Intermediate Accounting Volume 2, Seventh Canadian Edition Solution Manual

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Chapter 12:Financial Liabilities and ProvisionsCase12-1Ski Incorporated12-2PrescriptionsDepot Limited12-3Camani CorporationSuggested TimeTechnicalReviewTR12-1Financial liabilities and provisions (IFRS)......10TR12-2Financial liabilities and provisions (ASPE).....10TR12-3Provision, measurement...................................10TR12-4Guarantee.........................................................10TR12-5Provision, warranty..........................................5TR12-6Foreign currency..............................................5TR12-7Note payable....................................................5TR12-8Discounting, note payable................................10TR12-9Discounting, provision.....................................10TR12-10Classification liabilities....................................10AssignmentA12-1Common financial liabilities............................10A12-2Common financial liabilities: taxes.................20A12-3Common financial liabilities: taxes................20A12-4Foreign currency payables(*W)......................10A12-5Common financial liabilities and foreign currency25A12-6Provisions.........................................................20A12-7Provisions (*W)...............................................20A12-8Provisions.........................................................20A12-9Provision measurement....................................15A12-10Provision measurement....................................15A12-11Provisions; compensated absences..................15A12-12Provisions; warranty........................................15A12-13Provisions; warranty.......................................20A12-14Provisions; warranty.......................................25A12-15Discounting; no-interest note...........................15A12-16Discounting; low-interest note(*W)...............20A12-17Discounting; low-interest note.........................20A12-18Discounting; provision.....................................15A12-19Discounting; provision.....................................25A12-20Discounting; provision.....................................25A12-21Classificationand SCF.....................................20A12-22SCF..................................................................20A12-23Liabilities-ASPE...........................................10A12-24Liabilities-ASPE(*W)...................................20A12-25Liabilities-ASPE............................................20

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*WThe solution to this assignment ison the text website,Connect.The solutionis markedWEB.

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CasesCase 12-1Ski IncorporatedTo: Members of Board of DirectorsFrom: Accounting AdvisorOverviewSki Incorporated (SI) is a public company therefore you are using IFRS.The bank loanhas a minimum current ratio so you will need to be careful and watch for any impacts onthe ratio. You have had a tough year this year with a taxable loss so the bank financing iscritical to your operations. Management will be concerned with their bonus based on netincome but this will not be a concern this year with the taxable loss since there will not beany bonus.Issues1.Taxable loss2.Revenue recognition memberships3.Revenue recognition guests4.Special promotions5.Coupons6.Dealer Loan7.Lawsuit8.Lease9.Gasoline storage tanksAnalysis and Recommendations1.Taxable lossSI had a taxable loss of $400,000 in 20X5. Since this is the first ever taxable loss the losswould be carried back for up to three years to recover past taxes paid at the tax rates inthose years. Usually you would want to go back three years first so that if you incuranother loss next year you can still go back to the other two years if there is taxableincome remaining. This will result in an income tax receivable which will increasecurrent assets and have a positive impact on your current ratio.2.Revenue recognition membershipsThe contract with the customer is for the membership in the club. This would be a writtenagreement between the member and SI. There is one performance obligation,thepromised service is membership in the ski club. There is no transfer of the service until

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the membership is provided. The contract price is $10,000. The non-refundable deposit isan advance payment towards this initiation fee and is part of the overall transaction price.The performance obligation for the initiation fee is satisfied over the period of time thatthe member belongs to the club. The $10,000 would be recognized over the averageperiod a member belongs.There should be enough historical data available to come upwith a reasonable estimate.There would be no cash collection risk since the amount ispaid upfront.The annual fee is a written agreement between the member and SI. There is again oneperformance obligation the service for this year. The feeof$2,000 is the total contractprice and is received in 20X5 for the 20X6 ski season. This would be unearned revenuewhen received. Assuming the ski season goes from Dec 1 until March 31 $500 would berecognized in 20X5 and the remainder in 20X6 which would be the period in which theservice is performed.There would be no cash collection risk since the amount is paidupfront.3.Revenue recognition guestsThe contract with the guest is the written contract when they receive the ticket to skinotwhen the reservation is made since this reservation could be cancelled. The performanceobligation is the right to ski that day.The overall contract price is the price of the skiticket. The performance would be the right to ski on that day. There is no cash collectionrisk since the guest pays by credit card when they purchase the ticket.4.Special promotionsThe contract with the customer is the written contract when they receive the ticket andthe right to a future lesson. There are two separate performance obligations the right toski and the right to the lesson. The total contract price is $100. This price would need tobe allocated to the two separate performance obligations based on their relative fair value.Fair value ski pass80 = 61.5% x 100 = $61.50Fair value lesson50= 38.5%x 100 = $38.50Total fair value130The$61.50 for the ski pass theperformanceobligation would be satisfied on the day thatthey ski. For the $38.50 the performance obligation would be satisfied on theday theytake the lesson. There would be no cash collection risk assuming a credit card is used topurchase the special pass.5.CouponsIt must be determined if an economic loss would occur for the coupons. The coupons arefor $5 and the price of a ski pass is $80. This is a minor amount compared to the price ofthe ski pass so SI would still be selling the ski pass at a profit. Therefore, the couponsshould only be recognized as a cost when they are redeemed.

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6.Dealer LoanThe manufacturer of the ski lift has provided a 0% interest loan. This is often referred toas a dealer loan. The loan is either measured in FVTPL or other liabilities. Most liabilitiesare measured in other liabilities and since there is no mismatch I recommend this loan berecorded in other liabilities. SI is required to record the loan at fair value using the marketrate of interest which would be their incremental borrowing rate of 8%. Therefore, theloan would be recorded at $2.5 million (2 periods, 8%) = $2,143,350. The loan wouldthen be amortized using the effective interest method and interest expense of $171,468would be recorded in 20X5.This would not impact the current ratio in 20X5 because thefull amount would be presented as long term.7.LawsuitIt must be determined if the lawsuit is probable and if the amount can be measured. TheBoard has decided to settle the lawsuit therefore it is probable there will be a payment.The amount will be based on managements best estimate. Since there is a range thiswould be the midpoint of the range or $250,000should be accrued as a provision. Inaddition, there would be note disclosure on the details of the lawsuit.This liability wouldbe current if the payment is made next year which would have a negative impact on thecurrent ratio.8.LeaseThe lease would be an onerous contract since the costs exceed the benefits since theleased property will not be used by SI. A provision should be set up for the $10,000–5,000 = $5,000 x 24 months = $120,000.The current portion of the provision would havea negative impact on the current ratio.9.Gasoline storage tanksThe gasoline storage tanks would be set up as an item of property, plant and equipmentand depreciated over the 15 years. The costs to remove the tanks would be a legalobligation and would need to be set up as a decommissioning provision. The provisionwould be set up at the present value of the $2.5 million. The PV would be $2.5 million(15 periods, 8%) = $788,100. This amount would be debited to the gasoline storage tanksand credited to the provision. Since the life of the storage tanks and the decommissionprovision are the same the $10,788,100 would be depreciated over the 15 years whichwould be $719,207 of depreciation expense in 20X5. Interest expense of $63,048 wouldalso be recognized in 20X5 which would increase the decommissioning provision. Theasset would be a long term assetand the decommissioning provisions would be a longterm liabilityso thiswould not impact the current ratio.

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Case 12-2PrescriptionsDepot LimitedOverviewPrescriptions Depot Limited (PDL) is a large private company with revenues of $5.4billionandearningsof$295million.ThecompanycomplieswithIFRS,andiscontemplating a public offering in the medium term. GAAP compliance is thereforeimportant. Reporting objectives are to report growth in sales, especially year-over-yearsame-store sales growth, and stable earnings.Because of possible analyst interest, salesmeasurement is of critical importance.Ethicalreporting choices are critical, given thepossibility for increased scrutiny in the future; sudden changes in accounting policy at alater date may not be viewed with favor by analysts.Reporting objectives are meant tosupport a public offering.Issues1.Loyalty points program2.Decommissioning obligations3.Cash refund program4.Coupon programAnalysis and recommendations1.Loyalty points programPDL operatesa loyalty points program, which willimpact on the measurement ofsales revenue, important for analysts.Currently, a sale transaction with point value attached is recognized as a sale entirelyin the current period. An expense and liability for the cost–not sales value–of goodsto be redeemed in the future is recognized in the same time period as the sale.This policy maximizes the sales value recorded with the initial transaction. It does notreflect the substance of the transaction, though, which is that PDL has renderedmultiple deliverables in sale: both the initial sale, and the subsequent sale based onpoints value are being sold.Accordingly,PDL must consider an alternate approach to its loyalty point program:1.Thesale in the store is a contract with the customer but there are two separateperformance obligations. There is the sale of the goods now and the futureredemption of points. This loyalty program provides the customer with amaterial right.On a sale that involves issuance of points,the considerationreceived must be allocated between the sale of the product and the points on a

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relative stand alone basis. The value of points to be redeemed in the future isrecorded as unearned revenue.2.As is now the case, careful measurement of the amount-unearned revenue,now-includes analysis of redemption, bonus offers, breakage, expiry, andthe like.3.When points are redeemed, the sales value of the redemption transactionisrecorded as sales revenue and cost of goods sold reflects the merchandisepurchased.This approachdefers sales revenue and gross profit to later periods.As a result,current earnings(and sales) are lower, but future periods show highersalesand earnings.Trends may be affected. Analysts will react better to accurateinformation, and thereis time for this to be assessed since plans to offer sharestothe public are described as “medium term”.2.Decommissioning obligationPDL has an obligation to remove its customized, specialized pharmacy installations inleased premises. This is a future obligation based on a past action, and represents aprovision in the financial statements. It is not now recorded. This is essentiallyadecommissioning obligation, and standards require recognition.Accordingly, PDL must estimate the cost to restore premises, removing the customset-up. PDL must also estimate when restoration is likely to happen; lease renewalmust be assessed. Finally, a borrowing rate for the appropriate term and amount mustbe estimated, and a discounted liability calculated.The discounted liability is recognized as an asset and a liability. The asset isdepreciated over the life of the leased premises. Interest is accrued annually on theliability.Thesetwochargeswilldecreaseearnings,butrepresentappropriateaccounting measurement.Note also that estimatesmust be revised, and any changes in estimate are reflected ina revised present value and asset balance.3.Cash refund programThe cash refund program is now accounted for when the refund takes place, recordinga reduction to cash and a reduction to sales.Since the promotion involves a cash refund, an obligation exists to pay cash in thefuture, based on a past transaction.

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If there was a refund period open over the end ofareporting period,this accountingpolicy wouldnot capture the obligation to providerefunds. That is,if the six weekdocumentation window were open, after a given promotion, therewould be refunds tobe made based on recorded salesof the period. This obligation to provide refundswouldnot be reflected in the financialstatements.Therefore, PDL must estimate the extent of cash refunds waiting to be filedandrecord them as a liability when the promotionweekend ends. Estimates can be basedon past practice.The amount refunded to customers should be reported as a sales discount(a contra-sales account), not as a direct decrease to sales.It should also not be recorded as apromotion expense, as it is a reduction in sales value. Recording the amounts as asales discount is preferable to directly reducing sales, becauseitmay help preserveinformationabout the extent of program use for internal tracking.Analysesof salestrends may focus on net sales, so this accounting treatment may not improve salestrends,a corporate reporting objective.The policy will record refunds earlier, and may decrease earnings in the short term.Over time, there will be no cumulative difference to earnings.4.Coupon programThe coupon program is now accounted for byrecording sales at the amount of cashreceived from customers. PDL then reduces inventory–and thuscost of goods sold-for manufacturer rebates given for coupons redeemed.(i.e., debit accounts payable,and credit inventory which becomes cost of goods sold). Thishas the correct impacton gross profit (give or take some timing issues of inventory sale), but understatessales.SincePDLisincreasinglyconcernedwithcorrectmeasurementofsales,theaccounting policy for coupons must be revisited. The correct treatment:1.Sales is measured at the retail price, regardless of whether the value is receivedfrom customers ($20,000, in the case example) or from the manufacturerin theform ofcoupons ($5,000). The coupons are in essence an account receivable, usedto reduce an account payable.2.Merchandise is recorded at the invoice cost ($98,000) not the amount of cash paid($93,000).Using the existing accounting policy, sales are recorded at $20,000, and cost of goodssold (for many products, one assumes) at $93,000. With the revised system, sales are$25,000 and cost of goods sold is $98,000.There is no overall change to earnings, butsales aremore accurately stated, which ispreferable for PDL.

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ConclusionAny company with an eye on public markets must carefully assess its reportingpractices and ensure appropriate accounting is followed. PDL has several policies,for loyalty points, cash refunds and coupon transactions that impact on reportingofsalesandtimingofearnings.Inaddition,theyhaveunrecordeddecommissioning obligations. Appropriate accounting demonstrates the ethicalcommitment of management.

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Case 12-3Camani CorporationOverviewCamani Corporation has been negatively affected by economic conditions, and the 20X3financial results are under particular scrutiny to determine the viability of the existingstrategic model. The executive team will receive a “return to profitability” bonus if 20X3earnings are positive. Under these circumstances, there is obvious pressure to shadereporting policies and estimates to support higher earnings. There are significantethicalpressures on all stakeholders in the company, but especially management.Issues1.Calculate cash from operating activities, based on current draft financialstatements.2.Analyse reporting implications of identified estimated financial statementselements: legal issues, depreciation policy, technology contract, inventoryvaluation, restructuring and environmental liability.3.Re-calculate cash from operating activities, based on revised financial statementsAnalysis and conclusions1.Cash flow from operating activities, existing draft financial statementsExhibit 1 shows that cash flow from operating activities is a negative, at ($1,721).Earnings of $1,535 reflect cash flows of ($800), and dividends on common sharesare another ($921). The negative operating cash flows are caused by large build-upsin account receivable and inventory. The increase in accounts payable and accruedliabilities works to mitigate this, but is not as large as the inventory build-up.This is contrary to a return to profitability implied by positive earnings, and calls intoquestion the declaration of common dividends.2.Analysis of accounting policies and estimatesa.Legal issuesThe accrual has been made based on one set of expected values, resulting in theaccrual of $830. If a different, less optimistic set of probabilities is used, the accrualis $1,110:Total payment(in 000’s)AlternateprobabilityExpectedvalue

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(000’s)$ 1000%050020$ 100700302101,200303602,20020440$ 1,110This is an additional liability and expense of $280 (See Exhibit 2).b.Depreciation policyRetaining prior years’ estimates for depreciation amounts would result in $200additional depreciation. (See Exhibit 2).c.Technology servicesCC had recorded $1,200 as an estimate for technology services rendered; if the$4,000 contract is considered 45% complete (rather than 30%), another $600 (15%)must be recorded. This is a liability and presumably an expense. (See Exhibit 2).d.Inventory valuationRetainingprioryears’estimatesforinventoryvaluationwouldresultin$775additional write-down ($3,125-$2,350.) Note that inventory levels are higher in20X3, which is not consistent with less need for a valuation adjustment. Much mightdepend on the state of the economy, though, and a thorough review of the analysis theCC has prepared. (See Exhibit 2).e.RestructuringNo accrual has yet been recorded for a restructuring. The plan has not beenannounced or approved, and the plan is not formal the plan at this stage.Only aformal plan, once communicated, would meet the requirements of a constructiveliability. At this stage, recording is premature, and no accrual has been recorded.f.Environmental liabilityIf the liability had been recorded at 5%, rather than 7%, $329($400, 4 years, 5%)would have been recorded, rather than $306. Interest would have been $16, not $21(a $5 difference), and depreciation, over four years, would have been $82, rather than$77 (a $5 difference). These adjustments are minor, and are summarized in Exhibit 2.Effect on financial performance

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The adjustments indicated by these areas have been included in the revised draftstatement of financial position and financial performance shown in Exhibit 3. Thestatement of earnings now reflects a loss of $320. This would eliminate any return toprofitability bonus, and means that the operating strategy of the company needs to beassessed.3.Cash flow from operating activities, revised draft financial statementsThe reported loss of $320 is more consistent with the negative cash flow fromoperating activities. Exhibit 4 shows the revised operating activities section of theSCF. Cash used by operating activities is unchanged, at ($1,721). This demonstratesthe reason that many focus on the SCF, since it is unaffected by estimates thatunderlie earnings measurement.ConclusionAdditionalinformation should be requested by the audit committee in each theseareas, to gather evidence to support the accrual that has been made, or suggest amore appropriate amount. Since profits are marginal and there is significant incentivefor management to show profit in 20X3, very careful evaluation of these areas iswarranted.

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Exhibit 1Operating activities, SCFExisting draft summarized financial statementsCamaniCorporationOperating Activities Section of the Statement of Cash FlowYear ended 31 December 20x3Operating Activities:Net income..........................................................................$1,535Adjustments for non-cash items:Depreciation.......................................................................3,900Interest...............................................................................215,456Changes in current assets and current liabilities:Increase in accounts receivable.........................................(3,740)Increase in inventory.........................................................(6,950)Increase in prepaids...........................................................(87)Increase in accounts payable and accrued liabilities.........4,521(800)Cash paid for common dividends ($1,535 + $643 = $2,178-$1,257)(921)Net cash provided (used) by operations....................................$(1,721)Exhibit 2Camani CorporationAdjustments based on estimated amounts1)Expense($1,110-$830)................................................................280Accrued liabilities..........................................................................2802)Depreciation Expense ($4,100-$3,900).......................................200Plant and equipment (net)..............................................................2003)Expense.........................................................................................600Accrued liabilities..........................................................................6004)Expense($3,125-$2,350)............................................................775Inventory........................................................................................7755)None6)Depreciation expense ($82-$77)..................................................5Asset ($329-$306) less $5 extra depreciation................................18Interest expense ($21-$16)..........................................................5Accrued liabilities ($329-$306) less $5 change in interest..........18

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Exhibit 3Camani CorporationREVISED Summarized Draft 20X3 Financial StatementsREVISED Summarized DraftStatement of Financial PositionAt 31 December (in 000’s)Assets20X320X2Cash$ 2,340$ 1,680Accounts receivable16,78013,040Inventory (-$775)61,14554,970Prepaids542455Land5,8605,860Plant and equipment (net) (-$200 +$18)19,53818,650Other assets650290Total debits$106,855$94,945LiabilitiesAccounts payable and accrued liabilities(+$280 + $600)48,26842,867Long-term debt (+$18)53,54546,200EquityCommon shares5,6405,235Retained earnings ($643-$320 loss-$921 divs)(598)643Total credits$106,855$94,945REVISED Summarized DraftStatement of EarningsFor the year ended 31 December 20X3Sales revenue$104,910Cost of goods sold (+$775)(67,005)Depreciation expense (+$200 + $5)(4,105)Operating, administration and marketing (+$280 + $600-$5)(34,120)Earnings and comprehensive income$ (320)

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Exhibit 4REVISED Operating activities, SCFRevised draft summarized financial statementsCamaniCorporationOperating Activities Section of the Statement of Cash FlowYear ended 31 December 20x3Operating Activities:Net income (loss)................................................................( $320)Adjustments for non-cash items:Depreciation.......................................................................4,105Interest...............................................................................163,801Changes in current assets and current liabilities:Increase in accounts receivable.........................................(3,740)Increase in inventory.........................................................(6,175)Increase in prepaids...........................................................(87)Increase in accounts payable and accrued liabilities.........5,401(800)Cash paid for common dividends (unchanged)........................(921)Net cash provided (used) by operations....................................$(1,721)

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