CHAPTER 1

Liabilities

QUESTION 1 – 1
Define liabilities.

Answer 1 – 1
Liabilities are present obligations of an entity arising from past transactions or events, the
settlement of which is expected to result in an outflow from the entity of resources embodying
economic benefits.

QUESTION 1 – 2
What are the essential characteristics of an accounting liability?

ANSWER 1 – 2

a. The Liability is the present obligation of a particular entity.

The entity liable must be identified. It is not necessary that the payee to whom the
obligation is owed be identified.

b. The liability arises from past transaction or event.

This means that the liability is not recognized until it is incurred.

c. The settlement of the liability requires an outflow of resources embodying economic

benefits.

This is the very heart of the definition of an accounting liability. The obligation must be
to pay cash, transfer noncash asset or provide service at some future time.

Question 1 – 3

Give examples of liabilities.

Answer 1 – 3

Examples of liabilities include the following:

 a. Accounts payable to suppliers for the purchases of goods or services.
b. Amounts withheld from employees for taxes and for contributions to the Social Security
System or to pension funds.
c. Accruals for wages, interest, royalties, taxes, product warranties and profit sharing plans.
d. Dividends payable in cash or noncash asset.
e. Deposits and advances from customers, officers and shareholders
f. Debt obligations for borrowed funds – notes, mortgages and bonds payable
g. Income tax payable
h. Unearned revenue

QUESTION 1 – 4

Explain the “initial instrument” of liabilities.’

ANSWER 1 – 4

PFRS 9, paragraph 5.1.1, provides that an entity shall measure initially a financial liability at fair
value minus, in the case of financial liability not designated at fair value through profit or loss,
transaction costs that are directly attributable to the issue of the financial liability.

In other words, the transaction costs are included in the initial measurement of a financial
liability measured at amortized cost.

However, the transaction costs are expensed immediately if the financial liability is designated
initially as at fair value through profit or loss.

QUESTION 1 – 5

What is the meaning of “transaction costs?”

ANSWER 1 – 5

Transaction costs are incremental costs that are directly attributable to the issue of a financial
liability.

An incremental cost is one that would not have been incurred if the entity had not issued the
financial liability.

Transaction costs include:

a. Fees and commissions paid to agents, advertisers, brokers, and dealers.

b. Levies by regulatory agencies and securities exchanges
c. Transfer taxes and duties

Transaction costs do not include:

 a. Debt premiums or discounts
b. Financing costs
c. Internal administrative or holding costs

QUESTION 1 – 6

What is the meaning of “fair value” of financial liability?

ANSWER 1 – 6

Fair value is the price that would be paid to transfer a liability in an orderly transaction between
market participants at the measurement date.

Conceptually, the ‘fair value” of the liability is equal to the present value of the future cash
payment to settle the obligation.

The term “present value” is the discounted amount of the future cash outflow in settling an
obligation using the market rate of interest.

QUESTION 1 – 7

Explain the “subsequent measurement” of liabilities.

ANSWER 1 – 7

PFRS 9, paragraph 5.3.1, provides that after initial recognition, an entity shall measure a
financial liability:

1. At amortized cost. Using the effective interest method.

2. At fair value, through profit or loss.

QUESTION 1 – 8

What is the meaning of “amortized cost” of a financial liability?

ANSWER 1 – 8

The “amortized cost” of a financial liability is the amount at which the financial liability is
measured at initial recognition minus principal repayment, plus or minus the cumulative
amortization using the effective interest method of any difference between the initial amount and
the maturity amount.

Simply stated, the difference between the face amount and the present value of the financial
liability is amortized using the effective interest method.
Actually, the difference between the face amount and the present value is either discount or
premium on the issue of financial liability.

QUESTION 1 – 9

Explain the measurement of noncurrent liabilities.

ANSWER 1 – 9

Noncurrent liabilities, for example, bond payable and noninterest - bearing note payable, are
initially measured at present value and subsequently measured at amortized cost.

If the long-term note payable is interest-bearing, it is initially and subsequently measured at face
amount.

In this case, the face amount is equal to the present value of the note payable.

QUESTION 1 – 10

Explain the measurement of current liabilities.

ANSWER 1 – 10

Conceptually, all liabilities are initially measured at present value and subsequently measured at
amortized cost.

However, in practice, current liabilities or short-term obligations are not discounted anumore but
measured and reported at their face amount.

The reason is that the discount or the difference between the face amount and the present value is
usually not material and therefore ignored.

QUESTION 1 – 11

Explain the “fair value option” of measuring a financial liability.

ANSWER 1 – 11

PFRS 9, paragraph 4.2.2, provides that at initial recognition an entity may irrevocably designate
a financial liability at fair value through profit or loss when doing so results in more relevant
information.

In other words, under the fair value option, the financial liability, for example, bond payable, is
measured at fair value at every year-end and any change in fair value is recognized in profit or
loss.
The amortization rules for discount or premium no longer apply.

Accordingly, under the fair value option, the interest expense is recognized using the nominal or
stated interest rate and not the effective interest rate.

QUESTION 1 – 12

What are “estimated liabilities”?

ANSWER 1 – 12

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

In many cases, the date when the obligation is due is not also definite and in some instances, the
exact payee cannot be identified or determined.

But inspite of these circumstances, the existence of the estimated liabilities is valid and
unquestioned,

Estimated liabilities are either current or noncurrent in nature.

Examples include estimated liability is considered as a “provision” which is both probable and
measurable.

The subject matter of provision is discussed lengthily in Chapter 3.

QUESTION 1 – 13 Multiple choice (PFRS 9)

1. An entity shall measure initially a financial liability not designated at fair value through
profit loss at

a. Fair value
b. Fair value plus directly attributable transaction costs
c. Fair value minus directly attributable transaction cost
d. Face amount

2. Transaction costs directly attributable to the issue of a financial liability include all of the
following, except

a. Fees and commissions paid to agents

b. Levies by regulatory agencies
c. Transfer taxes and duties
d. Financing cost
 3. The initial fair value of a financial liability is defined as the

a. Amount for which a liability is paid

b. Amount for which a liability is paid in an orderly transaction
c. Amount for which a liability is paid between market participants
d. Amount for which a liability is paid in an orderly transaction between market
participants at the measurement date.

4. After initial recognition, an entity shall measure a financial liability at

I. Amortized cost using the effective interest method.

II. Fair value through profit or loss

a. I only
b. II only
c. Either I or II only
d. Neither I nor II

5. Which of the following statements is true in relation to the fair value option of
measuring a financial liability?

I. At initial recognition, an entity may irrevocably designate a financial liability at

fair value through profit or loss
II. The financial liability is measured at every year-end and any changes in fair value
are recognized in profit or loss.
III. The interest expense on the financial liability is recognized using the effective
interest rate.

a. I and II only
b. I and III only
c. II and III only
d. I, II and III

ANSWER 1 – 13
1. C
2. D
3. D
4. C
5. A

QUESTION 1 14 Multiple choice (IAA)

1. The conceptually appropriate method of measuring a liability is to

a. Discount the amount of expected cash outflows that are necessary to liquidate the
liability using the market rate of interest at the date the liability was initially incurred.
 b. Discount the amount of expected cash outflows that are necessary to liquidate the
liability using the market rate of interest at the date of the financial statements.
c. Record as liability the amount of cash that would be required to pay the liability in the
ordinary course of business on the date of the financial statements.
d. Record as liability the amount of cash actually received when a liability was incurred.

2. For a liability to exist

a. A past transaction or event must have occurred.

b. The exact amount must be known.
c. The identity of the party owed must be known.
d. A obligation to pay cash in the future must exist.

3. Which of the following represents a liability?

a. The obligation to pay for goods that an entity expects to order from suppliers next
year.
b. The obligation to provide goods that customers have ordered and paid for during the
current year.
c. The obligation to pay interest on a five-year note payable that was issued the last day
of the current year
d. The obligation to distribute an entity’s own shares next year as a result of a stock
dividend declared near the end of the current year.

4. Which of the following does not meet the definition of a liability?

a. The signing of a three-year employment contract at a fixed annual salary

b. An obligation to provide goods or services in the future
c. A note payable with no specified maturity date
d. An obligation that is estimated in amount

5. Which of the following statements in relation to liabilities is not valid?

a. Current liabilities shall not be offset against assets that are to be applied to their
liquidation.
b. Unasserted claims are never accrued because to do so would require an entity to
implicitly admit liability.
c. Commitments to make future purchases shall be accrued if losses become probable
and if the amount is reasonably measurable.
d. Estimated liabilities shall be accrued because there are known to exist and are only
uncertain as to amount.

Answer 1-14
1. a
2. a
3. b
 4. a
5. b

QUESTION 1-15 Multiple choice (IAA)

1. Which of the following is a characteristic of a current liability but not a noncurrent

liability?
a. Unavoidable obligation
b. Present obligation that entails settlement by probable future transfer of cash,
goods or services.
c. Settlement is expected within the normal operating cycle or within 12 months,
whichever is longer
d. The obligating event creating the liability has already occurred

2. Which of the following is not considered a characteristic of a liability?

a. Present obligation
b. Arises from past event
c. Results in an outflow of resources
d. Liquidation is reasonably expected to require use of existing resources classified
as current assets

3. What is the relationship between current liabilities and an operating cycle?

a. Liquidation of current liabilities is reasonably expected within the operating cycle
or one year, whichever is longer.
b. Current liabilities are the result of operating transactions
c. Current liabilities cannot exceed the amount incurred in operating cycle
d. There is no relationship between the two

4. What is the relationship between present value and the concept of a liability?
a. Present value is used to measure certain liabilities
b. Present value is not used to measure liabilities
c. Present value is used to measure all liabilities
d. Present value is used to measure noncurrent liabilities only

5. Which of the following is not an acceptable presentation of current liabilities?

a. Listing current liabilities in the order of maturity
 b. Listing current liabilities according to amount
c. Offsetting current liabilities against assets that are to be applied to their
liquidation
d. Showing current liabilities in the order of liquidation preference

ANSWERS 1-15
1. c
2. d
3. a
4. a
5. c

CHAPTER 2

CURRENT LIABILITIES
QUESTION 2-1
Explain an estimated premium liability.

ANSWER 2-1
Premiums are articles of value such as toys, dishes, silverware, and other goods and in some
cases cash payments, given to customers as result of past sales or sales promotion activities.
In order to stimulate the sale of their products, entities offer premiums to customers in return for
product labels, box tops, wrappers and coupons.
Accordingly, when the merchandise in sold, an accounting liability for the future distribution of
the premium arises and should be given accounting recognition.

QUESTION 2-2
What is a customer loyalty program?

ANSWER 2-2
Many entities use a customer loyalty program to build brand, loyalty, retain their valuable
customers and of course, increase sales volume.
The customer loyalty program is generally designed to reward customers for past purchases and
to provide them with incentives to make further purchases.
If a customer buys goods or services, the entity grants the customer award credits often
described as “points”.
The entity can redeem the “points” by distributing to the customer free or discounted goods or
services.

QUESTION 2-3
Explain the recognition and measurement of the “points” awarded under a customer loyalty
program.
ANSWER 2-3
Under IFRIC 13, an entity shall account for the award credits as a “separate component of the
initial sale transaction”.
In other words, the granting of award credits is effectively accounted for as “future delivery of
goods or services”.
Accordingly, the fair value of the consideration received with respect to the initial sale shall be
allocated between the award credits and the sale.
The consideration allocated to the award credits is measured at fair value. The fair value is equal
to the amount for which the award credits could be sold separately.
The subsequent recognition of the amount allocated to the award credits as revenue depends on
the following:
a. The entity supplies the awards itself.
b. A third party supplies the awards

QUESTION 2-4
Explain the recognition of the award credits “if the entity supplies the awards itself”.

ANSWER 2-4
If the entity supplies the awards itself, the consideration allocated to the award credits is initially
recognized as deferred revenue and subsequently recognized as revnue when the award credits
are redeemed.

The amount of revenue recognized shall be based on the number of award credits that have been
redeemed relative to the total number expected to be redeemed.

QUESTION 2-5
Explain the recognition of the award credits “if a third party supplies the awards”.

ANSWER 2-5
If a third party supplies the awards, the entity shall assess whether it is collecting the
consideration allocated to the award credits on its own account as principal in the transaction or
on behalf of the third party as agent of the third party.

Whether as principal or agent, the revenue from the award credits is recognized at the point of
initial sale.

The reason is that at this point, the entity has already fulfilled its obligation to the customer by
granting the award credits and the third party is obliged to supply the awards and of course
entitled to receive consideration for doings so.

If the entity is collecting the consideration as principal in the transaction, the amount of revenue
is equal to the gross consideration allocated to the award credits.

If the entity is collecting the consideration as agent of the third party, the amount of revenue is
equal to the net amount retained on its own account.

This net amount is the difference between the consideration allocated to the award credits and the
amount payable to the third party for supplying the awards.

QUESTION 2-6
Explain an estimated warranty liability

ANSWER 2-6
Home appliances like television sets, stereo sets, ratio sets, refrigerators and the like are often
sold under guarantee or warranty to provide free repair service or replacement during a specified
period if the products are defective.

Such entity policy may involve significant costs on the part of the entity if the products sold
prove to be defective in the future within the specified period of time.

Accordingly, at the point of sale, a constructive obligation arises and a liability is incurred.

QUESTION 2-7
Explain “payroll taxes payable”

ANSWER 2-7
Under our law, the entity as an employer is required to withhold from the salaries of each
employee the following:

a. Income tax payable by the employee

b. Employee’s contribution to the Social Security System or SSS
c. Employee’s contribution for Philhealth
d. Employee’s contribution to the Pag-ibig Fund

Such amounts withheld from the salaries of the employees shall be recognized as “payroll taxes
payable” until remitted by the entity to the appropriate government authority.

In addition to the amounts withheld from the salaries of the employees, the entity is required by
law to make a contribution for SSS, Philhealth and Pag-ibig fund representing its share in the
benefits of the employees

QUESTION 2-8
Explain “value added taxes payable”.

ANSWER 2-8
Under the National Internal Revenue Code, an entity is required to collect value added taxes
from customers on sales of tangible personal property and certain services.
Such value added taxes collected shall be recognized as “value added taxes payable” and
remitted monthly to the Bureau of Internal Revenue.

QUESTION 2-9
Explain “gift certificate payable”

ANSWER 2-9
Many megamalls, department stores and supermarkets sell gift certificates which are redeemable
in merchandise.

When the gift certificates are sold, the amount received is initially recognized as unearned
revenue or specifically “gift certificate payable”.

The subsequent redemption of the gift certificates is recognized by debiting gift certificate
payable and crediting sales revenue.

The Philippine Department of Trade and Industry recently ruled that gift certificates no longer
have an expiration period.

The gift certificates may be forfeited as other income when not presented for redemption for a
long period of time.

QUESTION 2-10
What are “refundable deposits”?

ANSWER 2-10
Refundable deposits consist of cash or property received from customers but which are
refundable after compliance with certain conditions.

The best example of a refundable deposit is the customer deposit required for returnable
containers like bottles, drums, tanks and barrels.

QUESTION 2-11
What are the four variations in the bonus computation?

ANSWER 2-11
Large entities often compensate key officers and employees by way of bonus for superior income
realized during the year.

The main purpose of this scheme is to motivate officers and employees by directly relating their
well-being to the success of the entity.

This compensation plan results in liability that must be measured and reported in the financial
statements. The bonus computation usually has four variations:

1. Bonus is expressed as a certain percent of income before bonus and before tax.
2. Bonus is expressed as a certain percent of income after bonus but before tax.
3. Bonus is expressed as a certain percent of income after bonus and after tax.
4. Bonus is expressed as a certain percent of income after tax but before bonus.

QUESTION 2-12
Explain a “deferred revenue”

ANSWER 2-12
Deferred revenue or unearned revenue is income already received but not yet earned.
Deferred revenue may be realizable within one year or in more than one year from the end of
reporting period.

If the deferred revenue is realizable within one year, it is classified as current liability.

Typical examples of current deferred revenue are unearned interest income, unearned rental
income and unearned subscription revenue.

If the deferred revenue is realizable in more than one year, it is classified as noncurrent liability.

Typical examples of noncurrent deferred revenue are unearned revenue from long-term service
contracts and long-term leasehold advances.

QUESTION 2-13 Multiple choice (IFRIC 13)

1. It is marketing scheme whereby an entity grants award credits to customers and the entity
can redeem the award credits in exchange for free or discounted goods or services.

a. Customer loyalty program

b. Premium Plan
c. Marketing Program
d. Loyalty Award
 2. The award credits granted to customers under a customer loyalty program is often
described as

a. Points
b. Awards
c. Credits
d. Royalty

3. The consideration allocated to the award credits is measured at

a. Fair value of the award credits

b. Carrying amount of goods to be received in exchange
c. Fair value of the goods to be received in exchange
d. The proportion of the fair value of the award credits relative to the total
consideration received from the initial sale of the goods

4. Under a customer loyalty program, if the entity supplies the awards itself, the
consideration allocated to the award credits

a. Shall be recognized as revenue immediately

b. Shall not be accounted for as revenue separately
c. Shall be recognized initially as deferred revenue and amortized as revenue over a
reasonable period not exceeding five years
d. Shall be recognized initially as deferred revenue and subsequently recognized as
revenue upon the redemption of the award credits

CHAPTER 3

PROVISIONS AND CONTINGENT

LIABILITY
 Introduction for Chapter 3 is missing

QUESTION 3-7

Explain the measurement of a provision.

ANSWER 3-7

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

The best estimate is the amount that an entity would rationally pay to settle the obligation at the
reporting date or to transfer it to a third party at that time.

Where a single obligation is being measured, the individual must likely outcome may be the best
estimate. However, even in such a case, the entity shall consider other possible outcomes.

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

QUESTION 3-8

Explain the “expected value method” of measuring a provision.

ANSWER 3-8

This is the statistical method of estimation applied where the provision being measured involves
a large population of items.

Under this method, the obligation is estimated by “weighting all possible outcomes by their
associated possibilities.”

QUESTION 3-9

Enumerate the other considerations in the measurement of provision.

ANSWER 3-9

a. The risks and uncertainties that inevitably surround many events and circumstances shall
be taken into account in reaching the best estimate of a provision.

b. Where the effect of the time value of money is material, the amount of provision shall be
present value of the expenditures expected to be required to settle the obligation.
 c. Future events that effect the amount required to settle an obligation shall be reflected in
the amount of a provision where there is a sufficient objective evidence that they will
occur.

Examples of such future events include new legislation and changes in technology.

d. Gains from expected disposal of assets shall not be taken into account in measuring a
provision.

e. Where some or all of the expenditure required to settlea provision is expected to be

reimbursed by another party, the reimbursement shall be recognized when it is virtually
certain that reimbursement will be received if the entity settles the obligation.

The reimbursement shall be treated as a separate asset and not “netted” against the
estimated liability for the provision.

The amount shall not exceed the amount of the provision.

However, in the income statement, the expense relating to the provision may be presented
net of the reimbursement.

f. Provisions shell be reviewed at each reporting date and adjusted to reflect the current
best estimate.

g. A provision shall be used only for expenditures for which the provision was originally
recognized.

h. Provision shall not be recognized for future operating losses.

i. If an entity has an onerous contract, the present obligation under the onerous contract
shall be recognized and measured as a provision.

QUESTION 3-10

Explain an “onerous contract.”

ANSWER 3-10

An onerous contract is a contract in which the unavoidable costs of meeting the obligation under
the contract exceed the economic benefits expected to be received under the contract.

PAS 37, paragraph 68, mandates that the unavoidable costs under a contract represent the “least
net cost of exiting from contract.”

Such cost is the lower amount between the cost of fulfilling the contract and the compensation
or penalty arising from failure to fulfill the contract.
QUESTION 3-11

Give examples of a provision.

ANSWER 3-11

1. Warranty

The best estimate of the warranty cost is recognized as a provision because in this case
there is clear legal obligation arising from an obligating event which is the sale of a
product with warranty.

2. Environmental contamination

If an entity has an environmental policy such that other parties would expect the entity to
clean up any contamination, or if the entity has broken current environmental legislation,
a provision for environmental damage shall be made.

The obligating event is the contamination of the property which gives rise to constructive
or legal obligation.

A provision is recognized for the best estimate of the cost of cleaning up the
contamination.

3. Decommissioning or abandonment cost

When an oil entity initially purchases an oil field it is put under a legal obligation to
decommission the site at the end of its life

The cost of abandonment or decommissioning shall be recognized as a provision and may

be capitalized as cost of the oil field.

4. Court case

After a wedding in the current year, ten people died possibly as a result of food poisoning
from products sold by the entity. Legal proceedings are started seeking damages from the
entity.

When the entity prepares the financial statements for the current year, its lawyers advise
that owing to the development in the case, it is probable that the entity would be found
liable.

A provision in recognized for the best estimate of the damages because on the basis of
available evidence, there is a present obligation.

5. Guarantee
 In the current year, an entity gives a guarantee of certain borrowings of another entity.

During the year, the financial condition of the borrower deteriorates and at year-end, the
borrower files a petition for bankruptcy.

A provision is recognized for the best estimate of the guarantee obligation because there
is a legal obligation arising from the obligating event which is the guarantee.

It is probable that an outflow of resources embodying economic benefits would be

required to settle the guarantee obligation because there is a petition for bankruptcy on
the part of the borrower.

QUESTION 3-12

What is restructuring?

ANSWER 3-12

PAS 37, paragraph 10, defines restructuring as a “program that is planned and controlled by
management and materially changes either scope of a business of an entity or the manner in
which that business is conducted”.

Examples of events that may qualify as restructuring include:

a. Sale or termination of a line of a business.

b. Closure of business location in a region or relocation of business activities from one
location to another.
c. Change in management structure, such as elimination of a layer of management.
d. Fundamental reorganization of an entity that has a material and significant impact on the
operations.

QUESTION 3-13

Explain the recognition of a provision for restructuring.

ANSWER3-13

A constructive obligation for restructuring arises when two conditions are present:

1. The entity has a detailed format plan for the restructuring outlining at least the business
or part of the business being restructured, the principal location affected, the location,
function and approximate number of employees who will be compensated for terminating
their employment, when the plan will be implemented, and the expenditures that will be
undertaken.
 2. The entity has raised valid expectation in the minds of those affected that the entity will
carry out the restructuring by starting to implement the plan and announcing its main
features to those affected by it.

QUESTION 3-14

What is the amount of restructuring provision?

ANSWER 3-14

A restructuring provision shall include only direct expenditures arising from the restructuring,
meaning, those expenditures that are necessarily entailed by the restructuring and not associated
with the ongoing activities of the entity.

For example, salaries and benefits of employees to be incurred after the operations cease and
that are associated with the closure of the operations shall be included in the amount of the
restructuring provision.

PAS 37, paragraph 81, specifically excludes the following expenditures from the restructuring
provision:

a. Cost of retraining or relocating continuous staff.

b. Marketing or advertising program to promote the new entity image.
c. Investment in new system and distribution network.

QUESTION 3-15

What is a contingent liability?

ANSWER 3-15

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

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

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

QUESTION 3-16

Explain the three ranges of outcome of future uncertain events.

ANSWER 3-16
The uncertainty relating to future events can be expressed by a range of outcome.

The range of outcome may be described as follows:

a. Probable – The future event is likely to occur. As a rule of thumb, probable means more
than 50% likely.

b. Reasonably probable – The future event is less likely to occur.

c. Remote – The future event is least likely to occur or the chance of the future event
occurring is very slight.

QUESTION 3-17

Distinguish a contingent liability and a provision.

ANSWER 3-17

The second definition of a contingent liability states that a contingent liability is a present
obligation.

However, the present obligation is either probable or measurable but not both to be considered a
contingent liability.

If the present obligationis both probable and measurable, it is not a contingent liability but a
provisionto be recognized in the financial statements.

QUESTION 3-18

What is the treatment of a contingent liability?

ANSWER 3-18

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

Required disclosures in relation to contingent liability

a. Brief description of the nature of contingent liability

b. An estimate of its financial effects.

c. An indication of the uncertainties that exist.

d. Possibility of any reimbursement

If the contingent liability is remote, no disclosure is necessary.

QUESTION 3-19

What is a contingent asset?

ANSWER 3-19

PAS 37, paragraph 10, defines a contingent asset as a “possible asset that arises from past event
and whose existence will be confirmed by the occurrence or nonoccurrence of one or more
uncertain future events not wholly within the entity’s control”.

A contingent asset shall not be recognized because this may result to recognition of income that
may never be realized.

However, when the realization of income is virtually certain, the related asset is no longer
contingent asset and its recognition is appropriate.

A contingent asset is only disclosed when it is probable.

Required disclosures in relation to contingent asset

a. Brief description of the contingent asset.

b. An estimate of the financial effect.

If a contingent asset is only possible or remote, no disclosure is required.

QUESTION 3-20 Multiple Choice (PAS 37)

1. Which of the following is the correct definition of a provision?

a. A possible obligation arising from past event
b. A liability of uncertain timing or amount
c. A liability which cannot be easily measured
d. An obligation to transfer funds to an entity

2. A provision shall be recognized as liability when

I. An entity has a present obligation as a result of a past event.

II. It is probable that an outflow of resources embodying economic benefits will be
required to settle the obligation.
III. The amount of the obligation can be measured reliably.

a. I and II only
b. I and III only
c. II and III only
 d. I, II, and III

3. A constructive obligation is an obligation

I. That is derives from an entity’s action that the entity will accept certain
responsibilities because of past practice, published policy or current statement.
II. The entity has created a valid expectation in other parties that it will discharge
those responsibilities.

a. I only
b. II only
c. Both I and II
d. Either I and II

4. It is an event that creates a legal or constructive obligation because the entity has no other
realistic alternative but to settle the obligation.
a. Obligating event
b. Past event
c. Subsequent event
d. Current event

5. An outflow of resources embodying economic benefits is regarded as “probable” when

a. The probability that the event will occur is greater than the probability that the
event will not occur.
b. The probability that the event will not occur is greater than the probability that the
event will occur.
c. The probability that the event will occur is the same as the probability that the
event will not occur.
d. The probability that the event will occur is 90% likely.

6. What amount is recognized as provision?

a. Best estimate of the expenditure
b. Minimum of the range
c. Maximum of the range
d. Midpoint of the range

7. Where there is a continuous range of possible outcomes, and each point in that range is
likely as any other, the range to be used is the
a. Minimum
b. Maximum
c. Midpoint
d. Sum of the minimum and maximum

8. When the provision involves a large population of items, the estimate of the amount

a. Reflects the weighting of all possible outcomes by their associated probabilities.

b. Is determined as the individual most likely outcome.

c. May be the individual most likely outcome adjusted for the effect of other possible outcomes.

d. Midpoint of the possible outcomes.

9. When the provision arises from a single obligation, the estimate of the amount

a. Reflects the weighting of all possible outcomes by their associated probabilities.

b. Is determined as the individual most likely outcome.

c. Is the individual most likely outcome for the effect of the other possible outcomes.

d. Midpoint of the possible outcomes.

10. Which statement is incorrect where some or all of the expenditure required to settle a provision is
expected to be reimbursed by another party?

a. The reimbursement shall be recognized only when it is virtually certain that the reimbursement would
be received if the entity settles the obligation.

b. The amount of the reimbursement shall not exceed the amount of the provision.

c. In the income statement, the expense relationg to the provision may be presented net of the
reimbursement.

d. The reimbursement shall not be treated as separate asset and therefore “netted” against the estimated
liability for the provision.

ANSWER 3-20

1. b 6. a
2. d 7. c
3. c 8. a
4. a 9. c
5. a 10. D

QUESTION 3-21 Multiple choice (PAS 37)

1. For an event to be an obligating event, it is necessary that the entity has no realistic alternative but to
settle the obligation created by the event and this is the case only:

I. Where the settlement of the obligation can be enforced by law.

II. Where the event creates valid expectation in other parties that the entity will discharge the obligation
as in the case of a constructive obligation.

a. I only
b. II only
c. Either I or II
d. Neither I nor II

2. Which of the following statements is true concerning the measurement of a provision?

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

II. The best estimate of the expenditure required to settle the present obligation is the amount that an
entity would rationally pay to settle the obligation at the end of reporting period or to transfer it to a third
party at that time.

a. I only
b. II only
c. Both I and II
d. Neither I nor II

3. Which of the following statements is true in relation to recognition of a provision?

I. No provision is recognized for costs that need to be incurred to operate in the future.

II. A provision for the decommissioning of an oil installation or a nuclear plant station shall be recognized
to the extent that an entity is obliged to rectify damage already caused.

a. I only
b. II only
c. Both I and II
d. Neither I nor II

4. Provisions shall be discounted if the effect is material. The discount rate should satisfy all of the
following except

a. Reflect current market assessment of the time value of money.

b. Reflect risks specific to the liability
c. Not reflect risks for which future cash flow estimates have been adjusted.
d. Be post-tax discount rate.

5. Which of the following terms is associated with recognizing a provision?

a. Possible
b. Virtually certain
c. Remote
d. Probable
ANSWER 3-21
1. c
2. c
3. c
4. d
5. d

QUESTION 3-22 Multiple choice (PAS 37)

1. Which of the following statements is true in relation to the measurement of a provision?

I. The risks and uncertainties that inevitably surround many events and circumstances shall be taken into
account in reaching the best estimate of a provision.

II. Where the effect of the time value of money is material, the amount of provision shall be the present
value of the expenditure expected to settle the obligation

a. I only
b. II only
c. Both I and II
d. Neither I nor II

2. Which of the following statements is true in relation to the measurement of a provision?

I. Future events that may affect the amount required to settle the obligation shall be reflected in the
amount of the provision where there is sufficient object evidence that the future events will occur.

II. Gains from expected disposal of assets shall be take into account ion measuring a provision.

a. I only
b. II only
c. Both I and II
d. Neither I nor II

3. Which of the following statements is incorrect concerning recognition of a provision?

a. Provisions shall be reviewed at the end of each reporting period and adjusted to reflect the current best
estimate.
b. A provision shall be used only for expenditures for which the provision was originally recognized.
c. Provisions shall be recognized for future operating losses.
d. If an entity has an onerous contract, the present obligation under the contract shall be recognized and
measured as a provision.

4. It is a contract in which the unavoidable costs of meeting the obligation under the contract exceed the
economic benefits to be received under the contract.

a. Onerous contract
b. Executory contract
c.Executed contract
d. Sale contract

5. The unavoidable costs under an onerous contract represent the “least net cost of exiting from the
contract” which is equal to

a. Cost of fulfilling the contract

b. Penalty arising from failure to fulfill the contract
c. Lower of cost of fulfilling the contract or the penalty arising from failure to fulfill the contract.
d. Higher of the cost of fulfilling the contract or the penalty arising from failure to fulfill the contract

ANSWER 3-22
1. c
2. a
3. c
4. a
5. c

QUESTIONS 3-23 Multiple choice (PAS 37)

1. This is defined as “a structured program that is planned and controlled by the management that
materially changes either the scope of a business of an entity or the manner in which that business is
conducted”.

a. Restructuring
b. Liquidation
c. Recapitalization
d. Corporate revamp

2. Examples of events that qualify as restructuring include all of the following, except

a. Sale or termination of business

b. Closure of business location in a region or relocation of business from one location to another
c. Change in management structure such as elimination of a layer of management
d. Fundamental reorganization of an entity that has an immaterial and insignificant impact on the
operation

3. Which is a cost of restructuring?

a. Cost of retraining or relocation continuing staff

b. Marketing or advertising cost
c. Investment in new system and distribution network
d. Cost of relocating business activities from one location to another

4. It is the abusive practice of manipulation and creative accounting by dumping all kinds of provisions
under banner of provision for restructuring.

a. Big bath provision

b. Creative accounting
c. Cookie jar
d. General reserve

5. A provision for restructuring is required when

I. The entity has a detailed plan for the restructuring.

II. The entity has raised valid expectation in the minds of those affected that the entity will carry out the
restructuring by announcing its main features to those affected by it

a. I only
b. II only
c. Both I and II
d. Neither I nor II
ANSWER 3-23

1. a
2. d
3. d
4. a
5. c

QUESTIONS 3-24 Multiple choice (IFRS)

1. A legal obligation is an obligation that is derived from all of the following, except

a. Legislation
b. A contract
c. Other operation of law
d. An established pattern of past practice

2. For which of the following should a provision be recognized?

a. Future operating losses

b. Obligations under insurance contracts
c. Reductions in fair value of financial instruments
d. Obligations for plant decommissioning costs

3. Provisions shall be recognized for all the following, except

a.Cleaning-up costs of contaminated land when an oil entity has a published policy that it will undertake
to clean up all contamination that it causes.
b. Restructuring costs after a binding sale agreement has a signed.
c. Rectification costs after a binding sale agreement has been signed.
d. Future refurbishment costs due to introduction of a new computer system.

4. An entity is closing one of its operating divisions, and the conditions for making restructuring provision
have been met. The closure will happen in the first quarter of the next financial year. At the current year-
end, the entity has announced the formal plan publicly and is calculating the restructuring provision.
Which of the following costs should be included in the restructuring provision?

a. Retraining staff continuing to be employed

b. Relocation costs relating to staff moving to other divisions
c. Contractually required costs of retraining staff being closed
d. Future operating losses of the division being closed up to the date of closure

5. An entity operates chemical plants. Its published policies include a commitment to making good any
damage caused to the environment by the operations. It has always honored this commitment. Which of
the following scenarios would give rise to an environmental provision?

a. On past experience it is likely that a chemical spill which would result in having to pay fines and
penalties will occur in the next year.
b. Recent research suggests there is a possibility that the entity’s actions may damage surrounding
wildlife.
c. The government has outlined plans for a new law requiring all environmental damage to be rectified.
d. A chemical spill from one of the entity’s plants has caused harm to the surrounding area and wildlife.

ANSWER 3-24

1. d
2. d
3. d
4. c
5. d

QUESTIONS 3-25 Multiple choice (IFRS)

1. When should a “provision” be recognized?

a. When there is a legal obligation arising from a past obligating event, the probability of the outflow of
resources is more than remote but less than probable, and a reliable estimate can be made of the amount
of the obligation.
b. When there is a constructive obligation as a result of a past obligating event, the outflow of resources is
probable, and a reliable estimate can be made of the amount of the obligation.
c. When there is a possible obligation arising from a past event, the outflow of resources is probable, and
an approximate amount can be set aside toward the obligation.
d. When management decides that it is essential that a provision be made for unforeseen circumstances
and keeping in mind this year the profits were enough but next year there may be losses.

2. A competitor has sued an entity for unauthorized use of its patented technology. The amount that the
entity may be required to pay to the competitor if the competitor succeeds in the lawsuit is determinable
with reliability, and according to the legal counsel it is less than probable but more than remote that an
outflow of the resources would be needed to meet the obligation. The entity that was sued shall at year-
end
a. Recognize a provision for the possible obligation
b. Make a disclosure of the possible obligation in the notes to financial statements
c. Make no provision or disclosure and wait until the lawsuit is finally decided and then the expense hat
amount paid on settlement, if any.
d. Set aside, as an appropriation, a contingency reserve, an amount based on the best estimate of the
possible liability

3. A factory owned by an entity was destroyed by fire. The entity lodged an insurance claim of the value
of the factory building and plant, and an amount equal to one year’s net profit. During the year, there were
a number of meetings with the representatives of the insurance company. Finally, before year-end, it was
decided that the entity would receive compensation for 90% of its claim. The entity received a letter that
the settlement check for that amount had been mailed, but it was not received before year-end. How
should the entity treat this in the financial statements?

a. Disclose the contingent asset in the footnotes.

b. Wait until next year when the settlement check is actually received and not recognized or disclose this
receivable at all since at year-end it is a contingent asset.
c. Record 90% of the claim as a receivable as it is virtually certain that the contingent asset will be
received.
d. Record 100% of the claim as a receivable at year-end as it is virtually certain that the contingent asset
will be received, and adjust the 10% next year when the settlement check is actually received.
4. The board of directors of an entity decided in the latter part of the current year to wind up
international operations in the Far East and move them to Australia. The decision was
based on a detailed formal plan of restructuring. This decision was conveyed to all
workers and management personnel at the headquarters in Europe. The cost of the
restructuring plan can be estimated reliably. How should the entity treat the restructuring
at the current year-end?
a. Disclose only the restructuring decision and the cost of restructuring because the
entity has not announced the restructuring to those affected by the decision and
thus has not raised an expectation that the entity would actually carry out the
restructuring.
b. Recognize a provision for restructuring since the board of directors has approved
it and it has been announced in the headquarters of the entity in Europe.
c. Mention the decision to restructure and the cost involved in the chairman’s
statement in the annual report.
d. Do nothing because the restructuring has not commenced before year-end
5. An entity has been served a legal notice at year-end by the Department of Environment
and Natural Resources to fit smoke detectors in its factory on or before middle of next
year. The cost of fitting smoke detector can be measured reliably. How should the entity
treat this at year-end?
a. Recognize a provision for the current year equal to the estimated amount.
b. Recognize a provision for the current year equal to one-half only of the estimated
amount.
c. No provision is recognized at year-end because there is no present obligation for
the future expenditure since the entity can avoid the future expenditure by
changing the method of operations but disclosure is required.
d. Ignore this for purpose of the financial statements at year-end.

ANSWER 3-25
1. b
2. b
3. c
4. a
5. c

QUESTION 3-26 Multiple choice (PAS 37)

1. A contingent liability is a
I. Possible obligation that arises from past event and whose existence will be
confirmed only by the occurrence or nonoccurrence of one or more uncertain
future events not only within the control of the entity.
II. Present obligation that arises from past event and it is probable that an outflow of
resources embodying economic benefits will be required to settle the obligation
and the amount of the obligation can be measured reliably.
 a. I only
b. II only
c. Both I and II
d. Neither I nor II
2. Which of the following statements in relation to a contingent liability is true?
a. An obligation as a result of the entity creating a valid expectation that it will
discharge its responsibilities is a contingent liability.
b. A present obligation that arises from past event but cannot be reliably measured is
a contingent liability.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
3. Which of the following statements is incorrect concerning a contingent liability?
a. A contingent liability is not recognized in the financial statements.
b. A contingent liability is disclosed only.
c. If the contingent liability is remote, no disclosure is required.
d. A contingent liability is both probable and measurable.
4. It is a possible asset that arises from past event and whose existence will be
confirmed only by the occurrence or nonoccurrence of one or more uncertain future
events not wholly within the control of the entity.
a. Contingent asset
b. Other asset
c. Suspense account
d. Current asset
5. Which of the following statements is incorrect concerning a contingent asset?
a. A contingent asset is not recognized in the financial statements because this
may result to recognition of income that may never be realized.
b. When the realization of income is virtually certain, the related asset is no
longer contingent asset and its recognition is appropriate
c. A contingent asset is only disclosed when the occurrence of the future event is
possible or remote.
d. The related gain arising from the contingent assets is recognized usually when
it is realized.

ANSWER 3-26

1. a
2. b
3. d
4. a
5. c

QUESTION 3-27 Multiple choice (AICOA Adapted)

1. the likelihood that the future event will or will not occur can be expressed by a range
of outcome. Which range means that the future event occurring is very slight?
a. Probable
b. Reasonably possible
c. Certain
d. Remote
2. An entity did not record an accrual for a present obligation but disclose the nature of
the obligation and the range of the loss. How likely is the loss?
a. Remote
b. Reasonably possible
c. Probable
d. Certain
3. A present obligation that is probable and for which the amount can be reliably
measured shall
a. Not be accrued but shall be disclosed in the notes to the financial statements.
b. Be accrued by debiting an appropriated retained earnings account and
crediting a liability account.
c. Be accrued by debiting an expense account and crediting an appropriated
retained earnings account
d. Be accrued by debiting an expense account and crediting a liability account.
4. An item that is not a contingent liability is
a. Premium offer to customers for labels or box tops
b. Accommodation endorsement on customer note
c. Additional compensation on customer note dispute now being arbitrated
d. Pending lawsuit
5. An entity has a self-insurance plan. Each year, the entity appropriated retained
earnings for contingencies in an amount equal to insurance premiums saved less
recognized losses from lawsuits and other claims. As a result of an accident in the
current year, the entity is a defendant in a lawsuit in which it would probably have to
pay measurable amount of damages. What are the effects of the lawsuit’s probable
outcome on the entity’s financial statements for the current year?
a. An increase in expenses and no effect on liabilities
b. An increase in both expenses and liabilities
c. No effect on expenses and an increase in liabilities
d. No effect on either expenses or liabilities
6. Contingent assets are usually recognized when
a. Realized
b. Occurrence is reasonably possible and the amount can be reliably measured
c. Occurrence is probable and the amount can be reliably measured
d. The amount can be reliably measured
7. Which of the following is the proper accounting treatment of a contingent asset?
a. Ac accrued account
b. Deferred earnings
c. An account receivable with an additional disclosure explaining the nature of
the transaction
 d. A disclosure only
8. When the occurrence of a contingent asset is probable and its amount can be reliably
measured, the contingent asset shall be
a. Recognized in the statement of financial position and disclosed.
b. Classified as an appropriation of retained earnings.
c. Disclosed but not recognized in the statement of financial position
d. Neither recognized in the statement of financial position nor disclosed.
9. An entity operates a plant in a foreign country. It is probable that the plant will be
expropriated. However, the foreign government has indicated that the entity will
receive a definite amount of compensation for the plant/ the amount of compensation
is less than the fair value but exceeds the carrying amount of the plant. The contingent
asset shall be reported.
a. As a valuation allowance as a part of shareholder’s equity
b. As a fixed asset valuation allowance account
c. In the notes to financial statements
d. In the statement of financial position
10. As year-end, an entity was suing a competitor for patent infringement. The award
from the probable favorable outcome could be reliably measured. The entity’s
financial statements shall report the expected award as
a. Receivable and revenue
b. Receivable and reduction of patent
c. Receivable and deferred revenue
d. Disclosure only

ANSWER 3 -27

1. d 6. a
2. b 7. d
3. d 8. c
4. a 9. c
5. b 10. D

QUESTION 3-28 Multiple choice (IAA)

1. contingent liabilities will or will not become actual liabilities depending on

a. Whether they are probable and measurable.
b. The degree of uncertainty.
c. The present condition suggesting a liability.
d. The outcome of a future event.
2. A contingent liability shall be recognized when
a. Any lawsuit is actually filed against an entity
b. It is certain that funds are available to pay the amount of the claim
c. It is probable that a liability has been incurred even though the amount of the
loss cannot be reliably measured.
d. The amount of the loss can be reliably measured and it is probable prior to
issuance of financial statements that a liability has been incurred.
3. How should a contingent liability be reported in the financial statements when it is
reasonably possible that the entity will have to pay the liability at a future date?
a. As a deferred liability
b. As an accrued liability
c. As a disclosure only
d. As an account payable with an additional disclosure explaining the nature of
the transaction
4. Disclosure usually is not required for
a. Contingent gains that are probable and can be reliably measured.
b. Contingent losses that are reasonably possible and cannot be reliably
measured.
c. Contingent losses that are probable and cannot be reliably measured.
d. Contingent losses that are remote and can be reliably measured.
5. Reporting in the body that are probable and can be reliably measured.
a. Loss contingencies that are probable and can be reliably measured.
b. Gain contingencies that are probable and can be reliably measured.
c. Loss contingencies that are possible and can be reliably measured.
d. All loss contingencies
6. Pending litigation would generally be considered
a. Nonmonetary liability
b. Contingent liability
c. Estimated liability
d. Current liability
7. Gain contingencies that are remote and can be reliably measured
a. Must be disclosed in a note to the financial statements
b. May be disclosed in a note to the financial statements
c. Must be reported in the body of the financial statements
d. Should not be reported or disclosed
8. A contingent liability
a. Has a most probable value of zero but may require a payment if a given future
event occurs.
b. Definitely exists as a liability but the amount or due date is indeterminate.
c. Is commonly associated with loss carryforward.
d. Is not disclosed in the financial statements.
9. Which of the following should be disclosed in the financial statements as a contingent
liability?
a. The entity has accepted liability prior to the year-end for unfair dismissal of an
employee and is top pay damages.
b. The entity has received a letter from a supplier complaining about an old
unpaid invoice.
c. The entity is involved in a legal case which it may possibly lose.
d. The entity has not yet paid certain claims under product warranties.
10. Provisions are accrued because the likelihood of an unfavorable outcome is
a. Virtually certain
b. Greater than 50%
 c. At least 75%
d. Possible

ANSWER 3-28

1. d 6. b
2. d 7. d
3. c 8. a
4. d 9. c
5. a 10. b
CHAPTER 4

BONDS PAYABLE

Question 4-1

What is bond?

Answer 4-1

A bond is a formal unconditional promise, made under seal, to pay a specified sum of
money at a determinable future date, and to make periodic interest payments at a stated
rate until the principal sum is paid.

In simple language, a bond is a contract of debt whereby one party called the borrower or
issuer borrows funds from another party called the investor or bondholder.

A bond indenture or deed of trust is the document which shows in detail the terms of the
bond and the rights and duties of the borrower and other parties to the contract.

QUESTION 4-2

Define or describe the following types of bondsTerm bonds

1. Serial bonds
2. Mortgage bonds
3. Collateral trust bonds
4. Debenture bonds
5. Registered bonds

6. Coupon or bearer bonds

7. Convertible bonds
 8. Callable bonds
9. Guaranteed bonds
10. Junk bonds
11. Commodity-backed bonds

Answer 4-2

1. Term bonds with a single date of maturity/

2. Serial bonds are bonds with series of maturity dates or bonds that mature installments.
3. Mortgage bonds are bonds secured by mortgage of real properties.
4. Collateral trust bonds are bonds secured by investments in stocks and bonds.
5. Debenture bonds are bonds without collateral security.
6. Registered bonds require the registration of the name of the bondholder on the books of
corporation.
Consequently, when the bondholder sells a bond, the old bond certificate is surrendered
and a new bond certificate is issued to the buyer. Interest is paid periodically to the
bondholder of record.
7. Coupon or bearer bonds- the name of the bondholder is not registered. Accordingly,
interest paid periodically to the bearer of the bond or the person submitting a detachable
interest coupon.
8. Convertible bonds are bonds that can be exchange for equity shares of issuing entity.
9. Callable bonds are bonds that can be called in for payment before the maturity date.
10. Guaranteed bonds are bonds issued whereby another party promises to make payment if
the borrower fails to do.
11. Junk bonds are high risk and high yield bonds issued by entities that are heavily indebted
or otherwise in weak financial position.
12. Commodity-backed bonds are bonds which are redeemable in terms of commodities such
as oil or precious metals.

QUESTION 4-3

Explain a “ premium on bonds payable”.

ANSWER 4-3

If the sales price of the bonds is more that the face value of the bonds, the bonds are said to be
sold at a premium.

The “premium on bonds payable” is in effect gin on the payable the issuing entity or borrower,
because it receives more than what it is obligated to pay under the bond issue.

The obligation of the issuing entity is limited only to the face value of the bonds.
The premium on bonds payable, however, is not treated as an outright gain but amortized over
the life of the bond by debiting premium on the bonds payable and crediting interest expense.

QUESTION 4-4

Explain a “discount on the bonds payable”.

ANSWER 4-4

If the sales price of the bonds is less than the face value of the bonds, the bonds are said to be
sold at a discount.

The “discount on bonds payable” is in effect a loss to the issuer entity because it receives less
than what it is obligated to pay which is equal to the face value.

However, the discount on the bonds payable is not treated outright loss but amortized over the
life of the bonds by debiting interest expense and crediting discount on bonds payable.

QUESTION 4-5

Explain “bond issue costs”

ANSWER 4-5

Bond issue cost or “transacti0on costs” are incremental costs that are directly attributable to the
issue of bonds payable.

Such cost include printing and engraving cost, promotion cost legal and accounting fee,
registration fee with regulatory authorities, commission paid to agents and underwrites and other
similar charges.

Bond issue costs are not treated as outright expenses but amortized over the life of the bond issue
in a manner similar to that used for discount on bonds payable.

Bond issue costs are conceived as cost of borrowing and therefor will increase interest expense.

The amortization of bond issue costs is recorded by debiting interest expense and crediting bond
issue costs.

QUESTION 4-6

Explain the measurement of bonds payable.

ANSWER 4-6

PFRS 9, paragraph 5.1.1 provides that bonds payable not designated at fair value minus
transaction cost that are directly attributable to the issue of the bonds payable.
The fair value of the bonds payable is equal to the present value of the future cash payments to
settle the bond liability.

Bond issue costs shall be deducted from the fair value or issue price of the bonds payable in
measuring initially the bonds payable.

However, if the bonds are designated and accounted for “at fair value through profit or loss” the
bond issue costs are treated as expense immediately.

Actually, the fair value of the bonds payable is the same as the issue price or net proceeds from
the issue of the bonds excluding accrued interest.

QUESTION 4-7

Explain the subsequent measurement of bonds payable.

ANSWER 4-7

PFRS 9, paragraph 5,3,1, provides that after initial recognition, bonds payable shall be measured
either:

a. At amortized cost, using the effective interest method

b. At fair value through profit or loss

QUESTION 5-8

Explain the “amortized cost” of bonds payable.

ANSWER 4-8

The “amortized cost” of bonds payable is the amount at which the bond liability is measured
initially minus principal repayment, plus or minus the cumulative amortization using the
effective interest method of any difference between the initial amount and the maturity amount.

Simply stated, the difference between the face amount and the present value is either discount of
premium on the issue of the bonds payable.

Accordingly, discount on bonds payable and bond issue cost are presented as deduction from
bond payable is an addition of bonds payable.

QUESTION 4-9

Explain the “fair value option” of measuring bonds payable.

ANSWER 4-9
PFRS 9, paragraph 4.2.2 provides that at initial recognition bonds payable may be irrevocably
designated as at fair value through profit or loss.

In other words, under fair value option, the bonds payable shall be measured initially at fair value
and remeasured at every year-end at fair value and any changes in fair value are recognized in
profit or loss.

There is no more amortization of bond issue cost, bonds discount and bond premium.

As a matter of fact, interest expense is recognized using the nominal or stated interest rate and
not the effective interest rate.

QUESTION 4-10

On January 1, 2013 an entity issued bonds with face amount of P5,000,000 and 12% stated rate
for P5,379,100. The bonds are sold to yield 10%. Interest is payable annually on December 31.
The entity paid bond issue cost of P100,000. On December 31,2013, the fair value of the bonds
is determined to be P5,300,000.

Prepare the journal entries for 2013 assuming the entity elects the fair valkue option of
measuring the bonds payable.

ANSWER 4-10

Jan. 1 Cash 5,379,100

Bonds payable 5,379,100

1 Transaction cost 100,000

Cash 100,000

Dec. 31 Interest expense 600,000

Cash (12% x 5,000,000) 600,000

31 Bonds payable 79,100

Gain from change in fair value 79,100

Bonds payable--- January 1, 2013 5,379,100

Fair vak\lue--- December 31, 2013 5,300,000

Decrease in fair value of bounds-- gain 79,100

QUESTION 4-11

What is the meaning of treasury bonds?

ANSWER 4-11

Treasury bonds are entity’s own bonds originally issued and re acquired but not canceled

QUESTION 4-12

Explain the accounting for treasury bonds.

ANSWER 4-12

When treasury bonds are required, the “treasury bonds account” is debited at face value and any
related unamortized premium or discount or issue cost is cancelled.

The difference between the acquisition cost and carrying amount of the treasury bonds is treated
as gain or loss on acquisition of treasury bonds.

Any accrued interest paid is charge to interest expense.

Treasury bonds are reported in the statement of financial position as a deduction from bonds
payable.

QUESTION 4-13

What is meant by bond refunding?

ANSWER 4-13

Bond refunding is floating of new bonds payable the proceeds from which are used in paying the
original bonds payable.

Simply stated, bond refunding is the premature retirement of the old bonds payable through the
issuance of new bonds payable.

QUESTION 4-14

What is the treatment of bond refunding charges?

ANSWER 4-14

The refunding charges include the unamortized bond discount or premium, unamortized bond
issuer cost and redemption premium on the old bonds being refunded.
PFRS 9, paragraph 3.3.1 provides that the bond refunding is an extinguishment of a financial
liability.

Paragraph 3.3.3 further provides that the difference between the carrying amount of the financial
liability extinguished and the consideration paid shall be include in profit or loss.

Accordingly, the refunding charges shall be accounted for as loss on early extinguishment of
debt.

QUESTION 4-15

Explain the effective interest method of amortizing discount on the bonds payable, premium on
bonds payable and bond issue cost.

ANSWER 4-15

The effective interest method or simply “interest method” or scientific method recognizes two
kinds of interest rate- nominal rate and effective rate.

The nominal rate is the rate appearing on the face of the bonds while the effective rate is the
actual interest incurred on the bond issue.

The effective rate is the rate that exactly discounts estimate cash future payments through the
expected life of the bonds payable or when appropriate , a shorter period to the net carrying
amount of the bonds payable.

The nominal rate is also known as coupon or stated rate.

The effective rate is also known as yield or market rate

If the bonds are sold at a discount, the effective rate is higher than nominal rate.

If the bonds are sold at premium, effective rate is lower than nominal rate.

AMORTIZATION OF BOND PREMIUM OR DISCOUNT

The annual amortization of premium or discount is the difference between the effective expense
and nominal interest expense.

The effective interest expense is computed by multiplying the carrying amount of the bonds
payable at the beginning of the year by the effective rate.

The nominal interest expense is computed by multiplying the face value of the bonds payable by
the nominal rate.
Under the effective interest method, bond issue cost must be lumped with the discount on the
bonds payable and netted against the premium on the bonds payabale.

QUESTION 4-16 Multiplied choices (PFRS 9)

1. Bonds payable not designated at fair value through profit loss shall be measured initially
at
a. Fair value
b. Fair value plus bond issue cost
c. Fair value minus bond issue cost
d. Face amount

2. After initial recognition, bonds payable shall be measured at

I. Amortized cost using the effective interest method.
II. Fair value through profit loss
a. I only
b. II only
c. Either I or II
d. Neither I or II
3. Which of the following statements is true in relation to the fair value option of measuring
a bond payable?
I. At initial recognition, an entity may irrevocably designate a bond payable at
fair value through profit or loss
II. The bond payable is remeasured at every year-end at fair value and any
changes in fair value are recognized in profit or loss.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
4. The amortization cost of bonds payable means
a. Face amount plus premium on bonds payable
b. Face amount minus discount on bonds payable
c. Face amount minus bond issue cost
d. Face amount plus premium on bonds payable, minus discount on bonds payable and
minus bond issue cost
5. Under the fair value optyion. Bonds payable shall be measured initially at
a. Fair value
b. Fair value plus bond issue cost
c. Fair value minus bond issue cost
d. Face amount

ANSWER 4-16

1. C 3. C 5. A
2. C 4. D
 Question 4-17 Multiple choice (AICPA ADAPTED)

1. Bonds that mature on a single date are called

a. Term bonds
b. Seriasl bonds
c. Debenture bonds
d. Callable bonds
2. Bonds are issued with scheduled maturities at various dates are called
a. Convertible bonds
b. Term bonds
c. Serial bonds
d. Callable bonds

3. Costs incurred in connection with the issuance of ten-year bonds which sold at a slight
premium shall be

a. Charged to retained earnings when the bonds are issued

b. Expensed in the year in which incurred
c. Capitalized as organization cost
d. Reported as a deduction from bonds payable and amortized over the ten-year bond term

4. Unamortized debt discount shall be reported as:

a. Direct deduction from the face amount of the debt

b. Direct deduction from the present value of the debt
c. Deferred charge
d. Part of the issue costs

5. The issuer of a 10-year term bond sold at par three years ago with interest payable May 1 and
November 1 each year, shall report at year-end

a. Liability for accrued interest

b. Addition to bonds payable
c. Increase in deferred charges
d. Contingent Liability

6. When the interest payment dates of a bond are May 1 and November 1, and a bond issue is
sold on June 1, the amount of cash received by the issuer will be

a. Decreased by accrued interest from June 1 to November 1

b. Decreased by accrued interest from May 1 to June 1
c. Increased by accrued interest from June 1 to November 1
d. Increased by accrued interest from May 1 to June 1
7. A bond issued on June 1 has interest payment dates of April 1 and October 1. Bond interest
expense for the current year ended December 31 is for a period of

a. Three months
b. Four months
c. Six months
d. Seven months

8. The market price of a bond issued at a discount is the present value of the principal amount at
the market rate of interest

a. Less the present value of all future interest payments at the market rate of interest
b. Less the present value of all future interest payments at the rate of interest stated on the bond
c. Plus the present value of all future interest payments at the market rate of interest.
d. Plus the present value of all future interest payments at the rate of interest stated on the bond

9. In theory, the proceeds from the sale of a bond would be equal to

a. The face amount of the bond

b. The present value of the principal amount due at the end of the life of the bond plus the present
value of the interest payments made during the life of the bond
c. The face amount of the bond plus the present value of the interest payments made during the
life of the bond
d. The sum of the face amount of the bond and the periodic interest payments

10. Under international accounting standard, the valuation method used for bonds payable is

a. Historical cost
b. Discounted cash flow valuation at current yield rate
c. Maturity amount
d. Discounted cash flow valuwation at yield rate at issuance

ANSWER 4-17
1. a 6. d
2. c 7. d
3. d 8. c
4. a 9. b
5. a 10. d

QUESTION 4-18 Multiple Choice (AICPA Adapted)

1. What is the effective interest rate of a bond measured at amortized cost?

a. The stated rate of the bond

b. The interest rate currently charged by the entity or by others for similar bond
c. The interest rate that exactly discounts estimated future cash payments through the expected
life of the bond or when appropriate, a shorter period to the net carrying amount of the bond
d. The basic risk-free interest rate that is derived from observable government bond prices.

2. For a bond issue which sells for less than face value, the market rate of interest is

a. Dependent on rate stated on the bond

b. Equal to rate stated on the bond
c. Less than rate stated on the bond
d. Higher than rate stated on the bond

3. What is the market rate of interest for a bond issue which sells for more than face value?

a. Less than rate stated on the bond

b. Equal to rate stated on the bond
c. Higher than rate stated on the bond
d. Independent of rate stated on the bond

4. If bonds are issued at a premium, this indicates that

a. The yield rate of interest exceeds the nominal rate

b. The nominal rate of interest exceeds the yield rate
c. The yield and nominal rates coincide
d. No necessary relationship exists between two rates.

5. Which of the following statements is true for a bond maturing on a single date when the
effective interest method of amortizing bond discount is used?

a. Interest expense as a percentage of the bond carrying amount varies form period to period
b. Interest expense increases each six-month period
c. Interest expense remains constant each six month period
d. Nominal interest rate exceeds effective interest rate

6. How would the amortization of premium on bonds payable affect each of the following?

Carrying amount of bond Net income

a. Increase Decrease
b. Increase Increase
c. Decrease Decrease
d. Decrease Increase

7. How would the amortization of discount on bonds payable affect each of the following ?

Carrying amount of bond Net income

a. Increase Decrease
b. Increase Increase
c. Decrease Decrease
d. Decrease Increase

8. An entity issued a bond with a stated rate of interest that is less than the effective interest rate
on the date of issuance. The bond was issued on one of the interest payment dates. What should
the entity report on the first interest payment date?

a. An interest expense that is less than the cash payment made to bondholders
b. An interest expenses that is greater than the cash payment made to bondholders.
c. A debit to the unamortized bond discount.
d. A debit to the unamortized bond premium.

9. A 20-year bond was issued at a premium with a call provision to retire the bond. When the
bond issuer exercised the call provision on an interest date, the call price exceeded the carrying
amount of the bond. The amount of bond liability removed from the accounts should have
equaled the

a. Cash
b. Face amount plus unamortized premium
c. Call price plus unamortized premium
d. Current market price

10. A ten-year term bond was issued at a discount with a call provision to retire the bond. When
the bond issuer exercised the call provision on an interest date, the carrying amount of the bond
was less than the call price. The amount of bond liability removed from the accounts should have
equaled the

a. Call price
b. Call price less unamortized discount
c. Face amount less unamortized discount
d. Face amount plus unamortized discount

ANSWER 4-18

1. c 6. d
2. d 7. a
3. a 8. b
4. b 9. b
5. b 10. C

QUESTION 4-19 Multiple Choice (AICPA Adapted)

1. A five- year term bond was issued on January 1, 2012 at a premium. The carrying amount
of the bond on December 31, 2013 would be

a. The same as the carrying amount on January 1, 2013

b. Higher than the carrying amount on January 1, 2013
c. Higher than the carrying amount on December 31, 2014
d. Lower than the carrying amount on December 31, 2014

2. A five-year bond was issued on January 1, 2012 at a discount. The carrying amount of the
bond on December 31, 2013 would be

a. Higher than the carrying amount on January 1, 2013

b. Lower than the carrying amount on January 1, 2013
c. The same as the carrying amount on January 1, 2013
d. Higher than the carrying amount on December 31, 2014
3. On January 1, 2013, an entity issued bonds at a discount. The bonds mature on December
31, 2017. The entity incorrectly used the straight line method instead of the effective
interest method to amortize the discount. How is carrying amount of the bonds affected
by the error?

December 31, 2013 December 31, 2017

a. Overstated Understated
b. Overstated No effect
c. Understated Overstated
d. Understated No effect

4. If bonds are initially sold at a discount and the straight line method of amortization is
used, interest expense in the earlier years

a. Will exceed what it would have been had the effective interest method of
amortization been used.
b. Will be less than what it would have been had the effective interest method of
amortization been used.
c. Will be the same as what it would have been had the effective interest method of
amortization been used.
d. Will be less than the coupon rate of interest.

5. At the beginning of the current year, an entity issued bonds at a discount. The entity
incorrectly used the straight line method instead of the effective interest method to
amortize the discount. What is the effect of the error on the following amounts at the
current year-end?

Bond carrying amount Retained earnings

a. Overstated Overstated
b. Understated Understated
c. Overstated Understated
d. Understated Overstated

ANSWER 4-19

1. C
2. A
3. B
4. A

The straight line method provides for uniform discount amortization but the effective interest
method provides for increasing discount amortization. Accordingly, the straight line interest
expense is higher than effective interest expense in the earlier years.

5. C

Since the straight line amortization of discount on bonds payable is higher than the discount
amortization under the effective interest method, the carrying amount of the bonds payable
will be overstated under the straight line method.

Consequently, in the earlier years, the straight line interest expense is higher than the
effective interest expense, resulting to lower net income and understated retained earnings.

QUESTIONS 4-20 Multiple choice (IAA)

1. Debentures are

a. Unsecured bonds
b. Secured bonds
c. Ordinary bonds
d. Serial bonds

2. When bonds are sold between interest dates, any accrued interest is credited to

a. Interest payable
b. Interest revenue
c. Interest receivable
d. Bonds payable

3. Which of the following is true of accrued interest on bonds that are sold between interest
dates?

a. The accrued interest is computed at the effective rate

b. The accrued interest will be paid to the seller when the bonds mature
 c. The accrued interest is extra income to the buyer
d. None of the above

4. Which of the following is true of a premium on bonds payable?

a. The premium or bonds payable is a contra shareholder’s equity account

b. The premium on bonds payable is an account that appears only on the books of the
investors
c. The premium on bonds payable increases amortization entries are made until the
balance reaches zero at maturity date.
d. The premium on bonds payable decreases when amortization entries are made until
the balance reaches zero at maturity date.

5. The carrying amount of a bond liability is

a. Call price of the bond plus bond discount or minus bond premium
b. Face value of the bond plus related premium or minus related discount
c. Face value of the bond plus related discount or minus related premium
d. Maturity value of the bond plus related discount or minus related premium.

6. When interest expense is calculated using the effective interest method, interest expense
equals

a. Actual amount of interest paid.

b. Carrying amount of the bonds multiplied by the stated interest rate.
c. Carrying amount of the bonds multiplied by the effective interest rate.
d. Maturity value of the bonds multiplied by the effective interest rate.

7. The proceeds from the issue of the bonds payable

a. Will always be equal to the face amount

b. Will always be less than the face amount
c. Will always be more than the face amount
d. May be equal, more or less than the face amount depending on market interest rate

8. When bonds are retired prior to maturity with proceeds from a new bond issue, any gain
or loss from the early extinguishment should be

a. Amortized over the remaining original life of the retired bond issue
b. Amortized over the life of the new bond issue
c. Recognized in retained earnings
d. Recognized in income from continuing operations
 9. An entity neglected to amortize the discount on outstanding bonds payable. What is the
effect of the failure to record premium amortization on interest expense and bond
carrying amount, respectively?

a. Understated and understated

b. Understated and overstated
c. Overstated and overstated
d. Overstated and understated

10. An entity neglected to amortize the premium on outstanding bonds payable. What is the
effect of the failure to record premium amortization on interest expense and bond
carrying amount, respectively?

a. Understated and understated

b. Understated overstated
c. Overstated and overstated
d. Overstated and understated

ANSWER 4-20

1. A 6. C
2. A 7. D
3. D 8. D
4. D 9. A
5. B 10. C
CHAPTER 5
COMPOUND FINANCIAL
INSTRUMENT

QUESTION 5-1

Define a “compound financial instrument”

ANSWER 5-1

PAS 32, paragraph 28, defines a compound financial instrument as a “financial instrument that contains
both a liability and an equity element from the perspective of the issuer”

In other words, one component of the financial instrument meets the definition of a financial liability and
another component of the financial instrument meets the definition of an equity instrument.

The common examples of compound financial instrument are as follows:

a. Bonds payable issued with share warrants

b. Convertible bonds payable

QUESTIONS 5-2

Explain the accounting for a compound financial instrument.

ANSWER 5-2

The issuer of a financial instrument shall evaluate the terms of the instrument whether it contains both the
liability and an equity component.

If the financial instrument contains both the liability and the equity component, PAS 32, paragraph 29,
mandates that such components shall be accounted for separately in accordance with the substance of the
contractual arrangement and the definition of a liability and an equity.

The approach in accounting for a compound financial instrument shall be allocated between the liability
and equity components.

In other words, the fair value of the liability component is first determined.

The fair value of the liability component is then deducted from the total consideration received from the
issuing the compound financial instrument.

The residual amount is allocated to the equity component.

QUESTION 5-3

Explain bonds payable issued with share warrants.

ANSWER 5-3

When the bonds are sold with share warrants, the bondholders are given the right to acquire shares of the
issuing entity at a specified price at some future time.

Actually, when bonds are sold with share warrants two securities are sold – the bonds and the share
warrants.

Share warrants attached to a bond may be detachable or nondeatachable.

Detachable share warrants can be traded separately from the bonds while nondetachable share warrants
cannot be traded separately.

QUESTION 5-4

Explain the accounting for bonds payable issued with share warrants.

ANSWER 5-4

Bonds issued with share warrants are considered as compound financial instrument.

Accordingly, the proceeds from the issuance of bonds payable with share warrants shall be accounted for
a partly liability and partly equity.

The proceeds shall be accounted between the bonds payable and the share warrants.

PAS 32 does not differentiate whether the equity component is detachable or nondetachable.

Whether detachable or nondetachable, share warrants have a value and therefore shall be accounted for
separately.

PAS 32, paragraph 31, provides that the equity instruments are instruments that evidence a residual
interest in the assets of an equity after deducting all its liabilities.

Therefore, the bonds are assigned an amount equal to the “market value of the bonds ex-warrant”.
Regardless of the market value of the warrants.

The residual amount or remainder of the issue price shall then be allocated to the share warrants.

If the bonds have no known market value ex-warrant, the amount allocated to the bonds is equal to the
present value of the bonds payable.

The present value of the bonds payable is the sum of the present value of the principal bond liability and
the present value of the future interest payments using the effective or the market interest rate for similar
bonds without the share warrants.

QUESTION 5-5

Explain the accounting for convertible bonds at the “time of original issuance”

ANSWER 5-5
Convertible bonds are conceived as compound financial instrument.

Accordingly, the issuance of convertible bonds shall be accounted for as partly liability and partly equity.

The issue price of the convertible bonds shall be allocated between the bonds payable and the conversion
privilege.

QUESTION 5-6

Explain the allocation of the “original issue price “ of the convertible bonds payable.

ANSWER 5-6

The economic effect of issuing convertible bonds is substantially the same as issuing simultaneously
bonds payable with share warrants.

Accordingly, the bonds are assigned an amount equal to the market value of the bonds without the
conversion privilege.

In the absence of the market value of the bonds without conversion privilege, the amount allocated to the
bonds is equal to the present value of the bonds payable.

The present value of the bonds payable is the sum of the present value of the principal bond liability and
the present value of the future interest payments using the effective or market interest rate for the similar
bonds without conversion privilege.

The residual amount or remainder of the issue price shall then be allocated to the conversion privilege or
equity component.

QUESTION 5-7

Explain in the accounting for the conversion of convertible bonds into share capital.

ANSWER 5-7

If bonds are converted into share capital of the issuing entity, the accounting problem is the measurement
of the share capital issued.

Application Guidance 32 of PAS 32 provides that on conversion of a convertible instrument at maturity,

the entity derecognizes the liability component and recognizes it as equity.

There is no gain or loss on conversion at maturity

The reason is that the convertible bonds is viewed in substance as an equity and conversion is really an
exchange of one type of equity capital for another.

The conversion is not considered a significant economic transaction and therefore no gain or loss would
be recognized.

Accordingly, the carrying amount of the bonds payable is the measure of the share capital issued because
the carrying amount is the “effective price” for the shares issued as a result of the conversion.

Any cost incurred in connection with the bonds conversion shall be deducted from the share premium, if
any. Otherwise, the cost incurred is treated as expense.
The carrying amount of the bonds payable is equal to the face value plus accrued interest if not paid, plus
unamortized premium or minus unamortized premium or minus unamortized discount and bond issue
cost.

QUESTION 5-8

Explain the treatment of the “ share premium from the conversion privilege” that was recognized at the
original issuance of the bonds”

ANSWER 5-8

The share premium from the conversion privilege that was recognized at the original issuance of the
convertible bonds payable shall form part of equity.

If the bonds are later converted, the “share premium from the conversion privilege” should be canceled
because this would effectively form part of the total consideration paid for the shares ultimately issued as
a result of bond conversion.

QUESTION 5-9

1. When an entity issued bonds payable that can be converted into ordinary shares, what will be the
effect on liabilities and equity respectively?

a.Increase and No effect

b. Increase and Increase
c. No effect and Increase
d. Decrease and Increase

2. An entity issued bonds payable with nondetachable share warrants. In computing interest expense for
the first year, the effective interest rate is multiplied by the

a. Proceeds received from the sale of the bonds

b. Face value of the bonds
c. Fair value of the bonds ex-warrant
d. Share warrants outstanding

3. When an entity issued bonds payable with detachable share warrants, how will share premium be
computed if the warrants are exercised by the bondholders?
a. It is the difference between the proceeds received based on the exercise price and the total par
or stated value of the shares issued.
b. It is the difference between the proceeds received based in the exercise price including the share
warrants outstanding and the total par or stated value of the shares issued.
c. It is the sum of the share warrants outstanding and the total par or stated value of the shares
issued.
d. It is the balance of the share warrants outstanding.
4. When an entity issued convertible bonds, how will share premium be computed if the bonds were
converted into ordinary shares?
a. It is the difference between the carrying amount of the bonds and the total paror stated value of
the shares issued.
b. It is the difference between the face value of the bonds and the total par or stated value of the
shares issued.
c. It is the difference between the carrying amount of the bonds including share premium from
conversion privilege and the total par or stated value of the shares issued.
 d. It is the difference between the face value of the bonds including the share premium from
conversion privilege and the total par or stated value of the shares issued.
5. The proceeds from the bonds issued with nondetachable share warrants shall be accounted for
a. Entirely as bonds payable
b. Entirely as shareholder’s equity
c. Partly as unearned revenue and partly as bonds payable
d. Partly as bonds payable and partly as shareholder’s equity

ANSWER 5-9
1. B
2. C
3. B
4. C
5. D

QUESTION 5-10

1. What is the principal accounting for a compound instrument?

a. The issuer shall classify a compound instrument as either a liability or equity based on
evaluation of the predominant characteristics of the contractual arrangement.
b. The issuer shall be classify the liability and equity components of a compound instrument
separately as liability or equity.
c. The issuer shall classify a compound instrument as a liability in the entirety, until covered
into equity component is detachable and separately transferable, in which case the liability
and equity components shall be presented separately.
d. The issuer shall classify a compound instrument as a liability in the entirety, until covered
equity.
2. How are the proceeds from issuing a compound instrument allocated between the liability and
equity components?
a. First, the liability component is measured at fair value, and then the remainder of the
proceeds is allocated to the equity component.
b. First, the equity component is measured at fair value, and then the remainder of the proceeds
is allocated to the liability component.
c. First, the fair values of both the equity component and the liability component are estimated.
Then the proceeds are allocated to the liability and equity component based on the relation
between the estimated fair value.
d. The equity component is measured at its intrinsic value. The liability component is measured
at the face amount less the intrinsic value of the equity component.
3. A bond convertible by the holder into a fixed number of ordinary shares of the entity is
a. A compound financial instrument
b. A primary financial instrument
c. A derivative financial instrument
d. An equity instrument

4. When bonds are issued with share warrants, a portion of the proceeds should be allocated to equity
when the bonds are issued with
I. Detachable share warrants

II. Nondetachable share warrants

a. I only
 b. II only
c. Both I and II
d. Neither I and II
5. Bondholders exchange their convertible bonds for ordinary shares. The carrying amount of these bonds
was lower than market value but greater than the par value of the ordinary shares issued. If the book value
is used, which of the following correctly states an effect of the conversion?

a. Shareholder’s equity is increased.

b. Share premium is decreased.

c. Retained earnings account increased

d. A loss is recognized

ANSWER 5-10

1. B

2. A

3. A

4. C

5. A

QUESTION 5-11

1. Convertible bonds
a. Have priority over other indebtedness.
b. Are usually secured by a mortgage.
c. Pay interest only in the event net income is sufficient to cover the interest.
d. May be exchanged for equity shares
2. The major difference between convertible bonds and bonds issued with share warrants is that
upon exercise of the warrants
a. The shares are held by the entity for a definite period before these are issued to be warrant
holder.
b. The holder has to pay a certain amount to obtain the shares.
c. The shares involved are restricted.
d. No shares premium can be part of the transaction.
3. The conversion of the bonds payable into ordinary shares is commonly recorded by
a. incremental method
b. proportional method
c. fair value method
d. book value or carrying amount method
4. When the cash proceeds from the bonds issued with share warrants exceed the fair value of the
bonds without the warrants, the excess should be credited to
a. Share premium – ordinary
b. Retained earnings
c. Liability account
d. Share premium – share warrants
 5. Proceeds from an issue of bonds with share warrants should not be allocated between the liability
and the equity components when
a. The fair value of the warrants is not readily available
b. Exercise of the warrants within the next reporting period seems remote
c. The warrants issued are nondetachable
d. Proceeds should b allocated between the liability and equity for all of these.

ANSWER 5-11

1. d
2. b
3. d
4. d
5. d
CHAPTER 6
NOTE PAYABLE AND DEBT
RESTRUCTURE

QUESTION 6-1

What is a promissory note?

ANSWER 6-1

A promissory note is an unconditional promise in writing made by one person to another , signed by the
marker, engaging to pay on demand or at fixed or determinable future time a sum certain in money to
order or to bearer.

QUESTION 6-2

Explain the “initial measurement” of note payable.

ANSWER 6-2

PFRS 9, paragraph 5.11, provides that a note payable shall be measured initially at fair value minus
transaction costs that are directly atrributable to the issue of the note payable.

In other words, transaction costs are included in the measurement of note payable.

However, if the note payable is irrevocably designated at fair value through profit or loss, the transaction
costs are expensed immediately.

The fair value of the note payable is equal to the present value of the future cash payment to settle the
note payable.

The term “present value” is the discounted amount of the future cash outflow in settling the note payable
using the market rate of interest.

QUESTION 6-3

Explain the “subsequent measurement” of note payable.

ANSWER 6-3

PFRS 9, paragraph 5.3.1 provides that after initial recognition, a note payable shall be measured either:

a. At amortized cost using the effective interest method

 b. At fair value through profit and loss if the note payable is designated irrevocably as measured at
fair value through profit and loss.
QUESTION 6-4

What is “amortized cost” of note payable?

ANSWER 6-4

The amortized cost of note payable is the amount at which the note payable is measured initially minus
principal repayment, plus or minus the cumulative amortization using the effective interest method of any
difference between the initial carrying amount and maturity amount.

Simply stated, the difference between the face amount and present value of the note payable is amortized
through interest expense using the effective interest method.

Actually, the difference between the face amount and present value is either discount or premium on the
issue of note payable.

QUESTION 6-5

Explain the “fair value option” of measuring note payable.

ANSWER 6-5

PFRS 9, paragraph 4.2.2, provides that at initial recognition a note payable may be irrevocably designated
as at fair value through profit or loss.

In other words, under the fair value option, the note payable shall be measured initially at fair value and
remeasured at every year-end at fair value and any changes in fair value are recognized in profit or loss.

There is no amortization of transaction cost, discount and premium on note payable.

As a matter of fact, interest expense is recognized using the nominal or stated interest rate and not the
effective interest rate.

QUESTION 6-6

On January 1, 2013, an entity borrowed from a bank P4,000,000 on a 12% 5-year interest bearing note.

The entity received P4,000,000 which is the fair value of the note on January 1, 2013. Transaction cost of
P100,000 was paid by the entity.

The fair value of the note payable was P3,500,000 on December 31, 2013 and P3,800,000 on December
31,2014.

The entity has elected irrevocably the fair value option for meaning the note payable.

Prepare all journal entries for 2013 and 2014.

ANSWER 6-6

2013

Jan 1 Cash 4,000,000

 Note payable 4,000,000

1 Transaction cost 100, 000

Cash 100,000

Dec. 31 Interest Expense (12% x 4,000,000) 480,000

Cash 480,000

Dec. 31 Note payable 500,000

Gain from exchange 500,000

Note payable-January 1, 2013 4,000,000

Fair value-December 31,2013 3,500,000

500,000

2014

Dec. 31 Interest expense 480,000

Cash 480,000

31 Loss from change in fair value 300,000

Note payable 300,000

Note payable-December 31, 2013 3,500,000

Fair value-December 31,2014 3,800,000

Increase in fair value of liability-loss 300,000

QUESTION 6-7

Explain briefly the treatment of the following:

a. Note issued solely for cash

b. Interest bearing note issued for property
c. Noninterest bearing note issued for property
ANSWER 6-7

a. When a note is issued solely for cash, the present value is equal to the cash proceeds.
b. When a property or noncash asset is acquired by issuing a promissory note which is interest
bearing, the property or asset is recorded at the purchase price.

The purchase price is reasonably assumed to be the present value of the note and therefore, the
fair value of the property because the note issued is the interest bearing.
c. When a noninterest bearing note is issued for property, the property is recorded at the cash price
of the property.
The cash price is assumed to be the present value of the note issued.
 The difference between the cash price and the face of the note issued represents the imputed
interest.
The imputed interest is based on the sound philosophy that no lender would part away with
money or property interest-free.

QUESTION 6-8

Explain “dacion en pago”

ANSWER 6-8

Dacion en pago arises when a mortgaged property is offered by the debtor in full settlement of the debt.

This transaction shall be accounted for as an “asset swap” form of debt restricting

This requires recognition of gain or loss based on the balance of the obligation including accrued interest
and other charges.

If the balance of the obligation including accrued interest and other charges is more than the carrying
amount of the property mortgaged, there is a gain on extinguishment of debt.

Otherwise, if the balance of the obligation is less than the carrying amount of property mortgaged, there is
a loss on the extinguishment of debt.

QUESTION 6-9

What is meant by “debt restructuring?”

ANSWER 6-9

Debt restructuring is a situation where the creditor, for economic or legal reasons related to the debtor’s
financial difficulties, grants to the debtor concession that would not otherwise be granted in normal
business relationship.

The concession either stems from an agreement between the creditor and debtor, or is imposed by law or a
court.

The objective of the creditor in a debt restructuring is to make the best of a bad situation or maximize
recovery of investment.

Thus, the creditor usually sustains an accounting loss on debt restructuring and the debtor realizes an
accounting gain.

QUESTION 6-10

What are the common forms of debt restructuring?

ANSWER 6-10

The common forms of debt restructuring are

a. Asset swap
b. Equity swap
c. Modification of terms
QUESTION 6-11

Explain an asset swap

ANSWER 6-11

Asset swap is the transfer of any asset such as real estate inventory or investment by the creditor in full
settlement of an obligation.

Under PFRS 9 paragraph 3.3.1 and 3.3.3 asset swap is treated as a derecognition of a financial liability or
extinguishment of an obligation.

The difference between the carrying amount of the financial liability and the consideration given shall be
recognized in profit or loss.

QUESTION 6-12

Explain an equity swap.

ANSWER 6-12

An “equity swap” is a transaction whereby a debtor and creditor may renegotiate the terms of a financial
liability with the result that the liability is fully or partially extinguished by the debtor issuing equity
instruments to the creditor.

Simply stated, equity swap is the issuance of share capital by the debtor to the creditor in full or partial
payment of an obligation.

QUESTION 6-13

How should an entity initially measure the equity instruments issued to extinguish a financial liability?

ANSWER 6-13

This accounting issue of “extinguishment of a financial liability by issuing equity instruments” is now
well-settled under IFRIC 19.

IRFIC 19 provides that when equity instruments issued to extinguish all or part of a financial liability are
recognized initially, an entity shall measure the equity instruments at the fair value of the entity
instruments issued, unless that fair value cannot reliably measured.

If the fair value of the equity instruments issued cannot be reliably measured, the equity instruments shall
be measured to reflect the fair value of the financial liability extinguished.

Needless to say, if both the fair value of the equity instruments issued and the fair value of the financial
liability extinguished cannot be measured reliably, the equity instruments issued shall be measured at the
“carrying amount of the financial liability extinguished”

Accordingly, the equity instruments issued to extinguish a financial liability shall be measured at the
following amounts in the order of priority.

a. Fair value of equity instruments issued

b. Fair value of liability extinguished
c. Carrying amount of liability extinguished
The difference between the carrying amount of the financial liability extinguished and the “initial
measurement” of the equity instruments issued shall be recognized in profit or loss.

Such gain or loss on extinguishment shall be disclosed as a separate line item in the income statement.

QUESTION 6-14

Explain modification of terms of a financial liability.

ANSWER 6-14

Modification of terms of a financial liability may involve either the interest or maturity value or
both.

Interest concession may involve a reduction of the interest rate, forgiveness of unpaid interest or
a moratorium on interest payment.

Maturity value concession may involve an extension of the maturity date or reduction of the
amount to be paid at maturity.

PFRS 9, paragraph 3.3.2, provides that a substantial modification of terms of an existing

financial liability shall be accounted for as an extinguishment of the old financial liability and the
recognition of a new financial liability.

Under Application Guidance B3.3.6 of PFRS 9, there is substantial modification of terms if the
gain or loss on extinguishment is at least 10% or 10% or more of the carrying amount of the old
financial liability.

The difference between the carrying amount of the old liability and the present value of new or
restructured liability shall be accounted for as gain or loss on extinguishment.

The present value of the new liability shall be determined using the original effective interest
rate.

Any costs or fees incurred as a result of the substantial modification of terms shall be recognized
as part of gain or loss on extinguishment.

QUESTION 6-15
Explain the accounting procedure if there is no substantial modification of terms of the old
financial liability.

ANSWER 6-15

Under Application Guidance B3.3.6, if the gain or loss on extinguishment of the old liability is
less than 10% of the carrying amount of the old liability, there is no substantial modification of
terms.

In this case, the gain or loss is not recognized because the modification is not an extinguishment
of the old liability.

Any costs incurred in modifying the terms are adjusted to the carrying amount of the old liability
and amortized over the remaining term of the modified liability.

In other words, the old liability is simply continued but with modified interest charges.

Accordingly, a new effective interest rate must be computed to equate the carryinh amount of
ghe old liability with the present value of the cash outflows of the modified liability.

QUESTION 6-16 Multiple choice (PFRS 9)

1. An entity shall measure initially a note payable not designated at fair value through profit or
loss at

a. Face amount
b. Fair value
c. Fair value plus transaction cost
d. Fair value minus transaction cost

2. After initial recognition, an entity shall measure a note payable at

a. Amortized cost
b. Fair value through profit or loss
c. Either amortized cost or fair value through profit or loss
d. Either amortized cost or fair value through other comprehensive income

3. What is the amortized cost of note payable?

a. The amount at which the note payable is initially recognized.

b. The amount at which the note payable is initially recognized minus principal repayment
c. The amount at which the note payable is initially recognized plus or minus the cumulative
effective interest amortization of the difference between the initial carrying amount and maturity
amount
d. The amount at which the note payable is initially recognized minus principal repayment, plus
or minus the cumulative effective interest amortization of the difference between the initial
carrying amount and maturity amount.

4. Under the fair value option, an entity shall measure the note payable initially at

a. Face amount
b. Fair value plus transaction cost
c. Fair value minus transaction cost
d. Fair value

5.Which of the following statements is incorrect in relation to the fair value option of measuring
note payable?

a. At initial recognition, an entity may irrevocably designate the note payable as at fair
value through profit or loss
b. At initial recognition, an entity may be irrevocably designate the note payable as at fair
value through other comprehensive income
c. The interest expense on note payable is recognized using the nominal or stated interest
rate
d. After initial recognition, the note payable is remeasured at fair value at every year-end
and any changes in fair value are recognized in profit or loss

ANSWER 6-16

1. D
2. C
3. D
4. D
5. B

QUESTIONS 6-17 Multiple Choice (AICPA Adapted)

1. When an entity issued a note solely in exchange for cash the present value of the note at
issuance is equal to

a. Face amount
b. Face amount discounted at the market rate
c. Proceeds received
d. Proceeds received discounted at the market interest rate
 2. An entity borrowed cash from a bank and issued to the bank a short-term non-interest
bearing note payable. The bank discounted the note at 10% and remitted the proceeds to the
entity. What is the effective interest rate?

a. Equal to the stated discount rate of 10%

b. More than the stated discount rate of 10%
c. Less than the stated discount rate of 10%
d. Independent of the stated discount rate of 10%

3. If the present value of a note issued in exchange for a property is less than the face amount, the
difference shall be

a. Included in the cost of the asset

b. Amortized as interest expense over the life of the note
c. Amortized as the interest expense over the life of the asset
d. Included in the interest expense in the year of issuance

4. The discount resulting from the determinantion of the present value of a note payable shall be
reported as

a. Deferred credit separate from the note

b. Direct deduction from the face amount of the note
c. Deferred charge separate from the note.
d. Addition to the face amount of the note.

5. At issuance date, the present value of a note payable shall be equal to the face amount of the
note

a. Bears a stated rate of interest which is realistic

b. Bears a stated rate of interest which is less than the prevailing market rate for similar notes
c. Is noninterest bearing and the implicit interest rate is for less than the prevailing market rate
for similar notes.
d. Is noninterest bearing and the implicit interest rate is equal to the prevailing market rate for
similar notes.

6. On September 1, 2013 , an entity borrowed cash and signed a two year interest bearing note on
which both the principal and interest are payable on September 1, 2015. How many months of
accrued interest would be included in the liability for accrued interest on December 31, 2013 and
December 31, 2014?

December 31, 2013 December 31, 2014

a. 4 months 16 months
b. 4 months 4 months
c. 12 months 24 months
d. 20 months 8 months

7. On September 1, 2013 , an entity borrowed cash and signed a one year interest bearing note on
which both the principal and interest are payable on September 1, 2014. How will the note
payable and the accrued interest be classified in the December 31, 2013 statement of financial
position?

Note payable Accrued interest

a. Current liability Noncurrent liability
b. Noncurrent liability Current liability
c. Current liability Current liability
d. Noncurrent liability No entry

8. A two year note was issued in an arm’s length transaction at face value solely for cash at the
beginning of this year. There was no other rights or privileges exchanged. The interest rate is
specified at 10% per year. Principal and interest are payable at maturity. The prevailing rate of
interest for a loan of this type of this 15% per year. What annual interest rate should be used to
record interest expense for this year and next year?

This year Next year

a. 10 percent 15 percent
b. 10 percent 10 percent
c. 15 percent 10 percent
d. 15 percent 15 percent

9. On October 1, 2011 an entity borrowed cash and signed a three-year interest bearing note on
which both the principal and interest are payable on October 1, 2014. On December 31, 2013,
accrued interest payable shall

a. Be reported as current liability

b. Be reported as noncurrent liability
c. Be reported as part of noncurrent note payable
d. Not be reported as liability

10. Which of the following statements concerning discount on note payable is incorrect?

a. Discount on note payable may be debited when an entity discounts its own not with the bank.
b. The discount on note payable is a contra liability account which is shown as a deduction from
note payable.
c. The discount on note payable represents interest charge applicable to future payable
d. Amortizing the discount on note payable causes the carrying amount of the liability to
gradually decrease over the life of the note.
ANSWER 6-17
1. C 6. A
2. B 7. C
3. B 8. B
4. B 9. A
5. A 10. D

QUESTION 6-18 Multiple choice (PFRS 9)

1. In a debt restructuring that is considered an asset swap the gain on extinguishment is
equal to the

a. Excess of the fair value of the asset over its carrying amount
b. Excess of the carrying amount of the debt over the fair value of the asset.
c. Excess of the fair value of the asset over the carrying amount of the debt.
d. Excess of the carrying amount of the debt over the carrying amount of the asset.

2. For a debt restructuring involving substantial modification of terms, it is appropriate for a

debtor to recognize a gain when the carrying amount of the debt

a. Exceeds the total future cash payments specified by the new terms
b. Is less than the total future cash payments specified by the new terms
c. Exceeds the present value of the future cash payment specified by the new terms
d. Is less than the present value of the future cash payments specified by the new terms

3. Under debt restructuring involving substantial modification of terms, the future cash
flows under the new terms shall be discounted using

a. Original effective interest rate

b. Interest rate under the new terms
c. Market rate of interest
d. Prime interest rate

4. There is substantial modification of terms of an old finance liability if the gain or loss on
extinguishment is

a. At least 10% of the carrying amount of the old liability

b. Less than 10% of the carrying amount of the old liability
c. At least 10% of the new liability
d. Less than 10 % of the new liability

5. The difference between the carrying amount of a financial liability extinguished and the
consideration given shall
 a. Be recognized in a profit or less
b. Be included in equity
c. Be included in retained earnings
d. Not be recognized
ANSWER 6-18
1. D
2. C
3. A
4. A
5. A
QUESTION 6-19 MULTIPLE Choice (IFRIC 19)
1. An entity shall initially measure equity instruments issued to extinguish all or part of a
financial liability at

a. Fair value of the equity instruments issued

b. Fair value of the liability extinguished
c. Par value of the equity instruments issued
d. Carrying amount of the liability extinguished

2. If the fair value of the equity instruments issued cannot be reliably measured, the equity
instruments issued to extinguish a financial liability shall be measured at

a. Fair value of the liability extinguished

b. Par value of the equity instruments issued
c. Carrying amount of the liability extinguished
d. Book value of the equity instruments issued

3. If both the fair value of the equity in instruments issued and the fair value of the financial
liability extinguished cannot be measured reliably, the equity instruments issued shall be
measured at

a. Carrying amount of the liability extinguished

b. Par value of equity instruments issued
c. Carrying amount of the equity instruments issued
d. Value assigned by the Board of Directors

4. The difference between the carrying amount of the financial liability extinguished and the
fair value of equity instruments issued or fair value of liability extinguished in the
absence of the fair value of equity instruments issued shall be recognized in

a. Profit or loss
b. Other comprehensive income
c. Retained earnings
d. General reserve
 5. The gain or loss from extinguishment of a financial liability by issuing equity
instruments shall be presented in the statement of comprehensive income as

a. Other income or other expense

b. Separate line item in profit or loss
c. Component of other comprehensive income
d. Component of finance cost
ANSWER 6-19
1. A
2. A
3. A
4. A
5. B
CHAPTER 7

OPERATING LEASE AND

LEASEBACK

QUESTION 7-1

Define a lease.

ANSWERS 7-1

PAS 17, paragraph 4, defines a lease as “an agreement whereby the lessor conveys to the lessee
in return for a payment or series of payments the right to use an asset for an agreed period of
time.”

Otherwise stated, a lease is an agreement between one party called the lessor and the other party
called the lessee whereby the lessee is granted the right to use the property owned by the lessor
for a specific period of time in consideration for certain payment in the form of rent.

Two kinds of lease are recognized, namely operating lease and finance lease.

QUESTION 7-2

Explain an operating lease on the part of the lessee.

ANSWER 7-2
PAS 17, paragraph 33, provides that “lease payments under an operating lease shall be
recognized as an expense on a straight line basis over the lease term unless another systematic
basis is more representative of the time pattern of the user’s benefit.”

In other words, the periodic rental is simply recognized as rent expense on the part of the lessee.

A lease bonus paid by the lessee to the lessor in addition to the periodic rental is treated as
prepaid rent expense by the lessee to be amortized over the lease term.

Leasehold improvements made by the lessee shall be depreciated over the life of the
improvements or lease term whichever is shorter.

The residual value of the leasehold improvement is ignored by the lessee in computing
depreciation because legally the leasehold improvement becomes the property of the lessor upon
expiration of the lease term.

Any security deposit refundable upon the lease expiration is accounted for as an asset by the
lessee.

QUESTION 7-3

Explain an operating lease on the part of the lessor.

ANSWER 7-3

PAS 17, paragraph 50, provides that “lease income form the operating lease on the part of the
lessor shall be recognized on a straight line basis over the lease term, unless another systematic
basis is more representative of the time pattern in which use benefit derived from the leased asset
is diminished.”

Otherwise stated, the periodic rental received by the lessor in an operating lease is simply
recognized as rent income.
A lessor shall present an asset subject to operating lease in its statement of financial position
according to the nature of the asset.

The lease property remains as an asset of the lessor and consequently, the lessor bears all
ownership or executory costs such as depreciation of leased property, real property taxes,
insurance and maintenance.

However, the lessor may pass on to the lessee the payment for taxes, insurance and maintenance
cost.

The depreciation policy for depreciable leased asset shall be consistent with the lessor’s normal
depreciation for similar asset.

Any security deposit refundable upon the lease expiration shall be accounted for as liability by
the lessor.

Any lease bonus received by the lessor from the lessee is recognized as unearned rent income to
be amortized over the lease term.

QUESTION 7-4

Explain the treatment of “initial direct costs” incurred by the lessor in an operating lease.

ANSWER 7-4

Initial direct costs are often incurred by the lessor and include amounts such as commissions,
legal fees and internal costs that are incremental and directly attributable to negotiating and
arranging a lease.

Initial direct costs incurred by the lessor in an operating lease shall be added to the carrying
amount of the leased asset and recognized as an expense over the lease term on the same basis
as the lease income.

QUESTION 7-5

Explain the treatment of unequal rental payments in an operating lease.

ANSWER 7-5

Paragraphs 33 and 50 of PAS 17 provide that “lease payments under an operating lease shall be
recognized as an expense on the part of the lessee or income on the par of lessor on a straight line
basis over the lease term unless another systematic basis is representative of the time pattern of
the user’s benefit.”
In other words, where the operating lease requires unequal cash payments, the total rental
payments for the lease term shall be amortized uniformly on the straight line basis as rent
expense on the part of the lessee or rent income on the part of the lessor over the lease term.

Simply worded, the rent expense of the lessee and rent income of the lessor must be equal over
the lease term.

QUESTION 7-6

What is a sale and leaseback transaction?

ANSWER 7-6

A sale and leaseback is an arrangement whereby one party sells a property to another party and
then immediately leases the property back from its new owner.

Thus, the seller becomes a seller-lessee and the purchaser, a purchaser-lessor.

The lease rent and the sale price is usually independent as they are negotiated as a package.

The accounting treatment of a sale and leaseback transaction depends upon the type of the lease
involved.

QUESTION 7-7

Explain the treatment of sale and leaseback if the leaseback is a finance lease.

ANSWER 7-7

PAS 17, paragraph 59, provides that “if the sale and leaseback transaction results in a finance
lease, any excess of the sale proceeds over the carrying amount shall not be immediately
recognized as income but deferred and amortized over the lease term.”
In simple language, if the leaseback is a finance lease any gain from the sale and leaseback is
deferred and amortized over the lease term but any loss on sale and leaseback is recognized
immediately.

QUESTON 7-8

Explain the treatment of sale and leaseback if the leaseback is an operating lease.

ANSWER 7-8

PAS 17, paragraph 61, provides the following rules if the leaseback is an operating lease:

1. If the sale or leaseback transaction is established at fair value, any gain or loss on sale and
leaseback shall be recognized immediately.

The transaction is established at fair value when the sale price is equal to the fair value.

2. If the sale price is below fair value, any gain or loss shall also be recognized immediately.

However, if the loss is compensated by future lease rental at below market value, the loss
is deferred and amortized in proportion to the lease payments over the period for which
the asset is expected to be used.

In this case, the loss is an artificial loss and more in the form of a prepaid rent and
therefore shall be deferred and amortized.

3. If the sale price is above fair value, the excess over the fair value is deferred and
amortized over the period for which the asset is expected to be used.

In other words, the excess of sale price over the fair value is a deferred gain and the
excess of the fair value over the carrying amounts is an outright gain.

QUESTION 7-9

What are the disclosures required in an operating lease on the part of the lessee?
 ANSWER 7-9

1. The total of future minimum lease payments under the noncancelable operating leases for
each of the following periods:
a. Not later than one year
b. Later than one year and not later than 5 years
c. Later than 5 years
2. The total of future minimum lease payments expected to be received under noncancelable
subleases at the end of reporting period.
3. Lease and sublease payments recognized as expense in the period, with separate amounts
for minimum lease payments, contingent rents and sublease payments.
4. A general description of the leassee’s significant leasing arrangements.

QUESTION 7-10

What are the disclosures required in an operating lease on the part of lessor?

ANSWER 7-10

1. Future minimum lease payments under noncancelable operating leases in the aggregate
and for each of the following periods:
a. Not later than one year
b. Later than one year and not later than 5 years
c. Later than 5 years
2. Contingent rent recognized as income in the period.
3. A general description of the lessor’s leasing arrangement.

QUESTION 7-11 Multiple choice (AICPA Adapted)

1. The appropriate valuation of an operating lease in the statement of financial position of the
lessee is

a. Zero
b. The absolute sum of the lease payments
c. The present value of the sum of the lease payments discounted at an appropriate rate
d. The market value of the asset at the inception of the lease

2. Rent received in advance by the lessor in an operating lease shall be recognized as revenue

a. When received
 b. At the lease inception
c. At the lease expiration
d. In the period specified by the lease

3. When should a lessor recognize in income a nonrefundable lease bonus paid by a lesse on
signing an operating lease?

a. When received
b. At the inception of the lease
c. At the lease expiration
d. Over the lease term

4. As an inducement to enter a lease, a lessor granted a lessee twelve months of free rent under a
five-year operating lease. The lease was effective at the beginning of the current year and
provides for monthly rental payments to begin at the beginning of next year. The lessee made the
first rental payment at the end of the current year. In the income statement for the current year,
the lessor shall report rent revenue equal to

a. Zero
b. Cash received during the current year
c. One-fourth of the total cash received.
d. One-fifth of the total cash to be received over the life of the lease

5. Lease payments under an operating lease shall be recognized as an expense in the income
statement on

a. Straight line basis over the lease term unless another systematic basis is representative of
the time pattern of the user’s benefit.
b. Diminishing balance basis
c. Sum of units basis
d. Cash basis

6. Lessors should show assets that are out on operating leases and income there from as which of
the following?

a. The asset should be kept off the statement of financial position according and lease
income should go to reserves.
b. The asset should be kept off statement of financial position and the lease income should
go to the income statement.
c. The asset should be shown in the statement of financial position according to its nature
and the lease income should go to reserves.
 d. The asset should be shown in the statement of financial position according to its nature
and the lease income should go to the income statement.

7. When equipments held under an operating lease is subleased by the original lessee, the
original lessee would account for the sublease as

a. Operating lease
b. Sales type lease
c. Direct financing lease
d. Finance lease

8. In an operating lease that is recorded by the lessee, the equal monthly rental payments shall be

a. Allocated between a reduction in the liability for the leased asset and depreciation
expense.
b. Allocated between a reduction in the liability for the leased asset and interest expense.
c. Recorded as a reduction in the liability for leased asset.
d. Recorded as a rental expense.

9. Which statement characterizes an operating lease?

a. The lessee records depreciation and interest

b. The lessee records the lease obligation related to the leased asset.
c. The lessor transfers title of the leased property to the lessee for the duration of the lease
term.
d. The lessor records depreciation and lease revenue.

10. A twenty-year operating lease provides for a 10% increase in annual rent every 5 years. In the
sixth year compared to the fifth year, what could be the effect on the expenses?

a. Rent and interest expense will both increase.

b. Interest expense will increase but not rent expense.
c. Rent expense will increase but not interest expense.
d. No increase in both rent and interest expense.

ANSWER 7-11

1. A 6. D
2. D 7. A

3. D 8. D

4. D 9. D

5. A 10. D

QUESTION 7-12 Multiple choice (PAS 17)

1. It is an arrangement whereby one party sells a property to another party and then
immediately leases the property back from its new owner.

a. Sale
b. Leaseback
c. Sale and leaseback
d. Operating lease

2. If the sale and leaseback transaction results in an operating lease that is clearly established at fair value
a. Any gain or loss on sale is recognized immediately in profit or loss.
b. Any gain or loss on sale is recognized in other comprehensive income.
c. Any gain on sale is deferred and any loss on sale is recognized in profit or loss.
d. Any gain or loss on sale is not recognized.

3. If the sale and leaseback transaction results in an operating lease and the sale price is below fair value
that is compensated by future rental at below market value, any indicated loss on sale is
a. Recognized immediately in profit or loss.
b. Recognized in other comprehensive income.
c. Deferred and amortized in proportion to the lease payments over the period for which the
asset is expected to be used.
d. Not recognized

4. If the sale and leaseback transaction results in an operating lease and the sale price is above fair value,
the excess of the sale price over fair value is
a. Deferred and amortized over the period for which the asset is expected to be used.
b. Recognized immediately in profit or loss.
c. Recognized in other comprehensive income.
 d. Not recognized.

5. If the sale and leaseback transaction results in a finance lease, any excess of sale price over the carrying
amount f the asset
a. Deferred and amortized as income over the lease term.
b. Deferred and amortized as income over the life of the asset.
c. Recognized in profit or loss immediately.
d. Recognized in other comprehensive income.

6. An entity sold a building at a gain and simultaneously leased back the building. If the lease was
reported as a finance lease at the time of sale, the gain should be reported as
a. Component of profit or loss
b. Component of other comprehensive income
c. Component of shareholder’s equity
d. An asset valuation allowance

ANSWER 7 - 12

1. C 4. a
2. a 5. a
3. c 6. d

CHAPTER 8

FINANCE LEASE – LESSEE

QUESTION 8 – 1
What is a finance lease?

ANSWER 8 – 1
Finance lease is not a lease as popularly understood but in substance a purchase of property by the lessee
from the lessor.
Actually, a finance lease is a “lease purchase”. Under USGAAP, a finance lease is the equivalent of a
capital lease.

Under PAS 17, paragraph 4, a finance lease is a lease that transfers substantially all the risks and
rewards incident to ownership of an asset. Title may or may not eventually be transferred.

Thus, on the part of the lessee, the finance lease is conceived as a purchase of an asset and therefore
involves the recognition of an asset and the corresponding lease liability.

On the part of the lessor, the finance lease is conceived as a transfer of property which involves the
recognition of a receivable and a revenue.

The excess of the gross investment in the lease over the cost of the property leased is treated as income.

QUESTION 8 – 2
What are the criteria in order that a lease shall be classified as a finance lease?

ANSWER 8 – 2
Under PAS 17, paragraph 10, among others, any of the following situations would normally lead to a
lease being classified as a finance lease:

a. The lease transfers ownership of the leased asset to the lessee at the end of the lease term.

b. The lessee has bargain purchase option.

A bargain purchase option means that the lessee has the option to purchase the asset at a price
which is expected to be sufficiently lower than the fair value of the asset at the date that the
option becomes exercisable, and that at the inception of the lease, it is reasonably certain that the
option will be exercised.
c. The lease term is for the major part of the economic life of the asset even if title is not transferred.

What percentage represents a “major part” - 60%? 75%? 80%? It is unfortunate that PAS 17 does
not provide a clearcut definition of a major part.

Under US GAAP, “major part” means at least 75% of the economic life of an asset. It is believed
that this should be followed until a clear guidance is provided by Philippine standard or
international accounting standard.

Of course , right thinking persons can debate whether the term “major part” implies a proportion
lower than 75%, for example, as little as 51%, or implies a higher proportion than 75%, such as
90%.

d. The present value of the lease minimum payment amounts to substantially all of the fair value of
the leased asset at the inception of the lease.

QUESTION 8 – 3
What constitiutes “ substantially all” in relation to the fair value of the leased asset?

ANSWER 8 – 3
PAS 17 does not define the term “ substantially all”.

Under US GAAP, “ substantially all” means at least 90% of the fair value of the leased asset.

There is room for debate over whether the term “ substantially all” implies a threshold lower than or
higher than 90%.

The debate can go on until there is a clear definition by Philippine standard or international accounting
standard.

QUESTION 8 – 4
What are the “other criteria” that could also lead to a lease being classified as finance lease?

ANSWER 8 – 4
Paragraphs 10 and 11 provide that , individually or in combination, the following situations could also
lead to a lease being classified as finance lease:

a. The leased asset is of a specialized nature such that only the lessee can use it without major
modification.
b. If the lessee cancels the lease, the lessor’s losses associated with the cancelation are borne by the
lessee.
c. Gains or losses from fluctuation in the fair value of the residual fall to the lessee.
d. The lessee has the ability to continue the lease for a secondary period at a rent which is
substantially lower than market rent.

QUESTION 8 – 5
Is a “cancelable lease” a finance lease?

ANSWER 8 – 5
The classification of finance lease is not a simple case of whether cancelable or noncancelable.

PAS 17 is very clear on the matter that if substantially all of the risks and rewards of ownership of an
asset have been transferred, the lease is a finance lease.

Therefore, the issue is whether there is a transfer of risks and rewards of ownership of an asset. As long as
there is such a transfer, the lease is a finance lease.

Unquestionably, a noncancelable lease transfers all of the risks and rewards of ownership of an asset and
therefore shall be classified as a finance lease.
However, if the lease is cancelable, the transfer of risks and rewards of ownership may be subject to
question.

If any party to the contract can just walk away anytime, there may be a limited transfer of risks and
rewards.

In general, if there is an option to cancel, and the lessee is likely to exercise such an option, then the
lease is likely to be an operating lease.

However, PAS 17, paragraph 11, states that “if the lessee can cancel the lease and the lessor’s losses
associated with the cancelation are borne by the lessee”, this could lead to the lease being classified as a
finance lease.

In other words, if the cancelable lease can be canceled only upon payment of an amount in the form of
penalty for the cancelation, the lease is a finance lease.

QUESTION 8 – 6
When is a cancelable lease deemed noncancelable?

ANSWER 8 – 6
PAS 17, paragraph 4, provides that a cancelable lease is “deemed noncancelable” and thus classified as
finance lease when:
a. The lease can be canceled only upon the occurrence of a remote contingency.
b. The lease can be canceled only with the permission of the lessor.

c. The lessee, upon cancelation, enters into a new lease for the same or equivalent asset with the
same lessor.

d. The lease can be canceled only upon payment of an additional amount or penaltyof such
magnitude that the lessee shall be discouraged from canceling the lease.

QUESTION 8 – 7
Distinguish inception of the lease and commencement of the lease.

ANSWER 8 – 7
Inception of the lease is the earlier of the date of the lease agreement and the date of commitment by the
parties to the principal provisions of the lease.

Accordingly, this is the date:

a. When a lease is classified as either an operating lease or a finance lease.
b. When the amounts to be recognized at the commencement of the lease are determined for a
finance lease.

Commencement of the lease is the date from which the lessee is entitled to exercise its right to use the
leased asset.
In other words, the commencement of the lease is the date of initial recognition of the assets, liabilities,
income or expenses resulting from the lease.

QUESTION 8 – 8
Explain the classification of a land and building lease.

ANSWER 8 – 8
a. When classifying a lease on land and building, an entity normally considers the land and building
elements separately.
b. A land lease with a lease term of several decades or longer may be classified as finance lease even
if title will not pass to the lessee at the end of the lease term.
c. The International Accounting Standards Board also states that when a lease includes both land
and building , an entity should determine the classification of the land lease and building lease
based on the classification criteria taking into account the fact that land normally has an indefinite
economic life.
d. The minimum lease payments are allocated between the land and building elements in proportion
to the relative fair value of the leasehold interests in the land and building elements at the
inception of the lease.
If the lease payments cannot be allocated reliably between the 2 elements, the entire lease is
classified as a finance lease, unless it is clear that both elements are operating leases.
e. Separate measurement of the land and building elements is not required when the lessee’s interest
in both land and building is classified as investment property.

QUESTION 8 – 9
In a finance lease, what amount is recognized as the cost of the asset and lease liability?

ANSWER 8 – 9
The lessee shall record an asset and lease liability equal to the fair value of the leased property at the
inception of the lease or the present value of the minimum lease payments, whichever is lower.

QUESTION 8 – 10
What is the meaning of “minimum lease payments”?

ANSWER 8 – 10
The “minimum lease payments” include the following:
a. Rental payments required during the lease term.
b. Any payment under a bargain purchase option.
c. Any guaranteed residual value if there is no bargain purchase option.

QUESTION 8 – 11
Explain contingent rent and executory costs.

ANSWER 8 – 11
Contingent rent and executory costs arenot included in the computation of the minimum lease payments.
Contingent rent is that portion of the lease payment that is not fixed in amount but is based on a factor
other than just the passage of time, for example, percentage of sales, amount of usage, price index, market
rate of interest.

Executory costs are ownership expenses such as maintenance, taxes and insurance for the leased property.
Such executory costs are expensed immediately when incurred.

QUESTION 8 – 12
Explain the treatment of initial direct costs incurred by the lessee in a finance lease.

ANSWER 8 – 12
Initial direct costs identified as directly attributable to activities performed by the lessee for a finance
lease are included as part of the amount recognized as an asset under the lease.

QUESTION 8 – 13
Define the following:
a. Bargain purchase option
b. Guaranteed residual value
c. Unguaranteed residual value

ANSWER 8 – 13

Bargain purchase option is the option of the lessee to purchase the asset at a price at which is expected to
be sufficiently lower than the fair value at the date the option becomes exercisable.
Guaranteed residual value is that part of the residual value which is guaranteed by the lessee or by party
related to the lessee, the amount of guarantee being the maximum amount that could in any event become
payable.

Unguaranteed residual value is that portion of the residual value of the leased asset, the realization of
which by the lessor is not assured or is guaranteed solely by a party related to the lessor.

QUESTION 8 – 14
Explain implicit interest rate and incremental borrowing rate.

ANSWER 8 – 14
In calculating the present value of the minimum lease payments, the discount factor is the interest rate
implicit in the lease, if this is practicable to determine.

The implicit interest rate is usually known to the lessee. Otherwise, the lessee’s incremental borrowing
rate may be used.
The interest rate implicit in the lease is the discount rate that causes the aggregate present value of the
minimum lease payments and the unguaranteed residual value to equal the fair value of the leased asset
and initial direct costs of the lessor.

The lessee’s incremental borrowing rate is the rate of interest is the rate of interest that the lessee would
have to pay on a similar lease, or the rate that the lessee would incur by borrowing funds to purchase the
asset over a similar term and similar security.

QUESTION 8-15

Explain the depreciation of the leased asset on the part of the lessee.

ANSWER 8-15

PAS 17, paragraph 28, provides that if there is reasonablecertainty that the lessee will obtain
ownership by the end of the lease term, depreciation is based on the useful life of the leased
asset.

Otherwise, the leased asset is depreciated over the shorter of the leased term or useful life of the
asset.

Accordingly, if the finance lease qualifies under the “transfer of ownership” and “bargain
purchase option” criteria, depreciation is based on the useful life of the asset.

If the finance lease qualifies under the “75%” and “90%” criteria, the leased asset is depreciated
over the useful life of the asset or lease term, whichever is shorter.

QUESTION 8-16

Explain the “actual purchase” of the leased asset on the part of the lessee in a finance lease.

ANSWER 8-16

When an entity actually purchase an asset that it has been leasing under a finance lease, the cost
of the asset purchased is equal to the carrying amount of the leased asset plus cash payment
minus the balance of the lease liability.

Carrying amount of the leased asset xx

Cash payment xx

Total consideration xx
Lease liability balance (xx)
Cost of asset actually purchased xx
QUESTION 8-17

What are the disclosures required in a finance lease on the part of the lessee?

ANSWER 8-17

1.The net carrying amount of each class of asset at the end of reporting period.

2. A reconciliation between the total future minimum lease payments at the end of reporting
period and their present value.

3. The total future minimum lease payments at the end of reporting period and their present value
for each of the following periods:

a. Not later than one year

b. Later than one year and not later than 5 years
c. Later than 5 years

4. Contingent rent recognized as expense in the period.

5. The total minimum sublease payments expected to be received under noncancelable subleases
at the end of reporting period.

6. A general description of the lease’s material leasing arrangements.

QUESTION 8-18 Multiple choice (PAS 17)

1. It is a contract that transfers substantially all the risks and rewards incidental to
ownership of an asset, although title may or may not eventually be transferred.

a. Lease
b. Finance lease
c. Operation lease
d. Lease purchase

2. The inception of the lease is the

a. Date of the lease agreement

b. Date of commitment by the parties to the principal provisions of the lease.
c. Earlier of the date of the lease agreement or date of commitment by the parties to the
principal provisions of the lease.
 d. Later of the date of the lease agreement or date of commitment by the parties to the
principal provisions of the lease

3. It is the date on which the lease is entitled to exercise the right to use the leased asset.

a. Inception of the lease

b. Commencement of the lease
c. Date of lease agreement
d. Date of commitment to the provisions of the lease

4. If there is a reasonable certainty that the lease will obtain ownership by the end of lease
term, the depreciation of the leased asset is based on the

a. Useful life of the asset

b. Lease term
c. Useful life of the asset or lease term, whichever is shorter
d. Useful life of the asset or lease term whichever is longer

5. The situations which would normally lead to a lease being classified as a finance lease
include all of the following except

a. The lease transfer ownership of the asset to the lessee by the end of the lease term
b. The lessee has the option to purchase the asset at a price which is expected to be
sufficiently higher than the fair value at the date the option becomes exercisable.
c. The lease term is for the major part of the economic life of the asset even if title is not
transferred.
d. The present value of the minimum lease payments amounts to at least substantially all
of the fair value of the leased asset at the inception of the lease.

6. Situations which individually or in combination could also lead to a lease being classified
as a finance lease being classified as a finance lease include all of the following, except

a. The lease asset is of a specialized nature such that only the lessee can use it without
major modification.
b. If the lessee cancels the lease, the lessor’s losses associated with the cancelation are
borne by the lessee.
c. Gains or losses from the fluctuation in the fair value of the residual fall to the lessee.
d. The lessee hast the ability to continue the lease for a secondary period at a rent which
is substantially the same as the market rent.
 7. At the commencement of the lease, the lessee shall recognize a finance lease as asset and
liability at an amount equal to

a. Fair value of the leased asset.

b. Present value of the minimum lease payments.
c. Fair value of the leased asset or present value of the minimum lease payments,
whichever is lower.
d. Fair value of the leased asset or present value of the minimum lease payments,
whichever is higher.
8. The minimum lease payments include all of the following, except

a. Rental payments over the lease term

b. Any amount guaranteed by the lessee or by a party related to the lessee
c. Payment required to exercise an option on the part of the lessee to purchase the asset
at a price which is expected to be sufficiently lower than the fair value at the option
exercise date.
d. Contingent rent

9. It is that portion of the lease payments that is not fixed in amount but is based on a factor
other than just the passage of time, for example, percentage of sales, amount of usage,
price index and market rate of interest.

a. Variable rent
b. Contingent rent
c. Bargain purchase option
d. Executory cost

10. Which of the following statements in relation to a finance lease is true?

I. Any initial direct costs incurred by a lessee are added to the amount of liability
recognized in the statement of financial position.
II. Any initial direct costs incurred by a lessee are added to the amount of the asset
recognized in the statement of financial position

a. I only
b. II only
c. Both I and II
d. Neither I nor II

ANSWER 8-18
 1. B
2. C
3. B
4. A
5. B
6. D
7. C
8. D
9. B
10. B

QUESTION 8-19 Multiple choice (PAS 17)

1. The interest rate implicit in the lease is the discount rate that causes the aggregate of the
present value of the minimum lease payments and the unguaranteed residual value to be
equal to the

a. Fair value of the leased asset.

b. Fair value of the leased asset and initial direct cost of the lessor.
c. Fair value of the leased asset and initial direct cost of the lessee.
d. Gross investment in the lease.

2. It is that portion of the residual value of the leased asset, the realization of which by the
lessor is not assured or is guaranteed solely by a party related to the lessor.

a. Residual value
b. Guaranteed residual value
c. Unguaranteed residual value
d. Minimum lease payment

3. It is that part of the residual value that is guaranteed by the lessee or by a party related to
the lessee, the amount of guarantee being the maximum amount that could in any event
become payable.

a. Bargain purchase option

b. Residual value
c. Guaranteed residual value
d. Unguaranteed residual value

4. Which of the following statements is true regarding land and building lease?

I. A land lease with a lease term of several decades or longer may be

classified as finance lease even if the title will not pass to the lessee at the
end of the lease term
 II. When a lease includes both land and building, an entity shall determine
the classification of the land lease and building lease based on the
“classification” criteria” taking into account that land normally has an
indefinite economic life.
a. I only
b. II only
c. Both I and II
d. Neither I nor II

5. A cancelable lease is deemed noncancelable under all of the following conditions, except

a. The lease can be cancelled only upon the occurrence of a remote contingency.
b. The lease term can be cancelled without the permission of the lessor.
c. The lessee, upon cancelation, enters into a new lease for the same or an
equivalent asset with the same lessor.
d. The lease can be cancelled only upon payment of a penalty of such magnitude
that the lessee shall be discouraged from cancelling the lease.

ANSWER 8-19

1. B
2. C
3. C
4. C
5. B
QUESTION 8-20 Multiple choice (IFRS)

1. The classification of a lease is normally carried out

a. At the end of the lease term

b. After a “cooloing off” period of one year
c. At the inception of the lease
d. When the entity deems it to be necessary

2. Where there is a lease of land and building and the title to the land is not transferred,
generally the lease is treated as if

a. The land is finance lease and the building is a finance lease.

b. The land is finance lease and the building is an operating lease.
c. The land is an operating lease and the building is a finance lease.
d. The land is an operating lease and the building is an operating lease.

3. The lease of land and building when split causes difficulty in the allocation of the
minimum lease payments. In this case, the minimum lease payments should be split

a. According to the relative fair value of two elements

b. By the entity based on the useful life of the two elements
c. Using the sum of the digits method
d. According to any fair method devised by the entity

4. The classification of a lease as either operating or finance lease is based on

a. The length of the lease.

b. The transfer of the risks and rewards of ownership.
c. The minimum lease payments being at least 50% of the fair value
d. The economic life of the asset.
 5. Which of the following situations would prima facie lead to a lease being classified as an
operating lease?

a. Transfer of ownership to the lessee at the end of lease term.

b. Option to purchase at an amount below the fair value of the asset.
c. The lease term is for a major part of the useful life of the asset.
d. The present value of the minimum lease payments is 50% of the fair value of the
asset.

ANSWER 8-20

1. c
2. c
3. a
4. b
5. d

QUESTION 8-21 Multiple choice (AICPA Adapted)

1. Generally accepted accounting principles require that certain lease agreement shall be
accounted for as purchase. The theoretical basis for this statement is that a lease of this
type

a. Effectively conveys all of the benefits and risks incident to the ownership of
property.
b. Is an example of form over substance.
c. Provides the use of the lease asset to the lessee for a limited period of time.
d. Must be recorded in accordance with the concept of cause and effect.

2. In determining the lessee’s capitalizable cost at the beginning of the lease term. The
payment call for by any bargain purchase option would be

a. Subtracted at present value.

b. Added at exercise price.
c. Added at present value.
d. Subtracted at exercise price.
 3. What are the three types of period costs that a lessee experiences with finance lease?

a. Interest expense, amortization expense, executor costs

b. Amortization expense, executor costs, lease expense
c. Executory costs, interest expense, lease expense
d. Lease expense, executor costs, initial direct costs

4. Which of the following statements is true regarding the lease term?

a. The lease term does not include all periods covered by bargain renewal option.
b. The lease term includes all periods for which failure to renew imposes a penalty
sufficiently high that the lessee probably will renew
c. The lease term may extend beyond the date a bargain purchase option becomes
exercisable.
d. The lease term does not include all periods representing renewals or extensions of
the lease at the lessee’s option.

5. At the inception, the lease term is 50% of the economic life of the leased property but the
lease contains a bargain purchase option. The lease should be recorded as

a. Neither asset nor liability

b. Asset but not a liability
c. Asset and a liability
d. Expense

6. What is the cost basis of an asset acquired in a finance lease

a. The absolute sum of the minimum lease payments over the lease term
b. The present value of the minimum lease payments including executor costs
discounted at an appropriate rate
c. The present value of the minimum lease payments exclusive of executor costs
discounted at an appropriate rate
d. The present value of the market value of the asset discounted at an appropriate
rate

7. At the inception of a finance lease, the guaranteed residual value should be

a. Included as part of minimum lease payments at present value

 b. Included as part of minimum lease payments at future value
c. Included as part of minimum lease payments only to the extent of the excess of
guaranteed residual value over estimated residual value
d. Excluded from minimum lease payments

8. For a finance lease, the amount recorded initially by the lessee as a liability should

a. Exceed the present value of the minimum lease payments

b. Exceed the minimum lease payments
c. Not exceed the fair value of the leased property at the inception of the lease
d. Equal the minimum lease payments

9. For a finance lease, the amount recorded initially by the lessee as a liability should normally

a. Exceed the minimum lease payments

b. Exceed the present value of the minimum lease payments at the beginning of the lease
c. Equal the minimum lease payments
d. Equal the present value of the minimum lease payments at the beginning of the lease

10. The lessee’s carrying amount of an asset from the capitalization of a lease would be
periodically reduced by

a. Total minimum lease payment

b. Portion of the minimum lease payment allocable to the interest
c. Portion of the minimum lease payment allocable to reduction of the lease liability
d. Depreciation of the asset

ANSWER 8-21
1. a 6. c
2. c 7. a
3. a 8. c
4. b 9. d
5. c 10. d

QUESTION 8-22 Multiple choice (IAA)

1. One of the four determinative criteria for a finance lease specifies that the lease term be
equal to or greater than

a. The economic life of the property.

b. 90 percent of the economic life of the property.
c. 75 percent of the economic life of the property.
d. 50 percent of the economic life of the property.
2. One of the four determinative criteria for a finance lease is that the present value at the
beginning of the lease term of the minimum lease payments equals or exceeds
 a. The fair value of the property.
b. 90 percent of the fair value of the property.
c. 75 percent of the fair value of the property.
d. 50 percent of the fair value of the property.

3. Which of the following is not included in the definition of minimum lease payments?

a. Any payment required by a bargain purchase option that is reasonably certain

b. Cost for services and taxes to be paid by and reimbursed to the lessor
c. Required payments over the lease term
d. Any amounts guaranteed by a party related to the lessee

4. The accounting concept that is principally used to classify leases into operating and finance is

a. Substance over form

b. Prudence
c. Neutrality
d. Completeness

5. Which of the following is not part of the minimum lease payments from the standpoint of the
lessee?

a. The minimum rental payments

b. Any guarantee the lessee is required to make at the end of the lease term regarding any
deficiency from a specified minimum
c. Any estimated residual value at the of the lease term
d. Any payment the lessee must make at the end of the lease term to purchase the leased
property under a bargain purchase option

6. From the standpoint of the lessee, the minimum lease payments include all of the following,
except

a. The guaranteed residual value.

b. The lessee’s obligation to pay executor cost.
c. The bargain purchase option.
d. Any payment that the lessee must make upon failure to extend or renew the lease.

7. Which of the following should be considered an executor cost?

a. Minimum lease payment

b. Interest expense incurred
c. Bargain purchase option
d. Maintenance cost
8. An entity leased a new machine having an expected useful life of 12 years. The
noncancelable lease term is 10 years. andthe entity may exercise a purchase option at the
 end of the noncancelable term. The machine shall be capitalized by the entity and depreciated
over

a. 9years
b. 12years
c. 10years
d. 10 or 12 years at entity’s option.

9. Which of the following statements concerning guaranteed residual value is appropriate for
the lessee?

a. The asset and related liability shall be increased by the absolute amount of the residual
value.
b. The asset and related liability shall be decreased by the absolute amount of the residual
value.
c. The asset and related liability shall be decreased by the present value of the residual
value.
d. The asset and related liability shall be increased by the present value of the residual
value.

10. If the residual value of a leased asset is greater than the amount guaranteed by the lessee

a. The lessee pays the lessor for the difference.

b. The lessee recognizes a gain at the end of the lease term.
c. The lessee has no obligation related to the residual value.
d. The lessor pays the lessee for the difference.

ANSWER 8-22
1. c 6. b
2. b 7. d
3. b 8. c
4. a 9. d
5. c 10. c

QUESTION 8-23 Multiple choice (AICPA Adapted)

1. At the beginning of the current year, a lessee signed a 7-year lease for equipment having a
10-year economic life. The present value of the monthly lease payments equaled 80% of the
fair value of the equipment. The lease agreement provided for neither a transfer of title to the
lessee nor a bargain purchase option. In the income statement for the current year, the lessee
shall report

a. Rent expense equal to the lease payments in the current year.

b. Rent expense equal to the lease payments in the current year less interest expense
c. Lease amortization equal to one-tenth of the equipment’s fair value
d. Lease amortization equal to one-seventh of 80% of the fair value of the equipment
2. An entity leased a tractor and a truck. The tractor lease does not contain a bargain purchase
option but the lease term is equal to 90% of the tractor’s economic life. The truck lease does
not transfer ownership of the truck to the entity by the end of the lease term is equal to 75%
of the truck’s economic life. How should the entity classify these leases?

a. Both leases should be classified as finance leases.

b. An operating lease for the tractor lease and as a finance lease for the truck lease.
c. Both the tractor and the truck lease should be classified as operating leases.
d. The tractor lease should be classified as a finance lease and the truck lease as an
operating lease.

3. The lessee’s lease liability for a finance lease would be periodically reduced by

a. Minimum lease payment plus the depreciation of the related asset

b. Minimum lease payment less the depreciation of the related asset
c. Minimum lease payment less the portion allocable to interest
d. Minimum lease payment

4. At the beginning of the current year, an entity made long-term improvements to a recently
leased building. The lease agreement provided for neither a transfer of title nor a bargain
purchase option. The present value of the minimum lease payments equaled 85% of the
building’s fair value and the lease term equaled to 70% of the building’s economic life. The
lessee shall recognize an asset for

a. Building
b. Leasehold improvements
c. Both building and leasehold improvements
d. Neither building nor leasehold improvements

5. A six-year finance lease entered into on December 31 of the current year specified equal
minimum annual lease payments due on December 31 of each year. The first minimum
annual lease payment paid on December 3 of the current year consists of which of the
following?

I. Interest expense
II. Lease liability

a. I only
b. II only
c. Both I and II
d. Neither I nor II

6. A six-year finance lease entered into on December 31 of the current year specified equal
minimum annual lease payments due on December 31 of each year, the first payment being
made on December 31 of the current year. The portion of the third minimum lease payment
 applicable to which of the following increased over the corresponding second minimum lease
payment?

I. Interest expense
II. Reduction of liability

a. I only
b. II only
c. Both I and II
d. Neither I nor II

7. A lessee had a ten-year finance lease requiring equal annual payments. The reduction of the
lease liability in second year should equal

a. The current liability shown for the lease at the end of first year
b. The current liability shown for the lease at the end of second year
c. The reduction of the lease liability in the first year
d. One-tenth of the original lease liability

8. A six-year finance lease specifies equal minimum annual lease payments. Part of this
payment represents interest and part represents a reduction in the lease liability. The portion
of the minimum lease payment in the fifth year applicable to the reduction of the lease
liability should be

a. Less than in the fourth year

b. More than in the fourth year
c. The same as in the sixth year
d. More than in the sixth year

9. The present value of the minimum lease payments should be used by the lessee in the
determination of

a. Finance lease liability

b. Operating lease liability
c. Both finance lease and operating lease liability
d. Neither finance lease liability nor operating lease liability

10. For which of the following transactions would be the use of the present value of an annuity-
due concept be appropriate in calculating the present value of the liability owed at the date of
incurrence?

a. A finance lease entered into with the initial lease payment due one month subsequent to
the signing of the lease.
b. A finance lease is entered into with the initial lease payment due upon signing of the
lease.
 c. a ten-year 8% bond is issued on January 1 with interest payable semiannually on January
1 and July 1 yielding 7%.
d. A ten-year 8% bond is issued on January 1 with interest payable semiannually on January
1 and July 1 yielding 9%.

ANSWER 8-23

1. a 6. b
2. a 7. a
3. c 8. b
4. b 9. a
5. b 10. b
CHAPTER 9

FINANCE LEASE – LESSOR

QUESTION 9-1

Contrast a sales-type lease from a direct financing lease.

ANSWER 9-1

Lessors classify a finance lease either as sales-type or direct financing lease.

1. The primary difference is the recognition of a manufacturer or dealer profit.

The sales-type lease recognizes a manufacturer or dealer profit. The direct financing lease
does not.

2. Both sales-type and direct financing lease recognize interest income or financial revenue.

QUESTION 9-2

Explain the following in connection with a “direct financing lease”:

1. Gross investment
2. Net investment in the lease
3. Unearned interest income
4. Initial direct cost

ANSWER 9-2

1. Gross investment in the lease

The gross investment in the lease is equal to the gross rentals for the entire lease term plus
the absolute amount of the residual value, whether guaranteed or unguaranteed. Actually,
this is the amount debited to lease receivable.

2. Net investment in the lease

 The net investment in the lease is equal to the cost of the asset plus any initial direct cost
incurred by the lessor.

3. Unearned interest income

The unearned interest income is the total financial revenue of the lessor which is the
difference between the gross investment and net investment in the lease.

4. Initial direct cost

In a direct financing lease, the initial direct cost incurred by the lessor is added to the cost of
the asset to get the net investment in the lease.

This would effectively spread the initial direct cost over the lease term and reduce the amount
of interest income.

Accordingly, the interest rate implicit in the lease is recomputed so as to include the initial
direct cost in the measurement of the lease receivable.

QUESTION 9-3

Explain the following in connection with a “sales type lease”.

1. Gross investment
2. Net investment in the lease
3. Unearned interest income
4. Sales
5. Cost of sales
6. Gross profit
7. Initial direct cost

ANSWER 9-3

1. Gross investment – this is equal to the gross rentals for the entire lease term plus the
absolute amount of the residual value, whether guaranteed or unguaranteed.

Recall that this is the same definition of gross investment in a direct financing lease.

2. Net investment in the lease – This is equal to the present value of the gross rentals plus
the present value of the residual value, whether guaranteed or unguaranteed.
3. Unearned interest income – This is the total financial revenue of the lessor which is the
difference between the gross investment and net investment in the lease.
4. Sales – The amount is equal to the net investment in the lease or fair value of the asset,
whichever is lower.
5. Cost of sales – This is equal to the cost of asset sold plus the initial direct cost incurred by
the lessor.
6. Gross profit – This is the usual formula of sales minus cost of sales.
7. Initial direct cost – This amount is expensed immediately in a sales type lease as
component of cost of sales.

QUESTION 9-4

Explain the “actual sale” of the leased asset by the lessor to the lessee.

ANSWER 9-4

When a lessor actually sells an asset that it has been leasing under a finance lease, the
difference between the sale price and the carrying amount of the lease receivable is
recognized in profit or loss.

The carrying amount of the lease receivable is equal to the balance of the lease receivable
minus the unearned interest income.

QUESTION 9-5

What are the disclosures required in a finance lease on the part of lessor?

ANSWER 9-5

1. A reconciliation between the gross investment in the lease and the present value of the
minimum lease payments receivable at the end of reporting period.
2. The gross investment in the lease and the present value of the minimum lease payments
receivable at the end of reporting period for each of the following periods:
a. Not later than one year
b. Later than one year and not later than 5 years.
c. Later than 5 years
3. Unearned finance income or unearned interest income.
4. Unguaranteed residual value accruing to the benefit of the lessor.
5. Accumulated allowance for uncollectible minimum lease payments receivable.
6. Contingent rent recognized as income in the period.
7. A general description of the lessor’s material leasing arrangements.

QUESTION 9-6 Multiple choice (PAS 17)

1. Gross investment in the lease is

a. Aggregate of the minimum lease payments under a finance lease of the lessor and any
unguaranteed residual value accruing to the lessor.
b. The minimum lease payments under a finance lease of the lessor.
c. Present value of minimum lease payments under a finance lease of the lessor and any
unguaranteed residual value.
d. Present value of the minimum lease payments under a finance lease of the lessor.
2. Net investment in a direct financing lease is equal to
a. Cost of the asset
 b. Cost of the asset plus initial direct cost paid by the lessor.
c. Cost of the asset minus guaranteed residual value.
d. Cost of the asset plus unguaranteed residual value.
3. Lessors shall recognize asset held under a finance lease as a receivable at an amount
equal to
a. Gross investment in the lease
b. Net investment in the lease
c. Gross rentals
d. Residual value, whether guaranteed or unguaranteed.
4. Which is the correct accounting treatment for a finance lease in the accounts of a lessor?
a. Treat as a noncurrent asset equal to net investment in the lease. Recognize all finance
payments in the income statement.
b. Treat as a receivable equal to gross amount receivable on lease. Recognize finance
payments in cash by reducing debt.
c. Treat as a receivable equal to net investment in the lease. Recognize finance payment
by reducing debt and taking interest to income statement.
d. Treat as a receivable equal to net investment in the lease. Recognize finance
payments in cash by reduction of debt.
5. Under a direct financing lease, the excess of aggregate rentals over the cost of leased
property shall be recognized as interest income of the lessor.
a. In increasing amounts during the lease term
b. In constant amounts during the lease term
c. In decreasing amounts during the lease term
d. After the cost of leased property has been fully recovered through rentals

ANSWER 9-6

1. a
2. b
3. b
4. c
5. c

QUESTION 9-7 Multiple choice (PAS 17)

1. Under a sales type lease, what is the meaning of gross investment in the lease?
a. Present value of minimum lease payments
b. Absolute amount of minimum lease payments
c. Present value of minimum lease payments plus present value of unguaranteed
residual value
d. Aggregate of minimum lease payments and unguaranteed residual value
2. Net investment in a sales type lease is equal to
a. Gross investment in the less unearned finance income
b. Cost of the leased asset
c. The minimum lease payments
d. The minimum lease payments less unguaranteed residual value
3. These are incremental costs that are directly attributable to negotiating and arranging
a lease.
a. Initial direct costs
b. Transaction costs
c. Costs of services
d. Executory costs
4. Initial direct costs incurred by the lessor under a sales type lease are
a. Charged to unearned income in the first period of the lease term.
b. Charged to cost of sales in the first period of the lease term.
c. Deferred and allocated over the lease term in proportion to the recognition of rent
revenue.
d. Deferred and allocated over the lease term on a straight line basis.
5. What is the treatment of unguaranteed residual value in determining the cost of sales
under a sales type lease?
a. The unguaranteed residual value is ignored.
b. The unguaranteed residual value is added to the cost of the leased asset.
c. The unguaranteed residual value is deducted from the cost of the leased asset at
absolute amount.
d. The unguaranteed residual value is deducted from the cost of the leased asset at
present value.
6. The sales revenue recognized at the commencement of the lease by a manufacturer or
dealer lessor is
a. Fair value of the asset
b. Present value of the minimum lease payments
c. Fair value of the asset or present value of the minimum lease payments,
whichever is lower.
d. Fair value of the asset or present value of the minimum lease payments,
whichever is higher.
7. The profit on a finance lease for lessors who are manufacturers r dealers shall
a. Not be recognized separately from finance income
b. Be recognized in the normal way on the transaction
c. Only be recognized at the end of the lease term
d. Be allocated on a straight line basis over the lease term
8. Which of the following statements characterizes a sales type lease?
a. The lessor recognizes only interest revenue over the life of the asset.
b. The lessor recognizes only interest revenue over the lease term.
c. The lessor recognizes a dealer profit at lease inception and interest revenue over
the lease term.
d. The lessor recognizes a dealer profit at lease inception and interest revenue over
the life of the asset.
9. The excess of the fair value of leased property at the inception of the lease over the
carrying amount shall be recognized by the dealer lessor as
a. Unearned income from a sales type lease
b. Unearned income from a direct financing lease
c. Manufacturer profit from a sales type lease
 d. Manufacturer profit from a direct financing lease
10. In a lease that is recorded as a direct sales type lease by the lessor, interest revenue
a. Does not arise
b. Shall be recognized over the period of the lease using the interest method
c. Shall be recognized over the period of the lease using the straight line method
d. Shall be recognized in full as revenue at the inception of the lease

ANSWER 9-7

1. d 6. c
2. a 7. b
3. a 8. c
4. b 9. c
5. d 10. B

CHAPTER 10

ACCOUNTING FOR INCOME TAX

QUESTION 10-1
Which entities are required to apply deferred tax accounting under PAS12?
ANSWER 10-1
Deferred tax accounting is applicable to all entities, whether public or nonpublic entities.
A public entity is one whose equity and debt securities are traded in a stock exchange or
over –the-counter market or whose equity or debt securities are registered with SEC in
preparation for sale of the securities in the exchange market.

QUESTION 10-2
Distinguish accounting income and taxable income.

ANSWER 10-2
Accounting income or financial income is the net income for the period before deducting
income tax expense. Under IAS, this is known “accounting profit”.

This is the income appearing on the traditional income statement and computed in
accordance with accounting standards.

Taxable income is the income for the period determined in accordance with the rules
established by the taxation authorities. Taxable income is the income appearing on the
income tax return and computed in accordance with the income tax law.

Taxable income may be defined also as the excess of taxable revenue over tax deductible
expenses and exemptions for the period as defined by the Bureau of Internal Revenue.

QUESTION 10-3
Explain the two basic differences between accounting income and taxable income.

ANSWER 10-3
1. Permanent differences are items of revenue and expenses which are included in
either accounting income or taxable income but will never be included in the other.

Actually, permanent differences pertain to nontaxable revenue and nondeductible

expenses.

Permanent differences do not give rise to deferred tax asset or liability because they
have no future tax consequences.

2. Temporary differences are differences between the carrying amount of an asset or

liability and its tax base.

Temporary differences include timing differences.

Temporary differences are differences between accounting income and taxable

income that originate in one period and reverse in one or more subsequent periods.

In other words, timing differences are items of income and expenses which are
included in both accounting income and taxable income but at different time periods.
 Accordingly, temporary differences give rise either to a deferred tax asset or deferred
tax asset or deferred tax liability.

QUESTION 10-4

Explain the two kinds of temporary differences

ANSWER 10-4

1. Taxable temporary difference is the temporary difference that will result in future taxable amount in
determining taxable income of future periods when the carrying amount of the asset or liability is
recovered or settled.

2. Deductible temporary difference is the temporary difference that will result in future
deductible amount in determining taxable income of future periods when the carrying amount of the
asset or liability is recovered or settled.

QUESTION 10-5

What is a deferred tax liability?

ANSWER 10-5

Deferred tax liability is the amount of income tax payable in future periods with respect to a taxable
temporary difference.

A deferred tax liability is the deferred tax consequence attributable to a future taxable amount or taxable
temporary difference.

Actually, a deferred tax liability arises from the following:

a. When the accounting income is higher than taxable income because of timing differences.
b. When the carrying amount of an asset is higher than the tax base.
c. When the carrying amount of a liability is lower than the tax base.

QUESTION 10-6

What is a “tax base”?

ANSWER 10-6

The tax base of an asset or a liability is the amount attributable to the asset or liability for tax purposes.

Warded in another way, the tax base of an asset or a liability is the amount of the asset or liability that is
recognized for tax purposes.

The tax base of an asset is the amount that will be deductible for tax purposes against future profit.
For example, if an entity has appropriately capitalized P1,000,000 as software development cost, the
carrying amount is P1,000,000 for accounting purposes.

However, if this amount is allowed as a one-time deduction for tax purposes, the tax base is zero
because the entire amount is expensed in the current year.

The tax base of a liability is normally the carrying amount less the amount that will be deductible for tax
purposes in the future.

For example, if an entity has recognized an estimated warranty liability of P500,000, the carrying amount
is P500,000 for accounting purposes.

However, an estimated warranty cost is deductible only when actually paid.

Thus, tax base is zero.

The carrying amount of P500,000 less the future deductible amount of P500,000 equals zero.

QUESTION 10-7

What are the types of temporary differences that result to higher accounting income than taxable
as a result of timing differences?

ANSWER 10-7

1. Revenues and gains are included in accounting income of the current period but are
taxable in future periods.
For example, an installment sale is included in accounting income at the time of sale and
included in taxable income when cash is collected in future periods.

2. Expenses and losses are deductible for tax purposes in the current period but deductible
for accounting purposes in future periods.
a. Accelerated depreciation for tax purposes and straight line depreciation for
accounting purposes.
b. Development cost may be capitalized and amortized over future periods in
determining accounting income but deducted in determining taxable income in the
period in which it is paid.
c. Prepaid expenses has already been deducted on a cash basis in determining
taxable income of the current period.
QUESTION 10-8

Give examples of temporary differences that technically are not timing differences but
nevertheless give rise to deferred tax liability.
ANSWER 10-8

1. Asset is revalued upward and no equivalent adjustment is made for tax purposes.
2. The carrying amount of investment in subsidiary, associate or joint venture is higher that
the tax base because the subsidiary, associate or joint venture has not distributed the
entire income to the parent or investor.
3. The cost of a business combination that is accounted for as an acquisition is allocated to
the identifiable assets and liabilities acquired at fair value and no equivalent adjustment
is made for tax purposes.
QUESTION 10-9

Explain the recognition of a deferred tax liability.

ANSEWR 10-9

PAS 12, paragraph 15, provides that “a deferred tax liability shall be recognized for all taxable
temporary difference arises from:

1. Goodwill resulting from a business combination and which is nondeductible for tax
purposes.
2. Initial recognition of an asset or liability in a transaction that is not a business
combination and affects neither accounting income nor taxable income.
3. Undistributed profit of subsidiary, associate or joint venture when:
a. The parent, investor or venture is able to control the timing of the reversal of the
temporary difference.
b. It is probable that the temporary difference will not reverse in the foreseeable
future.
QUESTION 10-10

What is deferred tax asset?

ANSWER 10-10

A deferred tax asset is the amount of income tax recoverable in future periods with respect to
deductible temporary difference and operating loss carry forward.

A deferred tax asset is the deferred tax consequence attributable to a future deductible amount or
deductible temporary difference and operating loss carry forward.

A deferred tax asset arises from the following:

a. When the taxable income is higher that accounting income because of timing
differences.
b. When the tax base of asset is higher that carrying amount.
c. When the tax base of a liability is lower than carrying amount.
QUESTION 10-11

What are the types of temporary differences that will result to taxable income higher than
financial income because of timing differences?

ANSWER 10-11

1. Revenues and gains are included in taxable income of current period but are included in
accounting income of future periods.
For example, rent received in advance is taxable at the time of receipt but deferred in
future periods for accounting purposes.

2. Expenses and losses are deducted from accounting income of current period but are
deductible for tax purposes in future periods. Examples are:
a. A probable and measurable litigation loss is recognized for accounting purposes
but deducted in determining taxable income when actually incurred or paid.
b. Estimated product warranty cost is recognized for accounting purposes in the
current period but deducted in determining taxable income when actually incurred
or paid.
c. Research cost is recognized as expense in determining accounting income but not
permitted as a deduction in determining taxable income until a later period.
d. An impairment loss is recognized for accounting purposes but ignored for tax
purposes until the asset is sold.
e. Doubtful accounts are recognized as expense for accounting purposes but
deductible for tax purposes only when written off as worthless.
QUESTION 10-12

Give examples of temporary differences that technically are not timing differences but
nevertheless give rise to deferred tax asset.

ANSWER 10-12

1. Asset is revalued downward and no equivalent adjustment is made for tax purposes.
2. The tax base of investment is subsidiary, associate or joint venture is higher that carrying
amount because the subsidiary, associate or joint venture has suffered continuing losses in
current and prior years.
3. Financial asset is carried at fair value which is less than cost but no equivalent
adjustment is made for tax purposes.
QUESTION 10-13

Explain the recognition of a deferred tax asset.

ANSER 10-13
PAS 12, paragraph 21, provides that “a deferred tax asset shall be recognized for all deductible
temporary differences and operating loss carry forward when it its probable that taxable income
will be available against which the deferred tax asset can be used”.

QUESTION 10-14

What is an operating loss carry forward?

ANSWER 10-14

Operating loss carry forward is an excess of tax deductions over gross income in a year that
may be carried forward to reduce taxable income in a future year. Thus, an operating loss carry
forward will give rise to a deferred tax asset.

Certain entities registered with the Board of Investments are permitted to carry over net
operating loss for tax purposes subject to limitations of the relevant law and implementing
regulations of the Board of Investments.

QUESTION 10-15

Define the following:

1. Current tax expense

2. Deferred tax expense or benefit
3. Income tax expense
ANSWER 10-15

1. Current tax expense is the amount of income tax paid or payable for the year as
determined by applying the provisions of the enacted tax law to the taxable income.
In other words, current tax expense is equal to taxable income multiplied by the current
tax rate.

2. Deferred tax expense or benefit is the change during the year in an entity’s deferred tax
liability and deferred tax asset.
If the increase in deferred tax liability is more than the increase in deferred tax asset,
there is net deferred tax expense.

Conversely, if the increase in deferred tax asset is more than the increase in deferred tax
liability, there is a net deferred tax benefit.

In other words, taxable temporary difference multiplied by the tax rate equals deferred
tax expense.

Deductible temporary difference multiplied by tax rate equals deferred tax benefit.
 3. Income tax expense is the sum of current tax expense and deferred tax expense or benefit.
This is the amount of tax expenses that appears on the income statement.

QUESTION 10-16

Explain a current tax liability and a current tax asset.

ANSWER 10-16

A current tax liability is the current tax expense or the amount of income tax actually payable.
This is classified as current liability.

Under our income tax law, income tax for corporations is payable every quarter.

If the amount of tax already paid for the current period exceeds the amount actually payable for
the period, the excess is recognized as current tax asset.

Actually, a current tax asset is a prepaid income tax and shall be classified as current asset.

QUESTION 10-17

Explain the measurement of current tax liability and current tax asset.

ANSWER 10-17

A current tax liability or current tax asset shall be measured using the tax rate that has been
enacted and effective at the end of the reporting period.

QUESTION 10-18

Explain the measurement of deferred tax liability or deferred tax asset.

ANSWER 10-18

A deferred tax liability or deferred tax asset shall be measured using the tax rate that has been
enacted by the end of the reporting period and expected to apply to the period when the asset is
realized or the liability is settled.

Illustration

The tax rate of 30% is applicable to the current taxable year. By the end of the current taxable
year, a new tax law has been enacted imposing a 25% tax rate effective next taxable year.

The current tax liability or current tax asset is measured at 30% but the deferred tax liability or
deferred tax asset is measured using the new tax rate of 25%
QUESTION 10-19

Explain the presentation of deferred tax liability and deferred tax asset.

ANSWER 10-19

PAS 12, paragraph 70, provides that “when an entity makes a distinction between current and
noncurrent asset and liabilities, it shall not classify deferred tax assets as currentassets and
deferred tax liabilities as current liabilities.”

Accordingly, a deferred tax asset shall be classified as noncurrent asset and a deferred tax
liability shall be classified as noncurrent liability regardless of reversal period.

Moreover, a deferred tax asset or deferred tax liability shall not be discounted.

QUESTION 10-20

May a deferred tax asset and deferred tax liability be offset against the other presentation
purposes?

ANSWER 10-20

PAS 12, paragraph 74, provides that an entity shall offset deferred tax asset and deferred tax
liability when:

a. The deferred tax asset and deferred tax liability relate to income taxes levied by the same
taxing authority.
b. The entity has a legalenforceable right to set off a current tax asset against a current tax
liability.
QUESTION 10-21

Explain the deferred tax consequence of revaluation of asset.

ANSWER 10-22

Generally, revaluation of an asset is not a taxable event. However, the future recovery of the
asset either through continuing use or through disposal would lead to a taxable amount.

The amount of depreciation based on cost deductible for tax purposes would differ from the
amount of depreciation based on revalued amount that is recognized for accounting purposes.

Consequently, the difference between the carrying amount and tax base of a revalued asset is a
temporary difference.
An upward revaluation shall give rise to a taxable temporary difference resulting to a deferred
tax liability.

Since the revaluation surplus is a component of other comprehensive income. The deferred tax
consequence is also recognized in other comprehensive income, meaning the deferred tax is
deducted from the revaluation surplus.

QUESTION 10-22

Explain “intraperiod tax allocation” and “interperiod tax allocation”

ANSWER 10-22

Intraperiod tax allocation is the allocation of income tax expense to the various revenues that
brought about the tax.

Intraperiod tax allocation associates the tax expense with the items in the income statement.

Thus, the total income tax expense is allocated to income from continuing operations. Income
from discontinued operations and prior period errors or items directly charged or credited to
retained earnings.

Interperiod tax allocation is the recognition of a deferred tax asset or deferred tax liability.

QUESTION 10-23

What are the approaches of accounting for deferred income tax? Which approach is required?

ANSWER 10-23

1. Income statement approach

This approach focuses on timing differences only in the computation of deferred tax
asset or deferred tax liability.

As the approach suggest, timing differences affect the income statement of one period
and will reverse in the income statement of one or more subsequent periods.

2. Statement of financial position approach

This approach considers all temporary differences including timing differences.

 There are temporary differences that affect the statement of financial position only and
therefore technically are not timing differences but nonetheless are recognized in
computing deferred tax asset or liability.

PAS 12 requires the use of the statement of financial position approach.

QUESTION 10-24

What are the procedures in determining the deferred tax asset or liability using the “statement of
financial position approach.”

ANSWER 10-24

To account for a deferred tax asset or liability, first prepare a statement of financial position that
shows all the assets and liabilities at their carrying amount.

The following procedures are then followed:

1. Determine tax base of the assets and liabilities in the statement of financial position.
2. Compare the carrying amount with the tax base.
3. The difference between the carrying amount and tax base normally will result to a
deferred tax asset or liability.
4. Permanent differences do not give rise to deferred tax asset or liability.
5. Apply the tax rate to the temporary differences.
6. Determine the beginning and ending balance of deferred tax asset or liability.
7. Recognize the net change between the beginning and ending balance of deferred tax asset
or liability.
8. The net change is the adjustment for the deferred tax asset or liability.

QUESTION 10 – 25 Multiple choice (PAS 12)

1. Which entities are required to apply deferred tax accounting?

I. Public entities
II. Nonpublic entities

a. I only
b. II only
c. Both I and II
d. Neither I nor II
2. It is profit for a period determined in accordance with the rules established by tax
authorities upon which income taxes are payable.
a. Accounting profit
b. Taxable profit
c. Net profit
d. Accounting profit subject to tax
3. It is the profit for a period before deducting tax expense.
a. Accounting profit
b. Taxable profit
c. Gross profit
d. Net profit
4. These are differences that will result in future taxable amount in determining taxable
profit of future periods when the carrying amount of the asset or liability is recovered or
settled.
a. Temporary difference
b. Taxable temporary differences
c. Deductible temporary difference
d. Permanent differences
5. These are differences that result in future deductible amount in determining taxable profit
in future periods when the carrying amount of the asset or liability is recovered or settled.
a. Taxable temporary differences
b. Deductible temporary differences
c. Taxable temporary and permanent differences
d. Deductible temporary and permanent differences
6. It is the deferred tax consequence attributable to a taxable temporary difference.
a. Deferred tax liability
b. Deferred tax asset
c. Current tax liability
d. Current tax asset
7. It is the deferred tax consequence attributable to a deductible temporary difference and
operating loss carry forward.
a. Deferred tax liability
b. Deferred tax asset
c. Current tax liability
d. Current tax asset
8. It is the amount of income tax payable in respect of the taxable profit.
a. Current tax expense
b. Total income tax expense
c. Deferred tax expense
d. Deferred tax benefit
9. It is the aggregate amount included in the determination of profit for the period in respect
of current tax and deferred tax.
a. Tax expense
b. Current tax expense
c. Deferred tax expense
d. Deferred tax benefit
 10. The deferred tax expense is equal to
a. Increase in deferred tax asset less the increase in deferred tax liability
b. Increase in deferred tax liability less the increase in deferred tax asset
c. Increase in deferred tax asset
d. Increase in deferred tax liability
ANSWER 10-25

1. C 6. A
2. B 7. B
3. A 8. A
4. B 9. A
5. B 10. B
QUESTION 10-26 Multiple choice (PAS 12)

1. It is the amount attributable to an asset or liability for tax purposes.

a. Carrying amount
b. Tax base
c. Measurement base
d. Taxable amount
2. An entity shall offset a deferred tax asset and deferred tax liability when
I. The deferred tax asset and deferred tax liability relate to income taxes levied by
the same taxing authority.
II. The entity has a legal enforceable right to offset a current tax asset against a
current tax liability.
a. I only
b. II only
c. Both I and II
d. Neither I nor II

3. A deferred tax liability shall be recognized for all

a. Permanent differences
b. Temporary differences
c. Taxable temporary differences
d. Deductible temporary differences
4. A deferred tax asset shall be recognized for all deductible temporary differences and
operating loss carry forward when
a. It is probable that taxable income will be available against which the deferred tax
asset can be used.
b. It is probable that accounting income will be available against which the deferred tax
asset can be used.
c. It is possible that taxable income will be available against which the deferred tax asset
can be used
 d. It is possible that accounting income will be available against which the deferred tax
asset can be used.
5. Which of the following statements is incorrect concern tax assets and liabilities?
a. Deferred tax asset and liabilities shall be discount
b. Tax assets and liabilities shall presented separately to other assets and liabilities in
the statement of financial position
c. Deferred tax assets and liabilities shall be distinguished from current tax assets and
liabilities.
d. When an entity makes a distinction between current and noncurrent assets and
liabilities, it shall not classify deferred tax assets and liabilities as current.
ANSWER 10-26

1. B
2. C
3. C
4. A
5. A
QUESTION 10-27 Multiple choice (PFRS)

1. Which of the following statements in relation to deferred tax assets and liabilities are
true?
I. Deferred tax liabilities are the income taxes payable in future periods in respect of
taxable temporary differences
II. Deferred tax assets are the amounts of income taxes recoverable in future periods
in respect of deductible permanent differences.
a. I only
b. II only
c. Both I and II
d. Neither I nor II

2. Deferred tax assets are the amount of income taxes recoverable in future periods in
respect of
a. The carry forward of unused tax losses only
b. Taxable temporary differences and carry forward of unused tax losses
c. Deductible temporary differences and carry forward of unused tax losses
d. Permanent differences
3. All of the following must be disclosed separately, except
a. The tax bases major items on which items deferred tax has been calculated.
b. The amount of deductible temporary differences for which no deferred tax asset is
recognized.
c. The amount of taxable temporary differences associated with investments in
subsidiaries and associates for which no deferred tax liability is recognized.
 d. The amount of income tax relating to each component of other comprehensive
income.
4. Which of the following statements in relation to income tax accounting is true?
I. Interest expense accrued but included in taxable profit on a cash basis shall be
classified under deductible temporary differences.
II. Where accumulated depreciation on an asset is greater than accumulated
depreciation, the amount shall be classified under deductible temporary
differences.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
5. Which of the following will give rise to a deferred tax asset?
I. Development cost have been capitalized and will be amortized but were deducted
in determining taxable profit in the period when incurred.
II. The tax base for a machine for tax purposes is greater than the carrying amount in
the financial statements at the end of the reporting period.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
ANSWER 10-27

1. A
2. C
3. A
4. C
5. B

QUESTION 10-28 Multiple choice (AICPA Adapted)

1. Justification for the method of determining periodic deferred tax expense is based on the
concept of
a. Matching of periodic expense to periodic revenue.
b. Objectivity in the calculation of periodic expense.
c. Recognition of asset and liabilities.
d. Consistency of tax expense measurement with actual tax planning strategies.
2. Which of the following differences would result in future taxable amount?
a. Expense or losses that are deductible after they are recognized in accounting income.
b. Revenues or gains that are taxable before they are recognized in accounting income.
 c. Expenses or losses that are deductible before they are recognized in accounting
income.
d. Revenues or gains that are recognized in accounting income but are never included in
taxable income.
3. A temporary difference which would result in a deferred tax liability is
a. Interest revenue on municipal bonds
b. Accrual of warranty expenses
c. Excess of tax depreciation over accounting depreciation
d. Subscription received in advance
4. A temporary difference which would result in a deferred tax asset is
a. Tax, penalty or surcharge.
b. Dividend received on share investment.
c. Excess tax depreciation over accounting depreciation
d. Rent received in advance included in taxable income at the time of receipt but
deferred for accounting purposes.
5. An entity cash basis taxpayer, prepared accrual basis financial statements. In the year-end
statement of financial position, the deferred income tax liabilities increased compared to
the prior year. Which of the following changes would cause the increase in deferred tax
liabilities?
I. An increase in prepaid insurance
II. An increase in rent receivable
III. An increase in warranty obligation
a. I only
b. II only
c. II and III
d. III only

6. An entity reported deferred tax assets and deferred tax liabilities at the end of the prior
year and at the end of the current year. For the current year, the entity should report
deferred tax expense or benefit equal to the
a. Decrease in the different tax assets
b. Increase in the deferred tax liabilities
c. Amount of the current liability plus the sum of the net changes in deferred tax asset
and deferred tax liabilities.
d. Sum of the net changes in deferred tax assets and deferred tax liabilities.
7. Because an entity uses different methods to depreciate equipment for accounting and
income tax purposes, the entity has temporary differences that will reverse during the
 next year and add to taxable income. Deferred taxes that are based on these temporary
differences shall be classified in the statement of financial position as
a. Contra account to current assets
b. Contra account to noncurrent asset
c. Current liability
d. Noncurrent liability
8. At the most recent year-end, an entity had a deferred tax liability arising from accelerated
depreciation than exceeded a deferred tax asset relating to rent received in advance which
is expected to reverse in the most recent year-end statement of financial position?
a. The excess of the deferred tax liability over the deferred tax asset as a noncurrent
liability.
b. The excess of the deferred tax liability over the deferred tax asset as a current liability
c. The deferred tax liability as a noncurrent liability
d. The deferred tax liability as a current liability.
9. The financial reporting basis of the plant assets exceeded the tax basis because a different
method of reporting depreciation is used for financial reporting purposes and tax
purposes. What is reported if there are no other temporary differences?
a. Current tax asset
b. Deferred tax asset
c. Deferred tax liability
d. Current tax payable
10. A deferred tax liability is computed using
a. Current tax law regardless of expected or enacted future tax law
b. Expected future tax law regardless of whether enacted or not
c. Current tax law unless a future enacted tax law is different
d. Either current or expected future tax law regardless of whether the expected future tax
law is enacted or not.

ANSWER 10-28

1. C 6. D
2. C 7. D
3. C 8. C
4. D 9. C
5. B 10. C
QUESTION 10-29 Multiple choice (AICPA Adapted)

1. Under current GAAP, which approach is used to determine income tax expense?
 a. Asset and liability approach
b. A “with and without” approach
c. Net of tax approach
d. Periodic expense approach
2. Temporary differences arise when revenues are taxable
I. After they are recognized in financial income
II. Before they are recognized in financial income
a. Both I and II
b. I only
c. Neither I nor II
d. II only
3. The amount of income tax applicable to transactions that are not reported in the
continuing operations section of the income statement is computed
a. By multiplying the item by the effective income tax rate.
b. As the difference between the tax computed based on taxable income without
including the item and the tax computed based on taxable income including the item.
c. As the difference between the tax computed on the item based on the amount used for
financial reporting and the amount used in computing taxable income.
d. By multiplying the item by the difference between the effective income tax rate and
the statutory income tax rate.

4. Which of the following statements is correct regarding the provision for income taxes in
the financial statements of a sole proprietorship?

a. The provision for income taxes should be bases on the business income using
individual tax rate.
b. The provision for income taxes should be based on business income using
corporate tax rate.
c. The provision for income taxes should be based on the proprietor’s total taxable
income, allocated to the proprietorship at the percentage that business income
bears to the proprietor’s total income.
d. No provision for income taxes is required.
ANSWER 10-29

1. A
2. A
3. B
4. D
QUESTION 10-30 Multiple choice (IAA)

1. The purpose of interperiod tax allocation is

a. Allow reporting entities to fully utilize tax losses carried forward from a previous
year.
b. Allow reporting entities whose tax liabilities vary significantly from year to year
to smooth payments to taxing agencies.
 c. Recognize an asset or liability for the tax consequences of temporary differences
that exist at the end of the reporting period.
d. Amortize the deferred tax liability shown in the statement of financial position.
2. The result of interperiod tax allocation is that
a. Wide fluctuations in an entity’s tax liability payments are eliminated.
b. Tax expenses shown in the income statement is equal to the deferred taxes shown
in the statement of financial position.
c. Tax liability shown in the statement of financial position is equal to the deferred
taxes shown in the previous year’s statement of financial position plus the income
tax expense shown in the income statement.
d. Tax expenses shown in the income statement is equal to income taxes payable for
the current year plus or minus the change in the deferred tax asset or liability
balances for the year.
3. Which of the following is an example of a temporary difference that would result in a
deferred tax liability?
a. Use of straight line depreciation for accounting purposes and an accelerated rate
for income tax purposes.
b. Rent revenue collected in advance when included in taxable income before it is
included in pretax accounting income.
c. Use of a shorter depreciation period for accounting purposes that is used for
income tax purposes.
d. Investment losses recognized earlier for accounting purposes that for tax
purposes.
4. Which of the following is the most likely item to result in a deferred tax asset?
a. Using a accelerated depreciation for tax purposes but straight line depreciation for
accounting purposes.
b. Using the cost recovery method of recognizing construction revenue for tax
purposes but using percentage of completion method for financial reporting
purposes.
c. Prepaid expense
d. Unearned revenue
5. An example of a “deductible temporary difference” occurs when
a. The installment sales method is used for tax purposes but the accrual method of
recognizing sales revenue is used for financial accounting purposes.
b. Accelerated depreciation is used for tax purposes but straight line depreciation is
used for accounting purposes.
c. Warranty expenses are recognized on the accrual basis for financial accounting
purposes but recognized for tax purposes as the warranty conditions are met.
d. The cost recovery method of recognizing construction revenue is used for tax
purposes but the percentage of completion method is used for financial
accounting purposes.
6. A deferred tax liability arising from the use of an accelerated method of depreciation for
tax purposes and the straight line method for financial reporting purposes should be
classified as
a. A current liability.
 b. A noncurrent liability.
c. A current liability for the portion of the temporary difference reversing within a
year and a noncurrent liability for the remainder.
d. An offset to the accumulated depreciation reported in the statement of financial
position.
7. An item that would create permanent difference in pretax financial income and taxable
income would be
a. Using accelerated depreciation for tax purposes and straight line depreciation for
book purposes.
b. Purchasing equipment previously leased under an operating lease in prior years.
c. Using percentage of completion method on long-term construction contracts.
d. Paying fines for violation of laws.
8. Recognizing tax benefit in a loss year due to a loss carryforward requires
a. Only a footnote disclosure.
b. Creating a new carryforward for the next year.
c. Creating a deferred tax asset.
d. Creating a deferred tax liability.
9. Interperiod tax allocation
a. Involves the allocation of income taxes between current and future periods.
b. Associates tax effect with a different items in the income statement.
c. Arises because certain revenue and expenses appear in the financial statements
either before or after they are included in the income tax return.
d. Arises because different income statement items are taxed at different rates.
10. In computing the charge in deferred tax asset or liability, which tax rate is used?
a. Current tax rate
b. Estimated future tax rate
c. Enacted future tax rate
d. Prior tax rate.
ANSWER 10-30

1. C 6. B
2. D 7. D
3. A 8. C
4. D 9. B
5. C 10. C