessor.

NOTES:

1. Definitions

An operating lease is a lease that does not transfer substantially all the risks and rewards incidental to
ownership of the underlying asset.

A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of
an underlying asset.

2. When is a lease classified as a finance lease?

Under IFRS 16, paragraph 63, among others, any of the following situations would normally lead to a
lease being classified as a finance lease by the lessor:

a. The lease transfers ownership of the underlying asset to the lessee at the end of the lease term.
b. The lessee has an option to purchase the asset at a price which is expected to be sufficiently lower
than the fair value at the date the option becomes exercisable. At the inception of the lease, it is
reasonably certain that the option will be exercised.
c. The lease term is for the major part of the economic life of the underlying asset even if title is not
transferred.
d. The present value of the lease payments amounts to substantially all of the fair value of the
underlying asset at the inception of the lease.

These four major criteria are determinative in nature, meaning, any one of these would normally result
to a conclusion that the lease contract is a finance lease.

3. Operating lease – Lessor

IFRS 16, paragraph 81, provides that a lessor shall recognize lease payments from operating lease as
income either on a straight line basis or another systematic manner.

The periodic rental received by the lessor in an operating lease is simply recognized as rent income.

The underlying asset remains as an asset of the lessor. Consequently, the lessor bears all ownership or
executory costs such as depreciation of leased property, real property taxes, insurance and maintenance
cost. However, the lessor may pass on to the lessee the payment for taxes, insurance and maintenance
cost.

• The depreciation shall be consistent with the lessor’s normal depreciation of similar asset.
• Initial direct cost shall be added to the carrying amount of the asset.
• Security deposit refundable upon the lease expiration shall be accounted for as liability by the lessor.
• Lease bonus received by the lessor from the lessee is recognized as unearned rent income to be
amortized over the lease term.

4. Unequal rental payments

Lease payments under an operating lease shall be recognized as income on a straight line basis or
another systematic manner.

This simply means that where the operating lease requires unequal cash payments, the total cash
payments for the lease term shall be amortized uniformly on the straight line basis as rent income over
the lease term.

END OF TOPIC 6

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Topic 7: DIRECT FINANCING LEASE

Objectives:

At the end of this topic, students are expected to:

5. Know the finance lease classification on the part of the lessor.

6. Define a direct financing lease.
7. Understand gross investment and net investment in a direct financing lease.
8. Recognize interest income in a direct financing lease using the effective interest method.

NOTES:

1. Finance lease classification

On the part of the lessor, a finance lease is either:

a. Direct financing lease

b. Sales type lease

2. Direct financing lease

The lessor in a direct financing lease is actually engaged in the financing business. Thus, a direct
financing lease is an arrangement between a financing entity and a lessee.

The income of the lessor is only in the form of interest income.

3. Accounting considerations

a. Gross investment – this is equal to the gross rentals for the entire lease term plus the absolute
amount of the residual value, whether guaranteed or unguaranteed.
b. Net investment in the lease – this is equal to the cost of the asset plus any initial direct cost paid by
the lessor.
c. Unearned interest income – this is the difference between the gross investment and net investment
in the lease.
d. Initial direct cost – in ad direct financing lease, the initial direct cost paid by the lessor is added to the
cost of the asset to get the net investment in the lease.

4. Journal entries

Commencement:
Lease receivable Xx
(Specific asset) Xx
Unearned interest income xx

With initial direct cost

Specific asset Xx
Cash Xx

Annual collection
Cash Xx
Lease receivable Xx

Amortization of (UII)
Unearned interest income
Interest income

END OF TOPIC 7

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Topic 8: SALES TYPE LEASE

Objectives:

At the end of this topic, students are expected to:

6. Understand a sales type lease on the part of lessor.

7. Define gross investment and net investment in a sales type lease.
8. Recognize profit on sale and interest income in a sales type lease.

NOTES:

1. Sales type lease

The lessor in the sales type lease is actually a manufacturer or dealer that uses as a means of facilitating
the sale of product.

Sales type lease involves the recognition of a manufacturer or dealer profit and interest income.

2. Accounting consideration

a. Gross investment – this is equal to the gross rentals for the entire lease term plus the absolute
amount of the residual value, whether guaranteed or unguaranteed. This is the same gross
investment in a direct financing lease.
b. Net investment in the lease – this is equal to the present value of the gross rentals plus the present
value of the residual value, whether guaranteed or unguaranteed.
c. Unearned interest income – this is the difference between the gross investment and net investment
in the lease.
d. Sales – the amount is equal to the net investment in the lease (PV of lease payments) or fair value
of the asset, whichever is lower.
e. Cost of goods sold – this is equal to the cost of the asset sold minus the present value of
unguaranteed residual value plus initial direct cost paid by the lessor.
f. Gross profit – this is the usual formula of sales minus cost of goods sold.
g. Initial direct cost – the amount is expensed immediately in a sales type lease component of cost of
goods sold.

3. Journal entries

Commencement:
Lease receivable Xx
Cost of goods sold Xx
Sales Xx
Unearned interest income Xx
Inventory Xx

With initial direct cost:

Cost of goods sold Xx
Cash Xx

Annual collection
Cash Xx
Lease receivable Xx

Amortization of (UII)
Unearned interest income Xx
Interest income Xx

END OF TOPIC 8

Reference:

Conrado T. Valix, Jose F. Peralta and Christian Aris M. Valix

Intermediate accounting Volume 2 (2023 edition)

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