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CHAPTER 9

Liabilities
QUESTIONS
Q9-1.
Liabilities are present obligations arising from past transactions or economic events that require
the entity to sacrifice economic resources to settle. Taxes payable is a liability because:
Obligation: An entity is required to pay the taxes it owes to government.
Past transactions or economic event: The obligation arises from the entitys economic
activity during the period.
Economic sacrifice: The government has to be paid in cash.
Q9-2.
A liability is an obligation to pay money or provide services at a future date. To satisfy the
criteria of IFRS, a liability must be a present obligation to the entity, require the sacrifice of
resources, and be the result of a past transaction or economic event. Not every obligation of an
entity meets these criteria. Operating leases, commitments, and contingent liabilities arent
reflected in the financial statements.
Q9-3.
A current liability must be settled within one year or one operating cycle. Its important to know
the amount of current liabilities to assess the liquidity of the entity. The distinction between
current and non-current liabilities is important to certain stakeholders, especially short-term
creditors because it helps them assess whether the entity has enough resources to fulfill
obligations that are due within the next year.
Q9-4.
The current portion of long-term debt is classified separately as a current liability because the
amount must be paid within the coming year (or operating cycle). If separate presentation wasnt
made stakeholders wouldnt know the payments that were required within the coming year. As a
result, assessing liquidity would be more difficult.
Q9-5.
The retail store should record the $100 of merchandise sold as revenue. Although the store will
collect $113 from the customer, it must remit $13 to the government on behalf of the customer.
The store has collected this amount but the money doesnt belong to the store, therefore the $13
should be recorded as a current liability HST Payable.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


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Q9-6.
Its necessary to estimate many liabilities because of the accrual basis of accounting. An entity
may incur an economic obligation with no external event (such as the receipt of an invoice) to
trigger recording it. Liabilities that must be estimated include accrued liabilities and provisions.
Provisions are generally more difficult to estimate. Examples of liabilities that require estimates
include (this is only a partial list, other examples are possible): warranty costs, liabilities for
affinity programs, gift card redemption, utilities used (but not yet billed), and liabilities to
redeem coupons.
Q9-7.
Proceeds from gift card sales are recorded as liabilities because the entity issuing the gift card
has received cash but has yet to provide the customer with goods or services in exchange for that
cash. A liability requires a probable sacrifice of economic resources and a past transaction. The
business will have to provide goods or services when a customer redeems the gift card (which is
the sacrifice) and the past transaction is the purchase of the card. Gift card sales are classified as
unearned revenue to an entity. When the gift card is redeemed by the customer the entity can
recognize revenue.
Q9-8.
An accrued liability is a liability that is recognized and recorded in the financial statements but
for which the recording isnt triggered by an external event such as receipt of a bill or invoice. A
provision is similar but there is more uncertainty about the timing and amount of the liability.

Liability
Accrued Liability

Provision

Example
Account Payable
Employee wages are
unpaid at the end of
the year
Warranty Expense

Cause of Recognition
Invoice from supplier
is provided
Adjusting entry to
match revenues and
expenses
Obligation to
customers that will
occur in the future at
an unknown amount.

Estimate
No estimate is
required
Estimate is required
but likely accurate
Estimate is required
and more difficult to
make

Q9-9.
Debt is risky for the issuing entity because the interest and principal payments have to be made
when required by the loan agreement regardless of how well or poorly the entity is doing.
Defaulting on interest or principal payments (failing to make interest or principal payments when
they are due) can have significant and costly economic and legal consequences for an entity. The
consequences include losing assets pledged against the debt and bankruptcy.

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Q9-10.
a. The effective rate of interest is the actual market rate of interest that investors require.
b. The coupon rate is the percentage of the face value of the bond that is paid to bondholders
each year as interest.
c. The maturity date is the date on which the bondholder will receive the principal amount of the
bond.
d. The proceeds of the bond issue is the amount of money that is received by the entity issuing
the bonds at the date of the issue.
e. The face value of the bond is the amount that the bondholder will receive at maturity.
Q9-11.
You would expect the unsecured loan to bear a higher interest rate because its more risky. Its
more risky because there is no security for the lender, which provides some insurance that some
of the lenders investment will be recovered in the event of default. Also, if the first loan has
priority over the second, meaning that it must be paid before the second loan, that too will
increase the interest rate on the second loan, again because the second lender faces more risk.
Q9-12.
When a zero interest loan is recorded on the balance sheet at its face value, the amount recorded
exceeds the present value of the payments to be made by the borrower a portion of the amount
reflects interest expense that will be paid for the use of the money. When the expense isnt
recorded, income is overstated (expenses are too low). A zero interest loan ignores the time value
of money. Even though the loan agreement states that the loan is interest-free, the economic
reality is that there is a cost to borrowing; people dont lend money interest-free.
Q9-13.
A bond discount is the difference between the face value of the bond and the proceeds of issuing
the bond when the market (effective) rate of interest is greater than the coupon rate. A bond
premium is the difference between the face value of the bond and the proceeds of issuing the
bond when the market rate of interest is less than the coupon rate. Bonds are often sold at a
discount or premium because the rate of interest at the date of issue can be different from that
expected when the terms of the bond were specified.

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Q9-14.
A restrictive covenant is an agreement made by the borrower that restricts its ability to take
certain actions such as additional borrowing or otherwise limits its behaviour in some way. They
are sometimes included to reduce the risk to the lender. The benefit to the lender is that the
borrower is restricted from taking action that would adversely affect the position of the lender
and thereby lower risk. The borrower benefits from the lower risk with a lower interest rates on
the loan. The borrower would prefer not to have the restriction, everything else being equal,
because the covenant may constrain the actions of the borrower. Covenants are the cost of a
lower borrowing cost.
Q9-15.
Bond discounts or premiums affect the interest expense because they are amortized over the life
of the bonds against income. The amount amortized is debited or credited to the interest expense
account. The amortization of a premium decreases the interest expense from the cash actually
paid during a period (so the interest expense is less than the cash paid) and the amortization of a
discount increases the interest expense above the amount paid in cash for interest during a
period.
Q9-16.
Gains and losses arise if the redemption value of the bond at the date the bonds are redeemed
differs from the carrying amount of the bond at that time. A gain is recognized when the
redemption amount is less than the carrying amount of the bond and a loss is recognized when
the redemption amount is greater than the carrying amount of the bond.
Q9-17.
Off-balance sheet liabilities are financing arrangements that allow an entity incur obligations
without the obligations appearing on the balance sheet (operating leases, commitments). Such
arrangements can be attractive because the entities appear to be less levered than they would if
they had arranged financing that would be on the balance sheet. The ability of financial statement
users to interpret financial statements is impaired when a company has off-balance sheet
obligations because they may not be able to make a good assessment of the amount of debt or
obligations the entity has from the balance sheet alone. Its possible to keep some liabilities off
the balance sheet because IFRS doesnt require certain obligations, which meet (or dont meet)
certain criteria, to be included on the balance sheet. Operating leases, for example, are leases that
dont transfer the risks and rewards of ownership and therefore arent included on the balance
sheet.

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Q9-18.
Managers have incentives to understate liabilities to persuade users of financial statements that
the company is more creditworthy, more liquid, more solvent, and less risky. For example, a
lender may be misled regarding the riskiness of a potential loan and might offer better terms.
There are also covenants based on or affected by liabilities and a manager might take steps to
avoid violating these covenants by understating liabilities. A manager could fail to accrue a
liability for which an invoice has not been received, or choose not to record the purchase of
inventory, which was in transit at the balance sheet date. A manager could also make low
estimates of accrued liabilities and provisions (e.g. warranties, coupons) or could arrange
transactions in ways that legitimately allow an entity to avoid recording a liability (operating
instead of capital lease).
Q9-19.
A capital lease transfers the benefits and risks of ownership to the lessee and an operating lease
doesnt. A capital lease results in an asset and a liability on the balance sheet of the lessee and a
depreciation expense and interest expense on the income statement of the lessee. The treatment is
equivalent to the entity having borrowed money to purchase the asset rather than leasing it. An
operating lease doesnt result in an asset or a liability on the balance sheet and the only expense
on the income statement is the lease payment (or the accrual thereof) to the lessor.
Q9-20.
For a capital lease the amount recorded on the balance sheet at the start of the lease is the present
value of the lease payments (Dr. Asset, Cr. Lease Liability). On subsequent balance sheets, the
recorded asset and liability are accounted for separately. The asset is depreciated over its useful
life and the liability is reduced by the principal component of each lease payment. There is no
reason why the principal payments should match the method used to match the cost of the asset
to revenue over its useful life (the period that its available to depreciate it).
Q9-21.
IFRS requires a lease to be classified as a capital lease if any of the three criteria are met: (i)
ownership: likely transfer of ownership of the asset to the lessee at the end of the lease, (ii)
economic life: lessee receives most of the economic benefits of the asset over its useful life, (iii)
consideration: PV of lease payments covers substantially all of the fair value of the leased asset.
If a lease meets none of the criteria listed above, its classified as an operating lease. The
problem of providing these principle-based criteria is that the generality allows for flexibility in
reporting and requires preparer judgement. Lease classification can materially affect financial
statements. The benefits include the promotion of substance over form and that guidelines exist
to prevent managers from abusing off balance sheet financing through operating lease
classification.

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Q9-22.
IFRS requires disclosure of operating lease obligations and significant purchase commitments
because they arent recorded on the balance sheet as liabilities. The two items are unrecognized
agreements that will affect the entities future cash flows, therefore disclosure of the
commitments is required.
Q9-23.
In a defined-contribution plan the pension benefits an employee receives upon retirement depend
on the amount contributed to the plan on behalf of that employee (by the employer and the
employee) and on the performance of the investments made with the funds in the pension plan.
The employers obligation is limited to making the required contribution each year. The
employee is entitled only to his or her share of what is in the plan on retirement.
In a defined-benefit plan the employer promises to provide employees with certain specified
benefits in each year they are retired. The contribution by the employer isnt defined and depends
on the return earned by the plan, the amount contributed, the amount that must be paid to
employees, and so on.
The defined benefit plan is more attractive to employees because the amount of their pension is
guaranteed. They dont face uncertainty about how the investments of the funds will perform.
The defined-contribution plan is less risky for employers because the amount they have to
contribute is specified. They dont face variable payments based on the performance of the
investments in the plan.
Q9-24.
The assets of the pension plan arent reported on the balance sheet because the funds dont
belong to the entity, they belong to the pension fund that manages them on behalf of the
employees. The sponsoring entitys assets arent understated since the assets of the pension plan
arent reflected in the sponsors financial statements. The underfunding is reflected on the
sponsors balance sheet as a liability.
Q9-25.
A problem with expensing pension costs when cash is paid to beneficiaries is that the cost of the
pension wouldnt be matched appropriately to revenues. The matching concept requires
recognizing the expense and recognizing the liability is required for representational faithfulness.
A pension is earned by an employee as he/she works for the company. Expensing the pension
when paid means the cost is being recognized after the employee has retired and is no longer
working for the company. As a result, the profitability of the company is overstated in those
periods when employees work for the company and become entitled to the future benefits and no
expenses are recorded because the payment of those benefits will be at a time in the distant
future. The leverage of the company is also all understated because no liability appears in the
balance sheet.

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Q9-26.
A subsequent event is an event that occurs after the balance sheet date but before the financial
statements are approved by the board of directors. There are two categories of subsequent events:
some that provide additional information about circumstances that existed at the year end and
some simply events that occurred subsequent to the balance sheet date (unrelated to the year-end
financial statements). If the information is about circumstances that existed at year-end, the
financial statements should be adjusted to reflect the new information. If the event occurred after
the balance sheet date and doesnt provide information about circumstances that existed at year
end there is no impact on the financial statements but the event should be disclosed in a note to
the financial statements.
Q9-27.
A commitment is a contractual agreement to enter into a transaction in the future. Commitments
are executory contracts and, under IFRS, these contracts are generally not recorded in the
financial statements. If significant, disclosure in the notes to the financial statements is
appropriate, as commitments may provide important information to stakeholders.
Q9-28.
A contingent liability is: (i) a possible obligation whose existence will be confirmed by the
occurrence of uncertain future events or, (ii) a present obligation arising from past events that
isnt recognized because an outflow of resources isnt probable or the amount cant be
sufficiently measured.
Contingent liabilities are disclosed only, unless the probability of occurrence is remote, in which
case note disclosure isnt required. If a contingent liability becomes measurable it should be
accrued (and its then called a provision).
Q9-29.
The interest coverage ratio is designed to measure the ability of an entity to meet its fixed
financing charges. In particular, the interest coverage ratio indicates the ease with which an
entity can meet its interest payments. The interest coverage ratio is income before interest
expense and tax expense divided by interest expense. The ratio indicates the number of times
income covers the interest expense. In the short run, however, its really cash that determines
whether or not the company can meet its obligations, not income. A cash interest coverage ratio
is also used in which cash from operations plus interest paid is divided by interest paid.
Q9-30.
The actual cost of borrowing is usually lower than the stated rate of interest because interest
expense is deductible from income in determining the amount of income tax owed. As a result,
the after-tax borrowing rate is lower than the stated rate. The actual cost and the stated rate will
be the same if a company doesnt pay income taxes, which may be the case if the company has
not been profitable and isnt expected to be for some time, or if an entity isnt subject to tax, such
as a not-for-profit organization.

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Q9-31.
Its really not possible to definitively assess the riskiness of this company without knowing the
industry and the events that have occurred during this period. The acceptable amount of debt in a
company's capital structure depends on factors such as the riskiness of the industry and the
quality of the assets provided as collateral. However, an increase in the ratio means the amount
of debt relative to equity in the capital structure has increased, which could imply increasing risk.
However, the previous capital structure could have contained less debt than optimal.
Q9-32 (Appendix).
Views such as these reflect a misperception regarding what deferred (future) taxes actually
represent. Future taxes arent owed to the government and arent a liability in that sense. They
simply represent differences between accounting for tax purposes and accounting for financial
reporting purposes. If financial reporting used the rules required for tax purposes the amount of
tax payable the entity would report would be the same in both cases and there would be no future
taxes. Future income taxes arise because of the accounting choices made by an entity and arent
the result of a government policy that provides deferrals to tax payers.
Q9-33 (Appendix).
Deferred (future) income tax assets and liabilities arise because the accounting methods used to
prepare the general purpose financial statements are sometimes different from the methods used
to calculate taxable income and the amount of income tax an entity must pay. Future income
taxes reflect the difference between the book value of assets and liabilities and their tax values,
multiplied by the tax rate.
Q9-34 (Appendix).
With the taxes payable method the income tax expense on the income statement is equal to the
amount of income taxes that must actually be paid to the government for the period. With the
future income tax method of accounting for income taxes, the income tax expense on the income
statement is the effective income tax rate times the income before income taxes for financial
reporting purposes (although the income tax expense is actually a plug that balances the entry
that includes the tax liability for the period and the adjustment to the balance sheet amounts of
future income taxes).
Q9-35 (Appendix).
The current expense represents the tax liability for the current period (the amount paid or payable
to the government). The future portion of the income tax expense represents the adjustment
needed to have the appropriate balances in the future income tax accounts on the balance sheet.

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EXERCISES
E9-1.
Issue date

a.
15-Jul-18

b.
15-Jul-18

c.
15-Jul-18

Maturity date

14-Jul-25

14-Jul-25

14-Jul-25

Annual

Annual

Annual

Face Value (FV)

40,000,000

40,000,000

40,000,000

Number of
periods

Effective rate (i)

3.00%

4.00%

5.00%

market /discount

Coupon rate (c)

4.00%

4.00%

4.00%

nominal/stated/contract

Annuity Payment

1,600,000

1,600,000

1,600,000

Proceeds (P) =
PV (Principal)
PV (annuity)
Proceeds (P) =

interest payments

PV (all cash flows)


$32,523,660

$30,396,713

$28,427,253

$9,968,453

$9,603,287

$9,258,197

$42,492,113

$40,000,000

$37,685,450

a.

b.

c.

E9-2.
Issue date

01-Dec-17

01-Dec-17

01-Dec-17

Maturity date

30-Nov-29

30-Nov-29

30-Nov-29

Annual

Annual

Annual

Face Value (FV)

15,000,000

15,000,000

15,000,000

Number of
periods

12

12

12

Effective rate (i)

9.00%

9.00%

9.00%

Coupon rate (c)

10.00%

9.00%

8.00%

Annuity Payment

1,500,000

1,350,000

1,200,000

Proceeds (P) =
PV (Principal)
PV (annuity)
Proceeds (P) =

PV (all cash flows)


$5,333,021

$5,333,021

$5,333,021

$10,741,088

$9,666,979

$8,592,870

$16,074,109

$15,000,000

$13,925,891

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E9-3.
a.
Dr. Cash (A+)
Cr. Working Capital Loan (L+)
To record the short-term bank loan

50,000
50,000

Dr. Working Capital Loan (L-)


50, 000
Dr. Interest Expense (E+)
1,250
Cr. Cash (A-)
51,250
To record the repayment of the short-term bank loan and interest
b.
Dr. Cash (A+)
Dr. Bond Discount (CL+)
Cr. Long-term debt bonds (L+)
To record issuance of long-term bonds

9,950,000
50,000

c.
Dr. Mortgage Loan (L-)
Dr. Interest Expense (E+)
Cr. Cash (A-)
To record monthly loan payments

10,000,000

2,538
8,212
10,750

E9-4.
For this question (# of days/365) may be used instead of months, thus a slightly different answer
may be given.
a.
Dec. 31
Dr. Interest Expense (E+)
2,083
Cr. Interest Payable (L+)
2,083
Accrued interest for five months ($100,000*.05*(5/12) = $2,083)
b.
Dec. 31
Dr. Interest Expense (E+)
250
Cr. Interest Payable (L+)
250
Accrued interest for two months ($25,000*.06*(2/12) =$250)
c. No adjusting entry is required as payments are made on the last day of each quarter, including
the last day of the year.
d.
Dec. 31
Dr. Interest Expense (E+)
12,250
Cr. Interest Payable (L+)
Accrued interest for three months ($700,000*.07*3/12)
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Note that a payment would have been made on October 2 for $12,500 so that amount doesnt
have to be accrued on December 31.
E9-5.
a.
Dr. Cash
62,000
Cr. Unearned revenue gift certificates

62,000

b.
Dr. Unearned revenue gift certificates
Cr. Revenue earned

24,000
24,000

Assuming a perpetual inventory system:


Dr. Cost of Sales
Cr. Inventory

15,000
15,000

c. The amount of the unused gift certificates would be a current liability of $38,000 ($62,000 $24,000) because the outstanding certificates can be redeemed at any time.
d. The transaction increases current assets and current liabilities by an equal amount. The effect
on the current ratio would depend on the current ratio before. If the ratio was below 1, the
transaction would increase the ratio, and if the current ratio was above 1, it would decrease it.
When the gift certificates are redeemed the current ratio would increase because the amount of
unearned revenue would decrease and there would be an increase in current assets as cash would
increase and inventory would decrease (inventory would likely decrease by less than the increase
in cash /accounts receivable).
e. The sale of a gift certificate isnt considered revenue because Juno has yet to provide goods or
services to the customer. Gift card sales are considered unearned revenue because the entity has
received cash but has not fulfilled the obligation to provide goods or services for that cash.
Unearned revenue is recognized as a liability for the amount received. The revenue recognition
criteria arent satisfied when the gift cards are sold.

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E9-6.
a.
Dr. Cash
4,875,000
Cr. Unearned revenue gift certificates

4,875,000

Dr. Unearned revenue gift certificates


Cr. Revenue earned

4,189,000
4,189,000

Assuming a perpetual inventory system:


Dr. Cost of Sales
Cr. Inventory

3,375,000
3,375,000

Dr. Unearned revenue gift certificates


198,440
Cr. Revenue earned
198,440
To record revenue for the gift cards that arent expected to be redeemed ($4,275,000 (opening
balance) + $4,875,000 (gift cards sold) - $4,189,000 (gift cards redeemed) = $4,961,000
(outstanding) *4% = $198,440)
b. The amount of the unused gift certificates would be a current liability of $4,762,560
[$4,961,000 - $198,440 (from part a)] because the outstanding certificates can be redeemed at
any time.
c. The transaction increases current assets and current liabilities by an equal amount. The effect
on the current ratio would depend on the current ratio before. If the ratio was below 1, the
transaction would increase the ratio, and if the current ratio was above 1, it would decrease it.
When the gift certificates are redeemed the current ratio would increase because the amount of
unearned revenue would decrease and there would be an increase in current assets as
cash/accounts receivable would increase and inventory would decrease (inventory would likely
decrease by less that the increase in cash /accounts receivable).
d. The sale of a gift certificate isnt considered revenue because Pages has yet to provide goods
to the customer. Gift card sales are considered unearned revenue because the entity has received
cash but has not fulfilled the obligation to provide goods for that cash. Unearned revenue is
recognized as a liability for the amount received. The revenue recognition criteria arent satisfied
when the gift cards are sold.

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E9-7.
Year-end September 30, 2017
a. The principle portion of the mortgage payment ($293,650 interest) would be classified as a
current liability because its due within the coming year. The remainder of the balance (due in 20
years) would be a non-current liability. (Remember that the payment is a blend of interest and
principal.)
b. The $125,200 withheld taxes would be a current liability because its payable to the
government and is due within the coming year.
c. The $2,500 deposit would be a current liability because the obligation will be fulfilled within
the next fiscal year (the deposit is unearned revenue).
d. The $150,000 due in December is a current liability because its due in the next fiscal year.
The remaining balance of $150,000 would be a non-current liability because its due more than
one year past the balance sheet date.
e. The $325,000 demand loan would be a current liability because it can be recalled by the bank
at any time.
f. Since the $3,000,000 total provision is divided equally over 3 years, $1,000,000 of the total
warranty provision would be classified as a current liability. The remaining $2,000,000 not
expected to be realized within the next fiscal year is a non-current liability.

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E9-8.
a.
Dr. Corporate Jet
Cr. Loan payable
Cr. Cash
Issue date

31-Mar-17

Maturity date

31-Mar-21

3,352,707
3,102,707
$250,000

Annual
Future Value

3,500,000

Number of
periods
Effective rate

4
5.00%

Annuity
Payment

875,000

Annual
PV (annuity)

$3,102,707

Cash payment
Cost of plane

250,000
$3,352,707

Despite being interest free the present value of the payments needs to be determined to
properly determine the value of the jet and loan. Value of jet = cash payment + present value of
loan payments.
b. The allocation of the payment between interest and reduction of principal is shown in the table
below. Assuming a 5% discount rate,
Rate

Discounted value method

5%

[1]
Cash

Interest

Loan

Date

Payment

Expense

payable

Net Liability

[1]-[2]

pre[4]-[3]

[2]

[3]

31-Mar-17

[4]

3,102,707

31-Mar-18

875,000

155,135

719,865

2,382,842

31-Mar-19

875,000

119,142

755,858

1,626,984

31-Mar-20

875,000

81,349

793,651

833,333

31-Mar-21

875,000

41,667

833,333

The journal entry on March 31, 2018:


Dr. Interest expense
Dr. Loan payable
Cr. Cash
The journal entry on March 31, 2019:
Dr. Interest expense

155,135
719,865
875,000

119,142

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Dr. Loan payable


Cr. Cash

755,858
875,000

The journal entry on March 31, 2020:


Dr. Interest expense
Dr. Loan payable
Cr. Cash

81,349
793,651

The journal entry on March 31, 2021:


Dr. Interest expense
Dr. Loan payable
Cr. Cash

41,667
833,333

875,000

875,000

c.
The liability would initially be recorded at the present value of the lease payments and would
decrease each year thereafter, as shown in column 4 of the table in part b. Assuming that March
31st is the companies year end, no accruals are necessary.
d. The liability couldnt be reported using the nominal value (the total of the payments,
$3,500,000) if Etzikom was following IFRS or ASPE. IFRS and ASPE require the present value
method to be used. The present value method requires that a discount rate be used therefore the
nominal method overstates the cost of the asset because the time value of money is ignored. By
ignoring the time value of money the actual liability is overstated.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-15
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-9.
a.
Dr. Cash
Cr. Sales
Cr. GST payable
December 10, 2017
Dr. GST payable
Cr. Cash

152,250
145,000
7,250

7,250
7,250

b.
Dr. Wages and salaries expense
42,000
Cr. Income tax withholdings payable
Cr. CPP payable
Cr. EI payable
Cr. Pension plan contributions
Cr. Union dues payable
Cr. Disability insurance payable
Cr. Charitable contributions payable
Cr. Cash

13,000
4,105
1,860
1,450
750
1,000
200
19,635

December 10, 2017


Dr. Income tax withholdings payable
Dr. CPP payable
Dr. EI payable
Dr. Pension plan contributions
Dr. Union dues payable
Dr. Disability insurance payable
Dr. Charitable contributions payable
Cr. Cash

22,365

13,000
4,105
1,860
1,450
750
1,000
200

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-16
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-10.
Year-end December 31, 2017
a. The pension withholdings are due within ten days and thus they are a current liability (pension
plan contribution = $4,000).
b. Normally payments for inventory are due long before a year unless there is a special
arrangement. This is a current liability ($68,000 accounts payable).
c. The $50,000 note payable is due and will be paid in March, thus its recorded as a current
liability. However, because the note is to be replaced with a long-term bank loan it could be
classified as a non-current liability, as long as the financing arrangement is secured. ($50 000
note payable)
d. This is a current liability because the service is to be provided in 2018 (less than one year from
current balance sheet date), (Unearned revenue = $10,000).
e. The $25,000 to be paid in 2018, is a current liability. The remaining amount of $75,000 isnt
due within one year is a non-current liability ($25,000 = loan payable).
f. The amount of $120,000 declared as dividends is to be paid in the next fiscal year therefore its
a current liability ($120 000 = dividends payable).
g. Because the bank can demand repayment at any time, the $300,000 demand loan would be
classified as a current liability ($300,000 = current loan payable).
E9-11.
a.
Debt-to-Equity Ratio = total liabilities / total shareholders equity
Interest Coverage Ratio = [(net income + interest expense + income tax expense) / interest
expense]
Debt-to-Equity
Interest Coverage
Naicam Ltd.
2.413
3.366
Riverton Inc.
1.258
6.403
b. Riverton Inc., would be considered a safer investment by a long-term lender. The debt-toequity ratio is lower, meaning that this entity carries proportionally less debt than Naicam and is
therefore less risky. An entity with relatively little debt is able to assume more if needed.
Rivertons interest coverage ratio is higher meaning that it has a better ability to meet interest
payments from its current income. This gives lenders more assurance that the borrower will be
able to make debt repayments.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-17
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-12.
a.
Debt-to-Equity Ratio = total liabilities / total shareholders equity
Interest Coverage Ratio = [(net income + interest expense + income tax expense) / interest
expense]
Debt-to-Equity
Interest Coverage
Lombardy Ltd.
.595
3.923
Savona Inc.
1.350
5.438
b. Its difficult to perform a complete ratio analysis without industry and trend information. The
information provided provides mixed evidence as to credit risk. Lombardy has a debt-to-equity
ratio of below 1, which means that its mainly financed with equity. Savona has a debt-to-equity
of above 1, which means that its financed with more debt than equity. This means that
Lombardy is financed less by debt and therefore there are fewer fixed charges. Savona reports a
higher interest coverage ratio, which means that it has more income per dollar of interest and so
is less risky insofar as meeting its interest payments. That said, Lombardys interest coverage
ratio is lower but it isnt too low.
E9-13.
a.
Dec. 31, 2017
Dr. Pension expense (E+, OE )
Cr. Cash (asset )
To record the pension contribution for 2017

200,000
200,000

b.
In addition, it would be necessary to accrue a liability for the unpaid part of the required
contribution:
Dr. Pension expense (E+, OE )
30,000
Cr. Pension liability (liability +)
30,000
To accrue the liability for the unpaid portion of the pension contribution for 2017 (230*$1,000 =
$230,000 - $200,000 = $30,000).
The $30,000 pension liability would be reported on Iskut Inc. December 31, 2017 balance sheet.
When Iskut makes its payment it would recorded the following journal entry:
Dr. Pension liability (liability +)
30,000
Cr. Cash (asset )
30,000
To record the final payment to the defined contribution pension plan

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-18
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-14.
a.
March 31, 2017
Dr. Pension expense ( E+, OE )
150,000
Cr. Cash (asset )
To record the funding contribution to the defined benefit pension plan

150,000

b.
While this could be a much more complicated answer, the idea is to have students recognize that
the unfunded portion of the pension obligation is a liability.
Dr. Pension expense (E+, OE )
100,000
Cr. Pension liability (liability +)
100,000
To accrue the liability for the unfunded portion of the pension expense for 2017

E9-15.
a. The contract is a commitment that will have a substantial impact on business over the next
three years. It would be appropriate to disclose the contract in the notes to the financial
statements so that users are aware of Sayabecs future purchase commitments. According to
IFRS, when neither party in a contract agreement has performed its part of the bargain, any
assets and liabilities associated with that contract arent recorded, but are disclosed.
b. The arrangement is a contingent liability, which involves a risk that the guarantee could
become a liability if the other company doesnt make the payments. There is no liability at the
present moment but full disclosure requires that the users of the financial statements be aware of
the arrangement as it substantially affects the risks faced by Sayabec. The existence of the
guarantee should be disclosed.
c. The bankruptcy is a subsequent event because the event occurred after year end, but before the
financial statements were issued. This event provides information about circumstances that
existed at year end because the customer was in financial distress at that time. The financial
statements should be adjusted to reflect the new information as a 75% decrease in accounts
receivable from a major customer will impact current assets reported.
d. The dividends declared are a subsequent event because the event occurred after year end, but
before the financial statements were approved by the board of directors. This event is unrelated
to circumstances that existed at year-end but may provide useful information to statement users.
The declaration should be note disclosed. No adjusting entries are made to the financial
statements.
e. The taxes stated as payable by the CRA would be a contingent liability because its a possible
obligation to the entity whose existence must be confirmed by a future event (the appeal and
possibly court). Unless its likely that Sayabec will have to pay, this should be disclosed in the
notes to the financial statements to make users aware of a possible future obligation that Sayabec
may face.
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual

Page 9-19
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-16.
a. The contract is a subsequent event because the event occurred after year end but before the
financial statements were issued. This event is unrelated to circumstances that existed at year-end
but will provide useful information to statement users since Langham will pay above market
prices to guarantee supply. Its also a commitment because it commits the company to
purchasing raw materials for five years. The contract should be note disclosed (if its material).
No adjusting entries are made to the financial statements for the 2017 year-end.
b. The claim is a contingent asset. The future outcome of this event is unknown to Langham and
the amount received, if any, cant be measured with certainty. Although there is much
uncertainty surrounding this transaction, the entity may potentially experience a gain, which may
be useful information to financial statement users. This event should be disclosed in the notes.
c. The contract for equipment is a commitment. Langham has committed to a future purchase
however the payment isnt due until 2020 (on delivery). Stakeholders should be aware of the
purchase commitment as it will result in a future outflow of resources, however the entity wont
realize an outflow of resources in the current period. This event should be note disclosed,
assuming the purchase of capital equipment is material.
d. The customers bankruptcy is a subsequent event. The event is unrelated to events that existed
at year end so only note disclosure is required, if the uncollectability of the receivables is
material. This event doesnt provide information about circumstances that existed at year end
because the customer wasnt at risk of bankruptcy at year end.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-20
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-17
a.
Issue date
Maturity date

31-Dec-17
31-Dec-21
Annual

Future Value

16,000,000

Number of periods

Effective rate

5.00%

Annuity Payment

4,000,000

Annual
PV (annuity)

$14,183,802

A liability of $14,183,802 would be reported on the Dec 31, 2017 balance sheet.
The following table provides the liability amount and interest expense for each year end:
rate

Discounted value method

5%

[1]
Date

Annual
payment

[2]

[3]

[4]

Interest
expense

Decrease in loan
payable at year
end

Liability at
year end

31-Dec-17

$14,183,802

31-Dec-18

4,000,000

709,190

3,290,810

10,892,992

31-Dec-19

4,000,000

544,650

3,455,350

7,437,642

31-Dec-20

4,000,000

371,882

3,628,118

3,809,524

31-Dec-21

4,000,000

190,476

3,809,524

b.
Recording the liability at $16,000,000 wouldnt reflect the time value of money. As a result the
asset and liability would be overstated.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-21
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-18.
a.
The proceeds of the bond issue are $4 594 455.
Issue date

01-Nov-17

Maturity date

31-Oct-22
Semi-Annual

Face Value (FV)

5,000,000

Number of periods

10

Effective rate (i)

4.00%

- 8% annually is 4% semi-annually

Coupon rate (c)

3.00%

- 6% annually, 3% semi-annually

Annuity Payment

150,000

Proceeds (P) =

- 5 periods is 10 semi-annual periods

- $300 000 annually, $150 000 semi-annually

PV (all cash flows)


Annual

PV (Principal)

$3,377,821

PV (annuity)

$1,216,634

Proceeds (P) =

$4,594,455

b.
Dr. Cash
Dr. Discount on bonds payable
Cr. Bonds payable

4,594,455
405,545
5,000,000

c.
SemiAnnual

C1

C2

C3

C4

C5

C6

C7

Carrying
Amt
Beginning
of period

Interest
Expense
C1 x 4%

Interest
Payment

Discount
Amortized
C2 - C3

Carrying Amt
Bond, end
C1 + C4

Bond Disc.
beginning

Bond Disc.
end
C6 - C4

01-Nov-17

$4,594,455

$405,545

30-Apr-18

$4,594,455

$183,778

$150,000

$33,778

4,628,233

405,545

$371,767

31-Oct-18

4,628,233

185,129

150,000

35,129

4,663,363

371,767

336,637

30-Apr-19

4,663,363

186,534

150,000

36,534

4,699,897

336,637

300,103

31-Oct-19

4,699,897

187,996

150,000

37,996

4,737,893

300,103

262,107

30-Apr-20

4,737,893

189,516

150,000

39,516

4,777,409

262,107

222,591

31-Oct-20

4,777,409

191,096

150,000

41,096

4,818,505

222,591

181,495

30-Apr-21

4,818,505

192,740

150,000

42,740

4,861,245

181,495

138,755

31-Oct-21

4,861,245

194,450

150,000

44,450

4,905,695

138,755

94,305

30-Apr-22

4,905,695

196,228

150,000

46,228

4,951,923

94,305

48,077

31-Oct-22

4,951,923

198,077

150,000

48,077

5,000,000

48,077

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-22
Copyright 2013 McGraw-Hill Ryerson Ltd.

d. Record interest expense on April 30 and October 31, 2018 and 2020
April 30, 2018
Dr. Interest Expense
Cr. Bond Discount
Cr. Cash
October 31, 2018
Dr. Interest Expense
Cr. Bond Discount
Cr. Cash
April 30, 2020
Dr. Interest Expense
Cr. Bond Discount
Cr. Cash
October 31, 2020
Dr. Interest Expense
Cr. Bond Discount
Cr. Cash

183,778
33,778
150,000

185,129
35,129
150,000

189,516
39,516
150,000

191,096
41,096
150,000

e. Record retirement of the bond on maturity


Dr. Bonds Payable
Cr. Cash

5,000,000

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

5,000,000

Page 9-23
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-19.
a.
Date

01-Sep-17

Maturity date

31-Aug-23
Annual

Face Value (FV)

2,000,000

Number of periods

Effective rate (i)

7.00%

Coupon rate (c)

9.00%

Annuity Payment

180,000

Proceeds (P) =

PV (all cash flows)


Annual

PV (Principal)

$1,332,684

PV (annuity)

$857,977

Proceeds (P) =

$2,190,661

b.
Dr. Cash
Cr. Premium on bonds payable
Cr. Bonds payable

2,190,661
190,661
2,000,000

c.
Effective Interest Method
C1

Annual

C2

C3

C4

C5

C6

C7

Bond
Prem.

Bond Prem.

beginning

Carrying Amt

Interest

Interest

Premium

Carrying
Amt

Beginning

Expense

Payment

Amortized

Bond, end

of period

C1 x 7%

C2 - C3

C1 + C4

01-Sep-17

end
C6 - C4

$2,190,661

$190,661

31-Aug-18

$2,190,661

$153,346

$180,000

$26,654

2,164,007

$190,661

$164,007

31-Aug-19

2,164,007

151,481

$180,000

28,519

2,135,488

$164,007

135,488

31-Aug-20

2,135,488

149,484

$180,000

30,516

2,104,972

135,488

104,972

31-Aug-21

2,104,972

147,348

$180,000

32,652

2,072,320

104,972

72,320

31-Aug-22

2,072,320

145,062

$180,000

34,938

2,037,382

72,320

37,382

31-Aug-23

2,037,382

142,618

$180,000

37,382

2,000,000

37,382

d. Record interest expense on August 31st, 2018, 2019, 2022


Aug 31, 2018
Dr. Interest Expense
Dr. Bond Premium
Cr. Cash

153,346
26,654

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

180,000

Page 9-24
Copyright 2013 McGraw-Hill Ryerson Ltd.

Aug 31, 2019


Dr. Interest Expense
Dr. Bond Premium
Cr. Cash

151,481
28,519

Aug 31, 2022


Dr. Interest Expense
Dr. Bond Premium
Cr. Cash

145,062
34,938

180,000

e.
Dr. Bonds Payable
2,000,000
Cr. Cash
To record retirement of the bond on maturity

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

180,000

2,000,000

Page 9-25
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-20.
Date

01-Feb-17

Maturity date

31-Jan-23

Face Value (FV)

Annual
8,000,000

Number of periods

Effective rate (i)

7.00%

Coupon rate (c)

7.00%

Annuity Payment

560,000

Proceeds (P) =

PV (all cash flows)

PV (Principal)
PV (annuity)
Proceeds (P) =

b.
Dr. Cash
Cr. Bond Payable

Annual
$5,330,738
$2,669,262
$8,000,000

8,000,000
8,000,000

c.
No premium or discount exists on the bond because the coupon rate is the same as the effective
interest rate.
d.
Jan 31, 2018
Dr. Interest Expense
Cr. Cash

560,000
560,000

Jan 31, 2020


Dr. Interest Expense
Cr. Cash

560,000

Jan 31, 2022


Dr. Interest Expense
Cr. Cash

560,000

560,000

e.
Dr. Bond Payable
8,000,000
Cr. Cash
To record the retirement of the bond at maturity

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

560,000

8,000,000

Page 9-26
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-21.
a.
Dr. Bonds payable
Dr. Premium on bonds payable
Dr. Loss on redemption of bonds
Cr. Cash

6,000,000
140,000
260,000
6,400,000

b.
Dr. Bonds payable
6,000,000
Dr. Premium on bonds payable
140,000
Cr. Cash
Cr. Gain on redemption of bonds

5,600,000
540,000

c. The gain or loss is simply the difference between the book value and the redemption value of
the bonds at the date of redemption. It simply reflects that the cost of borrowing is actually
greater or less than has been reflected on the income statement over the term of the bonds. The
loss or gain should be reported separately so that stakeholders will understand that this amount is
a non-recurring event and has no relation to the main business activities of the entity.
E9-22.
a.
Dr. Bonds payable
Dr. Loss on redemption of bonds
Cr. Cash
Cr. Discount on bonds payable

10,000,000
800,000

b.
Dr. Bonds payable
10,000,000
Cr. Cash
Cr. Discount on bonds payable
Cr. Gain on redemption of bonds

10,500,000
300,000

9,500,000
300,000
200,000

c. The gain or loss is simply the difference between the book value and the market value of the
bonds at the date of redemption. It simply reflects that the cost of borrowing is actually greater or
less than has been reflected on the income statement over the term of the bonds. The loss or gain
should be reported separately so that users will understand that this amount is a non-recurring
event and has no relation to the performance of the firm or of management.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-27
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-23.
a. The after-tax cost of borrowing is 8% (1-.25) = 6% or $300,000
b. The after-tax cost of borrowing is 5% (1-.13) = 4% or $21,750
c. Since not-for-profit organizations arent subject to taxes, the after-tax cost of borrowing is the
same as the cost of borrowing, or 5.5%.
d. The after-tax cost of borrowing is lower when the tax rate is higher, but it isnt beneficial for a
firm to face a higher tax rate because the amount of tax the entity will pay on its income will be
higher and so its net income will be lower. Also, it will have to pay more dollars out in cash in
taxes.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-28
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-24.
a. Operating Lease
i. If the lease is treated as an operating lease, no leased asset is reported on the balance sheet, as
operating leases qualify for off balance sheet financing.
ii. The same entry will be made each year.
Dr. Lease expense
Cr. Cash

87,500
87,500

b. Capital Lease
i. The asset recorded would be $312,996. This includes the present value of the lease payments
(289,811), plus the full amount of the payment due at the inception of the lease (87,500).
npr

rate

8.00%

87,500
pmt
312,996
PV (annuity)
Note: The annuity period is four years but it begins right
now (Feb 2017). This is the same as a three year annuity
beginning in one year plus the amount of the payment on
February 1, 2017. The present value of the annuity includes
the payment made on February 1, 2017

ii. February 1, 2017


Dr. Asset under capital lease
312,996
Cr. Lease Liability
To initially record the capital lease as an asset
Dr. Lease Liability
87,500
Cr. Cash
To record the first lease payment at the start of the lease.

312,996

87,500

iii. January 31, 2018


Dr. Lease Liability
69,460
Dr. Interest Expense
18,040
Cr. Cash
87,500
To record the lease payment ($225,496 x 8% = $18,040. $87,500 $18,040 = $69,460).
iv. January 31, 2018
Dr. Depreciation Expense
78,249
Cr. Accumulated Depreciation
78,249
To record depreciation on the leased asset ($312,996/4 years = $78,249)
v.
Carrying amount of lease liability
2018: $156,036

2020: $0

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-29
Copyright 2013 McGraw-Hill Ryerson Ltd.

*See below for calculations.

Carrying amount of leased asset


2018: $234,747

2020: $78,249

*See below for calculations.

Lease liability:

Date

[1]
Beginning
Balance
(Net - Liability)

[2]
Interest
Expense
[pre 1]*rate

[3]
Payments
(Cash)

[4]
Lease
Liability
[3]-[2]

Balance on
indicated date
[1]+[4]

01-Feb-17

$312,996

$-

($87,500)

($87,500)

$225,496

31-Jan-18

225,496

(18,040)

(87,500)

(69,460)

156,036

31-Jan-19

156,036

(12,483)

(87,500)

(75,017)

81,019

31-Jan-20

81,019

(6,481)

(87,500)

(81,019)

31-Jan-21
0
0
*Note: values slightly off due to rounding

Asset:

Date

[5]
Carrying amount
on the previous
indicated date

[6]
Depreciation
Expense
(straight-line)

Carrying
amount of leased
asset; on
indicated date

Accumulate
Amortization
4 Yrs

01-Feb-17

$312,996

$312,996

31-Jan-18

312,996

(78,249)

234,747

78,249

31-Jan-19

234,747

(78,249)

156,498

156,498

31-Jan-20

156,498

(78,249)

78,249

234,747

31-Jan-21

78,249

(78,249)

312,996

*Assuming Jan31is the year-end.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-30
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-25.
a, b & c.
Summary:
Lease equipment/liability
Depreciation expense
Interest expense

8%
$924,576
154,096
73,966

10%
$871,052
145,175
87,105

12%
$822,281
137,047
98,674

*See calculations below.

i) 8%
a.

b.

c.

Number of payments

Discount rate

8.00%

Payment

200,000

PV (annuity)

924,576

Useful Life

Amortization - SL

154,096

Net liability - June 1, 2017

924,576

Rate

8.00%

- Recorded as lease asset and lease liability

- (924,576 / 6 = 154,096)
- Annual Depreciation Expense assuming
straight-line depreciation

Interest Expense - May 31, 2018


(previous Net liability * rate) =

ii) 10%
a.

b.

c.

73,966

Number of payments

Discount rate

10.00%

Payment

200,000

PV (annuity)

871,052

Useful Life

Amortization - SL

145,175

Net liability - June 1, 2017

871,052

Rate

10.00%

- Interest expense

- Recorded as lease asset and lease liability

- (871,052 / 6 = 145,175)
- Annual Depreciation Expense assuming
straight-line depreciation

Interest Expense - May 31, 2018

iii) 12%
a.

(previous Net liability * rate) =

87,105

Number of payments

Discount rate

12.00%

- Interest expense

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-31
Copyright 2013 McGraw-Hill Ryerson Ltd.

b.

c.

Payment

200,000

PV (annuity)

822,281

Useful Life

Amortization - SL

137,047

Net liability - June 1, 2017

822,281

Rate

12.00%

- Recorded as lease asset and lease liability

- (822,281 / 6 = 137,047)
- Annual Depreciation Expense assuming
straight-line depreciation

Interest Expense - May 31, 2018


(previous Net liability * rate) =

98,674

- Interest expense

E9-26.
a. There would be no effect on cash flow. It would be subtracted when reconciling from net
income to CFO using the indirect method.
b. The proceeds would be a cash inflow from financing.
c. The payment would be an operating cash outflow or a financing cash outflow under IFRS.
Under ASPE it would be an operating cash outflow.
d. The repayment would be a financing cash outflow.
e. The loss isnt a cash flow but would be added to net income to determine cash flow from
operations on the statement of cash flows.
f. The amortization isnt a cash flow. The amortization of the discount is added back when
reconciling from net income to CFO using the indirect method.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-32
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-27.
a. Current Ratio and Debt-to-Equity Ratio before accounting for the lease:
i) Current Ratio = 1.26 (628,000/496,800)
ii) Debt-to-Equity Ratio = 4.17 [(496,800 + 3,400,000)/935200)
A lease accounted for as an operating lease isnt recorded on the statement of financial position
and only the lease payments are recorded when payable. Since we are ignoring the effects of
lease payments, the current ratio and debt-to-equity ratio would be unchanged. There would be
no effect on the income statement on the date of inception of the lease.
b. A capital lease is initially accounted for by debiting assets and crediting a liability for the
present value of the lease payments.
Number of Periods
Rate
Payment
PV (annuity)

8
6.00%
475,000
3,126,631

Non-current assets will increase by 3,126,631. The current liability is the principal portion of the
first payment $475,000 (6% of 2,651,631) = 315,602 and the non-current liability is the
difference between the asset recorded and the current liability.
Amounts before

Accounting for

accounting for lease

capital lease

Leases
Capital

Assets
Current

Operating

628,000

-475,000

153,000

628,000

Non-Current

4,204,000

3,126,631

7,330,631

4,204,000

Total Assets:

4,832,000

7,483,631

4,832,000

Liabilities
Current

496,800

315,902

812,702

496,800

Non-Current

3,400,000

2,335,729

5,735,729

3,400,000

Total Liabilities:

3,896,800

6,548,431

3,896,800

935,200

935,200

935,200

4,832,000

7,483,631

4,832,000

Share Equity
Total L & SE:

Ratio's

Current

1.26

0.19

1.26

Debt to Equity

4.17

7.00

4.17

Note that current assets decrease for the capital lease because the lease hasnt been accounted for
so all elements of the transaction, including cash, have to be adjusted. Current assets dont
change under the operating lease treatment because the lease payment is a prepaid so while cash
decreases, prepaids increase.
c. The capital lease method better reflects the leverage of the company. The lease clearly creates
an obligation for the entity so including the lease as a liability better captures the obligations of
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual

Page 9-33
Copyright 2013 McGraw-Hill Ryerson Ltd.

the firm. The lease payment that is due in one year represents a current obligation. Not including
it on the balance sheet overstates the current ratio. Excluding the entire liability understates the
total obligations and understates the debt-to-equity ratio.
d. Assuming that the information regarding the lease payments is provided in the financial
statements one could argue that well-informed stakeholders will respond to the financial
statements in the same way in either case. The treatment affects the accounting numbers, which
can affect the outcome of contracts and decisions that are based strictly on the numbers.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-34
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-28.
a.
Issue date

01-Jun-17

Maturity date

30-May-27

Face Value (FV)


Periods

Annual
$6,000,000
10

Effective rate

7%

Coupon rate

8%

Annual Payment

480,000

Proceeds (P) =

$6,421,415

Premium

421,415

The effective interest


rate must be calculated

Dr. Cash
Cr. Bonds Payable
Cr. Premium on Bonds Payable
To record the issuance of bonds

6,421,415
6,000,000
421,415

b.
Dr. Interest expense (449,499 x 7/12)
Dr. Premium on bonds payable (30,501 x 7/12)
Cr. Interest payable (480,000 x 7/12)
To record accrued interest at December 31, 2017

262,208
17,792
280,000

c.
Dr. Interest Payable
Dr. Premium on bonds payable
Dr. Interest Expense
Cr. Cash
To record interest payment on May 31, 2018

280,000
12,709
187,291
480,000

Effective Interest Method

Annual

C1
Carrying Amt
Beginning
of period

C2
Interest
Expense
C1 x 7%

C3
Interest
Payment

C4
Premium
Amortized
C2 - C3

01-Jun-17
31-Dec-17

C5
Carrying Amt
Bond, end
C1 - C4
$6,421,415

$6,421,415

$449,499

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

$480,000

$30,501

6,390,914

Page 9-35
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-29.
UCC =
=

Carrying amount =
=

Cost
$5,000,000
2,695,000

Cost
5,000,000
3,212,500

CCA
$2,305,000

Accumulated
Amortization
1,787,500

[1]
Tax Basis
UCC

[2]
Accounting basis
Carrying amount

[3]
Temporary Difference
deductible & (taxable)
[1]-[2]

$2,695,000

$3,212,500

($517,500)

Tax rate

45%

[4]
Future tax
Asset (liability)
[3]* tax rate
($232,875)

The balance in the future income tax account is a liability of $232,875.


E9-30.
UCC =
=

Carrying amount =
=

Cost
$1,400,000
580,000

Cost
1,400,000
250,000

[1]
Tax Basis
UCC

[2]
Accounting basis
Carrying amount

$580,000

$250,000

CCA
$820,000

Accumulated
Amortization
1,150,000

[3]
Temporary Difference
deductible & (taxable)
[1]-[2]
$330,000

Tax rate

[4]
Future tax
Asset (liability)
[3]* tax rate

20%

$66,000

The balance in the future income tax account is an asset of $66,000.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-36
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-31
a.
[3]

Year

Temp Diff
ded &
(tax)
[1]-[2]

[4]

[5]

[6]

[7]

Tax

Future tax

Beg

Taxes

asset (liab)

Bal

Adj.
(Cr.)
&Dr.
[4]-[5]

Taxable

rate

Income

Payable

[3]* tax
rate

2016
2017

Pre [4]

[8]

[-7]*tax
rate

Tax Exp
(Cr.)
&Dr.
[-6]-[8]

Current

Expense

Future

Expense

(benefit)

$368,750

$618,750

-250,000

-$150,000
$400,000

25%

100,000

-$150,000

$250,000

$2,475,000

-$618,750

Vibank should report a future income tax asset of $100,000 on its November 30, 2017 balance
sheet. ($400,000 * 25%)
*The opening balance on the balance sheet in the future income tax account was a credit or a
future tax liability $150,000. The ending balance needs to be a debit or future tax asset of
$100,000 (Tax basis > accounting basis by $400,000, therefore 25% * $400,000). To obtain a
debit balance of $100,000, a debit to future income taxes of $250,000 ($100,000 + $150,000) is
required.
b.
Income before taxes
Income tax expense
Current
Future
Net Income

$2,250,000
618,750
(250,000)
$1,881,250

Vibanks 2017 net income would be $1,881,250.


c. If the taxes payable method were used, the income tax expense would be equal to the current
income tax expense.
Income before taxes
Income tax expense
Net Income

$2,250,000
618,750
$1,631,250

d. The amounts differ because the deferred tax method requires that the income tax expense be
based accounting for financial reporting purposes, while the taxes payable method the income
tax expense is the amount of tax owed for the period, which is based on the requirements of the
Income Tax Act.
e.
Dr. Income tax expense
Dr. Future income taxes
Cr. Income taxes payable
To record income tax expense for fiscal 2017

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

368,750
250,000
618,750

Page 9-37
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-32.
a.
Year

[3]
Temp Diff
ded &
(tax)
[1]-[2]

Tax
rate

2017
2018

[4]
Future tax
asset (liab)
[3]* tax
rate

[5]
Beg
Bal
Pre [4]

[6]
Adj.
(Cr.)/
Dr.
[4]-[5]

[7]
Taxable
Income

[8]
Taxes
Payable
[-7]*tax
rate

($20,000)

($2,500)

$550,000)

($82,500)

Tax Exp
(Cr.)
&Dr.
[-6]-[8]

Current
Expense

Future
Expense
(benefit)

$82,500

2,500

-$20,000
($150,000(

15%

(22,500)

$85,000

Rossland should report a future income liability of $22,500 on the December 31, 2018 balance
sheet.
Note: the opening balance on the balance sheet in the future income tax account was a credit or a
future tax liability $20,000. The ending balance needs to be a credit or future tax liability of
$22,500 (Tax basis < accounting basis by $150,000, therefore 15% * $150,000). To obtain a
credit balance of $22,500, a credit to future income taxes of $2,500 ($20,000 + $2,500) is
required.
b.
Income before taxes $650,000
Income tax expense
Current
82,500
Future
2,500
Net Income
565,000
c. If the taxes payable method were used, the income tax expense would be equal to taxes
payable.
Income before taxes
Income tax expense
Net Income

650,000
82,500
567,500

d. The amounts differ because the deferred tax method requires that the income tax expense be
based accounting for financial reporting purposes, while the taxes payable method the income
tax expense is the amount of tax owed for the period, which is based on the requirements of the
Income Tax Act.
e.
Dr. Income tax expense (income statement)
Cr. Future income taxes (balance sheet)
Cr. Income taxes payable (15% of $550,000)

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

85,000
2,500
82,500

Page 9-38
Copyright 2013 McGraw-Hill Ryerson Ltd.

E9-33.
a.
UCC =

Cost - CCA
200,000
30,000
= 170,000

Carrying amount =

Cost - Depreciation
200,000
20,000
= 180,000

The accounting depreciation will be $200,000/10 = $20,000.


[1]
[2]
[3]
Tax Basis
Accounting basis
Temporary Difference
UCC
Carrying amount
deductible & (taxable)
Year
[1]-[2]
2017 170,000
180,000
(10,000)

Tax rate
16%

[4]
Future tax
Asset (liability)
[3]* tax rate
(1,600)

There is a future tax liability of $1,600 to be reported on the balance sheet.


b.
UCC =
=
Carrying amount =
=

Cost - CCA
200,000
30,000
170,000
Cost - Depreciation
200,000
40,000
160,000

The accounting depreciation will be $200,000/5 = $40,000.

Year
2017

[1]
Tax Basis
UCC
170,000

[2]
Accounting basis
Carrying amount
160,000

[3]
Temporary Difference
deductible & (taxable)
[1]-[2]
10,000

Tax rate
16%

[4]
Future tax
Asset (liability)
[3]* tax rate
1,600

There is a future tax asset of $1,600 to be reported on the balance sheet.


c.
UCC =
=

Cost - CCA
200,000
30,000
170,000

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-39
Copyright 2013 McGraw-Hill Ryerson Ltd.

Carrying amount=
=

Cost - Depreciation
200,000
60,000
140,000

The accounting depreciation will be 30% of 200,000 = $60,000.

[1]
Tax
Basis
UCC
Year
2017

[2]
Accounting
basis
Carrying
amount

170,000 140,000

[3]
Temporary
Difference
deductible &
(taxable)
[1]-[2]
30,000

Tax
rate
16%

[4]
Future tax
Asset
(liability)
[3]* tax
rate
4,800

There is a future tax asset of $4,800 to be reported on the balance sheet.


d.
UCC = Cost (-) - CCA
200,000
30,000
= 170,000

*The accounting depreciation will be =


$30,000; the same used for taxes.

Carrying amount= Cost (-) - Depreciation


200,000
30,000
= 170,000
[2]
Accounting
[3]
[1]
basis
Temporary Difference
Tax Basis
Carrying
deductible & (taxable)
Year
UCC
amount
[1]-[2]
2017
170,000
170,000
-

Tax rate
16%

[4]
Future tax
Asset (liability)
[3]* tax rate
-

There is no future tax reported on the balance sheet since the asset will have the same accounting
and tax values.
e. An income tax liability does indicate that cash will have to be paid at some future date but its
a tax effect that is relative to expenses and revenues recognized for accounting purposes (that is,
future income tax balances give information about how assets and liabilities have been accounted
for differently for tax and accounting purposes; they arent an actual amount of liability or
benefit). Another way of thinking about this is that future income taxes give information about
the amount of CCA available on assets (and the deductibility of expenses) relative to the
accounting used for these assets and liabilities. The payment isnt really unavoidable, since its
possible that the firm may never pay the amount indicated or at least not in the foreseeable future
(and the amount changes with tax rates and accounting policies). If the company continues to
acquire capital assets, as would be the case for a growing company, or if the company incurs
losses, no payments of cash will occur for a long time. Another difficulty is the fact that no
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual

Page 9-40
Copyright 2013 McGraw-Hill Ryerson Ltd.

indication is provided regarding when the future cash flows are expected to occur. A future tax
liability could represent a cash outflow that is expected in one year or over the next six years. In
this situation, because its simple, a user can infer the amount of tax benefit (CCA available) on
the asset in question. This information is helpful for predicting cash flows. As the situation
becomes more complexmore assets, different assets, liabilities that are accounted for
differently for accounting and taxit becomes much more difficult to understand the timing of
the impact of future tax amounts on cash flow.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-41
Copyright 2013 McGraw-Hill Ryerson Ltd.

PROBLEMS
P9-1.
a. Yes, there is a liability, because providing the warranty service will require a sacrifice of
resources (labour, inventory, pay someone to do the work), the obligation is unavoidable (if
warranty work is required it must be provided), and results from a past transaction (sale of
product). Intuitively this is a liability as well because there is an obligation to provide the
service. (Note that different people will have different intuitions.)
b. Yes, there is a liability but not on the balance sheet date of December 31, 2017. This loan
would be reported as a liability on December 31, 2018 because repaying the loan will require
a sacrifice of resources (cash to repay), the obligation is unavoidable (the bank has to be paid
or there will be legal repercussions), and results from a past transaction (a loan was made).
Intuitively this is a liability because money is owed to the bank, but only on a balance sheet
prepared after January 8, 2018.
c. Under IFRS the lease isnt considered a liability because its an operating lease. Although
there is an obligation resulting from a past transaction (lease signing) that will require an
economic sacrifice (lease payments), the lessee wont have obtained the risks and rewards of
ownership as a result of the lease. Since operating leases dont transfer the risks and rewards
of the lease to the lessee, they qualify for off-balance sheet financing and are recorded
directly through profit/loss. Intuitively, the fact that there is a firm commitment to make the
lease payments that cant be avoided suggests that a liability exists.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-42
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-2.
a. Yes, there is a liability because paying the interest will require a sacrifice of resources (cash to
repay) the obligation is unavoidable (the bank has to be paid its interest or there will be legal
repercussions), and results from a past transaction (a loan was made and interest has been
earned by the bank). Different interpretations could be provided from the intuitive standpoint.
One is that since the money isnt owed as of the financial statement date there is no liability;
that is, the liability doesnt come into effect until the money is actually due. The alternative
interpretation would be consistent with the IFRS view that the interest has been earned by the
bank and so is a liability even though it doesnt yet have to be paid (accrual).
b. The loan would be considered a liability because repayment will require a sacrifice of
resources, the entity has an obligation to repay and the loan was arranged in the past. It
doesnt have a definite repayment date, but the shareholder certainly could request repayment
at any time. A user of the financial statements should probably view the claim as a current
liability unless the shareholder is prepared to commit not to request repayment during some
time period. Intuitively, this would be considered a liability because the entity must repay the
shareholder loan, although some might argue that repayment of a loan from a shareholder
might be more discretionary than a loan from a bank.
c. Environmental liabilities are accrued because a sacrifice of resources will be required (the
costs to clean up must be incurred), the obligation is binding (unless government regulations
change the company must meet its requirements or face sanctions), and is the result of past
transactions (building the factory requires clean-up upon closing). Intuitively, since the
factory is expected to close in 25 years, some may think that its too early and the amount to
uncertain to record as a liability. However, since the liability legally binds the entity to restore
the land, the present value of estimated clean-up costs should be accrued.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-43
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-3.
D/E ratio = L/OE; Current ratio = CA/CL;
Interest coverage ratio = (NI + interest expense + tax expense)/ Interest expense;
Return on assets = (NI + ATI)/TA;
Debt/Equity
Year End: September 30, 2017

Ratio/Amount before taking the


transaction/ economic event into
account

Ratio

Current
Ratio

Interest
Coverage

Cash from
Operations

Return on
Assets

1.25:1

1.25

2.5

425,000

4.30%

a.

On Sept 30, 2017 Oskelaneo


accrued interest on a bank loan. The
interest will be paid in Dec 2017

Increase

Decrease

Decrease

No effect

Decrease

b.

Arranged new capital lease


September 30, 2017. No cash is paid
at the time

Increase

Decrease

No effect

No effect

Decrease

c.

Fire destroyed small building owned


by Oskelaneo on Oct 4, 2017

No effect

No effect

No effect

No effect

No effect

d.

Cash received for services to be


provided in February 2018

Increase

Decrease

No effect

Increase

Decrease

e.

Oskelaneo was sued in Jan 2017 but


a court ruling wont be made for 2
years. The companies lawyers state
that losing the lawsuits unlikely.

No effect

No effect

No effect

No effect

No effect

a.
Dr. Interest Expense (E+)
Cr. Interest Payable (L+)
To accrue interest on the bank loan
b.
Dr. Asset under capital lease (A+)
Cr. Lease liability (L+)
To record the lease arrangement only Lease arranged on the last day of the year so there is no
income statement effect.
c.
Subsequent event: the fire occurred after year-end and doesnt reflect conditions that existed at
year-end. Therefore, financial statements arent adjusted and ratios arent affected. The fire
should be note disclosed, if significant.
d.
Dr. Cash (A+)
Cr. Unearned Revenue (L+)
To record cash receipt of unearned revenue
e.
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual

Page 9-44
Copyright 2013 McGraw-Hill Ryerson Ltd.

Contingent Liability since the court decision isnt expected for 2 years, the probability that an
outflow of resources will occur cant be measured and isnt certain (i.e. That Oskelaneo will lose
the lawsuit and have to pay). Therefore, the lawsuit is disclosed only and doesnt impact the
2017 year-end ratios.
P9-4.
D/E ratio = L/OE; Current ratio = CA/CL;
Interest coverage ratio = (NI + interest expense + tax expense)/ Interest expense;
Return on assets = (NI + ATI)/TA;
Note that assumptions are required for some of these items. This is by design. Students should
learn to explicitly state what they are assuming.
Year End: April 30, 2017

a.
b.
c.

d.

e.

Ratio/Amount before taking the


transaction/ economic event
into account
Contract signed in Jan 2017 to
purchase raw materials
beginning fiscal 2018
Provided services paid for in
the previous fiscal year
Contribution to definedcontribution pension plan in
April 2017
Repaid bond that was classified
as current portion of long-term
debt in March 2017
In Nov 2016, paid $1,000,000
to settle a lawsuit that was
launched 3 years ago. The
amount owed has been accrued
earlier.

Debt/Equity
Ratio

Current
Ratio

Interest
Coverage

Cash from
Operations

Return on
Assets

.75:1

0.85

5.2

3,500,000

8.50%

No effect

No effect

No effect

No effect

No effect

Decrease

Increase

Increase

No effect

Increase

Increase

Decrease

Decrease

Decrease

Decrease

Decrease

Decrease

No effect

No effect

Increase

Decrease

Decrease

No effect

Decrease

Increase

a. This transaction represents a commitment and isnt recorded in the 2017 financial statements.
The commitment may be disclosed in the notes if significant to the entity.
b.
Dr. Unearned Revenue (L-)
Cr. Revenue (OE+)
c.
Dr. Pension Expense (OE-)
Cr. Cash (A-)
d.
Dr. Bond Payable (L-)
Cr. Cash (A-)

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-45
Copyright 2013 McGraw-Hill Ryerson Ltd.

e.
Dr. Lawsuit Payable (L-)
Cr. Cash (A-)
P9-5.
Report to Management,
Based on the information provided and my calculations (below), it would appear that purchasing
the new operating room would be more economical than leasing. If you were to lease operating
room, the present value of the payments would be $635,888.48. Purchasing the operating room
incurs a total cost of $500,000. If management is concerned about depleting the hospital
foundation they should pay for the operating room and fundraise to replenish the foundation,
which would be less costly than fundraising to cover the costs of monthly lease payments.
If you have any questions, please contact me.
C.A.
Cost to lease = $12,000 * 12 months * 5 years = $720,000
PV of cost to lease = $635,888.48 ($12,000pmt, 60 months, .42% per month).
Cost to purchase = $500,000

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-46
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-6.
Kulas current financial situation:
Income after taxes (combined)
Expenses:
Mortgage payment (2,000 x 12)
Lease payment (600 x 12)
Household expenses (5,200 x 12)
Vacations
Total Operating Expenses
Excess (Deficit) Income before interest
Interest expense (5,000 x 15%)
Total excess (deficit) income

$108,000
($24,000)
($7,200)
($62,400)
($8,000)
($101,600)
$6,400
($750)
$5,650

Savings: $5,650 is available for savings.


Asset: Savings $35,000 ($7,000 cash)
Liability: Credit card debt $5,000
Kulas financial situation after moving:
Income after taxes (combined)
Expenses:
Mortgage payment (2,400 x 12)
Lease payment (600 x 12)
Household expenses (5,700 x 12)
Vacations
Total Operating Expenses
Interest expense (5,000 x 15%)
Moving expense
Total expenses
Total excess (deficit) income

$108,000
($28,800)
($7,200)
($68,400)
($8,000)
($112,400)
($750)
($10,000)
($123,150)
($15,150)

Savings: since expenses are greater than income earned, there is no money available for savings
and the Kulas will have to finance the deficit by borrowing from past savings or increasing debt.
However, the moving expenses are a one-time expense so in future years the deficit would only
be $5,150.
Therefore: the Kulas cant currently afford to move because expenses exceed income earned.
Steps the Kulas can take:
1. Use savings available to cover moving expenses - $7,000
2. Use saving to repay credit card balance and save interest cost
3. Reduce vacation expense - $8,000
4. Examine household expenses to reduce expenditures; perhaps eating out, entertainment,
etc.
If the above steps are implemented, the deficit could be eliminated although no money would be
saved.
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual

Page 9-47
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-7.
Report to Controller,
Your primary objective for financial reporting is to avoid violating your current debt
covenants and show good stewardship perhaps by paying dividends to shareholders. Maintaining
the debt covenants is crucial because if you violate them you have to repay the 1,500,000 debt
and currently you have only $720,000 in current assets. In addition, money is needed for working
capital. A violation of the covenants may result in a renegotiation of the loan arrangement, which
may result in higher interest rates or at worst, receivership.
If nothing is done by year-end you are going to violate the current ratio covenant (exhibit
1). If you fail to get the loan then you must use $370,000 of your current assets to pay down your
current liabilities by the same amount (exhibit 1). This will prevent you from violating the
current ratio covenant.
With the new the long-term loan $750,000 will be used to purchase new equipment,
which will be accounted for as capital (non-current) assets. Before the balance sheet date, the
remaining $250,000 can either be used to increase cash and current assets or pay off current
liabilities. The greater amount of this money that is used to pay down the current liabilities the
greater effect it will have on the current ratio (compare exhibit 3 & 4). The same effect will
happen with the dividend. If you declare and pay dividends before the year-end, it will have a
better impact on the current ratio than if you just declare the dividends and increase your current
liabilities (compare exhibit 2 & 3).
Your final decision should be based on how much cash Bedeque requires in the bank as
working capital and how much in dividends the company is planning on paying this year.
$170,000 is the maximum amount of dividends you can pay (see exhibit 4). But depending on
how you balance your current assets compared to your current liabilities, this may reduce the
amount of dividend that you can pay out this year because the current ratio cant be violated.
In conclusion, its crucial that your loan be long-term, not a demand loan, which would
be classified as a current liability. This would allow you to meet your current ratio covenant (the
debt-to-equity covenant isnt at risk) and you would then have some flexibility to reduce you
other current liabilities and pay dividends.
Exhibit 1 - Current situation - No loan
Bedeque Inc.
Projected Balance Sheet
As of December 31, 2017
Current assets
Non-current assets

Total assets
Current ratio = CA/CL
Debt-to-equity = L/OE

$720,000
5,250,000

$5,970,000

Current liabilities
Non-current liabilities
Total liabilities
Common shares
Retained earnings
Total Shareholders' equity

$600,000
1,500,000
2,100,000
2,000,000
1,870,000
3,870,000

Total liabilities and shareholders' equity

$5,970,000

1.20
0.54

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-48
Copyright 2013 McGraw-Hill Ryerson Ltd.

With no additional financing Pay off $370,000 of current liabilities by using existing current assets to
maintain covenants
Current ratio = CA/CL
Debt-to-equity = L/OE

1.52
0.45

Exhibit 2 - Loan on a long term basis, $250,000 working capital asset & dividends declared but not paid
Increase in current assets (working capital)
$250,000
Increase in non-current liabilities (Long-term loan)
Increase in non-current assets
750,000
Increase in current liabilities (Dividends payable)
Decrease in retained earnings (Declare dividends)

Current assets
Non-current assets

Bedeque Inc.
Projected Balance Sheet
As of December 31, 2017
$970,000
Current liabilities
6,000,000
Non-current liabilities
Total liabilities
Common shares
Retained earnings

$640,000
2,500,000
3,140,000
2,000,000
1,830,000

Total Shareholders' equity


Total assets
Current ratio = CA/CL
Debt-to-equity = L/OE

$6,970,000

$1,000,000
40,000
(40,000)

3,830,000

Total liabilities and shareholders' equity

$6,970,000

1.52
0.82

Exhibit 3 - Loan on a long-term basis, $250,000 working capital asset, & dividends declared and paid
Increase in current assets (working capital)
Increase in non-current assets

$250,000
750,000

Increase in non-current liabilities (Long-term loan))

Decrease in current assets (Pay dividends)

(65,000)

Decrease in retained earnings (Declare dividends)

Current assets
Non-current assets

Total assets
Current ratio = CA/CL
Debt-to-equity = L/OE

Bedeque Inc.
Projected Balance Sheet
As of December 31, 2017
$905,000
Current liabilities
6,000,000
Non-current liabilities
Total liabilities
Common shares
Retained earnings
Total Shareholders' equity
$6,905,000

(65,000)

$600,000
2,500,000
3,100,000
2,000,000
1,805,000
3,805,000

Total liabilities and shareholders' equity

$6,905,000

1.51
0.81

Exhibit4 -Loan on a long-term basis, $250,000 reduction in current liabilities & dividends declared and paid
Increase in non-current assets
750,000
Decrease in current liabilities
Decrease in current assets (Pay dividends)
($170,000)
Increase in non-current liabilities (Long-term loan)
Decrease in retained earnings (Declare dividends)

Current assets

$1,000,000

Bedeque Inc.
Projected Balance Sheet
As of December 31, 2017
$550,000
Current liabilities

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

(250,000)
1,000,000
($170,000)

$350,000

Page 9-49
Copyright 2013 McGraw-Hill Ryerson Ltd.

Non-current assets

Total assets
Current ratio = CA/CL
Debt-to-equity = L/OE

6,000,000

$6,550,000

Non-current liabilities
Total liabilities
Common shares
Retained earnings
Total Shareholders' equity

2,500,000
2,850,000
2,000,000
1,700,000
3,700,000

Total liabilities and shareholders' equity

$6,550,000

1.57
0.77

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-50
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-8.
This is a challenging case-type scenario. The accounting issues themselves arent difficult
but the challenge is to determine the amount to accrue given conflicting information from
different experts in the organization, a variety of reporting objectives that might influence
managements decision making, and general uncertainty about the likely warranty costs.
Should a conservative approach be taken? This problem has no right answer and the
response below is simply one approach. In responding, students should demonstrate an
awareness of the alternatives, the objectives, and the inherent uncertainty of the situation.
Managers will follow different strategies depending on the objectives and will select
different alternatives from a set of reasonable choices. Students who seek the right answer
arent approaching the problem in a good way. Recognition of different acceptable
approaches demonstrates an understanding of one of the central themes of the book. See
the discussion of the case approach in Chapter 4.
Report to the president:
You have requested a report on the accounting and reporting implications of the concerns raised
by the quality control engineer. According to the quality control engineer there are significantly
more technical flaws with the new product line than are normally experienced with the
companys products. The estimate by the quality control manager (contested by the product
design engineer) is that the company could incur costs as much as $1,500,000 over the next
couple of years, above what is provided for currently accrued warranty expenses. An additional
accrual for expected costs would impact earnings negatively in the current fiscal year. Actual
warranty costs that will be incurred on products sold by the end of 2017 are difficult to estimate.
The current ratio is currently 1.23, just above the required covenant specified. This suggests that
the managers have a bias to not record any additional accruals. The accounting concern here is
how much additional expense, if any, should be recorded in 2017 and accrued as a liability on
the December 31, 2017 balance sheet. The range of alternatives is from no additional accrual in
2017 to an accrual of an additional $1,500,000. The implications for the financial statements are
summarized below:
No additional
accrual
$1,270,000

Maximum
accrual
-$230,000

11,150,000

11,150,000

9,100,000

10,600,000

28,750,000

28,750,000

31,400,000

29,900,000

Current ratio

1.23

1.05

Debt-equity ratio

1.21

1.32

Net income
Current assets
Current liabilities
Non-current
liabilities
Shareholders equity

Clearly, with the maximum accrual the current ratio falls below the 1.2 that is required by the
bank. The debt to equity ratio doesnt violate the 1.3 limit without additional accrual of warranty
costs, but with the maximum additional accrual this covenant is also violated.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-51
Copyright 2013 McGraw-Hill Ryerson Ltd.

The impact to the financial statements for the additional warranty cost accrual could be
significant depending on the amount of the accrual recorded. Income for 2017 will be
dramatically lower if the additional warranty costs are accrued. Given that the passive
shareholders hold 75% of the shares, the poor profitability will have to be explained. In any
event, these shareholders will presumably not be pleased. As part of management, you share in a
bonus pool. You should be aware that these accruals will have an adverse result to your
executive bonus pool.
Finally, and probably most important, you must consider the effect of the accrual on the bank
loan. Accruing the maximum of $1,500,000 in fiscal 2017 may result in the bank demanding
immediate repayment of the outstanding loan amount. Its conceivable that a portion of the
accrual could be treated as a non-current liability, which would improve the current ratio but not
the debt-equity ratio.
There are no implications of this matter for taxation, since only actual expenditures can be
expensed in the current year. It would, however, create future tax assets that would appear on the
balance sheet.
The likelihood that additional costs will be incurred based on the facts provided is high. The
estimate and accrual of $1,500,000 may be overly conservative. An accrual of about $1,250,000
could be absorbed without violating the covenants, but the company would be perilously close to
violating both of them. The position of the design engineer is likely biased, as may be the
position of the quality control engineer, but to a lesser degree.
In summary, additional accruals are likely necessary. The exact amount is a matter of judgment
based on a closer examination of the experience to date. The potential impacts on the firm of
alternative accounting treatments have been outlined.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-52
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-9.
The fact that Yarms debt-to-equity ratio is below the industry average is good news insofar as
evaluating its debt load and risk. However, the companys debt situation isnt as clear cut as its
debt-to-equity ratio would suggest because it has significant off-balance sheet financing
arrangements that should be taken into consideration when evaluating the debt load. The debt-toequity ratio can be recalculated taking the off-balance sheet items into consideration. This can be
done by determining the present value of these obligations. The analysis assumes that an
appropriate discount rate is 10%.
1.

Present value of the minimum lease payments:


(PVn, r = [1/(1 + r)n] x Amount to be paid)
Minimum Lease
Payments

2018
2019
2020
2021
2022
Total

2.

Present Value of Lease Payments


PVn, r = [1/(1 + r)n] x Amount to be paid

$750,000
775,000
810,000
850,000
800,000
$3,985,000

$681,818.18
640,495.87
608,564.99
580,561.44
496,737.06
$3,008,177.53

Present value of the commitment (present value of an annuity for three years):
Present Value of Commitment

Annual commitment
for three years

3.

$1,500,000

=
[1/r*[1 1\(1 + r)n]] x Amount to be paid in
each period
$1,243,426

Since Yarm will be incurring an additional $750,000 bank loan in February that debt
could also be included in the analysis (although it isnt a liabilityon or off balance
sheet) on December 31, 2017. If this loan is included in the analysis its present value
will be assumed to be equal to its face value of $750,000 because the date the loan
will begin is very close to the present.

Using the information from the above analysis we can recalculate Yarms debt-to-equity ratio.

New total liabilities = $3,470,000 + $3,008,177.53 + $1,243,426 + $750,000


= $8,471,604

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-53
Copyright 2013 McGraw-Hill Ryerson Ltd.

o Revised debt-to-equity ratio = $8,471,604/$3,000,000


= 2.82
If the $750,000 loan is excluded from the analysis the calculation of the revised debt-to-equity
ratio then:

New total liabilities = $3,470,000 + $3,008,177.53 + $1,243,426


= $7,721,604
o Revised debt-to-equity ratio = $7,721,604/$3,000,000
= 2.57

In either case the debt-equity ratio is higher than the industry average of 2.5, significantly if all
three adjustments are considered. As a result Yarm should not be so proud of its accomplishment
of keeping its debt load under control. However, what we dont know from the information
provided is the extent to which other companies in the industry also use off-balance sheet
arrangements. If they do as Yarm does then Yarms debt load and debt-to-equity ratio may still
be comparable to the industry average and with other companies in the industry. Indeed, the
long-term agreements to purchase supplies may be a shrewd move, depending on what prices of
the supplies do in the future. If these inputs are used by all competitors and there is little risk that
the supplies will have to be purchased but not used this commitment shouldnt be viewed
negatively.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-54
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-10.
Report to Intercity Bus Lines,
In answer to your question, frequent travel points would be considered a liability: the points are
awarded to customers when they travel the bus line (therefore they are based on a past
transaction), the company is obligated to honour the travel points and provide bus service
(unavoidable), and the company will be required to sacrifice resources in order to fulfill their
obligation (a seat on the bus, fuel, wages).
Measurement of frequent travel points can be tricky, however its required. To measure the
points, an estimate would need to be made regarding the expected redemption rate. To estimate a
redemption rate, management may look to industry and benchmark against similar companies
that offer similar programs. If similar industry information is unavailable, management may have
to decide on what they feel is appropriate. The appropriate accounting is to defer revenue for a
portion of the price a customer paid for the travel on an Intercity bus. The deferred revenue
would be recognized when the travel points were redeemed and used. (A student could also
reasonably recommend setting up a liability and an expense.) For example, if a customer paid
$100 for a trip and the value of the travel points received was $10, Intercity would debit cash for
$100, credit revenue for $90, and credit unearned revenue for $10.
As a result of these travel points, liabilities will increase and revenue will decrease (shareholders
equity will decrease). If the company has any debt covenants, these may be impacted (and
potentially breached). Management must consider how the users of their financial statements will
view the added liability and weigh this against the potential for increased revenue.
Management should consider factors such as the increased business that is anticipated from the
travel points and the expected redemption rate. They should also consider impacts that
redemption may have on capacity during peak seasons. For example, if no restrictions are placed
on redemption, then seats during peak travel times could be taken up by customers redeeming
points. As a result, management may consider imposing restrictions on when the seats can be
redeemed or the number of seats available for purchase with points on each trip.
If you have any other questions, please let me know.
C.A.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-55
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-11.
This is a case-like problem where students have to apply their understanding of the
accounting topics to a practical situation. The accounting itself is quite straight-forward
once its decided what the appropriate amounts are, but the challenge is determining the
appropriate amounts. Compounding the difficulties are the presence of concerns about
stock price and performance of the company. A high, conservative estimate might be
consistent with the spirit of conservatism but flies in the face of the desire to meet earnings
targets. The auditor serves as a constraint but he/she will have to rely on management to
gain insight about the redemption rate. Students should be encouraged to think broadly, to
probe alternatives, and to consider the environmental factors. Students who try to find the
right answer arent going about this problem in a good way.
a.
Report to the President of Urling Inc.:
As requested, I have prepared a report on the appropriate accounting treatment of the new rebate
promotion.
The following table indicates the total costs related to the products sold by the end of the year
and the remaining liability at year-end. Note that 1,500 coupons have already been redeemed for
$7,500 in rebates.

100% redemption
25% redemption
10% redemption
2% redemption

Total cost
$400,000
[(250,000 + 70,000)/4] X $5
100,000
40,000
8,000

Remaining liability
$392,500
92,500
32,500
500

The range of estimates provided by the manager suggests a liability from a minimum of $500 to
a maximum of $92,500 (25% upper limit). The low estimate isnt credible because $7,500 in
claims have already been processed (representing about 10% of the entres already sold (1,500
redemptions x 4 entres per redemption/250,000 entres sold) and another 70,000 entrees are
expected to be sold before the end of the year. Because this is a new program, its difficult to
assess whether the 25% suggested upper limits appropriate, given that the response to a
particular promotion may exceed the typical range, given that a $5 rebate will be worth the time
and postage for many people. The redemption rate to date may not be a complete indication of
the full impact because many people may have not yet purchased four entres but intend to do so
or may not have gotten around to mailing in for their money. I suggest a range of estimates from
10% to 25%, which indicates that an additional amount from $32,500 to $92,500 should be
accrued as an expense and added to the current liabilities.
After tax, these accruals would largely eliminate the anticipated increase in income for the year.
The consequences could be serious, since the stock price has been depressed and past estimates
have not been met. In the longer term, this promotion may prove to be a good strategy because it
may bring repeat customers for the new product. In the short term, the investors may be
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual

Page 9-56
Copyright 2013 McGraw-Hill Ryerson Ltd.

disappointed with earnings and that may bring lower stock prices and threats to your continued
position as president.
Therefore, I recommend that you accrue based on an assumption of a 10% redemption rate.
Since the financial statements will be audited, there must be a substantial accrual but the right
amount is ambiguous. If you choose the 10% assumption and accrue an additional $32,500, the
auditor may be satisfied. A more refined basis for estimating the response would be helpful
however it remains guesswork as to how successful the program will be. Assuming that you are
at least somewhat concerned about the risk of losing your position, you may not wish to choose
the more pessimistic estimate of 25%.
In summary, you must accrue an additional amount for rebates. The benefits of the promotion
will be received in the next year or two as those customers who have tried the product continue
to purchase additional entrees without coupons.
b.
Dr. Cash/Accounts receivable
Cr. Revenue
Cr. Deferred revenue
To account for the coupons.
Dr. Deferred revenue
Cr. Revenue
To record redemption of the coupons

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-57
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-12.
This question is designed to get students thinking about the challenges that face managers in
deciding how to deal with contingencies. The question has a lot of ambiguitiesthe community
seems fairly sure of its claim but the company and its lawyers say no; is it just posturing? In
answering, students have to consider the users. There are three owners who arent involved in
management who would likely want to be aware of the situation. There is a large bank loan
outstanding and the bank would likely want to know too. But if this is a frivolous suit, should the
bank be alarmed and perhaps withdraw its loan or increase the interest rates, or monitor Hoselaw
more closely? These are all situations that arent desirable for the company. Students should
identify the three reporting alternatives (accrue and disclose, disclose only, ignore for financial
reporting purposes). These alternatives should be discussed in light of the facts (what do the
accounting rules say) and from the perspective of the impact on stakeholders. The role requires a
report to the president of the company so ultimately recommendations should be made from the
view of management (which has shareholders involved). Students who just search for the right
answer are missing the pointaccounting and IFRS/ASPE are ambiguous enough here to allow
choice. And choice requires consideration of users and users needs. It isnt clear whether GAAP
is a constraint here, which requires an assumption. There is no right answer to this question.
Whats important is for students to demonstrate an understanding of the accounting issues and
importance of the context for addressing the issues.
A solution should include the following:
Identification of users and their objectives.
Consideration of the objectives of management (management decides how to account). This
should include a ranking of the objectives.
Identification of accounting alternatives.
Discussion of the pros and cons of the alternatives. This discussion should consider the facts
surrounding the situation (do the circumstances clearly support one treatment or is there room
for alternatives (probably the latter)) and from the perspective of the managers (what would
they most like to do with the lawsuit accounting wise and can this preference be supported).
Make a recommendation to management.
See the section in Chapter 4 on doing case analysis for more background.
A complete written solution isnt possible because of the many approaches that could be taken.
The framework above should provide useful guidance.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-58
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-13.
a.
Report to the President of Kakisa Design Furniture Shoppe:
Accounting for Lawsuit
This report addresses accounting issues pertaining to the resent $1 million lawsuit launched
against Kakisa Design Furniture Shoppe in May 2017. The information provided doesnt indicate
if Kakisa prepares its financial statements in accordance with IFRS or ASPE, so the report looks
at issues from an IFRS/ASPE and non-IFRS/ASPE perspective. However, it seems likely that
given the absentee ownership and the bank loans that IFRS/ASPE would be applied.
The lawsuit creates what is known as a contingent liability, or under IFRS if an amount can be
accrued a provision. A contingent liability is a possible liability. There will be a liability if
certain future events occur; in this case a settlement with the plaintiff or a decision by a court of
law that Kakisa is liable for damages. Information about contingent liabilities can be very
important to stakeholders. The information about the lawsuits irrelevant for tax purposes (there
is no actual loss at Dec 31, 2017 so there are no tax implications). Disclosures about the
contingent liability are likely very important to shareholders and the banker since they will
provide insight into risk and potential losses that the company might incur. A shareholder would
be very interested to know that the entity may suffer a $1 million loss in the future, especially if
the amount is material (the information doesnt give an indication of the size of the company).
This is the principle that should be applied in assessing whether to disclose information about a
contingent liability, whether IFRS/ASPE is a constraint or not. Given that Kakisas lawyers
believe that the company will lose the lawsuit, disclosure is appropriate.
Kakisas lawyers believe the company will have to pay something to the customers so under
IFRS a provision should be recorded provided an appropriate amount could be estimated. IFRS
requires the accrual of the best estimate of the amount of the settlement. The lawyers should be
asked to provide some insight on this. On the other hand, accruing an amount may pre-judge the
case and set a minimum amount that the customers could expect to receive. This could be
especially significant if more than the minimum amount of the range suggested by the lawyers is
accrued.
b. Settlement of the lawsuit in January 2019, which is presumably before the financial statements
have been approved for December 31, 2018, represents a subsequent event that clarifies an event
that was existing on the financial statement date. As a result, the full amount of the settlement of
$150,000 should be accrued in the 2018 financial statements.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-59
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-14.
a. There are two types of reasons for entering the lease: business reasons and financial reporting
reasons. One of the most likely reasons is that the financing arrangements are much easier to
make because Vista doesnt have to obtain separate financing for the purchase. As a new
company in may not have the cash to buy the equipment or the ability to borrow the amount.
Also, leasing allows for 100% financing of the cost of the asset and Vista wont have to seek
other sources of financing from lenders. Leasing, particularly leases that are treated as operating
leases, can offer some financial reporting benefits to the leasing entity because financing is offbalance sheet.
Three Criteria to help determine if its a capital or operating lease:
1
Ownership at end of leas/ bargain purchase option
2

Lessee economic benefit


(lease term/useful life)

No
lease term
useful life

10
10
100%

Lessor recovers financial benefit


Minimum net lease payments (MNLP)
10
npr
(MNLP)/(cost of asset)
9%
rate
300,000
excel - pv(rate,npr,-pmt,)
pmt
MNLP =
PV (annuity) 1,925,297
Cost of Asset =
2,000,000
(MNLP)/(cost of asset) =
96%

b.
The lease satisfies two of the three criteria for a capital lease. The term of the lease is
substantially all of the useful life of the asset (it will be technologically obsolete after 10
years).Also, the present value of the payments is $1,925,297, which is substantially all of the fair
market value of the asset. The company has the option to purchase the leased asset at fair market
value after the lease is over (however this isnt a bargain purchase option and purchase isnt
likely). Only one of the criteria needs to be met to record the lease as a capital lease, therefore
Vista should record as a capital lease.
c.
Dr. Asset under capital lease
Cr. Lease liability
To record the lease as a capital lease

1,925,297
1,925,297

If the lease were classified as an operating lease, no entry would be made.


d.
Liability
Date

OE - Exp
Asset
Capital Leases

Liability

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-60
Copyright 2013 McGraw-Hill Ryerson Ltd.

1-Jan-17
31-Dec-17
31-Dec-18
31-Dec-19
31-Dec-20
31-Dec-21
31-Dec-22
31-Dec-23
31-Dec-24
31-Dec-25
31-Dec-26

[1]
Beginning of
year balance of
lease liability
$1,925,297
1,798,574
1,660,446
1,509,886
1,345,776
1,166,895
971,916
759,388
527,733
275,229
0

[2]
Interest
Expense
[previous 1]*rate

[3]
Payments
(Cash)

($173,277)
(161,872)
(149,440)
(135,890)
(121,120)
(105,021)
(87,472)
(68,345)
(47,496)
(24,771)

($300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)

[4]
Decrease in Lease
Liability
[3]-[2]
($126,723)
(138,128)
(150,560)
(164,110)
(178,880)
(194,979)
(212,528)
(231,655)
(252,504)
(275,229)

December 31, 2017


Dr. Interest expense
Dr. Lease liability
Cr. Cash

173,277
126,723

December 31, 2020


Dr. Interest expense
Dr. Lease liability
Cr. Cash

135,890
164,110

300,000

300,000

If the lease was accounted for as an operating lease, the same entry would be made each year on
December 31:
Dr. Lease expense
Cr. Cash

300,000
300,000

e.
The amount reported for machinery (asset) on the balance sheet in January 2017 would be
$1,925,297, which is the present value of the lease payments.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-61
Copyright 2013 McGraw-Hill Ryerson Ltd.

f.
The equipment should be amortized over its useful life, which in this case is the term of the lease
since that is the time period over which the asset will contribute to revenues. The entry below
uses straight-line depreciation. Declining balance could be justified as well since the equipment
becomes obsolete technologically.
Capital Leases
[4]

Date
1-Jan-17
31-Dec-17
31-Dec-18
31-Dec-19
31-Dec-20
31-Dec-21
31-Dec-22
31-Dec-23
31-Dec-24
31-Dec-25
31-Dec-26

[5]

Carrying amount of
leased equipment
(Cost Accumulated Depreciation)
$1,925,297
1,732,768
1,540,238
1,347,708
1,155,178
962,649
770,119
577,589
385,059
192,530
-

Depreciation
Expense
(straight -line)
($192,530)
(192,530)
(192,530)
(192,530)
(192,530)
(192,530)
(192,530)
(192,530)
(192,530)
(192,530)

Equipment
cost
$1,925,297
1,925,297
1,925,297
1,925,297
1,925,297
1,925,297
1,925,297
1,925,297
1,925,297
1,925,297
1,925,297

Accumulated
Depreciation
($192,530)
(385,059)
(577,589)
(770,119)
(962,649)
(1,155,178)
(1,347,708)
(1,540,238)
(1,732,768)
(1,925,297)

The same entry would be made each year on December 31


Dr. Depreciation expense
192,530
Cr. Accumulated depreciation
192,530
g.
Balance Sheet
31-Dec-17
Liabilities not including lease
Capital lease
Total Liabilities
Capital Stock
Retained Earnings
Total Equity
Debt to equity

Capital

Operating

1,600,000
1,798,574
3,398,574
1,000,000
254,194
1,254,194

1,600,000

2.71

1.21

Capital
700,000
(173,277)
(192,530)

Operating
700,000

1,600,000
1,000,000
320,000
1,320,000

Income Statement
31-Dec-17
Net income before lease expense
Interest expense
Amortization expense
Lease expense
Income before taxes
Less Taxes
Net income

334,194
80,000

(300,000)
400,000
80,000

254,194

320,000

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-62
Copyright 2013 McGraw-Hill Ryerson Ltd.

h.
Effects on Income
Interest expense
depreciation expense
rent expense
Effect on Net income

31-Dec-17
Capital
Operating
(173,277)
(192,530)
(300,000)
(365,807)

(300,000)

31-Dec-20
Capital
Operating
(135,890)
(192,530)
(300,000)
(328,420)

(300,000)

Total Expenses
31-Dec-17
31-Dec-18
31-Dec-19
31-Dec-20
31-Dec-21
31-Dec-22
31-Dec-23
31-Dec-24
31-Dec-25
31-Dec-26
Total

Capital
(365,806)
(354,401)
(341,970)
(328,419)
(313,650)
(297,550)
(280,002)
(260,875)
(240,026)
(217,300)

Operating
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)

(3,000,000)

(3,000,000)

An operating lease has the same effect on income in every year (the expense is the lease
payment) however the effect of a capital lease continuously decreases (because the interest
expense decrease). Over the 10 years the total expense is the same for operating and capital.
i.
The classification of a lease under IFRS requires professional judgement. The two key
requirements are whether the lessee receives most of the economic benefits and the present value
of the lease payments is equal to most of the fair value of the economic benefits. To avoid
classification as a capital lease Vista would need to reduce the lease period significantly, which
would ensure that the present value of the lease payments is a smaller proportion of the fair
market value of the equipment and reduce the portion of the assets useful life that the lessee is
using. If classified as an operating lease, the lease liability wouldnt appear on the balance sheet,
therefore having a favourable effect on the debt-to-equity ratio.
j.
There are two arguments for treating the arrangement as a capital lease for the purposes of
properly evaluating the entities performance to determine management bonuses. The first is that
the income earned during the period should be related to the resources available, which clearly
includes the equipment. The second is the fact that the sum of the interest expense and the
depreciation expense reflects the actual cost of using the asset and the cost of financing. The
operating lease treatment is less specific. The balance sheet using the capital lease approach
would likely be more useful because it would capture the lease debt, which under the operating
lease is off balance sheet.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-63
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-15.
a.
There are two types of reasons for entering the lease: business reasons and financial reporting
reasons. One of the most likely reasons is that the financing arrangements are much easier to
make and Isachsen doesnt have to obtain separate financing for the purchase. Also, leasing
allows for 100% financing of the cost of the asset and Isachsen wont have to seek other sources
of financing from lenders. Leasing, particularly leases that are treated as operating leases, can
offer some financial reporting benefits to the leasing entity because financing is off-balance
sheet.
b.
1

Three Criteria to help determine if its a capital or operating


ownership at end of lease
yes

Lessee economic benefit


(lease term/useful life)

Lessor recovers financial benefit


Minimum net lease payments (MNLP)
(MNLP)/(cost of asset)
MNLP =
Cost of Asset =
(MNLP)/(cost of asset) =

lease term
useful life

4
6
67%

number of periods
discount rate
payment
PV (annuity)

4
11.0%
75,000
232,683
250,000
93.07%

The lease clearly satisfies the criteria for a capital lease since title to the equipment will transfer
to the lessee at the end of the term of the lease and the present value of the payments is $232,683,
which is a substantial amount of the fair market value of the asset.
c.
Dr. Asset under capital lease
Cr. Lease liability

232,683
232,683

If the lease were an operating lease, no entry would be made.


d.

1-May-18
30-Apr-19
30-Apr-20
30-Apr-21
30-Apr-22

Capital Leases
[1]
Beginning of
year balance of
lease liability
= [5]
232,683
232,683
183,279
128,439
67,568

[2]
Interest
Expense
[previous
1]*rate
(25,595)
(20,161)
(14,128)
(7,432)

[3]

[4]

[5]

Decrease in Lease
Liability
[3]-[2]

Ending balance

Payments
(Cash)
(75,000)
(75,000)
(75,000)
(75,000)

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

(49,405)
(54,839)
(60,872)
(67,568)

[1]-[4]
183,279
128,439
67,568
0

Page 9-64
Copyright 2013 McGraw-Hill Ryerson Ltd.

April 30, 2019


Dr. Interest expense
Dr. Lease liability
Cr. Cash

25,595
49,405

April 30, 2021


Dr. Interest expense
Dr. Lease liability
Cr. Cash

14,128
60,872

75,000

75,000

If the lease were accounted for as an operating lease, the same entry would be made each year:
Dr. Lease expense
75,000
Cr. Cash
75,000
e.
The amount on the balance sheet on May 2018 would be $232,683, which would be the present
value of the payments.
f.
The equipment should be depreciated over the time period during which the asset will contribute
to revenues. The range, based on the information provided is from six to eight years. Assuming
that six years is chosen, the annual depreciation expense will be $38,781. However, any amount
over the range would probably be acceptable and reasonable. The period of the lease isnt used
because the company will own the equipment at the end of the lease and so its appropriate to use
the equipments useful life.
Dr. Depreciation expense
Cr. Accumulated depreciation

38,781
38,781

Asset
[4]

OE - Exp
[5]

Asset

Asset

Carrying amount of
leased equipment
(Cost Accumulated Depreciation)

Depreciation
Expense
(straight -line)

Equipment
cost

Accumulated
Depreciation

$232,683
193,903
155,122
116,342
77,561
38,781
-

($38,781)
(38,781)
(38,781)
(38,781)
(38,781)
(38,781)

$232,683
232,683
232,683
232,683
232,683
232,683
232,683

($38,781)
(77,561)
(116,342)
(155,122)
(193,903)
(232,683)

Date
1-May-18
30-Apr-19
30-Apr-20
30-Apr-21
30-Apr-22
30-Apr-23
30-Apr-24

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-65
Copyright 2013 McGraw-Hill Ryerson Ltd.

g.
Retained Earnings - Beg
Balance Sheet
30-Apr-19
Liabilities not including lease
Capital lease
Total Liabilities
Capital Stock
Retained Earnings
Total Equity

450,000

450,000

Capital
$1,375,000
183,279
1,558,279
750,000
580,624
1,330,624

Operating
$1,375,000

1.17

1.04

Capital
$275,000
(25,595)
(38,781)

Operating
$275,000

Debt to equity
Income Statement
30-Apr-19
Net income before lease expense
Interest expense
Depreciation expense
Rent expense
Income before taxes
Less Taxes
Net income

1,375,000
750,000
570,000
1,320,000

210,624
80,000

(75,000)
200,000
80,000

$130,624

$120,000

h.
Effects on Income

Interest expense
Depreciation expense
Lease expense

30-Apr-19
Capital
Operating
($25,595)
(38,781)
($75,000)

30-Apr-21
Capital
Operating
($14,128)
(38,781)
($75,000)

Effect on Net income

($64,376)

($52,909)

30-Apr-19
30-Apr-20
30-Apr-21
30-Apr-22
30-Apr-23
30-Apr-24

($75,000)

($75,000)

Total Expenses
Capital
Operating
($64,376) ($75,000)
(58,941)
(75,000)
(52,909)
(75,000)
(46,213)
(75,000)
(38,781)
(38,781)
(300,000)

(300,000)

An operating lease has the same effect on income in every year (the expense is the lease
payment) however the effect of a capital lease continuously decreases (because the interest
expense decrease). Over the six years the total expense is the same for operating and capital.
i.
The classification of a lease under IFRS requires professional judgement. The two key
requirements are whether the lessee gets ownership of the leased assets at the end of the lease
and the present value of the lease payments is equal to most of the fair value of the economic
benefits. To avoid classification as a capital lease Isachsen would need to reduce the payments
and eliminate the clause that has the equipment become the property of Isachsen at the end of the
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual

Page 9-66
Copyright 2013 McGraw-Hill Ryerson Ltd.

lease term. The balance sheet would show much less debt with the result that users may perceive
the company to be less risky.
j.
There are two arguments for treating the arrangement as a capital lease for the purposes of
evaluating an investment in the company. The first one is that the income earned during the
period should be related to the resources available, which clearly includes the equipment. The
second is the fact that the sum of the interest expense and the depreciation expense reflects the
actual cost of using the asset and the cost of financing. The operating lease treatment is less
specific. The balance sheet using the capital lease approach would likely be more useful because
it would capture the lease debt, which under the operating lease is off balance sheet.

P9-16.
a. Ogoki would make the following journal entry during 2017:
Dr. Restructuring costs (income statement -)
Cr. Accrued restructuring liabilities (liabilities +)

75,000,000
75,000,000

The entry is made in 2017 because of conservatism, which requires recognition of a loss as soon
as its known. The restructuring loss would be shown as a loss, on a separate line (because of
how large it is).
b. The entry that would be made in 2018 is:
Dr. Accrued restructuring liabilities (liabilities -)
Cr. Cash

50,000,000
50,000,000

The entry would have no impact on the income statement. The full income statement effect was
reported in 2017.
c. If the cost of the restructuring turned out to be $50,000,000 and not the $75,000,000 that was
accrued in 2017 it would be necessary to reverse the $25,000,000 that was accrued in 2017 but
not incurred. That means that $25,000,000 of expenses that were recorded in 2017 would have to
be reversed and taken into income in 2018. The entry that would be required would be:
Dr. Accrued restructuring liabilities (liabilities -)
Cr. Restructuring costs (income statement +)

25,000,000
25,000,000

The effect of making too large an estimate in 2017 and the reversal in 2018 would be to reduce
income in 2017 by $25,000,000 (making it $25,000,000 lower than it would have been had an
accurate estimate been made) and make net income in 2018 be $25,000,000 higher than it would
have been otherwise.
There are two main reasons for the large estimation error in 2017. First, estimates can be difficult
to make. Anticipating the cost of a workforce reduction well in advance of actually incurring the
costs can be challenging. Add to that the conservative nature of accounting and the preference
not to overstate income and understate liabilities might lead management to make cautious
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual

Page 9-67
Copyright 2013 McGraw-Hill Ryerson Ltd.

estimates to avoid shortfalls in future (in which case management could be accused of
understating the cost of the restructuring in 2017). The other main reason for the estimation error
is the self-interests of management. Management might feel that it would benefit by taking a loss
in 2017 and then have it look good in 2018, benefited by the $25,000,000 adjustment.
This is part of what occurred at Nortel in the early 2000s. Management overstated its
restructuring costs one year and took the excess back into income the next year. The reversal of
the restructuring accrual allowed managers to earn bonuses as a result of the recovery.
However, the recovery was largely due to the reversal of the over-estimated accrual.
Compounding the situation was that management (in the case of Nortel) did not disclose the
reversal of its restructuring costs so while it appeared that the original loss was an unusual onetime event, the reversal was included in ordinary operations. So how Nortel reported the reversal
was misleading to the users of the financial statements.
P9-17.
a.
Dr. Cash
Cr. Loan payable

59,724,975
59,724,975

Dr. Locomotives
Cr. Cash

59,724,975
59,724,975

b.
Dr. Locomotives under lease
Cr. Lease liability

59,724,975
59,724,975

c.
No journal entries are required.
d.
Number of periods
MNLP =

20

Annual payment

$7,500,000

PV (annuity)

59,724,975

Interest rate =

11.0%

The implicit interest rate in the lease is 11%. Since the interest rate is the same under the
financing arrangement, the journal entries will essentially be the same for the financing and for
the capital lease. This shows that a capital lease tries to reflect the same effect as borrowing the
money. The cash flows will be the same for all three arrangements, so the differences will be in
the balance sheet and income statement of the operating lease versus the other alternatives. The
implications of the different arrangements may be a question of perceptions users have of the
creditworthiness of the company, but knowledgeable users of financial statements will view the
firm in the same way under all three options. However, any calculations that are based on the
financial statements, such as ratios and management bonuses, will obtain different results under
the operating lease. Differences would occur between the capital lease and the loan if the interest
rate used to calculate the value of the lease payments was different from the borrowing rate used
by the bank.
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual

Page 9-68
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-18.
a. b. and c.
*Payments made at beginning of period
Number of periods

20

Interest rate

12.00%

Annual payment

$4,200,000

PV (annuity)

$35,136,263

a.

b.

c.

31-Dec-17
No lease
Current Assets
Current Liabilities
Current ratio

Total Liabilities
Total Shareholders' Equity
Total Liabilities and shareholders equity
Debt/equity

01-Jan-18
Capital

Operating

$18,950,000

$18,950,000

$18,950,000

13,990,000

14,477,648*

13,990,000

1.35

1.31

1.35

$53,090,000

$88,226,263

$53,090,000

49,410,000

49,410,000

49,410,000

$102,500,000

$137,636,263

$102,500,000

1.07

1.79

1.07

*$4,200,000 - $3,712,352= $487,648; $487,648 + 13,990,000 = $14,477,648.

d.
Memo: Leasing Arrangement Implications
To: The President of Kincaid Airlines Ltd.
I have reviewed your plan to lease new aircraft and I have a few concerns worth noting. The
impact of the lease on the financial statements has been calculated (shown in the exhibits above).
If the lease is classified as a capital lease, Kincaid will violate the debt-to-equity covenant
stipulated in the bond issue agreement (debt-to-equity ratio of 1.79 over stipulated covenant of
1.3).
Currently, Kincaid must maintain covenants specified in the terms of a bond previously issued. If
covenants arent maintained, the bond will become due immediately. The bond amounts to
$39,100,000 and if covenants are breached and the bond comes due, current assets ($18,950,000)
arent sufficient to settle the entities obligation to bondholders. This could result in serious
liquidity problems for the entity and could possibly impair Kincaids ability to continue as a
going concern.
Since its crucial that covenants arent breached, Kincaid can try to arrange the terms of the lease
to qualify as an operating lease. Operating leases are accounted for off-balance sheet and
therefore wont affect the amount of debt recorded in the financial statements. Because recorded
debt wont increase, the debt-to-equity ratio will remain below the required covenant of 1.3.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-69
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-19.
a.
Issue date
Maturity date
Face Value (FV)
Number of periods
Effective rate (i)
Coupon rate (c)
Annuity Payment
Proceeds (P) =

Year end
1-Mar-17
28-Feb-23
Annual
10,000,000
6
5.0%
4%

31-Dec

Semi
12
2.5%
2%
200,000

market /discount
nominal/stated/contract
interest payments

PV (all cash flows)

PV (Principal)
PV (Interest payments)

Semi
$7,435,559
$2,051,553

Proceeds (P) =

$9,487,112

Discount =

(P)-(FV)
$512,888

excel - pv(rate,npr,,-fv)
excel - pv(rate,npr,-pmt,)

Proceeds of bond issue = $9,487,112


b.
Dr. Cash
Dr. Discount on bonds payable
Cr. Bonds payable

9,487,112
512,888
10,000,000

c.
Amortization Table-Effective Interest Method
Interest
payment

Interest
expense

Discount
amortization

01-Mar-17

Carrying amount
of bond at period
end

Unamortized
discount
(512,888)

9,487,112

(37,178)

(475,710)

9,524,290

238,107

(38,107)

(437,603)

9,562,397

239,060

(39,060)

(398,543)

9,601,457

200,000

240,036

(40,036)

(358,507)

9,641,493

200,000

241,037

(41,037)

(317,470)

9,682,530

200,000

242,063

(42,063)

(275,406)

9,724,594

200,000

243,115

(43,115)

(232,291)

9,767,709

28-Feb-21

200,000

244,193

(44,193)

(188,099)

9,811,901

31-Aug-21

200,000

245,298

(45,298)

(142,801)

9,857,199

28-Feb-22

200,000

246,430

(46,430)

(96,371)

9,903,629

31-Aug-22

200,000

247,591

(47,591)

(48,780)

9,951,220

28-Feb-23

200,000

248,780

(48,780)

10,000,000

31-Aug-17

200,000

237,178

28-Feb-18

200,000

31-Aug-18

200,000

28-Feb-19
31-Aug-19
28-Feb-20
31-Aug-20

*Note: numbers slightly off due to rounding

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-70
Copyright 2013 McGraw-Hill Ryerson Ltd.

d.
The journal entry on December 31, 2017 will be:
Dr. Interest expense (4/6)
Cr. Discount on bonds payable (4/6)
Cr. Interest Payable (4/6)
e.
The journal entry on March 31, 2018 will be:
Dr. Interest expense (1/6)
Cr. Discount on bonds payable (1/6)
Cr. Interest payable (1/6 x $200,000)
f.
The journal entry at maturity will be:
Dr. Bonds payable
Cr. Cash

158,739
25,405
133,334

39,843
6,510
33,333

10,000,000
10,000,000

Entry will be required to record interest expense for period from January 1-February 28 and
include an adjustment for the discount amortization.
Dr. Interest Expense (2/6)
82,927
Dr. Interest Payable (4/6)
133,333
Cr. Discount on bonds payable (2/6)
16,260
Cr. Cash
200,000

g.
The journal entry on Feb 28, 2020 will be (note that these entries ignore the recording and
payment of interest for the period but its assumed these entries have already been recorded):
Dr. Bonds payable
Dr. Loss on redemption of bonds
Cr. Discount on bonds payable
Cr. Cash

10,000,000
1,275,406
275,406
11,000,000

h.
The loss reflects the difference between the cash paid at the time of early retirement of the bond
and the carrying amount of the bond. The amount of cash paid was greater than the carrying
amount and this results in a loss. This may have been retired at an early date based on assessment
of market conditions, the company having idle funds and/or the interest in reducing a debt-toequity ratio.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-71
Copyright 2013 McGraw-Hill Ryerson Ltd.

P9-20.
Issue date
Maturity date
Face Value (FV)
Number of periods
Effective rate (i)
Coupon rate (c)
Annuity Payment
Proceeds (P) =

Year end
1-June-16
31-May-26
Annual
250,000,000
10
4.5%
5.0%
$12,500,000
PV (all cash flows)

PV (Principal)
PV (annuity)
Proceeds (P) =

31-Dec
31-Jan

market /discount
nominal/stated/contract
interest payments

$160,981,921
$98,908,977
$259,890,898
(P)-(FV)
9,890,898

Premium
.

b.
Dr. Cash
259,890,898
Cr. Premium on bonds payable
Cr. Bonds payable

9,890,898
250,000,000

c.
Effective interest method
[1]
Interest
Payment
(FV*c)

[2]
Interest
Expense
[1]-[3]

[3]
Amortization
Premium
Calculated

[4]
Unamortized
Premium
(pre amt)-[3]

[5]
Net bond
Liability (Carrying
amount)

31-May-17

12,500,000

11,695,090

804,910

9,890,898

259,890,898

9,085,988

259,085,988

31-May 18

12,500,000

11,658,869

841,131

8,244,858

258,244,858

31-May-19

12,500,000

11,621,019

878,981

7,365,876

257,365,876

31-May-20
31-May-21

12,500,000

11,581,464

918,536

6,447,341

256,447,341

12,500,000

11,540,130

959,870

5,487,471

255,487,471

31-May-22

12,500,000

11,496,936

1,003,064

4,484,407

254,484,407

31-May-23

12,500,000

11,451,798

1,048,202

3,436,205

253,436,205

31-May-24

12,500,000

11,404,629

1,095,371

2,340,835

252,340,835

31-May-25

12,500,000

11,355,338

1,144,662

1,196,172

251,196,172

31-May-26

12,500,000

11,303,828

1,196,172

(0)

250,000,000

01-Jun-16

*Note: numbers may be slightly off due to rounding

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

Page 9-72
Copyright 2013 McGraw-Hill Ryerson Ltd.

d.
The journal entry on December 31, 2016 will be:
Dr. Interest expense (7/12)
Dr. Premium on bonds payable (7/12)
Cr. Interest Payable (7/12)

The journal entry on December 31, 2017 will be


Dr. Interest expense (7/12)
Dr. Premium on bonds payable (7/12)
Cr. Interest Payable (7/12)
e.
The journal entry on May 31, 2017 will be:
Dr. Interest expense (5/12)
Dr. Interest Payable (7/12)
Dr. Premium on bonds payable (5/12)
Cr. Cash
The journal entry on May 31, 2018 will be:
Dr. Interest expense (5/12)
Dr. Interest Payable (7/12)
Dr. Premium on bonds payable (5/12)
Cr. Cash

6,822,136
469,531
7,291,667

6,801,008
490,659
7,291,667

4,872,954
7,291,667
335,379
12,500,000

4,857,862
7,291,667
350,471
12,500,000

f.
The journal entry on May 31, 2026 will be:
Dr. Bonds payable
Cr. Cash

25,000,000
25,000,000

Entry will be required to record interest expense for period from January 1-May 31 and include
an adjustment for the premium amortization.
Dr. Interest expense (5/12)
4,709,928
Dr. Interest Payable (7/12)
7,291,667
Dr. Premium on bonds payable (5/12)
498,405
Cr. Cash
12,500,000
g.
The journal entry on May 31, 2021 will be (note that these entries ignore the recording and
payment of interest for the period ended May 31, 2021 but its assumed these entries have
already been made):
Dr. Bonds payable
Dr. Premium on Bond Payable
Cr. Cash
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual

250,000,000
5,487,471
241,000,000

Page 9-73
Copyright 2013 McGraw-Hill Ryerson Ltd.

Cr. Gain on redemption of bonds

14,487,471

h. The decision to purchase all the bonds was a good one for Hamiota as cash paid to extinguish
the bonds was significantly less than the carrying value of the bond. Consequently, earnings
would be more favourably reported in the year-end 2021. This assumes Hamiota didnt have to
borrow to extinguish the bond and if it did the new interest cost was lower.

P9-21.
Depreciation chart for straight line and CCA for the first three years of asset life
Straight line

Year
End
Dec. 31
Purchase
2017
2018
2019

Cost
$900,00
0
900,000
900,000
900,000

Cost
RV
UL

900,000
10

Accounting for taxes

Accumulate
d

Carrying

Depreciatio
n

Depreciatio
n

Amount

Expense

Year
End

(AA)
$0
90,000
180,000
270,000

(AE)

Dec. 31

$900,00
0
810,000
720,000
630,000

$0
90,000
90,000
90,000

Purchase
2017
2018
2019

Cost
$900,00
0
900,000
900,000
900,000

AE=

90,000
Cost
Rate

900,000
30%

Undepreciate
d

CCA
amount

Cumulative
CCA
Balance

Capital cost

for the
period

(UCC)

(AE)

$0
135,000
364,500
525,150

$900,000
765,000
535,500
374,850

$0
135,000
229,500
160,650

a & b.
2017
$300,000
(90,000)

2018
$300,000
(90,000)

2019
$300,000
(90,000)

Net Income before taxes


Account for temporary differences
Add back depreciation
Subtract CCA
Taxable Income
tax rate

210,000

210,000

210,000

90,000
(135,000)
165,000
18%

90,000
(229,500)
70,500
18%

90,000
(160,650)
139,350
18%

Taxes Payable

$29,700

$12,690

$25,083

Net Income before depreciation


Depreciation Expense

a.
b.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


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Page 9-74
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c & d.
[1]
Tax Basis
UCC

[2]
Accounting basis
Carrying amount

Year
2017
2018
2019

$765,000
535,500
374,850
[7]
Taxable Income

Year
2017
2018
2019

$165,000
70,500
139,350

[3]
Temporary Difference
UCC - Carrying amount
[1]-[2]

Tax rate

($45,000)
(184,500)
(255,150)

18%
18%
18%

$810,000
720,000
630,000
[8]
Taxes Payable

Tax Expense

[7]*tax rate
$29,700
12,690
25,083

[4]
Future tax
liability
[3]* tax rate
($8,100)
(33,210)
(45,927)

[6]+[8]

Current
Expense
Same as [8]

Future
Expense
(benefit)
Same as [6]

$37,800
37,800
37,800

$29,700
12,690
25,083

$8,100
25,110
12,717

e.
2017
Dr. Income tax expense
37,800
Cr. Future income taxes [6]
Cr. Income tax payable [8] or part b

8,100
29,700

2018
Dr. Income tax expense
37,800
Cr. Future income taxes [6]
Cr. Income tax payable [8] or part b

25,110
12,690

2019
Dr. Income tax expense
37,800
Cr. Future income taxes [6]
Cr. Income tax payable [8] or part b

12,717
25,083

[5]
Beginning
Balance
(8,100)
(33,210)

[6]
Adjustment
(credit required)
[4]-[5]
$8,100
25,110
12,717

f & g.
Income statement for Accounting
2017
$210,000

2018
$210,000

2019
$210,000

29,700
8,100

12,690
25,110

25,083
12,717

$172,200

$172,200

$172,200

Net Income before taxes


Income tax expense

$210,000
29,700

$210,000
12,690

$210,000
25,083

Net Income

$180,300

$197,310

$184,917

Net Income before taxes


Income tax expense
Current
Future
Net Income

Taxes Payable method

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


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Page 9-75
Copyright 2013 McGraw-Hill Ryerson Ltd.

h. It can be argued that the taxes payable method really reflects the cash flows that are occurring
in the near future and is more relevant to the banker. The future income tax liability says
something about the amount of tax protection that exists on assets and that more CCA than
depreciation has been expensed meaning that in the future more cash will have to be paid in
income taxes than has been paid in the past, all else staying the same (for example, no additional
assets).

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Page 9-76
Copyright 2013 McGraw-Hill Ryerson Ltd.

USING FINANCIAL STATEMENT


Amounts are reported in Millions of dollars.
FS9-1.
a. Current liabilities: 2011: $4,153.0, 2010: $3,251.5,
Non-current liabilities: 2011: $3,776.8, 2010: $3792.1;
b. Trade and other payables: 2011: $1,640.9, 2010: $1,179.9
Trade payables and accrued liabilities: 2011: $1,598.6, 2010: $1,095.1
c. Debt-to-equity ratio = total debt / total equity
December 31, 2011 = $7,929.8 / $4,409.0 = 1.80
January 1, 2011 = $7,043.6 / $4,004.9 = 1.76
From 2010 to 2011, Canadian Tires debt-to-equity ratio increased very slightly because
liabilities increased at a faster rate than equity. An increase in a companys debt-to-equity
ratio generally means that an entity has become more risky because there are more fixed
obligations. In this case the increase is small and probably not a meaningful indicator of a
change in strategy or circumstances for the company.
d. Canadian Tires long term liabilities items are valued at their present value such as
provisions and debt.
e.
2011
2010
Net income
$467.0
$444.2
Interest expense
132.2
136.7
Income tax expense
162.9
142.6
Total
$762.10
$723.50
Interest coverage ratio

Interest coverage ratio =

5.76

5.29

Net income + Interest expense + tax expense


Interest expense

f.
2011
2010
Quick assets
$5,433.2 $5,490.5
Current assets
6,956.6 6,549.2
Current liabilities
4,153.0 3,251.5
Current ratio (current assets/current liabilities)
1.68
2.01
Quick ratio (quick assets/current liabilities)
1.31
1.69
Both Canadian Tires quick and current ratios have declined from 2010 to 2011. This
shows that their liquidity positioned has worsened slightly as they have fewer liquid
assets available to meet their liabilities as they become due. The quick ratio and current
ratio however indicate that Canadian Tire is not as risky since the both their quick and
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
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Page 9-77
Copyright 2013 McGraw-Hill Ryerson Ltd.

current assets is enough to cover current liabilities. Other factors that could be considered
in assessing liquidity would be cash from operations and the inventory and accounts
receivable turnover ratios.
g. Canadian Tires cash from operations was $1,405.5 in 2011 and $729.5 in 2010. Net
earnings in 2011 were $467.0 and $444.2 in 2010. The largest contributors to the
difference between net earnings and cash from operations are: impairment of loans
receivable, depreciation and amortization expense, and the change in non-cash working
capital accounts.
h. Canadian Tire reported $2,347.7 and $2,365.4 in non-current long-term debt on December
31, 2011 and January 4, 2011, respectively. Canadian Tire reported $27.9 and $354.2 as
the current portion of long-term debt on December 31 2011 and January1, 2011,
respectively. The total amount of long-term debt was $2,375.6 and $2,719.6 on December
31 2011 and January1, 2011, respectively.
FS9-2.
a. A contingent liability is a possible obligation whose existence has to be confirmed by a
future event that isnt in the control of the entity or an obligation with uncertainties about
the probability of whether payment will be made or the amount of payment (it doesnt
meet the definition of a provision). A contingent liability isnt recognized in the financial
statements but its disclosed in the notes if the probability of having to pay is remote.
b. The paragraph highlights that any and all legal contingencies the company is exposed to
will, in sum, not have a material effect on the company. This is not very useful as it does
not describe any of the lawsuits and thus does not allow users to make their own
determination of risk to the companys financial wellbeing. However, a large amount of
information about small immaterial lawsuits may not be very informative.
c. The second paragraph describes the companys pending lawsuit regarding credit card fees
and interest and their legality in Quebec. If accrued it would increase current liabilities by
0.6% and total liabilities by 0.3% and lower net income by 5%. As an investor, this
amount would probably not affect my decisions as its small impact is barely material.
However since the amount was disclosed I could restate the financial statements based on
a negative outcome and decide on whether or not to invest based on the restated
statements.
FS9-3.
a. Long-term debt on December 31, 2011: $237.7; Amount classified as current: $27.9
The current portion of long-term debt refers to the payments that must be made in the
next year. The purpose of classifying debt as current is to provide liquidity information
by informing stakeholders about the payments that are required in the next 12 months
(short term).
b. Canadian Tire reported a carrying value of $598.3 in Series 2008-1 Senior Notes on
December 31 2011 with a face value of $600.0. This debt matures on February 20, 2013
and carries an interest rate of 5.027%. It is important and useful for stakeholders to know
the maturity and interest rate because it helps them estimate future cash both by knowing
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
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Page 9-78
Copyright 2013 McGraw-Hill Ryerson Ltd.

the outflows that will be incurred as a result of the debt and assess future financing needs
(will the debt have to be refinanced when it comes due). Stakeholders can use the
information to estimate future interest costs if debt is refinanced.
c. Canadian Tires interest expense in 2011 and 2010 was $155.2 and $168.1, respectively.
It paid $176.6 in 2011and $190.5 in 2010. Interest expense and interest paid are different
due to accruals. At year end, a portion of the next interest payment would be owed but
not yet paid. As a result of the timing difference between payments and interest accruals,
interest expense and interest paid wont be the same. Also, amortization of bond
premiums and discounts cause differences between interest paid and interest expense.
d. Within 5 years, the company will have to repay lenders $1,740.1. This makes up 73% of
the companys debt load; however, assuming the companys liquidity and profitability
remain strong, the company should be able to service its debt. In 2013 and 2015 a
significant amount of debt is scheduled to be repaid ($655.8 in 2013 and $577.9 in 2015).
The concern would be that there could be an issue with having sufficient cash on hand to
repay these loans. However, the cash flow statement shows that the companys cash from
operations is high relative to these payments. More likely is that the company will
refinance these loans. However, if the company is unable to refinance, they may find
themselves unable to continue operating.
e. This statement is provided by companies are required to disclose the existence (without
providing any detail) of debt covenants. The amount of information provides lets users
know that Canadian Tire is in compliance of its covenants. While its past compliance
seems to indicate the company should continue compliance in the future, by failing to
disclose the exact covenant requirements, a user of the financial statements cannot make
his or her own forecast about the companys risk of non-compliance. Covenant violations
could mean bankruptcy for the company or additional costs.

FS9-4.
a. Income tax expense: December 31, 2011 = $162.9; January 1, 2011 = $142.6
Current portion 2011 = $169.3; current portion 2010 = $133.0
Deferred portion 2011 = $(6.4); future portion 2010 = $9.6
Taxes payable in 2011 = $3.9
Taxes paid in 2011 = $63.7
Income taxes paid and the current income tax expense are different because taxes are
often not paid in the reporting period. The current income tax expense is the amount of
tax that pertains to the current period, but some of the current expense might be paid in
another period.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


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Copyright 2013 McGraw-Hill Ryerson Ltd.

b. On December 31, 2011 Canadian Tire reported $66.1 in deferred income taxes liabilities.
This amount represents the differences between accounting for financial reporting
purposes (IFRS) and tax reporting of the carrying amount of assets and liabilities.
c. Canadian Tires statutory tax rate was 28.08% and 30.49% in 2011 and 2010,
respectively. Canadian Tires effective tax rate was 25.86% and 24.30% in 2011 and
2010, respectively. Canadian Tires tax rate based on current income tax expense was
26.88% and 22.67% in 2011 and 2010, respectively.
FS9-5.
a. A commitment is a contractual agreement to enter into a transaction in the future.
Agreements that commit an entity to purchase goods or services in the future usually
arent recorded as liabilities, according to IFRS. Significant commitments should be
disclosed in the notes to the financial statements.
b. Canadian Tire has entered into the following commitments: standby letters of credit and
performance guarantees to buy back inventory; buy back of franchise stores and third
party credit card processing and information technology services.
c. Total other commitments totaled $173.3 million.
Commitment
Letters of Credit
Buy back inventory
Buy back franchise stores, customs bond
3rd Party credit card processing
Total

2011
$25.8
69.9
9.2
68.4
$1,73.3

d. Canadian Tire has disclosed its commitments in the notes to the financial statements.
Commitments are disclosed, rather than accrued, because they have not met one of the
requirements of a liability a past transaction as the transaction has not yet occurred.
e. Commitments are only disclosed, not recorded in the financial statements. Commitments
give light to future cash outflows.
f. Yes, they are important because stakeholders wishing to assess the companys liquidity
will not have a complete picture of the obligations and future cash out flows of a
company if commitments were not disclosed.
FS9-6.
a. Operating leases are leases that are not classified as finance or capital leases, in which the
lessor retains the risk and rewards of ownership. It is a form of off-balance sheet
financing whereby the lease amount is expensed yearly on the income statement and
there is no asset and liability reported on the balance sheet. Operating lease obligations,
like commitments, are not accrued on the balance sheet but the lease obligation is
disclosed to the notes of the financial statements.

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Copyright 2013 McGraw-Hill Ryerson Ltd.

b. Canadian Tire has future commitments to pay $2,110.3 million in operating lease
payments.
c.
up to
up to
2012
2016
2025
Annual Payments
$290.6
$227.7*
$90.9**
Years of payment terms
1
4
10
Rate
10%
10%
10%
PV of payments @ 1, 2 & 5 years
$264.2
$656.2
295.5
Total amount to Capitalize
$1,215.9
*The annual payment is from Note 40. Canadian Tire reports that payments of $910.8
will be required over the four-year period 2013-2016. This amount is spread evenly over
the four years.
** The annual payment is from Note 40. Canadian Tire reports that payments of $908.9
will be required over the nine-year period 2017-2015. This amount is spread evenly over
the nine years.
The journal entry would be:
i.

ii.

iii.

Dr. Assets under capital lease (asset +) 1,215.9


Cr. Lease liability (liability +)

1,215.9

Classifying these leases as capital leases would increase the debt-to-equity ratio
because the lease amounts would be recorded on the balance sheet as liabilities
which would therefore increase debt.
Total liabilities per the December 31, 2011 balance sheet $7,929.8
Capital Lease Liability
1,215.9
Total liabilities including operating leases
$9,145.7
Total equity per the December 31, 2011 balance sheet
$4,409.0
Debt-to-equity ratio as originally calculated
1.80
Revised debt-to-equity ratio (include operating leases)
2.07
Classifying all leases as capital would provide more useful information regarding
the true obligations of an entity, which would therefore give a better indication of
an entitys true debt load. However, as these lease payments are provided in the
statements, users are still able to evaluate the companys ability to meet its
obligations.

FS9-7.
A guarantee is an agreement that requires a guarantor (Canadian Tire) to make payments to a
third party based on either changes in underlying conditions or the failure of another party to
satisfy contractual obligations with the third party (for example, guaranteeing the debt of another
party) (for example, one of Canadian Tires franchises). Guarantees do not meet the criteria of a
liability because an economic sacrifice is not probable. A guarantee will become a liability if it is
probable that the condition will exist where the company is required to meet its obligation as a
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guarantor. Guarantees are included in the notes because, even though they arent liabilities, they
provide information to stakeholders about payments an entity could be required to make in the
future. This information is useful to stakeholders as it helps them to assess the risks associated
with the company as well as identify the potential for additional payment requirements.
FS9-8.
A subsequent event is an economic event that occurs after an entitys year end, but before the
financial statements are approved. When a subsequent event provides additional information
about circumstances that existed at the year end, the financial statements should be adjusted to
reflect the new information. Subsequent events that are unrelated to circumstances that existed at
year end should only be disclosed in the notes to the financial statements if they are material or
significant. The second type of subsequent event is disclosed for completeness even though it has
no bearing on the year just ended.
Canadian Tire reported that on February 9, 2012 it declared a dividend. This is relevant to
stakeholders so that they can better evaluate Canadian Tires future cash flows. However, its not
likely the disclosure of this acquisition would be new information to stakeholders who closely
follow Canadian Tire especially if they already own shares; the declaration of a dividend would
have been communicated to them and would have been announced through other channels by the
company and reported in the business press. The subsequent event was disclosed in the notes
because it is an event occurring after the financial statement date and did not require an adjusting
entry. The disclosure is to help users of the financial statement to be aware of material events
that occur between the year-end and the financial statement release date.

FS9-9.
a. Companies have loyalty programs to promote their business and to encourage customers
to do repeat business (the discounts offered by Canadian Tire money are only available at
Canadian Tire).
b. The obligation exists when a dealer pays Canadian Tire money to acquire the paper based
Canadian Tire Money. The obligation exists because the Dealer retains the right to return
the money for cash.
c. The amount of the provision for Canadian Tires customer loyalty program on December
31, 2011 is $68.1 million.
d. The estimation of the provision is the fair value of the amount that can be redeemed
multiplied by the probability of redemption.
FS9-10.
a. A warranty is a promise by a seller or producer of a product to correct specified problems
with the product. Canadian Tire provides warranties to assure their customers that
Canadian Tire is standing behind the products it sells and that the product/service
performs as promised. Canadian Tire allows customers to return merchandise because it
wants to give its customer piece of mind on their purchase hence increasing the
likelihood of a sale.
b. Cost associated with providing warranty service are estimated and accrued as a provision
when the related product is sold. This is recorded at this time because the warranty is
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
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Copyright 2013 McGraw-Hill Ryerson Ltd.

considered as part of the sale and therefore the expense needs to be recognized in the
period in which it helped to earn the revenue (matching).
c. Canadian Tire estimates its warranty and returns costs when the underlining products or
services are sold. This is based on an estimate of historical costs discounted to its present
value. These costs are recorded at this time because it is the critical event that triggers the
obligation.
d. Canadian Tire reported a balance of $113.2 in warranty and returns provision as of
December 31, 2011. The portion of the amount that is noncurrent is $5.3. The amount has
changed from the beginning of the year to the end of the year because of new warranties,
utilizations (warranty service was provided), accretion, and the change in discount rates.
e. The adjusting entry that Canadian Tire recorded at the end of the period to record the
provision for warranty and returns is:
Dr. Warranty and returns expense (245.1+1.2+0.1)
Cr. Warranty and returns provision
Cr. Cost of Goods sold

246.4
3.5
242.9

FS9-11.
a. A provision is a liability that is a result of a past event that results in a present obligation
that can be estimated reliably and is probable that an outflow of economic benefits will
be required to settle the obligation. They are necessary to reflect expenses associated with
the revenue it helped to earn in the same reporting period.
b. Site restoration and decommissioning costs are obligations that are either legal or
constructive that are required at a future date when the asset is no longer in use. This cost
may include lease cancellation, environmental requirements, or legislative requirement
by under law. These costs require a future cash outflow and are associated with
ownership of the asset as a result they are capitalized and depreciated along with the
capital asset. The resulting obligation is then accreted to the date when the obligation
comes due. For Canadian Tire these would include the cost of cleaning up the site of a
gas station when its closed
c. The balance in the site restoration and decommissioning provision on January 1, 2011
was $24.8 and $26.8 on December 31, 2011. The increase in the balance can be
attributable to the additional amounts incurred, amounts fulfilled, accretion, and change
in the discount rate. The current portion of the provision is $7.4 and the long-term portion
is $19.4.
d. The current portion represents obligations that have to be settled within the next year
while the long-term portion is the obligations that estimated beyond one year.
e. It is very difficult to determine the exact amount of the provision since it represents a
future event, sometimes very far in the future. As a result the provision will have to be
adjusted as new facts regarding the estimates come to light such as change in government
regulations, impact of technological changes, lease terms, and useful lives.
f. Information about asset retirement obligations is useful to stakeholders as it provides
them with information regarding costs and cash flows that will be incurred in the future,
even if the estimates are quite uncertain.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition


Solutions Manual

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Copyright 2013 McGraw-Hill Ryerson Ltd.