840 Kieso IFRS Supplement PDF

NOTE: Since these are "Rough PP" KiesoIFRS_Supplement
running heads and folios will be

finalized in revise pp. Global Markets · 1
CHAPTER 1 FINANCIAL REPORTING AND ACCOUNTING STANDARDS
GLOBAL MARKETS
World markets are becoming increasingly intertwined. International consumers drive
Japanese cars, wear Italian shoes and Scottish woolens, drink Brazilian coffee and Indian
tea, eat Swiss chocolate bars, sit on Danish furniture, watch U.S. movies, and use Arabian
oil. The tremendous variety and volume of both exported and imported goods
indicates the extensive involvement in international trade—for many companies, the
world is their market.
To provide some indication of the extent of globalization of economic activity,
Illustration 1-1 provides a listing of the top 20 global companies in terms of sales.
Rank Rank
($ millions) Company Country Revenues ($ millions) Company Country Revenues
1 Wal-Mart Stores U.S. 378,799.0 11 Daimler Germany 177,167.1
2 ExxonMobil U.S. 372,824.0 12 General Electric U.S. 176,656.0
3 Royal Dutch Shell Netherlands 355,782.0 13 Ford Motor U.S. 172,468.0
4 BP U.K. 291,438.0 14 Fortis Belgium/Netherlands 164,877.0
5 Toyota Motor Japan 230,200.8 15 AXA France 162,762.3
6 Chevron U.S. 210,783.0 16 Sinopec China 159,259.6
7 ING Group Netherlands 201,516.0 17 Citigroup U.S. 159,229.0
8 Total France 187,279.5 18 Volkswagen Germany 149,054.1
9 General Motors U.S. 182,347.0 19 Dexia Group Belgium 147,648.4
10 ConocoPhillips U.S. 178,558.0 20 HSBC Holdings U.K. 146,500.0
Source: http://money.cnn.com/magazines/fortune/global500/2008/.
ILLUSTRATION 1-1
In addition, due to technological advances and less onerous regulatory requirements, Fortune Global 500
investors are able to engage in financial transactions across national borders and to
make investment, capital allocation, and financing decisions involving many foreign
companies. Also, many investors, in attempts to diversify their portfolio risk, have in-
vested more heavily in international markets. As a result, an increasing number of
investors are holding securities of foreign companies. For example, over a recent seven-
year period, estimated investments in foreign equity securities by U.S. investors increased
over 20-fold, from $200 billion to $4,200 billion.
An indication of the significance of these international investment opportunities
can be found when examining the number of foreign registrations on various securities
exchanges. As shown in Illustration 1-2, a significant number of foreign companies are
found on national exchanges.
ILLUSTRATION 1-2
Exchange Total Share Trading Total Domestic Foreign Foreign
International Exchange
(Location) ($ billions) Listings Listings Listings %
Statistics
NYSE (U.S.) $30,214.8 2,447 2,030 417 17.04
Nasdaq (U.S.) 13,618.6 2,934 2,571 363 12.37
Australian 1,146.7 2,076 1,993 83 4.00
Singapore 237.8 770 460 310 40.26
Tokyo (Japan) 4,902.6 2,394 2,373 21 0.88
London 5,961.2 3,156 2,461 695 22.02
Swiss 1,379.8 324 253 71 21.91
Deutsche Borse 3,526.2 840 749 91 10.83
(Germany)
Source: Focus: The Monthly Newsletter of Regulated Exchanges (November 2008).
2 · Chapter 1 Financial Reporting and Accounting Standards
As indicated, capital markets are increasingly integrated and companies have

greater flexibility in deciding where to raise capital. In the absence of market integra-
tion, there can be company-specific factors that make it cheaper to raise capital and
list/trade securities in one location versus another. With the integration of capital mar-
kets, the automatic linkage between the location of the company and location of the
capital market is loosening. As a result, companies have expanded choices of where to
raise capital, either equity or debt. The move toward adoption of international finan-
cial reporting standards has and will continue to facilitate this movement.
STANDARD-SETTING ORGANIZATIONS
For many years, many nations have relied on their own standard-setting organizations.
For example, Canada has the Accounting Standards Board, Japan has the Accounting
Standards Board of Japan, Germany has the German Accounting Standards Commit-
tee, and the United States has the Financial Accounting Standards Board (FASB). The
standards issued by these organizations are sometimes principles-based, rules-based,
tax-oriented, or business-based. In other words, they often differ in concept and objec-
tive. Starting in 2000, two major standard-setting bodies have emerged as the primary
standard-setting bodies in the world.
One organization is based in London, United Kingdom, and is called the Interna-
tional Accounting Standards Board (IASB). The IASB issues International Financial
Reporting Standards (IFRS), which are used on most foreign exchanges. These stan-
dards may also be used by foreign companies listing on U.S. securities exchanges. As
indicated earlier, IFRS is presently used in over 115 countries and is rapidly gaining
acceptance in other countries as well.
The other standard-setting organization is the Financial Accounting Standards
Board (FASB), which is based in the United States. All U.S.-based companies are re-
quired to use FASB standards when preparing financial statements and related finan-
cial information. Some note that FASB standards are more comprehensive and detailed,
whereas IASB standards are more conceptual and less rules-based. Regardless of view-
point, both Boards believe that a single set of high-quality global accounting standards
is needed to enhance comparability.
It is generally believed that IFRS has the best potential to provide a common plat-
form on which companies can report and investors can compare financial information.
As a result, our discussion focuses on IFRS and the organization involved in develop-
ing these standards—the International Accounting Standards Board (IASB). (A detailed
discussion of the U.S. system is provided in Appendix 1A at the end of the chapter.)
The two organizations that have a role in international standard-setting are the Interna-
tional Organization of Securities Commissions (IOSCO) and the IASB.
International Organization of Securities Commissions (IOSCO)

International Organization of Securities Commissions (IOSCO) does not set accounting
standards. Instead, this organization is dedicated to ensuring that the global markets
can operate in an efficient and effective basis. The member agencies (such as from France,
Germany, New Zealand, and the U.S. SEC) have resolved to:
• Cooperate together to promote high standards of regulation in order to maintain
just, efficient, and sound markets.
• Exchange information on their respective experiences in order to promote the de-
velopment of domestic markets.
• Unite their efforts to establish standards and an effective surveillance of interna-
tional securities transactions.
• Provide mutual assistance to promote the integrity of the markets by a rigorous
application of the standards and by effective enforcement against offenses.
Standard-Setting Organizations · 3
A landmark year for IOSCO was 2005 when it endorsed the IOSCO Memorandum of
Understanding (MOU) to facilitate cross-border cooperation, reduce global systemic
risk, protect investors, and ensure fair and efficient securities markets. (For more infor-
mation, go to http://www.iosco.org/.)
International Accounting Standards Board (IASB)

The standard-setting structure internationally is composed of four organizations—the
International Accounting Standards Committee Foundation, the International Account-
ing Standards Board (IASB), a Standards Advisory Council, and an International
Financial Reporting Interpretations Committee (IFRIC). The trustees of the International
Accounting Standards Committee Foundation (IASCF) select the members of the IASB
and the Standards Advisory Council, fund their activities, and generally oversee the
IASB’s activities.
The IASB is the major operating unit in this four-part structure. Its mission is to
develop, in the public interest, a single set of high-quality and understandable IFRS
for general-purpose financial statements. In addition to research help from its own staff,
the IASB relies on the expertise of various task force groups formed for various proj-
ects and on the Standards Advisory Council (SAC). The SAC consults with the IASB
on major policy and technical issues and also helps select task force members. IFRIC
develops implementation guidance for consideration by the IASB. We discuss the
IFRIC’s activities in more detail on page xx. Illustration 1-4 shows the current
organizational structure for the setting of international standards.
ILLUSTRATION 1-4
International Standard-
IASC FOUNDATION
Setting Structure
22 Trustees.
Appoint, oversee, raise funds
BOARD
12 Full-Time and 2 Part-Time Members
Set technical agenda. Prove standards,
exposure drafts, interpretations
INTERNATIONAL
STANDARDS ADVISORY COUNCIL FINANCIAL REPORTING
30 or More Members INTERPRETATIONS COMMITTEE
14 Members
Appoints
Reports to
Advises
Due Process
In establishing financial accounting standards, the IASB has a thorough, open, and
transparent due process. The IASB due process has the following elements: (1) an
independent standard-setting board overseen by a geographically and professionally
diverse body of trustees; (2) a thorough and systematic process for developing
standards; (3) engagement with investors, regulators, business leaders, and the global
accountancy profession at every stage of the process; and (4) collaborative efforts with
the worldwide standard-setting community.
To implement its due process, the IASB follows specific steps to develop a typical
IFRS, as Illustration 1-5 (on page xx) shows.
ILLUSTRATION 1-5
IASB Due Process
AGENDA Research Discussion
•Business Papers What do
combinations? you think?
•Derivatives?
•Segment
reporting?
Topics identified and placed on Research and analysis conducted Public hearing on proposed
Board's agenda. and preliminary views of standard.
pros and cons issued.
"Any more comments? "Here is

This will be your final IFRS."
chance."
IASB
Exposure Standard
Draft
Board evaluates research and public Board evaluates responses and changes
response and issues exposure draft. exposure draft, if necessary. Final
standard issued.
Furthermore, the characteristics of the Board, as shown below, reinforce the impor-
tance of an open, transparent, and independent due process.
• Membership. The membership consists of 14 members, two who are part-time.
Members are well-paid and appointed for five-year renewable terms. The 14 mem-
bers come from different countries.
• Autonomy. The IASB is not part of any other professional organization. It is ap-
pointed by and answerable only to the International Accounting Standards Com-
mittee Foundation.
• Independence. Full-time IASB members must sever all ties from their past employer.
The members are selected for their expertise in standard-setting rather than to rep-
resent a given country.
• Voting. Nine of 14 votes are needed to issue a new IFRS.
With these characteristics, the IASB and its members will be insulated as much as
possible from the political process, favored industries, and national or cultural bias.
Types of Pronouncements
The IASB issues three major types of pronouncements:
1. International Financial Reporting Standards.

2. Framework for financial reporting.
3. International financial reporting interpretations.
International Financial Reporting Standards. Financial accounting standards issued

by the IASB are referred to as International Financial Reporting Standards (IFRS). The
IASB has issued nine of these standards to date, covering such subjects as business
combinations and share-based payments.
Prior to the IASB (formed in 2001), standard-setting on the international level was
done by the International Accounting Standards Committee, which issued International
Accounting Standards (IAS). The committee issued 40 IASs, many of which have been
amended or superseded by the IASB. Those still remaining are considered under the
umbrella of IFRS.
Standard-Setting Organizations · 5
Framework for Financial Reporting. As part of a long-range effort to move away from
the problem-by-problem approach, the International Accounting Standards Committee
(predecessor to the IASB) issued a document entitled “Framework for the Preparation
and Presentation of Financial Statements” (also referred to simply as the Framework).
This Framework sets forth fundamental objectives and concepts that the Board uses in
developing future standards of financial reporting. The intent of the document is to
form a cohesive set of interrelated concepts—a conceptual framework—that will serve
as tools for solving existing and emerging problems in a consistent manner. For exam-
ple, the objective of general-purpose financial reporting discussed earlier is part of this
Framework. The Framework and any changes to it pass through the same due process
(discussion paper, public hearing, exposure draft, etc.) as an IFRS. However, this Frame-
work is not an IFRS and hence does not define standards for any particular mea-
surement or disclosure issue. Nothing in this Framework overrides any specific inter-
national accounting standard. The Framework is discussed more fully in Chapter 2.
International Financial Reporting Interpretations. Interpretations issued by the Inter-

national Financial Reporting Interpretations Committee (IFRIC) are also considered
authoritative and must be followed. These interpretations cover (1) newly identified fi-
nancial reporting issues not specifically dealt with in IFRS, and (2) issues where unsatis-
factory or conflicting interpretations have developed, or seem likely to develop, in the
absence of authoritative guidance. The IFRIC has issued over 15 of these interpretations
to date.6
In keeping with the IASB’s own approach to setting standards, the IFRIC applies
a principles-based approach in providing interpretative guidance. To this end, the IFRIC
looks first to the Framework for the Preparation and Presentation of Financial State-
ments as the foundation for formulating a consensus. It then looks to the principles
articulated in the applicable standard, if any, to develop its interpretative guidance and
to determine that the proposed guidance does not conflict with provisions in IFRS.
IFRIC helps the IASB in many ways. For example, emerging issues often attract
public attention. If not resolved quickly, they can lead to financial crises and scandal.
They can also undercut public confidence in current reporting practices. The next step,
possible governmental intervention, would threaten the continuance of standard-
setting in the private sector. IFRIC can address controversial accounting problems as
they arise. It determines whether it can resolve them or whether to involve the IASB
in solving them. In essence, it becomes a “problem filter” for the IASB. Thus, the IASB
will hopefully work on more pervasive long-term problems, while the IFRIC deals with
short-term emerging issues.
Hierarchy of IFRS
Because it is a private organization, the IASB has no regulatory mandate and therefore
no enforcement mechanism. Similar to the U.S. setting, in which the Securities and
Exchange Commission enforces the use of FASB standards for public companies, the
IASB relies on other regulators to enforce the use of its standards. For example, effec-
tive January 1, 2005, the European Union required publicly traded member country
companies to use IFRS.7
6
As indicated above, the predecessor organization to the IASB was also involved in the
standard-setting process. It had an interpretations committee called the Standing Interpretation
Committee, which issued 32 interpretations (a number of these are now superseded).
7
Certain changes have been implemented with respect to use of IFRS in the United States.
For example, under American Institute of Certified Public Accountants (AICPA) rules, a
member of the AICPA can only report on financial statements prepared in accordance with
standards promulgated by standard-setting bodies designated by the AICPA Council. In
May 2008, the AICPA Council voted to designate the IASB in London as an international
accounting standard-setter for purposes of establishing international financial accounting
and reporting principles, and to make related amendments to its rules to provide AICPA
members with the option to use IFRS.
Any company indicating that it is preparing its financial statements in conformity

with IFRS must use all of the standards and interpretations. The following hierarchy
is used to determine what recognition, valuation, and disclosure requirements should
be used. Companies first look to:
1. International Financial Reporting Standards;

2. International Accounting Standards; and
3. Interpretations originated by the International Financial Reporting Interpretations
Committee (IFRIC) or the former Standing Interpretations Committee (SIC).
In the absence of a standard or an interpretation, the following sources in descend-

ing order are used: (1) the requirements and guidance in standards and interpretations
dealing with similar and related issues; (2) the framework for financial reporting; and
(3) most recent pronouncements of other standard-setting bodies that use a similar con-
ceptual framework to develop accounting standards, other accounting literature, and
accepted industry practices, to the extent they do not conflict with the above. The over-
riding requirement of IFRS is that the financial statements provide a fair presentation
(often referred to as a “true and fair view”). Fair representation is assumed to occur if
a company follows the guidelines established in IFRS.
International Convergence
As discussed in the opening story, convergence to a single set of high-quality financial
reporting standards appears to be a real possibility. For example, in 2002 the IASB
and the FASB formalized their commitment to the convergence of U.S. GAAP and
international standards by issuing a memorandum of understanding (often referred to
as the Norwalk Agreement). The two Boards agreed to use their best efforts to:
1. Make their existing financial reporting standards fully converged as soon as prac-
ticable, and
2. Coordinate their future work programs to ensure that once achieved, convergence
is maintained.
As a result of this agreement, the two Boards identified a number of short-term

and long-term projects that would lead to convergence. For example, one short-term
project was for the FASB to issue a standard that permits a fair value option for finan-
cial instruments. This standard was issued in 2007, and now the IASB and the FASB
follow the same accounting in this area. Conversely, the IASB has issued a standard
related to borrowing costs that is more consistent with U.S. standards. Long-term
projects relate to such issues as revenue recognition, the conceptual framework, and
leases.
C O N V E R G E N C E C O R N E R
INTERNATIONAL FINANCIAL REPORTING

Most agree that there is a need for one set of international accounting standards. Here is why:
Multinational corporations. Today’s companies view the entire world as their market. For example, Coca-Cola (USA),
Intel (USA), and Nokia (FIN) generate more than 50 percent of their sales outside the United States, and many compa-
nies find their largest market is not in their home country.
Mergers and acquisitions. The mergers that led to international giants Kraft/Cadbury (USA and GBR) and
Vodafone/Mannesmann (GBR and DEU) suggest that we will see even more such mergers in the future.
Information technology. As communication barriers continue to topple through advances in technology, companies and
individuals in different countries and markets are becoming comfortable buying and selling goods and services from one
another.
Financial markets. Financial markets are some of the most significant international markets today. Whether it is currency,
equity securities (shares), bonds, or derivatives, there are active markets throughout the world trading these types of
instruments.
R E L E VA N T FA C T S ABOUT THE NUMBERS

• Generally accepted accounting principles (GAAP) The FASB and its predecessor organizations have been developing
for U.S. companies are developed by the Financial standards for over 60 years. The IASB is a relatively new organiza-
Accounting Standards Board (FASB). The FASB is a tion (formed in 2001). As a result, it has looked to the United States
private organization; the U.S. Securities and Exchange to determine the structure it should follow in establishing IFRS. Thus,
Commission (SEC) exercises oversight authority over the international standard-setting structure (presented on page 11) is
the actions of the FASB. very similar to the U.S. standard-setting structure. Presented below
• The fact that there are differences between IFRS and is a chart of the FASB’s standard-setting structure.
U.S. GAAP should not be surprising because standard-
setters have developed standards in response to different Financial Accounting Foundation
(FAF)
user needs. In some countries, the primary users of finan- Purpose
cial statements are private investors; in others, the primary To select members of the FASB and
its Advisory Council, fund their
users are tax authorities or central government planners. activities, and exercise general
oversight.
In the United States, investors and creditors have driven

accounting-standard formulation. Financial Accounting Standards Board Staff and Task
(FASB) Forces
• IFRS tends to be simpler and more flexible in its
Purpose Purpose
accounting and disclosure requirements. U.S. GAAP is To establish and improve standards of To assist Board on
financial accounting and reporting for the reporting issues by
more detailed. This difference in approach has resulted in guidance and education of the public, performing research,
analysis, and writing
including issuers, auditors, and users of
functions.
a debate about the merits of “principles-based” versus financial information.
“rules-based” standards.
Financial Accounting Standards Advisory Council
(FASAC)
• The U.S. SEC recently eliminated the need for foreign
Purpose
companies that trade shares in U.S. markets to reconcile To consult on major policy issues,
technical issues, project priorities,
their accounting with U.S. GAAP. and selection and organization of
task forces.
ON TH E HORIZON
Both the IASB and the FASB are hard at work developing standards that will lead to the elimination of major differences in
the way certain transactions are accounted for and reported. In fact, the IASB (and the FASB on its joint projects with the IASB)
has agreed to phase in adoption of new major standards over several years, beginning in 2010. The major reason for this pol-
icy is to provide companies time to translate and implement international standards into practice.
Much has happened in a very short period of time in the international accounting environment. It now appears likely that
in a fairly short period of time, companies around the world will be using a single set of high-quality accounting standards.
7
QUESTIONS
1. What is happening to world markets, and what are the 15. How are IASB discussion papers and IASB exposure
implications for financial reporting? drafts related to IASB standards?
10. What is the benefit of a single set of high-quality account- 16. Distinguish between IASB standards and the IASB frame-
ing standards? work for financial reporting.
11. Who are the two key international players in the devel- 17. Rank from most authoritative to least authoritative the
opment of international accounting standards? Explain following three items: IASB framework for financial
their role. reporting, IASB financial reporting standards, and inter-
13. What is the purpose of IOSCO? national financial reporting interpretations.
14. What is the mission of the IASB?
CONCEPTS FOR ANALYSIS

CA1-2 (IFRS and Standard-Setting) Presented below are five statements which you are to identify as
true or false. If false, explain why the statement is false.
1. The IASB uses a rules-based approach to its standard-setting process, whereas the FASB uses a
principles-based approach.
2. The objective of financial statements emphasizes a stewardship approach for reporting financial
information.
3. The purpose of the objective of financial reporting is to prepare a statement of financial position,
a comprehensive income statement, a cash flow statement, and a statement of changes in equity.
4. The difference between International Accounting Standards and IFRS is that International Account-
ing Standards are rules-based instead of principles-based.
5. The objective of financial reporting uses an entity rather than a proprietary approach in determin-
ing what information to report.
CA1-3 (Financial Reporting and Accounting Standards) Answer the following multiple-choice questions.
1. IFRS stands for:
(a) International Federation of Reporting Services.
(b) Independent Financial Reporting Standards.
(c) International Financial Reporting Standards.
(d) Integrated Financial Reporting Services.
2. The major key players on the international side are the:
(a) IASB and FASB. (c) SEC and FASB.
(b) IOSCO and the SEC. (d) IASB and IOSCO.
3. Which body from the U.S. side is similar to the IASB?
(a) SEC. (c) FASC.
(b) FASB. (d) FAF.
4. Accounting standard-setters use the following process in establishing international standards:
(a) Research, exposure draft, discussion paper, standard.
(b) Discussion paper, research, exposure draft, standard.
(c) Research, preliminary views, discussion paper, standard.
(d) Research, discussion paper, exposure draft, standard.
5. IFRS is comprised of:
(a) International Financial Reporting Standards and FASB financial reporting standards.
(b) International Financial Reporting Standards, International Accounting Standards, and inter-
national accounting interpretations.
(c) International Accounting Standards and international accounting interpretations.
(d) FASB financial reporting standards and International Accounting Standards.
6. The authoritative status of the Framework for Financial Reporting is as follows:
(a) It is used when there is no standard or interpretation related to the reporting issues under
consideration.
(b) It is not as authoritative as a standard but takes precedence over any interpretation related to
the reporting issue.
Using Your Judgment · 9
(c) It takes precedence over all other authoritative literature.

(d) It has no authoritative status.
7. The objective of financial reporting places most emphasis on:
(a) reporting to capital providers.
(b) reporting on stewardship.
(c) providing specific guidance related to specific needs.
(d) providing information to individuals who are experts in the field.
8. General-purpose financial statements are prepared primarily for:
(a) internal users.
(b) external users.
(c) auditors.
(d) government regulators.
9. Economic consequences of accounting standard-setting means:
(a) standard-setters must give first priority to ensuring that companies do not suffer any adverse
effect as a result of a new standard.
(b) standard-setters must ensure that no new costs are incurred when a new standard is issued.
(c) the objective of financial reporting should be politically motivated to ensure acceptance by
the general public.
(d) accounting standards can have detrimental impacts on the wealth levels of the providers of
financial information.
10. The expectations gap is:
(a) what financial information management provides and what users want.
(b) what the public thinks accountants should do and what accountants think they can do.
(c) what the governmental agencies want from standard-setting and what the standard-setters
provide.
(d) what the users of financial statements want from the government and what is provided.
CA1-6 (IASB Role in Standard-Setting) A press release announcing the appointment of the trustees
of the new International Accounting Standards Committee Foundation stated that the International
Accounting Standards Board (to be appointed by the trustees) “. . . will become the established author-
ity for setting accounting Standards.”
Instructions
(a) Identify the sponsoring organization of the IASB and the process by which the IASB arrives at a
decision and issues an accounting standard.
(b) Indicate the major types of pronouncements issued by the IASB and the purposes of each of these
pronouncements.
USING YOUR JUDGMENT

FI NANCIAL REPORTI NG
Financial Reporting Problem
Lola Otero, a new staff accountant, is confused because of the complexities involving accounting standard-
setting. Specifically, she is confused by the number of bodies issuing financial reporting standards of one
kind or another and the level of authoritative support that can be attached to these reporting standards.
Lola decides that she must review the environment in which accounting standards are set, if she is to
increase her understanding of the accounting profession.
Lola recalls that during her accounting education there was a chapter or two regarding the environ-
ment of financial accounting and the development of IFRS. However, she remembers that her instructor
placed little emphasis on these chapters.
Instructions
(a) Help Lola by identifying key organizations involved in accounting rule-making at the international level.
(b) Lola asks for guidance regarding authoritative support. Please assist her by explaining what is meant
by authoritative support.
10 · Chapter 1 Financial Accounting and Accounting Standards
BRI DGE TO TH E PROFESSION

Professional Research
As a newly enrolled accounting major, you are anxious to better understand accounting institutions
and sources of accounting literature. As a first step, you decide to explore the IASB’s Framework for the
Preparation of Financial Statements.
Instructions
Access the IASB Framework at the IASB website (http://eifrs.iasb.org/ ). When you have accessed the doc-
uments, you can use the search tool in your Internet browser to respond to the following items. (Provide
paragraph citations.)
(a) What is the objective of financial reporting?
(b) What other means are there of communicating information, besides financial statements?
(c) Indicate some of the users and the information they are most directly concerned with in economic
decision-making.
NOTE: Since these are "Rough PP" KiesoIFRS_Supplement
running heads and folios will be
finalized in revise pp. Which Cost Flow Assumption to Adopt? · 1
CHAPTER 8 VALUATION OF INVENTORIES: A COST-BASIS APPROACH
WHICH COST FLOW ASSUMPTION TO ADOPT?

During any given fiscal period, companies typically purchase merchandise at several
different prices. If a company prices inventories at cost and it made numerous purchases
at different unit costs, which cost price should it use? Conceptually, a specific identifi-
cation of the given items sold and unsold seems optimal. Therefore, the IASB requires
use of the specific identification method in cases where inventories are not ordinarily
interchangeable or for goods and services produced or segregated for specific proj-
ects. For example, an inventory of single-family homes is a good candidate for use of
the specific identification method. Unfortunately, for most companies, the specific iden-
tification method is not practicable. Only in situations where inventory turnover is low,
unit price is high, or inventory quantities are small are the specific identification crite-
ria met. In other cases, the cost of inventory should be measured using one of two cost
flow assumptions: (1) first-in, first-out (FIFO) or (2) average cost. [10]
To illustrate these cost flow methods, assume that Call-Mart Inc. had the follow-
ing transactions in its first month of operations.
Date Purchases Sold or Issued Balance

March 2 2,000 @ $4.00 2,000 units
March 15 6,000 @ $4.40 8,000 units
March 19 4,000 units 4,000 units
March 30 2,000 @ $4.75 6,000 units
From this information, Call-Mart computes the ending inventory of 6,000 units
and the cost of goods available for sale (beginning inventory ⴙ purchases) of $43,900
[(2,000 @ $4.00) ⫹ (6,000 @ $4.40) ⫹ (2,000 @ $4.75)]. The question is, which price or
prices should it assign to the 6,000 units of ending inventory? The answer depends on
which cost flow assumption it uses.
Specific Identification
Specific identification calls for identifying each item sold and each item in inventory.
A company includes in cost of goods sold the costs of the specific items sold. It includes
in inventory the costs of the specific items on hand. This method may be used only in
instances where it is practical to separate physically the different purchases made. As
a result, most companies only use this method when handling a relatively small num-
ber of costly, easily distinguishable items. In the retail trade, this includes some types
of jewelry, fur coats, automobiles, and some furniture. In manufacturing, it includes
special orders and many products manufactured under a job cost system.
To illustrate, assume that Call-Mart Inc.’s 6,000 units of inventory consists of 1,000
units from the March 2 purchase, 3,000 from the March 15 purchase, and 2,000 from
the March 30 purchase. Illustration 8-12 shows how Call-Mart computes the ending in-
ventory and cost of goods sold.
This method appears ideal. Specific identification matches actual costs against ac-
tual revenue. Thus, a company reports ending inventory at actual cost. In other words,
under specific identification the cost flow matches the physical flow of the goods.
On closer observation, however, this method has certain deficiencies in addition to its
lack of practicability in many situations.
2 · Chapter 8 Valuation of Inventories: A Cost-Basis Approach
ILLUSTRATION 8-12
Date No. of Units Unit Cost Total Cost
Specific Identification
Method March 2 1,000 $4.00 $ 4,000
March 15 3,000 4.40 13,200
March 30 2,000 4.75 9,500
Ending inventory 6,000 $26,700
Cost of goods available for sale $43,900

(computed in previous section)
Deduct: Ending inventory 26,700
Cost of goods sold $17,200
Some argue that specific identification allows a company to manipulate net income.
For example, assume that a wholesaler purchases identical plywood early in the year
at three different prices. When it sells the plywood, the wholesaler can select either the
lowest or the highest price to charge to expense. It simply selects the plywood from a
specific lot for delivery to the customer. A business manager, therefore, can manipulate
net income by delivering to the customer the higher- or lower-priced item, depending
on whether the company seeks lower or higher reported earnings for the period.
Another problem relates to the arbitrary allocation of costs that sometimes occurs
with specific inventory items. For example, a company often faces difficulty in relating
freight charges, storage costs, and discounts directly to a given inventory item. This re-
sults in allocating these costs somewhat arbitrarily, leading to a “breakdown” in the
precision of the specific identification method.4
Average Cost
As the name implies, the average cost method prices items in the inventory on the
basis of the average cost of all similar goods available during the period. To illustrate
use of the periodic inventory method (amount of inventory computed at the end of
the period), Call-Mart computes the ending inventory and cost of goods sold using a
weighted-average method as follows.
ILLUSTRATION 8-13
Date of Invoice No. Units Unit Cost Total Cost
Weighted-Average
Method—Periodic March 2 2,000 $4.00 $ 8,000
March 15 6,000 4.40 26,400
Inventory
March 30 2,000 4.75 9,500
Total goods available 10,000 $43,900
$43,900
Weighted-average cost per unit ⫽ $4.39
10,000
Inventory in units 6,000 units
Ending inventory 6,000 ⫻ $4.39 ⫽ $26,340
Cost of goods available for sale $43,900
Deduct: Ending inventory 26,340
Cost of goods sold $17,560
In computing the average cost per unit, Call-Mart includes the beginning inventory, if
any, both in the total units available and in the total cost of goods available.
4
The motion picture industry provides a good illustration of the cost allocation problem. Often
actors receive a percentage of net income for a given movie or television program. Some
actors, however, have alleged that their programs have been extremely profitable to the motion
picture studios but they have received little in the way of profit-sharing. Actors contend that
the studios allocate additional costs to successful projects to avoid sharing profits.
Exercises · 3
Companies use the moving-average method with perpetual inventory records.

Illustration 8-14 shows the application of the average cost method for perpetual records.
ILLUSTRATION 8-14
Date Purchased Sold or Issued Balance
Moving-Average
March 2 (2,000 @ $4.00) $ 8,000 (2,000 @ $4.00) $ 8,000 Method—Perpetual
March 15 (6,000 @ 4.40) 26,400 (8,000 @ 4.30) 34,400
Inventory
March 19 (4,000 @ $4.30)
$17,200 (4,000 @ 4.30) 17,200
March 30 (2,000 @ 4.75) 9,500 (6,000 @ 4.45) 26,700
SUMMARY OF LEARNING OBJECTIVES

•5 Describe and compare the methods used to price inventories. The IASB requires
use of the specific identification method in cases where inventories are not ordinarily
interchangeable or for goods and services produced or segregated for specific projects.
Only in situations where inventory turnover is low, unit price is high, or inventory
quantities are small are the specific identification criteria met. In other cases compa-
nies use one of two cost flow assumptions: (1) Average cost prices items in the inven-
tory on the basis of the average cost of all similar goods available during the period.
(2) First-in, first-out (FIFO) assumes that a company uses goods in the order in which
it purchases them. The inventory remaining must therefore represent the most recent
purchases.
APPENDIX 8A LIFO COST FLOW ASSUMPTION
As we discussed in the chapter, under IFRS, LIFO is not permitted for financial report-
ing purposes. In prohibiting LIFO, the IASB noted that use of LIFO results in invento-
ries being recognized in the statement of financial position at amounts that may bear
little relationship to recent cost levels of inventories. While some argued for use of LIFO
because it may better match the costs of recently purchased inventory with current prices,
the Board concluded that it is not appropriate to allow an approach that results in a
measurement of profit or loss for the period that is inconsistent with the measurement
of inventories in the statement of financial position. [12] Nonetheless, LIFO is permit-
ted for financial reporting purposes in the United States, it is permitted for tax purposes
in some countries, and its use can result in significant tax savings. In this appendix, we
provide an expanded discussion of LIFO inventory procedures.
EXERCISES
•5 E8-13 (FIFO and Average Cost Determination) LoBianco Company’s record of transactions for the
month of April was as follows.
Purchases Sales
April 1 (balance on hand) 600 @ $6.00 April 3 500 @ $10.00
4 1,500 @ 6.08 9 1,300 @ 10.00
8 800 @ 6.40 11 600 @ 11.00
13 1,200 @ 6.50 23 1,200 @ 11.00
21 700 @ 6.60 27 900 @ 12.00
29 500 @ 6.79 4,500
5,300
Instructions
(a) Assuming that periodic inventory records are kept, compute the inventory at April 30 using
(1) FIFO and (2) average cost.
(b) Assuming that perpetual inventory records are kept in both units and dollars, determine the
inventory at April 30 using (1) FIFO and (2) average cost.
(c) In an inflationary period, which inventory method—FIFO or average cost—will show the highest
net income?
•5 E8-14 (FIFO and Average Cost Inventory) Esplanade Company was formed on December 1, 2009. The
following information is available from Esplanade’s inventory records for Product BAP.
Units Unit Cost
January 1, 2010 (beginning inventory) 600 $ 8.00
Purchases:
January 5, 2010 1,100 9.00
January 25, 2010 1,300 10.00
February 16, 2010 800 11.00
March 26, 2010 600 12.00
A physical inventory on March 31, 2010, shows 1,500 units on hand.

Instructions
Prepare schedules to compute the ending inventory at March 31, 2010, under each of the following in-
ventory methods (round to two decimal places).
(a) Specific identification. (b) FIFO. (c) Weighted-average.
Under (a), 400 units from the beginning inventory are on hand and 1,100 units from the January 5 pur-
chase are on hand.
•5 E8-15 (Compute FIFO and Average Cost—Periodic) Presented below is information related to radios
for the Couples Company for the month of July.
Units Unit Units Selling
Date Transaction In Cost Total Sold Price Total
July 1 Balance 100 $4.10 $ 410

6 Purchase 800 4.30 3,440
7 Sale 300 $7.00 $ 2,100
10 Sale 300 7.30 2,190
12 Purchase 400 4.51 1,804
15 Sale 200 7.40 1,480
18 Purchase 300 4.60 1,380
22 Sale 400 7.40 2,960
25 Purchase 500 4.58 2,290
30 Sale 200 7.50 1,500
Totals 2,100 $9,324 1,400 $10,230
Instructions
(a) Assuming that the periodic inventory method is used, compute the inventory cost at July 31
under each of the following cost flow assumptions.
(1) FIFO. (2) Weighted-average.
(b) Answer the following questions.
(1) Which of the methods used above will yield the highest figure for gross profit for the income
statement? Explain why.
(2) Which of the methods used above will yield the highest figure for ending inventory for the
statement of financial position? Explain why.
•5 E8-16 (FIFO and Average Cost, Income Statement Presentation) The board of directors of Oksana Cor-
poration is considering whether or not it should instruct the accounting department to change from a first-
in, first-out (FIFO) basis of pricing inventories to an average cost basis. The following information is available.
Sales 20,000 units @ €50
Inventory, January 1 6,000 units @ 20
Purchases 6,000 units @ 22
10,000 units @ 25
7,000 units @ 30
Inventory, December 31 9,000 units @ ?
Operating expenses €200,000
Instructions
Prepare a condensed income statement for the year on both bases for comparative purposes (round to two
decimal places).
PROBLEMS
•2 •5 P8-4 (Compute Specific Identification, FIFO, and Average Cost) Hull Company’s record of transac-
tions concerning part X for the month of April was as follows.
Purchases Sales
April 1 (balance on hand) 100 @ $5.00 April 5 300
4 400 @ 5.10 12 200
11 300 @ 5.30 27 800
18 200 @ 5.35 28 150
26 600 @ 5.60
30 200 @ 5.80
Instructions
(a) Compute the inventory at April 30 on each of the following bases. Assume that perpetual inven-
tory records are kept in units only. Carry unit costs to the nearest cent.
(1) Specific identification; ending inventory is comprised of 100 units from beginning inventory
and 250 units from the April 26 purchase.
(2) First-in, first-out (FIFO).
(3) Average cost.
(b) If the perpetual inventory record is kept in dollars, and costs are computed at the time of each
withdrawal, what amount would be shown as ending inventory in 1, 2, and 3 above? Carry average
unit costs to four decimal places.

CA8-5 (Average Cost and FIFO) Draft written responses to the following items.
(a) Describe the cost flow assumptions used in average cost and FIFO methods of inventory valuation.
(b) Distinguish between weighted-average cost and moving-average cost for inventory costing
purposes.
(c) Identify the effects on both the statement of financial position and the income statement of using
the average cost method instead of the FIFO method for inventory costing purposes over a sub-
stantial time period when purchase prices of inventoriable items are rising. State why these effects
take place.
USING YOUR JUDGMENT

Financial Statement Analysis Cases
Case 1 Lumber Supply International
Lumber Supply International, a manufacturer of specialty building products, has its headquarters in
Boise, Idaho. The company, through its partnership in the Trus Joist MacMillan joint venture, develops
and manufactures engineered lumber. This product is a high-quality substitute for structural lumber,
and uses lower-grade wood and materials formerly considered waste. The company also is majority
owner of the Outlook Window Partnership, which is a consortium of three wood and vinyl window
manufacturers.
Following is Lumber Supply International’s adapted income statement and information concerning
inventories from its statement of financial position.
Lumber Supply International

Sales $618,876,000
Cost of goods sold 475,476,000
Gross profit 143,400,000
Selling and administrative expenses 102,112,000
Income from operations 41,288,000
Other expense 24,712,000
Income before income tax 16,576,000
Income taxes 7,728,000
Net income $ 8,848,000
Inventories. Inventories are valued at the lower-of-cost-or-market and include material, labor, and
production overhead costs. Inventories consisted of the following:
Current Year Prior Year
Finished goods $27,512,000 $23,830,000
Raw materials and
work-in-progress 34,363,000 33,244,000
61,875,000 57,074,000
Reduction to average cost (5,263,000) (3,993,000)
$56,612,000 $53,081,000
The average cost (AC) method is used for determining the cost of lumber, veneer, Microllam lumber, LSI
joists, and open web joists. Approximately 35 percent of total inventories at the end of the current year
were valued using the AC method. The first-in, first-out (FIFO) method is used to determine the cost of
all other inventories.
Instructions
(a) How much would income before taxes have been if FIFO costing had been used to value all inventories?
(b) If the income tax rate is 46.6%, what would income tax have been if FIFO costing had been used to value
all inventories? In your opinion, is this difference in net income between the two methods material?
Explain.
(c) Does the use of a different costing system for different types of inventory mean that there is a different
physical flow of goods among the different types of inventory? Explain.
Case 2 Noven Pharmaceuticals, Inc.

Noven Pharmaceuticals, Inc. (USA), headquartered in Miami, Florida, describes itself in a recent annual
report as follows.
Noven Pharmaceuticals, Inc.

Noven is a place of ideas—a company where scientific excellence and state-of-the-art manufacturing
combine to create new answers to human needs. Our transdermal delivery systems speed drugs
painlessly and effortlessly into the bloodstream by means of a simple skin patch. This technology has
proven applications in estrogen replacement, but at Noven we are developing a variety of systems
incorporating bestselling drugs that fight everything from asthma, anxiety and dental pain to cancer,
heart disease and neurological illness. Our research portfolio also includes new technologies, such as
iontophoresis, in which drugs are delivered through the skin by means of electrical currents, as well as
products that could satisfy broad consumer needs, such as our anti-microbial mouthrinse.
Noven also reported in its annual report that its activities to date have consisted of product devel-
opment efforts, some of which have been independent and some of which have been completed in con-
junction with Rhone-Poulenc Rorer (RPR) (FRA) and Ciba-Geigy (USA). The revenues so far have
consisted of money received from licensing fees, “milestone” payments (payments made under licensing
agreements when certain stages of the development of a certain product have been completed), and
interest on its investments. The company expects that it will have significant revenue in the upcoming
fiscal year from the launch of its first product, a transdermal estrogen delivery system.
The current assets portion of Noven’s statement of financial position follows.
Cash and cash equivalents $12,070,272

Investment securities 23,445,070
Inventory of supplies 1,264,553
Prepaid and other current assets 825,159
Total current assets $37,605,054
Inventory of supplies is recorded at the lower of cost (first-in, first-out) or net realizable value and con-
sists mainly of supplies for research and development.
Instructions
(a) What would you expect the physical flow of goods for a pharmaceutical manufacturer to be most
like: FIFO or random (flow of goods does not follow a set pattern)? Explain.
(b) What are some of the factors that Noven should consider as it selects an inventory measurement
method?
(c) Suppose that Noven had $49,000 in an inventory of transdermal estrogen delivery patches. These
patches are from an initial production run, and will be sold during the coming year. Why do you
think that this amount is not shown in a separate inventory account? In which of the accounts shown
is the inventory likely to be? At what point will the inventory be transferred to a separate inventory
account?
*Case 3 SUPERVALU
SUPERVALU (USA) reported that its inventory turnover ratio decreased from 17.1 times in 2006 to 15.8
times in 2007. The following data appear in SUPERVALU’s annual report.
Feb. 26, Feb. 25, Feb. 24,

2005 2006 2007
Total revenues $19,543 $19,864 $37,406
Cost of sales (using LIFO) 16,681 16,977 29,267
Year-end inventories using FIFO 1,181 1,114 2,927
Year-end inventories using LIFO 1,032 954 2,749
(a) Compute SUPERVALU’s inventory turnover ratios for 2006 and 2007, using:
(1) Cost of sales and LIFO inventory.
(2) Cost of sales and FIFO inventory.
(b) Some firms calculate inventory turnover using sales rather than cost of goods sold in the numerator.
Calculate SUPERVALU’s 2006 and 2007 turnover, using:
(1) Sales and LIFO inventory.
(2) Sales and FIFO inventory.
(c) Describe the method that SUPERVALU’s appears to use.
(d) State which method you would choose to evaluate SUPERVALU’s performance. Justify your choice.

In conducting year-end inventory counts, your audit team is debating the impact of the client’s right of
return policy both on inventory valuation and revenue recognition. The assistant controller argues that
there is no need to worry about the return policies since they have not changed in a while. The audit sen-
ior wants a more authoritative answer and has asked you to conduct some research of the authoritative
literature before she presses the point with the client.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/ ). When you have accessed
the documents, you can use the search tool in your Internet browser to respond to the following ques-
tions. (Provide paragraph citations if necessary.)
(a) Which statement addresses revenue recognition when right of return exists?
(b) When is this statement important for a company?
(c) Sales with high rates of return can ultimately cause inventory to be misstated. Why are returns
allowed? Should different industries be able to make different types of return policies?
(d) In what situations would a reasonable estimate of returns be difficult to make?
NOTE: since these are
"rough pp" running KiesoIFRS_Supplment_first pp
heads and folios will be
corrected in revise pp Lower-of-Cost-or-Net Realizable Value (LCNRV) · 1
CHAPTER 9 INVENTORIES: ADDITIONAL VALUATION ISSUES
LOWER-OF-COST-OR-NET REALIZABLE VALUE (LCNRV)

Inventories are recorded at their cost. However, if inventory declines in value below
its original cost, a major departure from the historical cost principle occurs. Whatever the
reason for a decline—obsolescence, price-level changes, or damaged goods—a company
should write down the inventory to net realizable value to report this loss. A company
abandons the historical cost principle when the future utility (revenue-producing
ability) of the asset drops below its original cost.
Net Realizable Value

Recall that cost is the acquisition price of inventory computed using one of the histor-
ical cost-based methods—specific identification, average cost, or FIFO. The term net
realizable value (NRV) refers to the net amount that a company expects to realize from
the sale of inventory. Specifically, net realizable value is the estimated selling price in
the normal course of business less estimated costs to complete and estimated costs to
make a sale. [1]
To illustrate, assume that Mander Corp. has unfinished inventory with a cost of
$950, a sales value of $1,000, estimated cost of completion of $50, and estimated selling
costs of $200. Mander’s net realizable value is computed as follows.
ILLUSTRATION 9-1
Inventory value—unfinished $1,000
Computation of Net
Less: Estimated cost of completion $ 50
Estimated cost to sell 200 250
Realizable Value
Net realizable value $ 750
Mander reports inventory on its statement of financial position at $750. In its income
statement, Mander reports a Loss on Inventory Write-Down of $200 ($950 $750).
A departure from cost is justified because inventories should not be reported at amounts
higher than their expected realization from sale or use. In addition, a company like
Mander should charge the loss of utility against revenues in the period in which the
loss occurs, not in the period of sale.
Companies therefore report their inventories at the lower-of-cost-or-net realizable
value (LCNRV) at each reporting date. Illustration 9-2 shows how two companies
indicate measurement at LCNRV.
ILLUSTRATION 9-2
Nokia (FIN) LCNRV Disclosures
Inventories are stated at the lower of cost or net realizable value. Cost is determined using standard
cost, which approximates actual cost on a FIFO basis. Net realizable value is the amount that can
be realized from the sale of the inventory in the normal course of business after allowing for the costs
of realization. In addition to the cost of materials and direct labor, an appropriate proportion of
production overhead is included in the inventory values. An allowance is recorded for excess inventory
and obsolescence based on the lower-of-cost-or-net realizable value.
Kesa Electricals (GBR)

Inventories are stated at the lower-of-cost-and-net realisable value. Cost is determined using the
weighted average method. Net realisable value represents the estimated selling price in the ordinary
course of business, less applicable variable selling expenses.
2 · Chapter 9 Inventories: Additional Valuation Issues
Illustration of LCNRV
As indicated, a company values inventory at LCNRV. A company estimates net realiz-
able value based on the most reliable evidence of the inventories’ realizable amounts
(expected selling price, expected costs to completion, and expected costs to sell). [2] To
illustrate, Regner Foods computes its inventory at LCNRV, as shown in Illustration 9-3.
ILLUSTRATION 9-3
Net Final
Determining Final Realizable Inventory
Inventory Value Food Cost Value Value
Spinach $ 80,000 $120,000 $ 80,000
Carrots 100,000 110,000 100,000
Cut beans 50,000 40,000 40,000
Peas 90,000 72,000 72,000
Mixed vegetables 95,000 92,000 92,000
$384,000
Final Inventory Value:

Spinach Cost ($80,000) is selected because it is lower than net realizable value.
Carrots Cost ($100,000) is selected because it is lower than net realizable value.
Cut beans Net realizable value ($40,000) is selected because it is lower than cost.
Peas Net realizable value ($72,000) is selected because it is lower than cost.
Mixed vegetables Net realizable value ($92,000) is selected because it is lower than cost.
As indicated, the final inventory value of $384,000 equals the sum of the LCNRV
for each of the inventory items. That is, Regner applies the LCNRV rule to each indi-
vidual type of food.
Methods of Applying LCNRV

In the Regner Foods illustration, we assumed that the company applied the LCNRV
rule to each individual type of food. However, companies may apply the LCNRV rule
to a group of similar or related items, or to the total of the inventory. For example, in
the textile industry, it may not be possible to determine selling price for each textile in-
dividually, and therefore it may be necessary to perform the net realizable value as-
sessment on all textiles that will be used to produce clothing for a particular season.1
If a company follows a group of similar-or-related-items or total-inventory ap-
proach in determining LCNRV, increases in market prices tend to offset decreases in
market prices. To illustrate, assume that Regner Foods separates its food products into
two major groups, frozen and canned, as shown in Illustration 9-4.
If Regner Foods applied the LCNRV rule to individual items, the amount of inven-
tory is $384,000. If applying the rule to major groups, it jumps to $394,000. If applying
LCNRV to the total inventory, it totals $415,000. Why this difference? When a company
uses a major group or total-inventory approach, net realizable values higher than cost
offset net realizable values lower than cost. For Regner Foods, using the similar-or-
related approach partially offsets the high net realizable value for spinach. Using the
total-inventory approach totally offsets it.2
1
It may be necessary to write down an entire product line or a group of inventories in a
given geographic area that cannot be practicably evaluated separately. However, it is not
appropriate to write down an entire class of inventory, such as finished goods or all inventory
of a particular industry. [3]
2
The rationale for use of the individual-item approach whenever practicable is to avoid
realization of unrealized gains, which can arise when applying LCNRV on a similar-or-
related-item approach (e.g., unrealized gains on some items offset unrealized losses on
other items). In general, IFRS prohibits recognition of unrealized gains in income.
Lower-of-Cost-or-Net Realizable Value (LCNRV) · 3
ILLUSTRATION 9-4
LCNRV by:
Alternative Applications
Individual Major Total of LCNRV
Cost LCNRV Items Groups Inventory
Frozen
Spinach $ 80,000 $120,000 $ 80,000
Carrots 100,000 110,000 100,000
Cut beans 50,000 40,000 40,000
Total frozen 230,000 270,000 $230,000
Canned
Peas 90,000 72,000 72,000
Mixed vegetables 95,000 92,000 92,000
Total canned 185,000 164,000 164,000
Total $415,000 $434,000 $384,000 $394,000 $415,000
In most situations, companies price inventory on an item-by-item basis. In fact, tax

rules in some countries require that companies use an individual-item basis barring
practical difficulties. In addition, the individual-item approach gives the lowest valu-
ation for statement of financial position purposes. In some cases, a company prices in-
ventory on a total-inventory basis when it offers only one end product (comprised of
many different raw materials). If it produces several end products, a company might
use a similar-or-related approach instead. Whichever method a company selects, it
should apply the method consistently from one period to another.3
Recording Net Realizable Value Instead of Cost

One of two methods may be used to record the income effect of valuing inventory at
net realizable value. One method, referred to as the cost-of-goods-sold method, debits
cost of goods sold for the write-down of the inventory to net realizable value. As a
result, the company does not report a loss in the income statement because the cost
of goods sold already includes the amount of the loss. The second method, referred
to as the loss method, debits a loss account for the write-down of the inventory to net
realizable value. We use the following inventory data for Ricardo Company to illus-
trate entries under both methods.
Cost of goods sold (before adjustment to net realizable value) $108,000

Ending inventory (cost) 82,000
Ending inventory (at net realizable value) 70,000
Illustration 9-5 shows the entries for both the cost-of-goods-sold and loss methods,
assuming the use of a perpetual inventory system.
ILLUSTRATION 9-5
Cost-of-Goods-Sold Method Loss Method
Accounting for the
To reduce inventory from cost to net Reduction of Inventory to
realizable value Net Realizable Value—
Cost of Goods Sold 12,000 Loss Due to Decline Perpetual Inventory
Inventory 12,000 of Inventory to Net System
Realizable Value 12,000
Inventory 12,000
3
Materials and other supplies held for use in the production of inventories are not written
down below cost if the finished products in which they will be incorporated are expected to
be sold at or above cost. However, a decline in the price of materials may indicate that the
cost of the finished products exceeds net realizable value. In this situation, the materials are
written down to net realizable value.
The cost-of-goods-sold method buries the loss in the Cost of Goods Sold account. The
loss method, by identifying the loss due to the write-down, shows the loss separate
from Cost of Goods Sold in the income statement.
Illustration 9-6 contrasts the differing amounts reported in the income statement
under the two approaches, using data from the Ricardo example.
ILLUSTRATION 9-6
Cost-of-Goods-Sold Method
Income Statement
Presentation—Cost-of- Sales revenue $200,000
Cost of goods sold (after adjustment to net realizable value*) 120,000
Goods-Sold and Loss
Methods of Reducing Gross profit on sales $ 80,000
Inventory to Net
Realizable Value Loss Method
Sales revenue $200,000
Cost of goods sold 108,000
Gross profit on sales 92,000
Loss due to decline of inventory to net realizable value 12,000
$ 80,000
*Cost of goods sold (before adjustment to net realizable value) $108,000

Difference between inventory at cost and net realizable value
($82,000 $70,000) 12,000
Cost of goods sold (after adjustment to net realizable value) $120,000
IFRS does not specify a particular account to debit for the write-down. We believe the
loss method presentation is preferable because it clearly discloses the loss resulting
from a decline in inventory net realizable values.
Use of an Allowance
Instead of crediting the Inventory account for net realizable value adjustments, com-
panies generally use an allowance account, often referred to as the “Allowance to
Reduce Inventory to Net Realizable Value.” For example, using an allowance account
under the loss method, Ricardo Company makes the following entry to record the
inventory write-down to net realizable value.
Loss Due to Decline of Inventory to Net Realizable Value 12,000
Allowance to Reduce Inventory to Net Realizable Value 12,000
Use of the allowance account results in reporting both the cost and the net realizable
value of the inventory. Ricardo reports inventory in the statement of financial position as
follows.
ILLUSTRATION 9-7
Inventory (at cost) $ 82,000
Presentation of Inventory
Allowance to reduce inventory to net realizable value (12,000)
Using an Allowance
Account Inventory at net realizable value $ 70,000
The use of the allowance under the cost-of-goods-sold or loss method permits both the
income statement and the statement of financial position to reflect inventory measured
at $82,000, although the statement of financial position shows a net amount of $70,000.
It also keeps subsidiary inventory ledgers and records in correspondence with the
Lower-of-Cost-or-Net Realizable Value (LCNRV) · 5
control account without changing prices. For homework purposes, use an allowance account
to record net realizable value adjustments, unless instructed otherwise.
Recovery of Inventory Loss

In periods following the write-down, economic conditions may change such that the
net realizable value of inventories previously written down may be greater than cost or
there is clear evidence of an increase in the net realizable value. In this situation, the
amount of the write-down is reversed, with the reversal limited to the amount of the
original write-down. [4]
Continuing the Ricardo example, assume that in the subsequent period, market
conditions change, such that the net realizable value increases to $74,000 (an increase of
$4,000). As a result, only $8,000 is needed in the allowance. Ricardo makes the following
entry, using the loss method.
Allowance to Reduce Inventory to Net Realizable Value 4,000
Recovery of Inventory Loss ($74,000 $70,000) 4,000
The allowance account is then adjusted in subsequent periods, such that inventory
is reported at the LCNRV. Illustration 9-8 shows the net realizable value evaluation for
Margin Company and the effect of net realizable value adjustments on income.
ILLUSTRATION 9-8
Inventory Amount Adjustment
Effect on Net Income of
at Net Required in of Allowance Effect
Inventory Realizable Allowance Account on Net Adjusting Inventory to
Date at Cost Value Account Balance Income Net Realizable Value
Dec. 31, 2010 $188,000 $176,000 $12,000 $12,000 inc. Decrease
Dec. 31, 2011 194,000 187,000 7,000 5,000 dec. Increase
Dec. 31, 2012 173,000 174,000 0 7,000 dec. Increase
Dec. 31, 2013 182,000 180,000 2,000 2,000 inc. Decrease
Thus, if prices are falling, the company records an additional write-down. If prices
are rising, the company records an increase in income. We can think of the net increase
as a recovery of a previously recognized loss. Under no circumstances should the
inventory be reported at a value above original cost.
Evaluation of the LCNRV Rule

The LCNRV rule suffers some conceptual deficiencies:
1. A company recognizes decreases in the value of the asset and the charge to expense
in the period in which the loss in utility occurs—not in the period of sale. On the
other hand, it recognizes increases in the value of the asset (in excess of original cost)
only at the point of sale. This inconsistent treatment can distort income data.
2. Application of the rule results in inconsistency because a company may value the
inventory at cost in one year and at net realizable value in the next year.
3. LCNRV values the inventory in the statement of financial position conservatively,
but its effect on the income statement may or may not be conservative. Net income
for the year in which a company takes the loss is definitely lower. Net income of
the subsequent period may be higher than normal if the expected reductions in sales
price do not materialize.
Many financial statement users appreciate the LCNRV rule because they at least
know that it prevents overstatement of inventory. In addition, recognizing all losses
but anticipating no gains generally avoids overstatement of income.
VALUATION BASES
Special Valuation Situations
For the most part, companies record inventory at LCNRV.4 However, there are some
situations in which companies depart from the LCNRV rule. Such treatment may be
justified in situations when cost is difficult to determine, the items are readily mar-
ketable at quoted market prices, and units of product are interchangeable. In this sec-
tion, we discuss two common situations in which net realizable value is the general
rule for valuing inventory:
• Agricultural assets (including biological assets and agricultural produce).
• Commodities held by broker-traders.
Agricultural Inventory
Under IFRS, net realizable value measurement is used for inventory when the inven-
tory is related to agricultural activity. In general, agricultural activity results in two
types of agricultural assets: (1) biological assets or (2) agricultural produce at the point
of harvest. [6]
A biological asset (classified as a non-current asset) is a living animal or plant, such
as sheep, cows, fruit trees, or cotton plants. Agricultural produce is the harvested prod-
uct of a biological asset, such as wool from a sheep, milk from a dairy cow, picked fruit
from a fruit tree, or cotton from a cotton plant. The accounting for these assets is as
follows.
• Biological assets are measured on initial recognition and at the end of each report-
ing period at fair value less costs to sell (net realizable value). Companies record a
gain or loss due to changes in the net realizable value of biological assets in income
when it arises.5
• Agricultural produce (which are harvested from biological assets) are measured at
fair value less costs to sell (net realizable value) at the point of harvest. Once har-
vested, the net realizable value of the agricultural produce becomes its cost, and
this asset is accounted for similar to other inventories held for sale in the normal
course of business.6
Illustration of Agricultural Accounting at Net Realizable Value

To illustrate the accounting at net realizable value for agricultural assets, assume that
Bancroft Dairy produces milk for sale to local cheese-makers. Bancroft began opera-
tions on January 1, 2011, by purchasing 420 milking cows for €460,000. Bancroft pro-
vides the following information related to the milking cows.
4
Manufacturing companies frequently employ a standardized cost system that predetermines
the unit costs for material, labor, and manufacturing overhead, and that values raw materials,
work in process, and finished goods inventories at their standard costs. Standard costs take
into account normal levels of materials and supplies, labor, efficiency, and capacity utilization,
and are regularly reviewed and, if necessary, revised in the light of current conditions. For
financial reporting purposes, the standard cost method may be used for convenience if the
results approximate cost. [5] Nokia (FIN) and Hewlett-Packard (USA) use standard costs for
valuing at least a portion of their inventories.
5
A gain may arise on initial recognition of a biological asset, such as when a calf is born.
A gain or loss may arise on initial recognition of agricultural produce as a result of harvesting.
Losses may arise on initial recognition for agricultural assets because costs to sell are deducted
in determining fair value less costs to sell.
6
Measurement at fair value or selling price less point of sale costs corresponds to the net
realizable value measure in the LCNRV test (selling price less estimated costs to complete
and sell) since at harvest, the agricultural product is complete and is ready for sale. [7]
Valuation Bases · 7
ILLUSTRATION 9-9
Milking cows
Agricultural Assets—
Carrying value, January 1, 2011* €460,000
Change in fair value due to growth and price changes €35,000
Bancroft Dairy
Decrease in fair value due to harvest (1,200)
Change in carrying value 33,800
Carrying value, January 31, 2011 €493,800
Milk harvested during January** € 36,000
*The carrying value is measured at fair value less costs to sell (net realizable value). The fair value of milking cows is
determined based on market prices of livestock of similar age, breed, and genetic merit.
**Milk is initially measured at its fair value less costs to sell (net realizable value) at the time of milking. The fair value
of milk is determined based on market prices in the local area.
As indicated, the carrying value of the milking cows increased during the month.
Part of the change is due to changes in market prices (less costs to sell) for milking
cows. The change in market price may also be affected by growth—the increase in
value as the cows mature and develop increased milking capacity. At the same time,
as mature cows are milked, their milking capacity declines (fair value decrease due to
harvest).7
Bancroft makes the following entry to record the change in carrying value of the
milking cows.
Biological Asset—Milking Cows (€493,800 €460,000) 33,800
Unrealized Holding Gain or Loss—Income 33,800
As a result of this entry, Bancroft’s statement of financial position reports the Biological
Asset—Milking Cows as a non-current asset at fair value less costs to sell (net realizable
value). In addition, the unrealized gains and losses are reported as other income and
expense on the income statement. In subsequent periods at each reporting date, Bancroft
continues to report the Biological Asset—Milking Cows at net realizable value and records
any related unrealized gains or losses in income. Because there is a ready market for
the biological assets (milking cows), valuation at net realizable value provides more
relevant information about these assets.
In addition to recording the change in the biological asset, Bancroft makes the fol-
lowing summary entry to record the milk harvested for the month of January.
Milk Inventory 36,000
The milk inventory is recorded at net realizable value at the time it is harvested
and an Unrealized Holding Gain or Loss—Income is recognized in income. As with
the biological assets, net realizable value is considered the most relevant for purposes
of valuation at harvest. What happens to the Milk Inventory that Bancroft recorded
upon harvesting the milk from the cows? Assuming the milk harvested in January was
sold to a local cheese-maker for €38,500, Bancroft records the sale as follows.
Cash 38,500
Cost of Goods Sold 36,000
Milk Inventory 36,000
Sales 38,500
Thus, once harvested, the net realizable value of the harvested milk becomes its cost,
and the milk is accounted for similar to other inventories held for sale in the normal
course of business.
A final note: Some animals or plants may not be considered biological assets but
would be classified and accounted for as other types of assets (not at net realizable
7
Changes in fair value arising from growth and harvesting from mature cows can be
estimated based on changes in market prices of different age cows in the herd.
value). For example, a pet shop may hold an inventory of dogs purchased from breeders
that it then sells. Because the pet shop is not breeding the dogs, these dogs are not
considered biological assets. As a result, the dogs are accounted for as inventory held
for sale (at LCNRV).
Commodity Broker-Traders
Commodity broker-traders also generally measure their inventories at fair value less
costs to sell (net realizable value), with changes in net realizable value recognized in
income in the period of the change. Broker-traders buy or sell commodities (such as
harvested corn, wheat, precious metals, heating oil) for others or on their own account.
The primary purpose for holding these inventories is to sell the commodities in the
near term and generate a profit from fluctuations in price. Thus, net realizable value is
the most relevant measure in this industry because it indicates the amount that the
broker-trader will receive from this inventory in the future.
Assessing whether a company is acting in the role of a broker-trader requires
judgment. Companies should consider the length of time they are likely to hold the
inventory and the extent of additional services related to the commodity. If there are
significant additional services, such as distribution, storage, or repackaging, the company
is likely not acting as a broker-dealer; thus, measurement of the commodity inventory
at net realizable value is not appropriate. For example, Carl’s Coffee Wholesalers buys
coffee beans and resells the commodity in the same condition after a short period of
time. Accounting for the coffee inventory at net realizable value appears appropriate.
However, if Carl expands the business to roast the beans and repackage them for resale
to local coffee shops, the coffee inventory should be accounted for at LCNRV, similar to
other inventory held for sale.8
8
Minerals and mineral products, such as coal or iron ore, may also be measured at net
realizable value, in accordance with well-established industry practices. In the mining
industry, when minerals have been extracted, there is often an assured sale under a forward
contract, a government guarantee, or in an active market. Because there is negligible risk of
failure to sell, measurement at net realizable value is justified. In these contexts, and similar
to the accounting for agricultural assets, minerals and mineral products are recorded at net
realizable value at the point of extraction, with a gain recorded in the period of extraction.
In subsequent periods, changes in value of minerals and mineral products inventory are
recognized in profit or loss in the period of the change.
INVENTORIES
In most cases, IFRS and U.S. GAAP related to inventory are the same. The major differences are that IFRS pro-
hibits the use of the LIFO cost flow assumption and records market in the LCNRV differently.

• The requirements for accounting for and reporting Presented below is a disclosure under U.S. GAAP related to inven-
inventories are more principles-based under IFRS. tories for Fortune Brands, Inc. (USA), which reflects application of
That is, U.S. GAAP provides more detailed guidelines U.S. GAAP to its inventories.
in inventory accounting.
• Who owns the goods—goods in transit, consigned
goods, special sales agreements—as well as the costs
Fortune Brands, Inc.
to include in inventory are essentially accounted for
the same under IFRS and U.S. GAAP. Current assets
Inventories (Note 2)
• A major difference between IFRS and U.S. GAAP
Leaf tobacco $ 563,424,000
relates to the LIFO cost flow assumption. U.S. GAAP Bulk whiskey 232,759,000
permits the use of LIFO for inventory valuation. IFRS Other raw materials, supplies and work
prohibits its use. FIFO and average cost are the only in process 238,906,000
two acceptable cost flow assumptions permitted Finished products 658,326,000
under IFRS. Both sets of standards permit specific $1,693,415,000
identification where appropriate.
• In the lower-of-cost-or-market test for inventory Note 2: Inventories
valuation, IFRS defines market as net realizable value. Inventories are priced at the lower of cost (average; first-in, first-out; and
minor amounts at last-in, first-out) or market. In accordance with generally
U.S. GAAP, on the other hand, defines market as
recognized trade practice, the leaf tobacco and bulk whiskey inventories
replacement cost subject to the constraints of net are classified as current assets, although part of such inventories due to
realizable value (the ceiling) and net realizable value the duration of the aging process, ordinarily will not be sold within one year.
less a normal markup (the floor). That is, IFRS does
not use a ceiling or a floor to determine market.
• Under U.S. GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. As a
result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in
a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported
on the income statement.
• Unlike property, plant, and equipment, IFRS does not permit the option of valuing inventories at fair value. As indicated above, IFRS
requires inventory to be written down, but inventory cannot be written up above its original cost.
• As indicated, IFRS requires both biological assets and agricultural produce at the point of harvest to be reported to net realizable value.
U.S. GAAP does not require companies to account for all biological assets in the same way. Furthermore, these assets generally are not
reported at net realizable value. Disclosure requirements also differ between the two sets of standards.
ON TH E HORIZON
One convergence issue that will be difficult to resolve relates to the use of the LIFO cost flow assumption. As in-
dicated, IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United
States because of its favorable tax advantages. In addition, many argue that LIFO from a financial reporting point
of view provides a better matching of current costs against revenue and therefore enables companies to compute
a more realistic income.
9
QUESTIONS
1. Where there is evidence that the utility of inventory goods, Cases
as part of their disposal in the ordinary course of business, 1 2 3 4 5
will be less than cost, what is the proper accounting Cost $15.90 $16.10 $15.90 $15.90 $15.90
treatment? Sales value 14.80 19.20 15.20 10.40 17.80
Estimated cost
2. Why are inventories valued at the lower-of-cost-or-net re- to complete 1.50 1.90 1.65 .80 1.00
alizable value (LCNRV)? What are the arguments against Estimated cost to sell .50 .70 .55 .40 .60
the use of the LCNRV method of valuing inventories? 5. What method(s) might be used in the accounts to record
3. What approaches may be employed in applying the LCNRV a loss due to a price decline in the inventories? Discuss.
procedure? Which approach is normally used and why? 6. What factors might call for inventory valuation at net
4. In some instances accounting principles require a depar- realizable value?
ture from valuing inventories at cost alone. Determine the 7. Briefly describe the valuation of (a) biological assets and
proper unit inventory price in the following cases. (b) agricultural produce.
BRIEF EXERCISES
•1 BE9-1 Presented below is information related to Rembrandt Inc.’s inventory.
(per unit) Skis Boots Parkas
Historical cost $190.00 $106.00 $53.00
Selling price 212.00 145.00 73.75
Cost to sell 19.00 8.00 2.50
Cost to complete 32.00 29.00 21.25
Determine the following: (a) the net realizable value for each item, and (b) the carrying value of each item
under LCNRV.
•1 BE9-2 Floyd Corporation has the following four items in its ending inventory.
Net Realizable
Item Cost Value (NRV)
Jokers €2,000 €2,100
Penguins 5,000 4,950
Riddlers 4,400 4,625
Scarecrows 3,200 3,830
Determine (a) the LCNRV for each item, and (b) the amount of write-down, if any, using (1) an item-by-
item LCNRV evaluation and (2) a total-group LCNRV evaluation.
•1 BE9-3 Kumar Inc. uses a perpetual inventory system. At January 1, 2011, inventory was Rs214,000,000
at both cost and net realizable value. At December 31, 2011, the inventory was Rs286,000,000 at cost and
Rs265,000,000 at net realizable value. Prepare the necessary December 31 entry under (a) the cost-of-goods-
sold method and (b) the loss method.
•2 BE9-4 Keyser’s Fleece Inc. holds a drove of sheep. Keyser shears the sheep on a semiannual basis and
then sells the harvested wool into the specialty knitting market. Keyser has the following information re-
lated to the shearing sheep at January 1, 2010, and during the first six months of 2010.
Shearing sheep
Carrying value (equal to net realizable value), January 1, 2010 €74,000
Change in fair value due to growth and price changes 4,700
Change in fair value due to harvest (575)
Wool harvested during the first 6 months (at NRV) 9,000
Prepare the journal entry(ies) for Keyser’s biological asset (shearing sheep) for the first six months of
2010.
•2 BE9-5 Refer to the data in BE9-4 for Keyser’s Fleece Inc. Prepare the journal entries for (a) the wool har-
vested in the first six months of 2010, and (b) the wool harvested is sold for €10,500 in July 2010.
Exercises · 11
EXERCISES
•1 E9-3 (LCNRV) Sedato Company follows the practice of pricing its inventory at LCNRV, on an individual-
item basis.
Item Cost Estimated Cost to Complete

No. Quantity per Unit Selling Price and Sell
1320 1,200 $3.20 $4.50 $1.60
1333 900 2.70 3.40 1.00
1426 800 4.50 5.00 1.40
1437 1,000 3.60 3.20 1.35
1510 700 2.25 3.25 1.40
1522 500 3.00 3.90 0.80
1573 3,000 1.80 2.50 1.20
1626 1,000 4.70 6.00 1.50
Instructions
From the information above, determine the amount of Sedato Company inventory.
•1 E9-4 (LCNRV—Journal Entries) Dover Company began operations in 2010 and determined its end-
ing inventory at cost and at LCNRV at December 31, 2010, and December 31, 2011. This information is
presented below.
Cost Net Realizable Value

12/31/10 £346,000 £322,000
12/31/11 410,000 390,000
Instructions
(a) Prepare the journal entries required at December 31, 2010, and December 31, 2011, assuming that
the inventory is recorded at LCNRV, and a perpetual inventory system using the cost-of-goods-
sold method.
(b) Prepare journal entries required at December 31, 2010, and December 31, 2011, assuming that the
inventory is recorded at cost, and a perpetual system using the loss method.
(c) Which of the two methods above provides the higher net income in each year?
•2 E9-7 (Valuation at Net Realizable Value) Matsumura Dairy began operations on April 1, 2010, with
purchase of 200 milking cows for ¥6,700,000. It has completed the first month of operations and has the
following information for its milking cows at the end of April 2010 (000 omitted).
Milking cows
Change in fair value due to growth and price changes* ¥(200,000)
Decrease in fair value due to harvest (12,000)
Milk harvested during April 2010 (at net realizable value) 72,000
*Due to a very high rate of calving in the past month, there is a glut of milking cows on the market.
Instructions
(a) Prepare the journal entries for Matsumura’s biological asset (milking cows) for the month of April
2010.
(b) Prepare the journal entry for the milk harvested by Matsumura during April 2010.
(c) Matsumura sells the milk harvested in April on the local milk exchange and receives ¥74,000.
Prepare the summary journal entry to record the sale of the milk.
•2 E9-8 (Valuation at Net Realizable Value) Mt. Horeb Alpaca Co. has a herd of 150 alpaca. The alpaca
are sheared once a quarter to harvest very valuable alpaca wool that is used in designer sweaters.
Mt. Horeb has the following information related to the alpaca herd at July 1, 2010, and during the first
quarter of the fiscal year.
Alpaca
Carrying value (equal to net realizable value), July 1, 2010 $120,000
Change in fair value due to growth and price changes 7,700
Decrease in fair value due to harvest (975)
Alpaca wool harvested during the first quarter (at net realizable value) 13,000
Instructions
(a) Prepare the journal entries for Mt. Horeb’s biological asset (Alpaca herd) for the first quarter.
(b) Prepare the journal entries for the Alpaca wool harvested in the first quarter.
(c) Prepare the journal entry when the Alpaca wool is sold for $14,500.
(d) Briefly discuss the impact on income of the following events related to the alpaca biological asset:
(1) a female alpaca gives birth to a baby alpaca, and (2) an older alpaca can only be sheared once
every other quarter due to irritation caused by repeated shearing over its life.

CA9-1 (LCNRV) You have been asked by the financial vice president to develop a short presentation
on the LCNRV method for inventory purposes. The financial VP needs to explain this method to the
president because it appears that a portion of the company’s inventory has declined in value.
Instructions
The financial vice president asks you to answer the following questions.
(a) What is the purpose of the LCNRV method?
(b) What is meant by “net realizable value”?
(c) Do you apply the LCNRV method to each individual item, to a category, or to the total of the in-
ventory? Explain.
(d) What are the potential disadvantages of the LCNRV method?
USING YOUR JUDGMENT

Marks and Spencer plc (M&S)
The financial statements of M&S are presented in Appendix 5B or can be accessed at the book’s companion
website, www.wiley.com/college/kiesoifrs.
Instructions
oifrs Refer to M&S’s financial statements and the accompanying notes to answer the following questions.
k ies
/
(a) How does M&S value its inventories? Which inventory costing method does M&S use as a basis for
llege
reporting its inventories?

/co
ww
(b) How does M&S report its inventories in the statement of financial position? In the notes to its finan-
m
.w
i l e y. c o
cial statements, what three descriptions are used to classify its inventories?
(c) What costs does M&S include in Inventory and Cost of Sales?
(d) What was M&S inventory turnover ratio in 2008? What is its gross profit percentage? Evaluate M&S’s
inventory turnover ratio and its gross profit percentage.

Jones Co. is in a technology-intensive industry. Recently, one of its competitors introduced a new prod-
uct with technology that might render obsolete some of Jones’s inventory. The accounting staff wants to
follow the appropriate authoritative literature in determining the accounting for this significant market
event.
Instructions
the documents, you can use the search tool in your Internet browser to respond to the following questions.
(Provide paragraph citations.)
(a) Identify the authoritative literature addressing inventory pricing.
(b) List three types of goods that are classified as inventory. What characteristic will automatically
exclude an item from being classified as inventory?
(c) Define “net realizable value” as used in the phrase “lower-of-cost-or-net realizable value.”
(d) Explain when it is acceptable to state inventory above cost and which industries allow this practice.
Note: since these are KiesoIFRS_Supplement_1st pp
"rough pages" the running heads and
folios will be corrected in revise pp. Kieso IFRS Supplement · 11-1
CHAPTER 11 DEPRECIATION, IMPAIRMENTS, AND DEPLETION
Component Depreciation
As indicated in Chapter 10, companies are required to use component depreciation. IFRS
requires that each part of an item of property, plant, and equipment that is significant
to the total cost of the asset must be depreciated separately. Companies therefore have
to exercise judgment to determine the proper allocations to the components. As an
example, when a company like Nokia (FIN) purchases a building, it must determine how
the various building components (e.g., the foundation, structure, roof, heating and cool-
ing system, and elevators) should be segregated and depreciated.
To illustrate the accounting for component depreciation, assume that EuroAsia
Airlines purchases an airplane for €100,000,000 on January 1, 2011. The airplane has a
useful life of 20 years and a residual value of €0. EuroAsia uses the straight-line method
of depreciation for all its airplanes. EuroAsia identifies the following components,
amounts, and useful lives, as shown in Illustration 11-8.
ILLUSTRATION 11-8
Components Component Amount Component Useful Life
Airplane Components
Airframe €60,000,000 20 years
Engine components 32,000,000 8 years
Other components 8,000,000 5 years
Illustration 11-9 shows the computation of depreciation expense for EuroAsia for 2011.
ILLUSTRATION 11-9
Components Component Amount Useful Life Component Depreciation
Computation of
Airframe € 60,000,000 20 €3,000,000 Component Depreciation
Engine components 32,000,000 8 4,000,000
Other components 8,000,000 5 1,600,000
Total €100,000,000 €8,600,000
As indicated, EuroAsia records depreciation expense of €8,600,000 in 2011, as follows.
Depreciation Expense 8,600,000

Accumulated Depreciation—Airplane 8,600,000
On the statement of financial position at the end of 2011, EuroAsia reports the airplane
as a single amount. The presentation is shown in Illustration 11-10.
ILLUSTRATION 11-10
Non-current assets
Presentation of Carrying
Airplane €100,000,000
Less: Accumulated depreciation—airplane 8,600,000
Amount of Airplane
€ 91,400,000
In many situations, a company may not have a good understanding of the cost of
the individual components purchased. In that case, the cost of individual components
should be estimated based on reference to current market prices (if available), discus-
sion with experts in valuation, or use of other reasonable approaches.
11-2 · Chapter 11 Depreciation, Impairments, and Depletion
Special Depreciation Issues

We still need to discuss several special issues related to depreciation:
1. How should companies compute depreciation for partial periods?

2. Does depreciation provide for the replacement of assets?
3. How should companies handle revisions in depreciation rates?
Depreciation and Partial Periods

Companies seldom purchase plant assets on the first day of a fiscal period or dispose
of them on the last day of a fiscal period. A practical question is: How much depreci-
ation should a company charge for the partial periods involved?
In computing depreciation expense for partial periods, companies must determine
the depreciation expense for the full year and then prorate this depreciation expense
between the two periods involved. This process should continue throughout the use-
ful life of the asset.
Assume, for example, that Steeltex Company purchases an automated drill ma-
chine with a five-year life for $45,000 (no residual value) on June 10, 2010. The com-
pany’s fiscal year ends December 31. Steeltex therefore charges depreciation for only
6 2 ⁄ 3 months during that year. The total depreciation for a full year (assuming straight-
line depreciation) is $9,000 ($45,000/5). The depreciation for the first, partial year is
therefore:
6 2⁄ 3
$9,000 $5,000
12
The partial-period calculation is relatively simple when Steeltex uses straight-line
depreciation. But how is partial-period depreciation handled when it uses an acceler-
ated method such as sum-of-the-years’-digits or double-declining-balance? As an illus-
tration, assume that Steeltex purchased another machine for $10,000 on July 1, 2010,
with an estimated useful life of five years and no residual value. Illustration 11-11 shows
the depreciation figures for 2010, 2011, and 2012.
Sometimes a company like Steeltex modifies the process of allocating costs to a par-
tial period to handle acquisitions and disposals of plant assets more simply. One vari-
ation is to take no depreciation in the year of acquisition and a full year’s depreciation
in the year of disposal. Other variations charge one-half year’s depreciation both in the
year of acquisition and in the year of disposal (referred to as the half-year convention),
or charge a full year in the year of acquisition and none in the year of disposal.
In fact, Steeltex may adopt any one of these several fractional-year policies in allo-
cating cost to the first and last years of an asset’s life so long as it applies the method
consistently. However, unless otherwise stipulated, companies normally compute
depreciation on the basis of the nearest full month.
IMPAIRMENTS
The general accounting standard of lower-of-cost-or-net realizable value for inventories
does not apply to property, plant, and equipment. Even when property, plant, and
equipment has suffered partial obsolescence, accountants have been reluctant to reduce
the asset’s carrying amount. Why? Because, unlike inventories, it is difficult to arrive
at a fair value for property, plant, and equipment that is not somewhat subjective and
arbitrary.
For example, Falconbridge Ltd. Nickel Mines (CAN) had to decide whether to
write off all or a part of its property, plant, and equipment in a nickel-mining opera-
tion in the Dominican Republic. The project had been incurring losses because nickel
prices were low and operating costs were high. Only if nickel prices increased by
approximately 33 percent would the project be reasonably profitable. Whether a write-off
Kieso IFRS Supplement · 11-3
was appropriate depended on the future price of nickel. Even if the company decided
to write off the asset, how much should be written off?
Recognizing Impairments
As discussed in the opening story, the credit crisis starting in late 2008 has affected
many financial and non-financial institutions. As a result of this global slump, many
companies are considering write-offs of some of their long-lived assets. These write-offs
are referred to as impairments.
A long-lived tangible asset is impaired when a company is not able to recover the
asset’s carrying amount either through using it or by selling it. To determine whether
an asset is impaired, on an annual basis, companies review the asset for indicators
of impairments—that is, a decline in the asset’s cash-generating ability through use or
sale. This review should consider internal sources (e.g., adverse changes in performance)
and external sources (e.g., adverse changes in the business or regulatory environment)
of information. If impairment indicators are present, then an impairment test must
be conducted. This test compares the asset’s recoverable amount with its carrying
amount. If the carrying amount is higher than the recoverable amount, the difference
is an impairment loss. If the recoverable amount is greater than the carrying amount,
no impairment is recorded. [3]
Recoverable amount is defined as the higher of fair value less costs to sell or value-
in-use. Fair value less costs to sell means what the asset could be sold for after de-
ducting costs of disposal. Value-in-use is the present value of cash flows expected from
the future use and eventual sale of the asset at the end of its useful life. Illustration 11-15
highlights the nature of the impairment test.
ILLUSTRATION 11-15
Impairment Test
Carrying Recoverable
Compared to
Amount Amount
Higher of
Fair Value Less

Value-in-Use
Costs to Sell
If either the fair value less costs to sell or value-in-use is higher than the carrying amount,
there is no impairment. If both the fair value less costs to sell and value-in-use are lower
than the carrying amount, a loss on impairment occurs.
Example: No Impairment
Assume that Cruz Company performs an impairment test for its equipment. The carrying
amount of Cruz’s equipment is $200,000, its fair value less costs to sell is $180,000, and its
value-in-use is $205,000. In this case, the value-in-use of Cruz’s equipment is higher than
its carrying amount of $200,000. As a result, there is no impairment.7
Example: Impairment
Assume the same information for Cruz Company above except that the value-in-use
of Cruz’s equipment is $175,000 rather than $205,000. Cruz measures the impairment
7
If a company can more readily determine value-in-use (or fair value less costs to sell) and it
determines that no impairment is needed, it is not required to compute the other measure. [4]
loss as the difference between the carrying amount of $200,000 and the higher of fair
value less costs to sell ($180,000) or value-in-use ($175,000). Cruz therefore uses the fair
value less cost of disposal to record an impairment loss of $20,000 ($200,000 $180,000).
Cruz makes the following entry to record the impairment loss.
Loss on Impairment 20,000
Accumulated Depreciation—Equipment 20,000
The Loss on Impairment is reported in the income statement in the “other income
and expense” section. The company then either credits Equipment or Accumulated
Depreciation—Equipment to reduce the carrying amount of the equipment for the
impairment. For purposes of homework, credit accumulated depreciation when recording an
impairment for a depreciable asset.
Impairment Illustrations
Presented below are additional examples of impairments.
Case 1
At December 31, 2011, Hanoi Company has equipment with a cost of VND26,000,000,
and accumulated depreciation of VND12,000,000. The equipment has a total useful life
of four years with a residual value of VND2,000,000. The following information relates
to this equipment.
1. The equipment’s carrying amount at December 31, 2011, is VND14,000,000

(VND26,000,000 VND12,000,000).
2. Hanoi uses straight-line depreciation. Hanoi’s depreciation was VND6,000,000
[(VND26,000,000 VND2,000,000) 4] for 2011 and is recorded.
3. Hanoi has determined that the recoverable amount for this asset at December 31,
2011, is VND11,000,000.
4. The remaining useful life of the equipment after December 31, 2011, is two years.
Hanoi records the impairment on its equipment at December 31, 2011, as follows.
Loss on Impairment (VND14,000,000 VND11,000,000) 3,000,000

Accumulated Depreciation—Equipment 3,000,000
Following the recognition of the impairment loss in 2011, the carrying amount of
the equipment is now VND11,000,000 (VND14,000,000 VND3,000,000). For 2012,
Hanoi Company determines that the equipment’s total useful life has not changed (thus,
the equipment’s remaining useful life is still two years). However, the estimated residual
value of the equipment is now zero. Hanoi continues to use straight-line depreciation
and makes the following journal entry to record depreciation for 2012.
Depreciation Expense (VND11,000,000/2) 5,500,000

Accumulated Depreciation—Equipment 5,500,000
Hanoi records depreciation in the periods following the impairment using the car-
rying amount of the asset adjusted for the impairment. Hanoi then evaluates whether
the equipment was further impaired at the end of 2012. For example, the carrying
amount of Hanoi’s equipment at December 31, 2012, is VND5,500,000 (VND26,000,000
VND12,000,000 VND3,000,000 VND5,500,000). If Hanoi determines that the recov-
erable amount at December 31, 2012, is lower than VND5,500,000, then an additional
impairment loss is recorded.
Case 2
At the end of 2010, Verma Company tests a machine for impairment. The machine has
a carrying amount of $200,000. It has an estimated remaining useful life of five years.
Because of the unique nature of the machine, there is little market-related information
on which to base a recoverable amount based on fair value. As a result, Verma deter-
mines the machine’s recoverable amount (i.e., the higher of value-in-use and fair value
less costs to sell) should be based on value-in-use.
To determine value-in-use, Verma develops an estimate of future cash flows based
on internal company information, based on cash budgets (and reflecting cash inflows
from the machine and estimated costs necessary to maintain the machine in its cur-
rent condition). [5] Verma uses a discount rate of 8 percent, which should be a pretax
rate that approximates Verma’s cost of borrowing.8 Verma’s analysis indicates that its
future cash flows will be $40,000 each year for five years, and it will receive a residual
value of $10,000 at the end of the five years. It is assumed that all cash flows occur at
the end of the year. The computation of the value-in-use for Verma’s machine is shown
in Illustration 11-16.
ILLUSTRATION 11-16
Present value of 5 annual payments of $40,000 ($40,000 3.99271, Table 6-4) $159,708.40
Value-in-Use Computation
Present value of residual value of $10,000 ($10,000 .68058, Table 6-1) 6,805.80
Value-in-use related to machine $166,514.20
The computation of the impairment loss on the machine at the end of 2010 is shown
in Illustration 11-17.
ILLUSTRATION 11-17
Carrying amount of machine before impairment loss $200,000.00
Impairment Loss
Recoverable amount of machine 166,514.20
Calculation Based on
Loss on impairment $ 33,485.80
Value-in-Use
The company therefore records an impairment loss at December 31, 2010, as follows.
Loss on Impairment 33,485.80

Accumulated Depreciation—Machine 33,485.80
The carrying amount of the machine after recording the loss is $166,514.20.
Reversal of Impairment Loss

After recording the impairment loss, the recoverable amount becomes the basis of the
impaired asset. What happens if a review in a future year indicates that the asset is no
longer impaired because the recoverable amount of the asset is higher than the carry-
ing amount? In that case, the impairment loss may be reversed.
To illustrate, assume that Tan Company purchases equipment on January 1, 2010,
for $300,000, with a useful life of three years, and no residual value. Its depreciation
and related carrying amount over the three years is as follows.
Year Depreciation Expense Carrying Amount

2010 $100,000 ($300,000/3) $200,000
2011 $100,000 ($300,000/3) $100,000
2012 $100,000 ($300,000/3) 0
8
Specifically, the pretax rate is determined taking into account market- and company-specific
borrowing rates, adjusted for any risks the market might attribute to expected cash flows for
the asset. [6]
At December 31, 2010, Tan determines it has an impairment loss of $20,000 and there-
fore makes the following entry.

Tan’s depreciation expense and related carrying amount after the impairment is as
indicated below.
Year Depreciation Expense Carrying Amount

2011 $90,000 ($180,000/2) $90,000
2012 $90,000 ($180,000/2) 0
At the end of 2011, Tan determines that the recoverable amount of the equipment is
$96,000, which is greater than its carrying amount of $90,000. In this case, Tan reverses
the previously recognized impairment loss with the following entry.

Recovery of Impairment Loss 6,000
The recovery of the impairment loss is reported in the “Other income and expense”
section of the income statement. The carrying amount of Tan’s equipment is now $96,000
($90,000 $6,000) at December 31, 2011.
The general rule related to reversals of impairments is as follows: The amount of
the recovery of the loss is limited to the carrying amount that would result if the im-
pairment had not occurred. For example, the carrying amount of Tan’s equipment at the
end of 2011 would be $100,000, assuming no impairment. The $6,000 recovery is there-
fore permitted because Tan’s carrying amount on the equipment is now only $96,000.
However, any recovery above $10,000 is not permitted. The reason is that any recovery
above $10,000 results in Tan carrying the asset at a value above its historical cost.
Cash-Generating Units
In some cases, it may not be possible to assess a single asset for impairment because
the single asset generates cash flows only in combination with other assets. In that case,
companies should identify the smallest group of assets that can be identified that gen-
erate cash flows independently of the cash flows from other assets. Such a group is
called a cash-generating unit (CGU).
For example, Santos Company is reviewing its plant assets for indicators of impair-
ment. However, it is finding that identifying cash flows for individual assets is very
cumbersome and inaccurate because the cash flows related to a group of assets are
interdependent. This situation can arise if Santos has one operating unit (machining
division) that manufactures products that are transferred to another Santos business
unit (packing division), which then markets the products to end customers. Because
the cash flows to the assets in the machining division are dependent on the cash flows in
the packing division, Santos should evaluate both divisions together as a cash-generating
unit in its impairment assessments.
Impairment of Assets to Be Disposed Of

What happens if a company intends to dispose of the impaired asset, instead of hold-
ing it for use? Recently, Kroger (USA) recorded an impairment loss of $54 million on
property, plant, and equipment it no longer needed due to store closures. In this case,
Kroger reports the impaired asset at the lower-of-cost-or-net realizable value (fair
value less costs to sell). Because Kroger intends to dispose of the assets in a short period
of time, it uses net realizable value in order to provide a better measure of the net cash
flows that it will receive from these assets.
Kroger does not depreciate or amortize assets held for disposal during the period
it holds them. The rationale is that depreciation is inconsistent with the notion of as-
sets to be disposed of and with the use of the lower-of-cost-or-net realizable value. In
other words, assets held for disposal are like inventory; companies should report
them at the lower-of-cost-or-net realizable value.
Because Kroger will recover assets held for disposal through sale rather than
through operations, it continually revalues them. Each period, the assets are reported
at the lower-of-cost-or-net realizable value. Thus, Kroger can write up or down an as-
set held for disposal in future periods, as long as the carrying amount after the write-
up never exceeds the carrying amount of the asset before the impairment. Companies
should report losses or gains related to these impaired assets as part of operating
income in “Other income and expense.”
Illustration 11-18 summarizes the key concepts in accounting for impairments.
ILLUSTRATION 11-18
Measurement of Graphic of Accounting for
Impairment Test
Impairment Loss Impairments
Recoverable amount* less Yes
Impairment
than carrying amount?
No
Assets held Assets held for

for use sale or disposal
No impairment
1. Impairment loss: excess 1. Lower-of-cost or fair value

of carrying amount over less costs to sell (net
recoverable amount. realizable value).
2. Depreciate on new 2. No depreciation taken.

cost basis.
3. Reversal of impairment
loss permitted.
*The higher of fair value less costs to sell or value-in-use.
DEPLETION
Natural resources, often called wasting assets, include petroleum, minerals, and timber-
lands. Natural resources can be further subdivided into two categories: (1) biological
assets such as timberlands, and (2) mineral resources such as oil, gas, and mineral
mining. The accounting and reporting requirements for biological assets such as tim-
berlands use a fair value approach and are discussed in Chapter 9. Here, we focus on
mineral resources, which have two main features: (1) the complete removal (consump-
tion) of the asset, and (2) replacement of the asset only by an act of nature.
Unlike plant and equipment, mineral resources are consumed physically over the
period of use and do not maintain their physical characteristics. Still, the accounting
problems associated with these resources are similar to those encountered with prop-
erty, plant, and equipment. The questions to be answered are:
1. How do companies establish the cost basis for write-off?

2. What pattern of allocation should companies employ?
Recall that the accounting profession uses the term depletion for the process of
allocating the cost of mineral resources.
Establishing a Depletion Base

How do we determine the depletion base for mineral resources? For example, a com-
pany like Total S.A. (FRA) makes sizable expenditures to find mineral resources, and
for every successful discovery there are many failures. Furthermore, it encounters long
delays between the time it incurs costs and the time it obtains the benefits from the
extracted resources. As a result, a company in the extractive industries, like Total S.A.,
frequently adopts a conservative policy in accounting for the expenditures related to
finding and extracting mineral resources.
Computation of the depletion base involves properly accounting for three types of
expenditures:
1. Pre-exploratory costs.
2. Exploratory and evaluation costs.
3. Development costs.
Pre-Exploratory Costs
Pre-exploratory expenditures are costs incurred before the company has obtained the
legal rights to explore a specific area. For example, Royal Dutch Shell (GBR and NLD)
may perform seismic testing of possible oil-drilling sites before incurring any substantial
costs of exploration. These costs (often referred to as prospecting costs) are generally
considered speculative in nature and are expensed as incurred.
Exploratory and Evaluation (E&E) Costs

Examples of some types of exploratory and evaluation (E&E) costs are as follows.
• Acquisition of rights to explore.
• Topographical, geological, geochemical, and geophysical studies.
• Exploratory drilling.
• Sampling.
• Activities in relation to evaluating the technical feasibility and commercial viability
of extracting a mineral resource.
Companies have a choice as regards to E&E costs. They can either write off these
costs as incurred or capitalize these costs pending evaluation. IFRS therefore provides
companies with flexibility as how to account for E&E costs at inception. [7]
The reason for the flexibility is that the accounting for these types of expenditures
is controversial. To illustrate, assume that Royal Dutch Shell is exploring for oil and
determines that the area of exploration has oil reserves. It therefore drills a well to de-
termine the amount of the reserves. Unfortunately, the well drilled results in a dry hole;
that is, no reserves are found. Shell then drills more wells and finds some oil reserves,
but some others are dry holes. The question is: Should the cost of the dry holes be cap-
italized? Or should only the cost of the wells that find reserves be capitalized?
Those who hold the full-cost concept (full capitalization) argue that the cost of
drilling a dry hole is a cost needed to find the commercially profitable wells. Others
believe that companies should capitalize only the costs of the successful wells. This is
the successful-efforts concept. Its proponents believe that the only relevant measure
for a project is the cost directly related to that project, and that companies should re-
port any remaining costs as period charges. In addition, they argue that an unsuccess-
ful company will end up capitalizing many costs that will make it, over a short period
of time, show no less income than does one that is successful.9
Development Costs
Once technical feasibility and commercial viability of production are demonstrated,
E&E assets are reclassified as development costs. Generally, the development phase
occurs when the company has determined that it has a reasonable level of mineral
resources in the ground so that production will be profitable. At this time, any E&E
assets recognized as assets are subsequently tested for impairment, to ensure that these
assets are not carried at an amount above their recoverable amount.
Companies divide development costs into two parts: (1) tangible equipment costs
and (2) intangible development costs. Tangible equipment costs include all of the trans-
portation and other heavy equipment needed to extract the resource and get it ready
for market. Because companies can move the heavy equipment from one extracting site
to another, companies do not normally include tangible equipment costs in the de-
pletion base. Instead, they use separate depreciation charges to allocate the costs of
such equipment. However, some tangible assets (e.g., a drilling rig foundation) cannot
be moved. Companies depreciate these assets over their useful life or the life of the re-
source, whichever is shorter.
Intangible development costs, on the other hand, are such items as drilling costs,
tunnels, shafts, and wells. These costs have no tangible characteristics but are needed
for the production of the mineral resource. Intangible development costs are consid-
ered part of the depletion base.
Companies sometimes incur substantial costs to restore property to its natural state
after extraction has occurred. These are restoration costs. Companies consider restora-
tion costs part of the depletion base. The amount included in the depletion base is the
fair value of the obligation to restore the property after extraction. A more complete
discussion of the accounting for restoration costs and related liabilities (sometimes re-
ferred to as environmental liability provisions) is provided in Chapter 13. Similar to
other long-lived assets, companies deduct from the depletion base any residual value
to be received on the property.
Write-Off of Resource Cost

Once the company establishes the depletion base, the next problem is determining how
to allocate the cost of the mineral resource to accounting periods.
Normally, companies compute depletion (often referred to as cost depletion) on a
units-of-production method (an activity approach). Thus, depletion is a function of
the number of units extracted during the period. In this approach, the total cost of the
mineral resource less residual value is divided by the number of units estimated to be
in the resource deposit, to obtain a cost per unit of product. To compute depletion,
the cost per unit is then multiplied by the number of units extracted.
For example, MaClede Co. acquired the right to use 1,000 acres of land in South
Africa to mine for silver. The lease cost is $50,000, and the related exploration costs on
the property are $100,000. Intangible development costs incurred in opening the mine
are $850,000. Total costs related to the mine before the first ounce of silver is extracted
9
Large international oil companies such as ExxonMobil (USA) use the successful-efforts
approach. Most of the smaller, exploration-oriented companies use the full-cost approach.
The differences in net income figures under the two methods can be staggering. Analysts
estimated that the difference between full-cost and successful-efforts for ChevronTexaco
(USA) would be $500 million over a 10-year period (income lower under successful-efforts).
are, therefore, $1,000,000. MaClede estimates that the mine will provide approximately
100,000 ounces of silver. Illustration 11-19 shows computation of the depletion cost per
unit (depletion rate).
ILLUSTRATION 11-19
Total cost ⴚ Residual value
Computation of Depletion ⴝ Depletion cost per unit
Total estimated units available
Rate
$1,000,000
$10 per ounce
100,000
If MaClede extracts 25,000 ounces in the first year, then the depletion for the year
is $250,000 (25,000 ounces $10). It records the depletion as follows.
Inventory 250,000
Accumulated Depletion 250,000
MaClede debits Inventory for the total depletion for the year and credits Accumu-
lated Depletion to reduce the carrying amount of the mineral resource. MaClede credits
Inventory when it sells the inventory. The amount not sold remains in inventory and
is reported in the current assets section of the statement of financial position.
Sometimes companies do not use an Accumulated Depletion account. In that case,
the credit goes directly to the mineral resources asset account. MaClede’s statement of
financial position would present the cost of the mineral resource and the amount of
accumulated depletion entered to date as follows.
ILLUSTRATION 11-20
Silver mine (at cost) $1,000,000
Statement of Financial Less: Accumulated depletion 250,000 $750,000
Position Presentation of
Mineral Resource
In the income statement, the depletion cost related to the inventory sold is part of the
cost of goods sold.
MaClede may also depreciate on a units-of-production basis the tangible equip-
ment used in extracting the silver. This approach is appropriate if it can directly assign
the estimated lives of the equipment to one given resource deposit. If MaClede uses
the equipment on more than one job, other cost allocation methods such as straight-
line or accelerated depreciation methods would be more appropriate.
Estimating Recoverable Reserves

Sometimes companies need to change the estimate of recoverable reserves. They do so
either because they have new information or because more sophisticated production
processes are available. Mineral resources such as oil and gas deposits and some rare
metals have recently provided the greatest challenges. Estimates of these reserves are
in large measure merely “knowledgeable guesses.”10
This problem is the same as accounting for changes in estimates for the useful lives
of plant and equipment. The procedure is to revise the depletion rate on a prospective
basis: A company divides the remaining cost by the new estimate of the recoverable re-
serves. This approach has much merit because the required estimates are so uncertain.
10
The IASB is undertaking a project on the extractive industry. The primary focus are the financial
reporting issues associated with mineral and other natural resource reserves. The key question is
whether and how to define, recognize, measure, and disclose reserves in the financial statements.
See http://www.iasb.org/CurrentProjects/IASBProjects/ExtractiveActivities/Summary.htm.
Liquidating Dividends
A company often owns as its only major asset a property from which it intends to
extract mineral resources. If the company does not expect to purchase additional prop-
erties, it may gradually distribute to shareholders their capital investments by paying
liquidating dividends, which are dividends greater than the amount of accumulated
net income.
The major accounting problem is to distinguish between dividends that are a re-
turn of capital and those that are not. Because the dividend is a return of the investor’s
original contribution, the company issuing a liquidating dividend should debit Share
Premium—Ordinary for that portion related to the original investment, instead of deb-
iting Retained Earnings.
To illustrate, at year-end, Callahan Mining had a retained earnings balance of
£1,650,000, accumulated depletion on mineral properties of £2,100,000, and share pre-
mium of £5,435,493. Callahan’s board declared a dividend of £3 a share on the 1,000,000
shares outstanding. It records the £3,000,000 cash dividend as follows.
Retained Earnings 1,650,000
Share Premium—Ordinary 1,350,000
Cash 3,000,000
Callahan must inform shareholders that the £3 dividend per share represents a £1.65
(£1,650,000 1,000,000 shares) per share return on investment and a £1.35 (£1,350,000
1,000,000 shares) per share liquidating dividend.
Presentation on the Financial Statements

Companies should disclose the following related to E&E expenditures.
1. The accounting policies for exploration and evaluation expenditures, including the
recognition of E&E assets.
2. The amounts of assets, liabilities, income and expense, and operating cash flow aris-
ing from the exploration for and evaluation of mineral resources.
The financial statement excerpts for Tullow Oil plc (GBR) in Illustration 11-21 high-
light the nature of these disclosures.
ILLUSTRATION 11-21
Tullow Oil plc Reporting of
(000) Exploration Costs
In the income statement
Exploration costs written off £ 226,701
In the statement of financial position

Intangible exploration and evaluation assets £1,417,777
In the statement of cash flows

Purchase of intangible exploration and evaluation of assets £ 323,569
Accounting Policies
Exploration, evaluation, and production assets
The Group adopts the successful efforts method of accounting for exploration and appraisal costs.
All license acquisition, exploration, and evaluation costs are initially capitalized in cost centers by well,
field, or exploration area, as appropriate. Directly attributable administration costs and interest payable
are capitalized insofar as they relate to specific development activities. Pre-license costs are expensed
in the period in which they are incurred. These costs are then written off as exploration costs in the
Income Statement unless commercial reserves have been established or the determination process
has not been completed and there are no indications of impairment. All field development costs are
capitalized as property, plant, and equipment. Property, plant, and equipment related to production
activities are amortized in accordance with the Group’s depletion and amortization accounting policy.
(k) Depletion and amortization—discovery fields
All expenditure carried within each field is amortized from the commencement of production on
a unit of production basis, which is the ratio of oil and gas production in the period to the estimated
quantities of commercial reserves at the end of the period plus the production in the period, generally
on a field by-field basis. Costs used in the unit of production calculation comprise the net book value
of capitalized costs plus the estimated future field development costs. Changes in the estimates of
commercial reserves or future field development costs are dealt with prospectively.
Where there has been a change in economic conditions that indicates a possible impairment in a
discovery field, the recoverability of the net book value relating to that field is assessed by comparison
with the estimated discounted future cash flows based on management’s expectations of future oil and
gas prices and future costs. Where there is evidence of economic interdependency between fields,
such as common infrastructure, the fields are grouped as a single cash-generating unit for impairment
purposes.
Any impairment identified is charged to the Income Statement as additional depletion and
amortization. Where conditions giving rise to impairment subsequently reverse, the effect of the
impairment charge is also reversed as a credit to the Income Statement, net of any depreciation that
would have been charged since the impairment.
REVALUATIONS
Up to this point, we have assumed that companies use the cost principle to value long-
lived tangible assets after acquisition. However, companies have a choice: They may
value these assets at cost or at fair value. [8]
Recognizing Revaluations
Network Rail (GBR) is an example of a company that elected to use fair values to ac-
count for its railroad network. Its use of fair value led to an increase of £4,289 million
to its long-lived tangible assets. When companies choose to fair value their long-lived
tangible assets subsequent to acquisition, they account for the change in the fair value
by adjusting the appropriate asset account and establishing an unrealized gain on the
revalued long-lived tangible asset. This unrealized gain is often referred to as revalu-
ation surplus.
Revaluation—Land
To illustrate revaluation of land, assume that Siemens Group (DEU) purchased land
for €1,000,000 on January 5, 2010. The company elects to use revaluation accounting
for the land in subsequent periods. At December 31, 2010, the land’s fair value is
€1,200,000. The entry to record the land at fair value is as follows.
Land 200,000
Unrealized Gain on Revaluation—Land 200,000
The land is reported on the statement of financial position at €1,200,000, and the
Unrealized Gain on Revaluation—Land increases other comprehensive income in the
statement of comprehensive income. In addition, if this is the only revaluation adjust-
ment to date, the statement of financial position reports accumulated other comprehen-
sive income of €200,000.
Revaluation—Depreciable Assets
To illustrate the accounting for revaluations of depreciable assets, assume that Lenovo
Group (CHN) purchases equipment for ¥500,000 on January 2, 2010. The equipment
has a useful life of five years, is depreciated using the straight-line method of depreci-
ation, and its residual value is zero. Lenovo chooses to revalue its equipment to fair
value over the life of the equipment. Lenovo records depreciation expense of ¥100,000
(¥500,000 5) at December 31, 2010, as follows.
December 31, 2010
Depreciation Expense 100,000

(To record depreciation expense in 2010)
After this entry, Lenovo’s equipment has a carrying amount of ¥400,000 (¥500,000
¥100,000). Lenovo receives an independent appraisal for the fair value of equipment at
December 31, 2010, which is ¥460,000. To report the equipment at fair value, Lenovo
does the following.
1. Reduces the Accumulated Depreciation—Equipment account to zero.

2. Reduces the Equipment account by ¥40,000—it then is reported at its fair value of
¥460,000.
3. Records Unrealized Gain on Revaluation—Equipment for the difference between the
fair value and carrying amount of the equipment, or ¥60,000 (¥460,000 ¥400,000).
The entry to record this revaluation at December 31, 2010, is as follows.
December 31, 2010

Equipment 40,000
Unrealized Gain on Revaluation—Equipment 60,000
(To adjust the equipment to fair value and record revaluation increase)
The equipment is now reported at its fair value of ¥460,000 (¥500,000 ¥40,000).11
The increase in the fair value of ¥60,000 is reported on the statement of comprehensive
income as other comprehensive income. In addition, the ending balance is reported in
accumulated other comprehensive income on the statement of financial position in the
equity section.
Illustration 11-22 shows the presentation of revaluation elements.
ILLUSTRATION 11-22
On the statement of comprehensive income:
Other comprehensive income
Financial Statement
Unrealized gain on revaluation—equipment ¥ 60,000 Presentation—
Revaluations
On the statement of financial position:
Non-current assets
Equipment (¥500,000 ¥40,000) ¥460,000
Accumulated depreciation—equipment (¥100,000 ¥100,000) 0
Carrying amount ¥460,000
Equity
Accumulated other comprehensive income ¥ 60,000
As indicated, at December 31, 2010, the carrying amount of the equipment is now
¥460,000. Lenovo reports depreciation expense of ¥100,000 in the income statement and
11
When a depreciable asset is revalued, companies use one of two approaches to record the
revaluation. As an alternative to the one shown here, companies restate on a proportionate
basis the cost and accumulated depreciation of the asset, such that the carrying amount of
the asset after revaluation equals its revalued amount.
an Unrealized Gain on Revaluation—Equipment of ¥60,000 in “Other comprehensive

income.” Assuming no change in the useful life of the equipment, depreciation in 2011
is ¥115,000 (¥460,000 4).
In summary, a revaluation increase generally goes to equity. A revaluation decrease
is reported as an expense (as an impairment loss), unless it offsets previously recorded
revaluation increases. If the revaluation increase offsets a revaluation decrease that went
to expense, then the increase is reported in income. Under no circumstances can the
Accumulated Other Comprehensive Income account related to revaluations have a
negative balance.
Revaluation Issues
The use of revaluation accounting is not an “all or nothing” proposition. That is, a com-
pany can select to value only one class of assets, say buildings, and not revalue other
assets such as land or equipment. However, if a company selects only buildings, reval-
uation applies to all assets in that class of assets. A class of assets is a grouping of items
that have a similar nature and use in a company’s operations. For example, a company
like Siemens (DEU) may have the following classes of assets: land, equipment, and
buildings. If Siemens chooses to fair value its land class, it must fair value all land. It
cannot selectively apply revaluation accounting to certain parcels of land within the
class and report them at fair value and keep the remainder at historical cost. To permit
such “cherry-picking” not only leads to a misleading mixture of historical cost and
fair value, but also permits a company to maximize its fair value through selective
revaluation.
Companies using revaluation accounting must also make every effort to keep the
assets’ values up to date. Assets that are experiencing rapid price changes must be
revalued on an annual basis; otherwise, less frequent revaluation is acceptable. The fair
value of items of property, plant, and equipment is usually their market value deter-
mined by appraisal.
Most companies do not use revaluation accounting. A major reason is the substan-
tial and continuing costs associated with appraisals to determine fair value. In addi-
tion, the gains associated with revaluations above historical cost are not reported in
net income but rather go directly to equity. On the other hand, losses associated with
revaluation below historical cost decrease net income. In addition, for depreciable
assets, the higher depreciation charges related to the revalued assets also reduce net
income.
Companies that choose revaluation accounting often are in highly inflationary
environments where the historical cost numbers are badly out of date. In addition, some
companies select the revaluation approach because they wish to increase their equity
base. Increases in its equity base may help a company meet covenant requirements or
provide additional assurances to investors and creditors that the company is solvent.
Appendix 11A illustrates the accounting for revaluations in more detail both for land
and depreciable assets.
PROPERTY, PLANT, AND EQUIPMENT

U.S. GAAP adheres to many of the same principles of IFRS in the accounting for property, plant, and equipment.
Major differences relate to use of component depreciation, impairments, and revaluations.

• Under both U.S. GAAP and IFRS, interest costs As indicated, impairment testing under U.S. GAAP is a two-step
incurred during construction must be capitalized. process. The graphic below summarizes impairment measurement
Recently, IFRS converged to U.S. GAAP. under U.S. GAAP. The key distinctions relative to IFRS relate to the
• The accounting for exchanges of non-monetary as- use of a cash flow recovery test to determine if an impairment test
sets has recently converged between IFRS and U.S. should be performed. Also, U.S. GAAP does not permit reversal of
GAAP. U.S. GAAP now requires that gains on exchanges impairment losses for assets held for use.
of non-monetary assets be recognized if the exchange
has commercial substance. This is the same framework
used in IFRS.
• U.S. GAAP also views depreciation as allocation of
Measurement of
cost over an asset’s life. U.S. GAAP permits the same Recoverability Test
Impairment Loss
depreciation methods (straight-line, diminishing-balance, Expected future undiscounted
Yes
net cash flows less Impairment
units-of-production) as IFRS. than carrying amount?
• IFRS requires component depreciation. Under U.S.
GAAP, component depreciation is permitted but is
No
rarely used.
• Under IFRS, companies can use either the historical Assets held Assets held
for use for disposal
cost model or the revaluation model. U.S. GAAP does No impairment
not permit revaluations of property, plant, and equipment
or mineral resources.
• In testing for impairments of long-lived assets, U.S. 1. Impairment loss: excess 1. Impairment loss: excess of
GAAP uses a two-step model to test for impairments of carrying amount over carrying amount over fair
fair value. value less cost of disposal.
(details of the U.S. GAAP impairment test is presented
in the “About the Numbers” discussion). As long as 2. Depreciate on new 2. No depreciation taken.
cost basis.
future undiscounted cash flows exceed the carrying
amount of the asset, no impairment is recorded. The 3. Restoration of impairment 3. Restoration of impairment
loss not permitted. loss permitted.
IFRS impairment test is stricter. However, unlike U.S.
GAAP, reversals of impairment losses are permitted.
ON TH E HORIZON
With respect to revaluations, as part of the conceptual framework project, the Boards will examine the measure-
ment bases used in accounting. It is too early to say whether a converged conceptual framework will recommend
fair value measurement (and revaluation accounting) for property, plant, and equipment. However, this is likely
to be one of the more contentious issues, given the long-standing use of historical cost as a measurement basis in
U.S. GAAP.
QUESTIONS
15. Walkin Inc. is considering the write-down of its long-term 20. List (a) the similarities and (b) the differences in the ac-
plant because of a lack of profitability. Explain to the man- counting treatments of depreciation and cost depletion.
agement of Walkin how to determine whether a write- 21. Describe cost depletion.
down is permitted.
22. Explain the difference between exploration and develop-
16. Last year Wyeth Company recorded an impairment on an ment costs as used in the extractive industries.
asset held for use. Recent appraisals indicate that the asset
23. In the extractive industries, businesses may pay dividends
has increased in value. Should Wyeth record this recovery
in excess of net income. What is the maximum permissi-
in value?
ble? How can this practice be justified?
17. Toro Co. has equipment with a carrying amount of
25. Tanaka Company has land that cost ¥15,000,000. Its fair
€700,000. The value-in-use of the equipment is €705,000,
value on December 31, 2010, is ¥20,000,000. Tanaka chooses
and its fair value less cost of disposal is €590,000. The
the revaluation model to report its land. Explain how the
equipment is expected to be used in operations in the
land and its related valuation should be reported.
future. What amount (if any) should Toro report as an
impairment to its equipment? 26. Why might a company choose not to use revaluation
accounting?
18. Explain how gains or losses on impaired assets should be
reported in income.
BRIEF EXERCISES
•4 BE11-6 Ortiz purchased a piece of equipment that cost $202,000 on January 1, 2010. The equipment has
the following components.
Component Cost Residual Value Estimated Useful Life

A $70,000 $7,000 10 years
B 50,000 5,000 5 years
C 82,000 4,000 12 years
Compute the depreciation expense for this equipment at December 31, 2010.
•4 BE11-8 Tan Chin Company purchases a building for HK$11,300,000 on January 2, 2010. An engineer’s
report shows that of the total purchase price, HK$11,000,000 should be allocated to the building (with a
40-year life), HK$150,000 to 15-year property, and HK$150,000 to 5-year property. Compute depreciation
expense for 2010 using component depreciation.
•5 BE11-9 Jurassic Company owns machinery that cost $900,000 and has accumulated depreciation of
$380,000. The present value of expected future net cash flows from the use of the asset are expected to be
$500,000. The fair value less cost of disposal of the equipment is $400,000. Prepare the journal entry, if
any, to record the impairment loss.
•6 BE11-10 Everly Corporation acquires a coal mine at a cost of $400,000. Intangible development costs
total $100,000. After extraction has occurred, Everly must restore the property (estimated fair value of the
obligation is $80,000), after which it can be sold for $160,000. Everly estimates that 4,000 tons of coal can
be extracted. If 700 tons are extracted the first year, prepare the journal entry to record depletion.
EXERCISES
•2 •3 •4 E11-9 (Component Depreciation) Morrow Manufacturing has equipment that is comprised of five
components (in ¥000).
Component Cost Estimated Residual Estimated Life (in years)
A ¥40,500 ¥5,500 10
B 33,600 4,800 9
C 36,000 3,600 8
D 19,000 1,500 7
E 23,500 2,500 6
Instructions
(a) Prepare the adjusting entry necessary at the end of the year to record depreciation for the year.
Assume that Morrow uses straight-line depreciation.
(b) Prepare the entry to record the replacement of component B for cash of ¥40,000. It was used for
6 years.
•4 E11-16 (Component Depreciation) Brazil Group purchases a tractor at a cost of $50,000 on January 2, 2010.
Individual components of the tractor and useful lives are as follows.
Cost Useful Lives
Tires $ 6,000 2 years
Transmission 10,000 5 years
Trucks 34,000 10 years
Instructions
(a) Compute depreciation expense for 2010, assuming Brazil depreciates the tractor as a single unit.
(b) Compute depreciation expense for 2010, assuming Brazil uses component depreciation.
(c) Why might a company want to use component depreciation to depreciate its assets?
•4 E11-17 (Component Depreciation) Presented below are the components related to an office block that
Veenman Company is considering purchasing for €10,000,000.
Component Useful Life Value
Land Indefinite life €3,000,000
Building structure 60-year life 4,200,000
Building engineering 30-year life 2,100,000
Building external works 30-year life 700,000
Instructions
(a) Compute depreciation expense for 2010, assuming that Veenman uses component depreciation.
(b) Assume that the building engineering was replaced in 20 years at a cost of €2,300,000. Prepare the
entry to record the replacement of the old component with the new component.
•5 E11-18 (Impairment) Presented below is information related to equipment owned by Pujols Company
at December 31, 2010.
Cost €9,000,000
Accumulated depreciation to date 1,000,000
Value-in-use 7,000,000
Fair value less cost of disposal 4,400,000
Assume that Pujols will continue to use this asset in the future. As of December 31, 2010, the equipment
has a remaining useful life of 4 years.
Instructions
(a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2010.
(b) Prepare the journal entry to record depreciation expense for 2011.
(c) The recoverable amount of the equipment at December 31, 2011, is €7,050,000. Prepare the journal
entry (if any) necessary to record this increase.
•5 E11-19 (Impairment) Assume the same information as E11-18, except that Pujols intends to dispose of
the equipment in the coming year.
Instructions
(a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2010.
(b) Prepare the journal entry (if any) to record depreciation expense for 2011.
(c) The asset was not sold by December 31, 2011. The fair value of the equipment on that date is
€5,100,000. Prepare the journal entry (if any) necessary to record this increase. It is expected that
the cost of disposal is €20,000.
•5 E11-20 (Impairment) The management of Sprague Inc. was discussing whether certain equipment
should be written off as a charge to current operations because of obsolescence. This equipment has a
cost of $900,000 with depreciation to date of $400,000 as of December 31, 2010. On December 31, 2010,
management projected the present value of future net cash flows from this equipment to be $300,000
and its fair value less cost of disposal to be $280,000. The company intends to use this equipment in
the future. The remaining useful life of the equipment is 4 years.
Instructions
(a) Prepare the journal entry (if any) to record the impairment at December 31, 2010.
(b) Where should the gain or loss (if any) on the write-down be reported in the income statement?
(c) At December 31, 2011, the equipment’s recoverable amount is $270,000. Prepare the journal entry
(if any).
(d) What accounting issues did management face in accounting for this impairment?
•6 E11-23 (Depletion Computations—Minerals) At the beginning of 2010, Callaway Company acquired
a mine for $850,000. Of this amount, $100,000 was ascribed to the land value and the remaining portion
to the minerals in the mine. Surveys conducted by geologists have indicated that approximately 12,000,000
units of the ore appear to be in the mine. Callaway incurred $170,000 of development costs associated
with this mine prior to any extraction of minerals. It also determined that the fair value of its obligation
to prepare the land for an alternative use when all of the mineral has been removed was $40,000. During
2010, 2,500,000 units of ore were extracted and 2,200,000 of these units were sold.
Instructions
Compute the following.
(a) The total amount of depletion for 2010.
(b) The amount that is charged as an expense for 2010 for the cost of the minerals sold during 2010.
•7 E11-24 (Revaluation Accounting) Croatia Company purchased land in 2010 for $300,000. The land’s
fair value at the end of 2010 is $320,000; at the end of 2011, $280,000; and at the end of 2012, $305,000. As-
sume that Croatia chooses to use revaluation accounting to account for its land.
Instructions
Prepare the journal entries to record the land using revaluation accounting for 2010–2012.
•7 E11-25 (Revaluation Accounting) Swarkski Company owns land that it purchased at a cost of $400,000
in 2008. The company chooses to use revaluation accounting to account for the land. The land’s value
fluctuates as follows (all amounts as of December 31): 2008, $450,000; 2009, $360,000; 2010, $385,000; 2011,
$410,000; and 2012, $460,000.
Instructions
Complete the following table below.
Value at Accumulated Other Other Comprehensive Recognized in
December 31 Comprehensive Income Income Net Income
2008
2009
2010
2011
2012
•7 E11-26 (Revaluation Accounting) Use the information in E11-25.

Instructions
Prepare the journal entries to record the revaluation of the land in each year.
•7 E11-27 (Revaluation Accounting) Falcetto Company acquired equipment on January 1, 2009, for
€12,000. Falcetto elects to value this class of equipment using revaluation accounting. This equipment is
being depreciated on a straight-line basis over its 6-year useful life. There is no residual value at the end
of the 6-year period. The appraised value of the equipment approximates the carrying amount at Decem-
ber 31, 2009 and 2011. On December 31, 2010, the fair value of the equipment is determined to be €7,000.
Instructions
(a) Prepare the journal entries for 2009 related to the equipment.
(b) Prepare the journal entries for 2010 related to the equipment.
(c) Determine the amount of depreciation expense that Falcetto will record on the equipment in 2011.
PROBLEMS
•5 P11-10 (Impairment) At the end of 2010, Silva Group tests a machine for impairment. The machine is
carried at depreciated historical cost, and its carrying amount is $150,000. It has an estimated remaining
useful life of 10 years. The machine’s recoverable amount is determined on the basis of a value-in-use
calculation, using a pretax discount rate of 15 percent. Management-approved budgets reflect estimated
costs necessary to maintain the level of economic benefit expected to arise from the machine in its cur-
rent condition. The following information related to future cash flows is available at the end of 2010.
Year Future Cash Flow Year Future Cash Flow
2011 $22,165 2016 $24,825
2012 21,450 2017 24,123
2013 20,550 2018 25,533
2014 24,725 2019 24,234
2015 25,325 2020 22,850
Instructions
Part I
(a) Compute the amount of the impairment loss at December 31, 2010.
(b) Prepare the journal entry to record the impairment loss, if any, at December 31, 2010.
Part II
In the years 2011–2013, no event occurs that requires the machine’s recoverable amount to be re-estimated.
At the end of 2014, costs of $25,000 are incurred to enhance the machine’s performance. Revised estimated
cash flows in management’s most recent budget are as follows.
Year Future Cash Flow Year Future Cash Flow
2015 $30,321 2018 $31,950
2016 32,750 2019 33,100
2017 31,721 2020 27,999
(c) Prepare the journal entry for an impairment or reversal of an impairment at December 31, 2014.
USING YOUR JUDGMENT

Instructions
esoifrs Refer to M&S’s financial statements and the accompanying notes to answer the following questions.
ki
/
(a) What descriptions are used by M&S in its statement of financial position to classify its property, plant,
llege
and equipment?
/co
ww
(b) What method or methods of depreciation does M&S use to depreciate its property, plant, and equipment?
m
.w
i l e y. c o
(c) Over what estimated useful lives does M&S depreciate its property, plant, and equipment?
(d) What amounts for depreciation and amortization expense did M&S charge to its income statement
in 2008 and 2007?
(e) What were the capital expenditures for property, plant, and equipment made by M&S in 2008, and 2007?

Matt Holmes recently joined Klax Company as a staff accountant in the controller’s office. Klax Company
provides warehousing services for companies in several European cities.
The location in Koblenz, Germany, has not been performing well due to increased competition and
the loss of several customers that have recently gone out of business. Matt’s department manager suspects
that the plant and equipment may be impaired and wonders whether those assets should be written down.
Given the company’s prior success, this issue has never arisen in the past, and Matt has been asked to
conduct some research on this issue.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). When you have accessed
tions. (Provide paragraph citations.)
(a) What is the authoritative guidance for asset impairments? Briefly discuss the scope of the standard
(i.e., explain the types of transactions to which the standard applies).
(b) Give several examples of events that would cause an asset to be tested for impairment. Does it appear
that Klax should perform an impairment test? Explain.
(c) What is the best evidence of fair value? Describe alternate methods of estimating fair value.
NOTE: since these are KiesoIFRS_Supplement_1st pp
"rough pages" the running heads
and folios will be adjusted in revise pages. Kieso IFRS Supplement · 12-1
CHAPTER 12 INTANGIBLE ASSETS
Internally Created Intangibles

Businesses frequently incur costs on a variety of intangible resources, such as scientific
or technological knowledge, market research, intellectual property, and brand names.
These costs are commonly referred to as research and development (R&D) costs. Intan-
gible assets that might arise from these expenditures include patents, computer soft-
ware, copyrights, and trademarks. For example, Nokia (FIN) incurred R&D costs to
develop its cell phones, resulting in patents related to its technology. In determining
the accounting for these costs, Nokia must determine whether its R&D project is at
a sufficiently advanced stage to be considered economically viable. To perform this
assessment, Nokia evaluates costs incurred during the research phase and the devel-
opment phase.
Illustration 12-1 indicates the two stages of research and development activities,
along with the accounting treatment for costs incurred during these phases.
ILLUSTRATION 12-1
Beginning Ready for Research and
of Project Sale or Use Development Stages
$$$ Expenditures $$$

Research Phase Development Phase
Expense Capitalize
Economic Viability
As indicated, all costs incurred in the research phase are expensed as incurred. Once
a project moves to the development phase, certain development costs are capitalized.
Specifically, development costs are capitalized when certain criteria are met, indicating
that an economically viable intangible asset will result from the R&D project. In essence,
economic viability indicates that the project is far enough along in the process such
that the economic benefits of the R&D project will flow to the company. Therefore, de-
velopment costs incurred from that point forward meet the recognition criteria and
should be recorded as an intangible asset.
In summary, companies expense all research phase costs and some development
phase costs. Certain development costs are capitalized once economic viability criteria
are met. IFRS identifies several specific criteria that must be met before development
costs are capitalized (which we discuss in more detail later in the chapter).2
IMPAIRMENT OF INTANGIBLE ASSETS

An intangible asset is impaired when a company is not able to recover the asset’s carry-
ing amount either through using it or by selling it. As discussed in Chapter 11, to deter-
mine whether a long-lived asset (property, plant, and equipment or intangible assets) is
impaired, a review is made of the asset’s cash-generating ability through use or sale. If
2
IFRS also prohibits recognition of intangible assets such as internally generated brands,
mastheads, and customer lists. These expenditures are similar to other costs to develop the
business as whole; therefore, they do not meet the separately identifiable criterion. [2]
12-2 · Chapter 12 Intangible Assets
the carrying amount is higher than recoverable amount, the difference is an impairment
loss. If the recoverable amount is greater than the carrying amount, no impairment is
recorded. [10] The specific procedures for recording impairments depend on the type of
intangible asset—limited-life or indefinite-life (including goodwill).
Impairment of Limited-Life Intangibles

The rules that apply to impairments of property, plant, and equipment also apply to
limited-life intangibles. At each statement of financial position date, a company should
review limited-life intangibles for impairment. Information indicating that an impair-
ment test should be performed might be internal (e.g., physical damage or adverse
changes in performance) or external (e.g., adverse changes in the business or regula-
tory environment, or technological or competitive developments). If there is an indica-
tion that an intangible asset is impaired, the company performs an impairment test:
compare the carrying value of the intangible asset to the recoverable amount.
Recall that recoverable amount is defined as the higher of fair value less costs to
sell or value-in-use. Fair value less costs to sell means what the asset could be sold for
after deducting costs of disposal. Value-in-use is the present value of cash flows ex-
pected from the future use and eventual sale of the asset at the end of its useful life.
The impairment loss is the carrying amount of the asset less the recoverable amount
of the impaired asset. As with other impairments, the loss is reported in profit or loss.
Companies generally report the loss in the “Other income and expense” section.
To illustrate, assume that Lerch, Inc. has a patent on how to extract oil from shale
rock, with a carrying value of $5,000,000 at the end of 2010. Unfortunately, several re-
cent non-shale-oil discoveries adversely affected the demand for shale-oil technology,
indicating that the patent is impaired. Lerch determines the recoverable amount for the
patent, based on value-in-use (because there is no active market for the patent). Lerch
estimates the patent’s value-in-use at $2,000,000, based on the discounted expected net
future cash flows at its market rate of interest. Illustration 12-7 shows the impairment
loss computation (based on value-in-use).
ILLUSTRATION 12-7
Carrying value of patent $ 5,000,000
Computation of Loss on
Recoverable amount (based on value-in-use) (2,000,000)
Impairment of Patent
Loss on impairment $ 3,000,000
Lerch records this loss as follows:

Loss on Impairment 3,000,000
Patents 3,000,000
After recognizing the impairment, the recoverable amount of $2,000,000 is the new cost
basis of the patent. Lerch should amortize the patent’s recoverable amount (new car-
rying amount) over its remaining useful life or legal life, whichever is shorter.
Reversal of Impairment Loss

What happens if a review in a future year indicates that an intangible asset is no longer
impaired because the recoverable amount of the asset is higher than the carrying
amount? In that case, the impairment loss may be reversed. To illustrate, continuing the
Lerch patent example, assume that the remaining life of the patent is five years with zero
residual value. Recall the carrying value of the patent after impairment is $2,000,000
($5,000,000 ⫺ $3,000,000). Thus, Lerch’s amortization is $400,000 ($2000,000 ⫼ 5) over
the remaining five years of the patent’s life. The amortization expense and related car-
rying amount after the impairment is shown in Illustration 12-8.
ILLUSTRATION 12-8
Year Amortization Expense Carrying Amount
Post-Impairment Carrying
2011 $400,000 $1,600,000 ($2,000,000 ⫺ $400,000) Value of Patent
2012 400,000 1,200,000 ($1,600,000 ⫺ $400,000)
2013 400,000 800,000 ($1,200,000 ⫺ $400,000)
2014 400,000 400,000 ($800,000 ⫺ $400,000)
2015 400,000 0 ($400,000 ⫺ $400,000)
Early in 2012, based on improving conditions in the market for shale-oil technology,
Lerch remeasures the recoverable amount of the patent to be $1,750,000. In this case,
Lerch reverses a portion of the recognized impairment loss with the following entry.
Patents ($1,750,000 ⫺ $1,600,000) 150,000
Recovery of Impairment Loss 150,000
The recovery of the impairment loss is reported in the “Other income and expense”
section of the income statement. The carrying amount of the patent is now $1,750,000
($1,600,000 ⫹ $150,000).15 Assuming the remaining life of the patent is four years, Lerch
records $437,500 ($1,750,000 ⫼ 4) amortization expense in 2012.
Impairment of Indefinite-Life Intangibles Other Than Goodwill

Companies test indefinite-life intangibles (including goodwill) for impairment annu-
ally.16 The impairment test for indefinite-life assets other than goodwill is the same as
that for limited-life intangibles. That is, compare the recoverable amount of the intan-
gible asset with the asset’s carrying value. If the recoverable amount is less than the
carrying amount, the company recognizes an impairment.
To illustrate, assume that Arcon Radio purchased a broadcast license for $2,000,000.
The license is renewable every 10 years if the company provides appropriate service
and does not violate Government Communications Commission (GCC) rules. Arcon
Radio has renewed the license with the GCC twice, at a minimal cost. Because it expects
cash flows to last indefinitely, Arcon reports the license as an indefinite-life intangible
asset. Recently, the GCC decided to auction these licenses to the highest bidder instead
of renewing them. Based on recent auctions of similar licenses, Arcon Radio estimates
the fair value less costs to sell (the recoverable amount) of its license to be $1,500,000.
Arcon therefore reports an impairment loss of $500,000, computed as follows.
ILLUSTRATION 12-9
Carrying value of broadcast license $ 2,000,000
Computation of Loss on
Recoverable amount (based on fair value less costs to sell) (1,500,000)
Impairment of Broadcast
Loss on impairment $ 500,000
License
Impairment of Goodwill
The timing of the impairment test for goodwill is the same as that for other indefinite-
life intangibles. That is, companies must test goodwill at least annually. However,
because goodwill generates cash flows only in combination with other assets, the
15
As with impairments of property, plant, and equipment, the amount of the recovery of the
loss is limited to the carrying value amount that would result if the impairment had not
occurred.
16
Note that the impairment test is performed every year (not only when there is an
impairment indicator). This more stringent impairment model for indefinite-life intangibles
(and goodwill) is used because these assets are not amortized and the recognized amounts
may be subject to significant judgment.
impairment test is conducted based on the cash-generating unit to which the goodwill
is assigned. Recall from our discussion in Chapter 11 that companies identify a cash-
generating unit based on the smallest identifiable group of assets that generate cash
flows independently of the cash flows from other assets. Under IFRS, when a company
records goodwill in a business combination, it must assign the goodwill to the cash-
generating unit that is expected to benefit from the synergies and other benefits arising
from the business combination.
To illustrate, assume that Kohlbuy Corporation has three divisions. It purchased
one division, Pritt Products, four years ago for $2 million. Unfortunately, Pritt experi-
enced operating losses over the last three quarters. Kohlbuy management is now re-
viewing the division (the cash-generating unit), for purposes of its annual impairment
testing. Illustration 12-10 lists the Pritt Division’s net assets, including the associated
goodwill of $900,000 from the purchase.
ILLUSTRATION 12-10
Property, plant, and equipment (net) $ 800,000
Net Assets of Pritt
Goodwill 900,000
Division, Including Inventory 700,000
Goodwill Receivables 300,000
Cash 200,000
Accounts and notes payable (500,000)
Net assets $2,400,000
Kohlbuy determines the recoverable amount for the Pritt Division to be $2,800,000,
based on a value-in-use estimate.17 Because the fair value of the division exceeds the
carrying amount of the net assets, Kohlbuy does not recognize any impairment.
However, if the recoverable amount for the Pritt Division were less than the carry-
ing amount of the net assets, then Kohlbuy must record an impairment. To illustrate,
assume that the recoverable amount for the Pritt Division is $1,900,000 instead of
$2,800,000. Illustration 12-11 computes the amount of the impairment loss to be
recorded.
ILLUSTRATION 12-11
Recoverable amount of Pritt Division $ 1,900,000
Determination of
Net identifiable assets (2,400,000)
Impairment for the
Pritt Division
Kohlbuy makes the following entry to record the impairment.

Goodwill 500,000
Following this entry, the carrying value of the goodwill is $400,000.

If conditions change in subsequent periods, such that the recoverable amount of
the Pritt Division’s assets other than goodwill exceeds their carrying value, Kohlbuy may
reverse an impairment loss on the Pritt Division assets other than goodwill. Goodwill
impairment loss reversals are not permitted. [11]
17
Because there is rarely a market for cash-generating units, estimation of the recoverable
amount for goodwill impairments is usually based on value-in-use estimates.
RESEARCH AND DEVELOPMENT COSTS

Research and development (R&D) costs are not in themselves intangible assets. How-
ever, we present the accounting for R&D costs here because R&D activities frequently
result in the development of patents or copyrights (such as a new product, process,
idea, formula, composition, or literary work) that may provide future value.
As discussed earlier (page xxx), IFRS requires that all research costs be expensed
as incurred. Development costs may or may not be expensed as incurred. Once a project
moves to the development phase, certain development costs are capitalized. Capital-
ization begins when the project is far enough along in the process such that the economic
benefits of the R&D project will flow to the company (the project is economically viable).19
For purposes of homework, assume that all R&D costs are expensed as incurred unless stated
otherwise.
19
All of the following criteria must be met to begin capitalizing development costs into the
carrying value of the related intangible: (1) The project achieves technical feasibility of
completing the intangible asset so that it will be available for use or sale; (2) the company
intends, and has the ability, to complete the intangible asset and use or sell it; (3) the intangible
asset will generate probable future economic benefits (there is a market for the asset or the
output of the asset); (4) the company has adequate technical, financial, and other resources to
complete the development of the intangible asset; and (5) the company can measure reliably
the development costs associated with the intangible asset to be developed. [12]
INTANGIBLE ASSETS
There are some significant differences between IFRS and U.S. GAAP in the accounting for both intangible assets
and impairments. U.S. GAAP related to intangible assets is presented in FASB literature addressing Goodwill and
Other Intangible Assets and Business Combinations. The accounting for research and development, start-up costs,
and advertising costs are prescribed in separate parts of the FASB literature.

• Both U.S. GAAP and IFRS segregate the costs as- To illustrate the effect of differences in the accounting for brands,
sociated with research and development into the two consider the following disclosure by GlaxoSmithKline plc (GBR) in a
components. Costs in the research phase are always recent annual report.
expensed under both IFRS and U.S. GAAP. Under IFRS,
however, costs in the development phase are capital- Notes to the Financial Statements
ized once economic viability is achieved. Intangible assets (in part):
The following table sets out the IFRS to U.S. GAAP adjustments required
• While IFRS permits some capitalization of internally
to the IFRS income statement for amortisation of brands:
generated intangible assets (e.g., brands and develop-
ment costs that meet economic viability criteria), U.S. Income Statement
GAAP requires expensing of all research and develop- (£ million)
ment costs. Amortisation charge under IFRS (139)
• Under U.S. GAAP, impairment loss is measured as Amortisation charge under US GAAP 1,454
the excess of the carrying amount over the asset’s fair IFRS to U.S. GAAP adjustment 1,315
value. Under IFRS, the impairment test is based on the
asset’s carrying amount compared to its recoverable Thus, GlaxoSmithKline would report lower income by £1.3 billion if it
amount (the higher of the asset’s fair value less costs accounted for its brands under U.S. GAAP.
to sell and its value-in-use).
• While IFRS allows reversal of impairment losses when there has been a change in economic conditions or in the expected use of the as-
set, under U.S. GAAP, impairment losses cannot be reversed for assets to be held and used; the impairment loss results in a new cost basis
for the asset. IFRS and U.S. GAAP are similar in the accounting for the impairments of assets held for disposal.
• With issuance of a recent converged statement on business combinations (IFRS 3 and SFAS No. 141—Revised ), IFRS and U.S. GAAP are
very similar for intangibles acquired in a business combination. That is, companies recognize an intangible asset separately from goodwill
if the intangible represents contractual or legal rights or is capable of being separated or divided and sold, transferred, licensed, rented, or
exchanged. In addition, under both U.S. GAAP and IFRS, companies recognize acquired in-process research and development (IPR&D) as a
separate intangible asset if it meets the definition of an intangible asset and its fair value can be measured reliably.
ON TH E HORIZON
The IASB and FASB have identified a project, in a very preliminary stage, which would consider expanded recog-
nition of internally generated intangible assets. As indicated, IFRS permits more recognition of intangibles com-
pared to U.S. GAAP. Thus, it will be challenging to develop converged standards for intangible assets, given the
long-standing prohibition on capitalizing intangible assets and research and development in U.S. GAAP. Learn
more about the timeline for the intangible asset project at the IASB website: http://www.iasb.org/current⫹Projects/
IASB⫹Projects/IASB⫹Work⫹Plan.htm.
12-6
QUESTIONS
15. Braxton Inc. is considering the write-off of a limited-life 18. Simon Company determines that its goodwill is impaired.
intangible because of its lack of profitability. Explain to It finds that its recoverable amount is $360,000 and its
the management of Braxton how to determine whether a recorded goodwill is $400,000. The fair value of its iden-
write-off is permitted. tifiable assets is $1,450,000. What is the amount of good-
16. Last year Zeno Company recorded an impairment on an will impaired?
intangible asset. Recent appraisals indicate that the asset 19. What is the nature of research and development costs?
has increased in value. Should Zeno record this recovery Can development costs be capitalized? Explain.
in value?
17. Explain how losses on impaired intangible assets should
be reported in income.
BRIEF EXERCISES
•7 BE12-6 Kenoly Corporation owns a patent that has a carrying amount of $300,000. Kenoly expects fu-
ture net cash flows from this patent to total $210,000 over its remaining life of 10 years. The recoverable
amount of the patent is $110,000. Prepare Kenoly’s journal entry, if necessary, to record the loss on
impairment.
•7 BE12-7 Use the information in BE12-6. Assume that at the end of the year following the impairment (after
recording amortization expense), the estimated recoverable amount for the patent is $130,000. Prepare
Kenoly’s journal entry, if needed.
•7 BE12-8 Waters Corporation purchased Johnson Company 3 years ago and at that time recorded good-
will of $400,000. The Johnson Division’s net assets, including the goodwill, have a carrying amount of
$800,000. The recoverable amount of the division is estimated to be $1,000,000. Prepare Waters’ journal
entry, if necessary, to record impairment of the goodwill.
•7 BE12-9 Use the information provided in BE12-8. Assume that the recoverable amount of the division is
estimated to be $750,000. Prepare Waters’ journal entry, if necessary, to record impairment of the goodwill.
•9 BE12-11 Treasure Land Corporation incurred the following costs in 2010.
Cost of laboratory research aimed at discovery of new knowledge $120,000

Cost of testing in search for product alternatives 100,000
Cost of engineering activity required to advance the design of a
product to the manufacturing stage 210,000
Prototype testing subsequent to meeting economic viability 75,000
$505,000
Prepare the necessary 2010 journal entry or entries for Treasure Land.
•9 BE12-12 Indicate whether the following items are capitalized or expensed in the current year.
(a) Purchase cost of a patent from a competitor.
(b) Research costs.
(c) Development costs (after achieving economic viability).
(d) Organizational costs.
(e) Costs incurred internally to create goodwill.
EXERCISES
•7 E12-14 (Copyright Impairment) Presented below is information related to copyrights owned by
Botticelli Company at December 31, 2010.
Cost $8,600,000
Carrying amount 4,300,000
Recoverable amount 3,400,000
Assume that Botticelli Company will continue to use this copyright in the future. As of December 31,
2010, the copyright is estimated to have a remaining useful life of 10 years.
Instructions
(a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2010. The
company does not use accumulated amortization accounts.
(b) Prepare the journal entry to record amortization expense for 2011 related to the copyrights.
(c) The recoverable amount of the copyright at December 31, 2011, is $3,500,000. Prepare the journal
entry (if any) necessary to record the increase in fair value.
•6 •7 E12-15 (Goodwill Impairment) Presented below is net asset information related to the Mischa Divi-
sion of Santana, Inc.
MISCHA DIVISION
NET ASSETS
AS OF DECEMBER 31, 2010
(IN MILLIONS)
Property, plant, and equipment (net) $ 2,600
Goodwill 200
Receivables 200
Cash 60
Less: Notes payable (2,700)
Net assets $ 360
The purpose of the Mischa division (cash-generating unit) is to develop a nuclear-powered aircraft. If suc-
cessful, traveling delays associated with refueling could be substantially reduced. Many other benefits
would also occur. To date, management has not had much success and is deciding whether a write-down
at this time is appropriate. Management estimated its future net cash flows from the project to be $400
million. Management has also received an offer to purchase the division for $335 million (fair value less
costs to sell). All identifiable assets’ and liabilities’ book and fair value amounts are the same.
Instructions
(a) Prepare the journal entry (if any) to record the impairment at December 31, 2010.
(b) At December 31, 2011, it is estimated that the division’s recoverable amount increased to $345 mil-
lion. Prepare the journal entry (if any) to record this increase in fair value.
•9 E12-16 (Accounting for R&D Costs) Margaret Avery Company from time to time embarks on a re-
search program when a special project seems to offer possibilities. In 2009 the company expends €325,000
on a research project, but by the end of 2009 it is impossible to determine whether any benefit will be de-
rived from it.
Instructions
(a) What account should be charged for the €325,000, and how should it be shown in the financial
statements?
(b) The project is completed in 2010, and a successful patent is obtained. The R&D costs to complete
the project are €130,000 (€36,000 of these costs were incurred after achieving economic viability).
The administrative and legal expenses incurred in obtaining patent number 472-1001-84 in 2010
total €24,000. The patent has an expected useful life of 5 years. Record these costs in journal entry
form. Also, record patent amortization (full year) in 2010.
(c) In 2011, the company successfully defends the patent in extended litigation at a cost of €47,200,
thereby extending the patent life to December 31, 2018. What is the proper way to account for this
cost? Also, record patent amortization (full year) in 2011.
(d) Additional engineering and consulting costs incurred in 2011 required to advance the design of a
new version of the product to the manufacturing stage total €60,000. These costs enhance the de-
sign of the product considerably, but it is highly uncertain if there will be a market for the new
version of the product. Discuss the proper accounting treatment for this cost.
PROBLEMS
•6 •7 P12-5 (Goodwill, Impairment) On July 31, 2010, Mexico Company paid $3,000,000 to acquire all of
the ordinary shares of Conchita Incorporated, which became a division (cash-generating unit) of Mexico.
Conchita reported the following statement of financial position at the time of the acquisition.
Non-current assets $2,700,000 Equity $2,400,000
Current assets 800,000 Non-current liabilities 500,000
Total assets $3,500,000 Current liabilities 600,000
Total equity and liabilities $3,500,000
It was determined at the date of the purchase that the fair value of the identifiable net assets of
Conchita was $2,750,000. Over the next 6 months of operations, the newly purchased division experienced
operating losses. In addition, it now appears that it will generate substantial losses for the foreseeable future.
At December 31, 2010, Conchita reports the following statement of financial position information.
Current assets $ 450,000
Non-current assets (including goodwill recognized in purchase) 2,400,000
Current liabilities (700,000)
Non-current liabilities (500,000)
Net assets $1,650,000
It is determined that the recoverable amount of the Conchita Division is $1,850,000.
Instructions
(a) Compute the amount of goodwill recognized, if any, on July 31, 2010.
(b) Determine the impairment loss, if any, to be recorded on December 31, 2010.
(c) Assume that the recoverable amount of the Conchita Division is $1,600,000 instead of $1,850,000.
Determine the impairment loss, if any, to be recorded on December 31, 2010.
(d) Prepare the journal entry to record the impairment loss, if any, and indicate where the loss would
be reported in the income statement.

CA12-1 (Development Costs) Dogwood Electronics has been working to develop a patented technol-
ogy for backing up computer hard drives. Dogwood had the following activities related to this project.
March 1 Dogwood incurred €10,000 in legal and processing fees to file and record a patent
for the technology.
April 5 Laboratory and materials fees to identify a working system, €23,000.
May 15 Prototype development and testing, €34,000.
June 1 Dogwood meets the economic viability threshold, upon receiving a firm contract for
the product.
June 30 Final development of product based on earlier tests, €45,000.
Instructions
(a) Prepare a schedule indicating Dogwood R&D costs to be expensed and Dogwood R&D costs to
be capitalized.
(b) Briefly discuss how the accounting for these costs will impact the information presented in
Dogwood’s income statement and statement of financial position. Discuss the effects in current
and future periods.
(c) Identify the criteria for determining “economic viability.”
USING YOUR JUDGMENT

The financial statements of M&S are presented in Appendix 5B or can be accessed at the book’s compan-
ion website, www.wiley.com/college/kiesoifrs.
Instructions
k ies
/
llege
(a) Does M&S report any intangible assets and goodwill in its financial statements and accompanying
notes? Briefly explain.
/co
ww
(b) How much selling and marketing expenses does M&S report in 2007 and 2008? Briefly discuss the
m
.w
i l e y. c o
significance of these expenses to M&S’s operating results.

King Company is contemplating the purchase of a smaller company, which is a distributor of King’s prod-
ucts. Top management of King is convinced that the acquisition will result in significant synergies in its
selling and distribution functions. The financial management group (of which you are a part) has been
asked to prepare some analysis of the effects of the acquisition on the combined company’s financial state-
ments. This is the first acquisition for King, and some of the senior staff insist that based on their recol-
lection of goodwill accounting, any goodwill recorded on the acquisition will result in a “drag” on future
earnings for goodwill amortization. Other younger members on the staff argue that goodwill accounting
has changed. Your supervisor asks you to research this issue.
Instructions
(a) Identify the accounting literature that addresses goodwill and other intangible assets.
(b) Define goodwill.
(c) Is goodwill subject to amortization? Explain.
(d) When goodwill is recognized by a subsidiary, should it be tested for impairment at the consolidated
level or the subsidiary level? Discuss.
NOTE: since these are KiesoIFRS_Supplement_first pp
"rough pages" the running heads
and folios will be adjusted in revise pages. Kieso IFRS Supplement · 13-1
CHAPTER 13 CURRENT LIABILITIES, PROVISIONS, AND CONTINGENCIES
Current Maturities of Long-Term Debt

Delhaize Group (BEL) reports as part of its current liabilities the portion of bonds,
mortgage notes, and other long-term indebtedness that matures within the next fiscal
year. It categorizes this amount as current maturities of long-term debt. Companies,
like Delhaize, exclude long-term debts maturing currently as current liabilities if they
are to be:
1. Retired by assets accumulated for this purpose that properly have not been shown
as current assets,
2. Refinanced, or retired from the proceeds of a new debt issue (discussed in the next
section), or
3. Converted into ordinary shares.
When only a part of a long-term debt is to be paid within the next 12 months, as
in the case of serial bonds that it retires through a series of annual installments, the
company reports the maturing portion of long-term debt as a current liability, and
the remaining portion as a long-term debt.
However, a company should classify as current any liability that is due on demand
(callable by the creditor) or will be due on demand within a year (or operating cycle,
if longer). Liabilities often become callable by the creditor when there is a violation of
the debt agreement. For example, most debt agreements specify a given level of equity
to debt be maintained, or specify that working capital be of a minimum amount. If the
company violates an agreement, it must classify the debt as current because it is a rea-
sonable expectation that existing working capital will be used to satisfy the debt.
To illustrate a breach of a covenant, assume that Gyro Company on November 1,
2011, has a long-term note payable to Sanchez Inc., which is due on April 1, 2013. Un-
fortunately, Gyro breaches a covenant in the note, and the obligation becomes payable
on demand. Gyro is preparing its financial statements at December 31, 2011. Given the
breach in the covenant, Gyro must classify its obligation as current. However, Gyro can
classify the liability as non-current if Sanchez agrees before December 31, 2011, to pro-
vide a period of grace for the breach of the agreement. The period of grace must end
at least 12 months after December 31, 2011, to be reported as a non-current liability. If
the agreement is not finalized by December 31, 2011, Gyro must classify the note payable
as a current liability. [2]
Short-Term Obligations Expected to Be Refinanced

Short-term obligations are debts scheduled to mature within one year after the date of
a company’s statement of financial position or within its normal operating cycle. Some
short-term obligations are expected to be refinanced on a long-term basis. These short-
term obligations will not require the use of working capital during the next year (or
operating cycle).3
At one time, the accounting profession generally supported the exclusion of short-
term obligations from current liabilities if they were “expected to be refinanced.” But
3
Refinancing a short-term obligation on a long-term basis means either replacing it with a long-
term obligation or equity securities, or renewing, extending, or replacing it with short-term
obligations for an uninterrupted period extending beyond one year (or the normal operating
cycle) from the date of the company’s statement of financial position.
13-2 · Chapter 13 Current Liabilities, Provisions, and Contingencies
the profession provided no specific guidelines, so companies determined whether a

short-term obligation was “expected to be refinanced” based solely on management’s
intent to refinance on a long-term basis. Classification was not clear-cut. For example,
a company might obtain a five-year bank loan but handle the actual financing with
90-day notes, which it must keep turning over (renewing). In this case, is the loan a
long-term debt or a current liability? It depends on refinancing criteria.
Refinancing Criteria
To resolve these classification problems, the IASB has developed criteria for determin-
ing the circumstances under which short-term obligations may be properly excluded
from current liabilities. Specifically, a company can exclude a short-term obligation from
current liabilities if both of the following conditions are met:
1. It must intend to refinance the obligation on a long-term basis; and

2. It must have an unconditional right to defer settlement of the liability for at least
12 months after the reporting date.
Intention to refinance on a long-term basis means that the company intends to

refinance the short-term obligation so that it will not require the use of working capital
during the ensuing fiscal year (or operating cycle, if longer). Entering into a financing
arrangement that clearly permits the company to refinance the debt on a long-term basis
on terms that are readily determinable before the next reporting date is one way to satisfy
the second condition. In addition, the fact that a company has the right to refinance at any
time and intends to do so permits the company to classify the liability as non-current.
To illustrate, assume that Haddad Company provides the following information
related to its note payable.
• Issued note payable of €3,000,000 on November 30, 2011, due on February 28, 2012.
Haddad’s reporting date is December 31, 2011.
• Haddad intends to extend the maturity date of the loan (refinance the loan) to June
30, 2013.
• Its December 31, 2011, financial statements are authorized for issue on March 15, 2012.
• The necessary paperwork to refinance the loan is completed on January 15, 2012.
Haddad did not have an unconditional right to defer settlement of the obligation
at December 31, 2011.
A graphical representation of the refinancing events is provided in Illustration 13-1.
ILLUSTRATION 13-1
Liability of €3,000,000 Refinancing Liability due Statements authorized
Refinancing Events
How to classify? completed for payment for issuance
December 31, 2011 January 15, 2012 February 28, 2012 March 15, 2012
In this case, Haddad must classify its note payable as a current liability because
the refinancing was not completed by December 31, 2011, the financial reporting date.
Only if the refinancing was completed before December 31, 2011, can Haddad classify
the note obligation as non-current. The rationale: Refinancing a liability after the state-
ment of financial position date does not affect the liquidity or solvency at the date of
the statement of financial position, the reporting of which should reflect contractual
agreements in force on that date. [3]
What happens if Haddad has both the intention and the discretion (within the loan
agreement) to refinance or roll over its €3,000,000 note payable to June 30, 2013? In this
case, Haddad should classify the note payable as non-current because it has the abil-
ity to defer the payment to June 30, 2013.
Dividends Payable
A cash dividend payable is an amount owed by a corporation to its shareholders as a
result of board of directors’ authorization (or in other cases, vote of shareholders). At
the date of declaration, the corporation assumes a liability that places the shareholders
in the position of creditors in the amount of dividends declared. Because companies
always pay cash dividends within one year of declaration (generally within three
months), they classify them as current liabilities.
On the other hand, companies do not recognize accumulated but undeclared divi-
dends on cumulative preference shares as a liability. Why? Because preference dividends
in arrears are not an obligation until the board of directors authorizes the payment.
Nevertheless, companies should disclose the amount of cumulative dividends unpaid
in a note, or show it parenthetically in the share capital section.
Dividends payable in the form of additional shares are not recognized as a liability.
Such share dividends (as we discuss in Chapter 15) do not require future outlays of
assets or services. Companies generally report such undistributed share dividends in
the equity section because they represent retained earnings in the process of transfer
to share capital.
SECTION 2 • PROVISIONS
A provision is a liability of uncertain timing or amount (sometimes referred to as an

estimated liability). Provisions are very common and may be reported either as current
or non-current depending on the date of expected payment. [5] Common types of pro-
visions are obligations related to litigation, warrantees or product guarantees, business
restructurings, and environmental damage.
For example, Vodafone (GBR) reported £906 million related to provisions for the
costs of cleaning up contaminated sites and for legal and regulatory disputes. Nokia
(FIN) reported €3,592 million for warranties, for intellectual property infringement
disputes, and for restructuring costs. Nestlé Group (CHE) reported CHF3,663 million,
primarily for restructuring and litigation costs.
The difference between a provision and other liabilities (such as accounts or notes
payable, salaries payable, and dividends payable) is that a provision has greater un-
certainty about the timing or amount of the future expenditure required to settle the
obligation. For example, when Siemens AG (DEU) reports an accounts payable, there
is an invoice or formal agreement as to the existence and the amount of the liability.
Similarly, when Siemens accrues interest payable, the timing and the amount are known.7
RECOGNITION OF A PROVISION
Companies accrue an expense and related liability for a provision only if the follow-
ing three conditions are met:
1. A company has a present obligation (legal or constructive) as a result of a past event;

2. It is probable that an outflow of resources embodying economic benefits will be re-
quired to settle the obligation; and
3. A reliable estimate can be made of the amount of the obligation.
If these three conditions are not met, no provision is recognized. [6]
7
The distinction is important because provisions are subject to disclosure requirements that
do not apply to other types of payables.
In applying the first condition, the past event (often referred to as the past obliga-
tory event) must have occurred. In applying the second condition, the term probable is
defined as “more likely than not to occur.” This phrase is interpreted to mean the prob-
ability of occurrence is greater than 50 percent. If the probability is 50 percent or less,
the provision is not recognized.
Recognition Examples
We provide three examples to illustrate when a provision should be recognized. It is
assumed for each of these examples that a reliable estimate of the amount of the
obligation can be determined. Illustration 13-4 presents the first example.
ILLUSTRATION 13-4
Provision Example 1 Warranty
Facts: Santos Company gives warranties to its customers related to the sale of its electrical
products. The warranties are for three years from the date of sale. Based on past experience,
it is probable (more likely than not) that there will be some claims under the warranties.
Question: Should Santos recognize at the statement of financial position date a provision for the
warranty costs yet to be settled?
Analysis: (1) The warranty is a present obligation as a result of a past obligating event—the past
obligating event is the sale of the product with a warranty, which gives rise to a legal obligation.
(2) The warranty results in the outflow of resources embodying benefits in settlement—it is probable
that there will be some claims related to these warranties.
Conclusion: Santos Company should recognize the provision.
When Santos sold its electrical products to customers, it undoubtedly signed a con-
tract to warranty the product. In other words, Santos had a legal obligation to honor
these warranties. A legal obligation generally results from a contract or legislation.
A constructive obligation is an obligation that derives from a company’s actions
where:
1. By an established pattern of past practice, published policies, or a sufficiently specific

current statement, the company has indicated to other parties that it will accept certain
responsibilities; and
2. As a result, the company has created a valid expectation on the part of those other
parties that it will discharge those responsibilities.
Example 2 presented in Illustration 13-5 demonstrates how a constructive obligation is

reported.
ILLUSTRATION 13-5
Provision Example 2 Refunds
Facts: Christian Dior (FRA) has a policy of refunding purchases to dissatisfied customers, even
though it is under no legal obligation to do so. Its policy of making refunds is generally known.
Question: Should Christian Dior record a provision for these refunds?
Analysis: (1) The refunds are a present obligation as a result of a past obligating event—the sale
of the product. This sale gives rise to a constructive obligation because the conduct of the store
has created a valid expectation on the part of its customers that the store will refund purchases.
(2) The refunds result in the outflow of resources in settlement—it is probable that a proportion of
goods are returned for refund.
Conclusion: A provision is recognized for the best estimate of the costs of refunds.
Example 3, the case of Morrison Grocers (GBR), in Illustration 13-6 presents a

situation in which the recognition of the provision depends on the probability of future
payment.
ILLUSTRATION 13-6
Lawsuit Provision Example 3
Facts: On November 30, 2011, assume that an employee filed a £1,000,000 lawsuit against
Morrison Grocers for damages suffered when the employee slipped and suffered a serious injury
at one of the company’s facilities. Morrison’s lawyers believe that Morrison will not lose the lawsuit,
putting the probability at less than 50 percent.
Question: Should Morrison recognize a provision for legal claims at December 31, 2011?
Analysis: Although a past obligating event has occurred (the injury leading to the filing of the
lawsuit), it is not probable (more likely than not) that Morrison will have to pay any damages.
Conclusion: Morrison does not need to record a provision. If, on the other hand, Morrison’s
lawyer determined that it is probable that the company will lose the lawsuit, then Morrison
should recognize a provision at December 31, 2011.
MEASUREMENT OF PROVISIONS
How does a company like Toyota (JPN), for example, determine the amount to report
for its warranty cost on its automobiles? How does a company like Carrefour (FRA)
determine its liability for customer refunds? Or, how does Novartis (CHE) determine
the amount to report for a lawsuit that it probably will lose? And, how does a company
like Total S.A. (FRA) determine the amount to report as a provision for its remediation
costs related to environmental clean-up?
IFRS provides an answer: The amount recognized should be the best estimate of
the expenditure required to settle the present obligation. Best estimate represents the
amount that a company would pay to settle the obligation at the statement of financial
position date. [7]
Measurement Examples
In determining the best estimate, the management of a company must use judgment,
based on past or similar transactions, discussions with experts, and any other pertinent
information. Here is how this judgment might be used in three different types of situ-
ations to arrive at best estimate:
• Toyota warranties. Toyota sells many cars and must make an estimate of the num-
ber of warranty repairs and related costs it will incur. Because it is dealing with a large
population of automobiles, it is often best to weight all possible outcomes by associ-
ated probabilities. For example, it might determine that 80 percent of its cars will not
have any warranty cost, 12 percent will have substantial costs, and 8 percent will have
a much smaller cost. In this case, by weighting all the possible outcomes by their
associated probabilities, Toyota arrives at an expected value for its warranty liability.
• Carrefour refunds. Carrefour sells many items at varying selling prices. Refunds to
customers for products sold may be viewed as a continuous range of refunds, with
each point in the range having the same probability of occurrence. In this case, the
midpoint in the range can be used as the basis for measuring the amount of the
refunds.
• Novartis lawsuit. Large companies like Novartis are involved in numerous litiga-
tion issues related to their products. Where a single obligation such as a lawsuit is
being measured, the most likely outcome of the lawsuit may be the best estimate
of the liability.
In each of these situations, the measurement of the liability should consider the time
value of money, if material. In addition, future events that may have an impact on the
measurement of the costs should be considered. For example, a company like Total
S.A., which may have high remediation costs related to environmental clean-up, may
consider future technological innovations that reduce future costs if reasonably certain
of happening.
COMMON TYPES OF PROVISIONS

Here are some common areas for which provisions may be recognized in the financial
statements:
1. Lawsuits 4. Environmental
2. Warranties 5. Onerous contracts
3. Premiums 6. Restructuring
Although companies generally report only one current and one non-current amount
for provisions in the statement of financial position, IFRS also requires extensive dis-
closure related to provisions in the notes to the financial statements. As discussed in
the opening story, companies do not record or report in the notes to the financial state-
ments general risk contingencies inherent in business operations (e.g., the possibility
of war, strike, uninsurable catastrophes, or a business recession). [8]
Litigation Provisions
Companies must consider the following factors, among others, in determining whether
to record a liability with respect to pending or threatened litigation and actual or pos-
sible claims and assessments.
1. The time period in which the underlying cause of action occurred.

2. The probability of an unfavorable outcome.
3. The ability to make a reasonable estimate of the amount of loss.
To report a loss and a liability in the financial statements, the cause for litigation
must have occurred on or before the date of the financial statements. It does not
matter that the company became aware of the existence or possibility of the lawsuit
or claims after the date of the financial statements but before issuing them. To eval-
uate the probability of an unfavorable outcome, a company considers the following:
the nature of the litigation, the progress of the case, the opinion of legal counsel, its
own and others’ experience in similar cases, and any management response to the
lawsuit.
With respect to unfiled suits and unasserted claims and assessments, a company
must determine (1) the degree of probability that a suit may be filed or a claim or
assessment may be asserted, and (2) the probability of an unfavorable outcome. For
example, assume that a regulatory body investigates the Nawtee Company for restraint
of trade, and institutes enforcement proceedings. Private claims of triple damages for
redress often follow such proceedings. In this case, Nawtee must determine the prob-
ability of the claims being asserted and the probability of triple damages being awarded.
If both are probable, if the loss is reasonably estimable, and if the cause for action is
dated on or before the date of the financial statements, then Nawtee should accrue the
liability.
Companies can seldom predict the outcome of pending litigation, however, with
any assurance. And, even if evidence available at the statement of financial position
date does not favor the company, it is hardly reasonable to expect the company to
publish in its financial statements a dollar estimate of the probable negative outcome.
Such specific disclosures might weaken the company’s position in the dispute and
encourage the plaintiff to intensify its efforts. As a result, many companies provide a
general provision for the costs expected to be incurred without relating the disclosure
to any specific lawsuit or set of lawsuits. Illustration 13-7 provides the disclosure by
Nestlé Group (CHE) related to its litigation claims.
ILLUSTRATION 13-7
Nestlé Group Litigation Disclosure
Notes to the financial statements (partial)

Litigation
Litigation provisions have been set up to cover tax, legal and administrative proceedings
that arise in the ordinary course of business. These provisions concern numerous cases
whose detailed disclosure could seriously prejudice the interests of the Group. Reversal
of such provisions refer to cases resolved in favor of the Group. The timing of cash
outflows of litigation provisions is uncertain as it depends upon the outcome of the
proceedings. These provisions are therefore not discounted because their present value
would not represent meaningful information. Group Management does not believe it is
possible to make assumptions on the evolution of the cases beyond the balance sheet date.
Warranty Provisions
A warranty (product guarantee) is a promise made by a seller to a buyer to make good
on a deficiency of quantity, quality, or performance in a product. Manufacturers com-
monly use it as a sales promotion technique. Automakers, for instance, “hyped” their
sales by extending their new-car warranty to seven years or 100,000 miles. For a spec-
ified period of time following the date of sale to the consumer, the manufacturer may
promise to bear all or part of the cost of replacing defective parts, to perform any nec-
essary repairs or servicing without charge, to refund the purchase price, or even to
“double your money back.”
Warranties and guarantees entail future costs. These additional costs, sometimes
called “after costs” or “post-sale costs,” frequently are significant. Although the future
cost is indefinite as to amount, due date, and even customer, a liability is probable in
most cases. Companies should recognize this liability in the accounts if they can rea-
sonably estimate it. The estimated amount of the liability includes all the costs that the
company will incur after sale and delivery and that are incident to the correction of
defects or deficiencies required under the warranty provisions. Thus, warranty costs
are a classic example of a provision.
Companies use two basic methods of accounting for warranty costs: (1) the cash-
basis method and (2) the accrual method.
Cash Basis
Under the cash-basis method, companies expense warranty costs as incurred. In other
words, a seller or manufacturer charges warranty costs to the period in which it
complies with the warranty. The company does not record a liability for future costs
arising from warranties, nor does it charge the period of sale. Companies frequently
justify use of this method, the only one recognized for certain tax jurisdictions, on the
basis of expediency when warranty costs are immaterial or when the warranty period
is relatively short. A company must use the cash-basis method when it does not accrue
a warranty liability in the year of sale either because:
1. It is not probable that a liability has been incurred, or

2. It cannot reasonably estimate the amount of the liability.
Accrual Basis
If it is probable that customers will make warranty claims and a company can reason-
ably estimate the costs involved, the company must use the accrual method. Under the
accrual method, companies charge warranty costs to operating expense in the year of
sale. The accrual method is the generally accepted method. Companies should use it
whenever the warranty is an integral and inseparable part of the sale and is viewed as
a provision. We refer to this approach as the expense warranty approach.
Example of Expense Warranty Approach. To illustrate the expense warranty method,

assume that Denson Machinery Company begins production on a new machine in July
2011 and sells 100 units at $5,000 each by its year-end, December 31, 2011. Each machine
is under warranty for one year. Denson estimates, based on past experience with a sim-
ilar machine, that the warranty cost will average $200 per unit. Further, as a result of
parts replacements and services rendered in compliance with machinery warranties, it
incurs $4,000 in warranty costs in 2011 and $16,000 in 2012.
1. Sale of 100 machines at $5,000 each, July through December 2011:

Cash or Accounts Receivable 500,000
Sales 500,000
2. Recognition of warranty expense, July through December 2011:

Warranty Expense 4,000
Cash, Inventory, Accrued Payroll
(Warranty costs incurred) 4,000
Warranty Expense 16,000
Warranty Liability
(To accrue estimated warranty costs) 16,000
The December 31, 2011, statement of financial position reports “Warranty liability”
as a current liability of $16,000, and the income statement for 2011 reports “Warranty
expense” of $20,000.
3. Recognition of warranty costs incurred in 2012 (on 2011 machinery sales):
Warranty Liability 16,000
Cash, Inventory, Accrued Payroll
(Warranty costs incurred) 16,000
If Denson Machinery applies the cash-basis method, it reports $4,000 as war-

ranty expense in 2011 and $16,000 as warranty expense in 2012. It records all of the
sale price as revenue in 2011. In many instances, application of the cash-basis method
fails to record the warranty costs relating to the products sold during a given period
with the revenues derived from such products. As such, it violates the expense
recognition principle. Where ongoing warranty policies exist year after year, the
differences between the cash and the expense warranty bases probably would not
be significant.
Sales Warranty Approach. A warranty is sometimes sold separately from the prod-
uct. For example, when you purchase a television set or DVD player, you are entitled
to the manufacturer’s warranty. You also will undoubtedly be offered an extended
warranty on the product at an additional cost.8
8
A company separately prices a contract if the customer has the option to purchase the
services provided under the contract for an expressly stated amount separate from the price
of the product. An extended warranty or product maintenance contract usually meets these
conditions.
In this case, the seller should recognize the sale of the television or DVD player
with the manufacturer’s warranty separately from the sale of the extended warranty.
This approach is referred to as the sales warranty approach. Companies defer revenue
on the sale of the extended warranty and generally recognize it on a straight-line basis
over the life of the contract. The seller of the warranty defers revenue because it has
an obligation to perform services over the life of the contract. The seller should only
defer and amortize costs that vary with and are directly related to the sale of the con-
tracts (mainly commissions). It expenses those costs, such as employees’ salaries, ad-
vertising, and general and administrative expenses, that it would have incurred even
if it did not sell a contract.
To illustrate, assume you purchase a new automobile from Hanlin Auto for $20,000.
In addition to the regular warranty on the auto (the manufacturer will pay for all re-
pairs for the first 36,000 miles or three years, whichever comes first), you purchase at
a cost of $600 an extended warranty that protects you for an additional three years or
36,000 miles. Hanlin Auto records the sale of the automobile (with the regular war-
ranty) and the sale of the extended warranty on January 2, 2011, as follows.
Cash 20,600
Sales 20,000
Unearned Warranty Revenue 600
It recognizes revenue at the end of the fourth year (using straight-line amortization) as
follows.
Unearned Warranty Revenue 200
Warranty Revenue 200
Because the extended warranty contract only starts after the regular warranty expires,
Hanlin Auto defers revenue recognition until the fourth year. If it incurs the costs of
performing services under the extended warranty contract on other than a straight-line
basis (as historical evidence might indicate), Hanlin Auto should recognize revenue
over the contract period in proportion to the costs it expected to incur in performing
services under the contract.
Premiums and Coupons

Numerous companies offer premiums (either on a limited or continuing basis) to cus-
tomers in return for boxtops, certificates, coupons, labels, or wrappers. The premium
may be silverware, dishes, a small appliance, a toy, or free transportation. Also, printed
coupons that can be redeemed for a cash discount on items purchased are extremely
popular. Another popular marketing innovation is the cash rebate, which the buyer
can obtain by returning the store receipt, a rebate coupon, and Universal Product Code
(UPC label) or “bar code” to the manufacturer.9
Companies offer premiums, coupon offers, and rebates to stimulate sales. Thus,
companies should charge the costs of premiums and coupons to expense in the pe-
riod of the sale that benefits from the plan. The period that benefits is not necessarily
the period in which the company offered the premium. At the end of the accounting
period, many premium offers may be outstanding and must be redeemed when
9
In the United States, nearly 40 percent of cash rebates never get redeemed, and some
customers complain about how difficult the rebate process is. See B. Grow, “The Great
Rebate Runaround,” BusinessWeek (December 5, 2005), pp. xx–xx. Approximately 4 percent
of coupons are redeemed. Redeemed coupons eventually make their way to the corporate
headquarters of the stores that accept them. From there, they are shipped to clearinghouses
operated by A. C. Nielsen Company (USA) (of TV-rating fame) that count them and report
back to the manufacturers who, in turn, reimburse the stores.
presented in subsequent periods. In order to reflect the existing current liability and to
match costs with revenues, the company estimates the number of outstanding premium
offers that customers will present for redemption. The company then charges the cost
of premium offers to Premium Expense. It credits the outstanding obligations to an ac-
count titled Premium Liability.
The following example illustrates the accounting treatment for a premium offer.
Fluffy Cakemix Company offered its customers a large non-breakable mixing bowl in
exchange for 25 cents and 10 boxtops. The mixing bowl costs Fluffy Cakemix Company
75 cents, and the company estimates that customers will redeem 60 percent of the box-
tops. The premium offer began in June 2011 and resulted in the transactions journal-
ized below. Fluffy Cakemix Company records purchase of 20,000 mixing bowls at
75 cents as follows.
Inventory of Premium Mixing Bowls 15,000

Cash 15,000
The entry to record sales of 300,000 boxes of cake mix at 80 cents would be:
Cash 240,000
Sales 240,000
Fluffy records the actual redemption of 60,000 boxtops, the receipt of 25 cents per
10 boxtops, and the delivery of the mixing bowls as follows.
Cash [(60,000 10) $0.25] 1,500

Premium Expense 3,000
Inventory of Premium Mixing Bowls 4,500
Computation: (60,000 10) $0.75 $4,500
Finally, Fluffy makes an end-of-period adjusting entry for estimated liability for
outstanding premium offers (boxtops) as follows.
Premium Expense 6,000

Premium Liability 6,000
Computation:
Total boxtops sold in 2011 300,000
Total estimated redemptions (60%) 180,000
Boxtops redeemed in 2011 (60,000)
Estimated future redemptions 120,000
Cost of estimated claims outstanding
(120,000 10) ($0.75 $0.25) $6,000
The December 31, 2011, statement of financial position of Fluffy Cakemix Company
reports an “Inventory of premium mixing bowls” of $10,500 as a current asset and
“Premium liability” of $6,000 as a current liability. The 2011 income statement reports
a $9,000 “Premium expense” among the selling expenses.
Environmental Provisions
Estimates to clean up existing toxic waste sites are substantial. In addition, cost esti-
mates of cleaning up our air and preventing future deterioration of the environment
run even higher.
In many industries, the construction and operation of long-lived assets involves
obligations for the retirement of those assets. When a mining company opens up a strip
mine, it may also commit to restore the land once it completes mining. Similarly, when
an oil company erects an offshore drilling platform, it may be legally obligated to dis-
mantle and remove the platform at the end of its useful life.
Accounting Recognition of Environmental Liabilities

As with other provisions, a company must recognize an environmental liability when
it has an existing legal obligation associated with the retirement of a long-lived asset
and when it can reasonably estimate the amount of the liability.
Obligating Events. Examples of existing legal obligations, which require recognition

of a liability, include, but are not limited to:
• Decommissioning nuclear facilities.
• Dismantling, restoring, and reclamation of oil and gas properties.
• Certain closure, reclamation, and removal costs of mining facilities.
• Closure and postclosure costs of landfills.
In order to capture the benefits of these long-lived assets, the company is gener-
ally legally obligated for the costs associated with retirement of the asset, whether
the company hires another party to perform the retirement activities or performs the
activities with its own workforce and equipment. Environmental liabilities give rise
to various recognition patterns. For example, the obligation may arise at the outset of
the asset’s use (e.g., erection of an oil-rig), or it may build over time (e.g., a landfill that
expands over time).
Measurement. A company initially measures an environmental liability at the best es-

timate of its future costs. The estimate should reflect the amount a company would pay
in an active market to settle its obligation (essentially fair value). While active markets
do not exist for many environmental liabilities, companies should estimate fair value
based on the best information available. Such information could include market prices
of similar liabilities, if available. Alternatively, companies may use present value tech-
niques to estimate fair value.
Recognition and Allocation. To record an environmental liability in the financial state-

ments, a company includes the cost associated with the environmental liability in the
carrying amount of the related long-lived asset, and records a liability for the same
amount. It records the environmental costs as part of the related asset because these
costs are tied to operating the asset and are necessary to prepare the asset for its in-
tended use. Therefore, the specific asset (e.g., mine, drilling platform, nuclear power
plant) should be increased because the future economic benefit comes from the use of
this productive asset. Companies should not record the capitalized environmental costs
in a separate account because there is no future economic benefit that can be associ-
ated with these costs alone.
In subsequent periods, companies allocate the cost of the asset to expense over the
period of the related asset’s useful life. Companies may use the straight-line method
for this allocation, as well as other systematic and rational allocations.
Example of Accounting Provisions. To illustrate the accounting for these types of

environmental liabilities, assume that on January 1, 2011, Wildcat Oil Company erected
an oil platform in the Gulf of Mexico. Wildcat is legally required to dismantle and
remove the platform at the end of its useful life, estimated to be five years. Wildcat
estimates that dismantling and removal will cost $1,000,000. Based on a 10 percent dis-
count rate, the fair value of the environmental liability is estimated to be $620,920
($1,000,000 .62092). Wildcat records this liability as follows.
January 1, 2011
Drilling Platform 620,920
Environmental Liability 620,920
During the life of the asset, Wildcat allocates the asset cost to expense. Using the
straight-line method, Wildcat makes the following entries to record this expense.
December 31, 2011, 2012, 2013, 2014, 2015

Depreciation Expense ($620,920 5) 124,184
Accumulated Depreciation 124,184
In addition, Wildcat must accrue interest expense each period. Wildcat records in-
terest expense and the related increase in the environmental liability on December 31,
2011, as follows.
December 31, 2011
Interest Expense ($620,920 10%) 62,092
Environmental Liability 62,092
On January 10, 2016, Wildcat contracts with Rig Reclaimers, Inc. to dismantle the
platform at a contract price of $995,000. Wildcat makes the following journal entry to
record settlement of the liability.
January 10, 2016
Environmental Liability 1,000,000
Gain on Settlement of Environmental Liability 5,000
Cash 995,000
As indicated, as a result of the discounting, Wildcat incurs two types of costs:

(1) an operating cost related to depreciation expense, and (2) a finance cost related to
interest expense. The recording of the interest expense is often referred to as “unwind-
ing the discount,” which refers to the fact that the obligation was discounted as a result
of present value computations. This discount can be substantial. For example, when
BP plc (GBR) changed its policy and started discounting its environmental provision,
it decreased its initial obligation by £350 million.
A company like Wildcat can consider future events when considering the measure-
ment of the liability. For example, a technological development that will make restora-
tion less expensive and is virtually certain to happen should be considered. Generally,
future events are limited to those that are virtually certain to happen, as well as tech-
nology advances or proposed legislation that will impact future costs.
Onerous Contract Provisions

Sometimes, companies have what are referred to as onerous contracts. These contracts
are ones in which “the unavoidable costs of meeting the obligations exceed the eco-
nomic benefits expected to be received.” [9] An example of an onerous contract is a
loss recognized on unfavorable non-cancelable purchase commitments related to in-
ventory items (discussed in Chapter 9).
To illustrate another situation, assume that Sumart Sports operates profitably in a
factory that it has leased and on which it pays monthly rentals. Sumart decides to re-
locate its operations to another facility. However, the lease on the old facility continues
for the next three years. Unfortunately, Sumart cannot cancel the lease nor will it be
able to sublet the factory to another party. The expected costs to satisfy this onerous
contract are €200,000. In this case, Sumart makes the following entry.
Loss on Lease Contract 200,000
Lease Contract Liability 200,000
The expected costs should reflect the least net cost of exiting from the contract, which
is the lower of (1) the cost of fulfilling the contract, or (2) the compensation or penal-
ties arising from failure to fulfill the contract.
To illustrate, assume the same facts as above for the Sumart example and the ex-
pected costs to fulfill the contract are €200,000. However, Sumart can cancel the lease by
paying a penalty of €175,000. In this case, Sumart should record the liability at €175,000.
Illustration 13-8 (on page xxx) indicates how Nestlé Group (CHE) discloses oner-
ous contracts.
ILLUSTRATION 13-8
Nestlé Group Onerous Contract
Disclosure
Notes to the financial statements (partial)
Other Provisions
Other provisions are mainly constituted by onerous contracts, liabilities for partial refund
of selling prices of divested businesses and various damage claims having occurred during
the period but not covered by insurance companies. Onerous contracts result from
unfavorable leases or supply agreements above market prices in which the unavoidable
costs of meeting the obligations under the contracts exceed the economic benefits
expected to be received or for which no benefits are expected to be received. These
agreements have been entered into as a result of selling and closing inefficient facilities.
Restructuring Provisions
The accounting for restructuring provisions is controversial. Once companies make a
decision to restructure part of their operations, they have the temptation to charge as
many costs as possible to this provision. The rationale: Many believe analysts often
dismiss these costs as not part of continuing operations and therefore somewhat irrel-
evant in assessing the overall performance of the company. Burying as many costs as
possible in a restructuring provision therefore permits companies to provide a more
optimistic presentation of current operating results.
On the other hand, companies are continually in a state of flux, and what consti-
tutes a restructuring is often difficult to assess. One thing is certain—companies should
not be permitted to provide for future operating losses in the current period when ac-
counting for restructuring costs. Nor should they be permitted to bury operating costs
in the restructuring cost classification. [10]
As a consequence, IFRS is very restrictive regarding when a restructuring provision
can be recorded and what types of costs may be included in a restructuring provision.
Restructurings are defined as a “program that is planned and controlled by management
and materially changes either (1) the scope of a business undertaken by the company;
or (2) the manner in which that business is conducted.” Examples of restructurings are
the sale of a line of business, changes in management structures such as eliminating a
layer of management, or closure of operations in a country.
For a company to record restructuring costs and a related liability, it must meet the
general requirements for recording provisions discussed earlier. In addition, to assure
that the restructuring is valid, companies are required to have a detailed formal plan
for the restructuring and to have raised a valid expectation to those affected by imple-
mentation or announcement of the plan.
Only direct incremental costs associated with the restructuring may be included in
the restructuring provision. At the same time, IFRS provides specific guidance related to
certain costs and losses that should be excluded from the restructuring provision. Illustra-
tion 13-9 provides a summary of costs that may and may not be included in a restructur-
ing provision.
ILLUSTRATION 13-9
Costs Included (direct, incremental) Costs Excluded
Costs Included/Excluded
• Employee termination costs related directly • Investment in new systems. from Restructuring
to the restructuring. • Lower utilization of facilities. Provision
• Contract termination costs, such as lease • Costs of training or relocating staff.
termination penalties. • Costs of moving assets or operations.
• Onerous contract provisions. • Administration or marketing costs.
• Allocations of corporate overhead.
• Expected future operating costs or expected
operating losses unless they relate to an
onerous contract.
In general, the costs-excluded list is comprised of expenditures that relate to the

future operations of the business and are not liabilities associated with the restructur-
ing as of the end of the reporting period. Therefore, such expenditures are recognized
on the same basis as if they arose independently of a restructuring. [11]
The case of Rodea Group’s solar panel division, presented in Illustration 13-10, pro-
vides an example of a restructuring.
ILLUSTRATION 13-10
Restructuring Example Closure of Division
Facts: On December 12, 2011, the board of Rodea decided to close down a division making solar
panels. On December 20, 2011, a detailed plan for closing down the division was agreed to by the
board; letters were sent to customers warning them to seek an alternative source of supply and
termination notices were sent to the staff of the division. Rodea estimates that it is probable that it
will have €500,000 in restructuring costs.
Question: Should Rodea report a restructuring liability if it has costs related to the restructuring?
Analysis: (1) The past obligating event for Rodea is the communication of the decision to the
customers and employees, which gives rise to a constructive obligation on December 31, 2011,
because it creates a valid expectation that the division will be closed. (2) An outflow of resources
in settlement is probable and reliably estimated.
Conclusion: A provision is recognized at December 31, 2011, for the best estimate of
closing the division, in this case, €500,000.
Self-Insurance
As discussed earlier, liabilities are not recorded for general risks (e.g., losses that might
arise due to poor expected economic conditions). Similarly, companies do not record li-
abilities for more specific future risks such as allowances for repairs. The reason: These
items do not meet the definition of a liability because they do not arise from a past
transaction but instead relate to future events.
Some companies take out insurance policies against the potential losses from fire,
flood, storm, and accident. Other companies do not. The reasons: Some risks are not
insurable, the insurance rates are prohibitive (e.g., earthquakes and riots), or they make
a business decision to self-insure. Self-insurance is another item that is not recognized
as a provision.
Despite its name, self-insurance is not insurance but risk assumption. Any com-
pany that assumes its own risks puts itself in the position of incurring expenses or
losses as they occur. There is little theoretical justification for the establishment of a
liability based on a hypothetical charge to insurance expense. This is “as if” accounting.
The conditions for accrual stated in IFRS are not satisfied prior to the occurrence of the
event. Until that time, there is no diminution in the value of the property. And unlike
an insurance company, which has contractual obligations to reimburse policyholders
for losses, a company can have no such obligation to itself and, hence, no liability either
before or after the occurrence of damage.10
Exposure to risks of loss resulting from uninsured past injury to others, however,
is an existing condition involving uncertainty about the amount and timing of losses
that may develop. A company with a fleet of vehicles for example, would have to ac-
crue uninsured losses resulting from injury to others or damage to the property of oth-
ers that took place prior to the date of the financial statements (if the experience of the
10
A commentary in the financial magazine Forbes (June 15, 1974), p. xx, stated its position
on this matter quite succinctly: “The simple and unquestionable fact of life is this: Business
is cyclical and full of unexpected surprises. Is it the role of accounting to disguise this
unpleasant fact and create a fairyland of smoothly rising earnings? Or, should accounting
reflect reality, warts and all—floods, expropriations and all manner of rude shocks?”
company or other information enables it to make a reasonable estimate of the liability).11

However, it should not establish a liability for expected future injury to others or dam-
age to the property of others, even if it can reasonably estimate the amount of losses.
DISCLOSURES RELATED TO PROVISIONS

The disclosures related to provisions are extensive. A company must provide a recon-
ciliation of its beginning to ending balance for each major class of provisions, identify-
ing what caused the change during the period. In addition, the provision must be
described and the expected timing of any outflows disclosed. Also, disclosure about
uncertainties related to expected outflows as well as expected reimbursements should
be provided. [12] Illustration 13-11 provides an example, based on the provisions note
in Nokia’s (FIN) annual report.
Nokia
Notes to the Financial Statements (partial)
27. Provisions
(€000,000)
IPR
Warranty Restructuring infringements Tax Other Total
At January 1, 2008 1,489 617 545 452 614 3,717
Exchange differences 16 — — — — 16
Acquisitions 1 — 3 6 2 12
Additional provisions 1,211 533 266 47 1,136 3,193
Change in fair value — — — — 7 7
Changes in estimates 240 211 92 45 185 773
Utilized during year 1,070 583 379 — 502 2,534
At December 31, 2008 1,375 356 343 460 1,058 3,592
Charged to profit and loss account 971 322 174 2 944 2,413
2008 2007 elimination of overlapping functions, and the realignment of

Analysis of total provisions at December 31: product portfolio and related replacement of discontinued
Non-current 978 1,323 products in customer sites. These expenses included EUR
Current 2,614 2,394 402 million (EUR 318 million in 2007) impacting gross
profit, EUR 46 million (EUR 439 million in 2007) research
Outflows for the warranty provision are generally expected and development expenses, EUR 14 million of reversal of
to occur within the next 18 months. Timing of outflows provision (EUR 149 million expenses in 2007) in selling and
related to tax provisions is inherently uncertain. marketing expenses, EUR 163 million (EUR 146 million in
The restructuring provision is mainly related to 2007) administrative expenses and EUR 49 million (EUR
restructuring activities in Devices & Services and Nokia 58 million in 2007) other operating expenses. EUR 790 million
Siemens Networks segments. The majority of outflows related was paid during 2008 (EUR 254 million during 2007).
to the restructuring is expected to occur during 2009. The IPR provision is based on estimated future settlements
In conjunction with the Group’s decision to discontinue for asserted and unasserted past IPR infringements. Final
the production of mobile devices in Germany, a restructuring resolution of IPR claims generally occurs over several
provision of EUR 259 million was recognized. Devices & periods. In 2008, EUR 379 million usage of the provisions
Services also recognized EUR 52 million charges related to mainly relates to the settlements with Qualcomm, Eastman
other restructuring activities. Kodak, Intertrust Technologies and ContentGuard.
Restructuring and other associated expenses incurred in Other provisions include provisions for non-cancelable
Nokia Siemens Networks in 2008 totaled EUR 646 million purchase commitments, provision for pension and other
(EUR 1,110 million in 2007) including mainly personnel social costs on share-based awards and provision for losses
related expenses as well as expenses arising from the on projects in progress.
11
This type of situation is often referred to as “an incurred but not reported” (IBNR) provision. ILLUSTRATION 13-11
A company may not be able to identify the claims giving rise to the obligation, but it knows Provisions Disclosure
a past obligating event has occurred.
SECTION 3 • CONTI NGENC I ES

In a general sense, all provisions are contingent because they are uncertain in timing
or amount. However, IFRS uses the term “contingent” for liabilities and assets that are
not recognized in the financial statements. [13]
CONTINGENT LIABILITIES
Contingent liabilities are not recognized in the financial statements because they are
(1) a possible obligation (not yet confirmed as a present obligation), (2) a present obliga-
tion for which it is not probable that payment will be made, or (3) a present obligation
for which a reliable estimate of the obligation cannot be made. Examples of contingent
liabilities are:
• A lawsuit in which it is only possible that the company might lose.
• A guarantee related to collectability of a receivable.
Illustration 13-12 presents the general guidelines for the accounting and reporting of
contingent liabilities.
ILLUSTRATION 13-12
Outcome Probability* Accounting Treatment
Contingent Liability
Guidelines Virtually certain At least 90% Report as liability (provision).
Probable (more likely than not) 51–89% probable Report as liability (provision).
Possible but not probable 5–50% Disclosure required.
Remote Less than 5% No disclosure required.
*In practice, the percentages for virtually certain and remote may deviate from those presented here.
Unless the possibility of any outflow in settlement is remote, companies should disclose
the contingent liability at the end of the reporting period, providing a brief description
of the nature of the contingent liability and, where practicable:
1. An estimate of its financial effect;
ILLUSTRATION 13-13 2. An indication of the uncertainties relating to the amount or timing of any outflow; and
Contingent Liability 3. The possibility of any reimbursement.
Disclosure
Illustration 13-13 provides a disclosure by Barloworld Limited (ZAF) related to its con-
tingent liabilities.
Barloworld Limited
(R 000,000)
2009 2008 2007
Contingent liabilities
Bills, lease and hire-purchase agreements discounted with recourse, other guarantees and claims 1,212 1,066 989
Buy-back and repurchase commitments not reflected on the balance sheet 294 517 449
The related assets are estimated to have a value at least equal to the repurchase commitment.
The group has given guarantees to the purchaser of the coatings Australian business relating to environmental claims. The
guarantees are for a maximum period of eight years and are limited to the sales price received for the business. Freeworld
Coatings Limited is responsible for the first AUD5 million of any claim in terms of the unbundling arrangement.
Warranties and guarantees have been given as a consequence of the various disposals completed during the year and
prior years. None are expected to have a material impact on the financial results of the group.
There are no material contingent liabilities in joint venture companies. Litigation, current or pending, is not considered
likely to have a material adverse effect on the group.
CONTINGENT ASSETS
A contingent asset is a possible asset that arises from past events and whose existence
will be confirmed by the occurrence or non-occurrence of uncertain future events not
wholly within the control of the company. [14] Typical contingent assets are:
1. Possible receipts of monies from gifts, donations, bonuses.

2. Possible refunds from the government in tax disputes.
3. Pending court cases with a probable favorable outcome.
Contingent assets are not recognized on the statement of financial position. If realiza-
tion of the contingent asset is virtually certain, it is no longer considered a contingent
asset and is recognized as an asset. Virtually certain is generally interpreted to be at
least a probability of 90 percent or more.
The general rules related to contingent assets are presented in Illustration 13-14.
ILLUSTRATION 13-14
Outcome Probability* Accounting Treatment
Contingent Asset
Virtually certain At least 90% probable Report as asset (no longer contingent). Guidelines
Probable (more likely than not) 51–90% probable Disclose.
Possible but not probable 5–50% No disclosure required.
Remote Less than 5% No disclosure required.
*In practice, the percentages for virtually certain and remote may deviate from those presented here.
Contingent assets are disclosed when an inflow of economic benefits is considered more
likely than not to occur (greater than 50 percent). However, it is important that disclo-
sures for contingent assets avoid giving misleading indications of the likelihood of
income arising. As a result, it is not surprising that the thresholds for allowing recog-
nition of contingent assets are more stringent relative to those for liabilities.
What might be an example of a contingent asset that becomes an asset to be
recorded? To illustrate, assume that Marcus Realty leases a property to Marks and
Spencer plc (M&S) (GBR). The contract is non-cancelable for five years. On Decem-
ber 1, 2011, before the end of the contract, M&S withdraws from the contract and is
required to pay £245,000 as a penalty. At the time M&S cancels the contract, a receivable
and related income should be reported by Marcus. The disclosure includes the nature
and, where practicable, the estimated financial effects of the asset.
QUESTIONS
8. How should a debt callable by the creditor be reported in 21. Explain the difference between a legal obligation and a
the debtor’s financial statements? constructive obligation.
9. Under what conditions should a short-term obligation be 25. What is an onerous contract? Give two examples of an
excluded from current liabilities? onerous contract.
10. What evidence is necessary to demonstrate the ability to 26. Define a restructuring. What costs should not be accrued
defer settlement of short-term debt? in a restructuring?
17. Define a provision, and give three examples of a provision. 29. What factors must be considered in determining whether
18. Under what conditions should a provision be recorded? or not to record a liability for pending litigation? For
threatened litigation?
19. Distinguish between a current liability, such as accounts
payable, and a provision.
20. How are the terms “probable” and “virtually certain”
related to provisions and contingencies?
BRIEF EXERCISES
•4 BE13-18 Management at Eli Company has decided to close one of its plants. It will continue to operate
the plant for approximately one year. It anticipates the following costs will be incurred as a result of this
closing: (1) termination compensation costs, (2) marketing costs to rebrand the company image, (3) future
losses for keeping the plant open for another year, and (4) lease termination costs related to the closing.
Indicate which, if any, of these costs should not be considered restructuring costs for purposes of estab-
lishing a provision.
•4 BE13-19 Luckert Company decided to cancel an existing lease on properties in one of its divisions, as
its operations in this area were no longer profitable. Unfortunately, Luckert has a non-cancelable lease
and cannot sublease the property. The present value of future lease payments under the lease is $2,000,000.
The penalty to break the lease is $1,450,000. Prepare the journal entry to record this cancelation.
EXERCISES
•2 E13-3 (Refinancing of Short-Term Debt) On December 31, 2010, Alexander Company had €1,200,000
of short-term debt in the form of notes payable due February 2, 2011. On January 21, 2011, the company
issued 25,000 ordinary shares for €36 per share, receiving €900,000 proceeds after brokerage fees and other
costs of issuance. On February 2, 2011, the proceeds from the share sale, supplemented by an additional
€300,000 cash, are used to liquidate the €1,200,000 debt. The December 31, 2010, statement of financial
position is authorized for issue on February 23, 2011.
Instructions
Show how the €1,200,000 of short-term debt should be presented on the December 31, 2010, statement of
financial position.
•2 E13-5 (Debt Classifications) Presented below are four different situations related to Mckee Corpora-
tion debt obligations. Mckee’s next financial reporting date is December 31, 2010. The financial statements
are authorized for issuance on March 1, 2011.
1. Mckee has a debt obligation maturing on December 31, 2013. The debt is callable on demand by
the lender at any time.
2. Mckee also has a long-term obligation due on December 1, 2012. On November 10, 2010, it breaches
a covenant on its debt obligation and the loan becomes due on demand. An agreement is reached
to provide a waiver of the breach on December 8, 2010.
3. Mckee has a long-term obligation of $400,000, which is maturing over 4 years in the amount of
$100,000 per year. The obligation is dated November 1, 2010, and the first maturity date is Novem-
ber 1, 2011.
4. Mckee has a short-term obligation due February 15, 2011. Its lender agrees to extend the maturity
date of this loan to February 15, 2013. The agreement for extension is signed on January 15, 2011.
Instructions
Indicate how each of these debt obligations is reported on Mckee’s statement of financial position on
December 31, 2010.
•4 E13-14 (Restructuring Issues) EADS Company is involved in a restructuring related to its energy
division. The company controller and CFO are considering the following costs to accrue as part of the
restructuring. The costs are as follows (amounts in ¥000).
1. The company has a long-term lease on one of the facilities related to the division. It is estimated
that it will have to pay a penalty cost of ¥400,000 to break the lease. The company estimates that
the present value related to payments on the lease contract are ¥650,000.
2. The company’s allocation of overhead costs to other divisions will increase by ¥1,500,000 as a result
of restructuring these facilities.
3. Due to the restructuring, some employees will be shifted to some of the other divisions. The cost
of retraining these individuals is estimated to be ¥2,000,000.
4. The company has hired an outplacement firm to help them in dealing with the number of termi-
nations related to the restructuring. It is estimated the cost for this company will be ¥600,000.
5. It is estimated that employee termination costs will be ¥3,000,000.
6. The company believes that it will cost ¥320,000 to move useable assets from the energy division to
other divisions in the company.
Instructions
Indicate how each of these costs should be reported in the financial statements.
•4 E13-15 (Restructuring) On December 31, 2010, the board of Dolman Group decided to close one of its
divisions. On December 31, 2010, a detailed plan for closing the division was agreed to by the board, and
letters were sent to customers and employees affected by this closure.
Instructions
(a) What is a restructuring? Provide two examples.
(b) To ensure that the restructuring is valid, what two conditions must take place?
(c) Possible costs that may be incurred during the restructuring are as follows: (1) investment in new
software as a result of closing the division, (2) cost of moving some assets of the closed division to
other parts of the company, (3) employee termination costs related to closing the division, (4) ex-
pected future operation losses in closing the division, and (5) onerous contract provisions related
to the closing. Indicate which (if any) of these costs may be part of a restructuring provision.
•4 •5 E13-16 (Provisions and Contingencies) Presented below are three independent situations. Answer the
question at the end of each situation.
1. During 2010, Maverick Inc. became involved in a tax dispute with the government. Maverick’s
attorneys have indicated that they believe it is probable that Maverick will lose this dispute. They
also believe that Maverick will have to pay the government between $800,000 and $1,400,000.
After the 2010 financial statements were issued, the case was settled with the government for
$1,200,000. What amount, if any, should be reported as a liability for this tax dispute as of Decem-
ber 31, 2010?
2. On October 1, 2010, Holmgren Chemical was identified as a potentially responsible party by its
Environmental Regulatory Agency. Holmgren’s management along with its counsel have concluded
that it is probable that Holmgren will be responsible for damages, and a reasonable estimate of
these damages is $6,000,000. Holmgren’s insurance policy of $9,000,000 has a deductible clause of
$500,000. How should Holmgren Chemical report this information in its financial statements at
December 31, 2010?
3. Shinobi Inc. had a manufacturing plant in Darfur, which was destroyed in the civil war. It is not
certain who will compensate Shinobi for this destruction, but Shinobi has been assured by govern-
mental officials that it will receive a definite amount for this plant. The amount of the compensa-
tion will be less than the fair value of the plant but more than its book value. How should the
compensation be reported in the financial statements of Shinobi Inc.?
•4 E13-20 (Provisions) The following situations relate to Bolivia Company.

1. Bolivia provides a warranty with all its products it sells. It estimates that it will sell 1,000,000 units
of its product for the year ended December 31, 2010, and that its total revenue for the product will
be $100,000,000. It also estimates that 60% of the product will have no defects, 30% will have
major defects, and 10% will have minor defects. The cost of a minor defect is estimated to be $5
for each product sold, and the cost for a major defect cost is $15. The company also estimates that
the minimum amount of warranty expense will be $2,000,000 and the maximum will be $10,000,000.
2. Bolivia is involved in a tax dispute with the tax authorities. The most likely outcome of this dispute
is that Bolivia will lose and have to pay $400,000. The minimum it will lose is $20,000 and the max-
imum is $2,500,000.
3. Bolivia has a policy of refunding purchases to dissatisfied customers, even though it is under no
obligation to do so. However, it has created a valid expectation with its customers to continue this
practice. These refunds can range from 5% of sales to 9% of sales, with any amount in between a
reasonable possibility. In 2010, Bolivia has $80,000,000 of sales subject to possible refund. The
average cost of any refund item is $12.
Instructions
Prepare the journal entry to record provisions, if any, for Bolivia at December 31, 2010.

CA13-3 (Refinancing of Short-Term Debt) Kobayashi Corporation reports in the current liability sec-
tion of its statement of financial position at December 31, 2010 (its year-end), short-term obligations of
¥15,000,000, which includes the current portion of 12% long-term debt in the amount of ¥10,000,000
(matures in March 2011). Management has stated its intention to refinance the 12% debt whereby no por-
tion of it will mature during 2011. The date of issuance of the financial statements is March 25, 2011.
Instructions
(a) Is management’s intent enough to support long-term classification of the obligation in this situation?
(b) Assume that Kobayashi Corporation issues ¥13,000,000 of 10-year debentures to the public in
January 2011 and that management intends to use the proceeds to liquidate the ¥10,000,000 debt
maturing in March 2011. Furthermore, assume that the debt maturing in March 2011 is paid from
these proceeds prior to the authorization to issue the financial statements. Will this have any
impact on the statement of financial position classification at December 31, 2010? Explain your
answer.
(c) Assume that Kobayashi Corporation issues ordinary shares to the public in January and that man-
agement intends to entirely liquidate the ¥10,000,000 debt maturing in March 2011 with the pro-
ceeds of this equity securities issue. In light of these events, should the ¥10,000,000 debt maturing
in March 2011 be included in current liabilities at December 31, 2010?
(d) Assume that Kobayashi Corporation, on February 15, 2011, entered into a financing agreement
with a commercial bank that permits Kobayashi Corporation to borrow at any time through 2012
up to ¥15,000,000 at the bank’s prime rate of interest. Borrowings under the financing agreement
mature three years after the date of the loan. The agreement is not cancelable except for viola-
tion of a provision with which compliance is objectively determinable. No violation of any pro-
vision exists at the date of issuance of the financial statements. Assume further that the current
portion of long-term debt does not mature until August 2011. In addition, management may
refinance the ¥10,000,000 obligation under the terms of the financial agreement with the bank,
which is expected to be financially capable of honoring the agreement. Given these facts, should
the ¥10,000,000 be classified as current on the statement of financial position at December 31,
2010?
USING YOUR JUDGMENT

esoifrs Instructions
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llege
Refer to M&S’s financial statements and the accompanying notes to answer the following questions.
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(a) What was M&S’s 2008 short-term debt and related weighted-average interest rate on this debt?
m
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i l e y. c o
(b) What was M&S’s 2008 working capital, acid-test ratio, and current ratio? Comment on M&S’s liquidity.
(c) What types of commitments and contingencies has M&S reported in its financial statements? What
is management’s reaction to these contingencies?

Hincapie Co. manufactures specialty bike accessories. The company is most well known for its product
quality, and it has offered one of the best warranties in the industry on its higher-priced products—a life-
time guarantee. The warranty on these products is included in the sales price. Hincapie has a contract
with a service company, which performs all warranty work on Hincapie products. Under the contract,
Hincapie guarantees the service company at least €200,000 of warranty work for each year of the 3-year
contract.
The recent economic recession has been hard on Hincapie’s business, and sales for its higher-end
products have been especially adversely impacted. As a result, Hincapie is planning to restructure its
high-quality lines by moving manufacturing for those products into one of its other factories, shutting
down assembly lines, and terminating workers. In order to keep some workers on-board, Hincapie plans
to bring all warranty work in-house. It can terminate the current warranty contract by making a one-time
termination payment of €75,000.
The restructuring plans have been discussed by management during November 2010; they plan to
get approval from the board of directors at the December board meeting and execute the restructuring in
early 2011. Given the company’s past success, the accounting for restructuring activities has never come
up. Hincapie would like you to do some research on how it should account for this restructuring accord-
ing to IFRS.
Instructions
(a) Identify the accounting literature that addresses the accounting for the various restructuring costs
that will be incurred in the restructuring.
(b) Advise Hincapie on the restructuring costs. When should Hincapie recognize liabilities arising from
the restructuring? What costs can be included? What costs are excluded?
(c) Does Hincapie have a liability related to the service contract? Explain. If Hincapie has a liability, at
what amount should it be recorded?
KiesoIFRS_Supplement_first pp
Note: since these are "Rough pages"
the running heads and folios will be Kieso IFRS Supplement · 16-1
adjusted in revise pages
CHAPTER 16 DILUTIVE SECURITIES AND EARNINGS PER SHARE
Accounting for Convertible Debt

Convertible debt is accounted for as a compound instrument because it contains both
a liability and an equity component. IFRS requires that compound instruments be
separated into their liability and equity components for purposes of accounting. [1]
Companies use the “with-and-without” method to value compound instruments.
Illustration 16-1 identifies the components used in the with-and-without method.
ILLUSTRATION 16-1
Fair value of convertible debt Fair value of liability component Equity component at
Convertible Debt
at date of issuance (with at date of issuance, based on date of issuance
both debt and equity ⫺ present value of cash flows ⫽ (without the debt
Components
components) component)
As indicated, the equity component is the residual amount after subtracting the liabil-
ity component. IFRS does not permit companies to assign a value to the equity amount
first and then determine the liability component. To do so would be inconsistent with
the definition of equity, which is considered a residual amount. [2]
To implement the with-and-without approach, companies do the following:
1. First, determine the total fair value of the convertible debt with both the liability and
equity component. This is straightforward, as this amount is the proceeds received
upon issuance.
2. The company then determines the liability component by computing the net present
value of all contractual future cash flows discounted at the market rate of interest.
This market rate is the rate the company would pay on similar non-convertible debt.
3. In the final step, the company subtracts the liability component estimated in the sec-
ond step from the fair value of the convertible debt (issue proceeds) to arrive at the
equity component. That is, the equity component is the fair value of the convertible
debt without the liability component
Accounting at Time of Issuance

To illustrate the accounting for convertible debt, assume that Roche Group (DEU) issues
2,000 convertible bonds at the beginning of 2011. The bonds have a four-year term with
a stated rate of interest of 6 percent, and are issued at par with a face value of €1,000
per bond (the total proceeds received from issuance of the bonds are €2,000,000). Interest
is payable annually at December 31. Each bond is convertible into 250 ordinary shares
with a par value of €1. The market rate of interest on similar non-convertible debt is
9 percent.
The time diagram in Illustration 16-2 depicts both the interest and principal cash flows.
ILLUSTRATION 16-2
PV
Time Diagram for
€2,000,000 Principal
Convertible Bond
i = 9%
PV OA
PV– €120,000 €120,000 €120,000 €120,000 Interest
0 1 2 3 4
n=4
16-2 · Chapter 16 Dilutive Securities and Earnings per Share
The liability component of the convertible debt is computed as shown in Illustration 16-3.
ILLUSTRATION 16-3
Fair Value of Liability Present value of principal: €2,000,000 ⫻ .70843 (Table 6-2; n ⫽ 4, i ⫽ 9%) €1,416,850
Present value of the interest payments: €120,000 ⫻ 3.23972 (Table 6-4; n ⫽ 4, i ⫽ 9%) 388,766
Component of Convertible
Bond Present value of the liability component €1,805,616
The equity component of Roche’s convertible debt is then computed as shown in Illus-
tration 16-4.
ILLUSTRATION 16-4
Fair value of convertible debt at date of issuance €2,000,000
Equity Component of
Less: Fair value of liability component at date of issuance 1,805,616
Convertible Bond
Fair value of equity component at date of issuance € 194,384
The journal entry to record this transaction is as follows.

Cash 2,000,000
Bonds Payable 1,805,616
Share Premium—Conversion Equity 194,384
The liability component of Roche’s convertible debt issue is recorded as Bonds

Payable. As shown in Chapter 14, the amount of the discount relative to the face value
of the bond is amortized at each reporting period so at maturity, the Bonds Payable ac-
count is reported at €2,000,000 (face value). The equity component of the convertible
bond is recorded in the Share Premium—Conversion Equity account and is reported
in the equity section of the statement of financial position. Because this amount is con-
sidered part of contributed capital, it does not change over the life of the convertible.3
Settlement of Convertible Bonds

We illustrate four settlement situations: (1) repurchase at maturity, (2) conversion at
maturity, (3) conversion before maturity, and (4) repurchase before maturity.
Repurchase at Maturity. If the bonds are not converted at maturity, Roche makes the
following entry to pay off the convertible debtholders.
Cash 2,000,000
(To record the purchase of bonds at maturity)
Because the carrying value of the bonds equals the face value, there is no gain or loss
on repurchase at maturity. The amount originally allocated to equity of €194,384 either
remains in the Share Premium—Conversion Equity account or is transferred to Share
Premium—Ordinary.
Conversion of Bonds at Maturity. If the bonds are converted at maturity, Roche makes
the following entry.
Share Capital—Ordinary 500,000
(To record the conversion of bonds at maturity)
3
Transaction costs related to the liability and equity components are allocated in proportion
to the proceeds received from the two components. For purposes of homework, use the Share
Premium—Conversion Equity account to record the equity component. In practice, there may be
considerable variance in the accounts used to record this component.
As indicated, Roche records a credit to Share Capital—Ordinary for €500,000 (2,000

bonds ⫻ 250 shares ⫻ €1 par) and the remainder to Share Premium—Ordinary for
€1,694,384. There is no gain or loss on conversion at maturity. The original amount
allocated to equity (€194,384) is transferred to the Share Premium—Ordinary account.
As a result, Roche’s equity has increased by a total of €2,194,384 through issuance and
conversion of the convertible bonds. This accounting approach is often referred to as the
book value method in that the carrying amount (book value) of the bond and related
conversion equity determines the amount in the ordinary equity accounts.
Conversion of Bonds before Maturity. What happens if bonds are converted before
maturity? To understand the accounting, we again use the Roche Group example.
A schedule of bond amortization related to Roche’s convertible bonds is shown in
Illustration 16-5.
ILLUSTRATION 16-5
SCHEDULE OF BOND AMORTIZATION
Convertible Bond
EFFECTIVE-INTEREST METHOD
6% BOND DISCOUNTED AT 9%
Amortization Schedule
Cash Interest Discount Carrying Amount

Date Paid Expense Amortized of Bonds
1/1/11 €1,805,616
12/31/11 €120,000 €162,506 €42,506 1,848,122
12/31/12 120,000 166,331 46,331 1,894,453
12/31/13 120,000 170,501 50,501 1,944,954
12/31/14 120,000 175,046 55,046 2,000,000
Assuming that Roche converts its bonds into ordinary shares on December 31, 2012,
Roche debits the Bonds Payable account for its carrying value of €1,894,453 (see
Illustration 16-5). In addition, Roche credits Share Capital—Ordinary for €500,000
(2,000 ⫻ 250 ⫻ €1) and credits Share Premium—Ordinary for €1,588,837. The entry to
record this conversion is as follows.
(To record the conversion of bonds before maturity)
There is no gain or loss on conversion before maturity: The original amount allocated
to equity (€194,384) is transferred to the Share Premium—Ordinary account.
Repurchase before Maturity. In some cases, companies decide to repurchase the convert-
ible debt before maturity. The approach used for allocating the amount paid upon
repurchase follows the approach used when the convertible bond was originally issued.
That is, Roche determines the fair value of the liability component of the convertible
bonds at December 31, 2012, and then subtracts this amount from the fair value of
the convertible bond issue (including the equity component) to arrive at the value for
the equity. After this allocation is completed:
1. The difference between the consideration allocated to the liability component and
the carrying amount of the liability is recognized as a gain or loss, and
2. The amount of consideration relating to the equity component is recognized (as a
reduction) in equity. [3]
To illustrate, instead of converting the bonds on December 31, 2012, assume that
Roche repurchases the convertible bonds from the bondholders. Pertinent information
related to this conversion is as follows.
• Fair value of the convertible debt (including both liability and equity components),
based on market prices at December 31, 2012, is €1,965,000.
• The fair value of the liability component is €1,904,900. This amount is based on
computing the present value of a non-convertible bond with a two-year term (which
corresponds to the shortened time to maturity of the repurchased bonds.)
We first determine the gain or loss on the liability component, as computed in Illustra-
tion 16-6.
ILLUSTRATION 16-6
Present value of liability component at December 31, 2012 (given above) € 1,904,900
Gain or Loss on Debt
Carrying value of liability component at December 31, 2012 (per Illustration 16-5) (1,894,453)
Repurchase
Loss on repurchase € 10,447
Roche has a loss on this repurchase because the value of the debt extinguished is
greater than its carrying amount. To determine any adjustment to the equity, we com-
pute the value of the equity as shown in Illustration 16-7.
ILLUSTRATION 16-7
Fair value of convertible debt at December 31, 2012 (with equity component ) €1,965,000
Equity Adjustment on
Less: Fair value of liability component at December 31, 2012 (similar 2-year
Repurchase of Convertible non-convertible debt) 1,904,900
Bonds
Fair value of equity component at December 31, 2012 (without debt component ) € 60,100
Roche makes the following compound journal entry to record the entire repurchase
transaction.
Loss on Repurchase 10,447
Cash 1,965,000
(To record the repurchase of convertible bonds)
In summary, the repurchase results in a loss related to the liability component and a
reduction in Share Premium—Conversion Equity. The remaining balance in Share
Premium—Conversion Equity of €134,294 (€194,384 ⫺ €60,000) is often transferred to
Share Premium—Ordinary upon the repurchase.
Induced Conversions
Sometimes, the issuer wishes to encourage prompt conversion of its convertible debt to
equity securities in order to reduce interest costs or to improve its debt to equity ratio.
Thus, the issuer may offer some form of additional consideration (such as cash or
ordinary shares), called a “sweetener,” to induce conversion. The issuing company
reports the sweetener as an expense of the current period. Its amount is the fair value
of the additional securities or other consideration given.
Assume that Helloid, Inc. has outstanding $1,000,000 par value convertible deben-
tures convertible into 100,000 ordinary shares ($1 par value). Helloid wishes to reduce
its annual interest cost. To do so, Helloid agrees to pay the holders of its convertible
debentures an additional $80,000 if they will convert. Assuming conversion occurs,
Helloid makes the following entry.
Conversion Expense 80,000
Share Premium—Ordinary 900,000
Cash 80,000
Helloid records the additional $80,000 as an expense of the current period and not as
a reduction of equity. [4]
Some argue that the cost of a conversion inducement is a cost of obtaining equity
capital. As a result, they contend that companies should recognize the cost of conver-
sion as a cost of (a reduction of) the equity capital acquired and not as an expense.
However, the IASB indicated that when an issuer makes an additional payment to en-
courage conversion, the payment is for a service (bondholders converting at a given
time) and should be reported as an expense.
Employee Share-Purchase Plans

Employee share-purchase plans (ESPPs) generally permit all employees to purchase
shares at a discounted price for a short period of time. The company often uses such
plans to secure equity capital or to induce widespread ownership of its ordinary shares
among employees. These plans are considered compensatory and should be recorded
as expense over the service period.
To illustrate, assume that Masthead Company offers all its 1,000 employees the
opportunity to participate in an employee share-purchase plan. Under the terms of the
plan, the employees are entitled to purchase 100 ordinary shares (par value £1 per share)
at a 20 percent discount. The purchase price must be paid immediately upon accept-
ance of the offer. In total, 800 employees accept the offer, and each employee purchases
on average 80 shares. That is, the employees purchase a total of 64,000 shares. The
weighted-average market price of the shares at the purchase date is £30 per share, and
the weighted-average purchase price is £24 per share. The entry to record this transac-
tion is as follows.
Cash (64,000 ⫻ £24) 1,536,000
Compensation Expense [64,000 ⫻ (£30 ⫺ £24)] 384,000
Share Capital—Ordinary (64,000 ⫻ £1) 64,000
(Issue shares in an employee share-purchase plan)
The IASB indicates that there is no reason to treat broad-based employee share
plans differently from other employee share plans. Some have argued that because
these plans are used to raise capital, they should not be compensatory. However, IFRS
requires recording expense for these arrangements. The Board notes that because these
arrangements are available only to employees, it is sufficient to conclude that the ben-
efits provided represent employee compensation.10 [6]
10
As indicated, employee share-purchase plans offer company shares to workers through
payroll deduction, often at significant discounts. Unfortunately, many employees do not
avail themselves of this benefit. Hopefully, if you have the opportunity to purchase your
company’s shares at a significant discount, you will take advantage of the plan. By not
participating, you are “leaving money on the table.”
DILUTIVE SECURITIES AND EARNINGS PER SHARE

Both the IASB and the FASB are working on a standard related to the distinction between liabilities and equity.
The IASB approach to account for certain dilutive securities, such as convertible debt and debt issued with share
warrants, is different than U.S. GAAP. The accounting and disclosure requirements for accounting for share options
and EPS computations are similar between IFRS and U.S. GAAP.

• A significant difference between U.S. GAAP and IFRS As indicated, a significant difference in U.S. GAAP and IFRS is the
is the accounting for securities with characteristics accounting for convertible debt. To illustrate, assume PepsiCo (USA)
of debt and equity, such as convertible debt. Under issued, at par, $10 million of 10-year convertible bonds with a coupon
U.S. GAAP, all of the proceeds of convertible debt are rate of 4.75%. Assuming the conversion is settled in shares, PepsiCo
recorded as long-term debt unless settlement is in cash. makes the following entry to record the issuance under U.S. GAAP.
Under IFRS, convertible bonds are “split”—separated
Cash 10,000,000
into the equity component (the value of the conversion
option) of the bond issue and the debt component.
• Both U.S. GAAP and IFRS follow the same model for Under IFRS, PepsiCo must split out the liability and equity component—
recognizing share-based compensation: The fair value of the value of the conversion option—of the bond issue.
shares and options awarded to employees is recognized Thus, IFRS records separately the bond issue’s debt and equity
over the period to which the employees’ services relate. components. Many believe this provides a more faithful representa-
tion of the impact of the bond issue. However, there are concerns
• Although the calculation of basic and diluted earnings
about reliability of the method used to estimate the liability compo-
per share is similar between U.S. GAAP and IFRS, the
nent of the bond.
Boards are working to resolve the few minor differences
in EPS reporting. One proposal in the FASB project
concerns contracts that can be settled in either cash or shares. IFRS requires that share settlement must be used, while U.S. GAAP gives
companies a choice. The FASB project proposes adopting the IFRS approach, thus converging U.S. GAAP and IFRS in this regard.
• Related to employee share-purchase plans, under IFRS all employee purchase plans are deemed to be compensatory; that is, compensa-
tion expense is recorded for the amount of the discount. Under U.S. GAAP, these plans are often considered non-compensatory and therefore
no compensation is recorded. Certain conditions must exist before a plan can be considered non-compensatory—the most important being
that the discount generally cannot exceed 5%.
• Modification of a share option results in the recognition of any incremental fair value under both IFRS and U.S. GAAP. However, if the
modification leads to a reduction, IFRS does not permit the reduction but U.S. GAAP does.
ON TH E HORIZON
The FASB has been working on a standard that will likely converge to IFRS in the accounting for convertible debt.
Similar to the IASB, the FASB is examining the classification of hybrid securities; the IASB is seeking comment on
a discussion document similar to the FASB Preliminary Views document, “Financial Instruments with Characteris-
tics of Equity.” It is hoped that the Boards will develop a converged standard in this area. While U.S. GAAP and
IFRS are similar as to the presentation of EPS, the Boards have been working together to resolve remaining dif-
ferences related to earnings per share computations.
16-6
QUESTIONS
4. Bridgewater Corp. offered holders of its 1,000 convertible the debentures is 104, and the ordinary shares are selling
bonds a premium of €160 per bond to induce conversion at $14 per share (par value $10). The company records the
into ordinary shares. Upon conversion of all the bonds, conversion as follows.
Bridgewater Corp. recorded the €160,000 premium as a Bonds Payable 960,000
reduction of Share Premium—Ordinary. Comment on Share Capital—Ordinary 800,000
Bridgewater’s treatment of the €160,000 “sweetener.” Share Premium—Ordinary 160,000
5. Explain how the conversion feature of convertible debt has Discuss the propriety of this accounting treatment.
a value (a) to the issuer and (b) to the purchaser. 11. Cordero Corporation has an employee share-purchase
6. What are the arguments for giving separate accounting plan which permits all full-time employees to purchase 10
recognition to the conversion feature of debentures? ordinary shares on the third anniversary of their employ-
7. Four years after issue, debentures with a face value of ment and an additional 15 shares on each subsequent an-
$1,000,000 and book value of $960,000 are tendered for niversary date. The purchase price is set at the market
conversion into 80,000 ordinary shares immediately after price on the date purchased less a 10% discount. How is
an interest payment date. At that time, the market price of this discount accounted for by Cordero?
BRIEF EXERCISES
•1 BE16-1 Archer Company issued £4,000,000 par value, 7% convertible bonds at 99 for cash. The net pres-
ent value of the debt without the conversion feature is £3,800,000. Prepare the journal entry to record the
issuance of the convertible bonds.
•1 BE16-2 Petrenko Corporation has outstanding 2,000 €1,000 bonds, each convertible into 50 shares of
€10 par value ordinary shares. The bonds are converted on December 31, 2010. The bonds payable has a
carrying value of €1,950,000 and conversion equity of €20,000. Record the conversion using the book value
method.
EXERCISES
•1 E16-2 (Issuance and Repurchase of Convertible Bonds) Assume the same information in E16-1, except
that Angela Corporation converts its convertible bonds on January 1, 2012.
Instructions
(a) Compute the carrying value of the bond payable on January 1, 2012.
(b) Prepare the journal entry to record the conversion on January 1, 2012.
(c) Assume that the bonds were repurchased on January 1, 2012, for €1,940,000 cash instead of being
converted. The net present value of the liability component of the convertible bonds on January 1,
2012, is €1,900,000. Prepare the journal entry to record the repurchase on January 1, 2012.
•1 E16-3 (Issuance and Repurchase of Convertible Bonds) On January 1, 2011, Cai Company issued a
10% convertible bond at par, with a face value of ¥100,000, maturing on January 1, 2021. The convertible
bond is convertible into ordinary shares of Cai at a conversion price of ¥2,500 per share. Interest is payable
semiannually. At date of issue, Cai could have issued non-convertible debt with a 10-year term bearing an
interest rate of 11%.
Instructions
(a) Prepare the journal entry to record the issuance of the convertible debt on January 1, 2011.
(b) On January 1, 2014, Cai makes a tender offer to the holder of the convertible debt to repurchase
the bond for ¥112,000, which the holder accepts. At the date of repurchase, Cai could have issued
non-convertible debt with a 7-year term at an effective-interest rate of 8%. Prepare the journal entry
to record this repurchase on January 1, 2014.
•1 E16-4 (Issuance, Conversion, Repurchase of Convertible Bonds) On January 1, 2011, Lin Company
issued a convertible bond with a par value of $50,000 in the market for $60,000. The bonds are convert-
ible into 6,000 ordinary shares of $1 per share par value. The bond has a 5-year life and has a stated
interest rate of 10% payable annually. The market interest rate for a similar non-convertible bond at
January 1, 2011, is 8%. The liability component of the bond is computed to be $53,993. The following bond
amortization schedule is provided for this bond.
EFFECTIVE-INTEREST METHOD
10% BOND DISCOUNTED AT 8%
Cash Interest Premium Carrying Amount

Date Paid Expense Amortized of Bonds
1/1/11 $53,993
12/31/11 $5,000 $4,319 $681 53,312
12/31/12 5,000 4,265 735 52,577
12/31/13 5,000 4,206 794 51,783
12/31/14 5,000 4,143 857 50,926
12/31/15 5,000 4,074 926 50,000
Instructions
(a) Prepare the journal entry to record the issuance of the convertible bond on January 1, 2011.
(b) Prepare the journal entry to record the accrual of interest on December 31, 2012.
(c) Assume that the bonds were converted on December 31, 2013. The fair value of the liability com-
ponent of the bond is determined to be $54,000 on December 31, 2013. Prepare the journal entry
to record the conversion on December 31, 2013. Assume that the accrual of interest related to 2013
has been recorded.
(d) Assume that the convertible bonds were repurchased on December 31, 2013, for $55,500 instead
of being converted. As indicated, the liability component of the bond is determined to be $54,000
on December 31, 2013. Assume that the accrual of interest related to 2013 has been recorded.
(e) Assume that the bonds matured on December 31, 2015, and Lin repurchased the bonds. Prepare
the entry(ies) to record this transaction.
•1 E16-5 (Conversion of Bonds) Schuss Inc. issued €3,000,000 of 10%, 10-year convertible bonds on April 1,
2010, at 98. The bonds were dated April 1, 2010, with interest payable April 1 and October 1. Bond dis-
count is amortized semiannually using the effective-interest method. The net present value of the bonds
without the conversion feature discounted at 11% (its market rate) was €2,800,000.
On April 1, 2011, €1,000,000 of these bonds were converted into 30,000 shares of €20 par value ordi-
nary shares. Accrued interest was paid in cash at the time of conversion.
Instructions
(a) Prepare the entry to record the issuance of the convertible bond on April 1, 2010.
(b) Prepare the entry to record the interest expense at October 1, 2010.
(c) Prepare the entry(ies) to record the conversion on April 1, 2011. (The book value method is used.)
PROBLEMS
•4 P16-3 (Share-Based Compensation) Assume that Sarazan Company has a share-option plan for top
management. Each share option represents the right to purchase a $1 par value ordinary share in the future
at a price equal to the fair value of the shares at the date of the grant. Sarazan has 5,000 share options
outstanding, which were granted at the beginning of 2010. The following data relate to the option grant.
Exercise price for options $40

Market price at grant date (January 1, 2010) $40
Fair value of options at grant date (January 1, 2010) $6
Service period 5 years
Instructions
(a) Prepare the journal entry(ies) for the first year of the share-option plan.
(b) Prepare the journal entry(ies) for the first year of the plan assuming that, rather than options, 700
shares of restricted shares were granted at the beginning of 2010.
(c) Now assume that the market price of Sarazan shares on the grant date was $45 per share. Repeat
the requirements for (a) and (b).
(d) Sarazan would like to implement an employee share-purchase plan for rank-and-file employees,
but it would like to avoid recording expense related to this plan. Explain how employee share-
purchase plans are recorded.
USING YOUR JUDGMENT

Instructions
k ies
/
(a) Under M&S’s share-based compensation plan, share options are granted annually to key managers
llege
and directors.
/co
ww
(1) How many options were granted during 2008 under the plan?
m
.w
i l e y. c o
(2) How many options were exercisable at March 29, 2008?
(3) How many options were exercised in 2008, and what was the average price of those exercised?
(4) How many years from the grant date do the options expire?
(5) To what accounts are the proceeds from these option exercises credited?
(6) What was the number of outstanding options at March 29, 2008, and at what average exercise
price?
(b) What number of diluted weighted-average shares outstanding was used by M&S in computing earn-
ings per share for 2008 and 2007? What was M&S’s diluted earnings per share in 2008 and 2007?
(c) What other share-based compensation plans does M&S have?

Richardson Company is contemplating the establishment of a share-based compensation plan to provide
long-run incentives for its top management. However, members of the compensation committee of the
board of directors have voiced some concerns about adopting these plans, based on news accounts re-
lated to a recent accounting standard in this area. They would like you to conduct some research on this
recent standard so they can be better informed about the accounting for these plans.
Instructions
the documents, you can use the search tool in your Internet browser to respond to the following questions.
(Provide paragraph citations.)
(a) Identify the authoritative literature that addresses the accounting for share-based payment compen-
sation plans.
(b) Briefly discuss the objectives for the accounting for share-based compensation. What is the role of
fair value measurement?
(c) The Richardson Company board is also considering an employee share-purchase plan, but the Board
does not want to record expense related to the plan. What are the IFRS requirements for the account-
ing for an employee share-purchase plan?
Note: since these are "Rough pages"
the running heads and folios will be KiesoIFRS_Supplement_First pp
adjusted in revise pages
17-2 · Chapter 17 Investments
CHAPTER 17 INVESTMENTS
ACCOUNTING FOR FINANCIAL ASSETS

A financial asset is cash, an equity investment of another company (e.g., ordinary or
preference shares), or a contractual right to receive cash from another party (e.g., loans,
receivables, and bonds). [1] The accounting for cash is relatively straightforward and
is discussed in Chapter 7. The accounting and reporting for equity and debt invest-
ments, as discussed in the opening story, is extremely contentious, particularly in light
of the credit crisis in the latter part of 2008.
Some users of financial statements support a single measurement—fair value—for
all financial assets. They view fair value as more relevant than other measurements in
helping investors assess the effect of current economic events on the future cash flows
of the asset. In addition, they believe that the use of a single method promotes consis-
tency in valuation and reporting on the financial asset, thereby improving the useful-
ness of the financial statements. Others disagree. They note that many investments are
not held for sale but rather for the income they will generate over the life of the invest-
ment. They believe cost-based information (referred to as amortized cost) provides the
most relevant information for predicting future cash flows in these cases. Others ex-
press concern that using fair value information to measure financial assets is unreliable
when markets for the investments are not functioning in an ordinary fashion.
After much discussion, the IASB decided that reporting all financial assets at fair
value is not the most appropriate approach for providing relevant information to fi-
nancial statement users. The IASB noted that both fair value and a cost-based approach
can provide useful information to financial statement readers for particular types of fi-
nancial assets in certain circumstances. As a result, the IASB requires that companies
classify financial assets into two measurement categories—amortized cost and fair
value—depending on the circumstances.
Measurement Basis—A Closer Look

In general, IFRS requires that companies determine how to measure their financial as-
sets based on two criteria:
• The company’s business model for managing its financial assets; and
• The contractual cash flow characteristics of the financial asset.
If a company has (1) a business model whose objective is to hold assets in order to col-
lect contractual cash flows and (2) the contractual terms of the financial asset provides
specified dates to cash flows that are solely payments of principal and interest on the
principal amount outstanding, then the company should use amortized cost. [2]1
For example, assume that Mitsubishi (JPN) purchases a bond investment that it
intends to hold to maturity. Its business model for this type of investment is to collect
interest and then principal at maturity. The payment dates for the interest rate and prin-
cipal are stated on the bond. In this case, Mitsubishi accounts for the investment at
amortized cost. If, on the other hand, Mitsubishi purchased the bonds as part of a trad-
ing strategy to speculate on interest rate changes (a trading investment), then the debt
1
The IASB indicates that the business model should be considered first. And, that the
contractual cash flow characteristics should be considered only for financial assets (e.g.,
debt investments) that are eligible to be measured at amortized cost. It states that both
classification conditions are essential to ensure that amortized cost provides useful
information about debt investments. [3]
investment is reported at fair value. As a result, only debt investments such as receiv-
ables, loans, and bond investments that meet the two criteria above are recorded at
amortized cost. All other debt investments are recorded and reported at fair value.
Equity investments are generally recorded and reported at fair value. Equity invest-
ments do not have a fixed interest or principal payment schedule and therefore cannot
be accounted for at amortized cost. In summary, companies account for investments
based on the type of security, as indicated in Illustration 17-1.
ILLUSTRATION 17-1
Type of Investment Assessment of Accounting Criteria Valuation Approach
Summary of Investment
Debt (Section 1) Meets business model (held-for-collection) and Amortized cost Accounting Approaches
contractual cash flow tests.
Does not meet the business model test Fair value
(not held-for-collection).
Equity (Section 2) Does not meet contractual cash flow test. Fair value*
*For some equity investments for which the investor exercises some control over the investee, use the equity method.
We organize our study of investments by type of investment security; within each

section, we explain how the accounting for investments in debt and equity securities
varies according to how the investment is managed and the contractual cash flow char-
acteristics of the investment.
SECTION 1 • DEBT I NVESTMENTS
Debt investments are characterized by contractual payments on specified dates of

principal and interest on the principal amount outstanding. Companies measure debt
investments at amortized cost if the objective of the company’s business model is to
hold the financial asset to collect the contractual cash flows (held-for-collection).
Amortized cost is the initial recognition amount of the investment minus repayments,
plus or minus cumulative amortization and net of any reduction for uncollectibility.
If the criteria for measurement at amortized cost are not met, then the debt in-
Objective•2
vestment is valued and accounted for at fair value. Fair value is the amount for
which an asset could be exchanged between knowledgeable willing parties in an Understand the accounting for debt
investments at amortized cost.
arm’s length transaction. [4]
Calculator Solution for

DEBT INVESTMENTS—AMORTIZED COST Bond Price
Only debt investments can be measured at amortized cost. If a company like Carrefour Inputs Answer
(FRA) makes an investment in the bonds of Nokia (FIN), it will receive contractual cash
N 10
flows of interest over the life of the bonds and repayment of the principal at maturity.
If it is Carrefour’s strategy to hold this investment in order to receive these cash flows
over the life of the bond, it has a held-for-collection strategy and it will measure the I 5
investment at amortized cost.2
PV ? –92,278
2
Classification as held-for-collection does not mean the security must be held to maturity.
For example, a company may sell an investment before maturity if (1) the security does not
meet the company’s investment strategy (e.g., the company has a policy to invest in only PMT 4,000
AAA-rated bonds but the bond investment has a decline in its credit rating), (2) a company
changes its strategy to invest only in securities within a certain maturity range, or (3) the
company needs to sell a security to fund certain capital expenditures. However, if a FV 100,000
company begins trading held-for-collection investments on a regular basis, it should assess
whether such trading is consistent with the held-for-collection classification. [5]
Example: Debt Investment at Amortized Cost

To illustrate the accounting for a debt investment at amortized cost, assume that
Robinson Company purchased $100,000 of 8 percent bonds of Evermaster Corporation
on January 1, 2011, at a discount, paying $92,278. The bonds mature January 1, 2016,
and yield 10 percent; interest is payable each July 1 and January 1. Robinson records
the investment as follows.
January 1, 2011
Debt Investments 92,278
Cash 92,278
As indicated in Chapter 14, companies must amortize premium or discount using

the effective-interest method. They apply the effective-interest method to bond invest-
ments in a way similar to that for bonds payable. To compute interest revenue, com-
panies compute the effective-interest rate or yield at the time of investment and apply
that rate to the beginning carrying amount (book value) for each interest period. The
investment carrying amount is increased by the amortized discount or decreased by
the amortized premium in each period.
Illustration 17-2 shows the effect of the discount amortization on the interest rev-
enue that Robinson records each period for its investment in Evermaster bonds.
ILLUSTRATION 17-2
8% BONDS PURCHASED TO YIELD 10%
Schedule of Interest
Revenue and Bond Bond Carrying
Discount Amortization— Cash Interest Discount Amount
Effective-Interest Method Date Received Revenue Amortization of Bonds
1/1/11 $ 92,278
7/1/11 $ 4,000a $ 4,614b $ 614c 92,892d
1/1/12 4,000 4,645 645 93,537
7/1/12 4,000 4,677 677 94,214
1/1/13 4,000 4,711 711 94,925
7/1/13 4,000 4,746 746 95,671
1/1/14 4,000 4,783 783 96,454
7/1/14 4,000 4,823 823 97,277
1/1/15 4,000 4,864 864 98,141
7/1/15 4,000 4,907 907 99,048
1/1/16 4,000 4,952 952 100,000
$40,000 $47,722 $7,722
a
$4,000 $100,000 .08 6⁄12
b
$4,614 $92,278 .10 6⁄12
c
$614 $4,614 $4,000
d
$92,892 $92,278 $614
Robinson records the receipt of the first semiannual interest payment on July 1,
2011 (using the data in Illustration 17-2), as follows.
July 1, 2011
Cash 4,000
Debt Investments 614
Interest Revenue 4,614
Because Robinson is on a calendar-year basis, it accrues interest and amortizes the

discount at December 31, 2011, as follows.
December 31, 2011
Interest Receivable 4,000
Again, Illustration 17-2 shows the interest and amortization amounts.

Robinson reports its investment in Evermaster bonds in its December 31, 2011,
financial statements, as follows.3
ILLUSTRATION 17-3
Statement of Financial Position
Reporting of Bond
Long-term investments Investments at
Debt investments $93,537
Amortized Cost
Current assets
Interest receivable $ 4,000
Income Statement
Other income and expense
Interest revenue ($4,614 $4,645) $ 9,259
Sometimes, a company sells a bond investment before its maturity. For example,
Robinson Company may sell securities as part of a change in its investment strategy
to move away from five-year debt investments, like the Evermaster bonds, to invest in
shorter-term bonds. Such a strategy would allow the bonds to reprice more frequently in
response to interest rate changes. Let’s assume that Robinson Company sells its invest-
ment in Evermaster bonds on November 1, 2013, at 993⁄4 plus accrued interest. The dis-
count amortization from July 1, 2013, to November 1, 2013, is $522 ( 4⁄6 $783). Robinson
records this discount amortization as follows.
November 1, 2013
Interest Revenue 522
Illustration 17-4 shows the computation of the realized gain on the sale.
ILLUSTRATION 17-4
Selling price of bonds (exclusive of accrued interest) $99,750
Computation of Gain on
Less: Book value of bonds on November 1, 2013:
Amortized cost, July 1, 2013 $95,671 Sale of Bonds
Add: Discount amortized for the period July 1, 2013,
to November 1, 2013 522
96,193
Gain on sale of bonds $ 3,557
Robinson records the sale of the bonds as:

November 1, 2013
Cash 102,417
Interest Revenue (4/6 $4,000) 2,667
Gain on Sale of Debt Investment 3,557
The credit to Interest Revenue represents accrued interest for four months, for which
the purchaser pays cash. The debit to Cash represents the selling price of the bonds
plus accrued interest ($99,750 $2,667). The credit to Debt Investments represents the
book value of the bonds on the date of sale. The credit to Gain on Sale of Debt Invest-
ment represents the excess of the selling price over the book value of the bonds.
3
Although the example here is based on a single investment, the IASB indicates that companies
evaluate the investment strategy (or business model for managing the investments) at a higher
level of aggregation than the individual security. As a result, a company may have more than
one investment strategy. That is, a company may hold a portfolio of investments that is managed
to collect contractual cash flows and another portfolio of investments that is managed to
realize gains and losses on fair value changes. [6]
DEBT INVESTMENTS—FAIR VALUE

In some cases, companies both manage and evaluate investment performance
Objective•3
on a fair value basis. In these situations, these investments are managed and
Understand the accounting for debt
evaluated based on a documented risk-management or investment strategy
investments at fair value.
based on fair value information. For example, some companies often hold debt
investments with the intention of selling them in a short period of time. These
debt investments are often referred to as trading investments because companies fre-
quently buy and sell these investments to generate profits in short-term differences
in price.
Companies that account for and report debt investments at fair value follow the
same accounting entries as debt investments held-for-collection during the reporting
period. That is, they are recorded at amortized cost. However, at each reporting date,
companies adjust the amortized cost to fair value, with any unrealized holding gain
or loss reported as part of net income (fair value method). An unrealized holding
gain or loss is the net change in the fair value of a debt investment from one period
to another.
Example: Debt Investment at Fair Value (Single Security)

To illustrate the accounting for debt investments using the fair value approach, assume
the same information as in our previous illustration for Robinson Company. Recall that
Robinson Company purchased $100,000 of 8 percent bonds of Evermaster Corporation
on January 1, 2011, at a discount, paying $92,278.4 The bonds mature January 1, 2016,
and yield 10 percent; interest is payable each July 1 and January 1.
The journal entries in 2011 are exactly the same as those for amortized cost. These
entries are as follows.
January 1, 2011
Cash 92,278
July 1, 2011
Cash 4,000
December 31, 2011

Interest Receivable 4,000
Again, Illustration 17-2 shows the interest and amortization amounts. If the debt
investment is held-for-collection, no further entries are necessary. To apply the fair value
approach, Robinson determines that, due to a decrease in interest rates, the fair value
of the debt investment increased to $95,000 at December 31, 2011. Comparing the fair
value with the carrying amount of these bonds at December 31, 2011, Robinson has an
unrealized holding gain of $1,463, as shown in Illustration 17-5.
4
Companies may incur brokerage and transaction costs in purchasing securities. For
investments accounted for at fair value (both debt and equity), IFRS requires that these
costs be recorded in net income as other income and expense and not as an adjustment
to the carrying value of the investment. [7]
ILLUSTRATION 17-5
Fair value at December 31, 2011 $95,000
Computation of Unrealized
Amortized cost at December 31, 2011 (per Illustration 17-2) 93,537
Gain on Fair Value Debt
Unrealized holding gain or (loss) $ 1,463
Investment (2011)
Robinson therefore makes the following entry to record the adjustment of the debt
investment to fair value at December 31, 2011.
Securities Fair Value Adjustment 1,463
Robinson uses a valuation account (Securities Fair Value Adjustment) instead of

debiting Debt Investments to record the investment at fair value. The use of the Secu-
rities Fair Value Adjustment account enables Robinson to maintain a record at amor-
tized cost in the accounts. Because the valuation account has a debit balance, in this
case the fair value of Robinson’s debt investment is higher than its amortized cost.
The Unrealized Holding Gain or Loss—Income account is reported in the other
income and expense section of the income statement as part of net income. This ac-
count is closed to net income each period. The Securities Fair Value Adjustment ac-
count is not closed each period and is simply adjusted each period to its proper val-
uation. The Securities Fair Value Adjustment balance is not shown on the statement
of financial position but is simply used to restate the debt investment account to fair
value.
Robinson reports its investment in Evermaster bonds in its December 31, 2011,
financial statements as shown in Illustration 17-6.
ILLUSTRATION 17-6
Financial Statement
Investments Presentation of Debt
Debt investments $95,000 Investments at Fair Value
Current assets
Income Statement
Unrealized holding gain or (loss) 1,463
Continuing with our example, at December 31, 2012, assume that the fair value of
the Evermaster debt investment is $94,000. In this case, Robinson records an unreal-
ized holding loss of $2,388, as shown in Illustration 17-7.
ILLUSTRATION 17-7
DEBT INVESTMENTS
Computation of
DECEMBER 31, 2012
Unrealized Gain on
Amortized Debt Investment (2012)
Investment Cost Fair Value Unrealized Gain (Loss)
Evermaster Corporation 10% bonds $94,925 $94,000 $ (925)
Less: Previous securities fair value
adjustment balance (Dr.) 1,463
Securities fair value adjustment (Cr.) $(2,388)
As indicated in Illustration 17-7, the fair value of the debt investment is now less than the
amortized cost by $925. However, Robinson had rerecorded an unrealized gain in 2011.
Therefore, Robinson records a loss of $2,388 ($925 $1,463), which offsets the gain
recorded in 2011, resulting in a credit in the Securities Fair Value Adjustment
account of $925. Robinson makes the following journal entry.
A credit balance in the Securities Fair Value Adjustment account of $925 ($2,388
$1,463) reduces the amortized cost amount to fair value. Robinson reports its investment
in Evermaster bonds in its December 31, 2012, financial statements as shown in
Illustration 17-8.
ILLUSTRATION 17-8
Financial Statement
Presentation of Debt Investments
Investments at Fair Debt investments $94,000
Current assets
Value (2012)
Income Statement
Unrealized holding gain or (loss) $ (2,388)
Assume now that Robinson sells its investment in Evermaster bonds on November
1, 2013, at 99 3⁄4 plus accrued interest, similar to our earlier illustration on page xxx. All
the entries and computations are the same as the amortized cost example. The only
difference occurs on December 31, 2013. In that case, since the bonds are no longer
owned by Robinson, the Securities Fair Value Adjustment account should now be re-
ported at zero. Robinson makes the following entry to record the elimination of the
valuation account.
Securities Fair Value Adjustment 925
Unrealized Holding Gain or Loss—Income 925
At December 31, 2013, the income related to the Evermaster bonds is as shown in
ILLUSTRATION 17-9 Illustration 17-9.
Income Effects on Debt
Investment (2011–2013)
Amortized Cost Fair Value

Unrealized Unrealized Gain
Years Interest Gain on Sale Gain (Loss) Total Interest Gain on Sale (Loss) Total
2011 $ 9,259 $ 0 $0 $ 9,259 $ 9,259 $ 0 $1,463 $10,722
2012 9,388 0 0 9,388 9,388 0 (2,388) 7,000
2013 7,935 3,557 0 11,492 7,935 3,557 925 12,417
Total $26,582 $3,557 $0 $30,139 $26,582 $3,557 $ 0 $30,139
As indicated, over the life of the bond investment, interest revenue and the gain on sale
are the same using either amortized cost or fair value measurement. However, under
the fair value approach, an unrealized gain or loss is recorded in each year as the fair
value of the investment changes; overall, the gains or losses net out to zero.
SUMMARY OF DEBT INVESTMENT ACCOUNTING

The following chart illustrates the basic accounting for debt investments. ILLUSTRATION 17-14
Summary of Debt
Investment Accounting
Debt Investments
Characteristics of the
Business model test: Yes Yes No
financial asset test: Fair value option? Amortized cost
Held-for-collection?
Contractual cash flows?
No No Yes
Fair value through income
SECTION 2 • EQU ITY I NVESTMENTS
An equity investment represents ownership interest, such as ordinary, prefer-

Objective•5
ence, or other capital shares. It also includes rights to acquire or dispose of own-
Understand the accounting for
ership interests at an agreed-upon or determinable price, such as in warrants and
equity investments at fair value.
rights. The cost of equity investments is measured at the purchase price of the
security. Broker’s commissions and other fees incidental to the purchase are
recorded as expense. [9]
The degree to which one corporation (investor) acquires an interest in the shares
of another corporation (investee) generally determines the accounting treatment for
the investment subsequent to acquisition. The classification of such investments
depends on the percentage of the investee voting shares that is held by the investor:
1. Holdings of less than 20 percent (fair value method)—investor has passive interest.
2. Holdings between 20 percent and 50 percent (equity method)—investor has signif-
icant influence.
3. Holdings of more than 50 percent (consolidated statements)—investor has control-
ling interest.
Illustration 17-15 lists these levels of interest or influence and the corresponding
valuation and reporting method that companies must apply to the investment.
ILLUSTRATION 17-15
Percentage
of Ownership 0% —¡ 20% —¡ 50% —¡ 100%
Levels of Influence
Determine Accounting
Level of Little or Methods
Influence None Significant Control
Valuation Fair Value Equity
Method Method Method Consolidation
The accounting and reporting for equity investments therefore depend on the level
of influence and the type of security involved, as shown in Illustration 17-16.
ILLUSTRATION 17-16
Unrealized Holding
Accounting and Reporting Category Valuation Gains or Losses Other Income Effects
for Equity Investments by
Holdings less
Category
than 20%
1. Trading Fair value Recognized in net Dividends declared;
income gains and losses
from sale.
2. Non- Fair value Recognized in “Other Dividends declared;
Trading comprehensive gains and losses
income” and as from sale.
separate component
of equity
Holdings between Equity Not recognized Proportionate share
20% and 50% of investee’s net
income.
Holdings more Consolidation Not recognized Not applicable.
than 50%
EQUITY INVESTMENTS AT FAIR VALUE

When an investor has an interest of less than 20 percent, it is presumed that the investor
has little or no influence over the investee. As indicated in Illustration 17-16, there are
two classifications for holdings less than 20 percent. Under IFRS, the presumption is
that equity investments are held-for-trading. That is, companies hold these securities to
profit from price changes. As with debt investments that are held-fortrading, the gen-
eral accounting and reporting rule for these investments is to value the securities at fair
value and record unrealized gains and losses in net income (fair value method).5
However, some equity investments are held for purposes other than trading. For
example, a company may be required to hold an equity investment in order to sell its
products in a particular area. In this situation, the recording of unrealized gains and
losses in income, as is required for trading investments, is not indicative of the com-
pany’s performance with respect to this investment. As a result, IFRS allows compa-
nies to classify some equity investments as non-trading. Non-trading equity invest-
ments are recorded at fair value on the statement of financial position, with unrealized
gains and losses reported in other comprehensive income. [11]
Example: Equity Investment (Income)

Upon acquisition, companies record equity investments at fair value.6 To illustrate, as-
sume that on November 3, 2011, Republic Corporation purchased ordinary shares of
three companies, each investment representing less than a 20 percent interest.
5
Fair value at initial recognition is the transaction price (exclusive of brokerage and other
transaction costs). Subsequent fair value measurements should be based on market prices,
if available. For non-traded investments, a valuation technique based on discounted expected
cash flows can be used to develop a fair value estimate. While IFRS requires that all equity
investments be measured at fair value, in certain limited cases, cost may be an appropriate
estimate of fair value for an equity investment. [10]
6
Companies should record equity investments acquired in exchange for non-cash consideration
(property or services) at the fair value of the consideration given, if the fair value can be
measured reliably. Otherwise, the value of the exchange can be determined with reference to the
fair value of the equity investment. Accounting for numerous purchases of securities requires
the preservation of information regarding the cost of individual purchases, as well as the dates
of purchases and sales. If specific identification is not possible, companies may use an average
cost for multiple purchases of the same class of security. The first-in, first-out method (FIFO) of
assigning costs to investments at the time of sale is also acceptable and normally employed.
Cost
Burberry €259,700
Nestlé 317,500
St. Regis Pulp Co. 141,350
Total cost €718,550
Republic records these investments as follows.

November 3, 2011
Equity Investments 718,550
Cash 718,550
On December 6, 2011, Republic receives a cash dividend of €4,200 on its investment

in the ordinary shares of Nestlé. It records the cash dividend as follows.
December 6, 2011
Cash 4,200
Dividend Revenue 4,200
All three of the investee companies reported net income for the year, but only Nestlé
declared and paid a dividend to Republic. But, recall that when an investor owns less
than 20 percent of the shares of another corporation, it is presumed that the investor
has relatively little influence on the investee. As a result, net income earned by the
investee is not a proper basis for recognizing income from the investment by the
investor. Why? Because the increased net assets resulting from profitable operations
may be permanently retained for use in the investee’s business. Therefore, the investor
earns net income only when the investee declares cash dividends.
At December 31, 2011, Republic’s equity investment portfolio has the carrying value
and fair value shown in Illustration 17-17.
ILLUSTRATION 17-17
EQUITY INVESTMENT PORTFOLIO
DECEMBER 31, 2011
Computation of Securities
Fair Value Adjustment—
Carrying Fair Unrealized Equity Investment
Investments Value Value Gain (Loss)
Portfolio (2011)
Burberry €259,700 €275,000 € 15,300
Nestlé 317,500 304,000 (13,500)
St. Regis Pulp Co. 141,350 104,000 (37,350)
Total of portfolio €718,550 €683,000 (35,550)
Previous securities fair value
adjustment balance –0–
Securities fair value
adjustment—Cr. €(35,550)
For Republic’s equity investment portfolio, the gross unrealized gains are €15,300, and
the gross unrealized losses are €50,850 (€13,500 €37,350), resulting in a net unrealized
loss of €35,550. The fair value of the equity investment portfolio is below cost by €35,550.
As with debt investments, Republic records the net unrealized gains and losses re-
lated to changes in the fair value of equity investments in an Unrealized Holding Gain
or Loss—Income account. Republic reports this amount as other income and expense.
In this case, Republic prepares an adjusting entry debiting the Unrealized Holding Gain
or Loss—Income account and crediting the Securities Fair Value Adjustment account
to record the decrease in fair value and to record the loss as follows.
December 31, 2011
On January 23, 2012, Republic sold all of its Burberry ordinary shares, receiving
€287,220. Illustration 17-18 shows the computation of the realized gain on the sale.
ILLUSTRATION 17-18
Net proceeds from sale €287,220
Cost of Burberry shares 259,700
Sale of Burberry Shares
Gain on sale of shares € 27,520
Republic records the sale as follows.

January 23, 2012
Cash 287,220
Gain on Sale of Equity Investment 27,520
In addition, assume that on February 10, 2012, Republic purchased €255,000 of

Continental Trucking ordinary shares (20,000 shares €12.75 per share), plus broker-
age commissions of €1,850.
Illustration 17-19 lists Republic’s equity investment portfolio as of December 31,
2012.
ILLUSTRATION 17-19
EQUITY INVESTMENT PORTFOLIO
Computation of Securities DECEMBER 31, 2012
Equity Investment Carrying Fair Unrealized
Investments Value Value Gain (Loss)
Portfolio (2012)
Continental Trucking €255,000a €278,350 € 23,350
Nestlé 317,500 362,550 45,050
St. Regis Pulp Co. 141,350 139,050 (2,300)
Total of portfolio €713,850 €779,950 66,100
Previous securities fair value
adjustment balance—Cr. (35,550)
Securities fair value adjustment—Dr. €101,650
a
The brokerage commissions are expensed.
At December 31, 2012, the fair value of Republic’s equity investment portfolio
exceeds carrying value by €66,100 (unrealized gain). The Securities Fair Value Adjust-
ment account had a credit balance of €35,550 at December 31, 2012. To adjust its
December 31, 2012, equity investment portfolio to fair value, the company debits the
Securities Fair Value Adjustment account for €101,650 (€35,550 €66,100). Republic
records this adjustment as follows.
December 31, 2012
Example: Equity Investments (OCI)

The accounting entries to record non-trading equity investments are the same as for
trading equity investments, except for recording the unrealized holding gain or loss.
For non-trading equity investments, companies report the unrealized holding gain or
loss as other comprehensive income. Thus, the account titled Unrealized Holding Gain
or Loss—Equity is used.
To illustrate, assume that on December 10, 2011, Republic Corporation purchased

€20,750 of 1,000 ordinary shares of Hawthorne Company for €20.75 per share (which
represents less than a 20 percent interest). Hawthorne is a distributor for Republic prod-
ucts in certain locales, the laws of which require a minimum level of share ownership
of a company in that region. The investment in Hawthorne meets this regulatory require-
ment. As a result, Republic accounts for this investment at fair value, with unrealized
gains and losses recorded in other comprehensive income (OCI).7 Republic records
this investment as follows.
December 10, 2011
Cash 20,750
On December 27, 2011, Republic receives a cash dividend of €450 on its invest-
ment in the ordinary shares of Hawthorne Company. It records the cash dividend as
follows.
December 27, 2011
Cash 450
Dividend Revenue 450
Similar to the accounting for trading investments, when an investor owns less than
20 percent of the ordinary shares of another corporation, it is presumed that the investor
has relatively little influence on the investee. Therefore, the investor earns income when
the investee declares cash dividends.
At December 31, 2011, Republic’s investment in Hawthorne has the carrying value
and fair value shown in Illustration 17-20.
ILLUSTRATION 17-20
Unrealized
Computation of Securities
Non-Trading Equity Investment Carrying Value Fair Value Gain (Loss)
Hawthorne Company €20,750 €24,000 €3,250
Non-Trading Equity
Previous securities fair value adjustment balance 0
Investment (2011)
Securities fair value adjustment (Dr.) €3,250
For Republic’s non-trading investment, the unrealized gain is €3,250. That is, the
fair value of the Hawthorne investment exceeds cost by €3,250. Because Republic has
classified this investment as non-trading, Republic records the unrealized gains and
losses related to changes in the fair value of this non-trading equity investment in an
Unrealized Holding Gain or Loss—Equity account. Republic reports this amount as a
part of other comprehensive income and as a component of other accumulated com-
prehensive income (reported in equity) until realized. In this case, Republic prepares
an adjusting entry crediting the Unrealized Holding Gain or Loss—Equity account and
debiting the Securities Fair Value Adjustment account to record the decrease in fair
value and to record the loss as follows.
December 31, 2011
Unrealized Holding Gain or Loss—Equity 3,250
7
The classification of an equity investment as non-trading is irrevocable. This approach is
designed to provide some discipline to the application of the non-trading classification,
which allows unrealized gains and losses to bypass net income. [12]
Republic reports its equity investments in its December 31, 2011, financial statements
as shown in Illustration 17-21.
ILLUSTRATION 17-21
Financial Statement
Investments
Presentation of Equity Equity investments €24,000
Investments at Fair
Value (2011) Equity
Accumulated other comprehensive gain € 3,250
Statement of Comprehensive Income

Dividend revenue € 450
Other comprehensive income

Unrealized holding gain € 3,250
During 2012, sales of Republic products through Hawthorne as a distributor did

not meet management’s goals. As a result, Republic withdrew from these markets and
on December 20, 2012, Republic sold all of its Hawthorne Company ordinary shares,
receiving net proceeds of €22,500. Illustration 17-22 shows the computation of the
realized gain on the sale.
ILLUSTRATION 17-22
Net proceeds from sale €22,500
Cost of Hawthorne shares 20,750
Sale of Shares
Gain on sale of shares € 1,750
Republic records the sale as follows.

December 20, 2012
Cash 22,500
Gain on Sale of Equity Investment 1,750
Because Republic no longer holds any equity investments, it makes the following entry
to eliminate the Securities Fair Value Adjustment account.8
Unrealized Holding Gain or Loss—Equity 3,250
In summary, the accounting for non-trading equity investments deviates from the
general provisions for equity investments. The IASB noted that while fair value pro-
vides the most useful information about investments in equity investments, recording
unrealized gains or losses in other comprehensive income is more representative for
non-trading equity investments. [14]
8
Once non-trading equity investments are sold, companies may transfer the balance of
unrealized holding gains or losses in Accumuluted other comprehensive income to retained
earnings. Transferring the balance to retained earnings has merit, as these gains or losses
would have been recorded in net income in a prior period if these securities were accounted
for as trading securities. Some contend that these unrealized gains or losses should be
“recycled”; that is, these amounts should be recorded in net income when a non-trading
investment is sold. The IASB rejected this approach because it would increase the
complexity of the accounting for these investments. [13]
IMPAIRMENT OF VALUE
A company should evaluate every held-for-collection investment, at each reporting
date, to determine if it has suffered impairment—a loss in value such that the fair
value of the investment is below its carrying value.10 For example, if an investee
experiences a bankruptcy or a significant liquidity crisis, the investor may suffer a
permanent loss. If the company determines that an investment is impaired, it writes
down the amortized cost basis of the individual security to reflect this loss in value.
The company accounts for the write-down as a realized loss, and it includes the amount
in net income.
For debt investments, a company uses the impairment test to determine whether
“it is probable that the investor will be unable to collect all amounts due according to
the contractual terms.” If an investment is impaired, the company should measure the
loss due to the impairment. This impairment loss is calculated as the difference be-
tween the carrying amount plus accrued interest and the expected future cash flows
discounted at the investment’s historical effective-interest rate. [18]
Example: Impairment Loss

At December 31, 2010, Mayhew Company has a debt investment in Bellovary Inc., pur-
chased at par for $200,000. The investment has a term of four years, with annual inter-
est payments at 10 percent, paid at the end of each year (the historical effective-interest
rate is 10 percent). This debt investment is classified as held-for-collection. Unfortu-
nately, Bellovary is experiencing significant financial difficulty and indicates that it will
be unable to make all payments according to the contractual terms. Mayhew uses the
present value method for measuring the required impairment loss. Illustration 17-24
shows the cash flow schedule prepared for this analysis.
ILLUSTRATION 17-24
Contractual Expected Loss of
Investment Cash Flows
Dec. 31 Cash Flows Cash Flows Cash Flows
2011 $ 20,000 $ 16,000 $ 4,000
2012 20,000 16,000 4,000
2013 20,000 16,000 4,000
2014 220,000 216,000 4,000
Total cash flows $280,000 $264,000 $16,000
As indicated, the expected cash flows of $264,000 are less than the contractual cash
flows of $280,000. The amount of the impairment to be recorded equals the difference
between the recorded investment of $200,000 and the present value of the expected
cash flows, as shown in Illustration 17-25.
ILLUSTRATION 17-25
Recorded investment $200,000
Computation of
Less: Present value of $200,000 due in 4 years at 10%
(Table 6-2); FV(PVF4,10%); ($200,000 .68301) $136,602 Impairment Loss
Present value of $16,000 interest receivable annually
for 4 years at 10% (Table 6-4); R(PVF-OA4,10%);
($16,000 3.16986) 50,718 187,312
10
Note that impairments tests are conducted only for debt investments that are held-for-
collection (which are accounted for at amortized cost). Other debt and equity investments
are measured at fair value each period; thus, an impairment test is not needed.
The loss due to the impairment is $12,688.11 Why isn’t it $16,000 ($280,000
$248,000)? A loss of $12,688 is recorded because Mayhew must measure the loss at a
present value amount, not at an undiscounted amount. Mayhew recognizes an impair-
ment loss of $12,688 by debiting Loss on Impairment for the expected loss. At the same
time, it reduces the overall value of the investment. The journal entry to record the loss
is therefore as follows.
Recovery of Impairment Loss

Subsequent to recording an impairment, events or economic conditions may change
such that the extent of the impairment loss decreases (e.g., due to an improvement in
the debtor’s credit rating). In this situation, some or all of the previously recognized
impairment loss shall be reversed with a debit to the Debt Investments account and
crediting Recovery of Impairment Loss. Similar to the accounting for impairments of
receivables shown in Chapter 7, the reversal of impairment losses shall not result in a
carrying amount of the investment that exceeds the amortized cost that would have
been reported had the impairment not been recognized.
TRANSFERS BETWEEN CATEGORIES

Transferring an investment from one classification to another should occur only
Objective•8
when the business model for managing the investment changes. The IASB expects
Describe the accounting for transfer
such changes to be rare. [19] Companies account for transfers between classifica-
of investments between categories.
tions prospectively, at the beginning of the accounting period after the change in
the business model.12
To illustrate, assume that British Sky Broadcasting Group plc (GBR) has a port-
folio of debt investments that are classified as trading; that is, the debt investments are
not held-for-collection but managed to profit from interest rate changes. As a result, it
accounts for these investments at fair value. At December 31, 2010, British Sky has the
following balances related to these securities.
Debt investments £1,200,000

Securities fair value adjustment 125,000
Carrying value £1,325,000
As part of its strategic planning process, completed in the fourth quarter of 2010,
British Sky management decides to move from its prior strategy—which requires ac-
tive management—to a held-for-collection strategy for these debt investments. British
11
Many question this present value calculation because it uses the investment’s historical
effective-interest rate—not the current market rate. As a result, the present value computation
does reflect the fair value of the debt investment, and many believe the impairment loss is
misstated.
12
The Board rejected retrospective application because recasting prior periods according to
the new investment model would not reflect how the investments were managed in the
prior periods. The IASB indicates that a change in a company’s investment business model
is a significant and demonstrable event, and it is likely that this change will be disclosed
when the change occurs. [20]
Sky makes the following entry to transfer these securities to the held-for-collection
classification.
January 1, 2011

Therefore, at January 1, 2011, the debt investments are stated at fair value. However,
in subsequent periods, British Sky will account for the investment at amortized cost.
The effective-interest rate used in the amortized cost model is the rate used to discount
the future cash flows to the fair value of British Sky’s debt investment of £125,000 on
January 1, 2011.
SUMMARY OF REPORTING TREATMENT OF INVESTMENTS

Illustration 17-26 summarizes the major debt and equity investment classifications and
their reporting treatment.
Valuation Approach and Reporting on the

Classification Statement of Financial Position Income Effects
Debt Investment
1. Meets business model (held- Amortized cost. Current or Non-current assets. Interest is recognized as revenue.
for-collection) and contractual
cash flow tests.
2. Does not meet the business Fair value. Current assets. Interest is recognized as revenue.
model test (not held-for-collection). Unrealized holding gains and losses
are included in income.
3. Fair value option Fair value. Current or Non-current assets. Interest is recognized as revenue.
Unrealized holding gains and losses
are included in income.
Equity Investment
1. Does not meet contractual cash Fair value. Current assets. Dividends are recognized as revenue.
flow test; holdings less than Unrealized holding gains and losses
20 percent (trading). are included in income.
2. Does not meet contractual cash Fair value. Non-current assets. Dividends are recognized as revenue.
flow test; holdings less than Unrealized holding gains and losses
20 percent (non-trading). are not included in income but in
other comprehensive income.
3. Holdings greater than 20 percent Investments originally recorded at cost with Revenue is recognized to the extent
(significant influence or control). periodic adjustment for the investor’s share of of the investee’s income or loss
the investee’s income or loss, and decreased reported subsequent to the date of
by all dividends received from the investee. the investment.
Non-current assets.
ILLUSTRATION 17-26
Summary of Investment
Accounting Approaches
INVESTMENTS
Until recently, when the IASB issued IFRS 9, the accounting and reporting for investments under IFRS and U.S.
GAAP were for the most part very similar. However, IFRS 9 introduces new investment classifications and in-
creases the situations when investments are accounted for at fair value, with gains and losses recorded in income.

• U.S. GAAP classifies investments as trading, available- The following example illustrates the accounting for investment im-
for-sale (both debt and equity investments), and held- pairments under IFRS. Belerus Company has a held-for-collection in-
to-maturity (only for debt investments). IFRS uses vestment in the 8 percent, 10-year bonds of Wimbledon Company.
held-for-collection (debt investments), trading (both The investment has a carrying value of €2,300,000 at December 31,
debt and equity investments), and non-trading equity 2011. Early in January 2012, Belerus learns that Wimbledon has lost
investment classifications. a major customer. As a result, Belerus determines that this invest-
• The accounting for trading investments is the same ment is impaired and now has a fair value of €1,500,000. Belerus
between U.S. GAAP and IFRS. Held-to-maturity (U.S. makes the following entry to record the impairment.
GAAP) and held-for-collection investments are accounted Loss on Impairment (€2,300,000 €1,500,000) 800,000
for at amortized cost. Gains and losses related to Debt Investments (HFC) 800,000
available-for-sale securities (U.S. GAAP) and non- Early in 2013, Wimbledon secures several new customers, and its
trading equity investments (IFRS) are reported in other prospects have improved considerably. Belerus determines the fair
comprehensive income. value of its investment is now €2,000,000 and makes the following
• Both U.S. GAAP and IFRS use the same test to deter- entry under IFRS.
mine whether the equity method of accounting should Debt Investments (HFC)
be used—that is, significant influence with a general (€2,000,000 €1,500,000) 500,000
guide of over 20 percent ownership. Recovery of Investment Loss 500,000
• The basis for consolidation under IFRS is control. Under U.S. GAAP, Belerus is prohibited from recording the recovery
Under U.S. GAAP, a bipolar approach is used, which in value of the impaired investment. That is, once an investment is im-
is a risk-and-reward model (often referred to as a paired, the impaired value becomes the new basis for the investment.
variable-entity approach) and a voting-interest
approach. However, under both systems, for consoli-
dation to occur, the investor company must generally
own 50 percent of another company.
• U.S. GAAP and IFRS are similar in the accounting for the fair value option. That is, the selection to use the fair value method must be
made at initial recognition, the selection is irrevocable, and gains and losses are reported as part of income. One difference is that U.S.
GAAP permits the fair value option for equity method investments.
• While measurement of impairments is similar, U.S. GAAP does not permit the reversal of an impairment charge related to available-for-sale
debt and equity investments. IFRS allows reversals of impairments of held-for-collection investments.
ON TH E HORIZON
At one time, both the FASB and IASB have indicated that they believe that all financial instruments should be
reported at fair value and that changes in fair value should be reported as part of net income. However, the recently
issued IFRS indicates that the IASB believes that certain debt investments should not be reported at fair value.
The IASB’s decision to issue new rules on investments, earlier than the FASB has completed its deliberations on
financial instrument accounting, could create obstacles for the Boards in converging the accounting in this area.
17-18
Embedded Derivatives
As we indicated at the beginning of this appendix, rapid innovation in the develop-
ment of complex financial instruments drove efforts toward unifying and improving
the accounting standards for derivatives. In recent years, this innovation has led to the
development of hybrid securities. These securities have characteristics of both debt
and equity. They often combine traditional and derivative financial instruments.
For example, a convertible bond (discussed in Chapter 16) is a hybrid instrument. It
consists of two parts: (1) a debt security, referred to as the host security, combined with
(2) an option to convert the bond to ordinary shares, the embedded derivative.
In accounting for embedded derivatives, some support an approach similar to the
accounting for other derivatives; that is, separate the embedded derivative from the
host security and then account for it using the accounting for derivatives. This sepa-
ration process is referred to as bifurcation. However, the IASB, based on concerns about
the complexity of the bifurcation approach, required that the embedded derivative and
host security be accounted for as a single unit.32 The accounting followed is based on
the classification of the host security.33
QUESTIONS
1. Describe the two criteria for determining the valuation of 8. Indicate how unrealized holding gains and losses should
financial assets. be reported for investments classified as trading and held-
2. Which types of investments are valued at amortized cost? for-collection.
Explain the rationale for this accounting. 9. (a) Assuming no Securities Fair Value Adjustment account
3. What is amortized cost? What is fair value? balance at the beginning of the year, prepare the adjust-
ing entry at the end of the year if Laura Company’s trad-
4. Lady Gaga Co. recently made an investment in the bonds
ing bond investment has a fair value €60,000 below
issued by Chili Peppers Inc. Lady Gaga’s business model
carrying value. (b) Assume the same information as part
for this investment is to profit from trading in response to
(a), except that Laura Company has a debit balance in its
changes in market interest rates. How should this invest-
Securities Fair Value Adjustment account of €10,000 at
ment be classified by Lady Gaga? Explain.
the beginning of the year. Prepare the adjusting entry at
5. Consider the bond investment by Lady Gaga in question 4. year-end.
Discuss the accounting for this investment if Lady Gaga’s
10. What is the fair value option? Briefly describe its applica-
business model is to hold the investment to collect inter-
tion to debt investments.
est while outstanding and to receive the principal at
maturity. 11. Franklin Corp. has an investment that it has held for
several years. When it purchased the investment, Franklin
6. On July 1, 2010, Wheeler Company purchased $4,000,000
accounted for the investment at amortized cost. Can
of Duggen Company’s 8% bonds, due on July 1, 2017. The
Franklin use the fair value option for this investment?
bonds, which pay interest semiannually on January 1 and
Explain.
July 1, were purchased for $3,500,000 to yield 10%. Deter-
mine the amount of interest revenue Wheeler should 12. Identify and explain the different types of classifications
report on its income statement for year ended December 31, for equity investments.
2010, assuming Wheeler plans to hold this investment to 13. Why is the held-for-collection classification not applicable
collect contractual cash flows. only to equity investments?
7. If the bonds in question 6 are classified as trading and they 14. Hayes Company purchased 10,000 ordinary shares of
have a fair value at December 31, 2010, of $3,604,000, Kenyon Co., paying $26 per share plus $1,500 in broker
prepare the journal entry (if any) at December 31, 2010, to fees. Hayes plans to actively trade this investment. Pre-
record this transaction. pare the entry to record this investment.
32
A company can also designate such a derivative as a hedging instrument. The company
would apply the hedge accounting provisions outlined earlier in the chapter.
33
As discussed in Chapter 16, the issuer of the convertible bonds would bifurcate the option
component of the convertible bonds payable.
BRIEF EXERCISES
•2 BE17-1 Garfield Company made an investment in €80,000 of the 9%, 5-year bonds of Chester Corpora-
tion for €74,086, which provides an 11% return. Garfield plans to hold these bonds to collect contractual
cash flows. Prepare Garfield’s journal entries for (a) the purchase of the investment, and (b) the receipt
of annual interest and discount amortization.
•2 •3 BE17-2 Use the information from BE17-1, but assume Garfield plans to actively trade the bonds to profit
from market interest rates changes. Prepare Garfield’s journal entries for (a) the purchase of the invest-
ment, (b) the receipt of annual interest and discount amortization, and (c) the year-end fair value adjust-
ment. The bonds have a year-end fair value of €75,500.
•2 BE17-3 Carow Corporation purchased, as a held-for-collection investment, €60,000 of the 8%, 5-year
bonds of Harrison, Inc. for €65,118, which provides a 6% return. The bonds pay interest semiannually.
Prepare Carow’s journal entries for (a) the purchase of the investment, and (b) the receipt of semiannual
interest and premium amortization.
•5 BE17-6 Fairbanks Corporation purchased 400 ordinary shares of Sherman Inc. as a trading investment
for £13,200. During the year, Sherman paid a cash dividend of £3.25 per share. At year-end, Sherman
shares were selling for £34.50 per share. Prepare Fairbanks’s journal entries to record (a) the purchase of
the investment, (b) the dividends received, and (c) the fair value adjustment.
•5 BE17-7 Use the information from BE17-6 but assume the shares were purchased to meet a non-trading
regulatory requirement. Prepare Fairbanks’s journal entries to record (a) the purchase of the investment,
(b) the dividends received, and (c) the fair value adjustment.
•8 BE17-11 Cameron Company has a portfolio of debt investments that it has managed as a trading invest-
ment. At December 31, 2010, Cameron had the following balances related to this portfolio: debt invest-
ments, £250,000; securities fair value adjustment, £10,325 (Dr). Cameron management decides to change
its business model for these investments to a held-for-collection strategy, beginning in January 2011. Pre-
pare the journal entry to transfer these investments to the held-for-collection classification.
EXERCISES
•1 •3 E17-1 (Investment Classifications) For the following investments, identify whether they are:
1. Debt investments at amortized cost.
2. Debt investments at fair value.
3. Trading equity investments.
4. Non-trading equity investments.
Each case is independent of the other.
(a) A bond that will mature in 4 years was bought 1 month ago when the price dropped. As soon as
the value increases, which is expected next month, it will be sold.
(b) 10% of the outstanding shares of Farm-Co was purchased. The company is planning on eventu-
ally getting a total of 30% of its outstanding shares.
(c) 10-year bonds were purchased this year. The bonds mature at the first of next year, and the com-
pany plans to sell the bonds if interest rates fall.
(d) Bonds that will mature in 5 years are purchased. The company has a strategy to hold them to
collect the contractual cash flows on the bond.
(e) A bond that matures in 10 years was purchased. The company is investing money set aside for an
expansion project planned 10 years from now.
(f) Ordinary shares in a distributor are purchased to meet a regulatory requirement for doing busi-
ness in the distributor’s region. The investment will be held indefinitely.
•2 E17-3 (Debt Investments) On January 1, 2010, Roosevelt Company purchased 12% bonds, having a
maturity value of $500,000, for $537,907.40. The bonds provide the bondholders with a 10% yield. They
are dated January 1, 2010, and mature January 1, 2015, with interest receivable December 31 of each year.
Roosevelt’s business model is to hold these bonds to collect contractual cash flows.
Instructions
(a) Prepare the journal entry at the date of the bond purchase.
(b) Prepare a bond amortization schedule.
(c) Prepare the journal entry to record the interest received and the amortization for 2010.
(d) Prepare the journal entry to record the interest received and the amortization for 2011.
•3 E17-5 (Debt Investments) Assume the same information as in E17-3 except that Roosevelt has an active
trading strategy for these bonds. The fair value of the bonds at December 31 of each year-end is as follows.
2010 $534,200 2013 $517,000
2011 $515,000 2014 $500,000
2012 $513,000
Instructions
(a) Prepare the journal entry at the date of the bond purchase.
(b) Prepare the journal entries to record the interest received and recognition of fair value for 2010.
(c) Prepare the journal entry to record the recognition of fair value for 2011.
•5 E17-9 (Equity Investments) On December 21, 2010, Zurich Company provided you with the follow-
ing information regarding its trading investments.
December 31, 2010
Investments (Trading) Cost Fair Value Unrealized Gain (Loss)
Stargate Corp. shares €20,000 €19,000 €(1,000)
Carolina Co. shares 10,000 9,000 (1,000)
Vectorman Co. shares 20,000 20,600 600
Total of portfolio €50,000 €48,600 (1,400)
Previous securities fair value adjustment balance –0–
Securities fair value adjustment—Cr. €(1,400)
During 2011, Carolina Company shares were sold for €9,500. The fair value of the shares on December 31,
2011, was: Stargate Corp. shares—€19,300; Vectorman Co. shares—€20,500.
Instructions
(a) Prepare the adjusting journal entry needed on December 31, 2010.
(b) Prepare the journal entry to record the sale of the Carolina Company shares during 2011.
(c) Prepare the adjusting journal entry needed on December 31, 2011.
•5 E17-10 (Equity Investment Entries and Reporting) Player Corporation makes an equity investment
costing $73,000 and classifies it as non-trading. At December 31, the fair value of the investment is $67,000.
Instructions
Prepare the adjusting entry to report the investments properly. Indicate the statement presentation of the
accounts in your entry.
•6 E17-18 (Equity Method) On January 1, 2010, Meredith Corporation purchased 25% of the ordinary
shares of Pirates Company for £200,000. During the year, Pirates earned net income of £80,000 and paid
dividends of £20,000.
Instructions
Prepare the entries for Meredith to record the purchase and any additional entries related to this invest-
ment in Pirates Company in 2010.
•7 E17-20 (Impairment) Komissarov Company has a debt investment in the bonds issued by Keune Inc.
The bonds were purchased at par for €400,000 and, at the end of 2010, have a remaining life of 3 years
with annual interest payments at 10%, paid at the end of each year. This debt investment is classified as
held-for-collection. Keune is facing a tough economic environment and informs all of its investors that it
will be unable to make all payments according to the contractual terms. The controller of Komissarov has
prepared the following revised expected cash flow forecast for this bond investment.
Expected
Dec. 31 Cash Flows
2011 € 35,000
2012 35,000
2013 385,000
Total cash flows €455,000
Instructions
(a) Determine the impairment loss for Komissarov at December 31, 2010.
(b) Prepare the entry to record the impairment loss for Komissarov at December 31, 2010.
(c) On January 15, 2011, Keune receives a major capital infusion from a private equity investor. It
informs Komissarov that the bonds now will be paid according to the contractual terms. Briefly
describe how Komissarov would account for the bond investment in light of this new information.
USING YOUR JUDGMENT

Instructions
oifrs
k ies Refer to M&S’s financial statements and the accompanying notes to answer the following questions.
/
(a) What investments does M&S report in 2008, and where are these investments reported in its finan-
llege
cial statements?
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(b) How are M&S’s investments valued? How does M&S determine fair value?
m
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i l e y. c o
(c) How does M&S use derivative financial instruments?

Your client, Cascade Company, is planning to invest some of its excess cash in 5-year revenue bonds
issued by the county and in the shares of one of its suppliers, Teton Co. Teton’s shares trade on the over-
the-counter market. Cascade plans to classify these investments as trading. They would like you to con-
duct some research on the accounting for these investments.
Instructions
(a) Since the Teton shares do not trade on one of the large securities exchanges, Cascade argues that the
fair value of this investment is not readily available. According to the authoritative literature, when
is the fair value of a security “readily determinable”?
(b) How is an impairment of a debt investment accounted for?
(c) To avoid volatility in their financial statements due to fair value adjustments, Cascade debated
whether the bond investment could be classified as held-for-collection; Cascade is pretty sure it will
hold the bonds for 5 years. What criteria must be met for Cascade to classify it as held-for-collection?
KiesoIFRS_SUpplement - 1stpp
Chapter 21 Accounting for Leases · 21–1
CHAPTER 21 ACCOUNTING FOR LEASES
This IFRS Supplement provides expanded discussions of accounting guidance under

International Financial Reporting Standards (IFRS) for the topics in Intermediate
Accounting. The discussions are organized according to the chapters in Intermediate
Accounting (13th or 14th Editions) and therefore can be used to supplement the U.S.
GAAP requirements as presented in the textbook. Assignment material is provided
for each supplement chapter, which can be used to assess and reinforce student
understanding of IFRS.
ACCOUNTING BY THE LESSEE

If Air France (FRA) (the lessee) capitalizes a lease, it records an asset and a liability
generally equal to the present value of the rental payments. ILFC (the lessor), having
transferred substantially all the benefits and risks of ownership, recognizes a sale by
removing the asset from the statement of financial position and replacing it with a re-
ceivable. The typical journal entries for Air France and ILFC, assuming leased and cap-
italized equipment, appear as shown in Illustration 21-1.
ILLUSTRATION 21-1
Air France ILFC
Journal Entries for
(Lessee) (Lessor)
Capitalized Lease
Leased Equipment XXX Lease Receivable XXX
Lease Liability XXX Equipment XXX
Having capitalized the asset, Air France records depreciation on the leased asset.
Both ILFC and Air France treat the lease rental payments as consisting of interest and
principal. U.S. GAAP
If Air France does not capitalize the lease, it does not record an asset, nor does ILFC PERSPECTIVE
remove one from its books. When Air France makes a lease payment, it records rental U.S. GAAP for leases uses
expense; ILFC recognizes rental revenue. bright-line criteria to
A lease is classified as a finance lease if it transfers substantially all the risks determine if a lease
and rewards incidental to ownership. In order to record a lease as a finance lease, arrangement transfers the
the lease must be non-cancelable. The IASB identifies the four criteria listed in risks and rewards of
ownership; IFRS is more
Illustration 21-2 for assessing whether the risks and rewards have been transferred
general in its provisions.
in the lease arrangement.
ILLUSTRATION 21-2
Capitalization Criteria (Lessee)
Capitalization Criteria
1. The lease transfers ownership of the property to the lessee. for Lessee
2. The lease contains a bargain-purchase option.1
3. The lease term is for the major part of the economic life of the asset.
4. The present value of the minimum lease payments amounts to substantially all of the fair value of
the leased asset. [1]
1
We define a bargain-purchase option in the next section.
21–2 · IFRS Supplement
Air France classifies and accounts for leases that do not meet any of the four criteria
as operating leases. Illustration 21-3 shows that a lease meeting any one of the four
criteria results in the lessee having a finance lease.2
Lease
Agreement
Is
Is Is Is Present
There a There a Lease Value of
Transfer of Bargain- Term for the Major
No No No Payments No
Ownership? Purchase Part of Economic Substantially
Option? Life? All of Fair
Value?
Operating
Yes Yes Yes Yes Lease
Finance
Lease
ILLUSTRATION 21-3
Diagram of Lessee’s
Criteria for Lease Thus, the proper classification of a lease is determined based on the substance of the lease
Classification transaction, rather than on its mere form. This determination often requires the use of
professional judgment of whether the risks and rewards of ownership are transferred.
Capitalization Criteria
Three of the four capitalization criteria that apply to lessees are controversial and can
U.S. GAAP be difficult to apply in practice. We discuss each of the criteria in detail on the follow-
PERSPECTIVE ing pages.
Much of the terminology for
lease accounting in IFRS and Transfer of Ownership Test
U.S. GAAP is the same. One If the lease transfers ownership of the asset to the lessee, it is a finance lease. This
difference is that finance
criterion is not controversial and easily implemented in practice.
leases are referred to as
capital leases in U.S. GAAP.
Bargain-Purchase Option Test
A bargain-purchase option allows the lessee to purchase the leased property for a price
that is significantly lower than the property’s expected fair value at the date the option
becomes exercisable. At the inception of the lease, the difference between the option price
and the expected fair value must be large enough to make exercise of the option rea-
sonably assured.
For example, assume that Brett’s Delivery Service was to lease a Honda Accord for
$599 per month for 40 months, with an option to purchase for $100 at the end of the
40-month period. If the estimated fair value of the Honda Accord is $3,000 at the end
2
A fifth criterion applies to the relatively less common setting in which the leased asset is
of such a specialized nature that only the lessee can use it without major modifications. If a
lease involves an asset with these characteristics, then the risks and rewards of ownership
are likely to transfer. In addition to the determinative criteria, lessees and lessors should
also consider the following indicators of situations that individually or in combination could
also lead to a lease being classified as a finance lease: (1) the lessee can cancel the lease,
and the lessor’s losses associated with the cancellation are borne by the lessee; (2) gains or
losses from the fluctuation in the fair value of the residual accrue to the lessee (e.g., in the
form of a rent rebate equaling most of the sales proceeds at the end of the lease); and (3) the
lessee has the ability to continue the lease for a secondary period at a rent that is substantially
lower than market rent. [2]
of the 40 months, the $100 option to purchase is clearly a bargain. Therefore, Brett must
capitalize the lease. In other cases, the criterion may not be as easy to apply, and
determining now that a certain future price is a bargain can be difficult.
Economic Life Test

If the lease period is for a major part of the asset’s economic life, the lessor transfers
most of the risks and rewards of ownership to the lessee. Capitalization is therefore
appropriate. However, determining the lease term and what constitutes the major part
of the economic life of the asset can be troublesome.
The IASB has not defined what is meant by the “major part” of an asset’s economic
life. In practice, following the IASB hierarchy, it has been customary to look to U.S. GAAP,
which has a 75 percent of economic life threshold for evaluating the economic life test.
While the 75 percent guideline may be a useful reference point, it does not represent an
automatic cutoff point. Rather, lessees and lessors should consider all relevant factors
when assessing whether substantially all the risks and rewards of ownership have been
transferred in the lease.3 For purposes of homework, assume a 75 percent threshold for the
economic life test, unless otherwise stated.
The lease term is generally considered to be the fixed, non-cancelable term of the
lease. However, a bargain-renewal option, if provided in the lease agreement, can ex-
tend this period. A bargain-renewal option allows the lessee to renew the lease for a
rental that is lower than the expected fair rental at the date the option becomes exer-
cisable. At the inception of the lease, the difference between the renewal rental and the
expected fair rental must be great enough to make exercise of the option to renew rea-
sonably assured. [3]
For example, assume that Carrefour (FRA) leases Lenovo (CHN) PCs for two years
at a rental of €100 per month per computer and subsequently can lease them for €10 per
month per computer for another two years. The lease clearly offers a bargain-renewal
option; the lease term is considered to be four years. However, with bargain-renewal
options, as with bargain-purchase options, it is sometimes difficult to determine what
is a bargain.
Determining estimated economic life can also pose problems, especially if the leased
item is a specialized item or has been used for a significant period of time. For exam-
ple, determining the economic life of a nuclear core is extremely difficult. It is subject
to much more than normal “wear and tear.”
Recovery of Investment Test

If the present value of the minimum lease payments equals or exceeds substantially
all of the fair value of the asset, then a lessee like Air France should capitalize the
leased asset. Why? If the present value of the minimum lease payments is reasonably
close to the fair value of the aircraft, Air France is effectively purchasing the asset.
As with the economic life test, the IASB has not defined what is meant by
“substantially all” of an asset’s fair value. In practice, it has been customary to look to
U.S. GAAP, which has a 90 percent of fair value threshold for assessing the recovery
of investment test. Again, rather than focusing on any single element of the lease
classification indicators, lessees and lessors should consider all relevant factors when
evaluating lease classification criteria.4 For purposes of homework, assume a 90 percent
threshold for the recovery of investment test.
3
See KPMG, Insights into IFRS, Fifth Edition (Thomson Reuters: London, 2008), pp. 1011; and
The International Financial Reporting Group of Ernst and Young, International GAAP, 2009 (John
Wiley and Sons: New York, 2009), p. 1356.
4
Ibid. The 75 percent of useful life and 90 percent of fair value “bright-line” cutoffs in U.S.
GAAP have been criticized. Many believe that lessees structure leases so as to just miss the
75 and 90 percent cutoffs, avoiding classifying leases as finance leases, thereby keeping
leased assets and the related liabilities off the statement of financial position. See Warren
McGregor, “Accounting for Leases: A New Approach,” Special Report (Norwalk, Conn.:
FASB, 1996).
Determining the present value of the minimum lease payments involves three im-
portant concepts: (1) minimum lease payments, (2) executory costs, and (3) discount rate.
Minimum Lease Payments. Air France is obligated to make, or expected to make, min-
imum lease payments in connection with the leased property. These payments include
the following. [4]
1. Minimum rental payments. Minimum rental payments are those that Air France
must make to ILFC under the lease agreement. In some cases, the minimum rental
payments may equal the minimum lease payments. However, the minimum lease
payments may also include a guaranteed residual value (if any), penalty for failure
to renew, or a bargain-purchase option (if any), as we note below.
2. Guaranteed residual value. The residual value is the estimated fair value of the
leased property at the end of the lease term. ILFC may transfer the risk of loss to
Air France or to a third party by obtaining a guarantee of the estimated residual
value. The guaranteed residual value is either (1) the certain or determinable amount
that Air France will pay ILFC at the end of the lease to purchase the aircraft at the
end of the lease, or (2) the amount Air France guarantees that ILFC will realize if
the aircraft is returned. If not guaranteed in full, the unguaranteed residual value
is the estimated residual value exclusive of any portion guaranteed.5
3. Penalty for failure to renew or extend the lease. The amount Air France must pay if
the agreement specifies that it must extend or renew the lease, and it fails to do so.
4. Bargain-purchase option. As we indicated earlier (in item 1), an option given to Air
France to purchase the aircraft at the end of the lease term at a price that is fixed
sufficiently below the expected fair value, so that, at the inception of the lease, pur-
chase is reasonably assured.
Air France excludes executory costs (defined below) from its computation of the
present value of the minimum lease payments.
Executory Costs. Like most assets, leased tangible assets incur insurance, maintenance,
and tax expenses—called executory costs—during their economic life. If ILFC retains
responsibility for the payment of these “ownership-type costs,” it should exclude, in
computing the present value of the minimum lease payments, the portion of each lease
payment that represents executory costs. Executory costs do not represent payment on
U.S. GAAP or reduction of the obligation.
PERSPECTIVE Many lease agreements specify that the lessee directly pays executory costs to the
IFRS requires that lessees appropriate third parties. In these cases, the lessor can use the rental payment without
use the implicit rate to adjustment in the present value computation.
record a lease unless it is
impractical to determine the Discount Rate. A lessee, like Air France, computes the present value of the minimum
lessor's implicit rate. U.S. lease payments using the implicit interest rate. [6] This rate is defined as the discount
GAAP requires use of the rate that, at the inception of the lease, causes the aggregate present value of the mini-
incremental rate unless the mum lease payments and the unguaranteed residual value to be equal to the fair value
implicit rate is known by the of the leased asset. [7]
lessee and the implicit rate While Air France may argue that it cannot determine the implicit rate of the lessor, in
is lower than the incremental
most cases Air France can approximate the implicit rate used by ILFC. In the event that
rate.
it is impracticable to determine the implicit rate, Air France should use its incremental
borrowing rate. The incremental borrowing rate is the rate of interest the lessee would
5
If the residual value is guaranteed by a third party, it is not included in the minimum lease
payments. (Third-party guarantors are, in essence, insurers who for a fee assume the risk of
deficiencies in leased asset residual value.) A lease provision requiring the lessee to make
up a residual value deficiency that is attributable to damage, extraordinary wear and tear,
or excessive usage is not included in the minimum lease payments. Lessees recognize such
costs as period costs when incurred. As noted earlier, such a provision could be an indicator
that a lease should be classified as a finance lease. [5]
have to pay on a similar lease or the rate that, at the inception of the lease, the lessee
would incur to borrow over a similar term the funds necessary to purchase the asset.
If known or practicable to estimate, use of the implicit rate is preferred. This is
because the implicit rate of ILFC is generally a more realistic rate to use in determining
the amount (if any) to report as the asset and related liability for Air France. In addition,
use of the implicit rate avoids use of an artificially high incremental borrowing rate that
would cause the present value of the minimum lease payments to be lower, support-
ing an argument that the lease does not meet the recovery of investment test. Use of
such a rate would thus make it more likely that the lessee avoids capitalization of the
leased asset and related liability.
Air France may argue that it cannot determine the implicit rate of the lessor and
therefore should use the higher incremental rate. However, in most cases, Air France
can approximate the implicit rate used by ILFC. The determination of whether or not
a reasonable estimate could be made will require judgment, particularly where the result
from using the incremental borrowing rate comes close to meeting the fair value test.
Because Air France may not capitalize the leased property at more than its fair value
(as we discuss later), it cannot use an excessively low discount rate.
Asset and Liability Accounted for Differently

In a finance lease transaction, Air France uses the lease as a source of financing. ILFC
finances the transaction (provides the investment capital) through the leased asset. Air
France makes rent payments, which actually are installment payments. Therefore, over
the life of the aircraft rented, the rental payments to ILFC constitute a payment of
principal plus interest.
Asset and Liability Recorded

Under the finance lease method, Air France treats the lease transaction as if it purchases
the aircraft in a financing transaction. That is, Air France acquires the aircraft and creates
an obligation. Therefore, it records a finance lease as an asset and a liability at either
(1) the present value of the minimum lease payments (excluding executory costs) or
(2) the fair value of the leased asset at the inception of the lease. The rationale for this
approach is that companies should not record a leased asset for more than its fair value.
Depreciation Period
One troublesome aspect of accounting for the depreciation of the capitalized leased as-
set relates to the period of depreciation. If the lease agreement transfers ownership of
the asset to Air France (criterion 1) or contains a bargain-purchase option (criterion 2),
Air France depreciates the aircraft consistent with its normal depreciation policy for
other aircraft, using the economic life of the asset.
On the other hand, if the lease does not transfer ownership or does not contain a
bargain-purchase option, then Air France depreciates it over the term of the lease. In
this case, the aircraft reverts to ILFC after a certain period of time.
Effective-Interest Method
Throughout the term of the lease, Air France uses the effective-interest method to allo-
cate each lease payment between principal and interest. This method produces a periodic
interest expense equal to a constant percentage of the carrying value of the lease obliga-
tion. When applying the effective-interest method to finance leases, Air France must use
the same discount rate that determines the present value of the minimum lease payments.
Depreciation Concept
Although Air France computes the amounts initially capitalized as an asset and recorded
as an obligation at the same present value, the depreciation of the aircraft and the dis-
charge of the obligation are independent accounting processes during the term of the
lease. It should depreciate the leased asset by applying conventional depreciation meth-
ods: straight-line, sum-of-the-years’digits, declining-balance, units of production, etc.
Finance Lease Method (Lessee)

To illustrate a finance lease, assume that CNH Capital (NLD) (a subsidiary of CNH
Global) and Ivanhoe Mines Ltd. (CAN) sign a lease agreement dated January 1, 2012,
that calls for CNH to lease a front-end loader to Ivanhoe beginning January 1, 2012. The
terms and provisions of the lease agreement, and other pertinent data, are as follows.
• The term of the lease is five years. The lease agreement is non-cancelable, requiring
equal rental payments of $25,981.62 at the beginning of each year (annuity-due basis).
• The loader has a fair value at the inception of the lease of $100,000, an estimated
economic life of five years, and no residual value.
• Ivanhoe pays all of the executory costs directly to third parties except for the prop-
erty taxes of $2,000 per year, which is included as part of its annual payments to CNH.
• The lease contains no renewal options. The loader reverts to CNH at the termina-
tion of the lease.
• Ivanhoe’s incremental borrowing rate is 11 percent per year.
• Ivanhoe depreciates similar equipment that it owns on a straight-line basis.
• CNH sets the annual rental to earn a rate of return on its investment of 10 percent
per year; Ivanhoe knows this fact.
The lease meets the criteria for classification as a finance lease for the following
reasons:
1. The lease term of five years, being equal to the equipment’s estimated economic life
of five years, satisfies the economic life test.
2. The present value of the minimum lease payments ($100,000 as computed below)
equals the fair value of the loader ($100,000).
The minimum lease payments are $119,908.10 ($23,981.62 5). Ivanhoe computes the
amount capitalized as leased assets as the present value of the minimum lease payments
(excluding executory costs—property taxes of $2,000) as shown in Illustration 21-4.
ILLUSTRATION 21-4
Computation of Capitalized amount ($25,981.62 $2,000) Present value of an annuity due of 1 for
5 periods at 10% (Table 6-5)
Capitalized Lease
$23,981.62 4.16986
Payments
$100,000
Ivanhoe uses CNH’s implicit interest rate of 10 percent instead of its incremental
Calculator Solution for
Lease Payment
borrowing rate of 11 percent because it knows about it.6 Ivanhoe records the finance
lease on its books on January 1, 2012, as:
Inputs Answer
Leased Equipment under Finance Leases 100,000
Lease Liability 100,000
N 5
Note that the entry records the obligation at the net amount of $100,000 (the pres-
ent value of the future rental payments) rather than at the gross amount of $119,908.10
I 10
($23,981.62 5).
Ivanhoe records the first lease payment on January 1, 2012, as follows.
PV ? 100,000 Property Tax Expense 2,000.00
Lease Liability 23,981.62
Cash 25,981.62
PMT –23,981.59
6
If it is impracticable for Ivanhoe to determine the implicit rate and it has an incremental
FV 0 borrowing rate of, say, 9 percent (lower than the 10 percent rate used by CNH), the present
value computation would yield a capitalized amount of $101,675.35 ($23,981.62 4.23972).
Thus, use of an unrealistically low discount rate could lead to a lessee recording a leased
asset at an amount exceeding the fair value of the equipment, which is generally prohibited
in IFRS. This explains why the implicit rate should be used to capitalize the minimum lease
payments.
Each lease payment of $25,981.62 consists of three elements: (1) a reduction in the
lease liability, (2) a financing cost (interest expense), and (3) executory costs (property
taxes). The total financing cost (interest expense) over the term of the lease is $19,908.10.
This amount is the difference between the present value of the lease payments ($100,000)
and the actual cash disbursed, net of executory costs ($119,908.10). The annual interest
expense, applying the effective-interest method, is a function of the outstanding liability,
as Illustration 21-5 shows.
ILLUSTRATION 21-5
IVANHOE MINES
Lease Amortization
LEASE AMORTIZATION SCHEDULE
ANNUITY-DUE BASIS Schedule for Lessee—
Annuity-Due Basis
Annual Reduction
Lease Executory Interest (10%) of Lease Lease
Date Payment Costs on Liability Liability Liability
(a) (b) (c) (d) (e)
1/1/12 $100,000.00
1/1/12 $ 25,981.62 $ 2,000 $ –0– $ 23,981.62 76,018.38
1/1/13 25,981.62 2,000 7,601.84 16,379.78 59,638.60
1/1/14 25,981.62 2,000 5,963.86 18,017.76 41,620.84
1/1/15 25,981.62 2,000 4,162.08 19,819.54 21,801.30
1/1/16 25,981.62 2,000 2,180.32* 21,801.30 –0–
$129,908.10 $10,000 $19,908.10 $100,000.00
(a) Lease payment as required by lease.

(b) Executory costs included in rental payment.
(c) Ten percent of the preceding balance of (e) except for 1/1/12; since this is an annuity due, no time has elapsed
at the date of the first payment and no interest has accrued.
(d) (a) minus (b) and (c).
(e) Preceding balance minus (d).
*Rounded by 19 cents.
At the end of its fiscal year, December 31, 2012, Ivanhoe records accrued interest
as follows.
Interest Expense 7,601.84
Interest Payable 7,601.84
Depreciation of the leased equipment over its five-year lease term, applying Ivanhoe’s
normal depreciation policy (straight-line method), results in the following entry on
December 31, 2012.
Depreciation Expense—Finance Leases 20,000
Accumulated Depreciation—Finance Leases 20,000
($100,000 5 years)
At December 31, 2012, Ivanhoe separately identifies the assets recorded under
finance leases on its statement of financial position. Similarly, it separately identifies the
related obligations. Ivanhoe classifies the portion due within one year or the operating
cycle, whichever is longer, with current liabilities, and the rest with non-current liabil-
ities. For example, the current portion of the December 31, 2012, total obligation of
$76,018.38 in Ivanhoe’s amortization schedule is the amount of the reduction in the
obligation in 2013, or $16,379.78. Illustration 21-6 shows the liabilities section as it relates
to lease transactions at December 31, 2012.
ILLUSTRATION 21-6
Non-current liabilities
Reporting Current and
Lease liability ($76,018.38 $16,379.78) $59,638.60 Non-Current Lease
Current liabilities Liabilities
Interest payable $ 7,601.84
Lease liability 16,379.78
Ivanhoe records the lease payment of January 1, 2013, as follows.

Property Tax Expense 2,000.00
Interest Payable 7,601.84
Lease Liability 16,379.78
Cash 25,981.62
Entries through 2016 would follow the pattern above. Ivanhoe records its other
executory costs (insurance and maintenance) in a manner similar to how it records any
other operating costs incurred on assets it owns.
Upon expiration of the lease, Ivanhoe has fully depreciated the amount capitalized
as leased equipment. It also has fully discharged its lease obligation. If Ivanhoe does
not purchase the loader, it returns the equipment to CNH. Ivanhoe then removes the
leased equipment and related accumulated depreciation accounts from its books.
If Ivanhoe purchases the equipment at termination of the lease, at a price of $5,000
and the estimated life of the equipment changes from five to seven years, it makes the
following entry.
Equipment ($100,000 $5,000) 105,000
Accumulated Depreciation—Finance Leases 100,000
Leased Equipment under Finance Leases 100,000
Cash 5,000
Classification of Leases by the Lessor

For accounting purposes, the lessor also classifies leases as operating or finance
leases. Finance leases may be further subdivided into direct-financing and sales-type
leases.
As with lessee accounting, if the lease transfers substantially all the risks and
rewards incidental to ownership, the lessor shall classify and account for the
arrangement as a finance lease. Lessors evaluate the same criteria shown in
Illustration 21-2 to make this determination.
The distinction for the lessor between a direct-financing lease and a sales-type
lease is the presence or absence of a manufacturer’s or dealer’s profit (or loss): A
sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease
does not. The profit (or loss) to the lessor is evidenced by the difference between the
fair value of the leased property at the inception of the lease and the lessor’s cost or
carrying amount (book value).
Normally, sales-type leases arise when manufacturers or dealers use leasing as a
means of marketing their products. For example, a computer manufacturer will lease
its computer equipment (possibly through a captive) to businesses and institutions.
Direct-financing leases generally result from arrangements with lessors that are prima-
rily engaged in financing operations (e.g., banks).
Lessors classify and account for all leases that do not qualify as direct-financing
or sales-type leases as operating leases. Illustration 21-7 shows the circumstances
under which a lessor classifies a lease as operating, direct-financing, or sales-type.
For purposes of comparison with the lessee’s accounting, we will illustrate only
the operating and direct-financing leases in the following section. We will discuss the
more complex sales-type lease later in the chapter.
Direct-Financing Method (Lessor)

Direct-financing leases are in substance the financing of an asset purchase by the lessee.
In this type of lease, the lessor records a lease receivable instead of a leased asset. The
lease receivable is the present value of the minimum lease payments plus the present value
of the unguaranteed residual value. Remember that “minimum lease payments” include:
Lease
Agreement
Is
Is Is Is Present
There a There a Lease Value of
Transfer of Bargain- Term for the Major
No No No Payments No
Ownership? Purchase Part of Economic Substantially
Option? Life? All of Fair
Value?
Operating
Yes Yes Yes Yes Lease
Finance
Lease
Does
Asset Fair Direct-
Sales-Type Value Equal
No Yes Financing
Lease Lessor's Book Lease
Value?
ILLUSTRATION 21-7
Diagram of Lessor’s
(1) rental payments (excluding executory costs), (2) bargain-purchase option (if any), Criteria for Lease
(3) guaranteed residual value (if any), and (4) penalty for failure to renew (if any). Classification
Thus, the lessor records the residual value, whether guaranteed or not. Also, recall
that if the lessor pays any executory costs, then it should reduce the rental payment
by that amount in computing minimum lease payments.
The following presentation, using the data from the preceding CNH/Ivanhoe ex- U.S. GAAP
PERSPECTIVE
ample on pages 1129–1131, illustrates the accounting treatment for a direct-financing
lease. We repeat here the information relevant to CNH in accounting for this lease Under IFRS, lessees and
transaction. lessors use the same lease
capitalization criteria to
1. The term of the lease is five years beginning January 1, 2012, non-cancelable, and determine if the risks and
requires equal rental payments of $25,981.62 at the beginning of each year. Payments rewards of ownership have
include $2,000 of executory costs (property taxes). been transferred to the lease.
U.S. GAAP has additional
2. The equipment (front-end loader) has a cost of $100,000 to CNH, a fair value at the lessor guidelines that
inception of the lease of $100,000, an estimated economic life of five years, and no payments are collectible and
residual value. there are no additional costs
3. CNH incurred no initial direct costs in negotiating and closing the lease transaction. associated with a lease.
4. The lease contains no renewal options. The equipment reverts to CNH at the termi-
nation of the lease.
5. CNH sets the annual lease payments to ensure a rate of return of 10 percent (implicit
rate) on its investment, as shown in Illustration 21-8.
ILLUSTRATION 21-8
Fair value of leased equipment $100,000.00
Computation of Lease
Less: Present value of residual value –0–
Payments
Amount to be recovered by lessor through lease payments $100,000.00
Five beginning-of-the-year lease payments to yield a
10% return ($100,000 4.16986a) $ 23,981.62
a
PV of an annuity due of 1 for 5 years at 10% (Table 6-5).
As shown in the earlier analysis, the lease meets the criteria for classification as a
direct-financing lease for two reasons: (1) The lease term equals the equipment’s
estimated economic life, and (2) the present value of the minimum lease payments
equals the equipment’s fair value. It is not a sales-type lease because there is no differ-
ence between the fair value ($100,000) of the loader and CNH’s cost ($100,000).
The Lease Receivable is the present value of the minimum lease payments (exclud-
illus 21-9 ing executory costs which are property taxes of $2,000). CNH computes it as follows.
ILLUSTRATION 21-9
Lease receivable ($25,981.62 $2,000) Present value of an annuity due of 1 for 5
Computation of Lease
periods at 10% (Table 6-5)
Receivable $23,981.62 4.16986
$100,000
CNH records the lease of the asset and the resulting receivable on January 1, 2012
(the inception of the lease), as follows.
Lease Receivable 100,000
Equipment 100,000
Companies often report the lease receivable in the statement of financial position
as “Net investment in finance leases.” Companies classify it either as current or non-
current, depending on when they recover the net investment.7
CNH replaces its investment (the leased front-end loader, a cost of $100,000) with
a lease receivable. In a manner similar to Ivanhoe’s treatment of interest, CNH applies
the effective-interest method and recognizes interest revenue as a function of the lease
receivable balance, as Illustration 21-10 shows.
ILLUSTRATION 21-10
CNH CAPITAL
Lease Amortization
LEASE AMORTIZATION SCHEDULE
Schedule for Lessor—
ANNUITY-DUE BASIS
Annuity-Due Basis
Annual Interest Lease
Lease Executory (10%) on Receivable Lease
Date Payment Costs Lease Receivable Recovery Receivable
(a) (b) (c) (d) (e)
1/1/12 $100,000.00
1/1/12 $ 25,981.62 $ 2,000.00 $ –0– $ 23,981.62 76,018.38
1/1/13 25,981.62 2,000.00 7,601.84 16,379.78 59,638.60
1/1/14 25,981.62 2,000.00 5,963.86 18,017.76 41,620.84
1/1/15 25,981.62 2,000.00 4,162.08 19,819.54 21,801.30
1/1/16 25,981.62 2,000.00 2,180.32* 21,801.30 –0–
$129,908.10 $10,000.00 $19,908.10 $100,000.00
(a) Annual rental that provides a 10% return on net investment.

(b) Executory costs included in rental payment.
(c) Ten percent of the preceding balance of (e) except for 1/1/12.
(d) (a) minus (b) and (c).
(e) Preceding balance minus (d).
*Rounded by 19 cents.
On January 1, 2012, CNH records receipt of the first year’s lease payment as follows.
Cash 25,981.62
Lease Receivable 23,981.62
Property Tax Expense/Property Taxes Payable 2,000.00
7
In the notes to the financial statements, the lease receivable is reported at its gross amount
(minimum lease payments plus the unguaranteed residual value). In addition, the lessor
also reports total unearned interest related to the lease. As a result, some lessors record
lease receivable on a gross basis and record the unearned interest in a separate account. We
illustrate the net approach here because it is consistent with the accounting for the lessee.
On December 31, 2012, CNH recognizes the interest revenue earned during the first
year through the following entry.
Interest Receivable 7,601.84
Interest Revenue—Leases 7,601.84
At December 31, 2012, CNH reports the lease receivable in its statement of finan-
cial position among current assets or non-current assets, or both. It classifies the portion
due within one year or the operating cycle, whichever is longer, as a current asset, and
the rest with non-current assets.
Illustration 21-11 shows the assets section as it relates to lease transactions at
December 31, 2012.
ILLUSTRATION 21-11
Non-current assets (investments)
Reporting Lease
Lease receivable ($76,018.38 $16,379.78) $59,638.60 Transactions by Lessor
Current assets
Interest receivable $ 7,601.84
Lease receivable 16,379.78
The following entries record receipt of the second year’s lease payment and recog-
nition of the interest earned.
January 1, 2013
Cash 25,981.62
Lease Receivable 16,379.78
Property Tax Expense/Property Taxes Payable 2,000.00
December 31, 2013
Interest Revenue—Leases 5,963.86
Journal entries through 2016 follow the same pattern except that CNH records no
entry in 2016 (the last year) for earned interest. Because it fully collects the receivable
by January 1, 2016, no balance (investment) is outstanding during 2016. CNH recorded
no depreciation. If Ivanhoe buys the loader for $5,000 upon expiration of the lease,
CNH recognizes disposition of the equipment as follows.
Cash 5,000
Gain on Sale of Leased Equipment 5,000
Disclosing Lease Data

In addition to the amounts reported in the financial statements related to lease assets
and liabilities, the IASB requires lessees and lessors to disclose certain information
about leases. These requirements vary based upon the type of lease (finance or operat-
ing) and whether the issuer is the lessor or lessee. These disclosure requirements provide
investors with the following information:
For lessees: [8]
• A general description of material leasing arrangements.
• A reconciliation between the total of future minimum lease payments at the end of
the reporting period and their present value.
8 Pub: callout for this ftn

For additional discussion on this approach and possible alternatives, see R. J. Swieringa,
deleted per msp
“When Current Is Noncurrent and Vice Versa!” The Accounting Review (January 1984), pp. 123–30;
1149? Please recite
and A. W. Richardson, “The Measurement of the Current Portion of the Long-Term Lease
Obligations—Some Evidence from Practice,” The Accounting Review (October 1985), pp. 744–52. in text or delete ftn8
and renumber?
• The total of future minimum lease payments at the end of the reporting period, and
their present value for periods (1) not later than one year, (2) later than one year and
not later than five years, and (3) later than five years.
For lessors: [9]
• A general description of material leasing arrangements.
• A reconciliation between the gross investment in the lease at the end of the reporting
period, and the present value of minimum lease payments receivable at the end of the
reporting period.
• Unearned finance income.
• The gross investment in the lease and the present value of minimum lease payments
receivable at the end of the reporting period for periods (1) not later than one year,
(2) later than one year and not later than five years, and (3) later than five years.
Illustration 21-12 presents financial statement excerpts from the 2008 annual report
of Delhaize Group (BEL). These excerpts represent the statement and note disclosures
typical of a lessee having both finance leases and operating leases.
ILLUSTRATION 21-12
Disclosure of Leases by Delhaize Group
Lessee (euro amounts in millions)
Non-Current Liabilities 2008

Long-term obligations under finance leases,
less current portion €643
Current Liabilities
Current obligations under finance leases € 44
19. Leases
Delhaize Group’s stores operate principally in leased premises. Lease terms generally range from one
to 30 years with renewal options ranging from three to 27 years. The schedule below provides the
General description
future minimum lease payments, which have not been reduced by minimum sublease income of €88
million due over the term of non-cancellable subleases, as of December 31, 2008:
(in million of euro) 2009 2010–2013 Thereafter Total
Finance leases
Future minimum lease payments 122 436 919 1,477
Less amount representing interest (78) (262) (450) (790)
Reconciliation, timing, and Present value of minimum lease payments 44 174 469 687
amounts of cash outflows Operating leases
Future minimum lease payments
(for non-cancellable leases) 241 812 1,132 2,185
Closed store lease obligations
Future minimum lease payments 13 34 22 69
The average effective interest rate for finance leases was 11.9% at December 31, 2008. The fair value
of the Group’s finance lease obligations using an average market rate of 8.3% at December 31, 2008
was €817 million.
Rent payments, including scheduled rent increases, are recognized on a straight-line basis over
the minimum lease term. Total rent expense under operating leases was €245 million in 2008, being
Additional information included predominately in “Selling, general and administrative expenses.” Certain lease agreements
also include contingent rent requirements which are generally based on store sales. Contingent rent
expense recognized in 2008 amounted €1 million.
Illustration 21-13 presents the lease note disclosure from the 2009 annual report of
Trinity Biotech plc (IRL). The disclosure highlights required lessor disclosures.
ILLUSTRATION 21-13
Trinity Biotech Disclosure of Leases by
Notes to Financial Statements Lessor
(in millions)
Note 16: Trade and Other Receivables (in part)

Finance Lease Commitments
The Group leases instruments as part of its business. Future minimum finance lease receivables with General description
non-cancellable terms are as follows:
December 31, 2009
US$’000
Minimum
Gross Unearned Payments Reconcilation and timing of
Investment Income Receivable amounts receivable and
unearned revenue
Less than one year 1,002 310 692
Between one and five years 1,559 453 1,106
2,561 763 1,798
Operating Lease Commitments

The Group has leased a facility consisting of 9,000 square feet in Dublin, Ireland. This property has
been sublet by the Group. The lease contains a clause to enable upward revision of the rent charge
Description of leased assets
on a periodic basis. The Group also leases instruments under operating leases as part of its business.
Future minimum rentals receivable under non-cancellable operating leases are as follows:
December 31, 2009
US$’000
Land and
Buildings Instruments Total Nature, timing, and
Less than one year 228 1,992 2,220 amounts of future rentals
Between one and five years 911 852 1,763
More than five years 399 — 399
1,538 2,844 4,382
SALE-LEASEBACKS
The term sale-leaseback describes a transaction in which the owner of the property
(seller-lessee) sells the property to another and simultaneously leases it back from the
new owner. The use of the property is generally continued without interruption.
Sale-leasebacks are common. Financial institutions (e.g., HSBC (GBR) and BBVA
(ESP)) have used this technique for their administrative offices, retailers (Liberty (GBR))
for their stores, and hospitals (Healthscope (AUS)) for their facilities. The advantages of
a sale-leaseback from the seller’s viewpoint usually involve two primary considerations:
1. Financing—If the purchase of equipment has already been financed, a sale-lease-

back can allow the seller to refinance at lower rates, assuming rates have dropped.
In addition, a sale-leaseback can provide another source of working capital, partic-
ularly when liquidity is tight.
2. Taxes—At the time a company purchased equipment, it may not have known that
it would be subject to certain tax laws and that ownership might increase its mini-
mum tax liability. By selling the property, the seller-lessee may deduct the entire
lease payment, which is not subject to these tax considerations.
Determining Asset Use

To the extent the seller-lessee continues to use the asset after the sale, the sale-lease-
back is really a form of financing. Therefore, the lessor should not recognize a gain or
loss on the transaction. In short, the seller-lessee is simply borrowing funds.
On the other hand, if the seller-lessee gives up the right to the use of the asset,
the transaction is in substance a sale. In that case, gain or loss recognition is ap-
Underlying Concepts
propriate. Trying to ascertain when the lessee has given up the use of the asset
A sale-leaseback is similar in is difficult, however, and the IASB has formulated complex rules to identify this
substance to the parking of
situation.9 To understand the profession’s position in this area, we discuss the
inventories (discussed in Chapter 8).
basic accounting for the lessee and lessor below.
The ultimate economic benefits
remain under the control of the
“seller,” thus satisfying the definition Lessee
of an asset. If the lease meets one of the four criteria for treatment as a finance lease (see
Illustration 21-3 on page 1125), the seller-lessee accounts for the transaction
as a sale and the lease as a finance lease. The seller-lessee should defer any
profit or loss it experiences from the sale of the assets that are leased back un-
der a finance lease; it should amortize that profit over the lease term (or the eco-
nomic life if either criterion 1 or 2 is satisfied) in proportion to the depreciation of
the leased assets.
For example, assume Stora Enso (FIN) sells equipment having a book value of
€580,000 and a fair value of €623,110 to Deutsche Bank (DEU) for €623,110 and leases
the equipment back for €50,000 a year for 20 years. Stora Enso should amortize the
profit of €43,110 over the 20-year period at the same rate that it depreciates the
€623,110. [10] It credits the €43,110 (€623,110 €580,000) to Unearned Profit on Sale-
Leaseback.
If none of the finance lease criteria are satisfied, the seller-lessee accounts for the
transaction as a sale and the lease as an operating lease. Under an operating lease, as
long as the sale-leaseback transaction is established at fair value, any gain or loss is
recognized immediately.10
Lessor
If the lease meets one of the lease capitalization criteria, the purchaser-lessor records
the transaction as a purchase and a direct-financing lease. If the lease does not meet the
criteria, the purchaser-lessor records the transaction as a purchase and an operating lease.
Sale-Leaseback Example
To illustrate the accounting treatment accorded a sale-leaseback transaction, assume
that Japan Airlines (JAL) (JPN) on January 1, 2012, sells a used Boeing 757 having a
carrying amount on its books of $75,500,000 to CitiCapital (USA) for $80,000,000. JAL
immediately leases the aircraft back under the following conditions:
1. The term of the lease is 15 years, non-cancelable, and requires equal rental payments
of $10,487,443 at the beginning of each year.
2. The aircraft has a fair value of $80,000,000 on January 1, 2012, and an estimated eco-
nomic life of 15 years.
3. JAL pays all executory costs.
4. JAL depreciates similar aircraft that it owns on a straight-line basis over 15 years.
5. The annual payments assure the lessor a 12 percent return.
6. JAL knows the implicit rate.
9
Sales and leasebacks of real estate are often accounted for differently. A discussion of the
issues related to these transactions is beyond the scope of this textbook.
10
If the sales price is not at fair value and the loss is compensated for by reduced future
lease payments (below market rates), the loss shall be deferred and amortized in proportion
to the lease payments over the period for which the asset is expected to be used. If the sales
price is above fair value, the excess over fair value shall be deferred and amortized over the
period for which the asset is expected to be used. [11]
This lease is a finance lease to JAL because the lease term is equal to the estimated
life of the aircraft and because the present value of the lease payments is equal to the
fair value of the aircraft to CitiCapital. CitiCapital should classify this lease as a direct- ILLUSTRATION 21-14
financing lease. Comparative Entries for
Illustration 21-14 presents the typical journal entries to record the sale-leaseback Sale-Leaseback for Lessee
transactions for JAL and CitiCapital for the first year. and Lessor
JAL (Lessee) CitiCapital (Lessor)

Sale of Aircraft by JAL to CitiCapital (January 1, 2012):
Cash 80,000,000 Aircraft 80,000,000
Aircraft 75,500,000 Cash 80,000,000
Unearned Profit on
Sale-Leaseback 4,500,000 Lease Receivable 80,000,000
Leased Aircraft under Aircraft 80,000,000
Finance Leases 80,000,000
Lease Liability 80,000,000
First Lease Payment (January 1, 2012):
Lease Liability 10,487,443 Cash 10,487,443
Cash 10,487,443 Lease Receivable 10,487,443
Incurrence and Payment of Executory Costs by JAL throughout 2012:
Insurance, Maintenance, (No entry)
Taxes, etc. XXX
Cash or Accounts Payable XXX
Depreciation Expense on the Aircraft (December 31, 2012):
Depreciation Expense 5,333,333 (No entry)
Accumulated Depr.—
Finance Leases 5,333,333
($80,000,000 15)
Amortization of Profit on Sale-Leaseback by JAL (December 31, 2012):
Unearned Profit on (No entry)
Sale-Leaseback 300,000
Depreciation Expense 300,000
($4,500,000 15)
Note: A case might be made for crediting Revenue instead of Depreciation Expense.
Interest for 2012 (December 31, 2012):
Interest Expense 8,341,507a Interest Receivable 8,341,507
Interest Payable 8,341,507 Interest Revenue 8,341,507a
a
Partial Lease Amortization Schedule:
Annual Rental Interest Reduction of
Date Payment 12% Balance Balance
1/1/12 $80,000,000
1/1/12 $10,487,443 $ –0– $10,487,443 69,512,557
1/1/13 10,487,443 8,341,507 2,145,936 67,366,621
AUTHORITATIVE LITERATURE
Authoritative Literature References
[1] International Accounting Standard 17, Leases (London, U.K.: International Accounting Standards Committee
Foundation, 2003), par. 10.
Foundation, 2003), paras. 10(e) and 11.
Foundation, 2003), par. 11(b).
Foundation, 2003), paras. 31 and 35.
Foundation, 2003), paras. 47 and 56.
QUESTIONS
7. Outline the accounting procedures involved in applying 9. Identify the lease classifications for lessors and the crite-
the operating method by a lessee. ria that must be met for each classification.
8. Outline the accounting procedures involved in applying 19. What disclosures should be made by lessees and lessors
the finance lease method by a lessee. related to future lease payments?
BRIEF EXERCISES
BE21-3 Rick Kleckner Corporation recorded a finance lease at $300,000 on January 1, 2011. The interest
rate is 12%. Kleckner Corporation made the first lease payment of $53,920 on January 1, 2011. The lease
requires eight annual payments. The equipment has a useful life of 8 years with no residual value. Prepare
Kleckner Corporation’s December 31, 2011, adjusting entries.
BE21-4 Use the information for Rick Kleckner Corporation from BE21-3. Assume that at December 31,
2011, Kleckner made an adjusting entry to accrue interest expense of $29,530 on the lease. Prepare Kleck-
ner’s January 1, 2012, journal entry to record the second lease payment of $53,920.
BE21-6 Assume that Lenovo (CHN) leased equipment that was carried at a cost of $150,000 to Sharon
Swander Company. The term of the lease is 6 years beginning January 1, 2011, with equal rental pay-
ments of $30,044 at the beginning of each year. All executory costs are paid by Swander directly to third
parties. The fair value of the equipment at the inception of the lease is $150,000. The equipment has a
useful life of 6 years with no residual value. The lease has an implicit interest rate of 8%, no bargain-
purchase option, and no transfer of title. Prepare Lenovo’s January 1, 2011, journal entries at the inception
of the lease.
BE21-7 Use the information for Lenovo from BE21-6. Assume the direct-financing lease was recorded at
a present value of $150,000. Prepare Lenovo’s December 31, 2011, entry to record interest.
*BE21-12 On January 1, 2011, Iniesta Animation sold a truck to Robben Finance for €33,000 and imme-
diately leased it back. The truck was carried on Iniesta’s books at €28,000. The term of the lease is 5 years,
and title transfers to Iniesta at lease-end. The lease requires five equal rental payments of €8,705 at the
end of each year. The appropriate rate of interest is 10%, and the truck has a useful life of 5 years with
no residual value. Prepare Iniesta’s 2011 journal entries.
EXERCISES
E21-2 (Lessee Computations and Entries, Finance Lease with Guaranteed Residual Value) Brecker Com-
pany leases an automobile with a fair value of €10,906 from Emporia Motors, Inc., on the following terms:
1. Non-cancelable term of 50 months.
2. Rental of €250 per month (at end of each month). (The present value at 1% per month is €9,800.)
3. Estimated residual value after 50 months is €1,180. (The present value at 1% per month is €715.)
Brecker Company guarantees the residual value of €1,180.
4. Estimated economic life of the automobile is 60 months.
5. Brecker Company’s incremental borrowing rate is 12% a year (1% a month). It is impracticable to
determine Emporia’s implicit rate.
Instructions
(a) What is the nature of this lease to Brecker Company?
(b) What is the present value of the minimum lease payments?
(c) Record the lease on Brecker Company’s books at the date of inception.
(d) Record the first month’s depreciation on Brecker Company’s books (assume straight-line).
(e) Record the first month’s lease payment.
E21-8 (Lessee Entries with Bargain-Purchase Option) The following facts pertain to a non-cancelable
lease agreement between Lennox Leasing Company and Gill Company, a lessee.
Inception date: May 1, 2010

Annual lease payment due at the beginning of
each year, beginning with May 1, 2010 €18,829.49
Bargain-purchase option price at end of lease term € 4,000.00
Lease term 5 years
Economic life of leased equipment 10 years
Lessor’s cost €65,000.00
Fair value of asset at May 1, 2010 €81,000.00
Lessor’s implicit rate 10%
Lessee’s incremental borrowing rate 10%
The lessee assumes responsibility for all executory costs.

Instructions
(Round all numbers to the nearest cent.)
(a) Discuss the nature of this lease to Gill Company.
(b) Discuss the nature of this lease to Lennox Company.
(c) Prepare a lease amortization schedule for Gill Company for the 5-year lease term.
(d) Prepare the journal entries on the lessee’s books to reflect the signing of the lease agreement and
to record the payments and expenses related to this lease for the years 2010 and 2011. Gill’s an-
nual accounting period ends on December 31. Reversing entries are used by Gill.
E21-9 (Lessor Entries with Bargain-Purchase Option) A lease agreement between Lennox Leasing
Company and Gill Company is described in E21-8.
Instructions
Refer to the data in E21-8 and do the following for the lessor. (Round all numbers to the nearest cent.)
(a) Compute the amount of the lease receivable at the inception of the lease.
(b) Prepare a lease amortization schedule for Lennox Leasing Company for the 5-year lease term.
(c) Prepare the journal entries to reflect the signing of the lease agreement and to record the receipts
and income related to this lease for the years 2010, 2011, and 2012. The lessor’s accounting period
ends on December 31. Reversing entries are not used by Lennox.
*E21-15 (Sale-Leaseback) Assume that on January 1, 2011, Peking Duck Co. sells a computer system to
Liquidity Finance Co. for ¥510,000 and immediately leases the computer system back. The relevant infor-
mation is as follows.
1. The computer was carried on Peking’s books at a value of ¥450,000.
2. The term of the non-cancelable lease is 10 years; title will transfer to Peking.
3. The lease agreement requires equal rental payments of ¥83,000.11 at the end of each year.
4. The incremental borrowing rate for Peking is 12%. Peking is aware that Liquidity Finance Co. set
the annual rental to ensure a rate of return of 10%.
5. The computer has a fair value of ¥510,000 on January 1, 2011, and an estimated economic life of
10 years.
6. Peking pays executory costs of ¥9,000 per year.
Instructions
Prepare the journal entries for both the lessee and the lessor for 2011 to reflect the sale-leaseback
agreement.
PROBLEMS
P21-4 (Statement of Financial Position and Income Statement Disclosure—Lessee) The following
facts pertain to a non-cancelable lease agreement between Alschuler Leasing Company and McKee Elec-
tronics, a lessee, for a computer system.
Inception date October 1, 2010

Lease term 6 years
Economic life of leased equipment 6 years
Fair value of asset at October 1, 2010 £300,383
Residual value at end of lease term –0–
Lessor’s implicit rate 10%
Lessee’s incremental borrowing rate 10%
Annual lease payment due at the beginning of
each year, beginning with October 1, 2010 £62,700
The lessee assumes responsibility for all executory costs, which amount to £5,500 per year and are to be
paid each October 1, beginning October 1, 2010. (This £5,500 is not included in the rental payment of
£62,700.) The asset will revert to the lessor at the end of the lease term. The straight-line depreciation
method is used for all equipment.
The following amortization schedule has been prepared correctly for use by both the lessor and the
lessee in accounting for this lease. The lease is to be accounted for properly as a finance lease by the lessee
and as a direct-financing lease by the lessor.
Annual
Lease Interest (10%) Reduction Balance of
Payment/ on Unpaid of Lease Lease
Date Receipt Liability/Receivable Liability/Receivable Liability/Receivable
10/01/10 £300,383
10/01/10 £ 62,700 £ 62,700 237,683
10/01/11 62,700 £23,768 38,932 198,751
10/01/12 62,700 19,875 42,825 155,926
10/01/13 62,700 15,593 47,107 108,819
10/01/14 62,700 10,822 51,818 57,001
10/01/15 62,700 5,699* 57,001 –0–
£376,200 £75,817 £300,383
*Rounding error is £1.
Instructions
(a) Assuming the lessee’s accounting period ends on September 30, answer the following questions
with respect to this lease agreement.
(1) What items and amounts will appear on the lessee’s income statement for the year ending
September 30, 2011?
(2) What items and amounts will appear on the lessee’s statement of financial position at
September 30, 2011?
September 30, 2012?
(4) What items and amounts will appear on the lessee’s statement of financial position at
September 30, 2012?
(b) Assuming the lessee’s accounting period ends on December 31, answer the following questions
December 31, 2010?
(2) What items and amounts will appear on the lessee’s statement of financial position at December
31, 2010?
December 31, 2011?
(4) What items and amounts will appear on the lessee’s statement of financial position at December
31, 2011?
P21-5 (Statement of Financial Position and Income Statement Disclosure—Lessor) Assume the same
information as in P21-4.
Instructions
(a) Assuming the lessor’s accounting period ends on September 30, answer the following questions
(1) What items and amounts will appear on the lessor’s income statement for the year ending
September 30, 2011?
(2) What items and amounts will appear on the lessor’s statement of financial position at
September 30, 2011?
September 30, 2012?
September 30, 2012?
(b) Assuming the lessor’s accounting period ends on December 31, answer the following questions
December 31, 2010?
December 31, 2010?
December 31, 2011?
December 31, 2011?
USING YOUR JUDGMENT

The financial statements of M&S can be accessed at the book’s companion website, www.wiley.com/
college/kiesoifrs.
Instructions
esoifrs Refer to M&S’s financial statements and the accompanying notes to answer the following questions.
ki
/
(a) What types of leases are used by M&S?

llege
(b) What amount of finance leases was reported by M&S in total and for less than one year?
/co
ww
m
i l e y. c o
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(c) What minimum annual rental commitments under all non-cancelable leases at March 29, 2008, did
M&S disclose?
Financial Statement Analysis Case

Delhaize Group
Presented in Illustration 21-30 are the financial statement disclosures from the 2008 annual report of
Delhaize Group (BEL).
Instructions
Answer the following questions related to these disclosures.
(a) What is the total obligation under finance leases at year-end 2008 for Delhaize?
(b) What is the total rental expense reported for leasing activity for the year ended December 31, 2008,
for Delhaize?
(c) Estimate the off–balance-sheet liability due to Delhaize operating leases at fiscal year-end 2008.

Daniel Hardware Co. is considering alternative financing arrangements for equipment used in its ware-
houses. Besides purchasing the equipment outright, Daniel is also considering a lease. Accounting for the
outright purchase is fairly straightforward, but because Daniel has not used equipment leases in the past,
the accounting staff is less informed about the specific accounting rules for leases.
The staff is aware of some general lease rules related to “risks and rewards,” but they are unsure
about the meanings of these terms in lease accounting. Daniel has asked you to conduct some research
on these items related to lease capitalization criteria.
Instructions
(a) What is the objective of lease classification criteria?
(b) An important element of evaluating leases is determining whether substantially all of the risks and
rewards of ownership are transferred in the lease. How is “substantially all” defined in the authori-
tative literature?
(c) Besides the non-cancelable term of the lease, name at least three other considerations in determining
the “lease term.”
KiesoIFRS_Supplement_Firstpp
Chapter 24 Presentation and Disclosure in Financial Reporting · 24–1
CHAPTER 24 PRESENTATION AND DISCLOSURE IN FINANCIAL REPORTING
This IFRS Supplement provides expanded discussions of accounting guidance under

International Financial Reporting Standards (IFRS) for the topics in Intermediate
Accounting. The discussions are organized according to the chapters in Intermediate
Accounting (13th or 14th Editions) and therefore can be used to supplement the U.S.
GAAP requirements as presented in the textbook. Assignment material is provided for
each supplement chapter, which can be used to assess and reinforce student
understanding of IFRS.
Differential Disclosure
A trend toward differential disclosure is also occurring.1 The IASB has developed
IFRS for small- and medium-sized entities (SMEs). SMEs are entities that publish U.S. GAAP
general-purpose financial statements for external users but do not issue shares or PERSPECTIVE
other securities in a public market. Many believe a simplified set of standards makes Due to the broader range of
sense for these companies because they do not have the resources to implement full judgments allowed in more
IFRS. principles-based IFRS, note
Simplified IFRS for SMEs is a single standard of fewer than 230 pages. It is de- disclosures generally are
signed to meet the needs and capabilities of SMEs, which are estimated to account for more expansive under IFRS
over 95 percent of all companies around the world. Compared with full IFRS (and many compared to U.S. GAAP.
national accounting standards), simplified IFRS for SMEs is less complex in a number
of ways:
• Topics not relevant for SMEs are omitted. Examples are earnings per share, interim
financial reporting, and segment reporting.
• Simplified IFRS for SMEs allows fewer accounting policy choices. Examples are no
option to revalue property, equipment, or intangibles, and no corridor approach
for actuarial gains and losses.
• Many principles for recognizing and measuring assets, liabilities, revenue, and
expenses are simplified. For example, goodwill is amortized (as a result, there is
no annual impairment test) and all borrowing and R&D costs are expensed.
• Significantly fewer disclosures are required (roughly 300 versus 3,000).
• To further reduce standard overload, revisions to the IFRS for SMEs will be limited
to once every three years.
Thus, the option of using simplified IFRS helps SMEs meet the needs of their financial
statement users while balancing the costs and benefits from a preparer perspective. [1]2
1
The IASB is evaluating disclosure issues such as those related to fair value measurements
and management commentary. However, as noted by one standard-setter, the usefulness of
expanded required disclosure also depends on users’ ability to distinguish between disclosed
versus recognized items in financial statements. Research to date is inconclusive on this matter.
See Katherine Schipper, “Required Disclosures in Financial Reports,” Presidential Address to
the American Accounting Association Annual Meeting (San Francisco, Calif.: August 2005).
2
In the United States, there has been a preference for one set of GAAP except in unusual
situations. With the advent of simplified IFRS for SMEs, this position is under review. Both
the FASB and the AICPA are studying the big GAAP/little GAAP issue to ensure that any
kind of differential reporting is conceptually sound and meets the needs of users. The FASB
has formed a Private Company Financial Reporting Committee, whose primary objectives
are to provide recommendations on FASB standard-setting for privately held enterprises
(see http://www.pcfr.org/ ).
FIRST-TIME ADOPTION OF IFRS

As discussed in Chapter 1, IFRS is growing in acceptance around the world. For exam-
ple, recent statistics indicate 40 percent of the Global Fortune 500 companies use IFRS.
And the chair of the IASB predicts that IFRS adoption will grow from its current level
of 115 countries to nearly 150 countries in the near future.
When countries accept IFRS for use as accepted accounting policies, companies
need guidance to ensure that their first IFRS financial statements contain high-quality
information. Specifically, IFRS 1 requires that information in a company’s first IFRS
statements (1) be transparent, (2) provide a suitable starting point, and (3) have a cost
that does not exceed the benefits. [6]
The overriding principle in converting from national GAAP to IFRS (the con-
version process) is full retrospective application of all IFRS. Retrospective application—
recasting prior financial statements on the basis of IFRS—provides financial statement
users with comparable information. However, the IASB recognizes that full retrospec-
tive application may be difficult in some situations, particularly when information
related to past periods is not readily available. In response, the IASB has established
guidelines to ensure that financial statement users have high-quality comparable infor-
mation while balancing the costs and benefits of providing comparable data.
General Guidelines
The objective of the conversion process is to present a set of IFRS financial statements
as if the company always reported on IFRS. To achieve this objective, a company must:
1. Identify the timing for its first IFRS statements.

2. Prepare an opening statement of financial position at the date of transition to IFRS.
3. Select accounting policies that comply with IFRS, and apply these policies retro-
spectively.
4. Consider whether to apply any optional exemptions and apply mandatory exceptions.
5. Make extensive disclosure to explain the transition to IFRS.
Relevant Dates
Once a company decides to convert to IFRS, it must decide on the following dates—the
transition date and the reporting date. The transition date is the beginning of the earli-
est period for which full comparative IFRS information is presented. The reporting date
is the closing statement of financial position date for the first IFRS financial statements.
To illustrate, assume that FirstChoice Company plans to provide its first IFRS state-
ments for the year ended December 31, 2014. FirstChoice decides to present compara-
tive information for one year only. Therefore, its date of transition to IFRS is January 1,
2013, and its reporting date is December 31, 2014. The timeline for first-time adoption
is presented in Illustration 24-14.
ILLUSTRATION 24-14
Last Statements
First-Time Adoption
under Prior GAAP
Timeline
Illus 24-14 ok as positioned Comparable Period First IFRS Reporting Period
here?
IFRS Financial Statements
Date of Transition Beginning of First Reporting Date

(Opening IFRS Statement IFRS Reporting Period
of Financial Position)
January 1, 2013 January 1, 2014 December 31, 2014

Illustration 24-14 shows the following.
1. The opening IFRS statement of financial position for FirstChoice on January 1, 2013,
serves as the starting point (date of transition) for the company’s accounting under IFRS.
2. The first full IFRS statements are shown for FirstChoice for December 31, 2014. In
other words, a minimum of two years of IFRS statements must be presented before
a conversion to IFRS occurs. As a result, FirstChoice must prepare at least one year
of comparative financial statements (for 2013) using IFRS.
3. FirstChoice presents financial statements in accordance with its national GAAP
annually to December 31, 2013.
Following this conversion process, FirstChoice provides users of the financial state-
ments with comparable IFRS statements for 2013 and 2014.
Implementation Steps
Opening IFRS Statement of Financial Position
As indicated, to start the conversion process, companies first prepare an opening IFRS
statement of financial position. This process involves the following steps.
1. Include all assets and liabilities that IFRS requires.

2. Exclude any assets and liabilities that IFRS does not permit.
3. Classify all assets, liabilities, and equity in accordance with IFRS.
4. Measure all assets and liabilities according to IFRS. [7]
Completing this process requires knowledge of both the prior GAAP used and IFRS
(which you have obtained by your study of this text). To illustrate, the following facts
for NewWorld Company are presented in Illustration 24-15.
ILLUSTRATION 24-15
OPE N I N G STATE M E NT OF FI NAN CIAL P O S ITI ON Policy Changes—Opening
Facts: NewWorld Company is preparing to adopt IFRS. It is preparing its opening statement of Statement of Financial
financial position on January 1, 2012. NewWorld identified the following accounting policy dif- Position
ferences between IFRS and the national GAAP it currently uses. Under national GAAP,
NewWorld:
1. Expenses development costs of €500,000 on a project that had met economic viability.
2. Does not make a provision for a warranty of €100,000 because the concept of a “construc-
tive obligation” was not recognized.
3. Does not capitalize design fees of €150,000 into the cost of machinery that was put into
service at the beginning of 2010, even though those costs were necessary to bring the as-
set to its working condition. The machinery has a 5-year life, no residual value, and NewWorld
uses straight-line depreciation.
Question: How should NewWorld account for these items in its opening IFRS state-
ment of financial position?
Solution:
1. IFRS allows the deferral of development costs in this case (see Chapter 12), and NewWorld
should capitalize these costs.
2. IFRS requires recognition of a warranty provision (see Chapter 13), so a liability should be
recorded.
3. Under IFRS, all costs incurred in bringing an asset to its place and condition for its intended
use are capitalized into the cost of the asset.
Adjustments as a result of applying IFRS for the first time are generally recorded in
retained earnings. NewWorld makes the following entries on January 1, 2012, to adjust
the accounts to IFRS treatment.
Development Costs (or related intangible asset) 500,000
Retained Earnings 500,000
(To capitalize development costs)

Warranty Liability 100,000
(To recognize warranty liability)
Equipment 150,000
(To recognized cost of machinery)
In each of these situations, NewWorld adjusts retained earnings for the differences
between IFRS and national GAAP to ensure that the opening statement of financial
position is reported in accordance with IFRS.
After recording these adjustments, NewWorld prepares its opening IFRS state-
ment of financial position. The January 1, 2012, statement of financial position is the
starting point (the date of transition). Subsequently, in 2012 and 2013 NewWorld pre-
pares IFRS financial statements internally. At December 31, 2013, it will formally adopt
IFRS.9
Exemptions from Retrospective Treatment

In some cases, adjustments relating to prior periods cannot be reasonably determined. In
other cases, it is “impracticable” to provide comparable information because the cost of
generating the information exceeds the benefits. The IASB therefore targeted exemptions
from the general retrospective treatment where it appeared appropriate. Two types of
exemptions are provided—required and elective.
Required Exemptions. The Board identified three areas in which companies are pro-
hibited from retrospective application in first-time adoption of IFRS:
1. Estimates.
2. Hedge accounting.
3. Non-controlling interests.
These required exemptions are imposed because implementation of retrospective

application in these areas generally requires companies to obtain information that may
not be readily available. In these cases, companies may have to re-create information
about past transactions with the benefit of hindsight. [9] For example, retrospective
application with respect to non-controlling interests requires information about condi-
tions and estimates made at the time of a business combination—an often difficult task.
In addition, this exception provides relief for companies that otherwise might have to
determine the allocation of transactions between owners and non-controlling interests
in periods prior to the transition period.
Elective Exemptions. In addition to the required exemptions for retrospective treat-

ment, the IASB identified specific additional areas in which companies may elect
exemption from retrospective treatment. These exemptions provide companies some
9
To maintain comparisons in the transition year, companies may present comparative
information in accordance with previous GAAP as well as the comparative information
required by IFRS. Companies must (a) label the previous GAAP information prominently as not
being prepared in accordance with IFRS, and (b) disclose the nature of the main adjustments
that would make it comply with IFRS. Companies need not quantify those adjustments. [8]
relief from full retrospective application. This simplifies the preparation of the first-
time IFRS statements. Areas addressed in Intermediate Accounting are presented in Il-
lustration 24-16.10
ILLUSTRATION 24-16
Companies may elect an exemption from retrospective application for one or more of the following areas.
Elective Exemption from
(a) Share-based payment transactions. Retrospective Treatment
(b) Fair value or revaluation as deemed cost.
(c) Leases.
(d) Employee benefits.
(e) Compound financial instruments.
(f) Fair value measurement of financial assets or financial liabilities at initial recognition.
(g) Decommissioning liabilities included in the cost of property, plant, and equipment.
(h) Borrowing costs.
Optional exemption from retrospective treatment is understandable for certain sit-

uations. The accounting for the areas identified above generally requires a number of
estimates and assumptions at initial recognition and in subsequent accounting. Depending
on the accounting under previous GAAP, the information necessary for retrospective
application may not be available, or may be obtained only at a high cost. We discuss
two examples.11
Exemption Example: Compound Securities. As discussed in Chapter 16, IFRS requires split-
ting the debt and equity components of convertible debt, using the “with and without”
approach. The subsequent accounting for the debt element reflects effective-interest amor-
tization on the estimated debt component. However, if the liability component is no longer
outstanding at the date of first-time adoption, retrospective application involves separat-
ing two portions of equity. The first portion is in retained earnings and represents the
cumulative interest accredited on the liability component. The other portion represents
the original equity component. Since the company would not have records on the debt
once it is no longer outstanding, it would be costly to re-create that information for retro-
spective application. As a result, a first-time adopter need not separate these two portions
if the liability component is no longer outstanding at the date of transition to IFRS.
Exemption Example: Fair Value or Revaluation as Deemed Cost. Companies can elect to
measure property, plant, and equipment at fair value at the transition date and use that
fair value as their deemed cost in accounting for those assets subsequent to the adop-
tion of IFRS. This exemption may also be applied to intangible assets in certain situa-
tions. By using the exemption, companies avoid re-creating depreciation records for
property, plant, and equipment, which is a costly exercise for many companies. In fact,
in providing this exemption, the IASB noted that reconstructed cost data might be less
relevant to users, and less reliable, than current fair value data. The Board therefore
concluded that it would allow companies to use fair value as deemed cost. A company
that applies the fair value as deemed cost exemption is not required to revalue the assets
subsequent to first-time adoption. [12]12
10
Other areas subject to the option are (1) business combinations; (2) insurance contracts;
(3) investments in subsidiaries, jointly controlled entities, and associates; (4) designation of
previously recognized financial instruments; (5) financial assets or intangible assets accounted
for as Service Concession Arrangements; and (6) transfers of assets from customers. [10]
11
Specific implementation guidance for other areas is provided in IFRS 1. [11]
12
In addition, IFRS does not restrict the use of fair value as deemed cost to an entire class
of assets, as is done for revaluation accounting (see discussion in Chapter 11). For example,
a company can use fair value for deemed cost for some buildings and not for others.
However, if a company uses fair value as deemed cost for assets whose fair value is above
cost, it cannot ignore indications that the recoverable amount of other assets may have
fallen below their carrying amount. Thus, an impairment may need to be recorded.
Presentation and Disclosure

Upon first-time adoption of IFRS, a company must present at least one year of com-
parative information under IFRS. [13] To comply with IAS 1, an entity’s first IFRS
financial statements shall include at least three statements of financial position, two
statements of comprehensive income, two separate income statements (if presented),
two statements of cash flows, and two statements of changes in equity and related
notes, including comparative information. Companies must explain how the transition
from previous GAAP to IFRS affected its reported financial position, financial perform-
ance, and cash flows.
A company’s first IFRS financial statements shall include reconciliations of:
• Its equity reported in accordance with previous GAAP to its equity in accordance
with IFRS at the transition date.
• Its total comprehensive income in accordance with IFRS to total comprehensive income
in accordance with previous GAAP for the same period. The reconciliation should
be prepared for latest period in the company’s most recent annual financial state-
ments under the previous GAAP. [14]
For example, Jones plc first adopted IFRS in 2012, with a date of transition to IFRS
January 1, 2011. Its last financial statements in accordance with previous GAAP were
for the year ended December 31, 2011. An example of Jones plc’s reconciliations for first-
time adoption is provided in Illustration 24-17 for the non-current asset section of the
statement of financial position.
ILLUSTRATION 24-17
Reconciliation of Equity Jones plc
for 2011 (amounts in £000)
The first IFRS financial statements include the reconciliations and related notes shown below.
Reconciliation of equity at January 1, 2011 (date of transition to IFRS)
Effect of
Previous Transition
Note GAAP to IFRS IFRS
1 Property, plant, and equipment £ 8,299 £100 £ 8,399
2 Goodwill 1,220 150 1,370
2 Intangible assets 208 (150) 58
3 Financial assets 3,471 420 3,891
Total non-current assets £13,198 £520 £13,718
Notes to the reconciliation at January 1, 2011:

1. Depreciation was influenced by tax requirements in accordance with previous GAAP, but in
accordance with IFRS reflects the useful life of the assets. The cumulative adjustment increased
the carrying amount of property, plant, and equipment by £100.
2. Intangible assets in accordance with previous GAAP included £150 for items that are transferred
to goodwill because they do not qualify for recognition as intangible assets in accordance with
IFRS.
3. Financial assets are all classified as non-trading equity investments in accordance with IFRS and
are carried at their fair value of £3,891. They were carried at cost of £3,471 in accordance with
previous GAAP. The resulting gains of £294 (£420, less related deferred tax of £126) are included
in the accumulated other comprehensive income.
Through this reconciliation, statement users are provided information to evaluate

the impact of the adoption of IFRS on the statement of financial position. In practice,
it may be helpful to include cross-references to accounting policies and supporting
analyses that give further explanation of the adjustments shown in the reconciliations.
The reconciliation for total comprehensive income for Jones with respect to the
gross profit section of the income statement is presented in Illustration 24-18.
ILLUSTRATION 24-18
Jones plc Reconciliation of Total
(amounts in £000) Comprehensive Income
Previous Effect of Transition for 2011
Note GAAP to IFRS IFRS
Revenue £20,910 £ 0 £20,910
1, 2, 3 Cost of sales (15,283) (97) (15,380)
Gross profit £ 5,627 £(97) £ 5,530
Notes to the reconciliation of total comprehensive income for 20X4:

1. A pension liability is recognized in accordance with IFRS but was not recognized in accordance
with previous GAAP. The pension liability increased by £130 during 2011, which caused increases
in cost of sales (£50), distribution costs (£30), and administrative expenses (£50).
2. Cost of sales is higher by £47 in accordance with IFRS because inventories include fixed and
variable production overhead in accordance with IFRS but not in accordance with previous
GAAP.
3. Depreciation was influenced by tax requirements in accordance with previous GAAP but reflects
the useful life of the assets in accordance with IFRS. The effect on the profit for 2011 was not
material.
Explanation of material adjustments to the statement of cash flows for 2011:

Income taxes of £133 paid during 2011 are classified as operating cash flows in accordance with
IFRS but were included in a separate category of tax cash flows in accordance with previous GAAP.
There are no other material differences between the statement of cash flows presented in accordance
with IFRS and the statement of cash flows presented in accordance with previous GAAP.
Summary
When companies adopt IFRS, they must ensure that financial statement users receive
high-quality information in order to compare financial statements prepared under IFRS
and previous GAAP. IFRS guidelines are designed to ensure that upon first-time adop-
tion, financial statements are comparable and that the costs and benefits of first-time
adoption are effectively managed.
AUTHORITATIVE LITERATURE
Authoritative Literature References
[1] International Financial Reporting Standard for Small and Medium-sized Entities (IFRS for SMEs) (London,
U.K.: IASB, 2009).
[2] International Accounting Standard 10, Events after the Reporting Period (London, U.K.: International
Accounting Standards Committee Foundation, 2007).
[3] International Accounting Standard 10, Events after the Reporting Period (London, U.K.: International
Accounting Standards Committee Foundation, 2007), par. 22.
[4] International Accounting Standard 34, Interim Financial Reporting (London, U.K.: International Accounting
Standards Committee Foundation, 2001).
[5] International Accounting Standard 34, Interim Financial Reporting (London, U.K.: International Accounting
Standards Committee Foundation, 2001), paras. B12–B19.
[6] International Financial Reporting Standard 1, First-time Adoption of International Financial Reporting Standards
(London, U.K.: IASB, 2003), par. 1.
(London, U.K.: IASB, 2003), par. BC 22B.
(London, U.K.: IASB, 2003), App. C and D.
(London, U.K.: IASB, 2003), App. B–E.
(London, U.K.: IASB, 2003), paras. D5–D8 and BC41–BC47.
QUESTIONS
6. What are the major types of subsequent events? Indicate 13. What are the accounting problems related to the presen-
how each of the following “subsequent events” would be tation of interim data?
reported. 14. Dierdorf Inc., a closely held corporation, has decided to
(a) Collection of a note written off in a prior period. go public. The controller, Ed Floyd, is concerned with pre-
senting interim data when an inventory write-down is
(b) Issuance of a large preference share offering.
recorded. What problems are encountered with invento-
(c) Acquisition of a company in a different industry. ries when quarterly data are presented?
(d) Destruction of a major plant in a flood. 15. What approaches have been suggested to overcome the
(e) Death of the company’s chief executive officer (CEO). seasonality problem related to interim reporting?
(f) Additional wage costs associated with settlement of 16. An article in the financial press entitled “Important Infor-
a four-week strike. mation in Annual Reports This Year” noted that annual
reports include a management commentary section. What
(g) Settlement of an income tax case at considerably more
would this section contain?
tax than anticipated at year-end.
17. “The financial statements of a company are manage-
(h) Change in the product mix from consumer goods to
ment’s, not the accountant’s.” Discuss the implications of
industrial goods.
this statement.
12. What are interim reports? Why is a complete set of finan-
20. What is the difference between an auditor’s unmodified
cial statements often not provided with interim data?
opinion or “clean” opinion and a modified one?
BRIEF EXERCISES
BE24-3 Morlan Corporation is preparing its December 31, 2010, financial statements. Two events that
occurred between December 31, 2010, and March 10, 2011, when the statements were issued, are described
below.
1. A liability, estimated at €160,000 at December 31, 2010, was settled on February 26, 2011, at €170,000.
2. A flood loss of €80,000 occurred on March 1, 2011.
What effect do these subsequent events have on 2010 net income?
BE24-10 Becker Ltd. is planning to adopt IFRS and prepare its first IFRS financial statements at Decem-
ber 31, 2013. What is the date of Becker’s opening statement of financial position, assuming one year of
comparative information? What periods will be covered in Becker’s first IFRS financial statements?
BE24-11 Bohmann Company is preparing its opening IFRS statement of financial position on January 1,
2012. Under its previous GAAP, Bohmann had capitalized all development costs of $50,000. Under IFRS,
only $10,000 of the costs related to a patent were incurred after the project met economic viability thresh-
olds. Prepare the entry (if any) needed to record this adjustment at the date of transition.
BE24-12 Stengel plc is preparing its opening IFRS statement of financial position on January 1, 2012. Under
its previous GAAP, Stengel used the LIFO inventory method. Under LIFO, its inventory is reported at
£250,000; under FIFO, which Stengel will use upon adoption of IFRS, the inventory is valued at £265,000.
Prepare the entry (if any) needed to record this adjustment at the date of issuance.
BE24-13 Latta Inc. is preparing its opening IFRS statement of financial position on January 1, 2012. Under
its previous GAAP, Latta had deferred certain advertising costs amounting to $37,000. Prepare the entry
(if any) needed to record this adjustment at the date of issuance
BE24-14 Smitz Company is preparing its opening IFRS statement of financial position on January 1, 2012.
Under its previous GAAP, Smitz did not record a provision for litigation in the amount of €85,000 that
would be recognized under IFRS. Prepare the entry (if any) needed to record this adjustment at the date
of issuance.
BE24-15 Porter Company is evaluating the following assets to determine whether it can use fair value
as deemed cost in first-time adoption of IFRS.
1. Biological assets related to agricultural activity for which there is no active market.
2. Intangible assets for which there is no active market.
3. Any individual item of property, plant, and equipment.
4. Financial liabilities that are not held for trading.
For each asset type, indicate if the deemed cost exemption can be used.
EXERCISES
E24-1 (Subsequent Events) Keystone Corporation issued its financial statements for the year ended
December 31, 2010, on March 10, 2011. The following events took place early in 2011.
(a) On January 10, 10,000 ordinary shares of $5 par value were issued at $66 per share.
(b) On March 1, Keystone determined after negotiations with the taxing authorities that income taxes
payable for 2010 should be $1,320,000. At December 31, 2010, income taxes payable were recorded
at $1,100,000.
Instructions
Discuss how the preceding subsequent events should be reflected in the 2010 financial statements.
E24-2 (Subsequent Events) For each of the following subsequent events, indicate whether a company
should (a) adjust the financial statements, (b) disclose in notes to the financial statements, or (c) neither
adjust nor disclose.
______ 1. Settlement of a tax case at a cost considerably in excess of the amount expected at year-end.
______ 2. Introduction of a new product line.
______ 3. Loss of assembly plant due to fire.
______ 4. Sale of a significant portion of the company’s assets.
______ 5. Retirement of the company president.
______ 6. Issuance of a significant number of ordinary shares.
______ 7. Loss of a significant customer.
______ 8. Prolonged employee strike.
______ 9. Material loss on a year-end receivable because of a customer’s bankruptcy.
______ 10. Hiring of a new president.
______ 11. Settlement of prior year’s litigation against the company.
______ 12. Merger with another company of comparable size.
*E24-7 (Opening Statement of Financial Position) Goodman Company is preparing to adopt IFRS. In
preparing its opening statement of financial position on January 1, 2012, Goodman identified the follow-
ing accounting policy differences between IFRS and its previous GAAP.
1. Under its previous GAAP, Goodman classified proposed dividends of €45,000 as a current liability.
2. Goodman had deferred advertising costs of €500,000.
Instructions
(a) Prepare the journal entries (if any) needed before preparation of Goodman’s opening statement
of financial position.
(b) Determine the net change in equity from these adjustments.
*E24-8 (Opening Statement of Financial Position, Disclosure) Lombardo Group is preparing to adopt
IFRS. It is preparing its opening statement of financial position on January 1, 2012. Lombardo identified
the following accounting policy differences between IFRS and its previous GAAP.
1. Lombardo had not made a provision for a warranty of €75,000 under previous GAAP because the
concept of a “constructive obligation” was not recognized.
2. Under previous GAAP, €60,000 paid for certain architect fees was not capitalized into the cost of
a building that was put into service at the beginning of 2011, even though those costs were neces-
sary to bring the asset to its working condition. The building has a 40-year life, no residual value,
and Lombardo uses straight-line depreciation.
Instructions
(a) Prepare the journal entries (if any) needed before preparation of Lombardo’s opening statement
of financial position.
(b) Determine the net change in equity from these adjustments.
(c) Brief describe the disclosures that Lombardo will make related to the adjustments in it first IFRS
financial statements.

CA24-7 (Interim Reporting) Snider Corporation, a publicly traded company, is preparing the interim
financial data which it will issue to its shareholders at the end of the first quarter of the 2010–2011 fiscal
year. Snider’s financial accounting department has compiled the following summarized revenue and
expense data for the first quarter of the year.
Sales $60,000,000
Cost of goods sold 36,000,000
Variable selling expenses 1,000,000
Fixed selling expenses 3,000,000
Included in the fixed selling expenses was the single lump-sum payment of $2,000,000 for television ad-
vertisements for the entire year.
Instructions
(a) Snider Corporation must issue its quarterly financial statements in accordance with IFRS regard-
ing interim financial reporting.
(1) Explain whether Snider should report its operating results for the quarter as if the quarter
were a separate reporting period in and of itself, or as if the quarter were an integral part of
the annual reporting period.
(2) State how the sales, cost of goods sold, and fixed selling expenses would be reflected in Snider
Corporation’s quarterly report prepared for the first quarter of the 2010–2011 fiscal year.
Briefly justify your presentation.
(b) What financial information, as a minimum, must Snider Corporation disclose to its shareholders
in its quarterly reports?
CA24-11 (Reporting of Subsequent Events) In June 2010, the board of directors for McElroy Enterprises
Inc. authorized the sale of £10,000,000 of corporate bonds. Jennifer Grayson, treasurer for McElroy Enter-
prises Inc., is concerned about the date when the bonds are issued. The company really needs the cash,
but she is worried that if the bonds are issued before the company’s year-end (December 31, 2010) the
additional liability will have an adverse effect on a number of important ratios. In July, she explains to
company president, William McElroy, that if they delay issuing the bonds until after December 31, the
bonds will not affect the ratios until December 31, 2011. They will have to report the issuance as a sub-
sequent event which requires only footnote disclosure. Grayson expects that with expected improved
financial performance in 2011 ratios should be better.
USING YOUR JUDGMENT

As stated in the chapter, notes to the financial statements are the means of explaining the items presented
in the main body of the statements. Common note disclosures relate to such items as accounting policies,
segmented information, and interim reporting. The financial statements of M&S can be accessed at the
book’s companion website, www.wiley.com/college/kiesoifrs.
Instructions
es oifrs
ki Refer to M&S’s financial statements and the accompanying notes to answer the following questions.
/
llege
(a) What specific items does M&S discuss in its Note 1—Summary of Significant Accounting Policies?
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ww
(List the headings only.)

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(b) For what segments did M&S report segmented information? Which segment is the largest? Who is
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M&S’s largest customer?

(c) What interim information was reported by M&S?

As part of the year-end audit, you are discussing the disclosure checklist with your client. The checklist
identifies the items that must be disclosed in a set of IFRS financial statements. The client is surprised by
the disclosure item related to accounting policies. Specifically, since the audit report will attest to the state-
ments being prepared in accordance with IFRS, the client questions the accounting policy checklist item.
The client has asked you to conduct some research to verify the accounting policy disclosures.
Instructions
(a) In general, what should disclosures of accounting policies encompass?
(b) List some examples of the most commonly required disclosures.

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CHAPTER 1 FINANCIAL REPORTING AND ACCOUNTING STANDARDS

As indicated, capital markets are increasingly integrated and companies have

International Organization of Securities Commissions (IOSCO)

International Accounting Standards Board (IASB)

"Any more comments? "Here is

1. International Financial Reporting Standards.

International Financial Reporting Standards. Financial accounting standards issued

International Financial Reporting Interpretations. Interpretations issued by the Inter-

Any company indicating that it is preparing its financial statements in conformity

1. International Financial Reporting Standards;

In the absence of a standard or an interpretation, the following sources in descend-

As a result of this agreement, the two Boards identified a number of short-term

INTERNATIONAL FINANCIAL REPORTING

R E L E VA N T FA C T S ABOUT THE NUMBERS

In the United States, investors and creditors have driven

CONCEPTS FOR ANALYSIS

(c) It takes precedence over all other authoritative literature.

USING YOUR JUDGMENT

BRI DGE TO TH E PROFESSION

CHAPTER 8 VALUATION OF INVENTORIES: A COST-BASIS APPROACH

WHICH COST FLOW ASSUMPTION TO ADOPT?

Date Purchases Sold or Issued Balance

Cost of goods available for sale $43,900

Companies use the moving-average method with perpetual inventory records.

SUMMARY OF LEARNING OBJECTIVES

APPENDIX 8A LIFO COST FLOW ASSUMPTION

A physical inventory on March 31, 2010, shows 1,500 units on hand.

July 1 Balance 100 $4.10 $ 410

CONCEPTS FOR ANALYSIS

USING YOUR JUDGMENT

Lumber Supply International

Case 2 Noven Pharmaceuticals, Inc.

Noven Pharmaceuticals, Inc.

Cash and cash equivalents $12,070,272

Feb. 26, Feb. 25, Feb. 24,

BRI DGE TO TH E PROFESSION

CHAPTER 9 INVENTORIES: ADDITIONAL VALUATION ISSUES

LOWER-OF-COST-OR-NET REALIZABLE VALUE (LCNRV)

Net Realizable Value

Kesa Electricals (GBR)

Final Inventory Value:

Methods of Applying LCNRV

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

Recording Net Realizable Value Instead of Cost

Cost of goods sold (before adjustment to net realizable value) $108,000

*Cost of goods sold (before adjustment to net realizable value) $108,000

Recovery of Inventory Loss

Evaluation of the LCNRV Rule

Illustration of Agricultural Accounting at Net Realizable Value

R E L E VA N T FA C T S ABOUT THE NUMBERS

Item Cost Estimated Cost to Complete

Cost Net Realizable Value

CONCEPTS FOR ANALYSIS

USING YOUR JUDGMENT

reporting its inventories?

BRI DGE TO TH E PROFESSION

CHAPTER 11 DEPRECIATION, IMPAIRMENTS, AND DEPLETION

Loss on Impairment (VND14,000,000 VND11,000,000) 3,000,000