Intermediate Accounting Vol 1 Canadian 2nd Edition Lo Solutions Manual 1

Chapter 3 Accrual Accounting
Solution Manual for Intermediate Accounting Vol 1 Canadian

2nd Edition Lo Fisher 0133098648 9780133098648
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Chapter 3
Accrual Accounting
N. Problems
P3-1. Suggested solution:
Not a
Significant significant
Factor contributor contributor
a. Improved technological capability (computers, Internet) √
b. A diffuse investor base comprising many people √
c. Increased pace of business transactions √
d. Invention of the printing press √
e. Establishment of regulators such as the Ontario Securities √
Commission
f. Creation of indefinite-life entities such as corporations √
g. Establishment of professional accounting organizations √
Not a
Significant significant
Factor contributor contributor
a. Establishment of accounting standard setters such as the √
International Accounting Standards Board
b. Invention of the double-entry system of bookkeeping √
c. Creation of indefinite-life entities such as corporations √
d. Development of credit cards and other substitutes for cash √
e. Preparation of periodic financial reports √
f. Incomplete transactions at reporting dates √
g. The going-concern assumption √
h. Accounting standards such as IFRS require accrual √*
accounting
Copyright © 2014 Pearson Canada Inc. 3-35

i. Financial reports using accrual accounting are simpler to √
understand compared with those prepared using cash
accounting
*For (h), accounting standards arguably are a contributing factor. However, accounting standards
regarding the use of accrual accounting are only formalizations of practices that derive from the
demand for accrual accounting. Indeed, we observe the use of accrual accounting for entities that
do not need to follow IFRS or other formal accounting standards.

The easy answer is that regulations (accounting standards, stock exchange requirements, etc.)
require companies to do so. However, this answer does not address the question of why
regulations have this requirement. Both business and regulations respond to market demands.
Investors and creditors of publicly accountable enterprises are numerous and have needs for
information at different times for their investing and lending decisions. It would be impractical
for enterprises to provide financial statements according to when each of these
investors/creditors requires the information. Therefore, companies provide the information on
fixed schedules annually or quarterly.
Accrual accounting numbers can be a better predictor of future cash flows because they smooth
out and reallocate cash flows to periods that better reflect the long-term average cash flow of the
enterprise. For example, an equipment purchase results in a large cash outflow but benefits the
company over many years, so allocating the cost of purchase over those years makes each year
more representative of the cash flow expected in a typical year.
* While it is true that the calculation of net present value (NPV) involves discounting cash
flows, this does not imply that accrual accounting numbers are not useful.
* It is important to recognize that capital budgeting and other applications of NPV always
involve the future, and the future is always uncertain.
* The difficult part of an NPV exercise is not the computation of discounted values, but
forecasting future cash flows accurately.
* Accounting numbers can help forecast those future cash flows because accrual
accounting reflects the results of both complete and incomplete transactions.
* Accrual accounting numbers also smooth out irregularities in cash flows such as large
purchases of property, plant, and equipment that produce benefits over many years.
* Thus, while accruals are not cash flows, they provide information that is useful for the
prediction of future cash flows.
a. When PPE are acquired, the business and finance assumption is that these assets will be
used for a number of years to directly or indirectly generate earnings. PPE will create
productive capacity that will allow the firm to operate in the future and produce revenues
or reduce costs, with the overall consequence of increasing net income and net cash
flows. As PPE are held for use, not for resale, they can be recorded on the balance sheet
at their depreciated net book value. The goal of recording PPE in this manner is to match
the recognition of the cost of the asset to expense with the period when the benefit of the
asset is realized. As PPE are expected to last for several years for the future service
potential of the asset to be realized, it is essential that the firm continue to exist into the
foreseeable future (i.e., continue to be a going concern) for this allocation process to

resolve itself. Restated, if a piece of PPE is to be depreciated over a 10-year useful life,
we are assuming that the firm will continue to operate for those 10 years for the
depreciation allocation process to fully expense the cost of the asset.
b. If the going-concern assumption is no longer valid (and the firm is going into
bankruptcy), then assets should be valued at their exit value. This usually will be their net
realizable value, which will likely result in a major reduction in the carrying value of the
asset on the balance sheet and a large loss recorded on the income statement.
c. Depreciation expense for 2013 and 2014 = $900,000 per year ($10,000,000 –
1,000,000)/10).
The depreciation for 2014 should not be the same because the firm will not
continue to operate, so the asset should be valued at its net realizable value. The value of
the machine on the balance sheet on December 31, 2014: $5,500,000.
The downward adjustment to the carrying value of the machine in 2014:
$2,700,000 (= 10,000,000 – 2 × 900,000 – 5,500,000). Technically, as will be seen in
Chapter 10, this amount would be separated into two components. The first is the normal
amount of depreciation that would have been recorded were the going concern
assumption were valid (i.e., $900,000). The remaining $1,800,000 is an additional
expense or loss due to the need to write down the machine’s value to net realizable value.
d. Prepaid rent should be reported at the unexpired value of the rent of $100,000.
If the company were not a going concern, it should value this amount at its net
realizable value—the amount it could recover if it were to ask for a refund from the
landlord—which is likely to be $0. If the premises could be sub-leased to another tenant,
then the prepaid rent could be reported at the value obtainable from the sub-lease.
e. When a company goes into bankruptcy, inventories should be valued at net realizable
value, such as the amount that would be received if it were sold in an auction. Such
forced liquidation would likely be less than the FIFO or average-cost values.
Item Estimates required

a. Accounts receivable Customer default rate; speed of collection
b. Inventories Costs of items sold/held; prices of inventory items
c. Equipment Useful lives; pattern of benefits obtained; residual
values at end of useful lives
d. Warranty liability Rate of defect; cost to repair or to replace product
e. Sales revenue Customer default rate; speed of collection
f. Revenue from long-term contract Profitability of contract; degree of progress fulfilling
contract
g. Cost of goods sold Costs of each item sold/held

a. Quality of earnings refers to how closely reported earnings correspond to earnings that
would be reported in the absence of management bias.
b. The practice of assessing earnings quality by comparing earnings and cash flows has
some merit but is imperfect.
The difference between earnings and cash flows generally can be referred to as
accruals. These accruals reflect economic circumstances, accounting standards,
professional judgment, ethics (the unbiased portion), as well as management bias
resulting from contractual incentives and managerial opportunism. To the extent accruals
reflect management bias, comparing earnings and cash flows helps to uncover that bias.
On the other hand, management bias comprises only one component of the
accruals; the other component is an unbiased reflection of economic circumstances. The
fundamental idea/assumption underlying accrual accounting is that accrual numbers are
more useful/meaningful compared to cash basis accounting. Using the difference between
accrual numbers and cash flows to assess the quality of earnings in effect says that cash
flows are more useful, and accruals made by accountants/management confuse the
picture rather than make the numbers more meaningful. If this were true, only the cash
flow statement is meaningful, while the balance sheet and income statement would be
useless. However, this is inconsistent with the observed demand for information in the
balance sheet and income statement.

a.
4-year
($ 000’s) Year 1 Year 2 Year 3 Year 4 Total
Cash flow statement
Operations
Inflow from sale of goods $ 5 $ 5 $10 $10 $30
Outflow for operating costs (3) (2) (1) (1) (7)
Cash flow from operations 2 3 9 9 23
Cash flow from investing activities (15) 0 0 7 (8)
Cash flow from financing activities 20 0 0 0 20
Net cash flow for the year 7 3 9 16 35
Cash at beginning of year 0 7 10 19 0
Cash at end of year $ 7 $10 $19 $35 $35

4-year
($ millions) Year 1 Year 2 Year 3 Year 4 Total
Statement of income and retained
earnings
Revenue ($5m/arrival) $5.0 $5.0 $10.0 $10.0 $30
Operating expenses ($1m/arrival) (1.0) (1.0) (2.0) (2.0) (6)
Depreciation ($0.5m/arrival) (0.5) (0.5) (1.0) (1.0) (3)
Loss on ships 0.0 (4.5) 0.0 (0.5) (5)
Write-off of prepaid expenses 0.0 (1.0) 0.0 0.0 (1)
Net income (loss) 3.5 (2.0) 7.0 6.5 15
Retained earnings at beginning of year 0.0 3.5 1.5 8.5 0
Retained earnings at end of year $3.5 $1.5 $ 8.5 $15.0 $15
Balance sheet
Cash $7.0 $10.0 $19.0 $35 $35
Prepaid expenses 2.0 2.0 1.0 0 0
Ships at cost 15.0 10.0 10.0 0 0
Less: accumulated depreciation (0.5) (0.5) (1.5) 0 0
Total assets 23.5 21.5 $28.5 $ 0 $ 0
Contributed capital $20.0 $20.0 $20.0 $20 $20
Retained earnings 3.5 1.5 8.5 15 15
Total equity $23.5 $21.5 $28.5 $35 $35
b. We observe that the total cash flows for operating activities ($23 million) and investing
activities (–$8 million) combine to result in $15 million, which equals the amount of net
income of $15 million over the four years.
In addition, just prior to dissolution of the company, we observe that the amount
of cash equals the balance in owners’ equity, at $35 million. Of this amount, $15 million
is return on capital (i.e., retained earnings), while $20 million is return of capital supplied
by the investors.
a. Annual net income with accounting policy set 1

2009 2010 2011 2012
Sales $3,000,00 $3,500,00 $4,000,00 $500,000
0 0 0
Operating expenses (2,100,000 (2,500,000 (2,700,000 (350,000)
) ) )
Warranty expense (9% of sales, except (270,000) (315,000) (360,000) (170,000)
2012)
Bad debt expense (5% of sales, except (150,000) (175,000) (200,000) (75,000)
2012)
Depreciation expense (straight line) (250,000) (250,000) (250,000) (250,000)
Gain on disposal 0 0 0 400,000
Net income 230,000 260,000 490,000 55,000

b. Annual net income with accounting policy set 2

2009 2010 2011 2012
Sales $3,000,00 $3,500,00 $4,000,00 $500,000
0 0 0
Operating expenses (2,100,000 (2,500,000 (2,700,000 (350,000)
) ) )
Warranty expense (10% of sales, except (300,000) (350,000) (400,000) (65,000)
2012)
Bad debt expense or recovery (ADA at (220,000) (355,000) (200,000) (175,000)
40% of gross A/R—see below)
Depreciation expense (50% declining (500,000) (250,000) (125,000) (62,500)
balance)
Gain on disposal 337,500
0 0 0
Net income (loss) (120,000) 45,000 575,000 535,000
Derivation of bad debt expense (BDE) for each year: Allowance for
Accounts doubtful accounts
receivable (ADA)
2009 Jan 1 balance 0
2009 Credit sales 3,000
Collections 2,600
Write-offs 100 100
220 BDE (plug)
2009 Dec 31 balance 300 ×40% = 120 Required balance
Collections 2,800
Write-offs 125 125
355 BDE (plug)
Collections 3,800
Write-offs 200 200
200 BDE (plug)
2012 Credit sales 500
Collections 1,200
Write-offs 175 175
175 BDE (plug)

c. Annual net cash flows:

2009 2010 2011 2012
Collections $2,600,000 $2,800,000 $3,800,000 $1,200,000
Cash operating expenses (2,100,000) (2,500,000) (2,700,000) (350,000)
Warranty expense paid (250,000) (275,000) (410,000) (180,000)
Purchase of capital asset (1,000,000)
Proceeds on disposal of capital asset 0 400,000
0 0
Net cash flow $ $ 25,000 $ 690,000 $1,070,000
(750,000)
d. Sum of income over four years using accounting policy set 1: $1,035,000
Sum of income over four years using accounting policy set 2: $1,035,000
Sum of net cash flows over four years: $1,035,000
These sums show that, from a company’s beginning to its end (cradle to grave), the sum
of net income and cash flows must be equal.
e. The differences in net incomes for the two scenarios is the result of using different
methods of accruing (or allocating, calculating) warranty, bad debt, and depreciation
expense.
f. The net income for 2012 is significantly higher using accounting policy set 2 than set 1
$535,000 versus $55,000). This is due to the fact that the first set of accounting policies
recorded much lower expenses in the earlier years, which means in later years and when
the firm was wound up this understatement of expenses must be reversed such that the
total of all the years for any type of expense is the same. For example, total bad debt
expense must equal the actual accounts written off (of $600,000), total warranty expense
must equal warranties paid (of $1115,000), and the sum of depreciation expense and gain
on disposal together must equal the difference in the cost of the computer and final
proceeds on disposal (of $600,000).

a. Net Income B would likely result in the highest share price as it shows a continuous
pattern of improving/growing earnings. Users are likely to extrapolate this growth pattern
into the future as earnings growth is an important component in the valuation of a share,
with higher growth expectation resulting in higher share prices. Net Income C would
likely have the lowest share price as there is a declining pattern of earnings. Net Income
D might be the lowest, as the high variability of earnings (volatility) would suggest that
the firm is very risky and predicting net income will be highly uncertain. Higher degrees
of risk should result in lower share prices.
b. Net Income B would likely give you the highest aggregate bonus, as each year’s earnings
are growing and the growth rate is increasing from 14% (3/22) in 2006 to 18% (6/34) in
2009. Clearly, you appear to be doing something right! If bonuses were based on
earnings, the absolute and relative growth in net income would have direct bearing on
your bonus as president.

c. As sole owner and chief executive officer, I am less concerned with what others think
about my company’s performance and more interested in its true economic performance.
Whereas Net Income A is the least interesting sequence, it likely captures the true
condition of the company—it shows that the firm is stable, neither growing nor declining
in profitability for the past five years. I may not like this summary, but it is likely the
most faithful representation of the company’s underlying condition. As owner/manager I
would also be interested in reducing or delaying the income taxes I pay. Net Income B
would likely do that, but it presents a distorted view of the company’s achievement that
may cause lower-level managers to make the wrong decisions.
d. Accounting does not change what actually occurs, but it does change what people may
believe occurred. In particular, accounting does not change cash flows (except income tax
and bonus payments), but different accrual policies will change reported net income. The
way financial accounting derives net income will influence what people think happened
in the past and present and therefore influence what users believe the future will be. This
is because users of financial statements use past and present achievement to predict future
achievements.
Pros of GAAP accrual accounting in government:

* Information becomes more relevant to users (taxpayers) for evaluating the use of tax
dollars.
* Provides better information on financial position—more complete reporting of assets and
liabilities.
* Budget balance not adversely affected by large capital investments.
* Increases government’s willingness to invest in projects that have long-term benefits,
such as infrastructure.
* Decreases incentives to sell assets just to get cash flow even if it is a bad deal.
* Therefore, accrual number will better measure performance than will cash surplus/deficit.
* Politicians are agents of the citizens in that taxpayers have entrusted the money to them.
* Having a better performance measure reduces agency problems (politicians being the
agents managing taxpayers’ money).
Cons:
* Accrual accounting uses more judgments.
* Politicians will have more latitude to affect reported numbers.
* Therefore, the numbers will be less reliable.
* Accrual numbers may be more difficult to understand for the average citizen.
* It will be more difficult to evaluate the government’s performance if the numbers are
more subjectively determined.
* Skeptics claim that some government spending programs (e.g., “make-work” projects) do
not have much future benefit and therefore would not qualify as assets.

The bankruptcy of Kingston Pen Ltd. occurred on February 14, 2015 due to continuing financial
difficulties, suggesting that the company was already in financial difficulty on December 31,
2014, the year-end of Bellevue Company. Therefore, the information about the bankruptcy
collected in the subsequent events period should be used in the measurement of the value of
accounts receivable at the year-end. The $55,000 receivable should be written off.
News about the closing of Trenton Homes became available on February 22, 2015,
during the subsequent events period. However, this information should not be use to measure the
value of accounts receivable as at December 31, 2014 because the cause of the company’s
closing was an unpredictable natural disaster (an ice dam). There is no indication that Trenton
Homes would be unable to pay Bellevue as at December 31, 2014.
The key difference in the treatment of the two receivables is whether the information
obtained in the subsequent events period reflects events and conditions prior to the year-end. As
at December 31, 2014, Kingston Pen was most likely already in financial difficult, whereas
Trenton Homes was financially healthy.
June 30, 2013

balance sheet
amount after
adjustment
Item (if any) Explanation
a. Inventory $75,000 Information obtained in the subsequent events period relates
– bottled (decrease of to a contamination event prior to year-end, so the decline in
water $25,000) inventory value should be recognized.
b. Equipment $80,000 Accident occurred after the year-end, so decline in value

– truck (no change) should not be reflected in the financial statements for June
30, 2013.
c. Investment $55,000 In an efficient market, the change in value after the year-end
– RBC (no change) reflects information and events occurring after the year-end.
shares The decline in value after June 30, 2013 is not relevant to the
measurement of value as at June 30, 2013.
d. Cash $67,000 A variety of different reasons could explain the change in
(no change) cash balance after the year-end. The $3,000 balance on
September 30 is not an indication that the cash balance is
overstated at the year-end of June 30, 2013.

a. No adjustment is required as the fire does not change any estimates or assumptions used
in valuing year-end amounts. This event should be disclosed in the notes to the financial
statements and the amount of the loss quantified; but not recorded, only described in the
notes. Mention should be made of the effect of the fire on the following year’s earnings.
Disclosure is required as all the relevant information is known and the event is significant
to the future operations of the company.
b. An adjustment is required as the market price is lower than cost, and inventory should be
valued at the lower of cost and market. The drop in market price is relevant to the
measurement of inventories at year-end because it reflects conditions at that point in time.
No additional disclosure; this is just an unfortunate but unusual operating occurrence.
c. New competition requires neither recognition nor disclosure. The event does not relate to
conditions at or prior to the year-end for recognition. The event is neither specific nor
unusual in nature to warrant disclosure.
d. Due to the new technology, you should review the assumptions for useful life, salvage
value, and depreciation methods and change the assumptions that are no longer
appropriate based on this new information. The depreciation expense for the current year
should reflect these new estimates. This is required as this information clarifies estimates
used at the year-end for calculating depreciation expense.
e. For the bankruptcy of a client, recognize the reduction in the carrying value of the
accounts receivable by 70% and make the necessary adjustment. This is required as this
new information relates to the measurement of receivables recognized at the year-end.
f. No adjustment and no disclosure; labour strikes are just an unfortunate aspect of normal
business operations. However, if the strike threatens the survival of the company it
should be disclosed, as this would put into question the validity of the going-concern
assumption.
a. Derivation of net income for the two sets of accounting policies:

Accounting policy set A 2012 2013 2014
Sales $11,000,000 $12,000,000 $12,800,000
Cost of goods sold (FIFO) (3,000,000) (3,200,000) (3,500,000)
Bad debts expense (6% of sales) (660,000) (720,000) (768,000)
Warranty expense (4% of sales) (440,000) (480,000) (512,000)
Depreciation expense (1,000,000) (1,000,000) (1,000,000)
Other operating expenses (3,000,000) (3,300,000) (3,900,000)
Net income $2,900,000 $3,300,000 $3,120,000

Accounting policy set B 2012 2013 2014

Sales $11,000,000 $12,000,000 $12,800,000
Cost of goods sold (average cost) (3,200,000) (3,300,000) (3,200,000)
Bad debt expense
(allowance at 10% of gross A/R – see (740,000) (735,000) (673,000)
below)
Warranty expense (aged analysis) (450,000) (490,000) (492,000)
Depreciation expense (1,000,000) (1,000,000) (1,000,000)
Other operating expenses (3,000,000) (3,300,000) (3,900,000)
Net income $2,610,000 $3,175,000 $3,535,000
Derivation of bad debt expense (BDE) for Accounting policy set B ($000’s):
Allowance for
Accounts doubtful accounts
receivable (ADA)
2012 Jan 1 balance 0
Collections 9,000
Write-offs 600 600
740 BDE (plug)
2012 Dec 31 balance 1,400 ×10% = 140 Required balance
Collections 10,500
Write-offs 650 650
735 BDE (plug)
2013 Dec 31 balance 2,250 ×10% = 225 Required balance
Collections 13,270
Write-offs 800 800
673 BDE (plug)
b. By coincidence, cumulative net income for the three years is the same for both situations
($9,320,000). As a result, retained earnings will be equivalent between the two methods.
c. Cumulative operating cash flows for the three years:

Total collections – purchases – warranties paid – other operating expenses: $9,108,000.
This amount is the same for both sets of policies because the balance sheet accounts for
the affected accounts are the same at the end of 2014. If the relevant balance sheet
accounts are the same, all timing differences between different accrual/allocation
methods have cancelled out. (This problem was designed to show identical total net
income for the three years.)
d. Net incomes are different between methods for each of the three years due to the timing
of when certain amounts were expensed. As the cumulative net incomes for the three

years happen to be the same, it is just a matter of when the warranty and bad debt
expenses were accrued. As accruals try to estimate actual expenditures or events that
occur later, the aggregate effects over multiple periods eventually net or wash out.
Accrual or allocation methods are ways of estimating amounts that will only be
clarified later when confirming events occur (warranty actually paid) or fail to occur
(account receivable actually written off due to non-payment). Accruals are essential as
accounting seeks to implement the matching principle, whereby expenses are matched
with revenues recognized to determine net income for a period.
Type of accounting change Accounting treatment

a. Change in estimate Prospective
b. Change in accounting policy Retrospective with restatement
c. Correction of an error Retrospective with restatement
Information known (or

Accounting change due to should have been known) in
Type of accounting change management choice? prior period?
a. Change in estimate No No
b. Change in accounting policy Yes n/a
c. Correction of an error No Yes
Type of
Situation change Treatment Discussion (not part of required)
a. Furniture Change in Prospective Due to new information
maker bad estimate
debts
b. Manufacturer Change in Prospective Due to new information (that credit
credit losses estimate losses are becoming material). Could
also be a change in accounting policy
and treat retrospectively to maintain
comparability from year to year.
c. Parking service Change in Retrospective with Not due to new information, but just a
bad debts accounting restatement of choice by management
policy prior periods
d. Shipbuilder Change in Prospective This is a change in circumstance,
revenue estimate which is a change in estimate. It is
recognition due to new information. This is a
change in accounting that reflects a
change in business policy, not a
change in accounting policy.

e. Electronics Change in Prospective Due to new information (enactment

retailer estimate of new law)
warranties
f. Clothing Change in Retrospective but Not due to new information.
company accounting likely unable to Retrospective treatment would be
inventory policy or restate prior ideal, but information on net
correction periods realizable values for prior years is
of error unlikely to be obtainable.

A change in accounting policy is a change that is due to management choice rather than the
arrival of new information. Accounting standards require such changes in policy choice to be
reflected retrospectively such that the financial statements in different periods are prepared with
the same accounting policies. This requirement enhances the comparability (consistency) or
financial statements from one period to another.
In contrast, changes in estimates reflect new information, and the arrival of new
information is not a choice made by management. Fundamentally, accrual accounting requires
making estimates using available information, and we accept that these estimates will be
imperfect due to uncertainty. Consequently, new information leads us to update these estimates
going forward but do not result in changes to estimates made in the past.

For prospective treatment For retrospective treatment (GAAP)
* If accounting policy alternatives are * Ensures comparability (consistency) among
available because different alternatives best reporting periods.
suit different circumstances, then such policy * Comparable financial statements allow for
changes should be considered to result from better predictions about the future.
changed circumstances. * Retrospective treatment provides more
* Changing circumstances cannot be relevant information because the impact of the
predicted with accuracy, so retrospective accounting change on several periods is not
treatment would inappropriately assume a artificially included in one reporting period.
certain amount of clairvoyance (the ability to * Retrospective treatment prevents
see the future). management from making accounting policy
* Retrospective treatment is not changes that temporarily and superficially
representationally faithful for the prior periods improve the appearance of current-year results
because the new accounting policy was not the due to one-time changes in accounting policy.
alternative chosen in those prior periods. * Reduction in earnings management
* Retrospective treatment allows management opportunities increases earnings quality and
to change past reported numbers, which erodes users’ confidence in financial reports.
readers’ confidence in the representational
faithfulness of financial statements.
* Retrospective treatment allows management
to spread out the effect of accounting policy
changes rather than show the full effect in the
year of change, potentially increasing chances
for earnings management.

Effects in year prior to change Effects in year of change

Type of Assets
accounting Treat- Assets or or liab-
change ment liabilities Equity Income ilities Equity Income
a. Change in Pro- — — — ↓$5,000 ↓$5,000 ↓$5,000
estimate spective assets
b. Correction Retro- ↑$8,000 ↑$8,000 ↑$8,000 no effect no effect ↓$8,000
of error spective asset
c. Change in Retro- ↓$3,000 ↓$3,000 ↓$3,000 ↓$7,000 ↓$7,000 ↓$4,000
accounting spective assets assets
policy
Effect of accounting change

on June 30, 2013 financial statements
Type of (indicate both direction and amount)
accounting change Treatment Assets Liabilities Equity Income
b. Correction of error. Retrospective -- ↑8,000 ↓8,000 ↓8,000
Change in
b. Retrospective ↓35,000 -- ↓35,000 ↓15,000
accounting policy
c. Change in estimate Prospective ↑100,000 -- ↑100,000 ↑100,000
a. Each of the six issues should be addressed as follows:
i. Long-Term Contracts: This is a clear change in accounting policy where the new policy
is deemed to be more appropriate, so it should be retrospectively applied.
ii. Accounts Receivable: This is not an error, but rather a change in estimate due to new
information. As the bankruptcy occurred after the subsequent-events period (i.e., after
completion of the audit), no adjustment to the 2014 financial statements is permitted.
iii. Machine Depreciation: This is a change in estimate of the useful life of the machine.
This new information should be applied prospectively to the depreciation charges for
2015 and subsequent periods. The depreciation expense for 2014 should remain and
reduce the carrying value of the machine accordingly for 2015. The remaining useful life
of the machine should be changed from 9 to 14 years (15 years total – 1 year elapsed) as
at January 1, 2015.

iv. Building Depreciation: The new depreciation method should be treated prospectively as
the new method is judged to be a more appropriate reflection of the consumption of
benefits than the prior method.
v. Inventories: This is an error correction as lower of cost and net realizable value should
have been used in 2014. The 2014 income statement should be adjusted accordingly. The
2015 inventory should be valued using this allowance.
vi. Warranties: This is an error as warranties should be accrued and matched with the
revenue recognized in that period. The 2014 and 2015 income statements should reflect
the warranty accrual and related change in expense.
b. The amended statements of comprehensive income:

2014 as 2014 as 2015 as 2015 as
originally amended originally amended
presented (answer) presented (answer)
Long-term contract income $3,000,000 $4,200,000 $4,000,000 $3,700,000
Other income (loss) (800,000) (800,000) (900,000) (900,000)
Bad debt expense (400,000) (400,000) (500,000) (500,000)
Depreciation expense—machine (500,000) (500,000) (500,000) (321,429) 1
Depreciation expense—building (300,000) (300,000) (270,000) (142,105) 2
Inventory write-down 0 (200,000) 0 (100,000) 3
Warranty expense (200,000) (350,000) 4 (320,000) (445,000) 5
Income before taxes 800,000 1,650,000 1,510,000 1,291,466
Income taxes (at 30%) (240,000) (495,000) (453,000) (387,440)
Net income $560,000 $1,155,000 $1,057,000 $904,026
1
(5,000,000 – 500,000) / (15 – 1) = 321,429
2
(3,000,000 – 300,000) / (20 – 1) = 142,105
3
(300,000 – 200,000) = 100,000
4
200,000 + 150,000 = 350,000
5
320,000 – 150,000 + 275,000 = 445,000

Relevant for
classification as
current?
Criteria (Yes/No)
a. The asset is expected to be sold in the entity’s normal operating cycle. Yes
b. The asset is traded in an active market. No
c. The asset is expected to be realized within 12 months after the balance Yes
sheet date.
d. The asset is held primarily for the purpose of being traded. Yes
e. The asset is expected to be consumed in the entity’s normal operating Yes
cycle.
f. The asset is an item of inventory. No
g. The asset is cash or cash equivalent. Yes
h. The asset is a receivable from another company. No
Relevant for
classification as
current?
Criteria (Yes/No)
a. The liability is expected to be settled in the entity’s normal operating Yes
cycle.
b. The liability requires settlement in cash. No
c. The liability is expected to be realized within 12 months after the Yes
balance sheet date.
d. The liability is held primarily for the purpose of being traded. Yes
e. The entity does not have an unconditional right to defer settlement of Yes
the liability for at least 12 months after the balance sheet date.
f. The liability is a line of credit owing to a financial institution. No
g. The liability is unavoidable. No

Required?
Line item (Yes/No)
a. Revenue Yes
b. Profit or loss (net income) Yes
c. Cost of goods sold No
d. General and administrative expenses No
e. Comprehensive income Yes
f. Labour costs No
g. Income tax expense Yes
h. Other comprehensive income Yes
i. Finance costs (interest expense) Yes
Type of operating expense Nature Function

a. Cost of goods sold √
b. Delivery √
c. Employee wages and benefits √
d. Administration √
e. Building depreciation √
f. Utilities (electricity, heating, etc.) √
g. Marketing and advertising √
h. Sales commissions √
i. Raw materials consumed √
j. Insurance √
“Nature” refers to the source of the expense, whereas “function” refers to the use. For example,
employees are the source of wage costs, so employee wages is according to nature. Some of
these wages go toward the production of goods that are later sold, so cost of goods sold is
according to use.

Wan Industries Limited

Balance Sheet
As at December 31, 2013
Current assets Current liabilities
Cash 334,000 Accounts payable 142,000
Accounts receivable 95,000 Interest payable 10,000
Inventory 51,000 Wages payable 15,000
Stationery 5,000 Unearned revenue 23,000
Prepaid rent 25,000 Current portion of LT debt 40,000
Total current assets 510,000 Total current liabilities 230,000
Non-current assets Non-current liabilities

Long-term loan receivable 300,000 Long-term loan payable 360,000
Equipment 500,000 Total liabilities 590,000
Less: accumulated depreciation (50,000)
Total non-current assets 750,000 Shareholders’ equity
Common stock 200,000
Retained earnings (see below) 470,000
Total shareholders’ equity 670,000
Total assets 1,260,000 Total liabilities and equity 1,260,000
Computation of retained earnings:

Sales revenue 800,000
Cost of goods sold (410,000)
Advertising expense (16,000)
Depreciation expense (12,000)
Income tax expense (35,000)
Interest expense (41,000)
Rent expense (75,000)
Stationery expense (14,000)
Wages expense (91,000)
Net income 106,000
Less dividends (21,000)
Retained earnings, Jan. 1 385,000
Retained earnings, Dec. 31 470,000

Company Company Company Company Company

A B C D E
Assets $500 $800 $1,500 $2,500 $4,000
Liabilities 350 425 1,100 1,800 2,800

Common Stock 20 175 125 100 500
Retained Earnings 130 200 275 600 700
Liabilities + Equity $500 $800 $1,500 $2,500 $4,000
Opening Retained Earnings $100 $140 $200 $500 $750

+ Net Income (Loss) 70 70 160 160 (40)
– Dividends (40) (10) (85) (60) (10)
Closing Retained Earnings 130 200 $275 $600 $700
a.
* Asset valuation is a process of determining the amount of benefit to carry forward
to future periods. Therefore, uncertainty is inherent in the process.
* The balance sheet embodies the most fundamental elements of the financial
statements, from which the elements of the income statement derive.
* Asset valuation involves capital maintenance concepts that enter into the
computation of income.
* Examples:
– Historical cost implies revenue recognition and expense matching on a
transactional basis (i.e., only when transactions occur).
– Making general price-level adjustments also implies revenue and expense
recognition on a transactional basis, but with adjustments for overall price
level changes.
– Using current values to measure the value of assets disregards
transactional data in favour of prevailing market price data.
– Stating assets at their present value implies revenue recognition as time
elapses, not at the dates of transactions.
b.
* Revenue involves increases in economic benefits during an accounting period in
the form of inflows or enhancements of assets or decreases in liabilities that result
in increases in equity, other than those relating to contributions from equity
participants, and arising from ordinary activities.
* Thus, recognition of revenue impacts the balance sheet by way of increments to
assets, decrements to liabilities.
* Examples:
– Recognizing revenue on a transactional basis only results in balance sheet
amounts that do not reflect changes in prices and market values.

c.
* The uncertainty of future benefits associated with research activities has resulted
in the rejection of recording research costs as an asset, which also implies
recognition of an expense. This expense does not match the revenues that could
be generated in the future from the research efforts.
a. The income statement with subtotal and operating expenses listed by nature is as follows:
Axo Inc.
Income Statement
For the year ended December 31, 2013
Sales $ 9,224,000
Raw material used (1,670,000)
Salaries and wages (5,210,000)
Depreciation (1,475,000)
Income before interest and taxes 869,000
Income before income taxes 514,000
Income from continuing operations 359,800
Income from discontinued operations, net of tax 17,500
Net income $ 377,300
 The $25,000 income from discontinued operation must be presented net of related tax of
$7,500.
b. The statement of changes in equity is as follows
Axo Inc.
Statement of changes in equity
Common Retained
shares earnings
Balance, January 1, 2013 $500,000 $ 817,000
Net income -- 377,300
Shares issued $200,000 --
Dividends declared -- (300,000)
Balance, December 31, 2013 $700,000 $ 894,300

a. The income statement with subtotal and operating expenses listed by function is as follows:
Boot Company
Income Statement
Sales $ 4,661,000
Cost of goods sold (3,775,000)
Gross profit 886,000
Marketing and advertising expenses (642,000)
Income before income taxes 244,000
Loss from discontinued operations (net of $42,800 income taxes) (64,200)
Net income $ 82,200
 The income tax expense of $97,600 equals 40% of pre-tax income of $244,000.
 The loss from discontinued operation must be presented net of tax. Pre-tax loss of $107,000
× 40% = $42,800 of income tax.
 Items of expense based on the nature of the expense have been excluded; the amounts for
depreciation, employee wages and benefits, and utilities are already included in the expenses
listed by function.

Boot Company
Common Retained
shares earnings
Balance, January 1, 2014, as originally reported $1,600,000 $ 443,000
Effect of change in accounting policy (-$62,000 net of income
-- (37,200)
tax of $24,800)
Balance, January 1, 2014, restated 1,600,000 405,800
Net income -- 82,200
Dividends declared -- (150,000)
Shares issued 400,000 --
Balance, December 31, 2014 $2,000,000 $ 338,000

a. The income statement with subtotal and operating expenses listed by nature is as follows:
Kalico Kats
Statement of comprehensive income
Sales $ 15,344,000
Raw material used (4,670,000)
Salaries and wages (7,210,000)
Depreciation – equipment (580,000)
Depreciation – plant (500,000)
Utilities expense (876,000)
Income before interest and taxes 1,508,000
Income before income taxes 1,343,000
Income from discontinued operations, net of tax (300,000)
Net income 505,800
Other comprehensive income – gain on land revaluation 3,000,000
Total comprehensive income $3,505,800
 The $25,000 income from discontinued operation must be presented net of related tax of
$7,500.

Kalico Kats
AOCI on
Common land Retained
shares revaluation earnings
Balance, January 1, 2015 $10,000,000 $ $1,834,000
Net income 505,800
Other comprehensive income – gain on land
3,000,000
revaluation
Issuance of common shares 5,000,000
Dividends declared ( 500,000)
Balance, December 31, 2015 $15,000,000 $3,000,000 $1,839,800

a. The statement of changes in equity is as follows

Davidson Company
Common AOCI on
Preferred shares AFS Retained
shares investments earnings
Balance, Jan. 1, 2013 $10,000,000 $20,000,000 $140,000 $7,212,000
Net income 838,000
Dividends declared ( 400,000)
Balance, Dec. 31, 2013 $10,000,000 $20,000,000 $140,000 $7,650,000
b. The balance sheet using the current / non-current presentation is as follows:

Davidson Company
Balance sheet
Current assets
Cash $ 457,000
Accounts receivable 3,035,000
Inventories 820,000
Total current assets 4,312,000
Non-current assets
Available-for-sale investments 1,640,000
Property, plant, and equipment – net 61,570,000
Intangible assets 1,750,000
Total non-current assets 64,960,000
Total assets $69,272,000
Current liabilities
Accounts payable 1,357,000
Income tax payable 125,000
Current portion of long-term debt 6,000,000
Total current liabilities 7,482,000
Non-current liabilities
Long-term debt 24,000,000
Total liabilities 31,482,000
Equity
Preferred shares 10,000,000
Common shares 20,000,000
Accumulated other comprehensive income on AFS investments 140,000
Retained earnings 7,650,000
Total equity 37,790,000
Total liabilities and equity $69,272,000
 Property, plant, and equipment is the total of equipment, plant, and land accounts net of their
accumulated depreciation: $5,520,000 + $50,000,000 + $12,000,000 – 3,450,000 -
$2,500,000 = $61,570,000.


Pluto Company
Balance sheet
Current assets
Cash $ 22,000
Accounts receivable 100,000
Prepaid expenses 45,000
167,000
Non-current assets
Available-for-sale investments 120,000
Equipment – net 60,000
Total non-current assets 180,000
Total assets $347,000
Current liabilities
Accounts payable $ 65,000
Unearned revenue 12,000
77,000
Bonds payable, due January 1, 2013, net of discount 112,000
Total liabilities 189,000
Equity
Common shares 80,000
Accumulated other comprehensive income on AFS investments 30,000
Retained earnings 48,000
Total equity 158,000
Total liabilities and equity $347,000
Pluto Company
Common AOCI on AFS Retained
shares investments earnings
Balance, Jan. 1, 2014 $80,000 $ -- $ 50,000
Correction of error (35,000)
Balance, Jan. 1, 2014, as restated 15,000
Gain on AFS investments 30,000
Net income 33,000
Balance, Dec. 31, 2014 $80,000 $30,000 $ 48,000

The following are the substantive errors contained in the summary financial statements.
* The Statement of Cash flow ($0 net change in cash) does not articulate with the change in
cash on the Statement of Financial Position ($70 decline).
* Net income ($940) and dividends (-$80) do not articulate with the change in retained
earnings (+$1460)
* Long-term debt should not be part of equity.
* Assets should be separated between current and non-current components.
* A statement of changes in equity is required.
The following are some of the articulation and reasonability tests that could be used. This is not
an exhaustive list.
First Articulation Test: Do the retained earnings add up? If one takes opening retained earnings
plus net income less dividends, will the result equal closing retained earnings?
Second Articulation Test: Is the cash position correct? If a statement of cash flows has been
prepared, does it reconcile the change in cash? If there is no statement of cash flows, does the
cash position seem reasonable given the investment and financing activities of the company?
Third Articulation Test: Does the depreciation expense on the income statement agree with the
change in accumulated depreciation on the balance sheet? (Note that this articulation test works
if there are no planned disposals of property, plant, and equipment in the forecast period.
First Reasonableness Test: Does the change in total assets support the change in revenue? If
revenues grow significantly, does the balance sheet expand in approximately the same
percentage?
Second Reasonableness Test: Are the return on equity and return on assets reasonable
percentages? Returns on equity or assets of more than 20% are suspicious if there is competition
that prevents enormous returns.
Third Reasonableness Test: Do the balances of inventory and accounts receivable appear
reasonable given the changes in revenue and cost of goods sold? Are the accounts receivable and
inventory turnover ratios reasonable given the seasonality of the industry?
Fourth Reasonableness Test: If there were major investments in new property, plant, and
equipment, do the changes in financing (long-term debt and share balances) appear reasonable?


a. The corrected balance sheet is as follows:
Maple Company
Balance sheet
Current assets
Cash $ 4,000
Accounts receivable 145,000
Inventory (note 1) 595,000
744,000
Non-current assets
Cars – net (note 2) 92,750
Equipment – net (note 3) 102,000
Land held for future development 228,000
Total non-current assets 422,750
Total assets $1,166,750
Current liabilities
Accounts payable $ 119,000
Credit balances in accounts receivable 55,000
Interest payable (note 4) 4,500
Bank loan payable 320,000
Current portion of loan due to shareholder 50,000
Total current liabilities 548,500
Loan due to shareholder 250,000
Total liabilities 798,500
Equity
Common shares (40,000 shares authorized and issue) 400,000
Retained earnings (deficit) (31,750)
Total equity 368,250
Total liabilities and equity $1,166,750
Notes:
1. Inventory includes car parts ($65,000) and cars intended for resale ($530,000), for a total of
$595,000
2. Car used by executives, at cost: $105,000.
Accumulated depreciation for a half year, straight-line over 3 years:
[$105,000 – ($105,000 × 30%)] / 3 × ½ = $12,250.
Net: $105,000 - $12,250 = $92,750.
3. Equipment cost $170,000.
Accumulated depreciation for one year, declining balance at double the straight-line rate with
5-year useful life: $170,000 × 40% = $68,000.
Net: $170,000 - $68,000 = $102,000.

4. Interest payable = $300,000 ×6% × 3/12 = $4,500.
b. The incident should not be recognized but should be disclosed in the 2015 financial
statements. Since the fire occurred after the 2015 year-end (i.e., after cutoff), the inventory value
at December 31, 2015 would not be adjusted. However, the first loss should be disclosed in the
notes to the 2015 financial statements. Since the loss caused significant changes to assets or
liabilities in 2016, users would want to be informed of this loss as part of the 2015 financial
statements, rather than waiting to be informed in the 2016 financial statements.
a. Canadian Tire shows operating expenses according to their nature in Notes 33 (“Cost of
Producing Revenue”) and Note 34 (“Operating Expenses by Nature”). The largest operating
expense by nature is, not surprisingly for a retailer, inventory cost of sales at $6,916.7 million
followed by personnel expenses at $817.4 million.
b. The income statement shows operating expenses by function (“Cost of producing

revenue” and “Operating expenses”).
c. The company presents or discloses operating expenses both by their nature and function
because the company chose to present the expenses by function in the income statement, and
when it does so, IAS 1 requires the company to also disclose operating expense by their nature.
Had the company presented operating expense by nature in the income statement, then it would
not have needed to disclose the expenses by function (although it could still choose to do so).
d. The presentation under previous deviates from IFRS in the following ways:
- Operating expenses includes interest expense; IFRS requires financing costs to be
presented separately from operating expenses.
- “Cost of merchandise sold and all other operating expenses except for the undernoted
items” is too ambiguous.

O. Mini-Cases
Case 1: Effects of Different Accrual Policies. Suggested solution:
To: Executive Committee

From: Vice-President Finance and Chief Financial Officer
Re: Accounting policies for depreciation and bad debt expense
Food Processing must make some critical and strategic choices as to the long-term orientation of
its accounting policies for depreciation and bad debt expenses. The policies selected must be
logical, practical, consistently applied, permitted by IFRS, and faithfully/fairly represent the
company’s achievements over the longer run as we cannot change them at will or regularly.
It should also be noted upfront that there is no such thing as “correct net income.” Financial
accounting uses accrual accounting, whereby the consequences of transactions and events often
must be allocated or assigned to several fiscal periods with no method of splitting up these amounts
being absolutely correct or undisputedly better than some other possibilities. For example,
depreciation expense is the apportioning of the cost of plant and equipment to expense over a series
of years. Different depreciation methods will record different depreciation expenses each year but
the total expensed cannot exceed the cost of the depreciated asset. The same is true for bad debt
expense. In the long run, the total bad debt expense must equal the amount of accounts receivable
actually written off. If more bad debts are expensed earlier on, in later periods less would be
charged to expense. So net income is set within a range of possible estimates, and in the longer run
the total income recorded using any set of accounting policies must be the same.
In selecting the orientation of these policies, we should be mindful of the objectives of the
shareholders to take the company public in four years. The accounting policies will influence the
perceptions of new investors as to the success and future prospects of Food Processing, and in
turn impact on the value they assign to the company in four years. While accounting policies do
not change reality and what really occurred, the policies will affect what external parties believe
the future earnings and cash flows will be. Finally, accounting policies will change net income
from period to period; they change cash flows only to the extent income taxes are affected. As
Canadian tax rules have their own methods for calculating depreciation and bad debt expenses, our
policies should not change the amount of income taxes paid.
Broadly described, I suggested three orientations to accounting policies noted: “conservative,”

“neutral,” and “liberal.” In the short run (first two or three years), the “conservative” approach
would result in the lowest income and the “liberal” methods the highest earnings. This would be
because under conservative allocation methods higher amounts would be expensed. For example,
in the earlier years depreciation expense would be materially larger than if liberal methods of
calculating depreciation were used. However, as the total amount to be expensed for depreciation
or bad debts cannot exceed the actual cost of the asset or the actual accounts receivable written off,
any excess or deficiency in the amounts charged to income would be reversed. If

depreciation expense was high in the earlier years, the amount expensed would decrease in later
years, and the same for bad debts.
Note also that the larger the relative amount expensed, the smaller the income in that year. A
conservative approach to accounting policies would lower net income in the first few years, but
as the amounts charged to expense decreased, this would increase the rate of growth of net
income in the medium term and longer term. The opposite would be the effect if liberal policies
were used. In the early years, expenses would be relatively less but would increase in subsequent
periods, resulting in a lower overall growth rate for net income later on.
As the owners have a plan to seek new investors in four years, a legitimate objective in selecting
accounting policies is to consider how our choice today will influence the perceptions of these
new investors in four years. A series of improving and growing earnings will reasonably bias the
price of Food Processing upward when the firm is ready for new investors, so I recommend
using the more conservative allocation policies from the start.
Further, as Food Processing is starting and the owners are also part of management, there is no
separation of ownership from management. In such a case, it would be prudent for the shareholders
to start by getting a cautious estimate of income and later, with the benefit of hindsight, learn that
a higher amount of income could be justified. This is preferable to learning the reverse lesson and
being disappointed later. Being conservative at the start would be both a wise business and
accounting strategy.
I have not considered in detail the “neutral” allocation approach as it would neither harm nor
advance the owners’ medium-term plans of inviting new investors to Food Processing. Being
neutral, while a compromise, fails to address the impossibility of deriving a “correct” net income
and is at best a half measure.

Case 2: Grosco’s Redeemable Preferred Shares. Suggested solution:
* To address this question, it is important to clearly understand when events took place.
* It is also necessary to quantify as much as possible because the bond covenant ratios are
clearly important. While the amount of information provided is limited, there is enough
to make accurate quantitative assessments of compliance with the covenants.
* The following chart displays the quantitative information given regarding the ratios.
* The superficial examination of the facts suggests that Grosco has no substantive issues
relating to the covenants and the related debt. That is, at December 31, 2012, the
company’s debt-to-equity ratio was below both thresholds, at 2.4:1.
* This conclusion does not consider the accounting treatment of the retractable preferred
shares and information in the subsequent events period.
* Management has treated the preferred shares as equity, as implied by the drop in the debt-
to-equity ratio on the date of issuance. However, we need to consider whether they
should instead be considered a liability.
* The preferred shares would be a liability if they arose from a past transaction, if they
entail the sacrifice of future resources, and if they are a present obligation (meaning that
Grosco does not have the discretion to avoid the outflow of resources).
* It is the last criterion that is contentious. Shares confer to the holder the benefit of
dividends, but dividends are always at the discretion of the company’s board of directors.

The cumulative aspect of these preferred shares does not alter this assessment. Therefore,
the dividends, by themselves, suggest that this is equity, as shares usually are.
* For the equity or liability determination, we also need to consider the retractable feature
of the preferred shares. These preferred shareholders have the right to retract the shares
beginning May 1, 2013, one year after issuance, which is less than one month away
(currently being sometime in April 2013). We have to consider the likelihood that the
shareholders will retract the shares.
* Why would they retract? At first blush, it does not seem likely that they will, since these
shareholders decided to invest less than a year ago.
* It needs to be recognized that the primary benefit of the shares is the promised stream of
quarterly dividends. Three payments have been made and the fourth is due by the end of
April 2013. However, the preliminary first-quarter financial statements show a debt-to-
equity ratio of 2.8:1, which violates Covenant A, barring the company from paying
dividends.
* It is important to note a subtle point: For the purpose of the year-end financial statements,
the March 31, 2013 debt-to-equity ratio is information from the subsequent-events
period, and it is relevant only to the extent that it provides information concerning
Grosco’s state of affairs at the year-end.
* So what does the 2.8:1 debt-to-equity ratio on March 31, 2013 say about conditions on
December 31, 2012? It provides information about the appropriate classification of the
preferred shares as equity or liability. The inability to pay dividends significantly
increases the likelihood that preferred shareholders will retract their shares.
* What would happen if this likelihood is assessed to be sufficiently high, such that the
preferred shares are classified as a liability on December 31, 2012? It is tempting at this
point to just say that the debt-to-equity ratio will go up, but by an unknown amount since
we do not have the dollar amounts involved. However, we can actually be quite specific
about what would happen, using the little information we have been given:
– First, pick any arbitrary amount for equity on April 30, 2012. Suppose it is $100
million.
– Then, using the ratios given, we can infer the other amounts.
– Denoting E = equity, D = debt, and Pfd = retractable preferred shares, the following
chart identifies the calculations.
* As shown in the chart below, we can infer that, if the retractable preferred shares were to
be classified as a liability, then the December 31, 2012, debt-to-equity ratio would be
3.2:1. If this were the case, Grosco would violate both Covenants A and B. Not only
would the company not be able to pay dividends, but it also would need to repay the bond
principal (whatever amount that may be). This outcome would require the debt to be
reclassified as a current liability. In addition, this outcome brings into doubt the
assumption that Grosco is a going concern.
* So, as the auditor, what do you do? This is a difficult situation, to say the least.
Option 1: Agree with management’s determination that the preferred shares should be
classified as equity.
Option 2: Reclassify the preferred shares as a liability.
Option 3: Delay the completion of the audit to obtain addition information regarding the
company’s financial condition and to see whether preferred shareholders retract their
shares.

* None of these options are without drawbacks, as each will have severe implications for
bondholders, common shareholders, preferred shareholders, and management, with
consequent risk of litigation. The decision is left as an open question that requires the
application of professional judgment.
* Note: This case is designed for the purpose of illustrating the issues surrounding timing,
uncertainty, incomplete information, and subsequent events. Partly reflecting the thorny
issues raised in this case, current accounting standards (e.g., IAS 32) require retractable
preferred shares (such as those involved in this case) to be classified as liabilities.
Standards relating to financial liabilities is beyond the level of preparation expected of
students at this level, so discussion of specific standards has been intentionally omitted.

Case 3: Sleep King Manufacturing Company. Suggested Solution:
a. Though the auditor might query all the above-mentioned issues, the issue of the biggest
concern should be the premature recognition of revenue with the December 28th
shipment. While SKMC management may be able to justify other issues, the premature
recognition of revenue was clearly a violation of accrual accounting principles. The terms
of sale were FOB destination, meaning revenue should only be recorded once the
mattresses were delivered to the destination of the client on January 2nd, 2012. The decision
of SKMC to recognize revenue related to this shipment showed that management did
not respect periodicity and cut-off. The company operated in a 12- month period and
the cut-off date for revenues was December 31, 2011. The auditor would probably
demand SKMC management to undo the recognition of the $20,000 in its
2011 financial statements.
b. Quality of earnings is defined as how closely reported earnings correspond to earnings

that would be reported in the absence of management bias. In this case, the auditor might
very be aware of the presence of management bias. First, there was strong motivation of
earnings management in SKMC management, because management bonus is directly tied
to net income. Second, there was the issue of premature revenue recognition. Third, there
were three significant changes of estimates in the current year and they all resulted in
increase in net income. Though it might be hard to say that these new estimates were all
biased, auditor might be skeptical of all estimates that resulted in increase in net income
in the current year. As a result, one may conclude earnings quality is low for SKMC.
c. In accrual accounting, many estimates are used to account for company’s transactions. In
a sense, there is a tradeoff between relevance and reliability. Estimates are essential because
they allow management to provide financial information to users that is timely and
relevant. However, financial statement users may be concerned about the reliability of
these estimates. It is usually not an easy task for auditor to assess whether estimates
provided by management are reasonable (i.e., they are true and fair). When there is an
extensive use of estimates in the financial statements, the benefit of providing relevant
information might be outweighed by the concerns about the reliability of these estimates.
d. The financial statement least affected by estimates would be the cash flow statement.
This is because the cash flow statement shows the company’s financial position based on
cash flows from operating, financing and investing activities. The statement is less
subject to the impact of accrual accounting and thus it is less affected by accounting
estimates.

Intermediate Accounting Vol 1 Canadian 2nd Edition Lo Solutions Manual 1

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Intermediate Accounting Vol 1 Canadian 2nd Edition Lo Solutions Manual 1

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Chapter 3 Accrual Accounting

Solution Manual for Intermediate Accounting Vol 1 Canadian

P3-1. Suggested solution:

P3-2. Suggested solution:

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P3-3. Suggested solution:

P3-4. Suggested solution:

P3-5. Suggested solution:

P3-6. Suggested solution:

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P3-7. Suggested solution:

Item Estimates required

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P3-8. Suggested solution:

P3-9. Suggested solution:

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P3-10. Suggested solution:

a. Annual net income with accounting policy set 1

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b. Annual net income with accounting policy set 2

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c. Annual net cash flows:

P3-11. Suggested solution:

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P3-12. Suggested solution:

Pros of GAAP accrual accounting in government:

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P3-13. Suggested solution:

P3-14. Suggested solution:

June 30, 2013

b. Equipment $80,000 Accident occurred after the year-end, so decline in value

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P3-15. Suggested solution:

P3-16. Suggested solution:

a. Derivation of net income for the two sets of accounting policies:

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Accounting policy set B 2012 2013 2014

c. Cumulative operating cash flows for the three years:

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P3-17. Suggested solution:

Type of accounting change Accounting treatment

P3-18. Suggested solution:

Information known (or

P3-19. Suggested solution:

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e. Electronics Change in Prospective Due to new information (enactment

P3-20. Suggested solution:

P3-21. Suggested solution:

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P3-22. Suggested solution:

Effects in year prior to change Effects in year of change

P3-23. Suggested solution:

Effect of accounting change

c. Change in estimate Prospective ↑100,000 -- ↑100,000 ↑100,000

P3-24. Suggested solution:

a. Each of the six issues should be addressed as follows:

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b. The amended statements of comprehensive income:

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P3-25. Suggested solution:

P3-26. Suggested solution:

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P3-27. Suggested solution: