Kieso: Intermediate Accounting 5/E

Kieso: Intermediate Accounting
5TH CANADIAN EDITION
Frequently Asked Questions

Frequently Asked Questions have been developed by professors and instructors across the country who use Kieso: Intermediate Accounting. They're based on questions that they have been asked by students taking their Intermediate Accounting course. They're organized by chapter..and there's more to come! If you have some of your own FAQ's that you'd like to submit, please e-mail cwells@wiley.com

Chapter 3 - The Accounting Process
Chapter 4 - Statement of Income and Retained Earnings
Chapter 5 - Balance Sheet and Statement of Cash Flows
Chapter 6 - Revenue Recognition
Chapter 7 - Cash and Receivables
Chapter 8 - Valuation of Inventories: Cost Flow Methods
Chapter 9 - Inventories: Additional Valuation Problems
Chapter 10 - Investments: Temporary and Long-Term:
Chapter 11 - Acquisitions and Dispositions of Tangible Capital Assets:
Chapter 12 - Depreciation and Depletion of Tangible Capital Assets:
Chapter 13 - Intangible Capital Assets:
Chapter 14 - Current Liabilities & Contingencies:
Chapter 15 - Long-Term Liabilities:
Chapter 16 - Shareholders' Equity: Issuance and Reacquisition of Share Capital:
Chapter 17 - Shareholders' Equity: Contributed Surplus and Retained Earnings:
Chapter 18 - Dilutive Securities and Earnings Per Share Calculations:
Chapter 19 - Accounting for Corporate Income Taxes
Chapter 20 - Pensions and Other Employees’ Future Benefits
Chapter 21 - Accounting for Leases
Chapter 22 - Accounting Changes and Error Analysis
Chapter 23 - Statement of Cash Flow
Chapter 24 - Basic Financial Statement Analysis
Chapter 25 - Full Disclosure in Financial Reporting


Chapter 3 - The Accounting Process

Question

There’s a worksheet presented in Exhibit 3-13. Is this the only way to prepare a worksheet?

Answer

A worksheet is merely a spreadsheet used to adjust account balances and to facilitate the preparation of financial statements. The actual adjusting journal entries must still be journalized in the general journal and then posted to the general ledger. there are different ways of setting up the worksheets. For example, a column could be added to calculate the cost of goods sold or assembly columns could be added to summarize some of the accounts for financial statement presentation. The important thing to remember is the purpose of the worksheet. Exhibit 3-13 just demonstrates a basic format that can be adjusted to personal requirements or preferences.

Chapter 4 - Statement of Income and Retained Earnings

Question

Why do some income statements include retained earnings on the bottom? Is this normal?

Answer

This is not unusual. This is referred to as a Statement of Income and Retained Earnings. As the name implies, it is a combination of the Statement of Income and the Statement of Retained Earnings. It is up to the management of the company to determine how it wants to present the financial statements. Some companies prefer to show the statements separately and others prefer the combined statement.

Chapter 5 - Balance Sheet and Statement of Cash Flows

Question

Why are dividends shown as a financing activity in the illustration on page 215?

Answer

Some people view the payment of dividends as a financing activity because the dividends are associated with the issued share capital. However, some people regard the payment of cash dividends as a normal part of the operating activities. Still others, prefer to show the dividend payment as a separate classification usually called the “Distribution to Shareholders”. The CICA Handbook requires the payment of dividend to be disclosed separately.

Question

The blue box on page 212 refers to cash equivalents? What are equivalents?

Answer

This refers to cash equivalents. These are “near cash” items such as term deposits, short-term investments, and short-term loans. Statements of Cash Flows are covered in detail in Chapter 23 of Volume 2 of the text.

Chapter 6 - Revenue Recognition

Question

On page 268, there is a formula given for the amount of the current period’s revenue (or gross profit) using the cost-to-cost method. Is revenue the same as gross profit?

Answer

No, total gross profits consists of total contract revenue less the most current estimated total contract costs. This is the equivalent of revenues minus the cost of goods sold to arrive at gross profit. There is a footnote on page 268 explaining this.

Chapter 7 - Cash and Receivables

Question 1

Since the petty cash fund is usually a small amount such as $200 or $300, why are there so many procedures over it when it is immaterial?

Answer

It is true that an individual petty cash fund is likely to be immaterial. However, what if the company has 500 branches and each branch has a $300 petty cash fund? This would add up to a substantial amount.

The other consideration is the vulnerability of the petty cash fund to misappropriation. The physical protection of the petty cash fund is very important because of the high inherent risk attached to it. Few assets are as portable as cash. If someone steals cash, it is easy to dispose of it - just spend it. It does not have to be converted into something else before it can be used.

Question 2

Is petty cash the same as a cash float?

Answer

A petty cash fund is set up as a convenient way to make the small cash disbursements required in the day to day operations of a business. For example, it is very convenient to use petty cash to pay courier charges, cab fares, postage due, etc.

A cash float is a set amount maintained by a business to enable them to make change, if required, on cash transactions. For example, a small grocery store may maintain a cash float of $.50 in pennies, $2.00 in nickels, $5.00 in dimes, $10.00 in quarters, $25.00 in loonies, $20.00 in five dollar bills, and $20.00 in ten dollar bills.

Chapter 8 - Valuation of Inventories: Cost Flow Methods

Question

If LIFO is not allowed for tax purposes in Canada, why would a company use it?

Answer

A company may use the LIFO method because it best reflects the cost flow of their inventory or the company may be a subsidiary and they are directed by the parent company to use LIFO. For tax purposes, a company using LIFO must adjust its cost of goods sold to a tax acceptable inventory valuation method. This is done on the schedule to reconcile accounting income to income for tax purposes (Revenue Canada’s T2S (1) schedule).

Chapter 9 - Inventories: Additional Valuation Problems

Question

In using the lower of cost and market approach to value inventory, we are being conservative. What happens if the market value is above cost at the year-end, but drops to below cost just after the year end?

Answer

Keep in mind that this inventory valuation appears on the balance sheet. The balance sheet is a “snapshot in time.” Therefore, at the year end, the inventory valuation would be at cost, which is the lower amount. The drop after year-end, if it is material, should be disclosed in a note to the financial statements.

Chapter 10 - Investments: Temporary and Long-Term:

Question - Temporary Investments:

With the stock market being so volatile in recent months, does it still make sense to follow the lower of cost or market rule for short-term marketable securities?

Answer:

Although there might be changes in the stock market on any given day that exceeds say 1% of a stock portfolio, these changes tend to even out even on the short run, say within a week. Whenever there are more significant, and more permanent changes, these changes become clearer indications concerning the realizable values of the stocks available to be traded. Management has classified the marketable securities as current, it intends to be able to convert these assets to cash within a very short period of time. Therefore, the intent of the lower of cost or market rule, which is to conservatively report the asset at its realizable value is being properly served.

Question 2 - Long-Term Investments:

Big company has significant influence over another company, we will call Small and appropriately, over the years has accounted for the investment using the equity method. Let’s say that in a particular year, Small experiences an unusual, maybe even extraordinary loss that causes the investment account in Small by Big, to turn into credit balance. Where do you classify the credit balance in the Long-Term Investment account on the Balance Sheet?

Answer:

The issue is not one of classification in the Balance Sheet. There would likely not be a credit balance created in the accounting for the loss of Small in the Long-Term Investment in Big’s accounts. This situation would only happen if the amount of the loss experienced by Small was so great, that even after multiplying it by Big’s proportionate ownership share or percentage, the resulting credit must exceed the current debit balance in the investment account. Therefore, the loss must be extreme to essentially overtake any remaining book values in the account of Small and cause it to have an overall deficit position. Notwithstanding, should this situation arise, Big would not, and could not, by the recording of equity accounting create a liability. In normal circumstances, Big would not be legally responsible for the shortfalls in income experienced by the investee (Small). Big would reduce their investment in Small to zero, but would not create a credit balance. Big’s equity accounting of the loss is therefore limited to the extent of the balance of its investment.

Chapter 11 - Acquisitions and Dispositions of Tangible Capital Assets:

Question: Completely Depreciated Capital Assets:

What do you do if you have a considerable amount of assets you know are completely depreciated but they are still on the books and still being used?

Answer:

This happens whenever the type of asset is of the level of quality in the workmanship that allows them to have practically indefinite life. As long as they are maintained properly they last partially forever. An example of this is high quality wood furniture such as boardroom tables and chairs. Allowing for good maintenance, these items experience very little wear and tear and, by and large, sometimes are considered to improve in value with age, as to their value since the workmanship is so rarely found in newer products that are currently available on the market.

Although their historical cost might have been significant, these assets remain completely amortized. This is in spite of a long estimated useful life being originally used in their amortization. Unless some significant costs have had to be incurred to make these assets retain their usefulness to the organization, (in this case being capitalized and amortized), they should remain in the accounts although there is not further cost left to be amortized. They should remain classified with other capital assets being amortized currently, since they are still used in operations. If the amounts involved are significant and it is believed to be relevant to the readers of the statements, one should consider moving them into a separate category within the capital asset list, as “completely amortized capital assets” with the corresponding amount appearing as the accumulated amortization.

Chapter 12 - Depreciation and Depletion of Tangible Capital Assets:

Question:

If you have to do Capital Cost Allowance (CCA) calculations for tax calculation purposes which are in turn based on completely different rules than Generally Accepted Accounting Principles (GAAP), why bother doing both? Don’t we have an argument from the Cost-Benefit Constraint of the Conceptual Framework, to allow us to adopt the CCA techniques for accounting?

Answer:

The overriding rule of GAAP is to establish a fair presentation of the financial operations of the entity. By adopting the CCA rules, we would not necessarily be achieving the best matching of the cost of amortization with the benefits it assisted us in producing in the entity. The objective is not to save time by avoiding a set of calculations, but to serve the objectives of the reader by adopting accounting policies that best fit the situation of the entity and that best report a fair presentation of its true results.

Chapter 13 - Intangible Capital Assets:

Question:

Let’s say that you are buying another business and you are in the process of obtaining the fair values of the assets and liabilities in order to quantify any goodwill that might have been recorded from the purchase transaction. In the list of assets of the business that you are buying is the balance of unamortized goodwill that was created from a previous purchase that business had made in the recent past. What do you do with that goodwill?

Answer:

Essentially you ignore that balance as it is not included in the assets and liabilities of the business you are acquiring. That goodwill is an unidentifiable asset, not just an intangible asset. It only existed following the valuation of certain assets and liabilities that were recorded at their fair market values at the time of that acquisition. To the extent that the assets that were acquired then are the same assets that will be subjected to a fair market valuation form this current purchase, they will again contribute to the creation of any goodwill that will result from the current transaction. A whole new account for Goodwill with its own amortization period will therefore come out of the current purchase transaction.

Chapter 14: Current Liabilities & Contingencies:

Question: - GST:

Under the Goods and Services Tax system, or Harmonized Tax system, is there ever a time when the government owes the business money instead of the other way around?

Answer:

As you know, the business must charge and collect GST on its goods and services provided to its customers. It is also allowed to offset this liability and any corresponding payments by an input tax credits (ITCs) which the business has in turn paid on the goods and services it has acquired within the same GST reporting period. The amounts are usually captured by the purchases, payables and payments accounting system at the time the entries are made for the purchases of assets or for expenses. This is one of the reasons why a GST payable account and a GST ITC or Receivable account are set up in the General Ledger. Instead of the business drawing a cheque to the government, and at the same time submitting a claim for the ITCs (receivables) and awaiting a cheque in return, the ITC claim is "netted" or offset against amounts owing and only the difference, usually business paying the government, is made.

Sometimes, the purchases for large assets, such as capital assets are so large, that the amount of the ITCs involved in those major purchases is more than enough to offset for the GST payable billed to customers within the reporting period. When this happens, the business doesn't wait until the deadline for the reporting of the GST Return, and prepares and submits it as soon as the information is available in order that the claim may be processed and the refund cheque received without delay. As a cash flow strategy, firms ensure that any progress billings on construction of assets they have contracted, as an example, are received by the end of the reporting period in order to make the claim of the GST Input credit. As long as the invoice is received, the credit can be claimed, the invoice need not have been paid.

Question: - Taxes Payable:

Is it possible for the taxes payable account to end up with a debit balance at the end of the year?

Answer:

Throughout the year, the corporation is required to make monthly instalments on the provincial and federal corporate income taxes it is expected to owe by the time it calculates its taxes using the corporate tax returns. As with individuals, the governments want the corporations to make payments of taxes in the current year based on the level of taxes actually paid in the previous fiscal year. Failure to make these monthly instalments attracts penalties and interest charges that could be very expensive to the corporation as these payments are not deductible for tax calculation purposes.

It is possible by the end of the fiscal year, following the payment of the appropriate amounts for instalments, for the corporation to experience a loss or much reduced net income. This outcome, in turn, results in the taxes payable, as calculated using the income tax return, to be a great deal lower than the amount of tax instalments. Once the tax expense is recorded, the result is a debit balance in the taxes payable account. Instalments made would have been debited to taxes payable account throughout the year. This debit balance represents an over instalment and will be refundable to the corporation once the tax returns are assessed. It is therefore properly characterized and classified on the financial statement as a receivable.

Chapter 15: Long-Term Liabilities:

Question: - Zero-coupon Bonds:

I have heard of stripped bonds or zero-coupon bonds, that don't pay any interest. Why would anybody want to invest in those. How are they recorded by the issuing companies?

Answer:

Stripped bonds are bonds which might result from having their coupons, which carry rights to regular interest payments, taken off and sold separately on the market. Common stripped bonds (or zero-coupon bonds) sold on the market are typically issued by the Provinces or their Hydro Companies. They are therefore very low risk bonds and are popular investment vehicles for the Registered Retirement Savings Plan (RRSP) investor. No interest cheques, say twice a year, are paid on these bonds. The cash flow is not needed to the RRSP investor. It would also be difficult to reinvest any interest at similar yields as the bond itself. Instead, the interest is imbedded in the price that is paid for the bond and is included in the maturity amount of the bond. That is why these bonds sell at a substantial discount.

As far as the recording of zero-coupon bonds to the issuer, the accounting entries do not change. The valuation of the bond at date of sale is simple in that it is recorded at the present value of the future cash flow of the maturity amount or face value of the bond only, since no interest payments are involved. In the periodic recording of interest expense, no amounts of cash outflow are recorded as there are no interest payment dates to these bonds. The large amount of discounts on bonds payable account for all of the interest costs between the original sale of the bond and the maturity of the bond. When using the effective interest method, the amount of the effective interest calculated becomes both the amount of the amortization to the bond discount and the interest expense.

Question: - Bonds:

When the market rate of interest increases dramatically and the bonds outstanding of a corporation are paying interest at a much reduced rate, can the corporation adjust the book value of the bond to reflect that the interest expense of the future is going to be very low, so long as the bond is outstanding?

Answer:

The reason the corporation is at an advantage for the future interest costs from its source of financing in bonds is not a consequence of any transactions that have taken place in the current period, but a consequence of the market rate of interest increasing far beyond the market rates at the time the bond was sold. The corporation is clearly a beneficiary of this turn of events. Since the disclosure requirements to the financial statements clearly indicate the rate of interest being paid on the bonds to maturity, the financial statement user is able to assess the impact this low rate of interest will have on the corporation's future profitability and cash flows.

One option the corporation might look into, depending on its current sources of cash and future ability to obtain financing, would be to consider redeeming, or buying back some of the bonds outstanding. Since the interest rate paid by the bonds is below the market rate, the bonds would be trading, on the market, at a substantial discount. The corporation could therefore buy back the bonds at a much lower price than the price when originally sold. The result would be to trigger a substantial gain on the redemption. Profit motives of the current year and cash otherwise available might be some factors affecting this decision.

In any event, the book value of the bonds do not change because of the external influences of fluctuating interest rates.

Chapter 16: Shareholders' Equity: Issuance and Reacquisition of Share Capital:

Question: - Share Repurchases:

You often hear of stock prices going up, on the stock market, when the company announces that it is going to buy back its own shares. Why is that?

Answer:

As part of the overall business strategy, the company might find that the current market price of their own shares is low and "undervalued". They believe that their business plans for the future will generate profits and expectations for profits that should drive the market price up. Instead of investing their available cash in other companies, they decide to buy back their own share now and, in the future, reissue shares at a much higher price and therefore be the beneficiary of the enhanced price of the stock.

This strategy assumes that the company has the necessary cash available from other, less expensive sources of debt or from excess cash balances, which might have otherwise been used for investments or for dividends. The shareholders who will be willing to sell their shares back to the company obviously do it willingly as the price is usually high enough to make it worth their while. Other investors who do not necessarily take up the offer to sell appreciate that the company is showing confidence in its future ability to generate increasing profits and that they will also benefit long-term from the "boost" in market price the stock will receive from the buy-back plan.

Question: - Stock Subscriptions:

Why use stock subscriptions for new stock issues?

Answer:

Often corporations have business plans which have time frames well beyond the next fiscal year. These business plans often draw upon the financial resources of the corporation at a significant level. In order to implement these plans, corporations must first set out a financing strategy to meet those demands on cash over the time frame developed in the plan. It is often the case that not all the cash is needed at the outset of the execution of the plan. Substantial delays might be available in the timing of cash outflows. These delays can therefore be matched and coordinated around the scheduled timing of the proceeds of stock subscriptions. From a subscriber's point of view, the ability to fix a price for the purchase of a stock while being able to postpone the payment of that stock, well into the future, is very attractive. By matching the timing of both inflows and outflows of necessary cash, the corporation has reduced the waste of idle cash while allowing shareholders to maximize their return of their investment.

Chapter 17: Shareholders' Equity: Contributed Surplus and Retained Earnings:

Question: - Dividend Policies:

There are several factors which widely held companies use in arriving at a dividend policy. How does this differ from those companies that are privately held by one or very few individuals.

Answer:

When the owner or few owners of a company essentially decide what is in the best interest of the company they own and control and their personal financial interest as shareholders, it becomes very flexible and easy to make plans to minimize overall tax burdens.

Corporations are perceived to be taxed twice. One tax is paid by the corporation and another tax paid by the shareholder when he or she received a dividend from the corporation. The dividend credit system allows corporations to be refunded part of their income taxes once they pay dividends to their shareholders. Flexibility and control in the timing and amounts of dividends is crucial to maximizing the tax advantages of these tax systems. A single shareholder can look at the overall outcome of a particular dividend policy on the corporate and personal income tax fronts and then decide what is the overall advantage of a given amount of dividends. The owner can then reinvest any cash received as a dividend back into the corporation, in order to assist it in the financing of the dividend, thus further enhancing the flexibility as to the timing and the amount of current and future dividends.

Question: - Stock Dividend:

Why are stock dividends not very popular?

Answer:

From the perspective of the shareholder, having more stocks of the same company (say 10 % more) does not change the overall ownership percentage in the company and does not mean that their wealth has been enhanced through this stock dividend. Although stock dividends they are not perceived as income from the point of view of the recipient, they are taxable. From a cash perspective, no cash is received although cash will have to be paid to settle any tax liability that is triggered by the receipt of the stock dividend. The only way the shareholder can get some cash flow from this dividend is to sell the additional stocks on the market. This will cause the shareholder to incur brokerage fees on odd lots of shares which likely result from a 10 % stock dividend, in our example.

In contrast, with a stock split, only the number of shares increases by a multiple of the number previously held and no tax liability is triggered. The market price of the stock reduces proportionately, thereby achieving the likely objective to make the stock price more affordable.

Chapter 18: Dilutive Securities and Earnings Per Share Calculations:

Question: - Convertible Preferred Shares:

In what situations would convertible preferred shares be attractive to investors?

Answer:

In a closely held company, when some of the goals of the investors goes beyond the existence and purpose of the corporation itself, the investment in the stock of a company might be a means to estate planning. A situation might exist where an older generation of shareholders, not needing to exercising voting rights to the management of a company, might be satisfied with holding non-voting preferred shares which might have conversion features to voting common shares. Although in their lifetime, the original shareholders of the preferred do not necessarily intend to convert these share, they might want to leave these shares to the next generation (sons & daughters) as part of an estate plan. The intention is that once these shares have been passed on to their offspring, they would then be available to be converted into voting common shares, allowing the new shareholders to be full participants, via their vote, to the management of the company. Meanwhile, to the older generation, the preferred shares might offer a very good dividend rate which give them the cash flow during retirement and the security of conversion to voting shares should they ever change their mind about the estate plan.

Question: - Earnings Per Share:

Why are the handbook rules for the calculation of Earnings Per Share (EPS) so conservative?

Answer:

EPS is the only ratio that appears on the face of the financial statements. If the financial statements are audited, so is the calculation of the EPS. The goal is to make the EPS figure come out to the lowest possible number, assuming that all dilutive securities would be converted to common shares. Stock analysts and investment organizations often quote EPS numbers as the predominant measure of the financial performance of the company, at the exclusion of a lot of details supporting the level of changes in that ratio from the last figures published. Tied into the EPS ratio is the Price Earnings Ratio or P/E ratio which is quoted along side the EPS. P/E is a yardstick for the potential investor to asses expectations of earnings in the future and also to measure the risk of owning the stock. In view of what are often limited amounts of tools used in the communication of the financial performance of the company, it is wise to want to report the most conservative figure possible in order to allow the investor the best possible perspective when arriving at future earnings expectations.

Chapter 19: Accounting for Corporate Income Taxes

Question

Why would the accounting profession in Canada change the way that companies have been accounting for corporate income taxes for more than 20 years? Was the previous method wrong?

Answer

There are three alternative approaches to accounting for corporate income taxes: the taxes payable approach, partial allocation, and full or comprehensive allocation. Both partial and comprehensive allocation can be applied using either the deferral or the accrual or liability methods. None of these approaches or methods is “right” or “wrong”, but each has theoretical and practical strengths and weaknesses. Prior to the adoption of the deferral method of comprehensive tax allocation in Canada in 1967, the taxes payable approach was the most frequently used method of accounting for corporate income taxes. However, many preparers and users of financial statements believed that this method did not disclose the full tax liability of the corporation at each balance sheet date, since tax consequences of timing differences were not recorded. The profession decided that the deferral method of comprehensive tax allocation would provide better matching on the income statement and would provide a balance sheet measure of potential future taxes. The income statement focus of the deferral method was very consistent with accounting thought in 1967.

Twenty years of experience with the deferral method, and a change in the focus of accounting thought, has caused the profession to reconsider the deferral method of accounting for corporate income taxes. One of the main problems with the deferral method is that it uses the current rate to record income tax expense and the related balance sheet amounts. Once recorded, the deferred tax asset or liability is not adjusted to reflect changes in the tax rate. This has caused a deferred amount on many corporations’ balance sheets that does not meet the definition of a liability (which was formally included in the CICA Handbook in 1981, 14 years after the deferral method was adopted). Another result of the use of the current rate was that deferred tax amounts were accumulating on companies' balance sheets, with no signs of ever being drawn down.

The profession has, after much heated debate, decided that the liability method will provide more informative financial statement presentation to users than the deferral method. This change does not imply that the deferral method was incorrect or wrong; instead, it reflects demand for more reliable valuations on the balance sheet, even at the expense of more volatility on the income statement. As well, the change is consistent the Accounting Standards Board’s mandate of increased harmonization of Canadian accounting standards with those of other countries. The liability method is the method recommended in the United States, our largest trading partner, and by the International Accounting Standards Committee.

Question

When applying loss carrybacks, does the loss always have to be applied to the third previous year? Can it be applied to the second previous year, or even to the year immediately preceding the loss?

Answer

Usually, the way to maximize the usefulness of a loss carryback is to carry it back as far as possible, to the third year prior to the loss year. That year’s income is only available for use for the current year's loss carryback - in the future, it will be ineligible. However, it is not mandatory that a loss be carried back three years. There may be situations, such as in periods of changing tax rates, where it is more advantageous to the company to carry the loss back to the second previous year, or the year immediately preceding the loss. The tax advisor must make this call based on professional judgement.

Chapter 20: Pensions and Other Employees’ Future Benefits

Question

What is the status of the 1997 Exposure Draft Employees’ Future Benefits?

Answer

The exposure draft, issued in June of 1997, had a response date of September 1997. The Accounting Standards Board will now consider the responses, and they may revise the exposure draft to incorporate some of the suggestions received. If there are significant changes, the Board will issue a re-exposure draft, asking for comments again. However, that is not expected in the case of Employees’ Future Benefits, since the intent of this exposure draft is mainly to eliminate differences between Canadian and US standards. It is more likely that the standard may be modified slightly and then be issued as a CICA Handbook section without further comment. The final standard is expected in the fall of 1998.

Information about the status of current CICA projects can be easily obtained by accessing the CICA’s website at: www.cica.ca

Question

How do the two sides of the pension worksheet relate? Each line entered into the worksheet has a debit and a credit, yet the final balancing figures are the same (either both a debit or both a credit). It is confusing!

Answer

The purpose of the “Memo Record” side of the pension worksheet is to provide details of, and keep track of the changes in the various unrecorded assets and liabilities that are represented on the balance sheet in a single figure, “Prepaid/Accrued Pension Cost”. In other words, the figures included under “Memo Record” MUST, by definition, be the same in both amount and sign (debit or credit) to the prepaid or accrued pension cost.

This concept is best demonstrated by the funding reconciliation schedule. As this schedule demonstrates, the difference between the projected benefit obligation and the plan assets represents the total amount of over- or under-funding of the pension plan. If there were no other unrecorded amounts, this net over- or under-funding would be the amount that appeared on the balance sheet as prepaid or accrued pension cost. However, both the current and the proposed section 3460 allow specific amounts to remain unrecognized, and be recorded in income over time. These unrecognized amounts are netted against the net over- or under-funding of the plan, and change the amount reported as prepaid or accrued. The final figure in the funding reconciliation schedule is the balance sheet figure - the accumulation of all amounts, which are kept track of by the memo records. Thus the total of the memo records, and the prepaid or accrual on the balance sheet represent the same number and therefore must both be debits or both be credits.

Chapter 21: Accounting for Leases

Question

The lessor always removes the present value of the residual when determining the amount to be recovered through lease payments, implying that he assumes that he will recover the residual. Why does the lessor always assume the residual value will be recovered, even when it is unguaranteed by the lessee? Doesn't an unguaranteed residual carry a certain amount of risk?

Answer

The lessor is in the driver's seat when it comes to setting up the terms of the lease. The lessor determines the fair market value to be recovered from the product being leased, based on market demands. The lessor also considers several factors in setting the interest rate implicit in the lease. Among these factors is the risk that the lessee will not care for and maintain the equipment in a manner that will insure that when it is returned, it is worth the expected residual value.

Thus it is the lessor who decides whether or not the residual should be guaranteed or unguaranteed. If the lessee is reliable, and there is a high probability that the equipment will be returned in good enough shape that the residual value will be recovered, the lessor will provide for an unguaranteed residual value. If, however, there is a high probability that the lessee will not maintain the equipment in good condition, the lessor will hedge his bets by requiring a guaranteed residual.

As discussed in the text, the residual value can be manipulated in such a way that the lessee avoids the capitalization criteria while the lessor meets these criteria. When the lessee wants this option, but the lessor demands a guaranteed residual, a third party often provides the guarantee for a fee. If the lessor pays the fee, he can recover it through an increased implicit rate and therefore higher lease payments.

Question

Why does the Handbook provide such specific instructions with respect to the interest rate that the lessee must use in calculating the present value of the minimum lease payments? Why can't the lessee just use the rate at which it could borrow the money and buy the asset (its incremental borrowing rate)? This reflects the lessee's economic risk profile.

Answer

The rate implicit in the lease reflects the economic reality of the lease transaction most accurately. In most cases, the lessee can determining the implicit rate, either by examining the lease documents (the lessor often must disclose it by law) or by working backwards through the lease using the lease payments and the residual value. The reason the lessee must use the lower of the implicit rate and its own discount rate is that the lower rate will provide a higher value of the leased asset, and increase the probability of capitalization. The Handbook is specific about which rate must be used because in the past lessees and lessors have attempted to circumvent the recommendations of Section 3065 by manipulating the interest rate used to calculate the present value of the minimum lease payments.

Chapter 22: Accounting Changes and Error Analysis

Question

Can a counterbalancing error occur in inventory if a perpetual inventory system is used by the company?

Answer

Counterbalancing errors, by definition, are errors that will correct themselves within a two-year period. One of the more common types of counterbalancing errors is when a company uses a periodic inventory system, and the ending inventory count is inaccurate. Since ending inventory is used to calculate cost of goods sold in a periodic system, the error in ending inventory causes an equal but opposite error in cost of goods sold for that year. And since ending inventory in one year becomes beginning inventory in the next year, and beginning inventory is used to calculate cost of goods sold in that next year, the error "flows through" in the second year.

Under at perpetual system, the ending inventory determined by an inventory count is used to confirm the ending inventory recorded by the accounting system. If the two figures are materially different, the company examines both the count and the perpetual inventory records to try to isolate the difference. As well, cost of goods sold is determined independently under a perpetual inventory system. The existence of two methods to determine ending inventory and cost of good sold figures means that it is much less likely that these figures will contain an error. Thus, a counterbalancing error will rarely occur.

Question

What happens if a company resolves a situation that has been ongoing for several years, and there are financial implications? For example, what if they were being reassessed by Revenue Canada on several years’ tax returns, and they found out in the current year that they had to pay back taxes? This does not seem to fit the definition of an accounting error, or a change in accounting estimate.

Answer

Prior to 1996, companies could report certain items that related to prior periods as prior period adjustments on the statement of retained earnings. Only specific items met the requirements of prior period adjustments, for example the event had to be something that was beyond management’s direct control. However effective in 1996, the Handbook recommendations which allowed prior period adjustments were removed, and now items such as the one described in the question are reported in the current year’s income. If they meet the requirements of Section 3480, Extraordinary items, they can be reported as such - otherwise they will more than likely be reported as unusual.

Chapter 23 - Statement of Cash Flow

Question

Suppose a company does a write-down of obsolete inventory; how is this shown on the Statement of Cash Flow?

Answer

This is not specifically shown on the Statement of Cash Flow. Since the entry to record the write-down would have been

DR       Loss on inventory due to obsolescence

CR       Inventory

there is no cash flow effect. The loss would be accommodated in the change in inventory adjustment in calculating the cash flows from operating activities.

Question

How are dividends shown on the Statement of Cash Flow?

Answer

The dividends actually paid out NOT the dividends declared are shown on the Statement of Cash Flow. They can be shown as an adjustment to arrive at cash flows from operating activities. However, in practice, they are often shown under a separate classification called "Distribution to Shareholders" (i.e. not an operating, financing, or investing activity).

Any unpaid dividends would be included in a dividend payable account. Any differences between the opening and ending balances of this account would be treated as an adjustment to arrive at the cash flows from operating activities.

Chapter 24 - Basic Financial Statement Analysis

Question

After I calculate a ratio, how can I tell if it's good? For example, if my current ratio is 1.25:1, that's good isn't it?

Answer

This is a verycommon question. Note that on page 1249 of the text, it says "that a single ratio by itself is not likely to be very useful". This means that a ratio is not useful unless you compare it to something. You can compare it to past performance, budgeted performance, or to the performance of others in the industry. You need to not only calculate relevant ratios, but also make relevant comparisons. Therefore, to tell if a ratio is "good" you must make the necessary comparisons.

Chapter 25 - Full Disclosure in Financial Reporting

Question

How do I decide how and what to disclose in the notes to the financial statements?

Answer

The CICA Handbook outlines the minimum disclosure requirements. Disclosure over and above the minimum is determined by management as the financial statements are the responsibility of management.

In determining how much more to disclose, management must bear in mind who the users of the financial statements are and their needs and objectives. However, management must also be aware of the sensitivity of the information disclosed. They would not, for example, want competitors to know certain things. They would not want to provide a user group with an advantage i.e. insider information.

When auditors audit a company's financial statements, do they do it from a finalized set of financial statements?

If you look at the standard auditor's report, you will note that the financial statements are the responsibility of management and that the auditor's responsibility is to provide an opinion on those statements. Auditors usually work together with management to come up with the final financial statements. Often, management has a draft set of financial statements that are provided to the auditors. If the auditor discovers any adjustments that are necessary to the financial statements, he/she will advise management and management will take the responsibility of adjusting the financial statements. If the auditor and management disagree on the adjustment, it may be necessary for the auditor to provide something other than an unqualified report.


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