Full-draft-as-of-dec-5-2019

CHAPTER 1 CASH AND CASH EQUIVALENTS

Cash In accounting, cash not just includes money in the form of currency and coins, but also negotiable instruments in the form of checks and money orders acceptable by the bank for immediate credit and bank deposits whether in a savings or current account. Dealing with cash – no specific standards PAS 1, paragraph 66, stated that an entity shall classify an asset as current when the asset is cash or a cash equivalent unless it is restricted to settle a liability for more than twelve months after the end of the reporting period. To be reported as “cash”, an item must be unrestricted in use. Cash includes the following items plus adjustments:  Undeposited currency and coins  Checks and money orders held unless the checks are postdated, defective or stale because these items shall still be included as receivables.  Unrestricted bank deposits, however checks that have been recorded as payments that have not been delivered or postdated must be restored back to the bank deposits’ balance with a corresponding liability for the payment that was made.  Funds on hand and deposits that are for current use and have been restricted for a liability that is classified as “current”. As mentioned in PAS 1, this includes petty cash fund, payroll fund and funds for taxes and dividends. Items included in cash:

Items not included in cash:

       

x x x x x x

Checks Bank Drafts Money Orders Petty Cash Fund Payroll Fund Dividend Fund Demand deposit Saving deposit

Cash on hand

Cash fund

Cash in bank

Sinking Fund Preferred Redemption Fund Plant Expansion Fund Insurance Fund Postdated Checks Restricted cash

Special Items of Cash A. Bank Overdraft – a credit or negative balance in the bank account of the depositor resulting from an issuance of a check that exceeds the amount of the deposit.  As a rule, an overdraft shall be classified as a current liability and not offset against current accounts with a positive or debit balance.  As an exception, if the overdraft is in a bank where there are other accounts that have a positive balance and those accounts are sufficient to cover the overdraft, the total cash shall be shown net of the overdraft. There can be an offset if the entity maintains two or more accounts in one bank and also if the amount is immaterial an overdraft can be offset against the other bank account – integral part of cash management. For example, an entity maintains three bank accounts: a. Cash in bank – First Bank, with a debit balance of P50,000 b. Cash in bank – Second Bank, which is overdrawn by P10,000 c. Cash in bank – Third Bank, with a debit balance of P80,000 The net cash balance is P120,000. The proper statement classification of the three accounts is as follows: Current asset: Cash in bank – First Bank 50,000 Cash in bank – Third Bank 80,000 Current liability: Bank overdraft – Second Bank 10,000 Note:*Not necessary to adjust and open a bank overdraft account in the ledger. In other words, the Cash in Bank – Second Bank account is maintained in a ledger with a credit balance. It is to be stated also that generally bank overdrafts are not permitted in the Philippines. B. Compensating Balance Agreement – deposits that a bank can use to offset an existing loan. It can also describe as a minimum amount of the deposit that a depositor agrees to maintain in order to guarantee future credit availability.  In the case of deposits that a bank can use to offset a loan, the assumption is that this amount is legally restricted to withdrawal and therefore excluded from cash, however in cases that it still remains to be unrestricted, the compensating balance shall be part of cash. If the compensating balance is legally restricted the following rules shall be followed: a) The related loan is short-term: If the deposit is legally restricted as to withdrawal by the borrower because of a formal compensating balance agreement, the compensating

balance is classified separately as “cash held as compensating balance” under current assets. b) The related loan is long-term: The compensating balance is classified as noncurrent investment.  An informal agreement to maintain a minimum amount of deposit will not be legally restricted and therefore included in cash. C. Undelivered or Unreleased Check – merely drawn and recorded but not given to the payee before the end of reporting period.  When the check is pending delivery to the payee at the end of reporting period, there is no payment because it is still subject to the entity’s control and may thus be canceled any time before delivery at the discretion of the entity. Adjusting entry is recorded as follows: Cash

xx Accounts payable or appropriate account

xx

 In practice, it is not very substantial and no evidence of actual cancelation of the check that’s the reason why the foregoing adjustment is sometimes ignored. D. Postdated Check Delivered – check drawn, recorded and already given to the payee but it bears a date subsequent to the end of reporting period. Adjusting entry is recorded as follows: Cash Accounts payable or appropriate account

xx xx

 There is no payment until the check can be presented to the bank for encashment or deposit. E. Stale Check or Check Long Outstanding – check not encashed by the payee within a relatively long period of time.  According to Negotiable Instruments Law, presentment must be made within reasonable time after issue if the instrument is payable on demand.  In banking practice, a check becomes stale if not encashed within six months from the time of issuance. But, even after three months only, the entity may issue a “stop payment order” to the bank for the cancelation of a previously issued check.

 Amount of stale check is immaterial: Accounted for as miscellaneous income. It is simply accounted as follows: Cash Miscellaneous Income

xx xx

 Amount of stale check is material and liability is expected to continue: Cash is restored and the liability is again set up. It is simply accounted as follows: Cash Accounts payable or appropriate account

Restoration of Cash Balance from: Unreleased Check Postdated Check Stale Check

Check as payment ↑Cash ↓Account Payable ↑Cash ↓Account Payable ↑Cash ↓Account Payable

xx xx

Check as receipt ↓Cash ↑Account Receivable ↓Cash ↑Account Receivable ↓Cash ↑Account Receivable

Cash Equivalents These are short-term and highly liquid investments that are readily convertible into cash and so near their maturity that they present insignificant risk of changes in value because of changes in interest rates. According to PAS 7, paragraph 6, only highly liquid investments that are acquired three months before maturity can qualify as cash equivalents. The three important characteristics for cash equivalents as mentioned in PAS 7 are shortterm, highly liquid and near maturity. In other words, short-term debt instruments with low risk (also low yield) and acquired 3 months or less from maturity date shall be considered as cash equivalents. Items included in cash equivalents:     

3-month BSP Treasury Bill BSP Treasury Bill purchased 3 months before maturity date 3-month Time Deposit 3-month Money Market Instrument or commercial paper Preference shares with specified redemption date purchased 3 months before redemption date

Items not included in cash equivalents: x

Equity securities because shares do not have maturity date.

Financial Statement Presentation Aggregate cash and cash equivalents should be shown as the 1st line item among the current assets. The details comprising the cash and cash equivalents should be disclosed in the notes to financial statements. Financial Statement Classification Classified as Cash and Cash Equivalents 1. Unrestricted/Current Use Investment

Classified as a separate line item Restricted/Noncurrent Use → Long-term

Note: Classification of cash fund as current or noncurrent should parallel the classification of the related liability. If material, foreign bank deposits subject to foreign exchange restriction shall be classified separately among noncurrent assets and restriction clearly indicated. 2. Excess cash should be invested in revenue-earning investment. e.g. Investment in Time Deposit, Money Market Instrument and Treasury Bills If Term ≤ 3 months

3 months < Term ≤ 1 year → Short-term Investment Term > 1 year → Long-term Investment

Note: There is an assumption of 3 month-term when the problem does not specify. Measurement of Cash - cash is measured at face value. Cash in foreign currency is measured at current exchange rate. In Local Currency = Face Value

In Foreign Currency*

If Recoverable Value < Face Value*

= Current Exchange Rate

= Estimated Realizable Value

Note:*Deposit in foreign bank which are subject to foreign exchange restriction, if material, should be classified separately among noncurrent assets and the restriction is clearly indicated. *Cash in bank or in financial institutions having financial difficulty or in bankruptcy should be shown at its estimated realizable value, if the recoverable value is estimated to be lower than the face value.

Details comprising cash and cash equivalents should be disclosed in the notes to financial statements. Accounting for cash shortage – Cash < Balance per book It is to be recorded as follows: Cash short or over Cash

xx xx

Cash short or over account is only a temporary or suspense account. It should be adjusted in preparation of financial statements. If the cashier or cash custodian is held responsible for the cash shortage, the adjustment should be: Due from cashier xx Cash short or over xx Accounting for cash overage – Cash > Balance per book It is to be recorded as follows: Cash Cash short or over

xx xx

The cash overage is treated as miscellaneous income if there is no claim on the same. Cash short or over Miscellaneous Income

xx xx

But where the cash overage is properly found to be the money of the cashier, the journal entry is: Cash short or over Payable to cashier

xx xx

Note:*Whether it is cash shortage or cash overage, the offsetting account is cash short or over account. It should be adjusted when statements are made.

Petty Cash Fund – money set aside to pay small expenses which cannot be paid conveniently by means of check. There are two methods of handling the petty cash:

1. Imprest Fund System – system of control of cash which requires that all cash receipt should be deposited intact and all cash disbursements should be made by means of check. In this system, payment of expenses requires no formal entries. Petty cashier generally requires a signed petty cash voucher for such payments and prepares memo entry in the petty cash journal.  Petty cash disbursement should be replenished only by means of check and not from undeposited collection.  If not replenished, the entry is to state the correct cash fund is: Expenses xx Petty cash fund xx Petty cash expenses are recorded upon replenishment. Replenishment amount = Petty cash disbursements 2. Fluctuating Fund System - checks drawn to replenish the fund do not necessarily equal the petty cash disbursement. Expenses are immediately recorded and petty cash fund fluctuates from to time. Petty cash expenses are immediately recorded. Replenishment amount = or > or < Petty cash disbursements Misstatement Practices Concerning Cash Balance: 1. Window Dressing - is a practice of opening the books of accounts beyond the close of the accounting period for the purpose of showing a better financial position and performance. 2. Lapping - consists of misappropriating a collection from one customer and concealing this defalcation when collection is made from another customer. 3. Kiting - is a transfer of cash from one bank to another bank usually employed at the end of the month.

PROBLEM 1-1 DLF Company reported the checkbook balance on December 31, 2019 at P8,000,000. In addition, the entity held the following items in the safe on that date: Check payable to the entity, dated January 2, 2020 in payment of a sale, not  included in December 31 check book balance Check payable to the entity, deposited December 15 and included in December 31 checkbook balance, but returned by bank on       December 30 stamped “NSF”. The check was redeposited on January 2, 2020 and cleared on January 5, 2020 Check drawn on the entity’s account, dated and recorded on       December 31, 2019 but not mailed until January 15, 2020 Coins and currencies on hand Three-month money market instruments

1,000,000

3,000,000 2,500,000 800,000 1,500,000

What is the correct amount of “cash” on December 31, 2019? a. b. c. d.

7,500,000 9,300,000 8,300,000 9,800,000

Problem 1-1 Answer C Checkbook balance

8,000,000

NSF check Undelivered check drawn

(3,000,000) 2,500,000

Coins and currencies

800,000

Total cash

8,300,000

The check payable to the entity is properly not included because it is postdated January 2, 2016. Technically, the three-month money market instruments are cash equivalents but not cash. PROBLEM 1-2 On December 31, 2019, an entity showed the following current assets: Cash Accounts receivable

500,000 2,500,000

Inventory Prepaid expenses Total current assets

2,000,000 100,000 5,100,000

Cash on hand including customer postdated check of P20,000 and employee IOU of P10,000 Cash in bank per bank statement (outstanding checks on December 31, 2019, P70,000) Total cash

130,000 370,000 500,000

Customers’ debit balances, net of customer deposit of P50,000 Allowance for doubtful accounts Sale price of goods invoiced to customers at 150% of cost on December 29, 2019 but delivered on January 5, 2020 and excluded from reported  Inventory Total accounts receivable

1,900,000 (150,000) 750,000 2,500,000

What is the adjusted cash balance? a. b. c. d.

500,000 470,000 430,000 400,000

PROBLEM 1-2 Answer D Cash on hand Customer postdated check Employee IOU Adjusted cash on hand Cash in bank per bank statement Outstanding checks Adjusted cash balance

130,000 ( 20,000) ( 10,000) 100,000 370,000 ( 70,000)

PROBLEM 1-3 On December 31, 2019, the cash account of SDG Company showed the following details: Undeposited collections Cash in bank – PCIB checking account Cash in bank – PNB (overdraft) Undeposited NSF check received from the customer, dated Dec. 1, 2019 Undeposited check from a customer, dated Jan. 15, 2020 Cash in bank – PCIB (fund for payroll)

60,000 500,000 (50,000) 15,000 25,000 150,000

300,000 400,000

Cash in bank – PCIB (saving deposit) Cash in bank – PCIB (money market instrument, 90 days) Cash in foreign bank (restricted) IOUs from officers Sinking fund cash Listed shares held as trading investment Petty cash fund (all funds were reimbursed on 12/31/2019) Time deposit (due February 1,2020) Treasury bills Traveler’s check

100,000 2,000,000 100,000 30,000 450,000 120,000 50,000 250,000 1,000,000 50,000

What is the total cash and cash equivalent on December 31, 2019? a. 4,100,000 b. 4,200,000 c. 4,080,000 d. 4,160,000 PROBLEM 1-3 Answer D Undeposited collections PCIB checking account PCIB payroll fund PCIB saving deposit Petty cash fund Time deposit Treasury bills Traveler’s check PCIB money market Total cash and cash equivalents

60,000 500,000 150,000 100,000 50,000 250,000 1,000,000 50,000 2,000,000 4,160,000

PROBLEM 1-4 Dion Company had the following balances on December 31, 2019: Cash in bank – current account Cash in bank – payroll account Cash in bank – restricted account for building construction to be disbursed in 2020 Cash on hand Time deposit

4,000,000 500,000 1,500,000 100,000 2,000,000

The cash on hand included P30,000 check payable to Dion, dated January 15, 2020. What total amount should be reported as cash and cash equivalents on December 31, 2019?

a. b. c. d.

6,600,000 6,630,000 6,570,000 4,600,000

PROBLEM 1-4 Answer C Cash in bank – current account Cash in bank – payroll account Cash on hand (100,000 – 30,000 postdated customer check) Time deposit Total cash and cash equivalents PROBLEM 1-5

4,000,000 500,000 70,000 2,000,000 6,570,000

Mayumi Company reported the following information at year-end:  Share investment of P500,000 that are very actively traded in the stock market.  Government treasury bills of P1,000,000 with a 10-year term but purchased on December 31 at which time they had two months to go until maturity.  Cash of P2,500,000 in the form of coin, currency, saving account and checking account.  Commercial papers of P700,000 with term of nine months but purchased on December 31 at which time they had three months to go until maturity. What total amount should be reported as cash? a. 3,500,000 b. 2,500,000 c. 3,000,000 d. 3,200,00 What total amount should be reported as cash equivalents? a. 1,700,000 b. 1,500,000 c. 2,200,000 d. 3,500,000 PROBLEM 1-5 Question 1 Answer B

Question 2 Answer A

Cash - coin, currency, saving and checking

2,500,000

Government treasury bills Commercial papers Total cash equivalents

1,000,000 700,000 1,000,000

PROBLEM 1-6

Maliksi Company had the following account balances at year-end: Cash in bank Cash on hand Cash restricted for addition to plant and expected to be disbursed next year

3,150,000 100,000 1,400,000

Cash in bank included P500,000 of compensating balance against short-term borrowing arrangement. The compensating balance is not legally restricted as to withdrawal. What total amount of cash should be reported under current assets at year-end? a. 3,150,000 b. 3,250,000 c. 1,400,000 d. 4,550,000 PROBLEM 1-6 Answer B Cash in bank Cash on hand Total cash

3,150,000 100,000 3,250,000

PROBLEM 1-7 On December 31, 2019, Malakas Company provided the following information: Petty Cash Fund Current account – First Bank Current account – Second Bank (overdraft) Money market placement – Third Bank Time deposit – Fourth Bank

50,000 4,000,000 (250,000) 500,000 2,100,000

 A check for P100,000 was drawn against First Bank current account dated and recorded December 29, 2019 but delivered to payee on January 15, 2020.  The Fourth Bank time deposit is set aside for land acquisition in January 2020. What total amount should be reported as cash and cash equivalents on December 31, 2019? a. 4,050,000 b. 4,000,000 c. 4,650,000 d. 4,500,000

PROBLEM 1-7 Answer C Petty Cash Fund Current account – First Bank (4,000,000 + 100,000) Money market placement – Third Bank Total cash and cash equivalents

50,000 4,100,000 500,000 4,650,000

PROBLEM 1-8 Jill Company provided the following information with respect to its cash and cash equivalents on December 31, 2019. Checking account at First Bank Checking account at Second Bank Treasury bonds Payroll account Value added tax account Foreign bank account – restricted Postage stamps IOU from president’s sister Credit memo from a vendor for a purchase return Traveler’s check NSF check Petty cash fund (P20,000 in currency and expense receipts for P30,000) Money order

(200,000) 2,500,000 2,000,000 500,000 400,000 100,000 50,000 350,000 80,000 300,000 100,000 50,000 150,000

What amount should be reported as unrestricted cash on December 31, 2019? a. 3,500,000 b. 4,600,000 c. 4,000,000 d. 3,870,000 PROBLEM 1-8 Answer C Checking account at Second Bank Payroll account Value added tax account Traveler’s check Petty cash fund

2,500,000 500,000 400,000 300,000 20,000

Money order Total unrestricted cash

150,000 3,870,000

PROBLEM 1-9 The cash account in XX Company’s ledger showed a balance at December 31, 2019 of P4,415,000 which consisted of the following: Petty cash fund Undeposited receipts, including a postdated customer check for P70,000 Cash in Allied Bank, per bank statement, with a check for P40,000 still outstanding Bond sinking fund Vouchers paid out of collections, not yet recorded IOU’s signed by employees, taken from collections

24,000 1,220,000 2,245,000 850,000 43,000 33,000 4,415,000

What amount should be reported as cash in the December 31, 2019 statement of financial position? a. 3,389,000 b. 3,379,000 c. 3,489,000 d. 3,449,000 PROBLEM 1-9 Answer B Petty cash fund Undeposited receipts (1,220,000 - 70,000) Cash in Allied Bank (2,245,000 – 40,000)

24,000 1,150,000 2,205,000 3,379,000

PROBLEM 1-10 Rold Company reported petty cash fund which compromised the following: Coins and currency Paid vouchers: Transportation Gasoline Office supplies Postage stamps Due from employees

4,960 300 750 900 870 455

3,275

Manager’s check returned by bank marked “NSF” Check drawn by the entity to the order of petty cash custodian

4,560 3,890

What is correct amount of petty cash fund for statement presentation purposes? a. 8,850 b. 8,235 c. 10,735 d. 7,460

PROBLEM 1-10 Answer C Coins and currency Check drawn by the entity to the order of petty cash custodian Correct amount of petty cash

4,960 3,890 8,850

PROBLEM 1-11 The cash account in the current assets section of the statement of financial position of Eva Company consisted of the following: Bond sinking fund Checking account in FEBTC (A P320,000 check is still outstanding per bank statement Currency and coins waiting deposit Deposit in a bank closed by BSP Petty cash fund (10 000 is in the form of paid vouchers) Receivables from officers and employees What is the amount of cash to be reported under current assets? a. b. c. d.

4,440,000 4,830,000 4,330,000 5,830,000

PROBLEM 1-11 Answer C

1,000,000 3,155,000 1,135,000 700,000 50,000 175,000 6,215,000

FEBTC Currency and coins Petty cash fund (50,000 – 10,000) Total

3,155,000 1,135,000 40,000 4,330,000

PROBLEM 1-12 On December 31, 2019, Remy Company had the following cash balances: Cash in bank – current account Cash in bank – sinking fund Petty cash fund Cash on hand Cash in bank – restricted account for plant addition, Expected to be disbursed in 2020 Treasury bills

4,000,000 2,000,000 50,000 500,000 1,500,000 1,000,000

The petty cash fund includes unreplenished December 2019 petty cash expense vouchers of P10,000 and employee IOU of P5,000. The cash on hand includes a P100,000 check payable to Remy dated January 15, 2020. In exchange for a guaranteed line of credit, Remy has agreed to maintain a minimum balance of P200,000 in its unrestricted current bank account. The sinking fund is set aside to settle a bond payable that is due on June 30, 2020. What total amount should be reported as “cash and cash equivalents” on December 31, 2019? a. 7,435,000 b. 5,435,000 c. 4,435,000 d. 5,535,000

PROBLEM 1-12 Answer A Petty cash fund (50,000 – 15000) Cash in bank – current account Cash on hand (500,000 – 100,000) Cash in bank – sinking fund Treasury bills Total cash and cash equivalents

PROBLEM 1-13

35,000 4,000,000 400,000 2,000,000 1,000,000 7,435,000

The statement of financial position of Rosie Company shows cash of 330,820. The following items were found to comprise this total amount: Checking account in Metrobank (outstanding checks as of year-end totaled 15,200) Savings account is Far East bank Petty cash fund (including expense receipts for 250) Cash on hand (undeposited sales receipts) Sinking fund cash Cash in foreign bank (in equivalent pesos) Customers' check on hand Traveler's Check Manager's Check Short term treasury bills

105,200 30,800 1,500 4,200 35,000 65,000 14,000 23,120 52,000

What is the correct amount of cash? a. 143,570 b. 143,000 c. 144,770 d. 243,570 PROBLEM 1-13 Answer D Checking account in Metrobank (outstanding checks as of year-end totaled 15,200) Savings account is Far East bank Petty cash fund (1500 - 250) Cash on hand (undeposited sales receipts) Cash in foreign bank (in equivalent pesos) Customers' check on hand Traveler's Check Manager's Check Total amount of cash

105,200 30,800 1,250 4,200 65,000 14,000 23,120 243,570

PROBLEM 1-14 Green Company’s general ledger showed a balance of 3,000,000 in its cash account on December 31, 2019. Included in this balance are the following items: DAIF checks returned by bank Savings account IOUs

30,000 750,000 1,500

Postage Stamps Bank draft Cash on hand Cash in sinking fund Customers’ check dated January 2020 Travel advances Traveler’s check

2,000 10,000 50,000 700,000 5,400 4,000 8,000

What is the correct balance of cash? a. 2,256,000 b. 2,300,000 c. 2,257,100 d. 2,260,000 PROBLEM 1-14 Answer C Balance per ledger Non-cash items: Customer’s NSF check IOUs Postage stamps Cash in sinking fund Customers’ postdated checks Travel advances Correct cash balance

3,000,000 (30,000) (1,500) (2,000) (700,000) (5,400) (4,000) 2,257,100

PROBLEM 1-15 Jose Company had the following account balances at December 31, 2019: Cash in Bank Cash restricted for bond payable due on June 30, 2021 Time Deposit Saving deposit set aside for dividend payable on June 30, 2020

5,000,000 2,000,000 6,000,000 1,000,000

In the December 31, 2019 statement of financial position, what total amount should be reported as “cash and cash equivalents”? a. 12,000,000 b. 14,000,000 c. 11,000,000 d. 13,000,000 PROBLEM 1-15 Answer B Cash in bank Time Deposit

5,000,000 6,000,000

Saving deposit Total cash and cash equivalents

1,000,000 12,000,000

PROBLEM 1-16 In the course of your audit of the Virgilio Corporation, its controller is attempting to determine the amount of cash to be reported on its December 31, 2019 balance sheet. The following information is provided:          

Commercial savings account of P1,200,000 and a commercial checking account balance of P1,800,000 are held at PS Bank. Travel advances of P360,000 for executive travel for the first quarter of the next year (employee to reimburse through salary deduction). A separate cash fund in the amount of P3,000,000 is restricted for the retirement of a long term debt. Petty cash fund of P10,000. An I.O.U. from a company officer in the amount of P40,000. A bank overdraft of P250,000 has occurred at one of the banks the company uses to deposit its cash receipts. At the present time, the company has no deposits at this bank. The company has two certificates of deposit, each totaling P1,000,000. These certificates of deposit have maturity of 120 days. Virgilio has received a check dated January 2, 2020 in the amount of P150,000. Virgilio has agreed to maintain a cash balance of P200,000 at all times at PS Bank to ensure future credit availability. Currency and coin on hand amounted to P15,000.

Based on the above information and the result of your audit, how much will be reported as cash and cash equivalent at December 31, 2019? a. 3,025,000 b. 2,825,000 c. 2,575,000 d. 5,025,000

PROBLEM 1-16 Answer A Savings account at PS Bank Checking account at PS Bank Petty cash fund Currency and coin Total

1,200,000 1,800,000 10,000 15,000 3,025,000

PROBLEM 1-17 De Guzman Company reported petty cash fund which compromised the following: Coins and currency Paid vouchers: Transportation 400 Gasoline 600 Office supplies 850 Postage stamps 460 Due from employees 900 Manager’s check returned by bank marked “NSF” Check drawn by the entity to the order of petty cash custodian

5,000

3,210 2,500

3,450

What is correct amount of petty cash fund for statement presentation purposes? a. 8,210 b. 10,710 c. 8,450 d. 7,500

PROBLEM 1-17 Answer C Coins and currency Check drawn by the entity to the order of petty cash custodian Correct amount of petty cash

5,000 3,450 8,450

PROBLEM 1-18 You noted the following composition of Felix Company’s “cash account” as of December 31, 2019 in connection with your audit: Demand deposit account 2,000,000 Time deposit – 30 days 1,000,000 NSF check of customer 40,000 Money market placement (due June 30, 2020) 1,500,000 Savings deposit in a closed bank 100,000 IOU from employee 20,000 Pension fund 3,000,000

Petty cash fund Customer’s check dated January 1, 2020 Customer’s check outstanding for 18 months Total

10,000 50,000 40,000 7,760,000

Additional information follows: a) Check of P200,000 in payment of accounts payable was recorded on December 31, 2019 but mailed to suppliers on January 5, 2020. b) Check of P100,000 dated January 15, 2020 in payment of accounts payable was recorded and mailed on December 31, 2019. c) The company uses the calendar year. The cash receipts journal was held open until January 15, 2020, during which time P400,000 was collected and recorded on December 31, 2019.

What is the total amount of cash and cash equivalents to be shown on the December 31, 2019 balance sheet? a. 3,310,000 b. 2,910,000 c. 1,910,000 d. 4,410,000 PROBLEM 1-18 Answer B Demand deposit account as adjusted: Demand deposit account per books Undelivered check Postdated check issued Window dressing of collection Time deposit - 30 days Petty cash fund Cash and cash equivalents

2,000,000 200,000 100,000 (400,000) 1,900,000 1,000,000 10,000 2,910,000

PROBLEM 1-19 You were able to gather the following from the December 31, 2019 trial balance of Hidalgo Corporation in connection with your audit of the company: Cash on hand 500,000 Petty cash fund 10,000 BPI current account 1,000,000 Security Bank current account No. 01 1,080,000

Security Bank current account No. 02 PNB savings account PNB time deposit

(80,000) 1,200,000 500,000

Cash on hand includes the following items:  Customer’s check for P40,000 returned by bank on December 26, 2019 due to insufficient fund but subsequently redeposited and cleared by the bank on January 8, 2020.  Customer’s check for P20,000 dated January 2, 2020, received on December 29, 2019.  Postal money orders received from customers, P30,000.

The petty cash fund consisted of the following items as of December 31, 2019. Currency and coins Employees’ vales Currency in an envelope marked “collections for charity” with names attached Unreplenished petty cash vouchers Check drawn by Hidalgo Corporation, payable to the petty cashier

2,000 1,600 1,200 1,300 4,000 10,100

Included among the checks drawn by Hidalgo Corporation against the BPI current account and recorded in December 2019 are the following: a. Check written and dated December 29, 2019 and delivered to payee on January 2, 2020, P80,000. b. Check written on December 27, 2019, dated January 2, 2020, delivered to payee on December 29, 2019, P40,000. The credit balance in the Security Bank current account No. 2 represents checks drawn in excess of the deposit balance. These checks were still outstanding at December 31, 2019. The savings account deposit in PNB has been set aside by the board of directors for acquisition of new equipment. This account is expected to be disbursed in the next 3 months from the balance sheet date. Based on the above and the result of your audit, what is the adjusted balances of cash and cash equivalents? a. 2,917,200 b. 3,052,000

c. 3,074,900 d. 3,066,000

PROBLEM 1-19 Answer D Unadjusted cash on hand NSF check Postdated check received Adjusted cash on hand Petty cash fund per total Employees' vales (IOU) Currency in envelope marked "collections for charity" Unreplenished petty cash vouchers Petty cash fund, as adjusted Unadjusted BPI current account Unreleased check Postdated check delivered Adjusted BPI current account

500,000 (40,000) (20,000) 440,000 10,100 (1,600) (1,200) (1,300) 6,000 1,000,000 80,000 40,000

Security Bank current account (net of overdraft of P80,000) PNB time deposit Cash and cash equivalents, as adjusted

1,120,000 1,000,000 500,000 3,066,000

PROBLEM 1-20 Batchy Company reported petty cash fund which compromised the following: Coins and currency Paid vouchers: Transportation 870 Gasoline 950 Office supplies 430 Postage stamps 200 Due from employees 950 Manager’s check returned by bank marked “NSF” Check drawn by the entity to the order of petty cash custodian

7,680

3,400 9,750 10,500

What is correct amount of petty cash fund for statement presentation purposes? a. 17,430 b. 11,080 c. 20,830 d. 18,180

PROBLEM 1-20 Answer D Coins and currency Check drawn by the entity to the order of petty cash custodian Correct amount of petty cash

7,680 10,500 18,180

Chapter 2 Bank Reconciliation Bank deposits Demand deposits  Also known as current

Saving deposit  An interest-bearing



Time Deposit An interest-bearing

or checking account.

deposit account held

bank deposit with a



Non- Interest bearing

at a bank or other

specified period of



Very liquid and can

financial institution.

maturity. It is a money

be accessed using

Though these

deposit at a banking

checks, automated

accounts typically pay

institution that cannot

teller machines, and

a modest interest rate,

be withdrawn for a

electronic debits,

their safety and

specific term or

among other methods.

reliability make them

period of time. When

Often allows for

a great option for

the term is over, it can

numerous withdrawals

parking cash you want

be either withdrawn or

and unlimited

available for short-

held for another term.

deposits, whereas

term needs.



savings accounts sometimes limit both.

Bank reconciliation is the process of matching the information held by bank in the form of a bank statement in the information in the entity’s book. The cash balance per book and the cash balance per bank must equal after the process of bank reconciliation which lead us to the main goal of bank reconciliation which is to ascertain the differences between the bank statement and the books of the entity. (Bragg, 2018).

Reconciling items Book reconciling items

(1) Credit memo- a document issued by the seller of goods or services to the buyer, reducing the amount that the buyer owes to the seller under the terms of an earlier invoice. (2) Debit memo- a document that records adjustments for three general cases: reduction in a bank customer's account balance, under-billing of goods or services, or an internal offset to a minor credit balance in a customer account. (3) Errors- these are errors committed by the entity in recording in the books. Bank reconciling items (1) Deposit in Transit- money that has been received by a company and sent to the bank, but has yet to be processed and posted to the account by the bank. (2) Outstanding checks- a company has issued and recorded in its general ledger accounts, but the check has not yet cleared the bank account on which it is drawn. This means that the bank balance will be greater than the company's true amount of cash. (3) Bank errors- these are errors made by the bank

Forms of Bank Reconciliation (a.) Adjusted balance method- is an accounting method that bases finance charges on the amount(s) owed at the end of the current billing cycle after credits and payments have been posted. (b.)Book to bank method- the book balance is reconciled with the bank balance. (c.) Bank to book balance- the bank balance is reconciled with the book balance. Bank Reconciliation Procedure 

The following bank reconciliation procedure assumes that you are creating the bank reconciliation in an accounting software package, which makes the reconciliation process easier:



Enter the bank reconciliation software module. A listing of uncleared checks and uncleared deposits will appear.



Check off in the bank reconciliation module all checks that are listed on the bank statement as having cleared the bank.



Check off in the bank reconciliation module all deposits that are listed on the bank statement as having cleared the bank.



Enter as expenses all bank charges appearing on the bank statement, and which have not already been recorded in the company's records.



Enter the ending balance on the bank statement. If the book and bank balances match, then post all changes recorded in the bank reconciliation and close the module. If the balances do not match, then continue reviewing the bank reconciliation for additional reconciling items. Look for the following items:



Checks recorded in the bank records at a different amount from what is recorded in the company's records.



Deposits recorded in the bank records at a different amount from what is recorded in the company's records.



Checks recorded in the bank records that are not recorded at all in the company's records.



Deposits recorded in the bank records that are not recorded at all in the company's records.



Inbound wire transfers from which a lifting fee has been extracted.

PROBLEMS 1. In preparing the bank reconciliation on December 31, 2020, Baretto Company provided the following data: Balance per bank statement

P4,000,000

Deposit in transit

720,000

Amount erroneously credited by bank to Baretto’s Account

240,000

Bank Service charge for December

5,000

Outstanding checks

875,000

What is the adjusted cash in bank on December 31, 2020? a. P2,005,000 b. P3600,000 c. P3,605,000 d. P2,000,000

2. On April 30, 2019, Casio Company received its bank statement. However, the closing balance of the account was unreadable. Attempt to contact the bank after hours did not secure the desired information. The following data are available in preparing the bank reconciliation: March 31, 2019 book balance Note collected by bank Interest earned on note NSF check of customer Bank service charge on NSF check Other bank service charges Outstanding checks Deposit on march 31 placed in night

P1,480,000 120,000 10,000 130,000 2,000 3,000 222,000 85,000

depository Checked issued by Icarus Company charged

20,000

to Daedalus Company

What is the cash balance per bank statement?

a. P1,475,000 b. P1,592,000 c. P1,470,000 d. P1,350,000

3. The following information was included in the bank reconciliation for Hephaestus Company for April 30,2020: Balance per bank statement Balance per ledger Deposit of July 30 not recorded by bank Debit memo-service charges Credit memo- collection of notes by bank for Hephaestus Company Outstanding checks

P1,240,000 750,000 300,000 15,000 350,000 ?

An analysis of the cancelled checks returned with the bank statement reveals the following: 

Checks for purchase of supplies was drawn for P60,000 but was recorded as P90,000



The manager wrote a check for travelling expenses of P145,000 while out of town. the check was not recorded.

What is the amount of outstanding checks on July 31? (a.) 600,000 (b.) 570,000 (c.) 550,000 (d.) 610,000

4. The book keeper in Lyka Company recently prepared the following bank reconciliation on December 31, 2019: Balance per bank statement Deposit in Transit Checkbook Printing Charge

P2,800,000 195,000 5,000

Error made by Lyka Company in recording

35,000

Check No. 02 (issued in December) NSF Check Outstanding Check Note Collected by bank (includes P15,000

110,000 100,000 215,000

interest) Balance per book

2,830,000

Lyka Company has P200,000 cash on hand on December 31, 2019. What amount should be reported by Lyka Company as “cash” in the statement of financial position on December 31, 2019? a. P2,930,000 b. P3,095,000 c. P2,895,000 d. P3,130,000 5. Casio Company’s reconciling items for the month of March included the following information: Balance per book Bank service charge for March Checks deposited by Casio during March was not collectible Deposits made but not yet recorded by bank Checks written and mailed but not yet

P920,000 20,000 40,000 140,000 100,000

recorded by bank All deposits in transit and outstanding checks have been properly recorded in Casio’s books. Casio Company found a check for P35,000, payable to Casio Company that had not yet been deposited and had not been recorded in Casio’s books. What is the adjusted cash in bank on April 30? a. P895,000

b. P900,000 c. P920,000 d. P955,000

6. Cash data related to Home Corporation for the month of February of the current year are as follows: Balance per book, February 28 Balance per bank, February 28 Undeposited collections NSF check received from a customer returned

P3130,000 3500,000 550,000 50,000

by the bank on March 5 with the February bank statement Outstanding checks Bank debit memo for safety deposit box rental

650,000 5,000

not recorded by depositor A creditor’s check for P30,000 was

300,000

incorrectly recorded in the depositor’s book as A customer’s check for P200,000 was recorded by the depositor as Neglected entry of the depositor to a check

20,000 125,000

drawn What is the adjusted cash in bank on February 28? a. P3,130,000 b. P3,500,000 c. P3,400,000 d. P2,950,000

7. Piattos Company’s newly hired assistant prepared the following bank reconciliation on December 31:

Book Balance Deposit in transit Collection of Note Interest on note Debit memo Error on Check No.173 NSF Check Preauthorized payments for water bills Outstanding Check

P1,405,000 750,000 2,500,000 150,000 1,145,000 45,000 220,000 205,000 1,650,000

Piattos authorized the bank to automatically pay its water bills as submitted directly to the bank. What is the adjusted cash in bank on March 31? a. P1,500,000 b. P1,405,000 c. P3,630,000 d. P2,500,000 8. On March 31,2019, the bank statement of GQ Company had an ending balance of P3.735,000. The following data were assembled in the course of reconciling the bank balance: 

The bank erroneously credited GQ Company for P21,000 on March 22.



During the month, the bank charged back NSF checks amounting to P23,000 of which P8,000 had been redeposited by March 25.



Collection for March 31 totaling P103,000 was deposited the following month.



Checks outstanding on March 31 amounted to P302,000.



Note collected by the bank for GQ Company was P80,000 and the corresponding bank charge was P5,000.

What is the unadjusted cash in bank per ledger on March 31, 2019? a. P3,515,000 b. P3,557,000 c. P3,455,000

d. P3, 497,000 9. The following data pertain to the cash transactions and bank account of Quinn Company for August of the current year: Cash Balance per book Cash balance per bank statement Bank service charge Debit memo Outstanding Checks Undeposited colletions Proceeds of loan (net of interest, P30,000) Erroneous credit Bank error NSF Check

P1,719,000 3,195,000 10,000 12,000 685,000 500,000 570,000 90,000 80,000 77,000

What is the adjusted cash in bank? a. P3,080,000 b. P2,910,000 c. P3,000,000 d. P2,990,000

10. The cash account in the ledger of Blue Company shows a balance of P1,652,000 at December 31. The bank statement, however, shows a balance of P2,090,000 at the same date, The only reconciling items consist of a bank service charge of P2,000, a large number of outstanding checks totaling P590,000 and a deposit in transit. What is the deposit in transit in the December 31 bank reconciliation? a. P150,000 b. P440,000 c. P154,000

d. P592,000

11. Elsa Company keeps all its cash in a checking amount. An examination of the entity’s accounting records and bank statement for the month ended December 31,2019 revealed a bank statement balance of P8,649,000 and a book balance of P8,524,000. A deposit of P950,000 placed in the bank’s night depository on December 29 does not appear on the bank statement. Checks outstanding on December 31 amount to P270,000. The bank statement shows that on December 25, the bank collected a note for Elsa Company and credited the proceeds of P935,000 to the entity’s account. The proceeds included P35,000 interest, all of which Elsa Company earned during the current period. Elsa Company has not yet recorded the said collection. Elsa Company discovered that check no. 0906 written in December for P183,000 in payment of an account had been recorded in the entity’s records as P138,0000. Included with the December 31 bank statement was an NSF Check for P250,000 that Elsa Company had received from Ana Company on December 20. Elsa Company has not yet recorded the returned check. The bank statement shows a P15,000 service charge for December. What is the journal entry to adjust the cash in bank on December 31, 2019? a. Net debit to cash in bank of P625,000 b. Net credit to cash in bank of P625,000 c. Debit to cash in bank of P935,000 d. Credit to cash in bank of P310,000

12. In preparing the September 30, 2019 bank reconciliation, Helen Company provided the following information

Balance per bank statement Deposit in transit Return of customer’s check for insufficient

P2,000,000 415,000 150,000

fund Outstanding checks Bank service charge for September

365,000 10,000

On September 30, 2019, what is the adjusted cash in bank? a. P1850,000 b. P1,855,000 c. P1,220,000 d. P2,000,000

13. The following information was included in the bank reconciliation for Ceres Company for January and February 2020: Checks and charges recorded by bank in

P550,000

February, including a February service charge of P8,000 and NSF check of P24,000 Service charge made by bank in January and

2,000

recorded by depositor in February. Total credits to cash in all journals during

620,000

February Customer’s NSF check returned in January

40,000

and redeposited in February (no entry made by depositor in either January or February). Outstanding checks on January 31, 2020 that cleared in February

230,000

What is the amount of outstanding checks on February 28, 2020? (a.) 282,000 (b.) 302,000 (c.) 518,000 (d.) 322,000\

14. In an audit of Troy Company on December 31, 2023 the following data are gathered: Balance per book Bank charges Outstanding checks Deposit in transit Customer note collected by bank Interest on customer note Customer check returned NSF Depositors note charged to account

P1,000,000 3,000 235,000 300,000 375,000 15,000 62,000 250,000

What is the adjusted cash in bank on December 31, 2023? a. P1,254,000 b. P1,257,000 c. P1,078,000 d. P1,075,000

15. While checking the cash account of Clarissa Company on December 31, 2019, the following information is discovered: Balance per book Balance per bank statement (outstanding checks of P987,000 Deposit in bank closed by BSP

P6,776,000 6,532,000 1,850,000

Deposit in Transit Currency and Coins counted Petty cash fund (of which P10,000 is in the

1,245,000 950,000 50,000

form of paid vouchers) Bank Charges not yet taken up in the book Bond sinking fund Receivables from employees Error in recording a check in the book. The

8,000 1,200,000 70,000 9,000

correct amount as paid by the bank is P89,000 instead of P98,000 as recorded in the book, or a difference of

What is the adjusted cash in bank on December 31, 2019? a. P6,776,000 b. P6,777,000 c. P6,769,000 d. P6,789,000

16. Marvin Company’s reconciling items for the month of December included the following information: Ending balance, December 31 Bank Service Charge for December Interest paid by bank to Marvin Company for

P2,890,000 12,000 10,000

December Deposits made but not yet recorded by the

350,000

bank Checks written and mailed but not yet

650,000

recorded by the bank In addition, Marvin Company discovered that it had drawn and erroneously recorded a check for 46,000 that should have been recorded for P64,000

What is the cash balance per ledger on December 31? a. P2,890,000 b. P2,590,000 c. P2,610,000 d. P2,580,000 17. Evans Company keeps all its cash in a checking account. An examination of the entity’s accounting records and bank statement for the month ended June 30, 2019 revealed the following information: Balance per book on June 30 Undeposited Collections Note Collections Outstanding Checks NSF Check Service Charge

P8,550,000 1,200,000 950,000 350,000 250,000 25,000

Evans discovered that a check written in June for P200,000 in payment of an account payable, had been recorded in the entity’s records as P20,000. What is the cash in bank to be reported in the statement of financial position on June 30, 2019? a. P9,045,000 b. P8,300,000 c. P9,360,000 d. P9,180,000

18. The accounts of Erobos company showed the following facts on August 31, 2023. Balance of cash in bank account Balance of bank statement Outstanding checks, august 31: Number 555

P1,300,000 1,200,000 2,000

861 55,000 862 35,000 863 30,000 864 66,000 865 70,000 Receipts of August 31, deposited September 1 275,000 Service charge for August 3,000 NSF check received from a customer 80,000 The cashier bookkeeper had misappropriated P30,000 and an additional P10,000 by charging sales discounts and crediting accounts receivable. The stub for check number 865 and the invoice relating thereto show that it was for P50,000. It was recorded incorrectly in the cash disbursement journal as P70,000. This check was drawn in payment of an account payable. Payment has been stopped on check number 555 which was drawn in payment of an account payable. The payee cannot be located. What is the adjusted cash in bank on August 31, 2023? (a.) 1,240,000 (b.) 1,230,000 (c.) 1,239,000 (d.) 1,235,000

19. Steve Company provided the following data for the purpose of reconciling the cash balance per book with the balance per bank statement on December 31, 2019: Balance per bank statement Outstanding Checks Deposit in transit NSF Checks (P50,000 had been redeposited and cleared by December 27) Erroneous credit to Steve’s account, representing proceeds of loan granted to another company

P2,000,000 400,000 200,000 150,000 300,000

Proceeds of note collected, net of service

750,000

charge of P20,000 What is the cash in bank to be reported in the December 31, 2019 statement of financial position? a. P1,500,000 b. P1,400,000 c. P1,800,000 d. P1,450,000

20. In reconciling the cash balance on December 31, 2023 with that shown in the bank statement, the following facts are gathered from the records of Jupiter Company: Balance per bank statement Balance per book Outstanding checks Deposit in transit Service charge Proceeds of bank loan, December 1, discounted for 6

P4,000,000 2,700,000 600,000 500,000 10,000 965,000

months at 12%, not recorded on Jupiter Company’s books Customer’s check charged back by bank for absence

50,000

of counter signature Deposit of P100,000 incorrectly recorded by bank as Check of Neptune Company charged by bank against

15,000 150,000

Jupiter account Customer’s note collected by bank in favor of Jupiter company Face Interest Total Collection fee Erroneous debit memo of December 28, to charged Jupiter account with settlement of bank loan Deposit of Neptune company credited to Jupiter company

P400,000 40,000 440,000 5,000

465,000 225,000 300,000

Prepare a bank reconciliation for Jupiter company on the month of December?

SOLUTIONS Problem 1.

Answer: C

Solution: Balance per bank statement Deposit in Transit

P4,000,000 720,000

Outstanding Checks

(875,000)

Bank Error

(240,000)

Adjusted Bank Balance

P3,605,000

Problem 2. Answer: B Solution: March 31, 2019 book balance Note collected by bank Interest earned on note NSF Check Bank Service Charges (2,000+3,000) Adjusted book balance

P1,480,000 120,000 10,000 (130,000) (5,000) P1,475,000

Balance per bank statement (SQUEEZE) Deposit in Transit Bank Error- erroneous charge Outstanding Checks Adjusted Bank Balance

P1,592,000 85,000 20,000 (222,000) P1475,000

Problem 3.

Answer: C

Solution: Balance per ledger Add: Collection of note Book error (90,000-60,000) Less: Service charges Unrecorded check for travelling expenses Adjusted book balance

P750,000 350,000 30,000 15,000 145,000 970,000

Balance per bank Add: Deposit in transit Less: Outstanding checks Adjusted bank balance Problem 4.

P1,240,000 300,00 570,000 970,000

Answer: B

Solution . Balance per bank

P2800,000

Deposit in transit

195,000

Outstanding Check

(100,000)

Adjusted cash in Bank Cash on hand

200,000

Total Cash

Problem 5.

P2,895,000 P3,095,000

Answer: A

Solution: Balance per book

P920,000

Unrecorded customer check

35,000

Bank Service Charge

(20,000)

NSF Check

(40,000)

Adjusted book balance

Problem 6.

P895,000

Answer: C

Solution Balance per book

P3130,000

Overstatement of creditor’s check

270,000

Understatement of customer’s check

180,000

NSF Check

(50,000)

Bank Debit Memo for safety deposit box

(5,000)

Unrecorded check

(125,000)

Adjusted book balance

P3,400,000

Balance per bank

P3,500,000

Undeposited Collections Outstanding Checks

(650,000)

Adjusted Bank Balance

Problem 7.

550,000 P3,400,000

Answer: C

Solution Book balance

P1,405,000

Collection of Note

2,500,000

Interest on Note

150,000

Book error on Check No. 173 Bank service charge

45,000 (45,000)

Water bills

(205,000)

NSF Check

(220,000)

Adjusted book balance

Problem 8.

P3,630,000

Answer: C

Solution. Balance per bank

P3,735,000

Erroneous bank credit

(21,000)

Deposit in transit

103,000

Outstanding checks

(302,000)

Adjusted bank balance

P3,515,000

Balance per book (SQUEEZE)

P3,455,000

NSF Check

(15,000)

Note Collected by bank

80,000

Service Charge

(5,000)

Adjusted book balance

P3,515,000

Problem 9.

Answer: C

Solution Balance per book

P1,719,000

Service Charge

(10,000)

Debit memo

(12,000)

Proceeds of bank loan

570,000

Proceeds of customer’s note

810,000

NSF Check

(77,000)

Adjusted book balance

P3,000,000

Balance per bank

P3,195,000

Outstanding checks

(685,000)

Deposit in transit

500,000

Erroneous credit

(90,000)

Bank error

80,000

Adjusted bank balance

Problem 10.

P3,000,000

Answer: A

Solution Balance per book Service Charge

P1,652,000 (2,000)

Adjusted book balance

P1,650,000

Balance per bank

P2,090,000

Deposit in transit (SQUEEZE) Total Outstanding Checks Adjusted bank balance

150,000 P2,240,000 (590,000) P1,650,000

Problem 11.

Answer: A

Solution: Book Balance

P8,254,000

Note Collected

935,000

Total

P9,459,000

Book Error (183,000-138,000) NSF Check

(45,000) (250,000)

Service Charge

(15,000)

Adjusted book balance

P9,149,000

Debit to cash in bank

P935,000

Credit to cash in bank

310,000

Net debit to cash in bank

Problem 12.

P625,000

Answer: C

Solution: Balance per bank

2,000,000

Deposit in Transit

415,000

Total

1,585,000

Outstanding Checks

(365,000)

Adjusted bank balance

1,220,000

Problem 13.

Answer: C

Solution. Checks and charges by bank in November Service charge in November NSF check in February Checks paid by bank in February

P550,000 (8,000) (24,000) 518,000

Total credits to cash in all journals during February Service charge in January recorded in February Checks issued by depositor in February Outstanding Checks— January 31 Total checks to be paid by bank Checks paid by bank in February Outstanding checks— February 28

Problem 14.

P620,000 (2,000) 618,000 230,000 848,000 (518,000) 330,000

Answer: D

Solution: Balance per book

P1,000,000

Bank charges

(3,000)

Note collected by bank Interest on Note

15,000

NSF

(62,000)

Note Charged to account Adjusted Book Balance

Problem 15.

375,000

(250,000) P1,075,000

Answer: B

Solution: Balance per book

P6776,000

Bank Charges

(8,000)

Book error in recording check Adjusted cash in bank Problem 16.

9,000 P6,777,000

Answer: C

Solution. Balance per bank

P2890,000

Deposit in transit

350,000

Outstanding Checks Adjusted bank balance

(650,000) P2,590,000

Balance per ledger (SQUEEZE)

P2,610,000

Interest Income

10,000

Service Charge

(12,000)

Book error (64,000-46,000)

(18,000)

Adjusted book balance

Problem 17.

P2,590,000

Answer: A

Solution. Balance per book

P8,550,000

Note collected by bank

950,000

Total

P9,500,000

Book error (200,000-20,000)

(180,000)

NSF Check

(250,000)

Service charge

(25,000)

Adjusted book balance Problem 18.

P9,045,000

Answer: C

Solution Balance per book Add: Overstatement of check

20,000

number 765 Check number 555 stopped

2,000

for payment Less: Service Charge NSF check Adjusted book balance Balance per bank Add: Undeposited collections Less:

P1,300,000

3,000 80,000

22,000

83,000 1,239,000 1,200,000 275,000

Outstanding checks Number 861 862 863 864 865 Adjusted bank balances

Problem 19.

55,000 35,000 30,000 66,000 50,000

236,000 1,239,000

Answer: A

Solution Balance per bank

P2,000,000

Deposit in transit

200,000

Total

P2,200,000

Outstanding Checks

(400,000)

Erroneous bank credit

(300,000)

Adjusted bank balance

P1,500,000

Problem 20.

Solution:

Balance per book Add: Proceeds of bank loan Note collected by bank Less: Service charge Customer’s check charged

P2,700,000 P965,000 465,000

1,430,000

15,000 50,000

65,000

back Adjusted book balance

Balance per bank Add: Deposit in transit Incorrect deposit Erroneous bank charge Erroneous debit memo Less:

4,065,000

P4,000,000 500,000 90,000 150,000 225,000

965,000

Outstanding checks Erroneous bank credit Adjusted bank balance

600,000 300,000

900,000 4,065,000

CHAPTER 3 Proof of Cash Proof of cash is a more detailed four-column bank reconciliation consisting of the beginning balance, receipts, disbursements and the ending balance. Compared to a simple bank reconciliation, a proof of cash also reconciles the receipts and disbursements of the bank and the depositor. It can be noted that the combined balances of beginning date and receipts is equal to the combined amount of disbursements and ending date. Preparing a proof of cash is suitable in determining discrepancies in the cash balance of an entity. The preparation of a proof of cash may become complicated due to the omission of one or combination of the beginning and ending balance of the following: book, bank, deposits in transit and outstanding checks. The omission of such information gives rise to the necessity of computing them. Computation of Book Balance Balance per book Add: Book debits – current month Total Less: Book credits – current month Balance per book – end of month

Book debits are receipts or increases in cash in bank recorded per book Book credits are disbursements or decreases in cash in bank recorded by book.

Computation of Bank Balance Balance per bank Add: Bank credits – current month Total Less: Bank debits – current month

Balance per bank– end of month

Bank debits are decreases in the account of the depositor which include debit memos such service charges and NSF checks and checks paid by the bank. Bank credits are increases in the account of the depositor which includes credit memos such as notes collected by bank and proceeds of bank loans and deposits acknowledged by the bank.

Computation of Deposits in Transit Deposits in transit – Beginning of month Add: Cash receipts deposited during the month Total deposits to be acknowledged by bank Less: Deposits acknowledged during the month Deposits in transit – end of the month

Computation of Outstanding Checks Outstanding checks – Beginning of month Add: Checks drawn during the month Total checks to be paid Less: Checks paid by the bank during the month Outstanding checks – end of the month

Illustration The following information pertains to BTS Corporation for the months of September and November 2019: Balance per ledger September 30

P

600,000

October 31

780,000

Bank Balance September 30

P

617,400

October 31

758,200

Book debits – October

2,580,000

Book credits – October

2,400,000

Bank debits – October

2,413,600

Bank credits - October

2,554,400

Deposits in Transit September 30

P

240,000

October 31

305,000

Outstanding Checks September 30

P

223,000

October 31

198,000

Bank service charges September 30

1,200

October 31

800

NSF (recorded by the company the following month) September 30

25,000

October 31

14,000

Bank credit memo for customer’s note collected by bank in September Face value – 60,000; interest – 600

60,600

Credit Memo for bank loan granted by bank on October 30

100,000

Book Sep. 30

Receipts

Disbursements

0ctober 31

Unadjusted book balance Bank service charge – Sept. Bank service charge – Nov. NSF- Sept. NSF – Nov. Credit memo - Note Collected Credit memo - Proceeds of Loan

600,000 (1,200) (25,000)

Adjusted book balance

634,400

60,600

2,580,000

2,400,000 (1,200) 800 (25,000) 14,000

(60,600) 100,000 2,619,400

780,000 (800) (14,000) 100,000

2,388,600

865,200

Bank Unadjusted bank balance Deposits in Transit– Sept. Deposits in Transit– Nov. Outstanding Checks - Sept. Outstanding Checks – Nov. Adjusted book balance

Sep. 31 617,400 240,000

Receipts 2,554,400 (240,000) 305,000

(223,000) 634,400

2,619,400

Disbursements 2,413,600

October 30 758,200 305,000

(223,000) 198,000 2,388,600

(198,000) 865,200

COMMENTS A. Bank service charges are book reconciling items. September service charge is deducted to beginning balance because it is a disbursement not deducted in the previous month therefore it is also deducted to current month disbursement because it is not a disbursement of October. October service charge is added to disbursement and deducted to ending balance because it is a disbursement of the current month. NSF checks were also treated the same in this problem. B. Bank credit memo for notes collected in September is added to Beginning balance and deducted to October receipts because it is an addition made by the bank to the depositors account in September. Bank credit memo for proceeds of loan granted in October is added to receipts and ending balance because it is an increase in the cash balance for the current month. C. September NSF check is deducted to beginning balance and disbursement because it was recorded as a receipt in previous month hence beginning balance is overstated. It is deducted from disbursement because it is a disbursement of September and not the current month.

D. September deposits in transit is added to beginning balance and deducted to receipt because it is a receipt that was not recorded previously therefore understating the beginning balance. October DIT is a receipt of current month therefore it is added to receipt and ending balance. E. September Outstanding check is deducted to beginning balance and disbursements because this is a disbursement of the previous month not recorded. October outstanding check is a disbursement of the current month hence it decreases the ending balance. Journal Entry Accounts Receivable

14,000

Cash in Bank

Bank Service Charge

14,000

800

Cash in Bank

800

Cash in Bank

100,000

Notes Payable – bank

100,000

PROBLEMS 1. Kish Company had the following data pertaining to the cash records for the months of October and November.

Book balance Cash receipts per book Cash disbursements per book

Bank balance Bank disbursements Bank receipts

NSF check

October 31 ?

November 30 1,000,000 1,500,000 2,500,000

2,200,000

? 2,600,000 1,300,000

60,000

40,000

Collections of accounts receivable not recorded by entity and corrected in subsequent month Overstatement of check in Payment of salaries corrected In subsequent month Deposit in transit Outstanding checks

30,000

50,000

90,000 130,000 270,000

120,000 260,000 30,000

Prepare a four-column bank reconciliation. BOOK

Unadjusted book balance NSF- Sept. NSF – Nov. Collection of Accounts Receivable- October 31 Collection of Accounts Receivable- November 30 Overstatement of Check - Oct. 31 Overstatement of Check - Nov. 31 Adjusted book balance

Oct. 31 Receipts 2,000,000 1,500,000 (60,000) 30,000

Disbursements 2,500,000 (60,000) 40,000

(40,000)

(30,000) 50,000

90,000

November 30 1,000,000

50,000

(90,000)

2,060,000 1,430,000

(120,000) 2,360,000

120,000 1,130,000

BANK Unadjusted bank balance Deposits in Transit– Oct.. Deposits in Transit– Nov. Outstanding Checks - Oct. Outstanding Checks – Nov. Adjusted book balance

Oct. 31 2,200,000 130,000

Receipts 1,300,000 (130,000) 260,000

(270,000) 2,060,000

1,430,000

Disbursements 2,600,000

November 30 900,000 260,000

(270,000) 30,000 2,360,000

2. Using data from item 1, what is the unadjusted book balance in October?

(30,000) 1,130,000

Unadjusted Cash Balance, Oct. 31(SQUEEZE)

2,000,000

Add: Receipts

1,500,000

Total

3,500,000

Less: Disbursements

2,500,000

Unadjusted Cash Balance, Nov. 30

1,000,000

3. Using data from item 1, what is the unadjusted bank balance in November? Unadjusted Cash Balance, Oct. 31

2,200,000

Add: Receipts

1,300,000

Total

3,500,000

Less: Disbursements

2,600,000

Unadjusted Cash Balance, Nov. 30

900,000

4. Using data from item 1, what is the adjusted bank balance in October? 2,060,000

5. Using data from item 1, what is the adjusted bank balance in November? 1,130,000

6. The bank is responsible for the preparation of proof of cash. FALSE

7. Furball Company prepared the following bank reconciliation on July 31: Balance per bank statement, July 31 Deposit in transit

4,500,000 400,000

Total Outstanding checks

4,900,000 (900,000)

Balance per book, July 31

4,000,000

The Bank statement for the month of August showed the following: Deposits, including P200,000 note collected by the bank for furball 10,500,000 Disbursements, including P140,000 DAIF and P10,000 service charge 8,500,000 All reconciling items on July 31 cleared through the bank in August. August 30 Outstanding checks

P600,000

Deposit in transit

P1,000,000

What is the adjusted cash in bank on August 30? a. 6,500,000 b. 6,700,000 c. 7,050,000 d. 6,900,000 Balance per bank statement, July 31 Deposits Disbursements Balance per bank, August 30 DIT OC Adjusted Balance

4,500,000 10,500,000 (8,500,000) 6,500,000 1,000,000 (600,000) 6,900,000

8. In the immediately preceding problem, what is the cash balance per book on August 30? a. 6,900,000 b. 6,850,000 c. 7,050,000 d. 5,900,000 Balance per Book, August 30 (SQUEEZE) Note Collected DAIF

6,850,000 200,000 ( 140,000)

Bank service charge Adjusted Book Balance

( 10,000) 6,900,000

9. In the immediately preceding problem, what is the amount of cash receipts per book in August? a. 10,900,000 b. 11,100,000 c. 10,100,000 d. 11,300,000

Deposit per bank statement, June

10,500,000

Note Collected

(200,000)

DIT, July

(400,000)

DIT, August

1,000,000

Cash Receipts per Book, August

10,900,000

10. Beautiful Guel Company prepared the following bank reconciliation on November 30. Balance per bank Deposit in transit Outstanding checks Balance per book

9,000,000 800,000 (1,200,000) ?

What is the balance per book? a. 8,300,000 b. 7,900,000 c. 8,900,000 d. 8,600,000 11. Arnold Company prepared the following bank reconciliation on December 31. Balance per bank Deposit in transit

? 1,000,000

Outstanding checks Balance per book

(1,250,000) 4,400,000

What is the balance per bank? a. 4,600,000 b. 4,400,000 c. 4,900,000 d. 4,650,000 12. The following are reconciling items that the entity journalizes, except: a. Service charge b. Collection of notes c. NSF Check d. Deposits in transit

13. The following are bank reconciling items, except: a. Service charge b. Collection of notes c. NSF Check d. Deposits in transit

14. Beginning deposits in transit is deducted to ___________. a. Beginning balance b. Ending balance c. Receipts d. Disbursements

15. The following are bank reconciling items, except: a. Deposits in transit b. Outstanding checks c. Bank error d. Collection of Notes

16. A proof of cash a. proves the existence of a bank account b. is a type of financial statement c. is a four-column bank reconciliation d. is prepared by the bank

17. Outstanding checks are reconciling items a. deducted to bank balance b. added to book balance c. deducted to book balance d. added to bank balance

18. Beginning deposits in transit is added to beginning balance and deducted to receipts. TRUE

19. Bank credit memo of the previous month is a bank reconciling item that must be added to beginning balance and deducted to receipts. FALSE

20. Outstanding checks of current month are book reconciling items that must be deducted to ending balance and added to disbursement. FALSE

CHAPTER 4: ACCOUNTS RECEIVABLE Introduction to Accounts Receivable We often go to the grocery buy necessities such as foods, beverages supplies etc. in which we usually pay in cash and then take possession of the product. In companies however, they must be willing to accept cash or on credit in exchange of the goods. This means that the entity would be willing to accept payment at a later date, and you (the buyer) would incur an obligation towards the entity. Transaction on credit usually results to: a. Higher sales – since buyers are more willing to purchase on credit rather than pay on cash b. Potential loss – the entity shoulders the risk of loss, which will happen if the buyer does not pay the amount it owes. If the buyer does not pay the seller will recognize 1. A bad debts expense which will be shown in the balance sheet. 2. A reduced amounts of accounts receivable shown in the balance sheet. Example Assume that on March 1 Petmalu Co. Sold 90000 worth of Laptops to clients with a credit term of net 20 days. Entry Accounts Receivable Sales

90000 90000

Under accrual basis income is recognized when earned regardless of whether paid or not. In this case income is earned and recognized but payment of cash shall be recognized after 20 days. (note: credit term net of 20 days represents the days the buyer may pay the full amount.)

SALES OF GOODS IN CREDIT When a company sells goods on account, the transaction results to an increase in income statement as a sales revenue and COGS, an increase and decrease in balance sheet as an

Accounts Receivable and Inventory. The final amount in the income statement of net profil (or loss) on the sale shall be reported in the Statement of Stockholder’s Equity. Shipping Terms and Freight Terms Shipping terms can sometimes be confusing. Buyers need to be fully aware of its Shipping and Freight terms before sendin away the good so that the buyer and seller can come to an agreement on who shall shoulder the costs in shipping the goods. Shipping terms can either be: a. FOB Destination - the seller shall take ownership of the goods until the buyer has received the product. b. FOB Shipping point - the buyer takes ownership upon shipment of the goods. Freight Freight Terms can be: a. Freight prepaid – seller pays the cost of shipping. b. Freight Collect – the buyer pays cost of shipping. To further summarize the concept kindly look at the diagram below: Transfer of Ownersp

FOB Shipping Point

SELLER

BUYER Transfer of Ownersp

FOB Destination

SELLER

BUYER Table 1

Example Assume that in the illustration Above Petmalu Co. Shipped their Laptops FOB Destination, freight collect that costs 1000. Entry Freight Out 10000 Allowance for freight Charge 10000

Now assume that Petmalu shipped their goods FOB Shipping point, freight collect. Entry None (there shall be no entry to the selling entity’s perspective since the buyer owns and shoulders transportation costs)

Credit Terms with discounts When a seller gives a credit term net of 30 days the buyer is due to pay the entire amount within 30 days after sales invoice date. But some companies find that they do not recieve payment on time even with long credit terms so these companies offer discounts to customers who pays within a short amount of time. These are called cash dicounts or early payment discount and the period of time to avail cash discount is called the dicount period. For example 2/10 net of 30 days. The 2% dicscount on the entire amount owed shall only apply within 10 days. If the customer does not pay withing the discount period of 10 days, the net purchase amount without the idcount is payable within 30 days after invoice date. Example Using the examples from above that on March 1 Petmalu Co. Sold 90000 Laptops with credit terms 2/10 net 30 days If the buyer is able to pay on or before March 11 (10 days) he/she may be able to deduct 1800 (0.02 x 90000) from the 90000 purchase price of the laptops And thus the entry shall be March 1 Accounts receivable Sales

90000

March 11 Cash Sales Discount Accounts Receivable

88200 1800

90000

90000

If the customer fails to avail the 2% discount the entry shall be: March 11 Cash

90000 Accounts Receivable

90000

Methods for Recording Credit Sales a. Gross Method – The accounts receivable and Sales are recorded at gross amount b. Net Method – The accounts receivables and sales are recorded ar net amount Example – GROSS METHOD Sale of Goods worth 5000 terms 2/15 net 20 days Accounts Receivable Sales

5000 5000

If payment is received within discount period Cash Sales Discount Accounts Receivable

4900 100 5000

Is payment was received beyond the discount Period Cash

5000 Accounts Receivable

5000

Example – NET METHOD Sale of Goods worth 5000 terms 2/15 net 20 days Accounts Receivable Sales

5000 5000

If payment is received within discount period Cash

4900 Accounts Receivable

4900

Is payment was received beyond the discount Period

Cash

5000 Accounts Receivable Sales Discount forfeited

4900 100

Note that in Gross method they used an account of Sales discount if payment was made within discount period while Net method uses Sales dicount forfeited if collection was made beyond dicsount period.

Allowance for Bad Debts Accounts Receivable are dound in the entity’s balance sheet classified as current asset since the account is highly liquid and can easily be converted to cash within a year. If not collected the Accounts receivable account can easuly be overstated in the balance sheet. To present the account accurately the entities usually estimate how much of the Accounts Receivable are not collectible. This estimate is a contra asset-account found in the balance sheet called Allowance for Bad Debts or Allowance for Doubtful Accounts. An increase or decrease in this account are recorded in the income statement as Bad Debts Expense or Doubtful Account Expense. There are two method of accounting for bad debts namely 1. Allowance Method 2. Direct Writeoff Method

Allowance method for reporting Credit losses To recognize doubtful account the entry shall be: Doubtful Accounts Allowance for Doubtful Accounts If the account is sure to be uncollectible the Accounts Receivable shall be written-off and shall be entries as follows: Allowance for Doubtful Accounts Accounts Receivable Example An Accounts Receivable of 10000 from the 50000 sale of Phones on credit are considered doubtful of collection

Doubtful Accounts Expense Allowance for Doubtful Accounts

10000 10000

The accounts are subsequently discovered are proved to be uncollectible Allowance for Doubtful Accounts Accounts Receivable

10000 10000

Recovery of an account After writing off the Acocunts receivable it is srill possible the seller has paid all or part of the account that has been wrritten off. Assume that in the previous example 10000 of Doubtful Account has been unexpectedly collected Steps to record a recovery of Account under allowance method:

1. Reinstate the account written off by reversing the entry Accounts Receivable Allowance for D

10000 oubtful Accounts

10000

2. Record the Accounts Receivable as if collected normally Cash

10000 Accounts Receivable

10000

Direct Writeoff Method Under direct Writeoff method Doubtfull Accounts are only recognized when the accounts are proved to be worthless or uncollectible.

Example A 5000 Accounts receivable are doubted to be collected. No entry 5000 Accounts receivable is sure to be worthless or uncollected

Doubtful Accounts Expense Accounts Receivable

5000 5000

Suddenly, 5000 of the Accounts receivable was collected Accounts Receivable Doubtful Accounts Expense

5000

Cash

5000 Accounts Receuvake

5000 5000

PROBLEMS: MULTIPLE CHOICE 1.On February 1 P222 woth of goods are sold with credit terms of 1/10 n/30. If the buyer paid the goods on Fenruary 9. How much cash should the seller expect to receive? a. 219.78 b. 200 c. 220.56 d. 199.30 2. On July 1, P800 of goods are sold with credit terms of 1/10. n/30. On July 5 the customer returned P100 of the goods. How much should the seller expect to receive if the buyer pays on June 8? a. 692 b. 693 c. 700 d. 792 3. With credit terms of 2/10. n/30, the discount rate is a. 2% b. 10% c. 30% d. None of the above 4. The Buyer is responsible for the costs of shipping when goods are sold with the terms?

a. FOB Destination b. FOB Origin c. FOB Shipping point d. None of the Above 5. On which financial statement would you find the Allowance for Doubtful Accounts a. Statement of Changes in Equity b. Income Statement c. Statement of Cash Flows d. Balance Sheet 6. Which method of reporting losses on Accounts Receivable is used for Financial Reporting a. Gross Method b. Allowance Method c. Direct Write-off Method d. Net Methog Allowance for Doubtful Accounts Expense has a credit balance of 50 000. It is discoverered hat one of its account receivable amounting to 1800 is worthless and needs to be written off. 7. Which account should be debited for 1800 when writing off the account? a. Allowance for Doubtful Accounts b. Accounts Receivable c. Accounts Payable d. None of the above 8. Which account should be credited? a. Allowance for Doubtful Accounts b.Accounts Receivable c. Accounts Payable d. None of the Above 9. 4. The Seller is responsible for the costs of shipping when goods are sold with the terms? a. FOB Destination b. FOB Origin c. FOB Shipping point d. None of the Above 10. When the Allowance for Doubtful Accounts appears on a company’s financial statements, its balance will be a _______ balance

a. Debit b. Credit c. Added d. Deducted PROBLEM SOLVING A sale of goods on june 1 credit terms 3/20, n/30 worth of 123450 has been sold by Etneb Co FOB Shipping Point Freight Collect, with freight costing 3200. The full amount was collected on June 21 11. Prepare Journal Entry on June 1 - June 21 using Gross Method Accounts Receivable Cash

123450

Cash Sales Discount Accounts Receivable

119746.5 3703.5 123450

123450

12. Prepare Journal Entry on June 1 – June 21 using Net Method Accounts Receivable Sales

119746.5 119756.5

Cash

119746.5 119746.5

Accounts Receivable

13. A company estimated that 700 of its 1000 Accounts receivable will be uncollectible. Its Allowance for Doubtful Accounts presently has a credit balance of 200. The adjusting entry will include a ______ to the Allowance for Doubtful Acocunts Answer: 500 Credit 14. A company estimated that 400 of its 1000 of Accounts Receivable will be uncollectibe. Its Allowance for Doubtful Accounts today has a debit balance of 300. The edjusting entry will include a ____ to Allowance for Doubtful Accounts Credit of 700

15. Ghosting Co. Sold Merchandise on account amounting to 32250000 on January 20. The terms are 3/10, n/30. The freight charge amounted to 500. FOB Destination Freight Collect. The amount was collected February 25 Prepare journal entries to record transactions under Net method. Answer: Accounts Receivable Freight Out Sale Allowance for freight charge

3225000 500

Cash

3225000

3225000 500

Accounts Receivable Sales Discount Forfeited

3160500 64500

16. On November 1 the following transactions occured in Enebenemen Co. 1. Sale of Merchandise on Accounr 5/10 n/30 2. Collection withing the discount period 3. Collection beyond Discount period 4. Sales Return granted

1000000 250000 100000 50000

Prepare journal Entries to record Transaction Answer Accounts Receivable Sales

1000000 1000000

Cash Sales Discount Accounts Receivable

950000

Cash

1000000 1000000

Accounts receivable Sales Return Accounts Receivable

50000 100000

50000 50000

17. On October 15 KadenangTanso Co. Sold 5 refridgerators. The sale price for each fridge is 12000. All sales are subject to term 2/10 n/30. The entity iused ross method of accounting for accounts Receivable Prepare journal entries to record sale Answer: Accounts Receivable Sales

60000 60000

18. TugsTugs Co. Sold 600000 worth of merchandise on january 10 with credit terms 2/10 n/30. The entity estimated sales and returns to be 100000 Prepare journal entry under Net method assuming the customer paid beyond ddeicount period Answer: Accounts Receivable Sales

600000

Sales Return Accounts receivable

100000

Cash

600000 Accounts Receivable Sales Discount Forfeited

600000 100000 588000 12000

19. Dododoo Co. Provided the following information for the current year in relation to accounts Receivable Accounts receivable - beg Credit Sales Sales Return Account Written-off Estimated future return on Dec. 31 Estimated uncollectible Accounts

2600000 1500000 50000 10000 25000 1000

What amount should be reported as the net realiable value of the Accounts receivable on Dec 31

Answer: Accounts Receivable - beg Credit Sales Sales Return Account Written-off Accounts Receivable – end Estimated future return Estimated uncollectible Accouts Net realizable Value

2600000 1500000 (50000) (10000) 4040000 (25000) (10000) 4005000

20. Inaantoknaako Co. Provided the following T-account summarizing the transactions affecting accounts receivable for the current year Accounts Receivable Jan 1. Balance

100000

Collection from customers

200000

Charge Sales

50000 Writeoff

20000

IOU’s ffrom employees 20000

Collection from Carrier Claims

1000

Compute the correct amount of the Accounts Recevable

Answer: Accounts Receivable – beginning Charge Sales Total Less: Collection from custimers Writeoff Total

1000000 50000 1050000 200000 20000

220000 830000

CHAPTER 5 Estimation of Doubtful Accounts

Methods of estimating doubtful accounts The three methods of estimating doubtful accounts are: 1. Aging the accounts receivable 2. Percent of accounts receivable 3. Percent of sales Aging of accounts receivable and percent of accounts receivable involves an account of financial position hence they are “statement of financial position approach” and they will yield required allowance for accounts receivable. While percent of sales involves an account of income statement hence it is an “income statement approach” and the resulting amount would be the doubtful accounts expense.

Aging of Accounts Receivable This method classifies accounts receivables into not due or past due. Each classification is then multiplied by the rate or percent of loss that the entity has experienced for every category. The resulting amount represents the required allowance for doubtful accounts at the end of the period. In order to determine whether the accounts are past due, the credit term is considered. For example, if the credit term is 2/10, n/30 and the account is already at 40 days then it is already 10 days past due. This means that the maximum credit term has been exceeded by 10 days.

Illustration Not due 1-30 days past due 31-60 days past due 61-90 days past due 91-180 days past due 181-365 days past due More than one year Total

Balance 600,000 500,000 400,000 350,000 240,000 160,000

Experience rate 2% 4% 12% 20% 21% 22%

Required Allowance 12,000 20,000 48,000 70,000 50,400 35,200

45,000 2,295,000

25%

11,250 246,850

Percent of Accounts Receivable This method is also a statement of financial position approach therefore the resulting amount would be the required allowance for doubtful accounts. In this method, a rate or percentage based on the past experience of the entity in its accounts is multiplied by the open accounts. Illustration Angeli Company reported the following account balance at year end: Accounts Receivable

5,000,000

Allowance for Doubtful Accounts

20,000

Credit sales

3,050,000

Doubtful accounts are estimated at 2% of accounts receivable. Journal Entry Doubtful Accounts

80,000

Allowance for Doubtful Accounts

Required Allowance (5,000,000 * 2%)

80,000

100,000

Less: Credit balance of Allowance for doubtful accounts

20,000

Doubtful Accounts Expense

80,000

Percent of Sales Doubtful accounts expense is obtained using this method by multiplying a rate to either credit sales or total sales. This rate is calculated by dividing bad debt losses in the prior year by the charge sales of the prior years.

Illustration The following accounts are reflected in the ledger Andrew Co. Accounts receivable

2,000,000

Allowance for doubtful accounts, Beginning

40,000

Sales

4,500,000

Sales return

50,000

Doubtful accounts expense is calculated as 2% of net sales

Sales

4,500,000

Sales return

50,000

Net Sales

4,450,000

Multiply by

2%

Doubtful Accounts Expense

89,000

Allowance for Doubtful accounts, Beginning Doubtful Accounts Expense

40,000 89,000

Allowance for Doubtful Accounts, Ending

129,000

PROBLEMS 1. Bet Ty Inc. reported the following account information before adjustments at year end. Compute for the required allowance of doubtful accounts using percent of accounts receivables method. Doubtful accounts are estimated at 4% of accounts receivable. Cash

500,000

Accounts receivable

525,000

Notes Receivable

350,000

Allowance for Doubtful accounts

20,000

Sales

3,000,000

Accounts receivable

525,000

Multiply: Rate Required Allowance

4% 21,000

2. In the immediately preceding problem, compute for the doubtful accounts expense. Allowance for Doubtful accounts, Beginning

20,000

Add: Doubtful accounts expense (SQUEEZE)

1,000

Required Allowance

21,000

3. The following information is reported by Alyssa Company: Allowance for Doubtful accounts, Beginning

170,000

Recoveries

30,000

Write off

235,000

The company historically computed allowance account using percent of net sales. However, it was decided that the doubtful accounts must be computed using aging of accounts receivable in the year-end adjusting entry. The following schedule was prepared for the aging of accounts receivable: Balance

Percent collectible

Not due

2,000,000

1-30 days past due

1,200,000

95

31-60 days past due

100,000

75

61-90 days past due

150,000

50

Over 90 days past due Additional accounts to be written off

120,000

0

30,000

Compute for the required allowance at year end.

1-30 days past due

1,200,000*5%

60,000

31-60 days past due

100,000*25%

25,000

61-90 days past due

150,000*50%

75,000

Over 90 days past due

120,000*0%

120,000

Required allowance

280,000

4. In the immediately preceding problem, compute for the doubtful accounts expense. Allowance for Doubtful accounts, Beginning

170,000

Recoveries

30,000

Doubtful Accounts Expense (SQUEEZE)

345,000

Total

545,000

Less: Write off

265,000

Required allowance at year end

280,000

5. In the immediately preceding problem, compute for the net realizable value of accounts receivable. Not due

2,000,000

1-30 days past due

1,200,000

31-60 days past due

100,000

61-90 days past due

150,000

Over 90 days past due

120,000

Accounts Receivable Less: Allowance for doubtful accounts NRV

3,570,000 280,000 3,290,000

6. Bonet Company reported the following balances at year year-end: Debit Accounts receivable Allowance for doubtful accounts

Credit

4,000,000 10,000

Credit sales

5,500,000

The entity estimates doubtful accounts using 4% of gross accounts receivable. Compute for required allowance during the year. a. 150,000 b. 160,000 c. 159,600 d. 220,000

7. In the immediately preceding problem, what is the doubtful accounts expense? a. 220,000 b. 160,000 c. 159,600 d. 150,000

8. Ga Lang Corporation provided the following information for the current year: Accounts Receivable

500,000

Allowance for doubtful accounts – January 1

50,000

Sales

5,500,000

The entity recorded doubtful accounts expense at the rate of 5% of credit sales. 40% of sales are cash sales. How much is the credit sales of the corporation? a. 3,300,000 b. 2,200,000 c. 3,000,000 d. 3,150,000

9. Using the information in problem 8, what is the amount of doubtful accounts expense? a. 160,000 b. 110,000 c. 165,000 d. 163,000

10. Using the information in problem 8, what is the required allowance? a. 215,000 b. 213,000 c. 160,000 d. 210,000

11. Using the percent of sales method, there is a proper matching of cost and revenue. TRUE

12. Both the percent of sales and percent of accounts receivable are income statement approach. FALSE

13. Both the percent of sales and percent of accounts receivable are statement of financial position approach. FALSE

14. Percent of sales determine doubtful accounts based on accounts past due. FALSE

15. Percent of Accounts receivable and Aging of accounts receivable would both yield doubtful accounts expense. FALSE

16. In order to determine accounts past due, discount period is considered. FALSE

17. An account receivable with a credit term of 2/10, n/60 which is currently held by the entity for 40 days is already 10 days past due. FALSE

18. Aging receivables is a method of establishing allowance for uncollectible accounts based on outstanding receivables. TRUE

19. The following are James Company’s unadjusted trial balance at year end: Accounts receivable

2,000,000

Allowance for Bad debts

16,000

Net Credit Sales

6,000,000

James estimates that 3% of the gross accounts receivable outstanding will become uncollectible. After adjustments, what is the balance of allowance for bad debts? a. 180,000 b. 164,000 c. 76,000 d. 60,000

20. Using the same information from no. 19, what is the amount of uncollectible accounts expense? a. 180,000 b. 164,000 c. 76,000 d. 60,000

CHAPTER 6 NOTES RECEIVABLE A note receivable is a written promise to receive a specific amount of cash from another party on one or more future dates. This is treated as an asset by the holder of the note. Overdue accounts receivable are sometimes converted into notes receivable, thereby giving the debtor more time to pay, while also sometimes including a personal guarantee by the owner of the debtor. The payee is the party who receives payment under the terms of the note, and the maker is the party obligated to send funds to the payee. The amount of payment to be made, as listed in the terms of the note, is the principal . The principal is to be paid on the maturity date of the note. INITIAL MEASUREMENT Short-term notes receivable is measured at face value and is not discounted. Conversely, long-term notes receivable is measured initially at present value which is the sum of all future cash flows discounted using the effective interest rate for the same or similar notes. INTEREST BEARING NOTES These notes are measured at face value or the present value upon issuance. ILLUSTRATION On January 1, 2019, Kaze Company sold to Haya Company a land costing P2,000,000, for P3,000,000. Ryoga Co. paid P1,000,000 down and signed a two-year promissory note for the balance plus 10% interest that will be compounded annually. The note matures at the beginning of 2021. Journal entries: 2019 Jan. 1

Dec. 31 2020 Dec. 31

Cash Notes receivable Land Gain on sale of land Accrued interest receivable Interest income (P2,000,000*10%)

P1,000,000 P2,000,000

Accrued interest receivable Interest income

P220,000

P2,000,000 P1,000,000 P200,000 P200,000

P220,000

(P2,200,000*10%) 2021 Jan. 1

Cash Notes receivable Accrued interest receivable

P2,220,000 P2,000,000 P220,000

NON-INTEREST BEARING NOTE These notes are measured at present value or the discounted value of the future cash flows using the effective interest rate. “Non-interest bearing” does not mean that it does not have any interest. It simply means that the interest is already included in the face amount of the note. ILLUSTRATION (1) Ichibi Company is a manufacturing company. On January 1, 2019, it sold a machinery costing P200,000 for P300,000. The buyer signed a non-interest bearing note for P300,000 to be paid in four equal installments every year-end. The cash selling price of the machinery is P250,000. Face value of note Present value (cash selling price) Unearned interest income Selling price To record the sale: Cost of machinery Notes receivable Gross income Sales Unearned interest income

P300,000 P250,000 P 50,000 P250,000 P200,000 P300,000 P 50,000 P250,000 P 50,000

To record the first installment collection: Cash P75,000 Note receivable

P75,000

To recognize the unearned interest as income: Unearned interest income P20,000 Interest income

P20,000

Computation of interest income: Notes receivable Fraction 2019 300,000 4/10 2020 225,000 3/10 2021 150,000 2/10 2022 75,000 1/10 750,000 ILLUSTRATION (2)

Interest income (50,000*4/10) = 20,000 (50,000*3/10) = 15,000 (50,000*2/10) = 10,000 (50,000*1/10) = 5,000 50,000

Journal entries for the current year:

On January 1, 2019, Anime Company sold to Cartoons Company an equipment costing P500,000 for P750,000. Cartoons Company paid P150,000 as down payment and signed a non-interest bearing note for P600,000 that is payable in three equal installment of P200,000 every year-end. Prevailing interest rate for similar notes 10% PV of an ordinary annuity of 1 at 10% for 3 periods 2.4869 Computation: Face value of note Present value (P200,000*2.4869) Unearned interest income

600,000 497,380 102,620

Present value of note Cash received Sales price Cost of equipment Gain on sale of equipment Date

Annual Collection

1/1/2019 12/31/2019

200,000

12/31/2020

200,000

12/31/2021

200,000

497,380 150,000 647,380 500,000 147,380 Interest Income 49,738 (497,380*10%) 34,712 (347,118*10%) 18,170

Journal entries for the current year: To record the sale: Cash Notes receivable Equipment Gain on sale of equipment Unearned interest income

Principal 150,262 (200,000-49,738) 165,288 (200,000-34,712) 181,830

Present Value 497,380 (497,380-150,262) 347,118 (347,118-165,288) 181,830 0

P150,000 P600,000

To record the first installment collection: Cash P200,000 Note receivable To record the interest income: Unearned interest income P49,738 Interest income

P500,000 P147,380 P102,620

P200,000 P49,738

SUBSEQUENT MEASUREMENT Long-term notes receivable are measured at amortized cost which is will be discussed in the succeeding chapter.

PROBLEMS On January 1, 2019, Naruto Company sold to Sasuke Company a land costing P2,500,000 for P3,500,000. Sasuke Co. paid P500,000 as down payment and signed a two-year promissory note for the balance plus 12% interest that will be compounded annually. The note matures at the beginning of 2021. 1. What is the interest income on 2019? A. B. C. D.

P300,000 P360,000 (P3,000,000*12%) P403,200 P420,000

2. What is the interest income on 2020? A. B. C. D.

P300,000 P360,000 P403,200 (P3,360,000*12%) P420,000

3. What is the amount of cash to be received on 2021? A. B. C. D.

P3,000,000 P3,763,200 (P3,000,000+P360,000+P403,200) P3,720,000 P3,360,000

Kyubi Company manufactured and sold a machinery costing P400,000 for P500,000. The buyer signed a non-interest bearing note for P500,000 to be paid in four equal installments every yearend. The cash sale price of the machinery is P450,000. 4. What is the interest income on 2019? A. B. C. D.

P50,000 P20,000 P15,000 P12,500

5. What is the interest income on 2020? A. P50,000 B. P20,000 C. P15,000

D. P12,500

6. What is the interest income on 2021? A. B. C. D.

P15,000 P10,000 P5,000 P50,000

7. What is the interest income on 2022? A. B. C. D.

P15,000 P10,000 P5,000 P50,000

Computation (Items 4-7): Face value of note Present value (cash sale price) Unearned interest income

2019 2020 2021 2022

Notes receivable 500,000 375,000 250,000 125,000 1,250,000

Fraction 4/10 3/10 2/10 1/10

P500,000 P450,000 P 50,000 Interest income (50,000*4/10) = 20,000 (50,000*3/10) = 15,000 (50,000*2/10) = 10,000 (50,000*1/10) = 5,000 50,000

Uchiha Company is a dealer in equipment and machineries. On December 31, 2019, the entity sold an equipment in exchange for a non-interest bearing note requiring five annual payments of P300,000. The first payment was made on December 31, 2020. Market interest rate for similar notes PV of 1 at 8% for 5 periods PV of an ordinary annuity of 1 at 8% for 5 periods 8. What is the carrying amount of the note receivable on December 31, 2019? A. P1,020,000 B. P1,500,000 C. P1,197,000 (P300,000*3.99) D. P1,200,000 9. What amount of interest income should be reported for 2020?

8% 0.68 3.99

A. B. C. D.

P81,600 P120,000 P95,760 (P1,197,000*8%) P96,000

K Company sold an equipment costing P400,000 which had a carrying amount of P250,000 on January 1, 2019. During the same day, the company received P75,000 down payment and a P300,000 non-interest bearing note due on January 1, 2022. There was no established exchange price for the equipment and the note had no ready market. Prevailing interest rate for a note of the same type at January 1, 2019 PV of 1 at 12% for 3 periods 10. What is the present value of the note on January 1, 2019? A. B. C. D.

P213,540 P239,165 P300,000 P375,000

11. What amount of interest income should be reported on January 1, 2019? A. B. C. D.

P36,000 P28,700 P25,625 (P213,540*12%) 0

What is the present value of the note on December 31, 2019? A. B. C. D.

P213,540 P239,165 P300,000 P375,000

12. What amount of interest income should be reported on December 31, 2019? A. B. C. D.

P36,000 P28,700 P25,625 0

13. What is the present value of the note on December 31, 2020? A. P213,540 B. P267,865 C. P300,000

12% 0.7118

D. P375,000 14. What amount of interest income should be reported on December 31, 2020? A. B. C. D.

P36,000 P28,700 P25,625 0

15. What is the present value of the note on December 31, 2021? A. B. C. D.

P225,000 P250,000 P300,000 P375,000

16. What is the amount of cash received on January 1, 2019? A. B. C. D.

P0 P50,000 P75,000 P100,000

17. What is the amount of cash to be received on December 31, 2019? A. B. C. D.

P0 P50,000 P75,000 P100,000

18. What is the amount of cash to be received on December 31, 2021? A. B. C. D.

P300,000 P225,000 P450,000 P0

Computation (Items 10-18): Face value of the note Present value (P300,000*.7118) Unearned interest income

300,000 213,540 86,460

Present value Cash received Sales price Carrying amount

213,540 75,000 288,540 250,000

Gain on sale of equipment

38,540

Date Interest income Unearned interest PV 1/1/2019 86,460 213,540 12/31/2019 (213,540*12%) 25,625 (86,460-25,625) 60,835 (213,540+25,625) 239,165 12/31/2020 (239,165*12%) 28,700 (60,835-28,700) 32,135 (239,165+28,700) 267,865 12/31/2021 (balancing figure) 32,135 (32,135-32,135) 0 (267,865+32,135) 300,000 19. Ryoma Company sold to Ryoga Company on January 1, 2019 a land costing P5,000,000 for P6,500,000. Ryoga Co. paid a down of P1,000,000 and signed a two-year promissory note for the remaining balance plus 12% interest that will be compounded annually. The note matures on January 1, 2021. Requirement: Prepare journal entries for 2019, 2020, and 2021. Journal entries: 2019 Jan. 1 Cash Notes receivable Land Gain on sale of land Dec. 31 Accrued interest receivable Interest income (P5,500,000*12%) 2020 Dec. 31 Accrued interest receivable Interest income (P6,160,000*12%) 2021 Jan. 1 Cash Notes receivable Accrued interest receivable

P1,000,000 P5,500,000 P5,000,000 P1,500,000 P660,000 P660,000 P739,200 P739,200 P6,899,200 P5,500,000 P1,399,200

20. On January 1, 2019, Tanaka Company sold to Mabuchi Company an equipment costing P500,000 for P750,000. Mabuchi Company paid P150,000 as down payment and signed a noninterest bearing note for P600,000 that is payable in three equal installment of P200,000 every year-end. Prevailing interest rate for similar notes PV of an ordinary annuity of 1 at 12% for 3 periods Requirement: Prepare journal entries for 2019, 2020, and 2021. Journal entries: 2019

12% 2.4018

Jan.

1

Dec. 31

2020 Dec. 31

2021 Dec. 31

Cash Notes receivable Equipment Gain on sale of equipment Unearned interest income Cash Notes receivable Unearned interest income Interest income

P150,000 P600,000

Cash Notes receivable Unearned interest income Interest income

P200,000

Cash Notes receivable Unearned interest income Interest income

P200,000

P500,000 P130,360 P119,640 P200,000 P200,000 P57,643 P57,643 P200,000 P40,560 P40,560 P200,000 P21,437 P21,437

Computation: Face value of note Present value (P200,000*2.4018) Unearned interest income

600,000 480,360 119,640

Present value of note Cash received Sales price Cost of equipment Gain on sale of equipment

480,360 150,000 630,360 500,000 130,360

Date

Annual Collection

1/1/2019 12/31/2019

200,000

12/31/2020

200,000

12/31/2021

200,000

Interest Income 57,643 (480,360*12%) 40,560 (338,003*12%) 21,437

Principal 142,357 (200,000-57,643) 159,440 (200,000-40,560) 178,563

Present Value 480,360 338,003 (480,360-142,357) 178,563 (338,003-159,440) 0

CAHPTER 7 LOANS RECEIVABLE

Loan Receivable Loan receivable is a financial asset in the form of loan given by a bank or other financial institutes to a borrower. The term of the loan may be classified as short-term but usually it is long-term receivable. Initial Measurement of Loan Receivable At initial recognition, an entity shall measure a financial asset at Fair Value plus transaction cost that are directly attributable to the acquisition of the financial asset. However, if the financial asset is measured at fair value through profit or loss the transaction cost directly attributable to the acquisition of the financial asset are expensed outright.(PFRS 9, paragraph 5.1.1) Loans receivable is financial asset not measured at fair value through profit or loss. Hence it should be initially measured at fair value plus transaction cost directly attributed to the acquisition of financial asset. The fair value of the loan receivable at initial recognition is normally the transaction price, which is the amount of the grated loan. The transaction costs directly attributed to the acquisition of loan receivable include Direct origination cost. Indirect origination costs on the other hand are treated as outright expense. Subsequent Measurement of Loan Receivable After the initial measurement, the financial asset shall be measured at: a. Fair value through profit or loss (FVPL) b. Fair value through other comprehensive income (FVOCI) c. Amortized cost The method of measurement depends on the business model of managing the financial asset which may be to realize fair value changes and to collect contractual cash flows. (PFRS 9, paragraph 5.2.1) If the business model is to hold the financial asset in order to collect contractual cash flows on specified date and the contractual cash flows are solely payment of principal and interest, the financial asset shall be measured at Amortized cost.(PFRS 9, paragraph 4.1.2)

Hence, a loan receivable is subsequently measured at amortized cost using the effective interest rate method. Amortized cost The amortized cost is the initial measurement of loan receivable less/minus principal payment, plus or minus cumulative amortization of any difference of initial carrying amount to the principal maturity amount and minus impairment loss or uncollectibility. If the initial amount recognized is lower than the principal amount, the amortization of the difference is added to the carrying amount. If the initial amount is higher the amortization is deducted to the carrying amount. Origination Fees The origination fees are fees charge by bank against the borrower. It’s a compensation of the bank for the creation of the loan. The origination fees are derived from the following activities: 1. 2. 3. 4.

Evaluation of collateral and security Negotiation of the terms of the loan Processing of the documents required Evaluation of borrower’s financial condition

Treatment for origination fees The origination cost received from the borrowers or clients are recognized as unearned interest income and will be amortized over the term of the loan. There are origination fees that are not chargeable against the borrower. These are fee are define as “direct origination costs”. Direct origination costs are cost incurred by the bank and not received from the borrower. Direct origination costs are also amortized over the term of the loan. The origination fee received and the direct origination costs incurred are included in the measurement of the loan receivable’s carrying amount. If the direct origination cost exceeds the origination fees received, the difference is charged to “direct origination cost, the amortization will decrease the interest income. However, if the origination fee is higher than the direct origination costs, the interest income will increase and the difference of the two is recorded as unearned interest income.

Illustration Smart Bank granted a 3-year loan to a borrower on January 1, 2020. The interest of the loan is 10% and payable annually starting December 21, 2020. The loan matures on December 31, 2022. Principal amount Origination fee received Direct origination costs incurred Indirect origination costs incurred

4,000,000 302,100 104,000 30,000

Initial measurement of the loan Principal amount Direct origination costs Origination cost Carrying amount

4,000,000 110,000 302,100 3,807,900

Note: the indirect origination costs are expense outright. Journal entries on January 1, 2020 1. Recording of the loan Loan receivable Cash

4,000,000 4,000,000

2. To record origination fee received Cash Unearned interest income

302,100

3. To record the direct origination costs Unearned Interest income Cash

110,000

302,100

110,000

The origination fee exceeds the amount of direct origination cost. Thus, there is an unearned interest income of P192,100 (302,100 – 110,000). A new effective interest rate must be computed, because of origination fees received and the direct origination costs incurred. After consideration of the direct origination costs and origination fees received, the effective rate is 12%. Since the initial carrying amount of the loan is lower than the principal amount the effective rate should be higher than the nominal rate because of discount of the loan.

Amortization table effective interest method

Date

Interest Receivabl e

Interest Income

Amortization

1-Jan

2020

31-Dec

2020

400,000

456,948

56,948

31-Dec

2021

400,000

463,782

63,782

31-Dec

2022

400,000

471,370

71,370

Carrying Amount 3,807,90 0 3,864,84 8 3,928,63 0 4,000,00 0

Note: there is a difference of P65 because of rounding the PV. Interest received = Principal x nominal interest rate Interest income = Carrying amount x effective interest rate Amortization = Interest received – interest income Carrying amount = Beginning carrying amount (prior year) + amortization Note: Since the carrying amount is lower than the principal amount, the amortization should be added.

Journal entries – December 31, 2020 Cash

400,000 Interest income

Unearned interest income Interest income

400,000 56,948 56,948

December 31, 2021 Cash

400,000 Interest income

Unearned interest income Interest income

400,000 63,782 63,782

December 31 ,2022 Cash

400,000 Interest income

Unearned interest income Interest income

400,000 71,370 71,370

On December 31, 2020’s statement of financial position, the loan receivable is presented at amortized cost. Loan Receivable Unearned interest income (192,100 - 56,948) Carrying amount- December 31, 2020

4,000,000 135,152 3,864,848

Impairment loss There is a possibility that the issuer of the loan will not be able to collect some or even all the amount of loan receivable due to borrower’s incapacity to pay (credit risk). If this happens, the loan receivable is impaired. According to the standards, an entity shall measure the loss allowance for a financial instrument at an amount equal to the lifetime expected credit losses if the credit risk on the financial instrument has increased significantly since initial recognition. (PFRS 9, 5.5.3) Credit losses occur because of the credit risk, it is the loss on the uncollectible payments of the borrower. In measuring the credit loss, the entity should consider the probability-weighted outcome, the time value of money and reasonable information. Any information, internally or externally are can be used on measuring the expected credit losses. The impairment loss amount is the difference of the carrying amount to the present value of estimated future cash flows discounted at original effective interest rate. The loans receivable’s carrying amount shall be deducted using either direct method or with allowance account.

Illustration Sugar bank granted five year loan of P10,000,000 to Pepper company on January 1, 2020. The terms require principal payment of P2,000,000 every year with interest of 10%, starting on December 31, 2020. On December 31, 2020 and December 31, 2021, Pepper Company made the required payments. Unfortunately, Pepper Company was unable to make the required payments on December 31, 2022 because of weak financial condition of the company due to low revenue during year 2022. After sugar bank assessed the collectability of the loan on December 31, 2022, the bank determined that the remaining principal will be collected; however, the interest payments will not be collected. On December 31, 2022, the loan receivable has a P6,600,000 carrying amount including the accrued interest of P 600,000. The projected cash flow from the loan on December 31, 2022 December 31, 2023 December 31, 2024 December 31, 2025 Present value of 1 at 10% For one period For two periods For three periods

1,000,000 2,000,000 3,000,000

.91 .83 .75

Computation of present value cash flow December 31, 2023 (1,000,000 x .91) December 31, 2024 (2,000,000 x .83) December 31, 2025 (3,000,000 x .75) Total present value of cash flow

910,000 1,660,000 2,250,000 4,820,000

Computation of impairment loss Carrying amount of the loan Present value of cash flow

6,600,000 4,820,000

Impairment loss

1,780,000

Journal entry on December 31, 2022 Loan impairment loss Accrued interest receivable Allowance for loan impairment

1,780,000 600,000 1,180,000

Note: since the interest is uncollectible, the accrued interest receivable should be credited directly. Computation of carrying amount-December 31, 2022 Loan receivable Allowance for loan impairment Carrying amount – December 31, 2022 December 31, 2023 * To record the collection of cash Cash Loan receivable *To record the interest Allowance for loan impairment Interest income

6,000,000 (1,180,000) 4,820,000

1,000,000 1,000,000 482,000 482,000

Interest income (4,820,000 x 10%) = 482,000 Note: The interest income is charge against the allowance of impairment. December 31, 2024 * To record the collection of cash Cash Loan receivable *To record the interest Allowance for loan impairment Interest income

2,000,000 2,000,000 430,200

Computation of interest income: Loan receivable – December 31, 2023 Allowance for loan impairment (1,180,000 – 482,000) Carrying amount – December 31, 2023 Original Effective interest rate

430,200

5,000,000 (698,000) 4,302,000 x10%

Interest income

430.200

December 31, 2025 * To record the collection of cash Cash Loan receivable *To record the interest Allowance for loan impairment Interest income

3,000,000 3,000,000 267,800

Computation of interest income: Loan receivable – December 31, 2023 Allowance for loan impairment (698,000 – 430,200) Carrying amount – December 31, 2023 Original Effective interest rate Interest income

267,800

3,000,000 (267,800) 2,732,200 x10% 273.220

Note: there is a difference in interest income due to rounding of the PV factor.

Three stage impairment approach Stage 1 – it covers debt instrument that have low credit risk. Under this stage 12-month expected credit loss is recognized. 12-month expected credit loss is the portion of the lifetime expected credit loss from default event within 12 months after reporting period. Stage 2 – it covers debt instrument that have declined significantly but do not have evidence of impairment. Lifetime expected credit loss is recognized under this stage. Lifetime expected credit loss is the expected credit loss resulting from all default events over the expected life of the debt instrument. It is measured for trade receivable using aging method, percentage of receivable and percentage of sales. Stage 3 – it covers debt instrument with evidence of impairment. Lifetime expected credit loss is recognized. Computation of interest income Under stages 1 and 2 the interest income is based on face amount.

Interest income = Face amount x interest rate Under stage 3 the interest income is based on net carrying amount. Net carrying amount = Face amount – allowance for credit loss. Interest income = Net carrying amount x interest rate

Multiple choice Theories 1. Which statement is true about the loan receivable? a. Loan receivable is initially measured at fair value plus transaction cost directly attributed to the acquisition of the loan. b. Direct origination cost and origination fees are included in measurement of loan receivable. c. Indirect origination costs are expense outright. d. All of the above 2. Which is true about subsequent measurement of loan receivable? a. The loan receivable is subsequently measured at amortized cost. b. The loan receivable is subsequently measured at fair value through profit or loss c. The loan receivable is subsequently measured at fair value through other comprehensive income. d. None of the above. 3. What are the fees charges by bank against the borrower for creation of the loan? a. Direct origination costs b. Indirect origination costs

c. Origination fees d. None of the above 4. The possibility of loss resulting from the failure of borrower to meet the contractual obligation is called? a. Credit losses b. Credit risk c. Estimated credit losses d. None of the above. 5. Which is considered in measuring the credit loss a. The probability-weighted outcome b. The time value of money c. Reasonable and supportable information d. All of the above True or False 1. Direct origination cost is not included in the transaction cost directly attributed to the acquisition of the loan. False 2. There is an accrued interest if the direct origination costs exceed the origination fees received. False 3. Indirect origination costs on the other hand are treated as outright expense. True 4. If the initial amount recognized is lower than the principal amount, the amortization of the difference is added to the carrying amount. True 5. If the initial amount is lower than the principal amount, the computed effective interest rate should be higher than the nominal rate. True

Problem 1 On January 1, 2019 Piggy Bank granted a loan to an individual barrower, with 10% interest payable annually. The loan matures in four years on December 31, 2022. Principal Direct origination cost Origination fee charged against the borrower

5,000,000 169,300 340,500

After considering the direct origination cost and the origination fees, the effective rate on the loan is 12% Requirements: 1. Prepare the necessary journal entries on the year 2019, 2020, 2021, and 2022.

Problem 2 Fleck Company borrowed a loan to Wayne Bank amounting to P3,300,000 on January 1, 2018 with a stated interest rate of 8% payable annually. The term of the loan is three years. Wayne Bank incurred P150,000 of direct origination cost and P50,000 indirect origination cost, In addition, Wayne Bank charged Fleck Company an origination fee amounting to P 280,000. The effective interest rate is 10%. Requirements: 1. What is the initial carrying amount of the loan receivable to be recognized in January 1, 2018? a. 3,300,000 b. 3,175,000 c. 3,343,000 d. 3,430,000 2. What amount should be reported as interest income for 2018? a. 264,000 b. 330,000 c. 317,500 d. 254,000 Solutions 1. Answer B Principal amount Direct origination cost incurred Origination cost received Carrying amount 2. Answer C Carrying amount Effective rate Interest income

3,300,000 150,000 (280,000) 3,175,000 3,175,000 x10% 317,500

Problem 3 Rich Bank granted a loan to a borrower on January 1, 2020. The loan has an interest rate of 8% payable annually starting December 31, 2020. The maturity of the loan is on December 31, 2023. Principal amount Origination fee

4,400,000 130,000

Direct origination cost

370,000

After the consideration of direct origination cost and origination fee, the effective rate on the loan is 6%. 1. What is the initial carrying amount of the loan receivable? a. 4,640,000 b. 4,400,000 c. 4,259,700 d. 4,000,000 2. What amount should be recorded as interest income for 2020? a. 362,000 b. 264,000 c. 255,582 d. 278,400 3. What is the carrying amount of the loan receivable on December 31, 2020? a. 4,566,400 b. 4,400,000 c.4,640,000 d. 4,000,000 Solutions 1. Answer A Direct origination cost 370,000 Origination fee received (130,000) Net direct origination cost 240,000 Principal amount 4,400,000 Carrying amount of loan receivable 4,640,000 2. Answer A Carrying amount 4,640,000 Effective interest rate x6% Interest income 2020 278,400 3. Answer A Interest income 2020 (278,400) Interest received 2020 352,000 Amortization (73,600) Carrying amount January 1, 2020 4,640,000 Carrying amount December 31, 2020 4,566,400 Problem 4 On January 1, 2021, Poor Bank granted a loan to a client with a 12% interest rate payable annually starting December 31, 2021. The term of the loan is three years.

Principal amount Direct origination cost incurred Origination fee received Indirect origination cost incurred

4,000,000 144,000 330,000 60,000

After considering the origination fee and direct origination cost, the effective interest rate is 14%. 1. What is the initial carrying amount of the loan receivable? a. 4,186,000 b. 4,000,000 c. 3,814,000 d. 3,754,000 2. What is the interest income for 2021? a. 480,000 b. 560,000 c. 533,960 d. 457,680 3. What is the carrying amount of the loan receivable on December 31, 2021? a. 4,000,000 b. 3,814,000 c. 3,867,960 d. 3,754,000 Solutions 1. Answer C Principal amount 4,000,000 Direct origination cost 144,000 Origination fee received 330,000 Carrying amount-January 1, 2021 3,814,000 2. Answer C Carrying amount-January 1, 2021 3,814,000 Effective interest rate x14% Interest income 2021 533,960 3. Answer C Interest income 2021 533,960 Interest received 2021 (480,000) Amortization 53,960 Carrying amount January 1, 2020 3,814,000 Carrying amount December 31, 2020 3,867,960

Problem 5

On January 1, 2019, Better Bank provides a loan to a client with. The loan has a 10% interest rate payable annually that will start on December 31, 2021. The loan matures in four years. Principal amount Direct origination cost incurred Origination fee received Indirect origination cost incurred

3,350,000 315,000 140,000 40,000

After considering the origination fee and direct origination cost, the effective interest rate is 8%. 4. What is the initial carrying amount of the loan receivable? a. 3,525,000 b. 3,350,000 c. 3,485,000 d. 3,175,000 5. What is the interest income for 2020? a. 335,000 b. 282,000 c. 330,000 d. 277,760 6. What is the carrying amount of the loan receivable on December 31, 2020? a. 3,414,760 b. 3,525,000 c. 3,175,000 d. 3,000,000 Solutions 1. Answer A Direct origination cost 315,000 Origination fee received (140,000) Net direct origination cost 175,000 Principal amount 3,350,000 Carrying amount of loan receivable 3,525,000 2. Answer D 3. Answer A

Date 1-Jan

2019

31-Dec 31-Dec

2019 2020

Interest Receivabl e

335,000 335,000

Interest Income

Carrying Amortization Amount 3,525,00 0 3,472,00 282,000 53,000 0 277,760 57,240 3,414,76

0

Problem 6 Bruce Bank grated a loan to a borrower on January 1, 2018 amounting to 10,000,000 with annual interest of 8%. The terms of the loan require principal payment of P2,000,000 each year for 5 years plus the interest. The first payment is due on January 1, 2019 The borrower made the required payments on January 1, 2019 and 2020. Unfortunately, during year 2019 the borrower experienced financial difficulties. After the bank reassesses the collectability of the loan on December 31, 2020, the bank determined that the remaining principal will be collected but the interests are not. The bank did not accrue the interest for 2020. The present value of 1 at 8%: For one period For two period For three period

0.93 0.86 0.79

Requirements: 1. What is the amount of impairment loss on 2020? a. 500,000 b. 420,000 c. 480,000 d. 400,000 Solutions 1. Answer B January 1, 2021 (1 x 2,000,000) January 1, 2022 (.93 x 2,000,000) January 1, 2023 (.86 x 2,000,000) Present value of loan Loan receivable Present value of loan Impairment loss Problem 7

2,000,000 1,860,000 1,720,000 5,580,000 6,000,000 (5,580,000) 420,000

On December 31, 2020, Best Bank has a loan receivable to a borrower amounting to P2,500,000 with 10% interest rate payable annually. The loan matures on December 31, 2024. However, the borrower experienced financial difficulties and will have hard time paying the necessary payments. The bank estimated that the entire principal will be paid at the maturity and 5% interest will be paid annually of the next 4 years. The bank did not accrue an interest in December 31, 2020. The PV of 1 at 10% for 4 periods is .68, and the present value of ordinary annuity at 10% for four periods is 3.17 1. What is the amount of impairment loss of the loan? a. 0 b. 443,300 c. 500,000 d. 403,750 2. What amount should be recorded as interest income for 2021? a. 209,625 b. 250,000 c. 200,000 d. 220,000 3. What is the carrying amount of the loan receivable on December 31, 2021? a. 2,096,250 b. 2,180,875 c. 2,500,000 d. 2,000,000 Solutions 1. Answer D Present Value of Principal (2,500,000 x .68) Present Value of Interest (125,000 x 3.17) Total present value Carrying amount Impairment loss Interest (2,500,000 x 5%) = 125,000 2. Answer A Interest income for 2021 (2,096,250 x 10%) Interest Received (2,500,000 x 5%) Amortization of Impairment loss 3. Answer B

1,700,000 396,250 2,096,250 (2,500,000) 403,750

209,625 (125,000) 84,625

Present value Amortization of impairment loss Carrying amount 2021

2,096,250 84,625 2,180,875

Problem 8 On December 31, 2019, Stark Bank has a 4-year loan receivable with face value of P7,000,000 dated January 1, 2018 that is due on December 31, 2020, the interest is payable at 10% every year. On December 31, 2017, the borrower was able to pay the interest due. However he informed the bank that the accrued interest in 2019 will be paid at the maturity date. After reassessing the collectability the bank determined that there is a high probability that the remaining interest payment will not be collected because of financial difficulty of the borrower. The PV of 1 for three periods is .75 1. What is the amount of impairment loss for 2019? a. 0 b. 2,000,000 c. 1,925,000 d. 1,950,000 Solutions 1. Answer C Loan receivable Accrued interest receivable (7,000,000 x 10%) Carrying amount Present value (7,700,000 x .75) Impairment loss

7,000,000 700,000 7,700,000 (5,775,000) 1,925,000

Problem 9 Arthur Bank has a loan receivable of 3,000,000 from a borrower on December 31, 2019. The loan’s carrying at face value and is due on December 31, 2023. The interest is payable at 9% each December 31. The interest due on December 31, 2019 was paid by the borrower but informed the bank that it would miss the next year interest payment. The borrower is expected to resume the payments of annual interest but the payment of the principal will be late by one year, with interest paid for that additional year at the time of principal payment. The PV of 1 at 9% is:

For two periods For three periods For four periods For five period

.84 .77 .71 .65

1. What is the loan impairment loss for 2019? a. 270,000 b.0 c. 252,100 d. 248,100 Solution 1. Answer D December 31, 2020 No payment of interest December 31, 2021 Interest (3,000,000 x 9%) December 31, 2022 Interest (3,000,000 x 9%) December 31, 2023 Interest (3,000,000 x 9%) December 31, 2024 Interest/principal (3,000,000 x 1.9) Present Value of loan Loan Receivable Present value Impairment loss

270,000 x.84 = 226,800 270,000 x.77 = 207,900 270,000 x.71 = 191,700 3,270,000 x.65 = 2,125,500 2,751,900

3,000,000 2,751,900 248,100

Problem 10 On January 1, 2020 Rogers Bank has a loan receivable from a borrower amounting to P15,000,000 with interest rate of 8%. The borrower is required to pay principal of P3,000,000 annually plus the interest. On the year 2020 and 2021, the borrower made the required payments but on year 2022 the borrower’s financial condition is weak and will have a difficult time on making payments, requiring the bank to reassess. On year end 2022 the bank has determined that the remaining principals are collectable. However, the interest payments are unlikely. The bank has accrued the interest for 2022. The expected principal payments: December 31, 2022 December 31, 2023 December 31, 2024

2,000,000 3,000,000 4,000,000

Present Value of 1 at 8% For one period 0.93 For two period 0.86 For three period 0.79 Requirement: 1. What is the amount of impairment loss? a. 2,110,000 b. 2,500,000 c. 2,120,000 d. 0 2. What is the carrying amount of the loan on year 2022? a. 8,439,210 b. 9,000,000 c. 7,600,000 d. 8,350,330 Solutions 1. Answer C December 31, 2022 (2,000,000 x .93) 1,860,000 December 31, 2023 (3,000,000 x .86) 2,580,000 December 31, 2024 (4,000,000 x .79) 3,160,000 Present value of loan 7,600,000 Carrying amount (9,000,000 x 1.08) 9,720,000 Present value of loan (7,600,000) Impairment loss 2,120,000 2. Answer C Loan receivable 9,000,000 Allowance for impairment (2,120,000 – 720,000) 1,400,000 Carrying amount 2022 7,600,000 .

Chapter 8 RECEIVABLE FINANCING Pledge, assignment and factoring Receivable financing Receivable financing is the capability to raise money out of its receivable. The financing of receivable occurs when an entity experienced financial difficulties due to business decline. Because of weak financial condition, the receivables of an entity are used in payments of its obligation or liabilities. Common forms of receivable financing. 1. 2. 3. 4.

Pledging of account receivable Assignment of account receivable Factoring of account receivable Discounting of notes receivable

Pledge of account receivable Pledge of account receivable is a form of receivable financing in which an entity uses or pledged its existing account receivable as collateral to secure the payment of the loan. The collection of the pledge account receivable is normally done by the borrower but may be required to turn over the collection to the bank. The recognition of the loan is done by debiting the cash and discount on note payable if the loan is discounted and crediting the note payable. Illustration On July 1, 2020, Lopez company borrowed P1,500,000 from a Bank and issued promissory note for the loan. The loan is discounted at 10% and it matures in one year. The Company pledged its account receivable amounting to P2,000,000 as collateral for the loan. Journal entry – July 1, 2020 Cash

1,350,000

Discount on notes payable 150,000 Note payable – bank Note: There is no entry in the pledging of account receivable

1,500,000

The term discounted means that the interest is deducted from the loan in advance. On December 31, 2020’s statement of financial position the note payable is presented follows: Note payable – bank 1,500,000 Discount on note payable (150,000 – 75,000) (75,000) Carrying amount 1,425,000 The discount on note payable must be amortized as an interest expense for 6 months from July 1 to December 31. Interest expense (150,000 x 6/12)

75,000

Discount on note payable

75,000

July 1, 2020 journal entry *Payment of the loan Note payable – bank Cash *amortization of discount on notes payable Interest expense Discount on notes payable – bank

1,500,000 1,500,000 75,000 75,000

Assignment of account receivable Assignment of account receivable is a more formal type of pledging of account receivable, wherein the borrower (assignor) transfers the rights in some account receivable to a lender (assignee) as collateral security for the loan. Distinction of assignment and pledged Pledge *Less formal type *General

Assignment *More formal type *Specific

Pledge is general because all the account receivable serves as collateral. Assignment is specific for the reason that it on assign specific account receivable as collateral for the loan.

The assignment is recorded by debiting the “Accounts receivable – assigned” and crediting the accounts receivable. Notification and Non-notification basis Notification and non-notification basis are two ways on assigning account receivable. Notification basis

Non-notification basis

*The customers are notified that their account *The customers are not aware of the were assigned assignment of the account. *The collections will go directly to the assignee

*the obligation to collect is still in the assignor side but later remits the collection to the assignee

Illustration – Notification basis Transactions January 1 Coffee company assigned P2,000,000 of its account receivable to a bank. The bank loans 85% minus bank charge of 5% on gross amount of accounts receivable assigned. The company signed a promissory note with 2% interest of the unpaid loan balance per month. 31 The company receive notice from the bank that P1,000,000 of assigned account were collected and 2% discount. The company made the payment of interest due. February 31 The company receive notice from the bank that P900,000 of assigned account were collected. Final settlement was made by the bank for excess collection and uncollectible accounts assigned of P100,000. Journal Entries January 1 *To assign account receivable. Accounts receivable- assigned Accounts receivable *To record the loan. Cash

2,000,000 2,000,000

1,600,000

Service charge (2,000,000 x 5%) Note Payable – bank (2,000,000 x 85%)

100,000 1,700,000

January 31 *To record Accounts assigned collection Note payable – bank Sales Discount (1,000,000 x 2) Accounts receivable – assigned

980,000 20,000

*To record interest payment Interest expense (1,700,000 x 2%) Cash

34,000

1,000,000

34,000

February 28 *To record collection, excess collection and interest expense. Cash 165,600 Interest expense (720,000 x 2) 14,400 Note payable – bank (1,700,000 – 980,000) 720,000 Accounts receivable – assigned

900,000

*To record uncollected assigned account Accounts receivable Account receivable – assigned

100,000

100,000

Illustration - Non-notification basis January 1 Coffee company assigned P2,000,000 of its account receivable to a bank. The bank loans 85% minus bank charge of 5% on gross amount of accounts receivable assigned. The company signed a promissory note with 2% interest of the unpaid loan balance per month. 6 Issued credit memo to a customer whose account was assigned for return of damaged merchandise amounting to P50,000. 15 the company collected P1,000,000 of the assigned account less discount of 2%

31 the company remitted the collection of the assigned account to the bank plus the interest payment for one month. February 2 The company determined that P20,000 of the assigned account is uncollectible or worthless. 22 Collected P900,000 of the assigned account. 28 Remitted the amount due for the loan balance plus the monthly interest. Journal Entries January 1 *To assign account receivable. Accounts receivable- assigned Accounts receivable

2,000,000

*To record the loan. Cash Service charge (2,000,000 x 5%) Note Payable – bank (2,000,000 x 85%)

1,600,000 100,000

2,000,000

1,700,000

January 6 *To record the sales return and allowances Sales return Account receivable – assigned January 15 *To record the collection of assigned account Cash Sales Discount (1,000,000 x 2%) Account receivable – assigned

980,000 20,000 1,000,000

January 31 *To record the remittance of the collection plus the interest Note payable – bank 980,000 Interest expense (1,700,000 x 2%) 34,000 Cash

1,014,000

February 2

*To record the write off Allowance for doubtful account Accounts receivable – assigned

20,000 20,000

February 22 *To record collection Cash Accounts receivable – assigned

900,000 900,000

February 28 *To record the remittance of collection Note payable – bank Interest expense (720,000 x 2) Cash

720,000 14,400 734,400

*To transfer the remaining balance of account receivable – assigned to account receivable. Account receivable 10,000 Account receivable – assigned 10,000 Account receivable – assigned balance (2,000,000 -1,900,000 – 20,000 – 50,000 -20,000) = 10,000 Factoring Factoring of account receivable is a form of finance receivable wherein an entity sells its accounts receivable to the bank called the factor on a without recourse, notification basis. A gain or loss is recognized as the difference between the proceeds received and the net carrying amount of the account factored. The difference of factoring and assigning is the ownership of the account receivable. In assignment of account, the entity or the borrower retains the ownership of the receivable. On the other hand, in factoring the ownership is actually transferred to the factor or the bank and the customers whose account are factored are notified.

Casual Factoring In times of financial distress an entity may factor some or all its account receivable to a bank to gain cash. Journal entry on factoring Cash xxx Allowance for doubtful account xxx Accounts receivable xxx Note: if there is gain on factoring, the gain is recognized by debiting” gain on factoring”. Loss is recognized by crediting “Loss in factoring” Factoring as a continuing agreement In this agreement, before the shipment of the goods the seller (entity) requests credit approval to the factor. If the request is approved, the account is sold to the factor at the time after the shipment of the goods. The factor may compensate a commission for the factoring services and he may also withhold an amount for security in case of sales return and allowance occurs. The amount withheld is called “factor’s holdback” that is recognized as receivable from factor classified as current asset. Illustration Luck company factored account receivable amounting to P400,000 to a finance entity with a term of 2/10, n/30. The factor charged a 5% commission and withheld 10% of the accounts receivable to cover sales return and allowances. Journal entry Cash Sales Discount (400,000 x 2%) Commission (400,000 x 5%) Receivable from factor (400,000 x 10%) Account receivable

332,000 8,000 20,000 40,000

If there is a sales return of P25,000, the entry would be: Sales return and allowance 25,000 Sales Discount (25,000 x 2%)

400,000

500

Receivable from factor

24,500

If all receivable factored are collected without further sales return, the entry would be: Cash (40,000 – 24,500) 15,500 Receivable from factor 15,500 True or False 1. If the business model is to hold the financial asset in order to collect contractual cash flows on specified date, the financial asset shall be measured at amortized cost. TRUE 2. Assignment of account receivable is more formal type of pledging. TRUE 3. Assignment of account receivable is general while pledge of account receivable is specific. FALSE 4. Under the non-notification basis of assignment of account receivable, the payments of the customers are directly to the assignee. FALSE 5. Under the notification basis of assignment of account receivable, the payments of the customers are directly to the assignee. TRUE 6. There is no necessary entry in recognizing pledged account receivable. TRUE 7. In Assignment of account receivable, the entity transfers the ownership of the account receivable to the assignee. FALSE 8. Factor’s holdback that is recognized as receivable from factor classified as noncurrent asset. FALSE 9. In factoring, the factor assumes the responsibility for uncollectible factored account. TRUE 10. If the loan is discounted, in the banking parlance this means that the interest for the term of the loan is deducted in advance. TRUE Multiple Choices 1. If the financial asset is held in order to collect contractual cash on specified date flow is measured at a. Amortized cost b. Fair value c. Net realizable value d. None of the above 2. Which of the following is a form of receivable financing? a. Pledge of account receivable b. Assignment of accounts receivable c. Factoring of the account receivable d. All of the above. 3. In this form of receivable financing an entity actually transfers ownership of the account receivable.

a. Pledge of account receivable b. Assignment of accounts receivable c. Factoring of the account receivable d. None of the above 4. Which statement is not true about Assignment of account receivable? a. Assigning is general because all accounts receivable serves as collateral security of the loan b. Assigning specific because specific account receivable is assigned as collateral security of the loan c. Assignment may be done either notification or non-notification basis. d. Assignment is more formal type of pledging account receivable. 5. Which is not true about notification and nonnotification basis? a. Under notification basis, the payment of the customers are directly to the assignee b. Under non-notification basis the collection of the accounts is in the side of assignor c. Under non-notification basis the customers continue to make the payments to the assignor. d. None of the above 6. Royal company factored P5,000,000 of account receivable to a finance entity. The factor charged a commission of 5% and retained a holdback equal to 10% of the account receivable. What is the cash amount received by Royal Company from the factoring a. 4,250,000 b. 5,000,000 c. 5,725,000 d. 4,000,000 Solution Gross amount Commission Factor’s holdback Cash received from factoring

5,000,000 (250,000) (500,000) 4,250,000

7. On January 1, Brilliant Company assigned its accounts receivable to a bank as collateral security of the loan amounting to P1,000,000 under non-notification basis. The bank advances 80% less service charge of P15,000. The loan was agreed to have a 3% interest per month. A promissory note was signed by the company On January 5, The Company issued a credit memo to a customer for return of damage merchandise for P20,000. The account is a assigned account.

On January 25, the company collected P500,000 on the assigned account less 3% discount. On January 31, the Company remitted the collection to the bank. What is the balance of the account receivable – assigned at the end of the month? a. 500,000 b. 465,000 c. 450,000 d. 1,000,000 Solution Initial amount of account receivable- assigned Collections Sales discount Sales return and allowance Balance

1,000,000 (500,000) (15,000) (20,000) 465,000

8. Bitter company factored P545,000 of account receivable with allowance for doubtful accounts of P55,000 for P500,000. What is the amount of loss on factoring? a. 50,000 b. 20,000 c. 10,000 d. 15,000 Solution Account receivable 545,000 Allowance for doubtful accounts (55,000) Cash received (500,000) Loss on factoring (10,000) 9. Sweet company factored P880,000 of account receivable with allowance for doubtful accounts of P88,000 for P930,500. What is the amount of loss or gain on factoring? a. 138,500 gain b. 140,000 gain c. 138,500 loss d. 140,000 loss Solution Cash 930,500 Allowance for doubtful account 88,000 Gain on factoring 138,500 Accounts receivable 880,000

10. Night company began to experience a financial distress and have a critical cash position. The Company was forced to factored P6,635,000 of account receivable to a finance entity to obtain money. The factor charged a commission of 20% based on the amount of the factored account. In addition: The factor withheld an amount equal to 10% of the account receivable in case of sales return. What is the cash amount received by Royal Company from the factoring. a. 4,644,500 b. 5,000,000 c. 5,308,000 d. 0 Solution Gross amount Commission Factor’s holdback Cash received from factoring

6,635,000 (1,327,000) (663,500) 4,644,500

Chapter 9: Receivable Financing: Discounting of Note Receivable INTRODUCTION A discount on note receivable happens when he present value of the payment received from the note are less than its face amount. Notes are usually sold with or without recourse, meaning the company discounting the note agrees to shoulder the cost if the maker dishonors the note. When notes receivables are sold with recourse, the company shall recognize a contingent liability that must be disclosed in the notes to financial statements. Contingent Liability – obligation to pay an amount in the future if an uncertain event occurs. Terms: a. Net proceeds – the value of the discounted note received from the endorsee (usually a bank or financial institution) b. Maturity Value – the value due on the note on time of maturity c. Maturity date – date of which the note must be paid d. Principal – amount that appears on the face of the note. e. Interest – amount of interest on full term of the note f. Interest rate – Interest rate shown on the face of the note Example 1 To make computing easier follow the steps to computing each: A 500000, 180-day 10% note dated March 30 was received from a customer and discounted without recourse on May 30 at 12% discount rate Step 1: Compute the Maturity Value Principal Interest (500000 x 10% x 180/360) Maturity Value

500000 25000 5250000

Note that the interest is computed as for the entire 180 day of the note to determine the maturity value Stet 2: Compute the Discount Discount (525000 x 12% x 120/360)

21000

Note that the discount period is the time remaining since March 30 – May 30 = 60 days and 180 days is the entire amount then: 180 – 60 = 120.

Step 3: Compute for net proceeds Maturity Value Discount Net Proceeds

525000 21000 504000

Step 4: Compute for Carrying Amount of the note Principal 500000 Accrued interest receivable (200000 x 10% x) 8333.33 60/360 Carrying Amount of Notes receivable

508333.33

Gain or Loss on Discounting If Carrying amount > Net proceeds = Loss on note discounting If Carrying amount < Net proceeds = Gain on note discounting In this case: Net proceeds Carrying Amount of Notes receivable Gain on Note discounting

504000 508333.33 (4333.33)

Journal Entry Since in the example there without recourse there shall be no contingent liability Cash 504000 Loss on note receivable discounting 4333.33 Note Receivable 500000 Interest Income 8333.33 Now assume that in the previous example the note was discounted with recourse, the transaction can either be accounted for either of the following a. Conditional Sale b. Secured Borrowing Conditional Sale If in the previous example the note is treated as a Conditional Sale the journal entry to record transaction is

Cash 504000 Loss on note receivable discounting 4333.33 Note Receivable discounted 500000 Interest income 8333.33 The note account title note receivable discounted is deducted from notes receivable in the statement of financial position If note is paid by maker in the date of maturity Note receivable discounted 500000 Note Receivable 500000 If note is dishonored by the maker and the bank charged the company 5000 Accounts Receivable 530000 Cash 530000 Notes receivable discounted Note Receivable

500000 500000

Note: The first entry is to record payment to the bank of the amount of the Maturity value plus any bank charges. The second entry is to cancel the contingent liability since the company is already paid and is no longer liable.

Secured borrowing Assume again the example above except that the note is treated as secured borrowing the entry shall be: Cash 504000 Interest Expense 4333.33 Liability for note receivable discounted Interest income

500000 8333.33

In secured borrowing, a liability is recorded equal to the amount of the face value of the note in place of note receivable. No gain or loss shall be recognized on if note receivable is discounted for as a Secured borrowing Note Paid by the maker in the date of maturity Liability for note receivable discounted Note Receivable

500000 500000

The liability and Note Receivable is derecognized if the maker paid the bank

Note dishonored by maker Accounts Receivable Cash

530000

Derecognition of liability and Note discounted Liability for note receivable discounted Note receivable

530000 500000 500000

Problems: 1. Which of the following is true? a. Maturity Value is the amount of interest deducted by bank in advance. b. Net proceeds refer to the value discounted of the note received c. Maturity date is the period of time from date of discounting to maturity date d. None of the above 2. Which of the following is True? a. Secured borrowing recognizes a contingent liability b. Secured borrowing does not recognize a gain or loss c. Note receivable discounted is added from the total notes receivable d. If note is paid by maker the liability for note receivable and note receivable is recognized 3. Which of the following is false? a. The accounting for notes receivable discounting depends on whether the discounting is with or without recourse b. In the absence of any evidence, a note receivable is assumed to be with recourse c. A discount of note receivable may be without recourse which means that the company or endorser shall pay the endorsee if the maker dishonors the note d. None of the Above 4. Which of the following is false? a. Under secured borrowing payment of note on maturity is an entry to a debit of Notes receivable and credit to Liability for note receivable discounted b. Under Conditional Sale an entry to record payment of note is to Debit Accounts Receivable and Credit Cash c. Under Conditional Sale an entry to cancel contingent liability is a debit to Note receivable discounted and a credit to Note Receivable

d. Under Secured Borrowing the entry to derecognize liability for note receivable is a debit to liability for note receivable discounted and a credit to note receivable Trulala Co. accepted from a customer a 1000000, 90-day, 12% note dated September 30, 2020. On October 31, 2019 the entity discounted without recourse the note at 15%. However, the proceeds were not received until November 1, 2019 5. What amount was received from the note receivable discounting? a. 25750 Principal 1000000 b. 1030000 1000000 x 12% x 90/360 30000 c. 30000 Maturity Value 1030000 d. 1004250 1030000 x 15% x 60/360 50025750 1004250 6. What amount should be reported as gain on note receivable discounting? a. 5750 1000000 b. 1000000 1000000 x 12% x 30/360 10000 c. 10000 Carrying Amount 1010000 d. 1010000 Net Proceeds 1004250 Gain on receivable discounting 5750 BangBang Co. received from a customer a 1 year, 600000 note with an annual interest rate of 8%. After holding the note for 6 months, the entity discounted the note at the bank at an interest rate of 10% 7. What amount of cash was received from the bank? a. 48000 Principal 600000 b. 600000 (600000 x 8%) c. 648000 Maturity Value d. 618000 (600000 x 10% x 6/12) e. None of the Above Net proceeds 618000 8. What is the loss on note receivable discounting? a. 6000 Principal b. 24000 (600000 x 8% x 6/12) c. 18000 Carrying Amount d. 0 Net Proceeds e. None of the above loss on note receivable disc. 9. What is the Carrying Amount of the note? a. 600000

600000 24000 624000 618000 6000

48000 648000 30000

b. 624000 c. 618000 d. None of the Amount 10. Statement 1: Contingent Liability – obligation to pay an amount in the future if an uncertain event occurs. Statement 2: Maturity Value – the value due on the note on time of maturity a. b. c. d.

Both statement is true Both statement is false Statement 1 is true while Statement 1 is false Statement 1 is false while Statement 2 is true

Problem solving 11. On july 1, 2019 AllMight Co. Sold goods in exchange for 2000000, 8 moth, non-interest bearing note receivable. At the time of the sale, the note’s market rate of interest was 12%. The note was discounted at 10% on September 1, 2019 What is the loss on note receivable discounting Answer: 2000000 – 1900000 = 100000 loss 12. Sinagtala Co. Received from a customer a one-year 200000 note bearing annual interest of 10%. Ater holding the note for 6 months, the entity discounted the note at the bank at an eddective interest rate of 12%. a. What amount of cash was received from the bank b. What is the loss on the note receivable discounting Answer: a. Principal Interest (200000 x 10%) Maturity Date

2000000 20000 220000

Less: Discount ( 220000 x 12% x 6/12) 13200 Net Proceeds 206800

b.

Principal Accrued interest receivable Carrying Amount

Net Proceeds Carrying Amount Loss on note receivable

200000 10000 210000 206800 (210000) (3200)

Co. provided the following transactions: Jan 1 – The entity sold merchandise for 600000 accepting the note for 1000000 for six months with interest to be paid at maturity at 10% March 1 – Hogwarts discounted the note without recourse at local bank at 20% July 1 – The customer paid the bank in full 13. Compute for Carrying Amount and Net Proceeds 14. Prepare Journal Entries

Answer: Principal Interest (600k x 10% x 6/12) Maturity Value Discount (106k x 20% x 2/12) Net proceeds

600000 30000 630000 (21200) 608800

Principal 600000 Accrued Int. Rec. (600k x 12% x 2/12) 12000 Carrying Amount of NR 612000 Net Proceeds Carrying Amount gain on note discounting

Journal Entries

608800 (612000) (3200)

January 1 Notes Receivable Sales March 1 Cash Loss on Note discounting Notes receivable Interest Income

600000 600000 608800 3200 600000 12000

July 1 No Entry Unicorn Co. received from customer a 3000000 value note term, 90 days and carried at an interest rate of 12%. On August 31 2019, the company discounted with recourse the note at the bank with a rate of 15%. The customer paid the note to the bank on October 30, 2019 15. Prepare Journal Entries assuming the discounting is accounted for as a secured borrowing 16. Compute for Carrying Amount and Net Proceeds Answer Principal 3000000 Interest (3M x 12% x 90/360) 90000 Maturity Value 3090000 Discount (3090k x 15% x 60/360) 77250 Net Proceeds 3012750 Principal 3000000 Accrued Int. Rec (3M x 12% x 30/360) 30000 Carrying Amount of NR 3030000 Net Proceeds Carrying Amount loss

3012750 3030000 17250

Journal Entry: Cash 3012750 Interest expense 17250 Liability for note receivable disc. 3000000 Interest Income 30000

Liability for note receivable discounted Note Receivable

3000000 3000000

17. Moonlight Co. Discounted at the bank a customer’s 3000000, 6 month, 10% , note receivable dated April 30, 2019 on June 30 2019. The bank discounted the note at 12% a. What amount should be reported as et proceeds from the discounted notes receivable b. What is the lodd on the note receivable discounting? Answer: a. Principal Interest (3M x 10% x 6/12) Maturity Value Discount (3150000 x 12% x 4/12) Net Proceeds

3000000 150000 3150000 (126000) 3024000

b. Principal Accrued Interest (3m x 10% x 2/12) Carrying Amount

3000000 50000 3050000

Net Proceeds 3024000 Carrying Amount 3050000 Loss on Note Receivable Discounting (26000)

Jhoto Co. Provided the ff. Data in the current year June 1 – A 5000000, 12%, 90-day note received from Hoenn Co. From goods sold July 1 account

Rreceived from Sinnoh Co. A 6000000, 10%, 60-day note in full payment of an

1 – Discounted Hoenn Co. At a bank at 12% 1 – Discounted Sinnoh Co. Note at abank at 12% Aug. 30 – The bank Notified Johto Co. That Sinnoh Co. Note has been paid

30 – The bank told Jhoto Co. That Hoenn Co. Dishonored the note and charged the amount of principal, interest and a fee of 20000 against Jhoto’s bank account 30 – Received payment in full from Aye Company for the dishonored note plus 12% Annual interest on the total amount due for four months. 18. Prepare journal entries if the note receivable discounting is accounted for as a secured borrowing. 19. Prepare journal entries if the note receivable discounting is accounted for as conditional sale with recognition of contingent liability.

Answers: 18 June 1 Notes Receivable Sales

5000000 5000000

July 1 Notes Receivable Sales

6000000 60000000

Cash 5047000 Interest expense 3000 Liability for note receivable discounted Interest income

5000000 50000

July 16 Cash 6008500 Interest Expense 16500 Liability for note receivable discounted 6000000 Interest Income 25000 August 30 Liability for note receivable discounted Notes Receivable Accounts Receivable Cash Liability for note receivable discounted Note Receivable Cash Accounts Receivable Interest Income Answers: 19

6000000 6000000

5170000 5170000 5000000 6000000 5376000 5170000 206800

June 1 Notes Receivable Sales

5000000 5000000

July 1 Notes Receivable Sales

Cash Loss on discounting Note receivable discounted Interest income July 16 Cash Loss on discounting Note receivable discounted Interest Income August 30 Note receivable discounted Notes Receivable

6000000 60000000

5047000 3000 5000000 50000 6008500 16500 6000000 25000 6000000 6000000

Accounts Receivable Cash

5170000 5170000

Note receivable discounted Note Receivable

5000000 6000000

Cash

5376000 5170000 206800

Accounts Receivable Interest Income

20. Frozen Co. Provided the following transactions: March 14 – Sale of merchandise 2050000 to a customer, FOB Destination 2/10 net 30 April 7 – Receipt of 60-day, 12% note dated April 4 from the customer. The face of the note was the amount of the invoice minus freight charge of 50000 paid by the customer in connection with the marhc 14 sale. 20 – The note of the customer was dicounted with the bank at 15% June 4 – Bank notified from the bank that the customer dishonored the note. Accordingly, the entity paid the bank the amount due including protest fee and other charges of 10000

July 4 – Receipt of cash from the customer for the full amount of the idebtedness plus interest on the original Face value Prepare Journal Entries Answer: March 14 Accounts Receivable Sales

2050000 2050000

April 7

2000000 50000 2050000

Notes receivable Freight Out Accounts Receivable

April 20 Cash Loss on Discounting Notes receivable discounted Interest Income

2001750 8250 2000000 10000

June 4

2050000 2050000

Accounts Receivable Cash Notes Receivable Discounted Notes Receivable

July 4 Cash Accounts Receivable Interest Income

2000000 2000000 2070000 2050000 20000

CHAPTER 10 INVENTORIES Definition According to IAS 2, Paragraph 6, inventories are assets held for sale in an ordinary course of business, in the process of production, in the form of materials to be consumed in the production or in rendering services. Inventories encompass goods purchased and held for resale (Merchandise Inventory): 1.) Raw Materials - To be used in production 2.) Work – in – Process - Partially completed goods 3.) Finished Goods - Completed goods and available for sale Inventories encompass service provider: 1.) Cost of service Classes of Inventories a.) Trading Concern – buys and sell goods b.) Manufacturing Concern – buys raw materials or goods and converted into finished goods available for sale. Goods Includible in the Inventory Economic control is the basic criteria for goods to be included in the inventory than physical possession. In simple words, economic control means having the legal ownership or title. Basically, goods are included in inventory when received by the buyer and recorded sold by the seller. However, Passing of Title serves as the determinant in classifying inventory. Examples: 1. 2. 3. 4.

Goods in transit FOB Destination and FOB Shipping Point Goods out on consignment/Consigned Goods Goods in the hands of salesmen or agents/Conditional Sales Goods held by customers on approval or on trial

In relation to the concept of Passing of Title, Under FOB Shipping Point, legal title is passes to buyer upon shipment of goods wherein seller should pay for the freight charge. On the other hand, under FOB Destination, legal title is passes to the buyer at the point of destination wherein buyer should pay for the freight charge.

Furthermore, Freight Terms (Freight Collect and Freight Prepaid) determine the person who actually paid the freight charge. In Freight Collect, buyer actually paid the freight charge while in Freight Prepaid, seller actually paid the freight charge. Maritime Shipping Terms FAS or Free Alongside – Title passes to the buyer when the goods are in the carrier’s possession in which the buyer is responsible for the charges. CIF or Cost, Insurance, Freight – Title passes to the buyer upon delivery of goods to the carrier in which the seller is responsible for the freight cost. Ex-Ship – Title passes to the buyer when the goods are unloaded in which seller should paid for the charges. CONSIGNED GOODS Goods that are in the possession of the agent or the one who sells it called consignee in behalf of the owner which is the consignor. These goods are included in inventory at cost plus freight and handling charges. The consignee earns commission (Commission Expense for the consignor) when goods are sold and remitted to consignor. ACCOUNTING FOR INVENTORIES 1.) PERIODIC SYSTEM – Physical counting of goods on hand at the end of accounting period in which physical quantities are multiplied to its unit cost to obtain the inventory value necessary in presenting Financial Statement. 2.) PERPETUAL SYSTEM – The entity maintains records of movements of inventory called stock cards. However, physical count should be also made at least once a year. PERIODIC SYSTEM PERPETUAL SYSTEM Purchase merchandise on account costing 100,000 Purchases 100, 000 Merchandise Inventory 100, 000 Accounts Payable 100,000 Accounts Payable 100,000 Paid 3,000 for the freight charge Freight in 3,000 Merchandise Inventory 3, 000 Cash 3,000 Cash 3,000 Return 30,000 worth of goods purchased to supplier Accounts Payable 30, 000 Accounts Payable 30, 000 Purchase Return 30,000 Merchandise Inventory 30,000 Sold merchandise on account worth 45,000 at 20% Gross Profit Rate Accounts Receivable 45, 000 Accounts Receivable 45, 000 Sales 45,000 Sales 45,000 Cost of Goods Sold 36,000 Merchandise Inventory 36,000

(45,000 x 80%) = 36,000 Customer returns 5,000 worth of merchandise Sales Return 5,000 Sales Return 5, 000 Accounts Receivable 5,000 Accounts Receivable 5,000 Merchandise Inventory 4 ,000 Cost of Goods Sold 4,000 (5,000 x 80%) = 4,000 To record ending Inventory Merchandise Inventory 41,000 Merchandise Inventory 41,000 Income Summary 41,000 Income Summary 41,000 (100,000+3,000-30,000-36,000+4,000) (The balance of Merchandise Inventory) INVENTORY SHORTAGE OR OVERAGE In the preceding illustration, the entity has Merchandise Inventory – Ending costing P41,000. Assume that the entity made physical count of inventory and shows that the on hand inventory is P38,000. The journal entry should be: Inventory Shortage (41,000-38,000) Merchandise Inventory

3,000 3,000

In such case of Inventory Overage, the entry will be just reversed of the entry in Inventory Shortage. If the Inventory Shortage is normal, it shall be closed to cost of goods sold, on the other hand, if it is abnormal, it shall be charge to other expense. TRADE DISCOUNT AND CASH DISCOUNT Trade Discount is the deduction from the list price to arrive at the amount that the buyer should pay and to encourage buyers to buy in a bulk of goods. Trade discount is not recorded. Cash Discount is the deduction in the invoice price when payment is made within the discount period. Cash discount encourages buyers to pay on time, thus, this is recorded as purchase discount for the buyer and sales discount for the seller. In determining the discount period, exclude the first day but include the last day. METHODS OF RECORDING PURCHASES 1.) Gross Method 2.) Net Method Gross Method

Net Method

On May 1, Jose purchased goods on account, P100,000, 2/10, n/30 Purchases 100,000 Accounts Payable 100,000

Purchases 98,000 Accounts Payable 98,000 (100,000 x 98% (2/10 or 2% discount within 10 days) On May 10, Jose paid the purchased goods. Accounts Payable 100,000 Purchases 98,000 Cash 98,000 Accounts Payable 98,000 Purchase Discount 2,000 Assume that Jose paid on May 13 Accounts Payable Cash

100,000 100,000

Accounts Payable Purchase Discount Lost Cash

98,000 2,000 100,000

COST OF INVENTORIES 1.) Cost of Purchase – includes purchase price, import duties, irrecoverable taxes, freight, handling and other costs directly attributable in purchasing of goods. 2.) Cost of Conversion – includes direct labor and overhead (Fixed and Variable) 3.) Other Costs – includes costs incurred in bringing the inventory to its present condition. It may include costs incurred for special order. Exclusion in Determining Cost of Inventories: a.) Abnormal Amounts b.) Storage Costs (If in Goods in Process, capitalized. If in Finished Goods, expensed) c.) Administrative Costs d.) Distribution and Selling Costs

PROBLEMS 1.) Lee Company provided the following information at the end of 2018: Materials in Transit, FOB Destination 100,000 Materials 2,000,000 Goods in process, at cost of materials and labor 1,440,000 Finished goods in storeroom, at cost including 4,000,000 20% overhead Finished goods, FOB seller 500,000 Consigned Goods, at selling price, cost, P200,000 280,000 Defective Materials returned to suppliers 200,000 Machine Lubricants 50,000 What is the cost of Lee’s Inventory at year end? a.) 7,440,000 b.) 8,000,000 c.) 8,570,000 d.) 8,050,000 2.) Arya Company has incurred the following costs during 2017. Cost of Purchases from Friendship Company 3,000,000 Trade Discounts already deducted by Friendship 200,000 Company Import Duties 180,000 Freight and insurance on purchases 700,000 Handling costs related to imports 40,000 After-sales warranty costs 140,000 Accounting Department salaries 700,000 What is the cost of Arya’s Inventory at year end? a.) 3,920,000 b.) 4,960,000 c.) 4,260,000 d.) 3,860,000

3.) What is the total amount of inventory to be measured based on the following: Materials 1,000,000 Irrecoverable purchase taxes 100,000 Storage costs of finished goods 220,000 Goods out on consignment, cost, 100,000 400,000 Finished Goods, FOB Shipping point 150,000 a.) 1,870,000 b.) 1,720,000 c.) 1,200,000 d.) 1,420,000 On January 31, 2017, Jon Company consigned 30 ovens to Daenerys Company costing P8,000 each and to be sold for P12,000 each. Jon Company paid P1,000 transportation cost and P2,000 handling cost. On December 28, 2017, Daenerys Company reported that only 22 ovens are sold and remitted P237,600, net of 10% agreed commission. 1.) What is the total amount of consignment sales revenue for 2017? a.) 264,000 b.) 176,000 c.) 237,600 d.) 360,000 2.) What should be the amount of consigned goods in Jon Company’s Inventory? a.) 360,000 b.) 240,000 c.) 243,000 d.) 240,600 Tyrion Merchandise is a regular buyer of Jamie Company which granted Tyrion trade discounts of 30% from the list price. Tyrion purchased a merchandise and received an invoice with a list price of P780,000, freight charge of P10,000, and the payment terms of 2/10, n/30. 1.) What is the net invoice price of Tyrion? a) 540,000 b) 790,000 c) 780.000 d) 546,000 2.) What is the total cost of the purchase made by Tyrion? a.) 780,000 b.) 556,000 c.) 546,000 d.) 790,000

3.) Assume that Tyrion payment is within the discount period, what is the total cost of purchase? a.) 550,800 b.) 546,000 c.) 556,000 d.) 544,880 On March 1, Cersie Company recorded purchases of inventory of P500,000 and P700,000 under credit terms of 2/15,net 30. The payment due on the P500,000 and P700,000 were remitted on March 16 and March 31, respectively. 1.) What is the amount to be recorded as net purchase under Net Method? a.) 1,000,000 b.) 1,200,000 c.) 1,176,000 d.) 1,190,000 2.) What is the net purchase under Gross Method? a.) 1,190,000 b.) 1,000,000 c.) 1,200,000 d.) 1,176,000 On May 1, 2016, Dominic Company sold merchandise with a list price of P3,000,000 to Hobbs on account in which Dominic allowed trade discounts of 20% and 10% and the credit terms is 2/10, n/30. The sale was made FOB Seller, Dominic paid P100,000 freight costs. On May 11, 2016 Hobbs paid in full amount. 1.) What amount should be reported as sales revenue? a.) 2,160,000 b.) 3,000,000 c.) 2,400,000 d.) 2,900,000 2.) What amount was received by Dominic as payment by Hobbs? a.) 2,216,800 b.) 2,160,000 c.) 2,380,200 d.) 2,840,800 TRUE OR FALSE 1.) Under gross method, purchase discount is deducted from purchases regardless of whether taken or not. FALSE

2.) Under net method, only purchase discount taken is deducted from purchases. FALSE 3.) Both trade discount and cash discount are recorded. FALSE 4.) Since Storage costs of finished goods in not an inclusion in the cost of inventory, therefore, it is recognized as an expense. TRUE 5.) If the entity is using Perpetual Inventory system which maintains the inventory transactions, then it is not necessary to do physical counting of inventories. FALSE 6.) Both normal and abnormal inventory shortage shall be expense outright. FALSE 7.) The journal entry for the sale of inventory under the Periodic and Perpetual is the same, however, only in Perpetual system the entity Cost of Goods Sold and Merchandise Inventory account is affected. TRUE

CHAPTER 11 INVENTORY COST FLOW Learning Objectives:     

To identify the three cost formulas To determine the cost of inventory using the FIFO cost formula To determine the cost of inventory using the Weighted Average cost formula To determine the cost of inventory using the Moving Average cost formula To apply the specific identification method

First in, First out (FIFO) The first in, first out method is a cost flow assumption that the goods are first purchased are also the goods first sold. This results in the remaining items in inventory being accounted for at the most recently incurred cost, so that the inventory asset recorded on the balance sheet contains cost that are quite close to the most recent costs that can be acquired in the market.

This method also results in older historical costs being matched against current revenues that reflect an improper matching of revenues and costs resulting understatement of cost of sales. The FIFO method provides the same results under either the periodic or perpetual inventory system. Illustration FIFO – Periodic Units

Unit cost

Total cost

Sales(in

units) Dec.

1 Beginning balance

700

150

105,000

10 Sale

500

15 Purchase

800

200

160,000

20 Sale

500

31 Purchase

300

300

Ending inventory is 800 units.

Dec. 15 Purchase 31 Purchase

Units 500 300 800

Unit cost 200 300

Total cost 100,000 90,000 190,000

Cost of Goods Sold Inventory-December 1 Purchases (160,000+90,000)

105,000 250,000

90,000

Goods available for sale

355,000 190,000 165,000

Inventory-December 31 Cost of goods sold FIFO – Perpetual

Date Dec.

Purchases Unit Total Units cost cost 1 10 15

800

200

300

300

Total cost

500

150

75,000

200 300

150 200

30,000 60,000

Units

160,000

20 31

Sales Unit cost

90,000

Units 700 200 200 800 500 500 300

Balance Unit Total cost cost 150 105,000 150 30,000 150 30,000 200 160,000 200 200 300

100,000 100,000 90,000

Cost of goods sold determine from the stock card: December

1 0 2 (30,000+60,00 0 0)

Cost of goods sold

75,000 90,000 165,00 0

Weighted Average - Periodic Using the weighted average method, the total cost of goods available for sale is divided by the number of units available for sale which yields the weighted average cost per unit. The cost of goods available for sale is calculated as the sum of the beginning inventory plus the net purchases. Inventory cost = Weighted average cost per unit x Ending inventory

Illustration Units

Unit cost

Total cost

Sales(in

units) Dec.

1 Beginning balance

700

150

105,000

10 Sale 15 Purchase

500 800

200

160,000

20 Sale 31 Purchase

500 300

300

90,000

Ending inventory is 800 units. Dec .

1 Beginning balance 1 5 Purchase 3 1 Purchase Total goods available for sale

Units

Unit cost

Total cost

700

150

105,000

800

200

160,000

300 1,800

300

90,000 355,000

Weighted average unit cost (355,000/1,800)

197.22

Inventory cost (800 x 197.22)

157,776

Cost of goods sold Inventory-December 1 Purchases Goods available for sale Inventory-December 31 Cost of goods sold

Weighted Average – Perpetual

105,000 250,000 355,000 (157,776) 197,224

Weighted Average – Perpetual method is also known as the moving average method. Under the moving average method, the average cost of each inventory item in the stock must be computed after every inventory purchase and purchase return. This is done by dividing the total cost of goods available after every purchase and purchase return by the total units available for sale to get the new weighted average unit cost. To get the inventory cost, the new weighted average unit cost is multiplied with the units on hand. Illustration Units Dec.

Unit cost

1 Beginning balance

Total cost

700

150

Sales(in units) 105,000

10 Sale

500

15 Purchase

800

200

160,000

20 Sale

500

31 Purchase

300

Units Decembe r

1 Balance 1 0 Sale Balance 1 Purchas 5 e Balance 2 0 Sale Balance 3 Purchas 1 e Total

300

Units cost

90,000

Total cost

700

150

105,000

(500) 200

150 150

(75,000) 30,000

800 1,000

200 190

160,000 190,000

(500) 500

190 190

(95,000) 95,000

300 800

300 231.25

90,000 185,000

Cost of goods sold determine from the stock card: December

1

75,000

0 2 0

95,000

Cost of goods sold

170,00 0

Specific Identification Specific identification method relates to inventory valuation used to track specific items in the inventory. Computation: Cost of inventory = Units on hand x actual unit cost Relative sales price method Relative sales price method is a technique used to allocate joint cost base on the prices at which products will be sold. This is based on the philosophy that the cost is proportionate to selling price. Example: Product X, Y and Z are purchased at basket price of 3,000,000. Product X Product Y Product Z

Sales Price 1,000,000 2,000,000 3,000,000 6,000,000

Fraction 1/6 2/6 3/6

Allocated Cost 500,000 1,000,000 1,500,000 3,000,000

Problem 11-1 An entity provided the following information: Jan .

1 5 1 5 1 6 2 5 2 6

Units

Unit cost

Total cost

Beginning balance Purchase

10,000 10,000

150 180

1,500,000 1,800,000

Sale

15,000

Sale return

1,000

Purchase

4,000

200

800,000

Purchase Return

2,000

200

400,000

1. Under FIFO, what amount should be reported as cost of goods sold? a.2,900,000 b.2,620,000 c.2,220,000 d.2,500,000 2. Under the weighted average, what amount should be reported as ending inventory? a.1,466,640 b.1,345,440 c.1,432,000

d.1,413,360 3. Under the moving average, what amount should be reported as ending inventory? a.1,690,000 b.1,390,000 c.1,790,000 d.1,600,000

Solution 11-1

1. Answer d 8,000 x 200 = 1,600,000 Cost of ending inventory Cost of goods sold Inventory, beg

1,500,000

Purchases

2,600,000

Goods available for sale

4,100,000

Inventory, end

1,600,000

Cost of goods sold

2,500,000

2. Answer a

Ja n

Units 10,00 5 0 2 4,000

Unit cost

Total cost 180000 180 0 200 800000

5 2 6

2,000 12,00 0

200

400000 220000 0

Weighted average unit cost (2,200,000/14,000)

183.33

Inventory cost (8,000 x 183.33)

1,466,640

3. Answer Unit cost

Total cost

10,000 10,000 20,000 (15,00 0) 5,000

150 180 165 165 165

1500000 1800000 3300000 (247500 0) 825000

1,000 6,000

165 165

165000 990000

4,000 10,000

200 179

800000 1790000

(2,000) 8,000

200 173.7

(400000) 1390000

Units Ja n

Beginning 1 balance 5 Purchase Balance 1 5 Sale Balance 1 6 Sales return Balance 2 5 Purchase Balance 2 Purchase 6 return Balance

5 Problem 11-2 Which of the following is not affected by the inventory valuation method used by an entity? a.Cost of goods sold b.Net income of the entity c.Amounts owed for income taxes d.Amounts paid to acquire merchandise Answer: D Problem 11-3 Ram Inc. is a wholesaler of office supplies. The activity for Model 2 calculators during August is shown below:

Augus t

1 7 1 2 2 1 2 2 2 9

Units

Unit cost

Inventory Purchase

2,000 3,000

36 37.2

Sale

3,600

Purchase

4,800

Sales

3,800

Purchase

1,600

38

38.6

1. If Ram Inc. uses a FIFO perpetual inventory system, the ending inventory of Model 2 calculators at August 31 is reported as a. 152,288 b.152,960 c.150,080

d.150,160 2. If Ram Inc. uses a weighted average cost periodic inventory system, the ending inventory of Model 2 calculators at August 31 is reported as a.150,080 b.152,960 c. 150,160 d. 146,400 Solution 11-3 1. Answer b

Date Aug

Purchases Unit Total Units cost cost 1 7

3,000

37.2

111600

12 21

4,800

38

1,600

38.6

61760

2. Answer a Unit Units cost Au g

1 2,000

36

7 3,000

37.2

2,000 1,600

36 37.2

1,400 2,400

37.2 38

182400

22 29

Unit s

Sales Unit Total cost cost

Total cost 72,000 111,60 0

Balance Unit Unit Total s cost cost 2,000 36 72000 2,000 36 72000 3,000 37.2 111600

72000 59520 1,400 1,400 4,800 52080 91200 2,400 2,400 1,600

37.2 37.2 38

52080 52080 182400

38 38 38.6

91200 91200 61760

2 1 4,800 2 9 1,600 11,40 0

38 38.6

182,40 0 61,760 427,76 0

Weighted average unit cost (427,760/11,400)

37.52

Inventory cost (4,000 x 37.52)

150,080

Problem 11-4 The following information was available from the inventory records of Castaway Company for January: Units

Unit cost

3,000

9.77

6-Jan 26-Jan

2,000 2,700

10.3 10.71

7-Jan 31-Jan

2,500 3,200

Balance at January 1 Purchases:

Sales:

Assuming that Castaway Company maintains a perpetual inventory records, what should be the inventory at January 31, using the moving average inventory method, rounded to the nearest peso? a. 20,474 b. 20,520 c. 20,725 d. 21,010

Solution 11-14 Answer c Date 1-Jan Balance Purchas 6-Jan e Balance

Units 3,000

Unit cost 9.77

2,000 5,000

10.3 9.98

7-Jan Sale Balance Purchas 26-Jan e Balance

(2,500) 2,500

9.98 9.98

2,700 5,200

10.71 10.36

31-Jan Sale Balance

(3,200) 2,000

10.36 10.36

Total cost 29,310 20,600 49,910 (24,950 ) 24,960 28,917 53,877 (33,152 ) 20,725

Problem 11-5 A company decided to change its inventory valuation method from FIFO to LIFO in a period of rising prices. What was the result of the change on ending inventory and net income in the year of the change? Ending inventory

Net Income

a.

Increase

Increase

b.

Increase

Decrease

c.

Decrease

Increase

d.

Decrease

Decrease

Answer: C Problem 11-6 Elixir Development Corporation bought a 10 hectare land in Novaliches, to be improved, subdivided into lots and eventually sold. Purchase price of the land was P58,000,000. Taxes and documentation expenses on the transfer of the property amounted to P800,000. The lots were classified as follows: Lot

Number of lots

Selling price per lot

Total clearing

class A B C D

10 20 40 50

P1,000,000 800,000 700,000 600,000

costs None P1,000,000 3,000,000 8,000,000

The cost per lot of class B lots under the relative sales price method of inventory valuation is? a. 674,285 b. 610,000 c. 602,380 d. 560,000 Solution 11-6 Answer b

A B C D

(10 x 1,000,000) (20 x 800,000) (40 x 700,000) (50 x 600,000)

Sales price

Fraction

Allocated cost

10,000,000

10/84

7,000,000

16,000,000

16/84

11,200,000

28,000,000

28/84

19,600,000

30,000,000 84,000,000

30/84

21,000,000 58,800,000

Allocated cost of class B Clearing cost of class B Total cost

11,200,000 1,000,000 12,200,000

12,200,000 / 20 = 610,000 Problem 11-7 Greece Company wholesales bicycles. It uses the perpetual inventory system. The company’s repoting date id December 31. At December 31, inventory on hnd consisted of 350 bicycles at P820 each and 43 bicycles at P850 each. During the month of Decembe the following inventoy transactions took place (all purchase and sales transactions are on credit)

2 Sold 300 bicycles for P1,200 each. Five bicycles were returned by a customer. They had originally cost P820 each amd were sold for P1,200 each. Purchased 55 bicycles at P910 each. Purchased 776 bicycles at P960 each. Sold 86 bicycles for P1,350 each. Returned one damaged bicycles to the supplier. This bicycle had been Purchased on 16 December 9 3 9 13 15

22 Sold 60 bicycles for P 1,250 each. 26 Purchased 72 bicycles at P980 each. Two bicycles sold on December 22 were returned by a customer. The bicycles were returned by a customer. The bicycles were badly damaged so it was decided to write 29 them off. they had original cost P910 each 1. The cost of goods sold for the month of December using moving average method is a. 367,230 b. 365,410 c. 366,320 d. 372,725 Solution 11-7 Answer d Date 1-Dec Balance 2-Dec Sale 3-Dec Sales Return Balance 9-Dec Purchase 13-Dec Purchase Balance 16-Dec Sale Balance Purchase 16-Dec Returns Balance 22-Dec Sale Balance

Units 393 300 5 98 55 76 229 86 143

Unit cost 823 823 823 823 910 960 890 890 890

Total cost 323,550 246,900 4,115 80,765 50,050 72,960 203,775 76,540 127,235

1 142 60 82

910 890 890 890

910 126,325 53,400 72,925

26-Dec Purchase Balance

72 154

Sales, Dec. 2 Sales return, Dec. 3 Sales, Dec. 15 Sales, Dec. 22 Cost of goods sold

980 932

72,560 143,485 P246,90 0 4,115 76,540 53,400 372,725

Chapter 12 Lower of Cost and Net Realizable Value Generally accepted accounting principles require that inventory be valued at lesser amount of its laid-down cost and the amount which it can likely be sold or its net realizable value. Net Realizable Value Net Realizable Value or NRV is the estimated selling price of the goods, minus the cost of sale or disposal. This valuation/measurement shall be used in determining the lower of cost or market of on-hand inventory items. The cost of sale as deduction in the estimated selling price are any reasonable costs of completing, transporting and disposing of inventory or any expenditure incurred by the purchaser in order to place the merchandise in the business and ready for sale. In order to determine if the costs of the inventory should be reduced, the following examinations are used: A. Spoilage B. Obsolescence C. Reduced demand from Customers If any of these were observed and happen in the inventory, the company will have to write off the inventory. The practice of inventory write-down is based upon the view that the inventory should not be recorded or carried higher than the amount the company is expecting to gain form them. Accounting for Inventory Write-down An inventory write-off is the process of removing inventory that has no value in the general ledger. When the market price of the inventory falls below its cost, accounting requires that the company should reduce the value of the inventory reported. However, if the cost is below its market price, there will be no problem because the increase in the value of the inventory is not recognized. Methods in Inventory Write-down There are two methods in writing off inventory, they are the direct write-off method or the direct method and the allowance method. A. Direct write-off method

In using the direct write-off method, the company will record a journal entry with a credit to the inventory asset account and a debit to an asset expense account. There is no allowance account, an asset is written off directly.

B. Allowance Method In using the allowance method, a business will record a journal entry with a credit to contra asset account, allowance for inventory write-down. An offsetting debit will be made to an expense account. When the asset is actually disposed, the inventory account will be credited and the allowance for inventory write-down account will be debited to reduce both. If the required allowance for inventory write-down is lesser than the one recorded, there will be a gain and reversal entry. However, the gain to be recorded should not excess the allowance balance. Illustration X company with P150,000 worth of inventory found out that P25,000 of it are damaged due to poor storing of the inventory. The company will have to record the loss to reflect the damaged goods. Direct method Inventory cost

P150,000

Damaged inventory

25,000

Net realizable Value

Inventory – December 31, 2019

P125,000

125,000

Income summary

125,000

Allowance Method Loss on inventory write-down Allowance for inventory write-down

25,000 25,000

However, if the inventory in 2020 has a net realizable value of P130,000 and cost of 145,000 the gain on reversal should be recorded as: Direct Method Inventory – December 31, 2020

130,000

Income summary

130,000

Allowance Method Cost in 2020

P145,000

NRV

130,000

Required allowance for 2020

P15,000

Required Allowance in 2019

(25,000)

Decrease in Allowance

(P10,000)

Allowance for inventory writedown Gain on inventory writedown

10,000 10,000

Purchase commitments Purchase commitments are commitments by the buyer to purchase some goods or services at some future date at a fixed price. A business will agree to purchase a commitment in order to fix its prices over a period of time. For example, a business will contract to purchase 100 units of goods at a fixed price of P25 each after 7 months. Businesses enter into purchase commitment to protect them from price increase. However, sometimes, before the maturity of the fixed date or on the fixed date of the purchase commitment, the price falls. Especially when the contract is not cancellable, the business will have to pay the product higher that its market value. Illustration

Suppose a business enter into a purchase commitment with a supplier to purchase 100 units of goods with a contract price of P25 each within six months. At the year end, none of the product was delivered and the price per unit has fallen into P20. Since the purchase commitment is non-cancellable, the business is contracted to purchase the 100 units at a price higher that its market value and therefore should recognize a loss. The purchase commitment loss is computed as follows. Contracted price

100*P25 = P2,500

Market value

100*P20 = (P2,000)

Purchase commitment loss

P500

Journal entry Loss on purchase commitments

500

Purchase commitments liability

500

The debit represents the loss recorded in the income statement of the business in the period in which the decline in price occurred. The credit represents the liability in the purchase commitments. Further decline in the Product Price Suppose that 7 months has passed, the business completes its contract and takes the delivery of the 100 units and adds them to its inventory. However, at the time of the delivery the price has declined even further to P18 a unit. Contract price

100*P25 = 2,500

Market value

10*P18 = (1,800)

Purchase commitments loss

Inventory

P700

1,800

Purchase commitments liability

500

Loss on purchase commitments

200

Accounts payable

2,500

Gain on purchase commitments Gain on purchase commitments occurs when at the date of the actual purchase or before the actual purchase, the market price of the product increases, the company will record a gain. However, if the increase in the product occurred after the decline, the gain to be recorded should be limited to the loss first recorded.

PROBLEMS Theory question-MC 12-1 Any write-down of the inventory to the net realizable value and all losses of the inventory shall be a. Recognized as operating expense on the period the write-down or loss occurs b. Recognized as other expense in the period the write-down or loss occurs c. Recognized as component of cost of goods sold in the period the write-down or loss occurs d. Deferred until the related inventory is sold Answer: C Theory question-MC 12-2 What is the accounting principle which supports the inventories being valued at lower of cost or net realizable value? a. Revenue recognition principle

b. Expense recognition principle c. Conservatism d. Lower of cost principle Answer: C Problem 12-3 By the end of the year the entity had 100 units in warehouse of Sung-gyi Co. Units are reported at 10,000 total cost. Recently a fire broke out and damaged the outer casing of units. Engineers have confirmed that product can still fetch full selling price if outer cover is replaced. Currently Sung-gyi is selling P110 per unit and cost of repair is estimated to P5 per unit. Additionally, entity will have to pay P2,000 in total towards the carrying cost to move the repaired goods form workshop to warehouse. Compute the value to which inventory should be reported. a. b. c. d.

10,000 11,000 8,500 0

12-4 From the preceding problem, what is the net realizable value of the entity? a. b. c. d.

10,000 11,000 8,500 0

12-5 What amount is the loss from the inventory writedown? a. b. c. d.

0 1,000 500 1,500

Answers: B, B, D Total cost of units Total sales price

10,000 (100*P110)

Less: Repair cost Carriage cost

(100*5)

11,000 500 2,000

(2,500)

( 8,500)

Loss on inventory write-down

1,500

NRV (8,500) < cost (10,000) therefore, inventory will be valued at 8,500 and recognize a loss of 1,500

Problem 12-6 Suzy Inc. makes miniature models of anime characters and Kpop Idols. Cost of year-end inventory is 7,388. However, recent sales has fall in prices. Therefore its NRV is now 5,300 only. Prepare the journal entry to record the write-down loss using: 1. Direct method 2. Allowance method Answers: 1. Direct method Inventory Income summary

5,300 5,300

2. Allowance method Loss on inventory write-down Allowance for inventory write-down

2,088 2,088

(7,388-5,300 = 2,088)

Problem 12-7 Grams Company is a retailer of authentic furniture and fixtures. At year end, the entity have the following inventory:

Dining tables

Total costs

NRV

100,000

125,000

Rocking chairs

55,000

35,000

Sofas

70,000

62,000

Utensils cabinet

15,000

17,000

What is the inventory at year end? a. b. c. d.

212,000 239,000 240,000 251,000

Answer: A LCNRV Dining tables

100,000

Rocking chairs

35,000

Sofas

62,000

Utensils cabinet

15,000 212,000

Theory question-MC 12-8 What method might be used in the accounts to record a loss due to a price decline in the inventory? a. Record the inventory at net realizable value and then reduce it to cost, thereby reflecting a loss in the current period. b. Record the inventory at cost and then reduce it to net realizable value, thereby reflecting a loss in the current period. c. Record the inventory at selling price and then reduce it to cost, thereby reflecting a loss in the current period. d. Record the inventory at cost and then reduce at selling price, thereby reflecting a loss in the current period. Answer: B

Theory question-MC 12-9 What factors might call for inventory valuation at net realizable value? a. b. c. d.

When the cost of the inventory is higher than its net realizable value. When there is no threat of obsolescence of the inventory. When the company has able to protect the inventory from damages caused by typhoon. When the cost of the inventory is lower than its net realizable value.

Answer: D Problem 12-10 Presented below is the information related to Leesi Inc.’s inventory (per unit)

Skis

Boots

Parkas

Historical cost

190

106

53

Selling price

212

145

73.75

Cost to sell

19

8

2.5

Cost to complete

32

29

21.25

Determine the net realizable value for each item. Problem 12-11 Determine the carrying value of each item under LCNRV. Answer: Item

Cost

NRV

LCNRV

Skis

190

161

161

Boots

106

108

106

Parkas

53

50

50

Problem 12-12 Floyd Corporation has the following four items in its ending inventory Item

Cost

NRV

Jokers

2,000

2,100

Penguins

5,000

4,950

Riddlers

4,400

4,625

Scarecrows

3,200

3,830

Determine the total cost of the LCNRV Problem 12-13 The amount written down, if any using an item-by-item LCNRV. Problem 12-14 The amount of write-down using the total-group LCNRV valuation. Solution: Item

Cost

NRV

LCNRV

Jokers

2,000

2,100

2,000

Penguins

5,000

4,950

4,950

Riddlers

4,400

4,625

4,400

Scarecrows

3,200

3,380

3,200

Total

14,600

15,505

14,550

Answers: 12-12 14,550 12-13 (14,600 – 14,550) 50 12-14 0, NRV>Cost Problem 12-15 Kufal Inc. uses a perpetual inventory system. At January 1, 2011, inventory was P214,000,000 at both cost and net realizable value. At December 31, 2011, the inventory was P286,000,000 at cost and P265,000,000 at net realizable value. Prepare the necessary December 31entry under the direct write-off method. Answer: Inventory-December 31, 2011 Income summary

265,000,000 265,000,000

Problem 12-16 Based on the preceding problem, prepare the necessary journal entries under the allowance method. Loss on inventory write-down

21,000,000

Allowance for inventory write-down

21,000,000

Problem 12-17 Dover Company began operations in 2010 and determined its year ending inventory at cost and LCNRV at December 3, 2010 and December 31, 2011. This information is presented below. Cost

NRV

12/31/10

346,000

322,000

12/31/11

410,000

390,000

Determine the LCNRV for December 31, 2010 and 2011. Answer: LCNRV 12/31/10

322,000

12/31/11

390,000

Problem 12-18 From the preceding problem, prepare the journal entries required at December 31, 2010, and December 31, 2011, assuming that the inventory is recorded at LCNRV, and a perpetual inventory system using the cost-of-goods-sold method. Answers: 12/31/10

Cost of Goods Sold

24,000

Allowance to Reduce Inventory to NRV

12/31/11

Allowance to Reduce Inventory to NRV Cost of Goods Sold

Problem 12-19

24,000

4,000 4,000

Prepare journal entries required at December 31, 2010, and December 31, 2011, assuming that the inventory is recorded at cost, and a perpetual system using the loss method. Answers: 13/31/10

Loss Due to Decline of Inventory to NRV

24,000

Allowance to Reduce Inventory to LCNRV 13/31/11

Allowance to Reduce Inventory to NRV

24,000 4,000

Recovery of Inventory Loss

4,000

Cost of inventory at 12/31/10

346,000

LCNRV at 13/31/10

(322,000)

Allowance amount needed to reduce inventory to NRV

24,000

Cost of inventory at 13/31/11

410,000

LCNRV 12/31/11

(390,000)

Allowance amount needed to reduce inventory to NRV

Recovery of previously recognized loss

20,000

24,000 (20,000) 4,000

Problem 12-20 Which of the two methods above provide the higher net income in each year? Answer: Both methods of recording lower-of-cost-or-NRV adjustments have the same effect on net income.

CHAPTER 13 Gross Profit Method Valuing Inventory An inventory valuation allows a company to provide a monetary value for items that make up their inventory. Inventories are usually the largest current asset of a business, and proper measurement of them is necessary to assure accurate financial statements. If inventory is not properly measured, expenses and revenues cannot be properly matched and a company could make poor business decisions. A company will chose an inventory accounting system, either perpetual or periodic. In perpetual inventory the accounting records must show the amount of inventory on hand at all times. Periodic inventory is not updated on a regular basis.

Definition of Gross Profit Method The gross profit method is a technique for estimating the amount of ending inventory. The gross profit method might be used to estimate each month's ending inventory or it might be used as part of a calculation to determine the approximate amount of inventory that has been lost due to theft, fire, or other reasons.

The gross profit method assumes that a company’s gross profit rate in the current period is similar to that of the previous periods. It estimates the cost of ending inventory by using the relationship between cost of goods available for sale, cost of goods sold, and ending inventory in the cost of goods sold model.

The gross profit method includes the following steps: Step 1. Calculate the historical gross profit rate, as shown below, ¿ Historical Gross Profit Rate=Gross Profit ¿ prior Periods Net sales ¿ prior Periods ¿ Step 2. Calculate the cost of goods available for sale in the current period, as shown below, Cost of Goods Available for Sale = Beginning Inventory + Net Purchases Step 3. Estimate the gross profit for the current period, as shown below,

Estimated Gross Profit= Historical Gross Profit Rate x Net Sales Revenue (current period) Step 4. Estimate the cost of goods sold for the period Estimate Costs of Goods Sold= Net Sales Revenue (current period) – Estimated Gross Profit Step 5. Determine the estimated cost of the ending inventory Ending Inventory= Cost of Goods Available for Sale – Estimated Cost of Goods Sold Example: Gross Profit Method Hardin Company has the following information related to its inventory: Net Sales for the period

130,000

Beginning inventory, cost

10,000

Net purchases for the period

90,000

Estimated historical gross profit rate on net sales

40%

Solution: Estimated gross profit rate (given)

40%

Beginning inventory, at cost

10,000

Net purchases

90,000

Cost of goods available for sale

100,000

Less: Estimated cost of goods sold: Net sales

130,000

Gross profit rate

x

Estimated gross profit

Sales Estimated gross profit

0.40

52,000

130,000 ( 52,000)

Cost of goods sold (130,000 – 52,000) Estimated cost of ending inventory

(78,000) 22,000

PROBLEMS PROBLEM 1 How is the gross profit method used as it relates to inventory valuation? a. Verify the accuracy of the perpetual inventory records. b. Verity the accuracy of the physical inventory. c. To estimate cost of goods sold. d. To provide an inventory value of LIFO inventories. PROBLEM 2 Which of the following is not a basic assumption of the gross profit method? a. The beginning inventory plus the purchases equal total goods to be accounted for. b. Goods not sold must be on hand. c. If the sales, reduced to the cost basis, are deducted from the sum of the opening inventory plus purchases, the result is the amount of inventory on hand. d. The total amount of purchases and the total amount of sales remain relatively unchanged from the comparable previous period. PROBLEM 3 The gross profit method of inventory valuation is invalid when a. a portion of the inventory is destroyed. b. there is a substantial increase in inventory during the year. c. there is no beginning inventory because it is the first year of operation. d. none of these. PROBLEM 4 Which statement is not true about the gross profit method of inventory valuation? a. It may be used to estimate inventories for interim statements. b. It may be used to estimate inventories for annual statements. c. It may be used by auditors. d. None of these. PROBLEM 5 The following information is available for October for Barton Company. Beginning inventory Net purchases Net sales Percentage markup on cost

$ 50,000 150,000 300,000 66.67%

A fire destroyed Barton’s October 31 inventory, leaving undamaged inventory with a cost of $3,000. Using the gross profit method, the estimated ending inventory destroyed by fire is

a. $17,000. b. $77,000. c. $80,000. d. $100,000. ANSWER: a ($50,000 + $150,000) – ($300,000 ÷ 5/3) – $3,000 = $17,000. PROBLEM 6 The following information is available for October for Norton Company. Beginning inventory Net purchases Net sales Percentage markup on cost

$100,000 300,000 600,000 66.67%

A fire destroyed Norton’s October 31 inventory, leaving undamaged inventory with a cost of $6,000. Using the gross profit method, the estimated ending inventory destroyed by fire is a. $34,000. b. $154,000. c. $160,000. d. $200,000. ANSWER: a ($100,000 + $300,000) – ($600,000 ÷ 5/3) – $6,000 = $34,000. PROBLEM 7 Miles Company, a wholesaler, budgeted the following sales for the indicated months: June July August Sales on account $1,800,000 $1,840,000 $1,900,000 Cash sales 180,000 200,000 260,000 Total sales $1,980,000 $2,040,000 $2,160,000 All merchandise is marked up to sell at its invoice cost plus 20%. Merchandise inventories at the beginning of each month are at 30% of that month's projected cost of goods sold. The cost of goods sold for the month of June is anticipated to be a. $1,440,000. b. $1,500,000. c. $1,520,000. d. $1,650,000. ANSWER: d (1 +0 .2)C = 1,980,000 1.2 1.2 C = $1,650,000.

Merchandise purchases for July are anticipated to be a. $1,632,000. b. $2,076,000. c. $1,700,000. d. $1,730,000. ANSWER: d COGS: July = $2,040,000 ÷ 1.2 = $1,700,000 Aug. = $2,160,000 ÷ 1.2 = $1,800,000 July's purchase = ($1,700,000 × .7) + ($1,800,000 ×0 .3) = $1,730,000.

PROBLEM 8 Reyes Company had a gross profit of $360,000, total purchases of $420,000, and an ending inventory of $240,000 in its first year of operations as a retailer. Reyes’s sales in its first year must have been a. $540,000. b. $660,000. c. $180,000. d. $600,000. ANSWER: a $360,000 + ($420,000 – $240,000) = $540,000. PROBLEM 9 On January 1, 2010, the merchandise inventory of Glaus, Inc. was $800,000. During 2010 Glaus purchased $1,600,000 of merchandise and recorded sales of $2,000,000. The gross profit rate on these sales was 25%. What is the merchandise inventory of Glaus at December 31, 2010? a. $400,000. b. $500,000. c. $900,000. d. $1,500,000. ANSWER: c COGS = $2,000,000 × .75 = $1,500,000 $800,000 + $1,600,000 – $1,500,000 = $900,000. PROBLEM 10 For 2010, cost of goods available for sale for Tate Corporation was $900,000. The gross profit rate was 20%. Sales for the year were $800,000. What was the amount of the ending inventory? a. $0. b. $260,000. c. $180,000. d. $160,000.

ANSWER: b $900,000 – ($800,000 × .80) = $260,000. PROBLEM 11 On April 15 of the current year, a fire destroyed the entire uninsured inventory of a retail store. The following data are available: Sales, January 1 through April 15 Inventory, January 1 Purchases, January 1 through April 15 Markup on cost

$300,000 50,000 250,000 25%

The amount of the inventory loss is estimated to be a. $60,000. b. $30,000. c. $75,000. d. $50,000. ANSWER: a $50,000 + $250,000 – ($300,000/1.25) = $60,000. PROBLEM 12 The sales price for a product provides a gross profit of 25% of sales price. What is the gross profit as a percentage of cost? a. 25%. b. 20%. c. 33%. d. Not enough information is provided to determine. ANSWER: c 25% ÷ (100% – 25%) = 33%. PROBLEM 13 Gamma Ray Corp. has annual sales totaling $650,000 and an average gross profit of 20% of cost. What is the dollar amount of the gross profit? a. $130,000. b. $97,500. c. $108,333. d. $162,500. ANSWER: c $650,000 – ($650,000 ÷ 1.20) = $108,333. PROBLEM 14 On August 31, a hurricane destroyed a retail location of Vinny's Clothier including the entire inventory on hand at the location. The inventory on hand as of June 30 totaled $320,000. Since June 30 until the time of the hurricane, the company made purchases of $85,000 and had sales of

$250,000. Assuming the rate of gross profit to selling price is 40%, what is the approximate value of the inventory that was destroyed? a. $320,000. b. $181,500. c. $205,000. d. $255,000. ANSWER: d ($320,000 + $85,000) – [$250,000 × (1 – 0.40)] = $255,000. PROBLEM 15 On October 31, a fire destroyed PH Inc.'s entire retail inventory. The inventory on hand as of January 1 totaled $680,000. From January 1 through the time of the fire, the company made purchases of $165,000 and had sales of $360,000. Assuming the rate of gross profit to selling price is 40%, what is the approximate value of the inventory that was destroyed? a. $680,000. b. $673,000. c. $485,000. d. $629,000. ANSWER: d ($680,000 + $165,000) – [$360,000 × (1 – 0.40)] = $629,000. PROBLEM 16 On March 15, a fire destroyed Interlock Company's entire retail inventory. The inventory on hand as of January 1 totaled $1,650,000. From January 1 through the time of the fire, the company made purchases of $683,000, incurred freight-in of $78,000, and had sales of $1,210,000. Assuming the rate of gross profit to selling price is 30%, what is the approximate value of the inventory that was destroyed? a. $2,048,000. b. $1,486,000. c. $1,564,000. d. $2,411,000. ANSWER: c $1,650,000 + $683,000 + $78,000 – [$1,210,000 × (1 – 0.30)] = $1,564,000. PROBLEM 17 Keen Company's accounting records indicated the following information: Inventory, 1/1/10 Purchases during 2010 Sales during 2010

$ 600,000 3,000,000 3,800,000

A physical inventory taken on December 31, 2010, resulted in an ending inventory of $700,000. Keen's gross profit on sales has remained constant at 25% in recent years.

Keen suspects some inventory may have been taken by a new employee. At December 31, 2010, what is the estimated cost of missing inventory? a. $50,000. b. $150,000. c. $200,000. d. $250,000. ANSWER: a $3,800,000 × 0.75 = $2,850,000 (COGS) $600,000 + $3,000,000 – $2,850,000 – $700,000 = $50,000 PROBLEM 18 An inventory taken the morning after a large theft discloses $60,000 of goods on hand as of March 12. The following additional data is available from the books: Inventory on hand, March 1 Purchases received, March 1 – 11 Sales (goods delivered to customers)

$ 84,000 63,000 120,000

Past records indicate that sales are made at 50% above cost. Instructions Estimate the inventory of goods on hand at the close of business on March 11 by the gross profit method and determine the amount of the theft loss. Show appropriate titles for all amounts in your presentation. Solution Beginning Inventory Purchases Goods Available Goods Sold ($120,000 ÷ 150%) Estimated Ending Inventory Physical Inventory Theft Loss

$ 84,000 63,000 147,000 80,000 67,000 60,000 $ 7,000

PROBLEM 19 On January 1, a store had inventory of $48,000. January purchases were $46,000 and January sales were $90,000. On February 1 a fire destroyed most of the inventory. The rate of gross profit was 25% of cost. Merchandise with a selling price of $5,000 remained undamaged after the fire. Compute the amount of the fire loss, assuming the store had no insurance coverage. Label all figures. Solution Beginning Inventory

$ 48,000

Purchases Goods available Cost of sale ($90,000 ÷ 125%) Estimated ending inventory Cost of undamaged inventory ($5,000 ÷ 125%) Estimated fire loss

46,000 94,000 (72,000) 22,000 (4,000) $18,000

PROBLEM 20 Utley Co. prepares monthly income statements. Inventory is counted only at year end; thus, month-end inventories must be estimated. All sales are made on account. The rate of mark-up on cost is 20%. The following information relates to the month of May. Accounts receivable, May 1 Accounts receivable, May 31 Collections of accounts during May Inventory, May 1 Purchases during May

$21,000 27,000 90,000 45,000 58,000

Instructions Calculate the estimated cost of the inventory on May 31. Solution Collections of accounts Add accounts receivable, May 31 Deduct accounts receivable, May 1 Sales during May

$ 90,000 27,000 (21,000) $ 96,000

Inventory, May 1 Purchases during May Goods available Cost of sales ($96,000 ÷ 120%) Estimated cost of inventory, May 31

$ 45,000 58,000 103,000 (80,000) $ 23,000

Chapter 14 Retail Inventory Method Retail inventory method is a method of estimating the value of the entity’s inventory that are large in size which is stated in PAS 2, paragraph 22. It also provides the ending inventory balance of an entity by measuring the cost of inventory relative to the price of the goods.

Treatment of items under Retail Inventory Method Purchase Discount Purchase Returns Purchase Allowance Departmental transfer out (credit) Departmental transfer in (debit) Sales discount Sales allowance Sales return Freight in Employee Discounts Normal shortage, shrinkage, spoilage, and breakage Abnormal shortage, shrinkage, spoilage, and breakage

Cost ✓ ✓ ✓ (deductions from purchases) ✓ (deductions from purchases) ✓ (addition to purchases)

Retail ✓

✓ (deductions from purchases) ✓ (addition to purchases)

Disregarded Deducted from sales ✓ (addition) Addition to sales ✓ (deductions from GAFS) ✓ (deductions from ✓ (deductions from GAFS) GAFS)

There are three approaches that can be used under the retail inventory method: (1) Conservative or conventional or lower of cost and net realizable value approach (2) Average cost approach (3) FIFO approach Illustration Cost Beginning inventory Purchases Net markup

Retail P650,000 P1,000,000 4,130,200 6,310,000 400,000

Net markdown Sales Normal Shoplifting Loss

350,000 6,720,000 120,000

Conservative and Average Cost Cost

Retail

Beginning inventory

P650,000

P1,000,000

Purchases

4,130,200

6,310,000

Net markup GAS Conservative

.

400,000

P4,780,200

P7,710,000

Cost Ratio (4,780,200/7,710,000) 62% Net markdown

.

GAS Average

P4,780,200

(350,000) P7,360,000

Cost Ratio (4,780,200/7,360,000) 64.95% Less: Sales

(P6,720,000)

Normal Shoplifting Loss

(P120,000)

Ending inventory at retail

P520,000

Conservative cost (520,000*62%)

P322,400

Average cost (520,000*64.95%)

P337,740 PROBLEMS

1. SeaGod Company used the average retail inventory method to account for inventory. The company gathered the following information: Beginning inventory Purchases Purchase returns Purchase discounts

Cost P200,000 2,030,000 35,000 40,000

Retail P704,000 3,750,000 32,000 80,000

Markup Markup cancellation Net markdown Normal shoplifting losses Sales

150,000 72,000 120,000 30,000 4,000,000

What amount should be reported as COST OF GOODS SOLD? (a.) 1,987,380 (b.)1,880,000 (c.) 1,992,000 (d.)1,900,000 2. In the preceding problem what is the cost of inventory under lower of cost and net realizable value? (a.) 168,000 (b.)172,620 (c.) 150,000 (d.)186,000

3. Thalia Company used the conventional retail inventory method to account for inventory. Thalia Company has the following information: Beginning inventory Purchases Purchase returns Purchase discounts Markup Markup cancellation Net markdown Employee discounts Sales

Cost P800,000 4,320,000 100,000 50,000

Retail P1,720,000 7,750,000 120,000 45,000 200,000 50,000 100,000 50,000 6,350,000

1. What amount should be reported as COST OF GOODS SOLD? (a.) 4,730,000 (b.) 4,370,000 (c.) 4,970,000 (d.) 4,900,000 4. Hokage Company had always measured finished goods at selling price and prepared the following statement on this basis: Sales Raw materials used at cost Labor

P1,200,000 450,000 475,000

Overhead Total Goods in process at cost January 1 545,000 December 31 600,000 Cost of goods manufactured Finished goods at selling price January 1 300,000 December 31 800,000 Gross income

110,000 1,035,000

55,000 980,000

500,000

500,000 700,000

1. What is the amount of goods manufactured at retail? (a.) 1,700,000 (b.)1,165,850 (c.) 2,000,000 (d.)300,000

5. Thief Company uses the average retail inventory method. On December 31, 2020 the following information relating to the inventory was gathered: Cost Inventory, January 1 Purchases Purchase Discounts Freight-in Markups Markdowns Sales Sales return Sales discount Sales allowance

Retail P190,000 2,990,000 40,000 150,000

450,000 4,750,000 300,000 50,000 4,400,000 100,000 50,000 30,000

1. What is the estimated cost of inventory on December 31, 2020? 6. If the thief company uses the conventional method of retail inventory what is the cost of ending inventory on December 31? (a.) 368,500 (b.) 372,295 (c.) 347,215 (d.) 378,500 7. TS Company used the conventional retail inventory method to account for inventory

Beginning inventory Purchases Net markup Net markdown Sales

Cost P550,000 5,450,000

Retail P1,500,000 7,700,000 400,000 100,000 6,500,000

1. What is the conventional cost ratio for TS Company? (a.) 62% (b.)63.83% (c.) 63% (d.)62.5% 2. What is the cost of ending inventory under conventional approach? (a.) 343,750 (b.) 351,065 (c.) 333,750 (d.)434,750 8. What amount should be reported as cost of goods sold? (a.) 5,648,000 (b.) 5,565,250 (c.) 5,656,250 (d.) 5,500,000 9. ADA Company uses the average cost retail inventory method: Beginning inventory Net purchases Departmental transfer- credit Net markup Inventory shortage- sales price Employee discounts Net markdown Sales

Cost P250,000 1,200,000 100,000

Retail

1. What is the estimated cost of ending inventory? (a.) 182,936 (b.)190,189 (c.) 182,277 (d.)180,000 10. What is the estimated cost of ending inventory under conservative method? (a.) 182,936 (b.)190,189 (c.) 182,277 (d.)180,000

P470,000 3,000,000 145,000 150,000 94,000 78,000 132,000 2,700,000

11. On December 31, 2018, the following information was available from Percy Company’s accounting records: Cost Inventory, January 1 Purchases Additional markups

P645,000

Retail P1,015,000

4,165,000 -----

5,300,000 210,000

4,810,000

6,525,000

Sales for the year totaled P5,035,000. Markdowns amounted to P70,000. Under the conventional approach, what is the ending inventory on December 31, 2018? (a.) (b.) (c.) (d.)

975,682 1,420,000 4,810,000 795,282

12. Festus Company uses the conservative cost retail inventory method. The following information is available for the year ended December 31, 2019. Inventory- January 1 Net Purchases Net markup Inventory shortage Employee discounts Sales (including sales of P400,000 of items which were marked down from P500,000

Cost P1,700,000 3,700,000

Retail P2,250,000 4,900,000 250,000 100,000 120,000 4,000,000

1. What is the estimated cost of inventory on December 31, 2019? (a.) 1,955,596 (b.)2,097,368 (c.) 1,555,596 (d.)2,997,368

13. What is the estimated cost of inventory under average method on December 31, 2019? (a.) 2,097,368

(b.)1,555,596 (c.) 2,997,368 (d.)1,955,596 14. Apollo Company used the conventional retail inventory method to account for inventory. Beginning inventory Purchases Markup

Cost P750,000 5,350,000

Retail P1,250,000 7,240,000 145,000

Sales for the year totaled P6,500,00. Markdown amounted to P130,000. 1. Under the average cost approach what amount should be reported as cost of goods sold? (a.) 4,700,000 (b.) 4,475,700 (c.) 4,745,000 (d.) 4,574,700 15. Athena Company provided the following data: Beginning inventory Cost

P400,000

Selling price

675,000

Cost

P3,040,000

Selling price

4,535,000

Purchases

Transportation in

45,000

Purchase discount

40,000

Purchase return: Cost

25,000

Selling price

40,000

Sales return

60,000

Sales discount

20,000

Markup

75,000

Markdown

50,000

Cancellation of markup

25,000

Cancellation of markdown

15,000

Sales

4,000,000

a. What is the estimated cost of ending inventory using the lower of average cost and net realizable value approach? (a.) 609,472 (b.)582,200 (c.) 614,100 (d.)596,400 b. What is the estimated cost of ending inventory using the average cost approach? (a.) 614,100 (b.) 616,859 (c.) 850,000 (d.) 616,589 16. Hypnos Company obtained the following information about the business: 2022 Beginning Inventory Purchases Purchase return Net Markup Net Markdown Sales Normal Spoilage and Breakage Departmental transfer out

Cost

Retail P90,000 196,000 2,000

P132,000 311,000 6,000 5,000 2,600 500,000 12,000

5,000

8,000

1. Determine the ending inventory using the FIFO approach under the retail inventory method? (a.) 57,240 (b.)307,400 (c.) 217,200 (d.) 164,664 17. What is the cost of goods sold of Hypnos Company? (a.) 57,240

(b.)307,400 (c.) 217,200 (d.)164,664 18. Acolus company gathered the following information from its records in the year 2025 Cost Beginning inventory Purchases Purchase returns Purchase allowances Purchase discounts Freight in Net markup Net markdown Abnormal losses Departmental transfer out

Retail P70,000 340,000 (20,000) (2,000) (1,000) 4,000

P126,000 438,000 (20,000)

24,000 (10,000) (22,000) (9,000) P264,000

(12,000) P524,000

19. Determine the cost of inventory on December 31, 2025 under the FIFO retail approach if the company has a sale of P520,000? Janus supermarket uses the retail method of inventory. At the end of May, the records provide the following: Purchases during May: at cost P2,400,000; at retail P4,000,000 Sales during May: P3,200,000 Inventory, May 1: at cost P450,000; at retail P800,000 Markup: 40,000 Markdown: 20,000 Abnormal losses: 12,300 Inventory shortage: 14,000 Estimate the inventory and the cost of goods sold under the FIFO approach of retail inventory method?

20. In the preceding problem what is the cost of goods sold to be recorded by the company?

SOLUTIONS Problem 1. ANSWER: A Cost Beginning inventory Purchase Purchase returns Purchase discounts Markup Markup cancellation GAFS Cost ratioconservative (2,165,000/4,506,000) Net markdown GAFS Cost ratio- average (2,160,000/4,380,000) Less: Sales Normal shoplifting losses Ending inventory Average cost (350,000*49.32%) 172,620 GAFS 2,160,000 Less: Ending Inventory (172,620) COGS 1,987,380

Retail P200,000 2,030,000 (30,000) (40,000)

P704,000 3,750,000 (32,000) 150,000 (72,000) 4,500,000

. 2,160,000 48% . 2,160,000 49.32 %

(120,000) 4,380,000 (4,000,000) (30,000) 350,000

Problem 2. ANSWER: A Problem 3. ANSWER: B Cost Beginning inventory Purchase Purchase returns Purchase discounts Markup Markup cancellation GAFS Cost ratioconservative (4,970,000/7,100,000) Net markdown GAFS Cost ratio- average (4,970,000/7,000,000) Less: Sales

Retail P800,000 4,320,000 (100,000) (50,000) . 4,970,000 70% . 4,970,000 71%

P1720,000 5,750,000 (120,000) (200,000) (50,000) 7,100,000 (100,000) 7,000,000 (6,350,000)

Employee Discounts Ending inventory Average cost (600,000*70%) 420,000 GAFS 4,970,000 Less: Ending Inventory (600,000) COGS 4,370,000

(50,000) 600,000

Problem 4. ANSWER: A Cost

Retail

Finished goods- January 1

172,950

300,000

Cost of goods manufactured

165,850

1,700,000

GAFS

338,800

2,000,000

Less: Finished Goods- December 31

461,200

800,000

COGS 800,000 Cost ratio: goods manufactured at cost/ goods manufactured at retail (980,000/1,700,000) =57.65% Finished Goods January 1- 300,000*57.65% = 172,950 December 31- 800,000*57.65% = 461,200

1,200,000

Problem 5. ANSWER: B Cost Inventory, January 1 Purchase Purchase discounts Freight in Markup GAFS Cost ratioconservative (3,283,000/4,900,000) Net markdown GAFS Cost ratio- average (3,283,000/4,850,000) Less: Sales Sales return

Retail 190,000 2,987,000 (40,000) 145,000 . 3,283,000 67%

450,000 4,750,000

. 3,283,000 67.69%

(50,000) 4,850,000

(300,000) 4,900,000

(4,400,000) 100,000

Ending inventory Conservative cost (550,000*67%)

550,000 P368,500

Average cost (550,000*67.69%)

P372,295

Problem 6. ANSWER: A Problem 7. ANSWER: D Beginning inventory Purchases Net markup GAFS Cost ratio- conservative (6,000,000/9,600,000) Net markdown GAFS Cost ratio- average (6,000,000/9,100,000) Less: Sales Ending inventory Average cost (550,000*62.5%) 343,750 GAFS 6,000,000 Less: Ending Inventory (343,750) COGS 5,656,250

Cost P550,000 5,450,000 . 6,000,000 62.5% . 6,000,000 63.83%

Retail P1,500,000 7,700,000 400,000 9,600,000 100,000 9,100,000 8,550,000 550,000

Problem 8. ANSWER: C Problem 9. ANSWER: B Problem 10. ANSWER: A Beginning inventory Net purchases Departmental transfer- credit Net markup GAFS Cost ratio- conservative (1,350,000/3,475,000) Net markdown GAFS Cost ratio – average (1,350,000/3,343,000) Less: Sales

Cost P250,000 1,200,000 (100,000) . 1,350,000 38.84% . 1,350,000 40.38%

Retail P470,000 3,000,000 (145,000) 150,000 3,475,000 (132,000) 3,343,000

(2,700,000)

Inventory shortage- sales price Employee discounts Ending inventory Conservative cost (471,000*38.84%)

(94,000) (78,000) 471,000 P182,936.4 or 182,936

Average cost (471,000*40.38%)

P190,189.8 or 190,189

Problem 11. ANSWER: A

Cost Available for sale Markdowns Sales Inventory – December 31 Conservative cost ratio (4,810,000/7,000,000) Inventory – December 31 at cost

Retail 4,810,000

6,525,000 (70,000) (5,035,000) 1,420,000 68.71% 975,682

Problem 12. ANSWER: A Problem 13. ANSWER: A Cost Inventory- January 1 Net Purchases Net markup GAFS Cost ratioconservative (5,400,000/7,400,000) Net markdown GAFS Cost ratio- average (5,400,000/6.900,000) Less: Sales Inventory shortage Employee discounts Ending inventory Conservative cost (2,680,000*72.97%) Average cost (2,680,000*78.26%)

Retail P1,700,000 3,700,000 5,400,000 72.97% . 5,400,000 78.26%

P2,250,000 4,900,000 250,000 7,400,000 (100,000) 6,900,000 (4,000,000) (100,000) (120,000) 2,680,000

P1,955,596 P2,097,368

Problem 14. ANSWER: D Beginning inventory Purchases

Cost P746,000 5,350,100

Retail P1,354,800 7,240,000

Net markup GAFS Cost ratio- conservative (5,996,100/8,690,000) Net markdown GAFS Cost ratio- average (5,996,100 /8,560,000) Less: Sales Ending inventory Average cost (2,060,000*69%) 1,421,400 GAFS 5,996,100 Less: Ending Inventory (1,421,400) COGS 4,574,700

. 5,996,100 69% . 5,996,100 70.05%

145,200 8,690,000 130,000 8,560,000 6,500,000 2,060,000

Problem 15. ANSWER: C ANSWER: B Cost Beginning inventory Purchases Transportation in

Retail 400,000

675,000

3,070,000

4,300,000

45,300

Purchase return

(25,000)

Purchase discount

(30,000)

Markup Cancellation of markup GAFS Cost ratio – conventional (3,450,000/4,985,000)

75,000 .

(25,000)

3,430,600

4,985,000

69%

Markdown Cancellation of markdown GAFS Cost ratio – average (3,430,600/4,950,000)

(40,000)

(50,000) .

15,000

3,430,600

4,950,000

69.31%

Less: Sales

4,000,000

Sales return

(60,000)

Ending inventory at selling price Conservative cost (890,000*69%)

890,000 P614,100

Average cost (890,000*69.31%)

P616,859

Problem 16. ANSWER: A 2022 Beginning Inventory Purchases Purchase return Net Markup Net Markdown (184,440/307,400) 60% GAFS Sales Normal Spoilage and Breakage Ending inventory at retail

Cost

Retail P90,000 186,480 (2,040)

P300,000 311,000 (6,000) 5,000 (2,600) 307,400 607,400 (500,000) (12,000)

. 184,440 274,440

95,400

FIFO cost (95,400*60%) = 57,240 GAFS

274,440

Ending inventory

(57,240) 217,200

Problem 17. ANSWER: C Problem 18. Solution Cost Beginning inventory Purchases Purchase returns Purchase allowances Purchase discounts

Retail P70,000 347,000 (20,000) (2,000) (1,320)

P126,000 450,000 (20,000)

Freight in Departmental transfer out Net markup Net markdown (319,680/432,000) 74% GAFS Less: Sales Abnormal losses

5,000 (9,000)

(12,000) 24,000 (10,000) 432,000 558,000

. 319,680 389,680

(520,000) (22,000) 16,000

FIFO cost (16,000*74%) = 11,840 Problem 19. Cost Beginning inventory Purchases Net markup Net markdown (2,371,800/4,020,000) 59% GAFS Less: Sales Abnormal losses Inventory shortage Ending inventory at retail FIFO cost (1,593,700*59%) = 940,283 GAFS

2,821,800

Ending inventory

(1,593,700)

COGS

1,228,100

Problem 20.

ANSWER: P1,228,100

Retail P450,000 2,371,800 . 2,371,800 2,821,800

P800,000 4,002,830 37,170 (20,000) 4,020,000 4,820,000 (3,200,000) (12,300) (14,000) 1,593,700

CHAPTER 15 FINANCIAL ASSET VALUE AT FAIR VALUE Learning Objectives:    

To define a financial asset To know the three classifications of financial asset in accordance with the PFRS 9 To determine the initial and subsequent measurement of financial asset To understand the measurement of financial asset at FVPL,FVOCI and at amortized cost of equity and debt investments

Definition of financial asset Financial asset refer to assets that arise from contractual agreements on future cash flows or from owning equity instruments of another entity. Financial assets include:     

Cash Equity instruments of an entity- for example a share certificate A contractual right to receive a financial asset from another entity-known as receivable The contractual right to exchange financial assets for liabilities with another entity under favorable conditions A contract that will settle in an entity’s own equity instruments

Not considered financial assets      

Property, plant and equipment Inventory Intangible assets Prepaid expenses Leased assets Intellectual properties

Classification of financial assets In accordance PFRS 9, paragraph 4.1.1, financial assets are to be classified in the following three categories: 1. Financial asset at fair value through profit and loss- including both equity securities and debt securities.

2. Financial asset at fair value through other comprehensive income- including both equity securities and debt securities. 3. Financial asset at amortized cost – including only the debt securities.

What is an equity security? Equity security is a financial instrument that representing an ownership of shares and right, warrants or options in a corporation. Examples:   

Common stock Preferred stock Put and call options

What is a debt security? Debt security is a financial asset the relationship between the issuer and an investor. Examples:     

Corporate bonds Commercial papers BSP treasury bills Government securities Redeemable preferred stock

Initial measurement of financial asset In accordance to the PFRS 9, at initial recognition, an entity shall measure financial asset at its fair value plus the transaction cost directly attributable to the acquisition of the financial asset in the case of financial asset at fair value through profit or loss. At the time of initial recognition, the financial asset held for trading are recognized at fair value through profit or loss, not including the transaction cost which are expensed outright. Subsequent measurement After the initial recognition, the entity classifies it based on the entity’s business model for managing the asset and the asset’s contractual cash flows, as follows:  

Fair value through profit or loss Fair value through other comprehensive income



Amortized cost

Financial assets at fair value through profit or loss Financial asset measured at “fair value through profit or loss” are the following: 



Financial asset held specifically for trading purposes -financial assets held for trading purposes are also known as trading securities. It is held for trading if the entity acquired it for the purpose of selling it in the near future. Financial asset to be measured at fair value under the fair value option at designation - The fair value option is applicable to all financial investments which can be irrevocably designated as fair value through profit or loss although it can satisfy the financial asset at fair value through other comprehensive income and amortized cost.

Gain or loss – Financial asset at fair value Gains and losses on “Financial assets at fair value through profit or loss” are immediately booked to the Income Statement. Illustration To record the acquisition Trading securities

xx

Cash

xx

To record the increase in fair value Trading securities

xx

Unrealized gain- TS

xx

To record the decrease in fair value Unrealized loss

xx

Trading securities

xx

Sale of trading securities 

Gain

Cash

xx Trading securities

xx

Gain on sale of trading securities

xx



Loss

Cash

xx

Loss on sale of trading securities

xx

Trading securities

xx

Equity investment at fair value through other comprehensive income Illustration To record the acquisition Financial asset-FVOCI

xx

Cash

xx

FVOCI – it means the financial asset is measured at fair value through OCI To record the increase in the market value Financial asset-FVOCI

xx

Unrealized gain-OCI

xx

To record the decrease in the market value Unrealized loss- OCI

xx

Financial asset- FVOCI

xx

Sale of equity investment 

Gain

Cash

xx Financial asset-FVOCI

xx

Retained earnings  Cash

xx

Loss xx

Retained earnings Financial asset-FVOCI

xx xx

The gain or loss in the equity investment at fair value through OCI is recognized in the retained earnings. Debt investment at amortized cost Amortized cost classification applies predominantly to debt investment which meets the following criteria:  The business model of the company which owns such financial assets is to collect the contractual cash flows rather than sell the asset to realize any capital gains.  The contractual cash flows of specific financial asset under consideration are on account of repayment of principal and interest and they occur on specified dates. Debt investment at fair value through OCI Financial asset are classified and measured at fair value through other comprehensive income if the following criteria are met:  The business model whose objective is achieved by both collecting contractual cash flows and selling financial assets.  The contractual cash flows of specific financial asset under consideration are on account of repayment of principal and interest and they occur on specified dates.

TRUE or FALSE ________1.The fair value option is applicable to all financial instruments. ________2.The gain or loss in the equity investment at fair value through OCI is not recognized in the retained earnings. ________3.The financial asset-FVOCI is normally classified as current asset. ________4.Financial asset is recognized initially at fair value. ________5.Intangible assets, physical assets, prepaid expenses and leased expenses are considered as financial assets. ________6.The unrealized loss is reported in the income statement as other income. ________7.The unrealized gain is reported in the income statement as other income. ________8.The gain or loss in the sale of trading securities is reported in the income statement. ________9.If the fair value is higher than the carrying amount the difference is an unrealized loss. ________10. If the fair value is higher than the carrying amount the difference is an unrealized gain. Answer key 1. 2. 3. 4.

TRUE FALSE FALSE TRUE

5. FALSE 6. FALSE 7. TRUE 8. TRUE 9. FALSE 10. TRUE

Problem 15-1 At the beginning of the year , Gem company purchased marketable equity securities as a trading investment. For the year ended December 31,2019, the company recognized an unrealized loss of P300,000 There were no security transactions during 2020. The entity provided the following information on December 31, 2020:

Security A B

Cost 3,000,000 1,800,000 4,800,000

Market value 2,400,000 2,200,000 4,600,000

In the 2020 income statement, what amount should be reported as unrealized gain or loss? a. Unrealized gain 100,000 b. Unrealized loss 150,000 c. Unrealized gain 150,000

d. Unrealized loss 100,000 Solution 15-1 Answer a Market value-December 31,2020 Carrying amount equal to market value

4,600,00 0

on December 31,2019 Unrealized gain in 2020

4,500,00 0 100,000

Cost Unrealized loss-2019 Market value- December 31,2019

4,800,00 0 300,000 4,500,00 0

Problem 15-2 On December 31,2019, Kayos Company appropriately reported a P200,000 unrealized loss Securit y A B C

Cost 3,000,00 0 1,800,00 0 2,000,00 0 6,800,00 0

Market value (December 31,2020) 2,400,000 2,100,000 1,500,000 6,000,000

1.What is the market value of the investment on December 31,2019? a.6,700,000 b.6,600,000

c.6,800,000 d.6,500,000 2.What amount of loss on these securities should be included in the statement of comprehensive income for the year ended December 31, 2020 as component of other comprehensive income? a.0 b.500,000 c.600,000 d.800,000 3.What cumulative amount of loss on these securities should be reported in the statement in changes of equity for the year ended December 31,2020 as component of other comprehensive income? a.0 b.500,000 c.600,000 d.800,000

Solution 15-2 1. Answer b Total cost Unrealized loss in 2019 Market value - December 31,2019

6,800,00 0 (200,000) 6,600,00 0

2. Answer c Market value-December 31,2020 Market value-December 31,2019

6,000,000 (6,600,000

Unrealized loss in 2020

) (600,000)

3. Answer d Market value-December 31,2020 Original historical cost Cumulative unrealized loss- December 31,2020

6,000,000 (6,800,00 0) (800,000)

Problem 15-3 At te beginning of the current year, Magma Company purchased marketable equity securities to be held as trading for P3,000,000. The entity also paid transaction cost amounting to P500,000. The securities has a market value of P3, 300,000 at the year end and the transaction cost that would be incurred on sale is estimated at P100,000. No securities were sold during the current year. What amount of unrealized gain or loss on these securities should be reported in the income statement for the current year? a.300,000 loss b.300,000 gain c.200,000 loss d.200,000 gain Solution 15-3 Answer b Fair value Acquisition cost-Trading Unrealized gain- included in profit or loss CHAPTER 16 EQUITY INVESTMENTS Dividends, Share split and Share Right Definition

3,300,00 0 3,000,00 0 300,000

Investments are assets acquired to earn additional profit aside from the revenue producing activities or the ordinary course of business. Thus, Investments can be equity or debt securities. Acquisition of Investments Measurement According to PFRS 9 which takes place the requirement of PAS 39 (Recognition and Measurement), financial asset shall be initially recognized at fair value which is considered as the transaction price plus transaction cost directly attributable to the acquisition. Note that directly attributable transaction cost of financial asset must be capitalized except when the financial asset acquired is held for trading which must be expense outright. Acquisition by Exchange Measurement in order of priority 1.) Fair Value of asset given 2.) Fair Value of asset received 3.) Carrying amount of asset given If more than two financial assets are acquired in a lump sum or at a single cost, the cost must be allocated based on the fair value of each financial asset. The single cost of financial asset must be allocated to the one that has known market value and the remainder shall be allocated to those financial assets that do not have market value. Classification of Investments in Equity 1. 2. 3. 4. 5.

Financial Asset at fair value through profit or loss (FVPL) Financial Asset at fair value through other comprehensive income (FVOCI) Investment in Associate Investment in Subsidiary Investment in unquoted equity instrument (measured at cost if fair value is cannot be determined)

Sale of Equity Shares According to Paragraph 3.2.12 of PFRS 9, the difference between net proceeds from sale and the carrying amount of the investment measured at fair value through profit or loss shall be taken as gain or loss. In case of sale of same class equity share acquired on different dates at different costs, FIFO or Average Cost Approach must be used in determining the cost of shares sold. DIVIDENDS Significant dates in dividends distribution

a. Date of Declaration – when Board of Directors declares the distribution of dividends and approved the payment. b. Date of Record – the entity will provide the actual list of shareholders who are entitled to receive dividends. (NO ENRTY) c. Date of Payment – dividends are distributed and paid to the shareholders. Date of Declaration

Shares Selling: “Dividend-on”

Shares Selling: “Ex-Dividend”

Date of Record

Shares sold are carrying the right to receive dividends.

Date of Payment

Only shares are sold, the right to receive dividends are still in the original shareholder.

Dividends shall be recognized as income when right to receive payment is established. However, dividends shall be recognized as income at the date of declaration because at that date legal liability to the corporation arises. CASH DIVIDENDS Accordingly, cash dividends are recognized as income as when received or becomes receivable if securities are measured at fair value through profit or loss, or at fair value though other comprehensive income. However, cash dividends do not affect investment account. Illustration Assume that Aries Corporation acquired 2,000 shares of Mary Corporation at P100 per share. If Aries received P15 per share cash dividend, the entry is: Cash (2000x15) Dividend Income

30,000 30,000

In case Aries sells the investment for 180,000, the entry will be: Cash 180,000 Loss on sale of Investment 50,000 Investment in shares (2,000x100) Dividend Income (2,000x15)

200,000 30,000

PROPERTY DIVIDENDS Dividends distributed in the form of non-cash asset which are considered income and recorded at fair value by the investor.

Illustration Assume that Mary Corporation distributes 2,000 shares of Conor Corporation which are held as investment by Mary Corporation with a fair market value of P120 per share as a property dividend in Aries Corporation, the entry in Aries Corporation is: Investment in shares (2,000x120) Dividend Income

240,000 240,000

LIQUIDATING DIVIDENDS When the entity have the intention to close the business believing that it can no longer generate profit, liquidating dividends are distributed and paid either in the form of cash or noncash assets as a return of invested capital but not an income. Note the when liquidating dividends exceeds the cost of investment, the difference is credited to gain on investment. In contrast, when investment greater than the liquidating dividend received, the balance is written off as a loss. Illustration Assume that a shareholder of Aries Corporation receives P80,000 dividend as an equal amount to his investment, the entry in Aries Corporation is: Cash or other appropriate account Investment in shares

80,000 80,000

SHARE OR STOCK DIVIDENDS Shares dividend in which the entity issues its own shares and is also known as bonus issue. Share dividends can be same class held by shareholder or different from the class held by the shareholder. Share dividends in whatever class are not an income. SHARE DIVIDENDS OF SAME CLASS Share dividends are recorded as memorandum entry. Share dividends affect the carrying value per share held by the investor without affecting the total cost of investment.

Illustration Assume that a shareholder of Aries Corporation acquired 500 shares costing P60,000 or P120 per share. Shareholder receives 100 share dividends. The entry is: Memo Entry: Received 100 new shares of Aries Company representing share dividend on 500 original held. Shares new held, 600 shares.

However, the cost per share now is P100 computed as P60,000 total cost divided by 600 new shares. SHARE DIVIDENDS DIFFERENT FROM THOSE HELD Original cost of the investment is allocated between the original shares and the share dividends on the basis of market value of each at the date of receipt. Illustration Assume that a shareholder of Aries Corporation acquired 500 ordinary shares costing P60,000. Shareholder receives 100 share dividends (preference share). The market value of ordinary and preference share is P110 and 90, respectively. The entry is: Investment in Preference Share Investment in Ordinary Share Original Cost: P60,000 Share Dividend: 100 shares Ordinary Shares: 100 shares x 110 = 11,000 Preference Shares: 100 shares x 90 = 9,000

Allocated Cost

Fraction 20,000 (Market 11/20x60,000 33,000 Value) 9/20x60,000 27,000

SHARES RECEIVED IN LIEU OF CASH DIVIDEND Considered as income at fair value of the shares received, if fair value is cannot be determined, the income shall be equal to the cash dividends that would have been received. To record receipt of shares Investment in Shares Dividend Income (Number of shares x fair value per share)

xxx xxx

CASH RECEIVED IN LIEU OF SHARE DIVIDEND A.) AS-IF APPROACH The share dividends are assumed to be received and subsequently sold at the cash received. Thus, there can be gain or loss to be recognized. Illustration Assume that a shareholder of Aries Corporation acquired 500 ordinary shares costing P60,000. Shareholder receives P15,000 cash in lieu of 100 share dividends. The P60,000 cost will be applied to 600 new shares and the cost per share will be P100. Cash

15,000 Investment in Share (100 shares x 100) Gain on Investment

10,000 5,000

B.) BIR APPROACH The cash received will be recognized as income, as is. Cash

15,000 Dividend Income

15,000

SHARES SPLIT Shares split do not affect the equity (retained earnings). Only memorandum entry is necessary in share split. Share split can be: A.) Split Up – original shares are replaced by a larger number of shares which results to a decrease in par value per share. Example: A shareholder owns 1,000 shares and the share split up 5-for-1. The shareholder receives 5,000 new shares (1000 x 5). B.) Split Down – original shares are replaced by a smaller number of shares which results to an increase in par value per share. Example: A shareholder owns 1,000 shares and the share split up 1-for-5. The shareholder receives 200 new shares (1,000/ 5). SPECIAL ASSESSMENTS Additional capital contribution of the shareholders and recorded as additional cost of the investment through debiting to Investment in shares account and crediting cash account. REDEMPTION OF SHARES Only Preference Share can be called for redemption, thus, it is recorded the same way as sale of share. SHARE RIGHT Share rights are intact to every share, which means that the number of share rights is equal to the number of shares held. However, in such cases, there can be specified number of rights required in acquiring a share. PFRS 9 stated that investment in equity instruments must be measured at fair value. Three important dates in issue of rights: a.) Date of declaration of rights

b.) Date of issue of rights c.) Date of rights expiration ACCOUNTING FOR SHARE RIGHTS 1.) Accounted for separately 2.) Not Accounted for separately Between the Date of Declaration and Date of Record  Shares that are selling are right-on which means that shares and rights are treated as one.  Shares and rights cannot be sold separately.

Between the Date of Record and Expiration Date  Shares that are selling are ex-right which means that shares and rights are treated separately.  Shares and rights can be sold separately.

Illustration: Toto Lee purchased 6,000 shares worth P750,000 and received 6,000 share rights to subscribe for new shares at P120 per share for every 3 rights held. The market value per share and right is P140 and 8, respectively. Original Investment Receipt of Share Right

Accounted for Separately Investment in Shares 750,000 Cash 750,000 (6,000 rights x 8) Share rights 48,000 Investment in shares 48,000

Exercise of (6,000 / 3 x 120) = 240,000 Share Rights Investment in shares 288,000 Cash 240,000 Share rights 48,000 Share Rights Cash 48,000 are not Share rights 48,000 exercised but sold Note: There can be gain or loss on sale. Expiration of share rights

Loss on share rights Share rights

Not Accounted for Separately Investment in Shares 750,000 Cash 750,000 Memorandum Entry: Received 6,000 share rights to subscribe for new shares at P120 per share for every 3 rights held, or a total of 2,000 new shares. (2,000 new shares x 120) = 240,000 Investment in shares 240,000 Cash 240,000 Cash Share rights

xxx xxx

Note: There is NO gain or loss on sale. The amount debited and credited is the amount of sale.

xxx xxx Memorandum Entry

Note: The amount debited and credited is the amount expired or not exercised.

If there is no fair value the theoretical or parity value based on market value of the share shall be used. When the share is selling right-on

Market value of share right on minus subscription price Number of rights to purchase one share plus 1

=

Value of one right

When share is selling ex-right Market value of share ex-right minus subscription price Number of rights to purchase one share

=

Value of one right

PROBLEMS During 2019, Jack Company acquired shares of Jill Company. April 1 15,000 shares @ P90 P1,350,000 August 1 25,000 shares @ P100P2,500,000 Transactions for 2019 February 15 Received 20% share dividend. May 20 Received cash dividend of P20 per share November 10 Sold 20,000 shares @ P100 per share 1.) What is the gain on the sale of shares under FIFO approach? a.) 483,333 b.) 652,400 c.) 450,000 d.) 553,667 2.) What is the gain on sale of share if Average method is used? a.) 495,667 b.) 395,833 c.) 555,000 d.) 552,847 3.) What is the dividend income for the year? a.) 900,000 b.) 800,000 c.) 960,000 d.) 1,200,000 Floor Company owns 15,000 shares of 150,000 Luna’s Company shares. On July 1 of 2018, Luna Company declared and paid P2,000,000 dividends. 1.) What is the dividend income to be reported by Floor Company?

a.) b.) c.) d.)

300,000 200,000 400,000 150,000

On September 2019, Josh Company acquired 20,000 shares at 90 per share. Subsequently, Josh Company received 20,000 share rights to purchase 1 share for 5 share rights at P80 per share. On December 1, the market value of each shares and share rights are P88 and 10, respectively. 1.) What should be the amount to be recorded as Investment in share rights on December 1? a.) 90,000 b.) 100,000 c.) 120,000 d.) 200,000 2.) What should be the amount to be recorded as Investment in shares through the exercise of share rights? a.) 880,000 b.) 900,000 c.) 200,000 d.) 520,000 Amanda Company issued share rights to subscribe to its stock, the ownership of 5 shares entitling the shareholders to subscribe for 1 share at P110. Dawson Company owns 20,000 shares of Amanda Company costing P2,200,000. The share is quoted right-on at P130. What is the cost of the new investment in shares if all of the share rights are exercised? a.) b.) c.) d.)

605,500 500,400 506,600 500,000

TRUE OR FALSE 1.) The single cost of investment acquired or in a lump sum is allocated based on its par value or stated value. FALSE 2.) The order of priority is not necessary in determining the cost of investment acquired by exchange. FALSE 3.) Ana received cash dividend of P10 per share. Her share was determined to be 50,000, therefore, Ana received P500,000 dividend income. In such case, cash dividend received by Ana affects her investment account. FALSE 4.) When the shares are sold after the date of declaration but before the date of record, the shares sold carry the right to receive dividends. TRUE

5.) When the shares are sold after the date of record but before the date of payment, original shareholder has still the right to receive dividends. TRUE 6.) Property Dividend can be in the form of Merchandise. TRUE 7.) When liquidating dividend received the amount will be debited to cash or other appropriate account (other non-cash asset account), which should be considered and recorded as income. FALSE 8.) Danica has an original share of 5,000 at P50 per share or P250,000. On July 30, Danica received 500 share dividends. The total share of Danica as of July 30 is 5,500, therefore, the total cost of her share is P275,000. FALSE 9.) Share dividend increases the total number of shares while maintaining the total cost which results to a reduction in cost per share. TRUE 10.) Split up increases both number of shares and cost per share. FALSE 11.) Split down decreases number of shares and maintaining the total cost of shares. TRUE 12.) Since Share split reduces or increases the number of shares, therefore, it has a direct effect to the total cost of shares held. FALSE 13.) There can be a loss or gain in upon receiving of liquidating dividends. TRUE

CHAPTER 17 INVESTMENT IN ASSOCIATE Basic Principles

Types of Investments Through the concept of “intercorporate share investment”, an entity may have a significant influence or may control the financial and operating activities of another entity by purchasing its equity shares. Below 20% Financial Asset at Fair Value

20% to 50% Significant Influemce

Above50% Control

Outstanding Ordinary Shares of an Investee

Ownership of less than 20% of outstanding ordinary shares of an investee does not manifest significant influence over the investee entity. In order to have the power to participate in the financial and operating policy decisions, an investor must own 20% to 50% of the outstanding ordinary shares. With such investment, an investor can be said to have a significant influence over the investee entity and it is so-called “investment in associate”. Such influence carries on potential voting rights which should be currently exercisable or convertible.

On the other hand, having beyond 50% of the equity shares demonstrates power to govern or control over the entity and known as “investment in subsidiaries”. Investment in Associate The existence of significant influence is usually based on meeting the required rate of 2050% ownership of outstanding ordinary shares. However, PAS 28 paragraph 6 states that this threshold does not always demonstrate it. There are some factors that evidence significant influence which includes:  Material transactions between parties involved  Representation in the board of directors  Partaking in policy making Meanwhile, an investor may lose its significant influence over an investee through:  Contractual agreement  Control of the government, court or regulator against the associate This results to loss of the power to participate in the financial and operating policy decisions of the investee. Accounting Procedures for Investment in Associate Equity Method  Follows the movement of the equity of the associate  Economic relationship wherein the investor and the investee are viewed as a single economic unit  Under this method, investment is classified as noncurrent asset and cash dividend is not treated as an income but a return of investment  Dividend distributions reduce the carrying amount of the investment Illustration 1. At the beginning of the year, C Company acquired 30,000 shares which represent 30% of outstanding ordinary shares of D Company for P100 per share. The acquisition cost equaled the carrying amount of net assets acquired. Investment in associate P3,000,000 Cash P3,000,000 2. D Company reported net income of P6,000,000 for the current year. C Company recognized 30% share of the net income. Investment in associate P1,800,000 Cash P1,800,000 3. D Company issued 10% share dividend.

MEMO ENTRY: Received 3,000 ordinary shares representing 10% share dividend on 30,000 shares. (The share dividend will not affect the equity interest.) 4. On the following year of operation, D Company reported a net loss of P2,000,000. Loss on investment P600,000 Investment in associate P600,000 5. On the same year, the investee declared and paid cash dividend of P2,000,000. Cash P600,000 Investment in associate P600,000

Treatment of Heavy Losses PAS 28, paragraph 38, provides that if an investor’s shares of losses of an associate equals or exceeds the carrying amount of an investment, the investor discontinues recognizing its share of further losses. When the associate reports income, the investor resumes until its share in the net income covered unrecognized share in losses. Impairment Loss PAS 28, paragraph 40, requires that an impairment loss shall be recognized whenever the carrying amount of the investment in associate exceeds recoverable amount. Recoverable amount must be determined between fair value less cost of disposal and value in use, whichever is higher. The impairment loss recognized applies wholly to the investment. Preference Shares In case an investee has outstanding cumulative preference shares:  Investor computes its share of earnings or losses after deducting the preference dividends, regardless of when there is a declaration of dividends or none. In case an investee has outstanding noncumulative preference shares:  Investor computes its share of earnings after deducting the preference dividends only when it was declared. Other Changes in Equity A change in the investor’s proportionate interest is inevitable due to changes in the investee’s equity such as revaluation of property, plant and equipment and differences arising

from foreign exchange translations. The share of the investor in these changes is recognized directly in equity.

True or False 1. If an investor company owns 52% of the outstanding ordinary shares of an investee company, the investor company merely has a significant influence over the other. F 2. Due to a possible neglect of corporate duty, Shai Company was subjected to government control. If Bossing Company has a significant influence on Shai Company, Bossing Company losses the power to partake in the financial decisions of Shai Company due to the incident. T 3. The sole way to have a significant influence over an investee company, an investor must acquire more than 20% but not more than 50% of the outstanding ordinary shares. F 4. The investor’s share of the profit or loss of the investee is recognized as investment income. T 5. The goodwill is not included in the carrying amount of the investment. F 6. The excess of cost attributable to goodwill is amortized. F 7. The entire investment in associate excluding goodwill is tested for impairment at the end of each reporting period. F 8. Dividend distributions reduce the carrying amount of the investment. T 9. Under the equity method, the investor and the investee are not one and not the same but they are viewed as single economic unit. F 10. The equity method is applicable even if the investor does not have a significant influence over the investee. F Problems 1. Paul Company acquired 20% of the outstanding ordinary shares of Mich Company for P8,000,000. The carrying amount of the acquired net assets was P7,200,000. The excess cost over carrying amount was attributed to an undervalued equipment on the investee’s balance sheet. The asset had a remaining useful life of 5 years. For the current year, Mich Company reported net income of P2,000,000 and paid cash dividend of P750,000. What is the carrying amount of the investment in associate at year end? a. P7,840,000

b. P8,000,000 c. P8,090,000 d. P8,690,000 2. On January 1, 2020, Fallen Grace Company purchased 10% of Willford Company’s outstanding ordinary shares for P3,000,000. Fallen Grace Company is the largest single shareholder of Willford. Majority of Willford company’s board of directors are Fallen Grace’s officers. The investee reported net income of P4,000,000 for the current year and paid cash dividend of P1,500,000. What amount should be reported as investment in Willford Company at year end? a. P400,000 b. P3,250,000 c. P3,400,000 d. P3,690,000 For items 3-5, refer to this problem. At the beginning of the current year, Halterground Company purchased 40% of the outstanding ordinary shares of Fantasia Company, paying P6,400,000 when the carrying amount of the net assets of Fantasia Company equaled P12,500,000. The difference was attributed to equipment which had a carrying amount of P3,000,000 and fair market value of P5,000,000 and to building which had carrying amount of P2,500,000 and a fair value of P4,000,000. The remaining useful life of the equipment and building was 4 years and 12 years, respectively. During the current year, Fantasia Company reported net income of P5,000,000 and paid cash dividend of P2,500,000. 3. What is the excess of cost over the carrying amount of assets acquired? a. P 0 b. P1,400,000 c. P3,000,000 d. P5,000,000 4. What amount should be reported as investment income for the current year? a. P1,000,000 b. P1,750,000 c. P1,800,000 d. P2,000,000

5. What is the carrying amount of the investment in associate at year-end? a. P6,400,000 b. P7,150,000 c. P7,400,000 d. P8,150,000 6. On April 1, 2020, Zach Company purchased 40% of the outstanding ordinary shares of Luck Warm Company for P10,000,000. On the same date, Luck Warm net assets were P20,000,000 and Zach cannot attribute the excess of the cost of its investment in Luck Warm over its equity in Luck Warm’s net assets to any particular factor. The investee’s net income for 2020 is P5,000,000. What amount should be reported as investment income for 2020? a. P1,400,000 b. P1,500,000 c. P1,850,000 d. P2,000,000 7. On July 1, 2020, Angel Company purchased 25% of Devine Company’s outstanding ordinary shares and no goodwill resulted from the purchase. Angel appropriately carried this investment at equity and the balance in Angel’s investment account was P1,900,000 on December 31, 2020. Devine Company reported net income of P1, 200,000 for the year ended December 31, 2020, and paid cash dividend totaling P480,000 on December 31, 2020. How much did Angel pay for 25% interest in Devine? a. P1,720,000 b. P1,870,000 c. P2,020,000 d. P2,170,000 For items 8-10, refer to this problem. On January 1, 2020, Jenica Company acquired 30% of the outstanding ordinary shares of Erika Company for an amount of P5,000,000. On this date, Erika Company net assets had a carrying amount of P12,000,000. The equity method is used by Jenica Company in accounting for this investment. A machinery with an average remaining life of 5 years had a fair value that was P2,500,000 in excess of its carrying amount. The remaining difference between the purchase price and the carrying amount of the underlying equity cannot be attributed to any asset. Hence, the remaining difference is allocated to goodwill.

At the end of the year, Erika Company reported net income of P4,000,000 and cash dividend of P1,000,000. 8. What amount should be reported as investment income for 2020? a. P920,000 b. P1,050,000 c. P1,200,000 d. P1,350,000 9. What is the implied goodwill from the acquisition? a. P0 b. P650,000 c. P750,000 d. P1,400,000 10. What is the carrying amount of the investment in associate at year end? a. P5,000,000 b. P5,400,000 c. P5,750,000 d. P5,900,000

paid

CHAPTER 18 INVESTMENT IN ASSOCIATE Other Accounting Issues Upstream and Downstream Transactions Upstream transactions involve the selling of an associate’s assets such as inventory and noncurrent assets to the investor. This transaction results to the elimination of unrealized profit in determining the investor’s share in the profit or loss of the associate. Illustration Camille Company acquired 25% of the outstanding ordinary shares of Dinah Company. During the year, Dinah Company reported a net income of P3,000,000. It also sold inventory amounting to P400,000 for P500,000 to Camille Company. Te inventory remained unsold by Camille Company at the end of the year and Dinah Company paid no dividend. Computation of the share of Camille Company in the profit Dinah Company: Net income P3,000,000 Unrealized profit (100,000) Adjusted net income P2,900,000 Camille Company’s share in the profit= P2,900,000 x 25%= P725,000 *If the inventory was sold by Camille Company on the following year. The company will realize its share in the profit equal to P25,000 (P100,000 x 25%). In recognizing its share, the journal entry would be a debit to Investment in Associate account and a credit to Investment Income. On the other hand, downstream transactions involve the selling of an investor’s assets to the associate. Like in upstream transactions, unrealized profit must also be eliminated in determining the investor’s share in the profit or loss of the associate. Investment Having No Significant Influence In the previous chapter, the equity method in accounting for investment in associate was discussed. The equity method is not applicable when the investor fails to have a significant influence due to either investment of less than 20% or contractual agreement or government control. However, PAS 28 paragraph 17 states that the equity method cannot be also used when the investor:  Is a parent corporation that is exempt from preparing consolidated FS  Is a wholly-owned or partially-owned subsidiary  Debt and equity instruments are not traded Fair Value Method and Cost Method

Fair value method and cost method are methods used in accounting for investment of less than 20% interest. Fair value method is used when financial asset is measured at fair value through profit or loss and through other comprehensive income. Meanwhile, cost method is used in unquoted equity instruments. In applying these methods, dividends received by the investor from the investee are accounted for as dividend income. The investor and investee are independent entities and the investor does not share in the profit or loss of the investee. Illustration Cost Method o At the beginning of the year, an investor acquired 20,000 shares of the 200,000 outstanding ordinary shares of another company at P150 each. Investment in shares 3,000,000 Cash 3,000,000 o During the year, the investee reported net income of P2,000,000. NO ENTRY o The investor received 10% share dividend at the end of the year. Memo entry: Received 2,000 ordinary shares as 10% share dividend. Shares now held, 22,000 shares. o On the following year, the investee had a net loss of P1,000,000. NO ENTRY o Nonetheless, the investee declared and paid a cash dividend of P1,000,000 at the end of the year. Cash 100,000 Dividend income 100,000 o The investor sold 1,000 ordinary shares at P200 each. Cash 200,000 Investment in shares 136,364 Gain on sale of investment 63,636 Computation: Sale price (1,000x200) 200,000 Cost of shares sold (1,000/22,000x3,000,000) 136,364 Gain on sale of investment 63,636

True or False 1. Unlike in upstream transaction, profit in downstream transaction must not be eliminated. F

2. When an investor ceases to have a significant influence over an investee, the use of equity method is no longer applicable. T 3. The profit on the sale of an associate’s inventory to the investor must be realized by the investor immediately. F 4. The investor and the investee are independent of the other under the equity method. F 5. Fair value method is applied with nonmarketable equity investment. F 6. Under the fair value and cost methods, dividends received by the investor are accounted for as dividend income. T 7. An investment in associate can always be accounted for using the equity method. F 8. Fair value method is applicable when a legal relationship exists between the investor and the investee. T 9. Under the cost method, the financial asset is measured at fair value through profit or loss or through other comprehensive income. F 10. When an investor is a wholly-owned subsidiary, it can always use the equity method in accounting for an investment in associate. F Problems For items 1-5, refer to this problem. At the beginning of the year 2020, an investor acquired 20% of the outstanding ordinary shares of an investee. The assets and liabilities of the investee are recorded at fair value. At the middle of the year, the investee company sold inventory with a cost of P100,000 for P150,000 to the investor. It was sold by the investor on February 10, 2021. The investee reported net income of P2,000,000 and P2,500,000 on 2020 and 2021, respectively. It paid no dividend. 1. How much is the investor’s share in the profit for 2020? a. P350,000 b. P390,000 c. P400,000 d. P450,000 2. How much is the investor’s share in the unrealized profit in 2020? a. P10,000 b. P20,000 c. P30,000 d. P0 3. What is the entry to record the investor’s share in the profit of the associate in 2020? a. Cash P350,000 Investment in associate P350,000

b. Cash Investment income

P390,000 P390,000

c. Investment income P400,000 Investment in associate P400,000 d. Investment in associate P390,000 Investment income

P390,000

4. How much is the investor’s share in the profit for 2021? a. P490,000 b. P500,000 c. P510,000 d. P520,000 5. If the investor was able to sell the inventory on December 31, 2020, what is the amount to be recognized by the investor as share in the profit of the investee on 2021? a. P490,000 b. P500,000 c. P510,000 d. P520,000 For items 6-8, refer to this problem. Mathhew Company has a 30 % equity interest on Michelle Company. The significant influence of Matthew Company over the investee was acquired when it purchased 30% of the outstanding ordinary shares of Michelle Company on January 1, 2020 for P 3,000,000. During 2020, Michelle Company earned P1,200,000 and paid dividends of P600,000. It also reported earnings of P 900,000 for the six months ended June 30, 2021, and P3,000,000 for the year ended December 31, 2021 but paid dividends of P1,500,000 on October 1, 2021. Mathhew Company sold half of the investment in Michelle Company for P3,000,000 cash. On this date, the investment is measured at fair value through profit or loss. The fair value of the retained investment is P3,200,000 on July 1,2021 and P3,400,000 on December 31,2021. 6. What amount should be recognized as investment income for 2020 as a result of the investment? a. P180,000 b. P270,000 c. P360,000 d. P540,000 7. In December 31, 2020 balance sheet, what is the carrying amount of the investment?

a. P3,000,000 b. P3,360,000 c. P2,760,000 d. P3,180,000 8. What total amount of income should be reported for 2021? a. P3,245,000 b. P3,445,000 c. P3,220,000 d. P3,175,000 For items 9-10, refer to this problem. Tin Co. purchased 10% of the total ordinary shares outstanding of Ange Company. for P3,000,000 at the beginning of the year 2019. On January 12, 2020, it purchased an additional 15% for P6,750,000. The investments were accounted through the use of the cost method. During the time of the second acquisition of interest, the fair value of the ten percent interest was P4,500,000 and Ange Company’s net assets had a carrying amount equaled to P36,000,000. Currently, the net assets of Angge Company has a fair value tantamount to the carrying amount, except for a machinery which had a fair value increased by P4,000,00 and remaining useful life of five years. Additional data for 2020 were as follows: Net income P8,000,000 Cash dividend P5,000,000 9. What is the carrying amount of the investment in associate at end of 2020? a. P10,500,000 b. P11,550,000 c. P11,800,000 d. P12,000,000 10. How much gain should be recognized on remeasurement? a. P0 b. P1,500,000 c. P2,250,000 d. P4,500,000

CHAPTER 19 FINANCIAL ASSET AT AMORTIZED COST Bond Investment

Definition of Bond Bond is a written and signed promise to pay a certain amount of money on a certain date, with periodic interest payment at a stated rate. A bond in a simple sense is a result of an investor lending money to the bond issuer in exchange for interest payment. Types of Bond  Serial Bonds - bonds that mature in installments  Term Bonds - bonds that mature on single date  Convertible Bonds - bonds that can be exchange for share capital  Callable Bonds - bonds that can be redeemed prior to their maturity date  Secured Bonds - bonds that have security , such as mortgage or pledge of other collateral  Debenture Bonds/Unsecured Bonds - bonds that are not protected by any collateral. Acquisition of Bonds a. Acquired on interest date When bonds are acquired on interest date, there is no premium or discount nor any accrued interest at the date of acquisition. Illustration: On March 1 of the current year, Akigami Company purchased 100, P1,000 12% bonds. Bonds pay interest semiannually on March 1 and September 1 and mature on January 1, 2024.

Mar. 1

Acquisition of the bonds Investment in bonds

100,000

Cash (100 x 1,000) Sept. 1

100,000

Receive semiannual interest Cash (100,000 x 12% x 6/12)

6,000

Interest income

6,000

Dec. 31 Adjustments for accrued interest Accrued interest receivable

4,000

Interest income

4,000

(100,000 x 12% x 4/12)

b. Acquired between interest dates When bonds are acquired between interest dates, adjustment is necessary for the interest accrued between the last interest payment date and the acquisition date. Illustration: On May 1, 2019, Fabio company purchased 12% P1,000,000 face amount bonds plus accrued interest. Interest is payable semiannually on June 1 and December 1. Bonds are dated June 1, 2018 and mature on June 1, 2023. May 1

Acquisition of bonds Investment in bonds Interest income

1,000,000 50,000

Cash June 1.

1,050,000

Receive semiannual interest Cash

60,000

Interest income Dec. 1.

60,000

Receive semiannual interest Cash

60,000 Interest income

Dec. 31

60,000

Adjustment for accrued interest Accrued interest income Interest income

10,000 10,000

Bonds Acquired at a Discount When bonds are acquired below the prevailing market rate, the bonds are at a discount. It occurs when the investors are only willing to pay less than the face amount of the bond because its stated rate is lower than the market rate. Bonds Acquired at a Premium When bonds are acquired above the prevailing market rate, the bonds are at a premium. It occurs at the time that the investors are willing to pay more than the face amount of the bonds. Amortization of Premium or Discount a. Effective Interest Method - Effective interest method uses constant rate to determine the amount to be amortize. b. Straight-Line Method - Straight-line method provides recognition for an equal amount of discount or premium amortization each period. The amount of monthly amortization is determined by dividing the discount or premium at purchase or acquisition date to the number of months remaining to the bonds maturity date. Illustration 1: Amortization of Discount On May 1, 2020, Shikeku company purchased P200,000 face amount 12% bonds at 96. Bonds pay interest semiannually on May 1 and November 1 and mature on May 1, 2025.

Dec. 31

Amortization of the bond discount for 8 months from May1 to December 31, 2020. Investment in bonds

800

Interest income

800

Face amount

200,000

Cost (200,000 x 97%)

(194,000)

Discount

6,000

Annual amortization (6,000/5 years)

1,200

Amortization for 8 months (1,200 x 8/12)

800

Illustration 2: Amortization of Premium On February 1, 2020, Takai purchased 12% 500,000 face amount bonds at 105 on February 1, 2020. Interest is payable semiannually on April 1 and October 1. Bonds are dated April 1, 2019 and mature on April 1, 2024. Dec. 3 Amortization of the bond premium for 11 months from February 1 to December 31, 2020 Investment in bonds Interest income

500 500

Face amount

500,000

Cost (500,000 x 1.05)

(525,000)

Premium

(25,000)

Life of bonds (from February 1, 2020 to April 1, 2024) 50 months Monthly amortization (25,000/50) Sales of Bonds

500

On the sale of bonds, it is necessary to determine the carrying amount of the bonds. Carrying amount is used to determine the gain or loss on the sale. Thus, the total amount of amortization of discount and premium from acquisition date up to the date of sales should be recognized. Illustration: On February 1, 2021, Akki Company sold bonds at 103. The company acquired the bonds last August 1, 2019 with face amount of P1,000,000, 12% interest at 91. Interest are payable semiannually on May 1 and November 1 and mature May 1, 2023. Sale price (1,000,000 x 103)

1,030,000

Accrued interest (Nov. 1, 2020 – February 1, 2021 1,000,000 x 12% x 3/12)

30,000

Total cash received

1,060,000

Original cost (1,000,000 x .91)

910,000

Amortization (August 1, 2019 - February 1,2021) ((90,000/45) x 18)

36,000

Carrying amount of bonds, February 1, 2021

946,000

Sale price (1,000,000 x 103)

1,030,000

Gain on sale of bonds

84,000

Journal entries Update first the amortization of discount Investment in bonds

2,000

Interest income (90,000/45 x 1 month) Record the sale of the bonds Cash

1,060,000

2,000

Investment in bonds

946,000

Interest income

30,000

Gain on sale of bond investment

84,000

Problem 1 Sadara Company acquired 1,500, P5,000 12% bonds at 97 plus accrued interest on June 1, 2020 to be held as financial asset at amortized cost. The bonds pay interest semiannually on March 1 and September 1. Bonds are dated March 1, 2019 and mature on March 1, 2024. Required: Prepare journal entries for the year 2020. Answer: June 1. Investment in bonds (7,500,000 x .97) Interest income (7,500,000 x 12% x 3/12)

7,275,000 225,000

Cash Sept. 1. Interest income (7,500,000 x 12% x 3/12)

7,500,000 225,000

Cash Dec. 31.

Accrued interest receivable

225,000 300,000

(7,500,000 x 12% x 4/12) Interest income Dec. 31.

Investment in bonds

300,000 35,000

Interest income

35,000

Face amount

7,500,000

Cost

(7,275,000)

Discount

225,000

Life of bonds

45 months

Monthly amortization (225,000/45)

5,000

Amortization for 8 months (5,000 x 7)

35,000

Problem 2 On April 1, 2019, Lihiko Company purchased bonds with face amount of P5,000,000 at 91 plus accrued interest. Bonds pay interest of 12% semiannually on January 1 and July 1. Bonds are dated January 1, 2018 and mature on January 1, 2023. 1. What is the amount of the accrued interest at the date of acquisition? a. 273,000 b. 150,000 c. 300,000 d. 0 Answer: B (5,000,000 x 12% x 3/12) 2. What is the total amount of cash paid? a. 4,700,000 b. 5,000,000 c. 5,047,000 d. 4,550,000 Answer: A Cost (5,000,000 x 91%) Accrued interest

4,550,000 150,000

Total cash paid

4,700,000

3. What is the amount to be recorded as amortization for the year ended December 31, 2019? a. 450,000 b. 10,000 c. 90,000 d. 100,000 Answer: C (10,000 x 9 months) Face amount Cost Discount Life of bonds Monthly Amortization (450,000/45)

5,000,000 (4,550,000) 450,000 45 months 10,000

Problem 3 At the beginning of the year, Flabio Company purchased P1,500,000 face amount 12% bonds at 110 plus accrued interest. Bonds pay interest semiannually on Febraury 1 and August 1 and mature on February 1, 2021. Required: Prepare journal entries for the current year. Answer: Jan. 1 Investment in bonds Interest income (1,500,000 x 12% x 5/12)

1,650,000 75,000

Cash Feb. 1 Cash Interest income (1,500,000 x 12% x 1/12)

1,1725,000 15,000 15,000

Aug. 1 Cash

90,000 Interest income (1,500,000 x 12% x 6/12)

90,000

Dec. 31 Accrued interest income

75,000

Interest income (1,500,000 x 12% x 5/12)

75,000

Dec. 31 Interest income (6,000x12)

72,000

Investment in bonds

72,000

Face amount

1,500,000

Cost

(1,650,000)

Premium Monthly amortization (150,000/25)

(150,000) 6,000

Problem 4 Chisu Company purchased a 12% P2,500,000 face amount bonds at 92 plus accrued income on July 1,2020. The bonds pay semiannually on May 1 and November 1 and mature on November 1, 2023. Required: Prepare a journal entry for the acquisition of bonds. Answer: Investment in bonds (2,500,000 x .92) Interest income (2,500,000 x 12% x 2/12) Cash

2,500,000 50,000 2,550,000

Problem 5 Konch Company purchased a 12% P900,000 face amount bonds at 106 plus accrued income on November 1, 2020. The bonds pay semiannually on May 1 and November 1 and mature on November 1, 2023. 1. What is the amount to be amortized at December 31, 2020? a. 1,500 b. 3,000 c. 1,350 d. 4,500 Answer: B (18,000 x 2/12) 2. What is the amount to be amortized at December 31, 2021? a. 15,000 b. 16,200 c. 27,000 d. 18,000 Answer: D Face amount Cost

900,000 (954,000)

Premium

(54,000)

Annual amortization (54,000/3 years)

18,000

Problem 6 On May 1, 2019, Khila Company purchased bonds with face amount of P3,000,000 at 95 plus accrued interest. Bonds pay interest of 12% semiannually on January 1 and July 1. Bonds are dated July 1, 2018 and mature on July 1, 2023. What is the amount of accrued interest?

a. 120,000 b. 150,000 c. 360,000 d. 180,000 Answer: A (3,000,000 x 12% x 4/12)

Problem 7 On June 1, 2019, Lalite Company purchased bonds with face amount of P2,500,000 at 105 plus accrued interest. Bonds pay interest of 12% semiannually on February 1 and August 1 and mature on August, 2023. What is the total cash paid? a. b. c. d.

2,500,000 2,625,000 2,725,000 2,400,000

Answer: C Cost (2,500,000 x 1.05)

2,625,000

Accrued interest (2,500,000 x 12% x 4/12) Total cash paid.

100,000 2,725,000

Problem 8 Kataa Company acquired 1,000, P6,000, 12% bonds at 103 plus accrued interest on May 1, 2020 to be held as financial asset at amortized cost. The bonds pay interest semiannually on February 1 and August 1. Bonds are dated February 1, 2019 and mature on February 1, 2024. Required: Prepare all necessary journal entries for year 2020.

Answer: May 1. Investment in bonds (6,000,000 x 1.03)

6,180,000

Interest income (7,500,000 x 12% x 3/12)

180,000

Cash

6,360,000

Aug. 1. Interest income (7,500,000 x 12% x 3/12)

180,000

Cash Dec. 31.

180,000

Accrued interest receivable

300,000

(6,000,000 x 12% x 5/12) Interest income Dec. 31.

300,000

Interest income

32,000

Investment in bonds Face amount Cost Premium Life of bonds

32,000 6,000,000 (6,180,000) (180,000) 45 months

Monthly amortization (225,000/45)

4,000

Amortization for 8 months (5,000 x 8)

32,000

Problem 9 Haya Company purchased a 12% P1,500,000 face amount bonds at 92 plus accrued income on July 1,2020. The bonds pay semiannually on May 1 and Nobember 1 and mature on November 1, 2023. Required: Determine the amount of premium or discount. Answer: Discount of P120,000

Face amount

1,500,000

Cost (1,500,000 x .92)

(1,380,00)

Discount

120,000

Problem 10 Mitsi Company provides the following transactions in bonds held for trading during the current year. May 1

Purchase 1,500, P1,000, 12% bonds of Sheti Company at 105 plus accrued interest. The bonds pay interest annually on December 1.

Dec. 31

Purchase 1,000, P5,000, 12% bonds of Latti Company at 98 plus accrued interest. Semiannual payment of interest is on April 30 and October 31.

Dec. 31 The following quotations were obtained: Sheti Company

102

Latti Company

99

Required: a. Prepare journal entries to record the transactions. b. Present the investment on December 31. Answer: Requirement A May 1 Trading securities ( 1,500,000 x 1.05) Interest income (1,500,000 x 12% x 5/12)

1,575,000 75,000

Cash Dec. 1 Trading securities (5,000,000 x .98)

1,650,000 4,900,000

Interest income (5,000,000 x 12% x 1/12)

50,000

Cash

4,950,000

Dec. 31 Cash

180,000

Interest income (1,500,000 x 12%)

180,000

Accrued interest income

50,000

Interest income (5,000,000 x 12% x 1/12) Trading securities

50,000 5,000

Unrealized gain – TS

5,000

Requirement B Carrying amount

Fair market

Sheti bonds

1,575,000

1,530,000

Latti bonds

4,900,000

4,950,000

6,475,000

6,480,000

Problem 11 (Multiple Choices: Part 1) 1. It provides an equal amount of premium or discount amortization each accounting period. a. Straight line method b. Effective interest method c. Accrued interest method

d. Interest income method 2. A bonds that can be redeemed prior to the date of maturity. a. Callable bonds b. Convertible bonds c. Serial bonds d. Term bonds 3. It gives the bondholders the right to exchange their bonds for share capital. a. Callable bonds b. Convertible bonds c. Secured bonds d. Serial bonds 4. A bonds issued with collateral. a. Debenture bonds b. Secured bonds c. Serial bonds d. Term bonds Answer: 1. A

2. A

3. B

4. B

Problem 12(True or False) 1. When bonds are acquired on interest date, there no accrued interest at the date of acquisition. 2. When bonds are acquired below the fair market value, the bonds are at a premium. 3. Premium occurs when the investor is willing to pay more than the face value of the bonds Answer: 1. True 2. False

3. True

Problem 13 Akati acquired convertible bonds and wants to redeem it prior to the date of maturity. Can Akati redeem it before the maturity date?

a. Yes, because convertible bonds can be redeemed before the maturity date. b. No, because only callable bonds can be redeemed prior to the date of acquisition. c. Yes, since Akati is the bondholder, he can redeem it anytime he wants. Answer: B

Problem 14 Sahta company acquired 12% bonds with face amount of 3,000,000 at 98 including accrued interest of P90,000. Bonds are held for trading. Required: Prepare journal entries for the acquisition. Answers: Trading securities Accrued interest

2,940,000 90,000

Cash

3,030,000

Problem 15 On November 30, 2019, Hatakki Company purchased 100, P10,000, 12% interest at 89 including accrued interest. Interest are payable annually on June 31 and mature June 31, 2024. Required: Prepare entries for the amortization of discount for the year ended 2019.

Answer: Interest income

2,000

Investment in bonds

2,000

Face amount

1,000,000

Cost (1,000,000 x .89)

(890,000)

Discount

110,000

Life of bonds Monthly amortization (110,000/55)

55 months 2,000

Problem 16 Mitsuki Company purchased 1,000, 1,000, 12% interest at 109 including accrued interest on October 1, 2019. Interest are payable annually on July 1 and mature July 1, 2024. 1. What amount should be recorded as accrued interest? a. 30,000 b. 40,000 c. 50,000 d. 60,000 Answer: A (1,000,000 x 12% x 3/12) 2. What is the total amount of premium? a. 100,000 b. 90,000 c. 120,000 d. 0 Answer: B

Face amount

1,000,000

Cost (1,000,000 x 1.09) Premium

(1,090,000) (90,000)

3. What is the total amount of discount? a. 100,000 b. 90,000 c. 120,000 d. 0 Answer: D ;There is no discount since it is acquired above the prevailing market rate.

Problem 17 On October 1, of the current year, Watabe Company purchased 1,500, 1,000, 12% interest at 106 including accrued interest. Interest are payable semiannually on January 1 and July 1 and mature July 1, 2023. What is the amount of premium amortization at the year end? Answer: P 6,000 (2,000 x 3) Face amount

1,500,000

Cost (1,500,000 x 1.06)

(1,590,000)

Premium Life of bonds Monthly amortization (90,000/45)

(90,000) 45 months 2,000

Problem 18 Judha purchased 12% bonds with face amount of 300,000 at 102 including accrued interest of P12,000. Bonds are held for trading. Required: Prepare journal entry to record the acquisition. Answer: Trading securities Interest income

306,000 12,000

Cash

318,000

Problem 19 Makira Company sold bonds at 103 on January 1, 2021 The company acquired the bonds last August 1, 2019 with face amount of P1,000,000, 12% interest at 91. Interest are payable semiannually on May 1 and November 1 and mature May 1, 2023. Required: a. Determine the total amount of cash received b. Determine the gain or loss on the sale of bond investment c. Prepare a journal entry for the sale of bond investment Answer: Requirement A Sale price (1,000,000 x 103)

1,030,000

Accrued interest (Nov. 1, 2020 – Jan 1, 2021) (1,000,000 x 12% x 2/12) Total cash received

20,000 1,050,000

Requirement B Original cost (1,000,000 x .91)

910,000

Amortization (August 1, 2019 - January 1,2021) ((90,000/45) x 17)

34,000

Carrying amount of bonds, February 1, 2021 Sale price (1,000,000 x 103)

944,000 1,030,000

Gain on sale of bonds

86,000

Requirement C Journal entries Cash

1,050,000

Investment in bonds

944,000

Interest income

20,000

Gain on sale of bond investment

86,000

Problem 20 On May 1,2019, Biskus Company acquired P2,000,000 12% bonds at 98 plus accrued interest. Interests are payable January 1 and July 1 and mature July 1 2023. The bonds are held for trading. What is the correct entry to record the acquisition of bond? a. Investment in bonds

1,960,000

Interest income

60,000

Cash b. Trading securities.

2,020,000 1,960,000

Interest income Cash

60,000 2,020,000

c. Both A and B are correct d. Neither A nor B Answer: D ;The amount of interest income is wrong

CHAPTER 20 Effective Interest Method (Amortized cost, FVOCI and FVPI) Effective Interest Method The effective interest method is a technique for calculating the actual interest rate in a period based on the amount of a financial instrument's book value at the beginning of the accounting period. Thus, if the book value of a financial instrument decreases, so too will the amount of related interest; if the book value increases, so too will the amount of related interest. This method is used to account for bond premiums and bond discounts. The effective interest method is preferable to the straight-line method of charging off premiums and discounts on financial instruments, because the effective method is considerably more accurate on a period-to-period basis. However, it is also more difficult to compute than the straight-line method, since the effective method must be recalculated every month, while the straight-line method charges off the same amount in every month. Thus, in cases where the amount of the discount or premium is immaterial, it is acceptable to instead use the straight-line method. By the end of the amortization period, the amounts amortized under the effective interest and straight-line methods will be the same. Under PFRS 9, bond discount and bond premium shall be amortized using the effective interest rate Effective interest method is also known as scientific method or simply “interest method” This method distinguishes two kinds of interest rate, namely nominal rate and effective rate. The effective rate is the yield rate or market rate which is the actual or true rate of interest which the bondholder earns on the bond investment. Effective rate versus nominal rate -Effective Rate is the rate that exactly discounts estimated future cash payments through the expected life of the bond or when appropriate, a shorter period to the net carrying amount of the bond. The Nominal Rate is the coupon rate or stated rate appearing on the face of the bond. -The effective rate and the nominal rate are the same if the cost of the bond investment is equal to the face value. -When the bonds are acquired at a premium, the effective rate is lower than the nominal rate. The reason is that the premium is a loss on the part of the bondholder. -On the other hand, when the bonds are acquired at a discount, the effective rate is higher than the nominal rate. The reason is that the discount is a gain on the part of the bondholder. -Both of them, the effective rate and nominal rate are necessary in applying the effective interest method.

A bond premium occurs when investors are willing to pay more than the face value of a bond, because its stated interest rate is higher than the prevailing market interest rate. A bond discount occurs when investors are only willing to pay less than the face value of a bond, because its stated interest rate is lower than the prevailing market rate. The difference between the interests earned or interest income and the interest received represents the premium or discount amortization. Interest earned or interest income= effective rate multiply to the carrying amount of the bond investment Interest received= nominal rate multiply to the face amount of the bond. The carrying amount of the bond investment is the initial cost gradually increased by periodic amortization of discount or gradually reduced by periodic amortization of premium. Illustration. Effective interest method-Discount On January 2020, an investor acquired for a 5-year 9% 100,000 bond issued in a 10% market for 96,149, let's highlight a few points: 1. The bond discount of 3,851 must be amortized to Interest Expense over the life of the bond. The amortization will cause the bond's book value to increase from 96,149 on January 1, 2020 to 100,000 just prior to the bond maturing on December 31, 2024. 2. The corporation must make an interest payment of 4,500 (100,000 x 9% x 6/12) on each June 30 and December 31 that the bonds are outstanding. The Cash account will be credited for 4,500 on each of these dates. 3. The effective interest rate is the market interest rate on the date that the bonds were issued. In our example the market interest rate on January 1, 2020 was 5% per semiannual period for 10 semi-annual periods. 4. The effective interest rate is multiplied times the bond's book value at the start of the accounting period to arrive at each period's interest expense. 5. The difference between Item 2 and Item 4 is the amount of amortization. Date

Interest received

Interest income

Discount amortization

Carrying amount

January 1,2020

4500

96149

June 30,2020

4500

4807

307

96456

December 31,2020

4500

4822

322

96778

June 30,2021

4500

4839

339

97117

December 31,2021

4500

4856

356

97473

June 30,2022

4500

4874

374

97847

December 31,2022

4500

4892

392

98239

June 30,2023

4500

4912

412

98651

December 31,2023

4500

4933

433

99084

June 30,2024

4500

4954

454

99538

December 31,20204

4500

4962

462

100000

Totals

45000

48851

3851

Illustration. Effective interest rate method for amortizing the bond premium pertaining to a 5year 9% 100,000 bond issued in an 8% market for 104,100 on January 1, 2020, let's outline a few concepts: 1. The bond premium of 4,100 must be amortized to Interest Expense over the life of the bond. This amortization will cause the bond's book value to decrease from 104,100 on January 1, 2018 to 100,000 just prior to the bond maturing on December 31, 2024. 2. The corporation must make an interest payment of 4,500 (100,000 x 9% x 6/12) on each June 30 and December 31. This means that the Cash account will be credited for 4,500 on each interest payment date. 3. The effective interest rate method uses the market interest rate at the time that the bond was issued. In our example, the market interest rate on January 1, 2020 was 4% per semiannual period for 10 semi-annual periods. 4. The effective interest rate is multiplied times the bond's book value at the start of the accounting period to arrive at each period's interest expense. 5. The difference between Item 2 and Item 4 is the amount of amortization.

The following table illustrates the effective interest rate method of amortizing the 4,100 premium on a corporation's bonds payable: Date

Interest received

Interest income

Premium amortization

Carrying amount 104100

June 30,2020

4500

4164

336

103764

December 31,2020

4500

4151

349

103415

June 30,2021

4500

4137

363

10305

December 31,2021

4500

4122

378

102674

June 30,2022

4500

4107

393

102281

December 31,2022

4500

4091

409

10187

June 30,2023

4500

4075

425

101447

January 1,2020

December 31,2023

4500

4058

442

101005

June 30,2024

4500

4040

460

100545

December 31,20204

4500

3955

545

1000

Totals

4500

40900

4100

PROBLEMS PROBLEM 1 The present value factor at 8% for one period is 0.92593, for two periods is 0.85734, for three periods is 0.79383, for four periods is 0.73503, and for five periods is 0.68058. Given these factors, what amount should be deposited in a bank today to grow to $100 three years from now? a.$100/0.79383 b. $100/(0.92593/3) c. ($100/0.92593 + $100/0.85734 + $100/0.79383) d. $100 X 0.79383 PROBLEM 2 Bonds payable should be disclosed on the balance sheet. a. b. c. d.

At their face value minus any unamortized premiums. At their face value plus any unamortized premiums. At their maturity value. d. At their face value.

PROBLEM 3 When the contract interest rate for a bond exceeds the effective interest rate of the bond, then:

a. b. c. d.

The price of the bond will be equal to the future cash flow associated with the bond. The bond will be issued at a premium. The bond will be issued at a discount. The face value of the bond will fluctuate over its life.

PROBLEM 4 On April 1, 20X1, German Corporation issued $100,000 of 7%, 5-year bonds dated April 1, 20X1, at 101. Interest is paid on March 31 and September 30. The proper entries to record bond interest expense for the (entire) year ended 20X1 would include a decrease in interest expense for premium amortization in the amount of (round to the nearest dollar and assume straight-line amortization): a. b. c. d.

$0 $117 $150 $200

PROBLEM 5 Jeske Company issued $1,000,000 of 8% bonds at a time when the market rate of interest was 10%. If the bonds were issued at a $50,000 discount and interest was paid annually, how much was interest expense for the first full year of the bond issue (utilize the effective-interest amortization technique)? a. $76,000 b. $80,000 c. $95,000 d. $100,000 Solution: $95,000. The bonds’ carrying value ($1,000,000 – $50,000) times the effective interest rate (10%) yields the total interest expense. PROBLEM 6 Billings Corporation retired $1,000,000 face of bonds payable. At the time of the retirement, the bonds had unamortized discount of $20,000, and all interest accruals and payments were current. Under the outstanding covenants, Billings was required to pay the bond holders 103.

a. The transaction caused Billings to recognize a loss of $50,000. b. The transaction caused Billings to recognize a gain of $50,000. c. The transaction caused Billings to recognize a loss of $30,000. d. The transaction caused Billings to recognize a gain of $20,000. PROBLEM 7 You are thinking of borrowing $250,000 to buy a new house. If you are going to finance this purchase at 12% interest per annum, and make 360 level monthly payments to pay off the loan, how much will your payments be?

a. $250,000/360 b. $250,000/present value factor for lump sum at 360 months and 1% per period c. $250,000/present value factor for annuity of 360 months at 1% per period d. $250,000 X present value factor for annuity of 360 months at 1% per period

PROBLEM 8 Assume that Kamchatny Vladimir borrowed $100,000 on January 1 of Year 1, at 5% interest per annum. On December 31, of Year 1, an $8,000 payment is made. On December 31, of year 2, another $8,000 payment is made. Using normal assumptions about interest and principal reduction, how much is the unpaid balance of Vladimir’s loan after the second payment?

a. $100,000 b. $94,000 c. $93,850 d. $84,000 Solution: $93,850. The first payment is $5,000 of interest ($100,000 X .05) and $3,000 principal reduction. The resulting principal balance for Year 2 is $97,000; which accrues interest of $4,850 ($97,000 X .05). The $8,000 payment in Year 2 therefore reduces the principal by $3,150 ($8,000 – $4,850) to $93,850.

PROBLEM 9 On July 1, 2011, Alloeh-V Company paid P 1,198,000 of 10%,20-year bonds with a face value amount of P 1,000,000. Interest is paid on December 31 and June 30. The bonds were purchased to yield 8%. Alloeh-V uses the effective interest method to recognize interest income from this long term investment. What should be reported as the carrying amount of tge bonds u te December 31,2011 statement of financial position? a.1,207,900 b. 1,198,000 c. 1,195,920 d. 1,193,050 Solution Date July 1,2011 December 31,2011

Interest received

Interest income

Premium amortization

50,000

47,920

2,080

Interest received =1,000,000 x 10% x 6/12 =50,000 Interest income = 1,198,000 x 8% x 6/12 =47,920

Carrying amount 1,198,000 1,195,920

PROBLEM 10 On July,2013, East Company purchased as a long-term investment P500,000 face amount,8%bonds of Rand Company for P4,615,000 to yield 10% per year. The bonds pay interest semiannually on January 1 and July 1. On December 31,2011,what amount should be reported as interest receivable? a. b. c. d.

184,600 200,000 230,750 250,000

Solution: Accrued interest receivable from July 1 to December 31,2011 (5000000 x 8% x 6/1) 200;000 PROBLEM 11 On July 2011, Pell Company purchased Green Company ten-year,8% with a face amount of 5000000 for 200,000. The bonds mature on June 30.2019 and pay interest semiannually on June 30 and December 31. Using the interest method, Pell recorded bond discount amortization of P18000 for the six months ended December 31,2011. What amount should be reported as interest income for 2011? a. b. c. d.

168,000 182,000 .200,000 218,000

Solution Interest received from July 1 to December 31,2011 (5,000,000 x 8% x 6/12)

200,000

Bond discount amortization for six months

18,000 ______ 18,000

Interest income for 2011

PROBLEM 12 On January 1,2012, Russia Company purchased 5-year bonds with face value of p8000000 and stated interest of 10% per year payable semiannually January 1 and July 1. He bonds were acquired to yield 8%. Present value factors are: Present value of an annuity of 1 for 10 periods at 5% 7.72 Present value of an annuity of 1 for 10 periods at 4% 8.11 Present value of 1 for 10 periods at 4% 0.6756

What is the purchase price of the bonds? a. 7,382,400 b. 8,617,600 c. 8,648,800 d. 7,351,200 Solutions PV of principal (8,000,000 x .6756) PV of semiannual interest payments (400,000 x 8.11) Purchase price or present value of the bonds

5,404,800 3,244,000 8,648,800

PROBLEM 13 With connection to the above problem, what is the carrying amount of the bond investment on December 31,2012? a. 8,594,752 b. 8,540,704 c. 8,538,542 d. 8,302,848 Date January 1,2012 July 1,2012 December 31,2012

Interest received

Interest income

Premium amortization

400,000 400,000

345,952 343,790

54,048 56,210

Carrying amount 8,648,800 8,594,752 8,538,542

PROBLEM 14 On July 1,2013, Bukang Liwayway Company purchased bonds with face value of P2,000,000. The bonds are dated January 1,2012 and mature on January 1, 2017. The interest on the bonds is 10% payable semiannually every June 30 and December31. The prevailing market rate of interest on the bonds is 12%. The present value of 1 at 6% for 8 periods is .63, and the present value of an ordinary annuity of 1 at 6% for 8 periods is 6.21. What is the present value of the bonds on January 1,2013? a. b. c. d.

1,881,000 1,888,000 1,360,000 1,480,000

Solution PV of principal (2,000,000 x .63) PV of semiannual interest payments (100,000 x 6.21)

1,260,000 621,000

Present value or market price of bonds

1,881,000

PROBLEM 15 On Ajnuary 2014,Dean Company purchased ten-year bonds with a face value of P1,000,000 and a stated interest rate of 8% per yearpyable semiannually July 1 nad January 1. The bonds were acquired to yield 10%. Present value factors are as folloes: Present value of 1 for 10 periods at 10%

.386

Present value of 1 for 20 periods at 5%

.377

Present value of an annuity of 1 for 10 periods at 10%

6.145

Present value of an annuity of 1 for 20 periods at 5%

12.462

What is the purchase price of the bonds? a. b. c. d.

1,124,620 1,100,000 1,000,000 875,380

Solution PV of principal (1,000,000 x .377)

377,000

PV of semiannual interest payments (40,000 x 12.462)

498,480

Total present value

875,480

PROBLEM 16 On January 2020, Arabian Company purchased serial bonds with face value of P3,000,000 and stated 12% interest payable annually every December 31. The bonds are to be held as financial asset at amortized cost with a 10% effective yield. The bonds mature at an annual instalment of P1,000,000 every December 31. The rounded present value of 1 at 10% for: One period

0.91

Two periods

0.83

Three periods

0.75

What is the present value of the serial bonds on January 1,2020? a. b. c. d.

3,106,800 3,060,000 3,045,000 3,149,400

Solution Principal payment

1,000,000

Interest payment (3,000,000 X 12%) 360,000 Total payments on December 31,2020

1,360,000

Principal payment

1,000,000

Interest payment (3,000,000 X 12%) 240,000 Total payments on December 31,2021

1,240,000

Principal paymet

1,000,000

Interst payment (3,000,000 X 12%) 120,000 Total paymets on December 31,2022

1,120,000

December 31,2020 payment (1,360,000 x .91)

1,237,600

December 31,2021 payment (1,240,000 x .83)

1,029,200

December 31,2022 payment (1,120,000 x .75)

840,000

Total present value on January 1,2020

3,106,800

PROBLEM 17 On January 1,2020, Krungkrung Company purchased bonds with face value of P5,000,000 at a cost of P4,700,000 to be held as financial asset at amortized cost. The stated interest is 10% payable annually every December 31. The bonds mature in 4 years or January 1,2024. What amount of interest income should be reported by Krungkrung Company for the year ended December 31,2020 under the effective interest method? a. b. c. d.

500,000 470,000 5,170,000 562,590

Solution : Interest income (4,700,000 x 11.97%)

562,590

PROBLEM 18 Under ____________, an equal amount of discount is allocated to each interest period, whereas, under the ____________ method of amortization, interest expense is calculated as a constant percentage of the bond carrying value.

Answer: (straight-line amortization, straight line amortization),(effective interest)

PROBLEM 19 An ____________ is a series of equal cash flows. Answer: (annuity)

PROBLEM 20 The set amount to be repaid on a bond’s maturity date is known as ____________, whereas, the bond payable amount less any unamortized discount or plus any unamortized premium is known as ____________.

Answer: (face value), (carrying value)

Chapter 21

CHAPTER 22 Investment Property Definition and initial recognition of investment property Investment property is property (land or a building, or part of a building, or both) held by the owner or by the lessee under a finance lease to earn rentals or for capital appreciation or both, rather than for: (a) use in the production or supply of goods or services or for administrative purposes, or (b) sale in the ordinary course of business. Notes Property held for the purposes described above are inventories. Provided that the owner-occupied property described in paragraph 16.2(a) is expected to be used during more than one period, it is property, plant and equipment. Investment property generates cash flows largely independently of the other assets held by an entity. This distinguishes investment property from owner-occupied property. The production or supply of goods or services (or the use of property for administrative purposes) generates cash flows that are attributable not only to property, but also to other assets used in the production or supply process. Judgement is sometimes needed to determine whether a property qualifies as investment property. For example, when an entity provides ancillary services to the occupants of a property it holds, it treats the property as investment property if the services are insignificant to the arrangement as a whole. Examples – investment property Ex 1 An entity owns a building that it rents out to independent third parties under operating leases in return for rental payments. The building is classified as an item of investment property by the entity (lessor). It is a property held to earn rentals. Ex 2 An entity owns a building that it rents out to independent third parties under operating leases in return for rental payments. The entity provides cleaning, security and maintenance services for the lessees of the building. If the services provided by the entity are insignificant to the arrangement as a whole, then the property is investment property. In most cases cleaning, security and maintenance services will be insignificant and hence the building would be classified as investment property.

When the services provided are significant the property should be classified as property, plant and equipment. For example, if an entity owns and manages a hotel, services provided to guests are significant to the arrangement as a whole. Ex 3 An entity owns a building that it rents out to an independent third party (the lessee) under an operating lease in return for fixed rental payments. The lessee operates a hotel from the building including a range of services commonly provided by boutique hotels. The entity does not provide any services to hotel guests and its rental income is unaffected by the number of guests that occupy the hotel (ie the entity is a passive investor). The building is an investment property of the entity. The entity is not engaged in the business of operating a hotel business (ie the entity is a passive investor). Ex 4 An entity (parent) owns a building that it rents out to its subsidiary under an operating lease in return for rental payment. The subsidiary uses the building as a retail outlet for its products. In the consolidated financial statements of the parent the building is not classified as an item of investment property. The consolidated financial statements present the parent and its subsidiary as a single entity. The consolidated entity uses the building for the supply of goods. Therefore the building is accounted for by the consolidated group as an item of property, plant and equipment. In the separate financial statements of the parent the building is classified as investment property. It is a property held to earn rentals. In the individual financial statements of the subsidiary the arrangement is accounted for as an operating lease in accordance with Section 20 Leases. Ex 5 An entity acquired a tract of land as a long-term investment because it expects its value to increase over time. No rentals are expected to be generated from the land in the foreseeable future. The land is classified as investment property. It is property held for capital appreciation. The land is not held for sale in the ordinary course of business. Ex 6 An entity holds land for an undetermined future use. Notes In accordance with Section 20 Leases, a lessee under an operating lease does not recognize a leased asset and does not recognize the related lease obligation in its statement of financial position (see Section 20). Furthermore, if the lessee makes an upfront payment relating to a property interest held under an operating lease, the lessee accounts for that payment as a prepaid expense, not as an item of property. However, paragraph 16.3 allows for such an entity (as the lessee) to elect, on a propertyby-property basis, to account for the operating lease of investment property as if it were a finance lease in accordance with Section 20, provided that the property would otherwise meet the

definition of an investment property and the lessee can measure the fair value of the property interest without undue cost or effort on an ongoing basis. A property interest that is held by a lessee under an operating lease may be classified and accounted for as investment property using this section if, and only if, the property would otherwise meet the definition of an investment property and the lessee can measure the fair value of the property interest without undue cost or effort on an ongoing basis. This classification alternative is available on a property-by-property basis. MIXED USED PROPERTY Mixed use property shall be separated between investment property and property, plant and equipment. However, if the fair value of the investment property component cannot be measured reliably without undue cost or effort, the entire property shall be accounted for as property, plant and equipment in accordance with Section 17. Measurement at initial recognition An entity shall measure investment property at its cost at initial recognition. The cost of a purchased investment property comprises its purchase price and any directly attributable expenditure such as legal and brokerage fees, property transfer taxes and other transaction costs. If payment is deferred beyond normal credit terms, the cost is the present value of all future payments. Measurement after recognition Investment property whose fair value can be measured reliably without undue cost or effort shall be measured at fair value at each reporting date with changes in fair value recognized in profit or loss. If a property interest held under a lease is classified as investment property, the item accounted for at fair value is that interest and not the underlying property An entity shall transfer a property to, or from, investment property only when the property first meets, or ceases to meet, the definition of investment property.

PROBLEMS Question 1 Investment property is defined as: a. property (land or a building, or part of a building, or both) held for sale in the ordinary course of business. b. property (land or a building, or part of a building, or both) held to earn rentals. c. property (land or a building, or part of a building, or both) held for capital appreciation. d. property (land or a building, or part of a building, or both) held to earn rentals or for capital appreciation or both. Question 2 A property interest that is held by a lessee under an operating lease may be classified and accounted for as investment property if, and only if, a. the property would otherwise meet the definition of an investment property and the lessee can measure the fair value of the property interest without undue cost or effort on an ongoing basis. Furthermore, the entity accounts for all its qualifying operating leasehold property interests as investment property. b. the property would otherwise meet the definition of an investment property and the lessee can measure the fair value of the property interest without undue cost or effort on an ongoing basis (irrespective of whether other qualifying operating leasehold property interests are accounted for as investment property (ie the election is available to the entity on a property-by-property basis)). c. the property would otherwise meet the definition of an investment property and the lessee accounts for all of its investment property (and qualifying operating leasehold property interests) at fair value with the change in fair value recognized in profit or loss. d. the property would otherwise meet the definition of an investment property and the lessee accounts for all of its investment property (and qualifying operating leasehold property interests) using a cost-amortization-impairment model set out in Section 17. Property, Plant and Equipment. Question 3 An entity operates a bed and breakfast from a building it owns. The entity also provides its guests with other services including housekeeping, satellite television and broadband internet access. The daily room rental is inclusive of these services. Furthermore, upon request, the entity conducts tours of the surrounding area for its guests. Tour services are charged for separately. The entity should account for the building as: a. inventory b. investment property

c. property, plant and equipment Question 4 An entity must measure its investment property after initial recognition: a. either at fair value or using the cost-depreciation-impairment model (same accounting policy for all investment property). b. either at fair value or using the cost-depreciation-impairment model (elected item by item). c. at fair value. d. at fair value, for those properties that fair value can be measured reliably without undue cost or effort on an ongoing basis, with all other investment property accounted for using the cost-depreciation-impairment model in Section 17. Question 5 Investment property whose fair value cannot be measured reliably without undue cost or effort on an ongoing basis is accounted for after initial recognition: a. as inventory in accordance with Section13. b. as property, plant and equipment in accordance with Section 17. c. as a financial asset in accordance with Section 11. d. as an intangible asset with a finite useful life in accordance with Section 18. Question 6 A building is owned by a subsidiary (lessor) to earn rentals under an operating lease from its parent (lessee). The parent manufactures its products in the rented building. The fair value of the building can be measured reliably without undue cost or effort on an ongoing basis. The building is: a. accounted for as an item of property, plant and equipment by the subsidiary and an investment property by the group. b. accounted for as an investment property by the subsidiary and as an item of property, plant and equipment by the group. c. accounted for as an investment property by both the subsidiary and the group. d. accounted for as an item of property, plant and equipment by both the subsidiary and the group. Question 7 On 1 January 2011 an entity acquired a building for CU95,000, including CU5,000 nonrefundable purchase taxes. The purchase agreement provided for payment to be made in full on 31 December 2011. Legal fees of CU2,000 were incurred in acquiring the building and paid on 1 January 2011. The building is held to earn lease rentals and for capital appreciation. An appropriate discount rate is 10 per cent per year.

The entity shall measure the initial cost of the building at: a. CU88,364 b. CU97,000 c. CU102,000 d. CU107,000 Question 8 On 1 January 2011 an entity acquired an investment property (building) in a remote location for CU100,000. After initial recognition, the entity measures the investment property using the costdepreciation-impairment model, because its fair value cannot be measured reliably without undue cost or effort on an ongoing basis. At 31 December 2011 management:  assessed the building’s useful life at 50 years from the date of acquisition  presumed the residual value of the building to be nil (given that the fair value cannot be determined reliably)  assessed that the entity will consume the building’s future economic benefits evenly over 50 years from the date of acquisition  declined an unsolicited offer to purchase the building for CU130,000. This is a ‘one-off’ offer that is unlikely to be repeated in the foreseeable future. The entity should measure the carrying amount of the building on 31 December 2011 at: a. CU98,000 b. CU100,000 c. CU130,000 d. CU127,400 Question 9 On 31 December 2012 the entity reassessed the remaining useful life of the investment property described in Question 8 as 73 years. The revised assessment is supported by new information that became available in late 2012. The entity should measure the carrying amount of the building on 31 December 2012 at: a. CU130,000 b. CU96,676 c. CU126,533 d. CU97,333 Question 10 On 1 January 2011 an entity acquired a tract of land for an undetermined purpose. On 1 January 2014 the entity started constructing a building on the land for use as its administrative headquarters. On 1 January 2015 the entity’s administrative staff moved into that building.

Three years later (on 1 January 2018) the entity’s administrative staff moved into newly acquired premises. The old building was immediately rented to an independent third party under an operating lease. On 31 December 2019 the entity accepted an unsolicited offer from the tenant to purchase the building from the entity with immediate effect. The fair value of the property (land and related buildings) can be measured reliably without undue cost or effort on an ongoing basis. The entity shall account for the tract of land and the related building as: a. investment property from 1 January 2011 to 31 December 2019. b. investment property during 2011–2013 and 2018–2019 and as property, plant and equipment during 2014–2017. c. investment property during 2011–2013 and as property, plant and equipment during 2014–20110. d. property, plant and equipment during 2011–2017 and as investment property during 2018–2019. Question 11 Which of the following is not an example of investment property? 

 Land held for undetermined future use



 Property leased to another entity under a finance lease



 Property leased to another entity under an operating lease



 Property being constructed for future use as an investment property

Question 12 If an entity uses part of a building for their own use, and rents the remainder. How should this be treated?  

 All as investment property under IAS 40 – Investment Property  Account for separately under ‘IAS - 16 Property, Plant and Equipment’ and ‘IAS - 40 Investment Property’



 All under IAS 16 – Property, Plant and Equipment



 None of these

Question 13

If an entity uses the cost model for investment property, it must also disclose the fair value of the investment property. 

 True



 False

Question 14 A parent leases an office building to a subsidiary. In which financial statements will the property appear as investment property? 

 Parent company



 Subsidiary



 Consolidated financial statements



 None of these

Question 15 Under IAS 40 – Investment Property, where should a gain or loss on disposal be recognized? 

 Income Statement



 Statement of Changes in Equity



 Statement of Financial Position



 None of these

Question 16 Property being constructed on behalf of third parties is an investment property under IAS 40 – Investment Property until the contract is complete. 

 True



 False

Question 17 An investment property should initially be measured at ___ 

 Market value



 Fair value



 Net realizable value



 Cost

Question 18 If an entity wishes to change from a cost model to fair value model under IAS 40 – Investment Property, when may it do so? 

 When the board of directors approves a change



 When a change will result in a more appropriate presentation



 When the value of the assets will improve with a revised model



 When the market for these properties is fluctuation

Question 19 Mega Corp owns a field near an industrial estate. The company has not decided what to do with this land. Is it an investment property under IAS 40? 

 Yes



 No

Question 20 Which of the following is not a transfer from or to investment property under IAS 40? 

 Commencement of owner occupation



 Transfer from undetermined use to an operating lease



 Commencement of development with a view to sale



 End of construction of development

Chapter 23

Chapter 24

Chapter 25 Property, Plant and Equipment

Property, plant, and equipment (PP&E) are long-term assets vital to business operations and not easily converted into cash. Property, plant, and equipment are tangible assets, meaning they are physical in nature or can be touched. The total value of PP&E can range from very low to extremely high compared to total assets. It is important to note when calculating equity.

Characteristics of PPE a. Tangible assets or one with physical substance b. PPE are expected to be used over a period of more than one year c. PPE are used in business operations.

Companies list their net PP&E on their financial statements. Potential investors and analysts look at a company's PP&E to determine the kinds of capital expenditures it's making and how it raises funding for its projects.

Examples of property, plant, and equipment (PP&E) include: a. Vehicles like trucks b. Office furniture c. Machinery d. Buildings e. Undeveloped land f. Land g. Land Improvements

Recognition An item of PPE should be recognised as an asset, if it is probable that future economic benefits associated with the asset will flow to the entity and the cost of the item can be measured reliably. Future economic benefits occur when the risks and rewards of the asset's ownership have passed to the entity. PPE is initially recognised at its cost, which is the fair value of the consideration given.

Elements of cost a. Purchase price, including import duties, non-refundable purchase taxes. b. All the directly attributable costs necessary to bring the asset into working condition should be capitalised: these costs include delivery and installation costs and architects' fees.

After initial recognition, the asset should be measured at cost less accumulated depreciation and impairment losses or at a revalued amount, which is its fair value less subsequent depreciation and impairment losses. In this case, fair value must be reliably measurable. Revaluations must be made with sufficient regularity to ensure that the carrying amount is not materially different from fair value. However, if an asset is revalued, then the entire class of asset must be revalued. The fair value of property is its market value. A professionally qualified valuer normally undertakes the valuation. IAS 16 does not use the value to the business model. As a consequence, IAS 16 is not prescriptive in requiring such things as non-specialised properties to be valued at existing use value (EUV), at depreciated replacement cost and properties surplus to requirements to be valued at open market value.

Acquisition of Property The following are the ways of acquiring a property 1. Cash basis 2. On account subject to cash discount 3. Installment basis 4. Issuance of share capital

5. Issuance of bonds payable 6. Exchange 7. Donation 8. Government grant 9. Construction

Cash basis acquisition of PPE If item of property, plant and equipment is acquired on cash basis then its a simple transaction of one asset increasing and the other decreasing. For example entity bought a machinery of $100,000 paying by cash then journal entry will be as follows:

Machinery a/c 100,000 Cash a/c

100,000

Similarly, if asset is bought paying by cheque then bank account will be credited. For example if entity bought printer to be used in head office for $2,000 and paid the supplier via cheque then journal entry will be:

Office equipment a/c 2,000 Bank a/c

2,000

PPE acquired on Lump-sum basis If multiple assets are acquired as part of one deal for which a single payment is made it is called lump-sum purchase. For example entity has acquired land, building and installed machinery for 200,000. Although all assets are acquired under one deal, we still have to recognize the assets separately in the statement of financial position thus we need to know the values of each individual assets.

To allocate the purchase consideration entity use relative fair values of asset and divide the total consideration on pro-rata basis. If it is not possible to determine the fair values of assets then there are other allocation basis available like future income basis, replacement cost basis. Entity is required to use such basis of allocation that render true and fair values of assets.

Example – Lump-sum purchase of property, plant and equipment

PPE acquired on account

Entity may acquire an asset on credit basis meaning that payment will be made at a later date. This will create a liability at the time of acquisition which is recorded by crediting an account with appropriate title which is usually the name of supplier.

For example a building is acquired by business worth $20,000 and promised to pay the full amount in 2 months time to Momhil Plc. This will be recorded as follows:

Building a/c

20,000

Accounts Payable a/c

20,000

Acquisition on installment basis Entities may acquire asset on such contracts where payment has been delayed for significant period of time. Unlike credit basis purchase where payment is made in few months time, in deferred payment contracts actual cash outflow may occur after 5 years or 10 years of actual purchase. Under such contracts, the deferred portion of consideration will be recorded on present value basis in the cost of assets. However, unwinding charge will be treated as finance cost for the period and recorded in the income statement instead of being capitalized as cost of the asset. To make proper calculations, discount rate to be used for present value calculation must be known and the period over which payment is deferred must also known with certainty. Usually it is written as part of contract or a separate instrument is used like bond.

Issuance of Share Capital Philippine GAAP states that if shares are issued for consideration other than actual cash, the proceeds shall be measured at the fair value of the consideration received. Whereas, when a property is acquired through the issuance of share capital, the property shall be measured at the following order of priority:

a. Fair value of the property received b. Fair value of the share capital c. Par value or stated value of the share capital

Issuance of bonds payable Acquisition of a property by issuing a bonds payable, PFRS 9 provides that the entity shall measure the financial liability at fair value plus transaction costs that are directly attributable to the issue of the financial liability. Property acquired shall be measured in the following order:

a. Fair value of bonds payable b. Fair value of asset received c. Face amount of bonds payable

PPE acquired on exchange basis Sometimes entity acquires a new asset in exchange of old one. As new asset is coming in and old asset is going out therefore it is acquisition and disposal of asset at the same time.

The exchange is recognized at carrying amount when:

a. Measurement of asset received or given is not reliable. b. The exchange lacks commercial substance. Commercial Substance happens when the cash flows of the asset received differ significantly from the cash flows of asset transferred.

For example a new asset worth 10,000 is acquired and no payment is made to supplier except that entity gave and old asset in exchange. In this case disposal consideration of old asset is 10,000

Another example can be where entity acquired new asset that has a fair value of 15,000. Entity paid 7,500 in cash and also gave a used asset as part of purchase consideration. In this case the disposal value of old asset can be found using this simple formula:

New asset value = Cash + Old asset sales value 15,000 = 7,500 + Old asset sales value 15,000 – 7,000 = Old asset sales value Old asset sales value = 7,500

Donation Commission on Audit provides the following section for the accounting treatment of donation in the following situations. Sec. 9. Non-exchange Transaction. PPE acquired through a non-exchange transaction, such as donation, presidential proclamation, taxes, transfers and grants, its cost shall be measured at its fair value as at the date of acquisition. However, this does not constitute revaluation. If the fair value cannot be determined, the asset should be recorded at a nominal value (the value that is stated on currency or face value). Sec. 10. Donation without Condition. Cost of PPE acquired through donation without condition shall be taken up at its fair value at the date it is acquired. All expenses incurred in connection with the donated asset, such as delivery and installation costs, shall be included in the

amount recognized as asset. The fair value of the PPE shall be recognized as Income from Grants and Donations. Sec. 11. Donation with Condition. Where a PPE is acquired thru donation with conditions or restrictions, a liability account shall be recognized until the conditions or restrictions have been fulfilled.

PROBLEMS For number 1-4 January 1, 2017, an entity disclosed the following balances: Land Land improvements Buildings Machinery and equipment

4,000,000 1,300,000 20,000,000 8,000,000

During the current year, the following transactions occurred: * A tract of land was acquired for P2,000,000 cash as a building site. *

A plant facility consisting of land and building was acquired in exchange for 200,000 shares of the entity. On the acquisition date, each share had a quoted price of P45 on a stock exchange. The plant facility was carried on the seller’s books at P1,600,000 for land and P5,400,000 for the building at the exchange date. Current appraised values for the land and the building, respectively, are P2,000,000 and P8,000,000. The building has an expected life of forty years with a P200,000 residual value.

*

Items of machinery and equipment were purchased at a total cost of P4,000,000. Additional costs incurred were freight and unloading P100,000 and installation P300,000. The equipment has a useful life of ten years with no residual value.

* Expenditures totaling P1,200,000 were made for new parking lot, street and sidewalk at the entity’s various plant locations. These expenditures had an estimated useful life of fifteen years. *

Research and development costs were P1,100,000 for the year.

*

A machine costing P200,000 on January 1, 2010 was scrapped on June 30, 2017. Straight line depreciation had been recorded on the basis of a 10-year life with no residual value.

*

A machine was sold for P500,000 on July 1, 2017. Original cost of the machine sold was P700,000 on January 1, 2014, and it was depreciated on the straight line basis over an estimated useful life of eight years and a residual value of P50,000.

1. What is the total cost of land on December 31, 2017? 7,800,000 7,600,000 8,000,000 6,800,000 2. What is the total cost of land improvements on December 31, 2017? 1,200,000 3,600,000 1,300,000 2,500,000 3. What is the total cost of buildings on December 31, 2017? 28,000,000 25,400,000 27,200,000 27,000,000 4. What is total cost of machinery and equipment on December 31, 2017? 12,400,000 11,500,000 11,000,000 11,700,000

SOLUTION Question 1 Answer A Land – January 1 Land acquired for cash Land acquired by issuing shares (2/10 x 9,000,000) Land – December 31

4,000,000 2,000,000 1,800,000 7,800,000

Quoted price of shares issued for land and building (200,000 x P45)

9,000,000

Current appraized value : Land

2,000,000

Building

8,000,000

Total

10,000,000

The total cost of the land and building is equal to the quoted price of the shares which is allocated prorata to the land and building based on the current appraised value.

Question 2 Answer D Land improvements – January 1 Expenditures for parking lot, street and sidewalk Balance – December 31

1,300,000 1,200,000 2,500,000

Question 3 Answer C Buildings – January 1 Building acquired by issuing shares (8/10 x 9,000,000) Balance – December 31

20,000,000 7,200,000 27,200,000

Question 4 Answer B Machinery and equipment - January 1 Machinery and equipment purchased Freight and unloading Installation Machinery scrapped Machinery sold Machinery equipment – December 31

8,000,000 4,000,000 100,000 300,000 ( 200,000) ( 700,000) 11,500,000

5. October 1, 2005, Tonya Company purchased a machine for P250,000 that was placed in service on November 30, 2005. Tonya incurred additional costs for this machine, as follows:

Shipping 10,000 Installation 15,000 Testing 35,000 In Tonya’s December 31, 2005 balance sheet, the machine’s cost should be reported at a.250000 b.295,000 c.300,000 d.310,000

6. On August 1, 2006, Bamco purchased a new machine on a deferred payment basis. A down payment of P100,000 was made and the balance is payable in P100,000 annually for 4 years. The current interest is 12%.The present value of an annuity at 12% for 5 years is 3.04 and the present value of an amount at the end of 5 th year at 12% is .064. The same machine could be acquired on cash basis at P400,000. Bamco should record the machine at a. 500,000 b. 400,000 c. 403,735 d. 303,735

7. To save transportation costs, X acquired its needed equipment in exchange of its inventory located in the supplier’s business place. The equipment acquired has cash price of P650,000. The inventory of X has cost of P550,000, and X paid P80,000 cash for the difference in fair value of the two assets in exchange. In the books of X, the exchange is to be accounted as resulting to a. gain of 20,000 b. loss of 20,000 c. gain of 30,000 d. loss of 30,000

8. X issued 100,000 of its common shares in the treasury stocks, in exchange for a delivery truck. The treasury stocks with P10 par were selling at P12 at date of exchange. The treasury shares

were previously acquired at cost of P11/share. The delivery truck has cash price of P1,250,000. In the books of X, the exchange will result to a. gain of P150,000 b. loss of P50,000 c. gain of P50,000 d. no gain/no loss

9. Residual value is specifically: a. The gross cash amount that is received from the ultimate sale of the asset, at the end of its life b. Scrap value c. The net cash amount that is received from the ultimate sale of the asset, at the end of its life

10. Useful life of an asset refers to the life: a. Of the asset whilst it is available for use in the firm b. The average of A and C c. Of the asset throughout its life, in the hands of any number of owners

11. Spare parts and servicing equipment are usually accounted for as: a. Inventory b. A separate class of fixed assets c. Expenses written off to the profit or loss on buying

12. Repairs and maintenance costs are normally: a. Capitalised b. Expensed in the profit or loss as incurred

c. Recorded as deferred expenses

13. Recognition of costs (to be capitalised) ceases when: a. Full production capacity has been reached b. The accounting period ends c. The item is in the location and capable of operating

14. Incidental income and expenses (such as using a site as a temporary car park) should be: a. Capitalised into the asset b. Taken to the profit or loss c. Ignored

CHAPTER 26 GOVERNMENT GRANT Government Grants These are assistance by the government in the form of transfers of economic resources to an entity as a result of entity’s past or future compliance with certain specified conditions relating to the operating activities of the entity. However, it does not include those forms of government assistance which cannot be reliably measured in monetary terms and transactions with government which are not distinguishable from the normal trading transactions of the entity. Government Assistance These are actions by the government undertaken to provide economic benefits to an entity or range of entities which qualify certain conditions. These do not have exact value placed upon them in monetary terms. Grants related to Assets The government grants which are available for the construction, acquisition or purchase of certain assets are called grants related to assets. It may be having some certain conditions attached to it regarding the nature, use or location of the asset. Grants related to Income These are government grants other than grants related to assets, and are normally available for development or improvements. Such as grant for improvement in working conditions for employees, grant for the creation of job vacancies, and grant for the training of the staff. Recognition of Government Grants Government grants are only permitted to be recognized when it is reasonably certain that: a. Grant will be received and; b. The entity will satisfy the predetermined conditions related to the government grant. Approaches for the Recognition of Government Grant There are two broad approaches to the accounting for government grants: 1. Deferred Income Approach Under this approach, government grant is recognized in statement of profit or loss using appropriate method over the periods in which the entity recognizes the related costs, for which the grant is intended to compensate. 2. Deduction to Assets Approach Under this approach, government grant is recognized outside the profit or loss because government grants are not earned, so, it is not appropriate to recognize these in profit or loss.

Moreover, government grants are financing components, thus, it should be treated as such in the statement of financial position as part of equity. Illustration (1) Tomoe Company received a government grant of P10,000,000 for the acquisition of research and development facility with a cost of P50,000,000 and useful life of 5 years with no salvaged value. Journal entries: Cash Deferred grant income Building Cash Depreciation Accumulated depreciation (P50,000,000/5 years) Deferred grant income Grant income (P10,000,000/5 years)

P10,000,00 0 P10,000,000 P50,000,00 0 P50,000,000 P10,000,00 0 P10,000,000 P2,000,000 P2,000,000

Note: Grant related to non-depreciable asset, such as land, requiring fulfillment of certain conditions shall be recognized as income over the periods which bear the cost of meeting the conditions.

Illustration (2) Kou Company received a grant of P30,000,000 from Korean government to compensate the damages incurred from a massive cyclone. Journal entries: Cash Grant income

P30,000,00 0 P30,000,000

Note: A government grant that becomes receivable as compensation for expenses or losses already incurred or for the purpose of giving immediate financial support to the entity with no further related costs shall be recognized as income of the period in which it becomes receivable.

Illustration (3) On January 1, 2019, Naruse Company received a government grant of P8,000,000 for the acquisition of equipment for P10,000,000. It is to be depreciated on a straight line basis over 10 years with a residual value of P500,000. Journal entries for the current year Using deferred income approach: To record the acquisition of the asset: Equipment P10,000,00 0 Cash To record the government grant: Cash Deferred grant income To record the annual depreciation: Depreciation Accumulated depreciation (P10M-P500,000/10 years)

P10,000,000

P8,000,000 P8,000,000 P950,000 P950,000

To recognize the income from government grant: Deferred grant income P800,000 Grant income (P8,000,000/10 years)

P800,000

Using deduction from asset approach: To record the acquisition of the asset: Equipment P10,000,00 0 Cash To record the government grant: Cash Equipment To record the annual depreciation: Depreciation Accumulated depreciation Acquisition cost Government grant Net cost Residual value

P10,000,000

P8,000,000 P8,000,000 P150,000 P150,000* P10,000,000 ( 8,000,000) P 2,000,000 ( 500,000)

Depreciable amount Annual depreciation (P1,500,000/10 years)

P 1,500,000 P 150,000*

Illustration (4) On January 1, 2019, an entity received P20,000,000 government grant related to a building that is purchased on same date at a cost of P30,000,000. It has a useful life of 10 years with no residual value. On January 1, 2021, the full amount of the grant became repayable due to non-compliance of the entity with the conditions attached in the government grant. Using deferred income approach: 2019 Jan. 1

Building

1

Cash Cash

Dec. 31 Dec. 31 2020 Dec. 31 Dec. 31 2021 Jan. 1

Dec. 31

Deferred grant income Depreciation Accumulated depreciation (P30,000,000/10 years) Deferred grant income Grant income (P20,000,000/10 years)

P30,000,00 0 P30,000,000 P20,000,00 0 P20,000,000 P3,000,000 P3,000,000 P2,000,000 P2,000,000

Depreciation Accumulated depreciation Deferred grant income Grant income

P3,000,000

Deferred grant income

P16,000,00 0 P4,000,000

Loss on repayment of grant Cash Depreciation Accumulated depreciation

P3,000,000 P2,000,000 P2,000,000

P20,000,000 P3,000,000 P3,000,000

Building Accumulated depreciation (P3,000,000*3 years) Carrying amount (December 31, 2021) Using deduction from asset approach: 2019 Jan. 1

Building

P30,000,000

P30,000,000 ( 9,000,000) P21,000,000

1 Dec. 31 2020 Dec. 31 2021 Jan. 1 Dec. 31

Cash Cash Building Depreciation Accumulated depreciation (P10,000,000/10 years)

P30,000,000 P20,000,000 P20,000,000 P1,000,000 P1,000,000

Depreciation Accumulated depreciation

P1,000,000

Building Cash Depreciation Accumulated depreciation

P20,000,000

P1,000,000 P20,000,000 P7,000,000* P7,000,000

Depreciation on original carrying amount Depreciation on increased carrying amount (P20,000,000/10*3) Total depreciation for 2021

P1,000,000

Building (P10,000,000+ P10,000,000) Accumulated depreciation (P1,000,000+ P1,000,000+P7,000,000) Carrying amount (December 31, 2021)

P30,000,000

P6,000,000 P7,000,000*

( 9,000,000) P21,000,000

Note: Whether the entity follows the deferred income approach or the deduction from asset approach, the carrying amount after repayment of the grant is the same.

PROBLEMS: 1. Government grants should be recognized when there is: A. Absolute certainty that the entity will comply with the conditions attaching to them and the grant will be received. B. Reasonable assurance that the entity will comply with the conditions attaching to them and the grant will be received. C. A probability that the entity will comply with the conditions attaching to them and the grant will be received. D. Some possibility that the entity will comply with the conditions attaching to them and the grant will be received. 2. Which statement is not true about the recognition of government grant? A. Government grants are recognized in profit or loss on a systematic basis over the periods in which the entity recognizes as expenses the related costs for which the grants are intended to compensate. B. A government grant that becomes receivable as compensation for expenses or losses already incurred or for the purpose of giving immediate financial support to the entity with no future related costs is recognized in profit or loss of the period in which it becomes receivable. C. An entity recognizes government grants only when there is reasonable assurance that the entity will comply with the conditions attached to them and the grants will be received. D. An entity recognizes government grants even when there is no reasonable assurance that the entity will comply with the conditions attached to them and the grants will be received.  3. IAS 20 deals with almost all types of government grants, except: A. Grant related to income or reimbursement of expenditures B. Grant related to agriculture C. Grant for ecological measures D. Grant for research and development 4. Which of the following is not covered by IAS 20? A. Tax breaks B. Employment grants C. Subsidized loans D. Forgivable loans 4. Which of the following can be considered a government grant? A. Grant related to agriculture under IAS 41. B. Government assistance in the form of tax reliefs, such as tax breaks, tax holidays, etc. C. Government loan at a below-market rate of interest.

D. Government assistance whose value cannot be reasonably measured, such as technical or marketing advice. 5. Which of the following is not a correct treatment of government grants related to income? A. Present as a separate credit under a general heading (eg. ‘Other income’) B. Deduct from the related expense C. Deduct from the cost of the asset 6. Which of the following is not a correct treatment of government grants related to an asset? A. Deferred income B. Credit to income in period received C. Deducting the grant from the carrying amount of the asset

7. Which statement is not true under the income approach? A. Government grant is recognized in statement of profit or loss using appropriate method over the periods in which the entity recognizes the related costs. B. Government grant is recognized in statement of profit or loss using appropriate method over the periods for which the grant is intended to compensate. C. Government grant should be recognized directly in equity because these are received from an equity participant. D. Government grant should not be recognized directly in equity because these are received from a source other than equity participants.

8. If an entity receives a non-monetary asset as a grant, this is accounted for at? A. B. C. D.

Market value Fair value Present value Discounted value

9. If a grant must be repaid it is A. B. C. D.

An error A revision of an accounting policy A revision of an accounting estimate A new transaction

10. Which of the following disclosures is not a requirement of IAS 20? A. B. C. D.

Accounting policy adopted for grants Nature and extent of grants recognised in the financial statements Current grant applications in process Unfulfilled conditions, contingencies attaching to recognised grants

11. An entity receives a forgivable loan from the local government. It does not expect to meet the relevant terms for forgiveness. This loan should be treated as? A. Government Grant B. Liability 12. On January 1, 2019, Haru Company purchased a machine for P3,000,000. The entity received a government grant of P600,000 in relation to the acquisition. The machine is to be depreciated on a 20% declining balance over 5 years with a residual value of 150,000. Using deferred income approach, what amount should be recorded as depreciation at the end of the year? A. B. C. D.

P150,000 P90,000 P600,000 (P3,000,000*20%) P480,000

13. Using the previous example, what amount should be recorded as depreciation at the end of the year under the deduction from asset approach? A. B. C. D.

P150,000 P90,000 P600,000 P480,000 [P3,000,000-P600,000)*20%]

14. An entity received a P25,000 grant toward the purchase of new equipment that costs P100,000. The equipment has a five-year life and is depreciated on a straight-line basis. Prepare journal entries for the current year using deferred income approach and deduction from asset approach. Answer: Deferred income approach:

Equipment Cash

P100,000

Cash Deferred grant income

P25,000

Depreciation (P100,000/5) Accumulated depreciation

P20,000

Deferred grant income Grant income (P250,000/5)

P5,000

P100,000 P25,000 P20,000 P5,000

Deduction from asset approach: Equipment Cash

P100,000

Cash Equipment

P25,000

Depreciation (P75,000/5) Accumulated depreciation

P15,000

P100,000 P25,000 P15,000

15. Kou Company received a grant of P20,000,000 from the Japanese government to compensate for massive losses due to a recent earthquake. Prepare the journal entries for the current year to record the grant. Answer: Cash

P20,000,00 0

Grant income

P20,000,000

16. On January 1, 2019, a foreign government granted Kazehaya Company a P11,000,000 loan for acquiring land to be used as a building site. The grant is a five-year zero-interest loan evidenced by a promissory note. The market rate of interest is 6% and the present value of 1 for 5 periods at 6% is .7473. Prepare journal entries for 2019 and 2020. Answer:

2019 Jan. 1

Dec. 31 31 2020 Dec. 31 31

Cash

P11,000,00 0 2,779,700

Discount on notes payable Loan payable Deferred grant income Interest expense Discount on notes payable Deferred grant income Grant income

P11,000,000 2,779,700 493,218 493,218 493,218 493,218

Interest expense Discount on notes payable Deferred grant income Grant income

522,811.08 522,811.08 522,811.08 522,811.08

Computation: Carrying amount, 1/1/2019 (P11,000,000*.7473) Interest for 2019 (P8,220,300*6%) Carrying amount, 1/1/2020 Interest for 2020 (P8,713,518*6%)

P8,220,300 493,218 P8,713,518 P522,811.08

17. On January 1, 2019, an entity received P10,000,000 government grant related to a building that is purchased on same date at a cost of P20,000,000. It has a useful life of 10 years with no residual value. On January 1, 2021, the full amount of the grant became repayable due to non-compliance of the entity with the conditions attached in the government grant. Prepare journal entries for 2019, 2020 and 2021 using deferred income approach. Answer: 2019 Jan. 1

Building

1

Cash Cash

Dec. 31 Dec. 31

Deferred grant income Depreciation Accumulated depreciation (P20,000,000/10 years) Deferred grant income Grant income

P20,000,00 0 P20,000,000 P10,000,00 0 P10,000,000 P2,000,000 P2,000,000 P1,000,000 P1,000,000

(P10,000,000/10 years) 2020 Dec. 31 Dec. 31 2021 Jan. 1 Dec. 31

Depreciation Accumulated depreciation Deferred grant income Grant income

P2,000,000

Deferred grant income Loss on repayment of grant Cash Depreciation Accumulated depreciation

P8,000,000 P2,000,000

P2,000,000 P1,000,000 P1,000,000

P10,000,000 P2,000,000 P2,000,000

18. Using the same problem, determine the carrying amount after repayment of the grant using deferred income approach. Solution: Building Accumulated depreciation (P2,000,000*3 years) Carrying amount (December 31, 2021)

P20,000,000 ( 6,000,000 ) P14,000,000

19. Using the same problem, prepare journal entries for 2019, 2020 and 2021 using deduction from asset approach. 2019 Jan. 1 1 Dec. 31 2020 Dec. 31 2021 Jan. 1 Dec. 31

Building Cash Cash Building Depreciation Accumulated depreciation (P10,000,000/10 years)

P20,000,000

Depreciation Accumulated depreciation

P1,000,000

Building Cash Depreciation Accumulated depreciation

P10,000,000

P20,000,000 P10,000,000 P10,000,000 P1,000,000 P1,000,000

P1,000,000 P10,000,000 P4,000,000*

* Depreciation on original carrying amount Depreciation on increased carrying amount

P4,000,000 P1,000,000

(P10,000,000/10*3) Total depreciation for 2021

P3,000,000 P4,000,000

20. Using the same problem, determine the carrying amount after repayment of the grant using deduction from asset approach. Building (P10,000,000+ P10,000,000) Accumulated depreciation (P1,000,000+ P1,000,000+P4,000,000) Carrying amount (December 31, 2021)

P20,000,000 ( 6,000,000 ) P14,000,000

Chapter 27

Chapter 28 Land and Building Land is considered to be the asset with the longest term, it cannot be depreciated. Thus, the life span of land is indefinite. Land is classified as long-term asset or a fixed asset on business’ balance sheet, because it is not expected to convert cash in just a span of one year. When acquiring a land, certain costs are ordinary and necessary that should be assigned to land. These costs include the a. b. c. d. e. f. g. h. i. j. k.

cost of the land title fees legal fees survey costs and zonal fees site preparation costs like grading, clearing and draining the costs to demolish an old structure real estate commissions title search and title transfer fees title insurance premiums existing mortgage not or unpaid taxes (back taxes) assumed by the purchaser and other similar expenditures

All of these costs are directly attributed to get the land ready for intended use. The account debits the entire costs to Land. Land Improvements The costs of the land improvements includes all expenditures associated with making the improvements to the land for its intended use. This asset category includes the ff: a. b. c. d. e.

Parking lots Sidewalks Landscaping Irrigation systems And other similar expenditures

Land and land improvements have separate account for considering depreciation. Land have an indefinite life and is not subject to depreciation. However, land improvements like parking lots, irrigations and many more wear out throughout the years, hence, it is depreciated. Building Building, like land, is also a noncurrent long-term asset of the company. However, the building is depreciated throughout the years because it is subject to wear and tear, damages like calamity and so on and so forth. When acquiring or constructing a building, the costs that is

capitalize to the building would include all the expenses associated with purchasing or construction of the building for its preparation for its intended use. Like the case in the land, companies acquire or construct buildings for several purposes, investment or for usage. The cost of the building must include: a. Purchase price (includes the price paid to the seller for the old structure) b. Closing costs (include professional fees paid to attorneys, agencies including title searches, title insurance, survey costs, as well as fees paid to the government entities to register the sale) c. Construction costs (materials, labor, and overhead costs associated with the construction of the building. d. Fees (construction permits, architectural, and engineering services) Generally, the cost of new building starts with the excavation of land to receive the new structure. The cost of demolishing and removing the existing structure from the land, as well as the cost for grading, clearing trees and levelling are costs attributable to the land and not to the building. Building Improvements Building improvements are capital events that materially extends the life of the building and/or increase the value of it. These improvements are capitalized and are recorded as an addition of value to the existing building if the expenditure meets the capitalization threshold. Unlike, land improvements these improvements are not accounted separately for a building is also subject to depreciation. Building fixtures, ventilating system, lighting system, elevator and others if put in within the construction of the building and are immovable or attached to, the costs are capitalized to the building account. However if such fixtures are movable, these are recorded to furniture and fixtures account.

Cost Assignment The correct amount of cost to allocate to a productive asset like land and building are based on those expenditures that are ordinary and necessary to get the item in place and in place for its intended use. Such amount include the purchase freight (less any negotiated amount), permits, ordinary installation, and other normal costs associated with getting the property ready for intended usage. These costs are termed capital expenditures and are assigned to the asset account. GAAP determines if the demolition costs are capitalized or expensed depending on the ff. situations.

a. If the land and building are purchased with the intention to use the land and demolish the building, the cost to demolish the old building is capitalized to Land improvements. b. If land and building arte purchased with the intention to use the land, demolish the building and build a new one, capitalize the cost to demolish the building as part of cost of new building if demolition occurs thereafter. c. If land and building are purchased with the initial intention to use the land and building, expense the costs to demolish the existing building at a later date. The demolition cost are an expense associated with the cost of using the existing asset as and are not capitalized in the cost of the new asset.

PROBLEMS Problem 28-1 Mi-len Co. purchased an old farm on the outskirts of Nueva Ecija to be used as a factory site. The company paid P10,000,000 for the property. The company agreed to pay the unpaid taxes of P300,000. Attorneys’ and other legal cost of P81,000. The company demolished the old structures for P900,000. The company where able to sell some structure for P135,000. What is the cost of the land? a. b. c. d.

P11,145,000 P11,146,000 P14,150,000 P16,146,000

Answer: B Cost of Factory Site Back taxes Attorneys’ fees and other legal fees Demolition Sale of salvaged parts Total Land Cost

P10,000,000 300,000 81,000 900,000 (135,000) P11,146,000

Problem 28-2 Anieting Co. decided to purchase a new land with the intention of constructing new building. The following are the data for the acquisition of the land. Land Closing Costs Costs of demolishing old warehouse What is the cost of the land? a. b. c. d.

P21,600,000 P21.820,000 P21,060,000 P21,280,000

P20,500,000 560,000 220,000

Answer: C Land Closing costs Land cost

P20,500,000 560,000 P21,060,000

Problem 28-3 and 4 JR Inc. decided to acquire a land for the construction of a new resort to be used in business. The following were incurred by JR Inc. in the acquisition of land. Land Razing Costs Residual value Legal Fees Survey Plans Title Insurance Liability Insurance Construction Interest

P450,000 42,000 6,300 1,850 2,200 65,000 1,500 900 2,740,000 170,000

What is the cost of the land? a. b. c. d.

589,000 2,978,100 489,500 489,050

What is the cost of the building? a. b. c. d.

589,000 2,978,100 489,500 489,050

Answer: D, B The allocation of costs is as follows: Land Land Razing Costs

P450,000 42,000

Building

Residual value Legal Fees Survey Plans Title Insurance Liability Insurance Construction Interest

(6,300) 1,850 2,200 65,000 1,500 900 2,740,000 170,000 P498,050

P2,978,100

Problem 28-5 and 6 During the current year Johnny Company had the following transactions for the purchase of its new building. Purchase of land as a building site Architect Fees Legal Fees for the purchase of land Demolition Salvage sale Construction of new building

500,000 100,000 25,000 75,000 20,000 1,800,000

What is the cost of the building? a. b. c. d.

1,955,000 1,980,000 2,480,000 525,000

What is the cost of the land? a. b. c. d.

1,955,000 1,980,000 2,480,000 525,000

Answers: A, D Land Purchase of land as a building site Architect Fees Legal Fees for the purchase of land

Building

500,000 100,000 25,000

Demolition Salvage sale Construction of new building

75,000 (20,000) 1,800,000 P525,000

P1,955,000

Problem 28-7 Lany Inc. acquired an existing building in exchange of 50,000 ordinary shares. The list price of the building is P8,000,000 and the shares have affair value of P120. The entity also incurred the following transactions. Payment to tenants to vacate the building Unpaid property taxes assumed by Lany Assessment by city for sewerage project Driveways and parking lot bays Cost of grading and leveling Cost of new wing attached to the building Cost of new ventilation system Remodeling costs prior to occupancy

65,000 100,000 10,000 550,000 45,000 750,000 300,000 200,000

What is the total cost of the building? a. b. c. d.

9,115,000 7,115,000 7,415,000 7,125,000

Answer: B Cost of ordinary shares exchanged (50,000×120) Payment to tenants to vacate the building Unpaid property taxes assumed by Lany Cost of new wing attached to the building Remodeling costs prior to occupancy

P6,000,000 65,000 100,000 750,000 200,000 P7,115,000

Problem 28-8 An entity purchased land and an old hotel on which it is located with the plan to tear down the hotel and build a new hotel on the site. Any allocated cost to the old hotel should be:

a. b. c. d.

Depreciated over the period from the acquisition to the date the hotel is to be tear down Written off as loss in the year the hotel was torn down Capitalized as part of the cost of the land Capitalized as part of the cost of the building

Answer: B

Problem 28-9 On January 2019. Flor Company purchased a track of land with an old building which is razed shortly after acquisition to make room for the construction of new building. The costs incurred in connection with the acquisition were: Total purchase price (the old building has a fair value of P300,000) Agent commission Legal fees for the purchase contract Guarantee insurance Cost of razing the old building Salvaged values of old building materials

3,000,000 100,000 50,000 10,000 150,000 25,000

What is the cost of the land? a. b. c. d.

2,865,000 3,165,000 2,860,000 2,990,000

Answer: A Total purchase price (3000,000 – 300,000) Agent commission Legal fees for the purchase contract Guarantee insurance

2,700,000 100,000 50,000 10,000 2,860,000

Problem 28-10 In the preceding problem, the construction of the building was started right after the razing of the old building. The following costs are incurred by the company: Construction of new building

16,000,000

Furniture and Fixtures attached to the building Ventilation and other equipment acquired later on after the construion

260,000 350,000

What is the total cost of the building? a. b. c. d.

16,385,000 10,385,000 16,260,000 16,735,000

Answer: A Cost of razing the old building Salvaged values of old building materials Construction of new building

150,000 (25,000) 16,000,000

Furniture and Fixtures attached to the building

260,000 16,385,000

Problem 28-11 Reddhots Inc. purchased a track of land as a factory site for 3,200,000. The company demolished the old building and sold the materials it salvaged. Demolition of old building Legal fees for purchase contract Guarantee insurance Sale of salvaged materials

180,000 160,000 22,000 70,000

What is the initial carrying amount of the land? a. b. c. d.

3,632,000 3,562,000 3,382,000 3,458,000

Answer: B Land Legal fees for purchase contract Guarantee insurance Problem 28-12 and 13

3,200,000 160,000 22,000 3,382,000

On Januray 2019, Jeff Company decided to expand its operations and had purchased land and an old building for construction of a new manufacturing plant, the following costs were incurred in purchasing the property and constructing the new building. Purchase price (the old building has no fair value) Payment of property and taxes Title search and insurance Special assessment for city improvements on water and sewer Building permit Cost to demolish old building Contract cost of new building Architect fee Sidewalk and parking lot Fire insurance on building

2,500,000 100,000 50,000 150,000 30,000 60,000 7,000,000 200,000 100,000 40,000

What is the cost of the land? a. b. c. d.

2,860,000 2,810,000 2,800,000 2,750,000

Answer: D Purchase price (the old building has no fair value) Payment of property and taxes Title search and insurance Sidewalk and parking lot

2,500,000 100,000 50,000 100,000 2,750,000

Problem 28-13 In the preceding problem, what is the cost of the building? a. b. c. d.

7,440,000 7,290,000 7,390,000 7,330,000

Answer: B Building permit Cost to demolish old building Contract cost of new building

30,000 60,000 7,000,000

Architect fee

200,000 7,290,000

Problem 28-14 Grace Inc. acquired an existing building in exchange of 20,000 ordinary shares. The list price of the building is P3,500,000 and the shares have affair value of P150. The entity also incurred the following transactions. Payment to tenants to vacate the building Unpaid property taxes assumed by Grace Assessment by city for sewerage project Driveways and parking lot bays Cost of grading and leveling Cost of new wing attached to the building Cost of new ventilation system Remodeling costs prior to occupancy

65,000 100,000 10,000 550,000 45,000 750,000 300,000 200,000

What is the total cost of the building? a. b. c. d.

6,115,000 4,115,000 4,415,000 4,125,000

Answer: B Cost of ordinary shares exchanged (20,000×150) Payment to tenants to vacate the building Unpaid property taxes assumed by Grace Cost of new wing attached to the building Remodeling costs prior to occupancy

P3,000,000 65,000 100,000 750,000 200,000 P4,115,000

Problem 28-15 On January 2019. Just Company purchased a track of land with an old building which is razed shortly after acquisition to make room for the construction of new building. The costs incurred in connection with the acquisition were: Total purchase price (the old building has a fair value of P200,000) Agent commission Legal fees for the purchase contract Guarantee insurance

6,000,000 120,000 50,000 10,000

Cost of razing the old building Salvaged values of old building materials

200,000 50,000

What is the cost of the land? a. b. c. d.

5,980,000 6,200,000 6,080,000 5,200,000

Answer: A Total purchase price (6,000,000 – 200,000) Agent commission Legal fees for the purchase contract Guarantee insurance

5,800,000 120,000 50,000 10,000 5,980,000

Problem 28-16 In the preceding problem, the construction of the building was started right after the razing of the old building. The following costs are incurred by the company: Construction of new building Furniture and Fixtures attached to the building Ventilation and other equipment acquired later on after the construion

14,000,000 260,000 350,000

What is the total cost of the building? a. b. c. d.

14,410,000 14,140,000 10,140,000 11,140,000

Answer: A Cost of razing the old building Salvaged values of old building materials Construction of new building Furniture and Fixtures attached to the building

200,000 (50,000) 14,000,000 260,000 14,410,000

Problem 28-17 Alexis Co. decided to purchase a new land with an old warehouse. The old warehouse was eventually razed after the acquisition by Alexis. The following are incurred by the company.

Land Closing Costs Costs of demolishing old warehouse Sale of salvaged materials from the warehouse Legal fees in purchase contract of the land

11,000,000 350,000 250,000 50,000 10,000

What is the cost of the land? a. b. c. d.

P11,600,000 P11.820,000 P11,360,000 P11,280,000

Answer: C Land Closing Costs Legal fees in purchase contract of the land

11,000,000 350,000 10,000 11,360,000

Problem 28-18 EXO Inc. decided to acquire a land for the construction of a new resort to be used in business. The following were incurred by EXO Inc. in the acquisition of land. Land Razing Costs Residual value Legal Fees Survey Plans Title Insurance Liability Insurance Construction

P520,000 55,000 6,300 1,850 2,200 77,000 10,000 5,000 2,850,000

What is the cost of the building? a. b. c. d.

2,589,000 2,540,000 3,600,000 2,934,200

Answer: D Survey

2,200

Plans Liability Insurance Construction

77,000 5,000 2,850,000 2,934,200

Problem 28-19 and 20 During the current year Miggy Company had the following transactions for the purchase of its new building. Purchase of land as a building site Architect Fees Legal Fees for the purchase of land Demolition Salvage sale Construction of new building Furniture and fixtures attached to the Building Ventilation purchased within the construction of the building Agent Commission

15,000,000 200,000 125,000 110,000 85,000 17,500,000 620,000 60,000 1,500,000

What is the cost of the building? a. b. c. d.

18,405,000 15,550,000 16,650,000 16,625,000

What is the cost of the land? a. b. c. d.

18,405,000 15,550,000 16,650,000 16,625,000

Answers: A, D Land Purchase of land as a building site Architect Fees Legal Fees for the purchase of land Demolition Salvage sale

Building

15,000,000 200,000 125,000 110,000 (85,000)

Construction of new building Furniture and fixtures attached to the Building Ventilation purchased within the construction of the building Agent Commission

17,500,000 620,000 60,000 1,500,000 16,625,000

18,405,000

CHAPTER 29- Machinery Machinery is a noncurrent or long-term asset account which reports the cost of the machinery. Machinery will be depreciated over its useful life by debiting the income statement account Depreciation Expense and crediting the balance sheet account Accumulated Depreciation (a contra asset account). Cost(s) to Capitalize: a. Purchase price including import duties and non-refundable purchase taxes after deducting trade discounts and rebate. b. Cost directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by the management. c. Insurance on machinery while in transit. d. Cost of special foundations if required. e. Assembling and installation cost. f. Cost of conducting trial runs. Costs to capitalize are mainly all expenditures incurred in acquiring the machinery and the preparation for its intended use. Self-Constructed Machinery: In cases where the entity constructs its own machinery, there would be an issue in determining cost of such machinery. Without a purchase price, the company must allocate costs and expenses incurred to determine the cost to capitalize for the machinery such as: a. Direct Material b. Direct Labor c. Overhead, which includes; heat, light, insurance, property taxes on factory buildings and equipment, factory supervisory labor, depreciation of fixed assets, and supplies. Equipment Equipment includes delivery and transportation equipment, office equipment, machinery, furniture and fixtures, furnishings, factory equipment, and similar fixed assets. Cost(s) to Capitalize: a. Purchase price including other necessary costs, such as broker’s commissions and nonrefundable purchase taxes. b. Freight, handling charges, and insurance on the equipment while in transit c. Cost of necessary special foundations or platforms d. Assembling and installation costs e. Initial estimate of decommissioning and restoration costs for which the entity has a present obligation

Cost(s) NOT included: a. Cost of relocating the equipment after it has been put to the location and condition originally intended by management. b. Cost of training personnel who will be responsible in operating the equipment c. Cost of dismantling and removing an old equipment belonging to the entity prior to the installation of a new equipment PROBLEMS: 1. In testing for unrecorded retirements of equipment, to verify this assumption you will most likely to: a. Select items of equipment from the accounting records and then locate them during the plant tour. b. Compare depreciation journal entries with similar prior-year entries in search of fully depreciated equipment. c. Inspect items of equipment observed during the plant tour and then trace them to the equipment subsidiary ledger. d. Scan the general journal for unusual equipment additions and excessive debits to repairs and maintenance expense. 2. Additions to equipment are sometimes understated. Which of the following accounts would be reviewed to gain reasonable assurance that additions are not understated? a. Accounts payable c. Depreciation expense b. Gain on disposal of equipment d. Repair and maintenance expense 3. You obtain the following information pertaining to Puto Se Co. Machinery for 2020 in connection with your audit of the company’s financial statements. Blance as of December 31,2019: Machinery and equipment 22,500,000 Accumulated depreciation – Machinery and Equipment 6,250,000 Puto Se Co. uses straight line method over the ten-year useful life of the machinery and equipment. On April 1, 2020, a machine purchased for P575,000 on April 1, 2015 was destroyed by fire. Puto recovered P387,500 from its insurance company. On July 1, 2020, machinery and equipment were purchased at a total invoice cost of P7,000,000; additional cost of P125,000 for freight and P625,000 for installation were incurred. How much is the Accumulated depreciation – Machinery and Equipment as of December 31, 2020 where salvage value is immaterial? a. P8,844,375 b. P8,614,375 c. P8,830,000 d. P8,556,875

4. The following items relate to the acquisition of a new machine by Bongabon Corporation in 2020: Invoice price of machinery Cash discount not taken Freight on new machine Cost of removing the old machine Loss on disposal of the old machine Gratuity paid to operator of the old machine who was laid off Installation cost of new machine Repair cost of new machine damaged in the process of installation Testing costs before machine was put into regular operation Salary of engineer for the duration of the trial run Operating cost during first month of regular use Cash allowance granted because the new machine proved to be of inferior quality

P2,000,000 40,000 10,000 12,000 150,000 70,000 60,000 8,000 15,000 40,000 250,000 100,000

How much should be recognized as cost of the new machine? a. P1,985,000 c. P1,930,000 b. P1,993,000 d. P2,025,000 5. An improvement made to a machine which increased the fair value and production capacity without extending the useful life of the machine should be a. expensed immediately b. debited to accumulated depreciation c. capitalized in the machine account d. allocated between accumulated depreciation

6. Which of the following would ordinarily be treated as a revenue expenditure rather than a capital expenditure? a. cost of servicing and overhaul to restore or maintain the originally assessed standard of performance b. the replacement of a major component of building c. an addition to an existing building d. cost of improvement that is expected to provide discernible future benefit 7. Which of the following costs should not be capitalized? a. replacement of roof of building every 15 years b. cost of site preparation c. installation and assembly cost d. replacement of small spare parts annually 8. Which of the following subsequent expenditure should be expensed immediately? a. expenditure made to increase the efficiency or effectiveness of an existing asset b. expenditure made to extend the useful life of an existing asset c. expenditure made to maintain an existing asset in operating condition d. expenditure made to add new asset 9. An expenditure made in connection wuth a machine being used by an entity shoul be a. expensed if it merely extends the useful life but does not improve the quality b. expensed if it merely improves the quality but does not extend the useful life c. capitalized if it maintains the machine in normal operating condition d. capitalized if it increases the quantity of units produced by the machine 10. On January 1, year 1, an entity acquires for $100,000 a new piece of machinery with an estimated useful life of 10 years. The machine has a drum that must be replaced every five years and costs $20,000 to replace. Continued operation of the machine requires an inspection every four years after purchase; the inspection cost is $8,000. The company uses the straight-line method of depreciation. Under IFRS, what is the depreciation expense for year 1? a. $10,000 b. $10,800 c. $12,000 d. $13,200

11. Wilson Company maintains its records under IFRS. During the current year Wilson sold a piece of equipment used in production. The equipment had been accounted for using the revaluation method and details of the accounts and sale are presented below. Sales price $100,000 Equipment book value (net) 90,000 Revaluation surplus 20,000 Which of the following is correct regarding recording the sale? a. The gain that should be recorded in profit and loss is $30,000. b. The gain that should be recorded in other comprehensive income is $10,000. c. The gain that should be recorded in other comprehensive income is $30,000. d. The gain that should be recorded in profit and loss is $10,000; the $20,000 revaluation surplus should be transferred to retained earnings. 12. On June 18, year 4, Dell Printing Co. incurred the following costs for one of its printing presses: Purchase of collating and stapling attachment

$84,000

Installation of attachment

36,000

Replacement parts for overhaul of press

26,000

Labor and overhead in connection with overhaul

14,000

The overhaul resulted in a significant increase in production. Neither the attachment nor the overhaul increased the estimated useful life of the press. What amount of the above costs should be capitalized? a. $0 b. $84,000 c. $120,000 d. $160,000 13. A building suffered uninsured fire damage. The damaged portion of the building was refurbished with higher quality materials. The cost and related accumulated depreciation of the damaged portion are identifiable. To account for these events, the owner should a. Reduce accumulated depreciation equal to the cost of refurbishing. b. Record a loss in the current period equal to the sum of the cost of refurbishing and the carrying amount of the damaged portion of the building. c. Capitalize the cost of refurbishing and record a loss in the current period equal to the carrying amount of the damaged portion of the building. d. Capitalize the cost of refurbishing by adding the cost to the carrying amount of the building.

14. Derby Co. incurred costs to modify its building and to rearrange its production line. As a result, an overall reduction in production costs is expected. However, the modifications did not increase the building’s market value, and the rearrangement did not extend the production line’s life. Should the building modification costs and the production line rearrangement costs be capitalized? Building modification costs Production line rearrangement costs a. Yes No b. Yes Yes c. No No d. No Yes 15. Initial test batches are allowable as directly attributable cost of machine. FALSE 16. If a company purchased a land with an office building. The building has a useful life of 20 years and it should be depreciated over the useful life of the land. FALSE 17. An expenditure that benefits only the current period is a revenue expenditure and therefore reported as an expense. TRUE 18. If a machinery is removed and retired to make room for the installation of a new one, the removal cost not previously recognized as a provision is charged to expense. TRUE 19. Subsequent cost that maintains the existing level of standard performance should be expensed when incurred. TRUE 20. Insurance of sold machinery can be capitalized either FOB destination or shipping point. FALSE

CHAPTER 30: DEPRECIATION Straight line and Variable Method

Depreciation-is the systematic allocation of the depreciable amount of an asset over its useful life. Depreciation of an asset begins when it is available for use and it ceases when held for sale (or included in a disposal group that is classified as held for sale). Therefore, depreciation does not cease when the asset becomes idle or retired from the active use unless the asset is fully depreciated. However, under the usage methods of depreciation, the depreciation can be zero while there is no production. The residual value and the useful life of an asset shall be reviewed at least at each financial yearend and, if expectations differ from previous estimates, the change shall be accounted for as a change in an accounting estimate. Depreciation is recognized even if the fair value of the asset exceeds its carrying value; as long as the asset’s residual value does not exceed its carrying amount. The depreciation amount of an asset is determined after deducting its residual value. In practice, the residual value of an asset is often insignificant and therefore immaterial in the calculation of the depreciable amount. The residual value of an asset may increase to an amount equal to or greater than the carrying value of an asset. If it does, the asset’s depreciation charge is zero unless and until its residual value subsequently decreases to an amount below the asset’s carrying amount. The depreciation method applied to an asset shall be reviewed at least at each financial year-end, if there has been a significant change in the expected pattern of consumption of the future economic benefits embodied in the asset, the method shall be changed to reflect the changed pattern. Such a change shall be accounted for as a change in accounting estimate. Derecognition- an item of property, plant and equipment should be derecognized when:

a.) It is disposed b.) No future economic benefit

Methods of Depreciation 1. Straight-line method -Considers depreciation as a function of time rather than as a function of usage. -Straight line rate is determined by dividing 100% by the life of the asset in years. Formula: (Acquisition cost-Residual value)/ useful life Journal entry: Depreciation Expense Accumulated Depreciation 2. Composite and group method -Under the composite method, assets that are dissimilar in nature or assets that have different physical characteristics and vary widely in useful life, are grouped and treated as a single unit, -Under the group method, all assets that are similar in nature and in estimated useful life are grouped and treated as a single unit.

3. Working hours method -Depreciation rate per hour is computed by dividing the depreciable amount by estimated useful life in terms of service hours. -Depreciation rate per hour is then multiplied by the actual hours worked in one period to get the depreciation for that period.

4. Output or production method -Depreciation rate per unit is computed by dividing the depreciable amount by the estimated useful life in terms of units of output. -Depreciation rate per unit is then multiplied by the yearly output to get the annual depreciation.

PROBLEMS 1. On January 1,2019 Lodi Company bought machinery under a contract that required a down payment of P100,000, plus 24 monthly payments of P50,000 each, for total cash payments of P1,300,000. The cash price of the machinery was P1,100,000. The machinery has a useful life of 10 years and residual value of P50,000. Lodi uses straight line depreciation. What amount should Lodi report as depreciation for 2019? Solution: (P1,100,000-P50,000)/10= P105,000 2. Justine Company purchased an asset with a useful life of 10 years on January 1, 2019 for P6,500,000. On December 31, 2019, the amount the entity would receive from the disposal of the asset if it was already of the age and in condition expected at the end of its useful life was estimated at P700,000. Inclusive of inflation, the actual amount expected to be received on disposal was estimated at P900,000. What is the depreciation charge for 2019? Solution: (P 6,500,000-P700,000)/10= P580,000 3. The following information is taken from the statement of financial position of Petmalu Company on December 31,2019 and December 31,2018. 2019 Building cost

2018

P25,000,000

P25,000,000 Accumulated depreciation-buildings

P5,000,000

P3,875,000 Petmalu did not acquire or dispose of any buildings during 2019. The straight line method of depreciation is used. If residual value is assumed to be 10% of asset cost, what is the average useful life of the buildings?

Solution: Accumulated depreciation-2019 P5,000,000 Accumulated depreciation-2018 3,975,000 Annual depreciation P1,125,000 Average life (25,000,000-2,500,000)/1,125,000

20

4. On January 1,2019, Jocelle Company acquired equipment for P1,000,000 with a 10-year useful life and P100,000 residual value. The straight line method depreciation is used. During 2023, after its 2010 financial statements has been issued, Jocelle determined that this equipment’s remaining useful life was only four more years and its residual value would be P40,000. What is the carrying amount of the equipment on December 31,2023? Solution: Cost-January 1, 2019 Accumulated depreciation on January 1,2023

P1,000,000 360,000

(P900,000/10x4) Carrying amount on January 1,2023

640,000

Depreciation for 2023 (640,000-40,000/4)

150,000

Carrying amount- December 31,2023

P490,000

5. Cardo Company’s depreciation policy on machinery is as follows: 

A full year’s depreciation is taken in the year of an asset’s acquisition.



No depreciation is taken in the year of an asset’s disposition.



The estimated useful life is five years.



The straight line method is used.

On June 30,2019, Cardo sold for P2,300,000 a machine acquired in 2016 for P4,200,000. The estimated residual value was P600,000. What amount of gain on the disposal should Cardo record in 2019? Solution: Sale Price

P2,300,000

Carrying amount of machine: Cost-2016

P4,200,000

Accumulated depreciation-12/31/18 (4,200,000-600,000/5x3)

2,160,000

2,040,000

Gain on disposal

260,0000

No depreciation is recognized from January 1 to June 30,2019 because the depreciation policy is that no depreciation is taken in the year of an asset’s disposition.

6. Hakdog Company acquired an aeroplane in 2019. At the time of acquisition, the cost of the jet frame was P46,000,000 and the additional cost of the engine was P6,000,000. In 2022, the engine was replaced with a new one costing P12,000,000. At the time of replacement, the accumulated depreciation to date on the jet frame was P17,500,000 and on the engine was P 4000,000. What amount should be derecognized at the date of replacement? Solution: Cost of old engine Accumulated Depreciation Carrying amount

P6,000,000 4,000,000 P2,000,000

7. Mimiyuh Company acquired a drilling machine on October 1,2019 at a cost of P2,500,000 and depreciated it at 25% per annum on as straight line basis. On October 1,2021, the entity’s spent P500,000 on upgrade to the machine in order to improve its efficiency and increase the inflow of economic benefits over the machine’s remaining life. What depreciation expense should be recognized for the year ended September 30,2021? Solution: Original life (100%/25%)

4 years

Years, expired on October 1, 2021

2

Remaining life

2

Depreciation on original cost (2,500,000x25%) Depreciation on improvement (500,000/2) Total depreciation for year ended September 30,2023

P625,000 250,000 P875,000

8. Zeinab Company purchased a boring machine on January 1, 2019 for P8,100,000. The useful life of the machine is estimated at 3 years with a residual value at the end of this period of P600,000. During its useful life, the expected units of production are 12,000 units in 2019, 7000 units in 2020, and 5000 units in 2021, and P5,000 units in 2013. What is the depreciation expense for 2020 using the most appropriate depreciation method? Solution: Rate per unit (8,100,000-600,000) / 24,000 units Depreciation for 2020 (7,000x312.50)

312.50 P2,187,500

9. Jimbo Company acquired a machine in the first week of July 2019 and paid the following bills: Invoice price Freight in

P5,000,000 50,000

Installation cost

150,000

Cost of removing the old machine preparatory to the installation of the new machine

100,000

The estimated life of the machine is 8 years or a total of 100,000 working hours with no residual .The operating hours of the machine totaled 5,000 hours in 2019 and 12,000 hours in 2020. The entity follows the working hours method of depreciation. On December 31,2020, what is the carrying amount of the machine? Solution: Cost (5,000,000+50,000+150,000) Accumulated depreciation- December 31,2020

P5,200,000 884,000

(17,000 hours x 52) Carrying amount- December 31,2020

P4,316,000

Rate per hour (5,200,000/100,000)

52

10. Micah Company uses the composite method of depreciation based on composite rate of 25%. At the beginning of 2019, the total cost of equipment was P5,000,000 with a total residual value of P600,000. The accumulated depreciation was P3,000,000 at the time. In January 2019, Micah purchased an equipment for P2,500,000 with no residual value. At the end of 2019, Micah sold an equipment with an original cost of P1,000,000 and a residual value P200,000 for P350,000. This asset was acquired on January 1,2017. What is the depreciation for 2019? Solution: Total cost-January 1,2019

P5,000,000

Cost of new asset acquired

2,500,000

Cost of asset sold

(1,000,000)

Remaining cost- December 31,2019

P6,500,000

Depreciation for 2019 (25%x6,500,000)

P1,625,000

11. Jana Company purchased a depreciable asset for P100,000. The estimated salvage value is P10,000, and the estimated useful life is 10 years. The straight-line method will be used for depreciation. What is the depreciation base of this asset? Solution: P100,000-P10,000= P90,0000 12. Faye Company purchased a depreciable asset for P200,000. The estimated salvage value is P20,000, and the estimated useful life is 10 years. The straight-line method will be used for depreciation. What is the depreciation base of this asset? Solution: P200,000-P20,000=P180,000 13. Chechi Company purchased a depreciable asset for P200,000. The estimated salvage value isP10,000,ang the estimated useful life is 10,000 hours. Chechi used the asset for 1,100 hours in the current year. The activity method will be used for depreciation. What is the depreciation expense on this asset?

Solution: [(P200,000-P10,000)/10,000] x 1,100= P20,900 14. The first cost of a a machine is P1, 800,000 with a salvage value of P300,000 at the end of its six years of life. Determine the total deprecation after three years using the straight line method of depreciation. Solution: (1,800,000-300,000)/6= P250,000 250,000 (3)= P750,000 15. A commercial building has a salvage value of P1000,000 after 50 years. Annual depreciation is P2,000,000. Using the straight-line method, how many years after should you sell the building for P30,000,000? Solution: Annual depreciation=(FC-SV)/n

Total depreciation=FC-BV

P2,000,000=(FC-1)/50

=P101,000,000-

P30,000,000 FC=P101,000,000

=P71,000,000

Total depreciation= Annual depreciation (n) P71,000,000=2(n) n=35.5 years 16. On January 1,2019, Chechi Company purchased a machine for P504,000 that was placed in service on March 1,2019. Additional costs incurred to bring the asset to its location and prepare for its intended use were: shipping,P4,000 and installation and testing cost,P6,000. The estimated useful life of the asset was 10 years and has an estimated salvage value of P34,000. What amount of depreciation should be recognized for the year ended December 31,2019? Solution: Purchase Price

P504,000

Add: Incidental and necessary costs: Shipping

P4,000

Installation and Testing

6,000

Total Cost

10,000 P514,000

Less: Estimated Salvage value

34,000

Depreciable cost

P480,000

Divide: Estimated useful life

10 years

Annual depreciation

P48,000

Depreciation for 2019 (from 03/01 to 12/31) P48,000 x 10/12 = P40,000 17. On January 2, 2019, Jang geun suk Corp. bought machinery under a contract that required a down payment of P100,000, plus 24 monthy payments of P50,000 each, for total cash payments of P1,300,000. The cash equivalent price of the machinery was P1,100,000. The machinery has an estimated useful life of 10 years and estimated salvage value of P50,000. Jang geun suk Corp. uses straight line depreciation. How much should Jang geun suk Corp. report in its 2019 profit or loss as depreciation for the machinery? Solution: Cost (cash price) Salvage value Depreciable cost Divide: Estimated useful life Depreciation, 2019

P1,100,000 (

50,000)

P1,050,000 10 P 105,000

18. On January 1,2019, Lili Corporation bought machinery under a contract that required a down payment of P50,000, plus 24 monthly payments of P25,000 each, for total cash payments of P650,000. The cash equivalent price of the machinery was P550,000. The machinery has an estimated useful life of 10 years and estimated salvage value of P25,000. Lili uses the straightline method of depreciation. How much should Lili Corp. report in its 2019 profit or loss as depreciation for the machinery? Solution: Cost of the asset (cash price) Less: Estimated salvage value Depreciable cost

P550,000 25,000 P525,000

Divide: Estimated useful life Annual depreciation

10 years P 52,500

19. On January 2,2019, Shin hye Company purchased a transportation equipment costing P2,400,000. The new asset has an estimated useful life of 8years with no salvage value. Shin hye Company depreciates this type of asset using the straight line method. On January 2,2021, Shin hye Company determined that the machine has a useful life of 6 years from the date of acquisition with no salvage value. As a result of the change in the estimated useful life of the asset, what is the carrying value of the transportation equipment as of December 31,2021? Solution: Cost

P2,400,000

Less: Accumulated depreciation 2019 & 2020 (P2,400,000x 2/8)

600,000

Book value as of date of change, January 2,2021

P1,800,000

Divide: Remaining new life New life

6 years

Expired life( date of change)

2 years

4 years

Depreciation for 2021

P 450,000

Book value, January 1,2021

P1,800,000

Less: Depreciation-2021

450,000

Carrying value as of December 31,2021

P1,350,000

20. Jini Company uses straight line depreciation for its property, plant, and equipment, which stated at cost, consisted of the following:

2019 Land

250,000

2018 250,000

Buildings

1,950,000

1,950,000

Machinery and equipment

6,950,000

6,500,000

Total

9,150,000

8,700,000

Less: Accumulated depreciation

4,000,000

3,700,000

5,150,000

5,000,000

The depreciation for 2019 and 2020 was P550,000 and P500,000,respectively. What amount was debited to accumulated depreciation during 2019 because of plant, property, and equipment retirements? Solution: Accumulated depreciation-December 31,2018 Add: Depreciation for 2019

P3,700,000 550,000

Total Less: Accumulated depreciation on property retirement (squeeze) Accumulated depreciation-December 31,2019

4,250,000 250,000 P4,000,000

DEPRECIATION Sum of years’ digit and declining method Accelerated Depreciation Methods Under accelerated methods (decreasing-charge methods), depreciation charges decrease over the useful life of the asset.  Depreciation is higher in the early years of the asset’s useful life and lower in the later years. This depreciation method is based on the philosophy that the revenue-generating capacity of the asset declines due to passage of time. Thus, higher depreciation should be recognized in the early years of the asset’s useful life when higher revenues are generated. The following are applications of accelerated depreciation: 1. Sum-of-the-years’ digits (SYD) 2. Declining Balance Method Sum-of-the-years’ digits (SYD) Sum-of-the-years’ digits (SYD) depreciation - depreciation is computed by applying a series of fractions to the depreciable amount of the asset. A fraction is derived by dividing the asset’s remaining useful life by the sum of digits in the life of the asset. For example, an asset with a 4-year useful life would have a sum of year’s digits of 10 (4+3+2+1). The series of fractions then would be 4/10,3/10,2/10,1/10, with 4/10 as the fraction to be used in the first year of the asset’s useful life, 3/10 in the second year, and so on. These decreasing fractions are multiplied to the depreciable amount of the asset to determine the accelerated depreciation. The formula below maybe used. Life+1 SYD Denominator = Life x 2 Illustration: SYD On January 1, 2019, APC Company acquired equipment with an estimated useful life of 4 years and a residual value of P40,000 for a total purchase cost of P200,000. Initial cost of equipment Residual value Depreciable amount SYD Denominator = Life x

200,000 (40,000) 160,000 Life+1 2

=4x

The depreciation table is prepared as follows:

4+ 1 2

= 10

Date

1/1/19 12/31/19 12/31/20 12/31/21 12/31/22

Depreciable amount a

SYD Rate b

Depreciation

160,000 160,000 160,000 160,000

4/10 3/10 2/10 1/10

64,000 48,000 32,000 16,000 160,000

c=axb

Accumulated Depreciation d = cumulative balance of c 64,000 112,000 144,000 160,000

Carrying Amount e = historical cost - d 200,000 136,000 88,000 56,000 40,000

Notice that SYD method results in decreasing periodic depreciation charges over the life of the asset. Declining Balance Method Under this method, depreciation is computed by applying a fixed rate on the asset’s carrying amount, rather than depreciable amount. Unlike the other depreciation methods, the double declining method initially ignores the residual value. The residual value is considered only at the latter part of the asset’s useful life by adjusting the depreciation charge(s) so that the carrying amount does not fall below the residual value. The double declining rate is computed as follows: 2 Double Declining rate = Life A variation of the double declining is the 150% declining balance method. The rate is computed as follows: 1.5 150% Declining Rate = Life Illustration: Double-declining balance method On Jan. 1, 2019, APC Company acquired equipment with an estimated useful life of 5 years and a residual value of P40,000 for a total purchase cost of P200,000 The double declining rate is computed as follows: 2 Double declining rate = = 40% 5 The depreciation table is prepared as follows: Date Double Carrying Depreciation Declining amount rate a b = hist. cost - c = a x b d Jan. 1, 2019 Dec. 31, 2019 40% 200,000 80,000 Dec. 31, 2020 40% 120,000 48,000 Dec. 31, 2021 40% 72,000 28,800

Accumulated depreciation d = prev. balance +c 80,000 128,000 156,800

Dec. 31, 2022

n/a

Dec. 31, 2023

n/a

43,200 40,000 40,000

- 3,200

160,000

160,000

160,000

Notes:  Depreciation equals double declining rate times carrying amount. The residual value is initially ignored. This is a unique characteristic of the double declining balance method. In other depreciation methods, residual value is not ignored.  On December 31, 2022, double declining rate times the carrying amount equals P17,280 (405 x 43,200). Recognizing this amount would cause the carrying amount to fall below the residual value. Thus, only P3,200 (43,200 – 40,000) is recognized as depreciation in 2022 in order to bring the carrying amount equal to the residual value.  No depreciation is recognized in 2023 because the asset is now fully depreciated.

DEPRECIATION Sum of years’ digit and declining method PROBLEMS Problem 1 On April 1, 2019, Escobio Company purchased new machinery for P3,300,000. The machinery has an estimated useful life of five years with residual value of P300,000. Depreciation is computed by the sum of the years’ digits method. What is the accumulated depreciation on December 31, 2020? a. b. c. d.

1,600,000 1,800,000 1,200,000 1,000,000

Solution Answer a SYD = 1+2+3+4+5 SYD = 15 April 1, 2019 to March 31,2020 (5/15 x 3,000,000) April 1, 2020 to March 31,2021 (4/15 x 3,000,000) Accumulated Depreciation – March 31, 2021

1,000,000 800,000 1,800,000

April 1,2019 – December 31,2019 (1,000,000 x 9/12)

750,000

January 1, 2020 – March 31, 2020 (1,000,000 x 3/12) April 1, 2020 – December 31, 2020 (800,000 x 9/12) Total 2020 depreciation

250,000 600,000 850,000

Accumulated Depreciation – December 31, 2020 (750,000 + 850,000)

1,600,000

Problem 2 On July 1, 2019, Galang Company purchased an equipment for P5,000,000. Residual value was estimated at P200,000. The equipment is depreciated over ten years using the double declining balance method. What is the depreciation expense for 2020? a. 1,000,000 b. 900,000 c. 768,000 d. 960,000 Solution Answer b Straight line rate (100% / 10 years) Fixed Rate (10 x 2)

10% 20%

2019 depreciation (5,000,000 x 20% x 6/12) 2020 depreciation (5,000,000 – 5,000,000 x 20%)

500,000 900,000

Problem 3 Fajardo company purchased a machine on July 1, 2019 for P6,000,000. The machine has an estimated useful life of five years and a residual value of P800,000. The machine is being depreciated by the 150% declining balance method. For the year ended December 31, 2020, what amount should Fajardo record as depreciation expense on the machine? a. 1,530,000 b. 1,326,000 c. 1,040,000 d. 1,800,000 Solution Answer a Straight line rate (100% / 5) Fixed rate (20% x 150%) Depreciation from July 1 to December 31, 2019 (6,000,000 x 30% x 6/12) Depreciation for 2020 (6,000,000 – 900,000 x 30%)

20% 30% 900,000 1,530,000

Problem 4 Dimaunahan Company purchased a machine for P4,500,000 on January 1, 2019. The machine has an estimated useful life of four years and a residual value of P500,000. The machine is being depreciated using the sum of the years’ digits method. What is the carrying amount of the asset on December 31, 2020? a. 2,900,000 b. 2,700,000

c. 1,700,000 d. 1,350,000 Solution Answer c SYD = 1+2+3+4 = 10 Acquisition cost Accumulated Depreciation 2019 (4/10 x 4,000,000) 2020 (3/10 x 4,000,000) Carrying Amount – December 31, 2020

4,500,000 1,600,000 1,200,000

2,800,000 1,700,000

Problem 5 On January 1, 2019, Dinio Company acquired an equipment with useful life of 8 years and residual value of P300,000. The depreciation applicable to this equipment was P900,000 for 2020, using the double declining balance method. What is the acquisition cost of the equipment? a. 3,600,000 b. 4,500,000 c. 4,800,000 d. 5,100,000 Solution Answer c Fixed rate (100% / 8 years x 2) 25% Carrying amount – 1/1/2020 (900,000 / 25%) Carrying amount – 1/1/2019 (3,600,000 / 75%)

3,600,000 4,800,000

Problem 6 In January 1, 2019, Del Mundo Company purchased equipment at a cost of P6,000,000. The equipment has a useful life of eight years with residual value of P600,000. Del Mundo considered various methods of depreciation and selected the sum of years’ digits method. On December 31, 2020, what is the accumulated depreciation? a. P750,000 less than under the straight line method b. P750,000 less than under the double declining balance method c. P900,000 greater than under the straight line method d. P900,000 greater than under the double declining balance method Solution Answer c SYD = 1+2+3+4+5+6+7+8 = 36 2019 depreciation (5,400,000 x 8/36) 2020 depreciation (5,400,000 x 7/36) Accumulated Depreciation – 12/31/2020 (SYD) Accumulated Depreciation – 12/31/2020 (SL) (5,400,000 / 8 x 2) SYD greater than straight line

1,200,000 1,050,000 2,250,000 1,350,000 900,000

Problem 7 On January 1, 2019, Diamat Company purchased a large quantity of personal computers. The cost of these computers was P6,000,000. On the date of purchase, the management estimated that the computers would last approximately 4 years and would have a residual value at that time of P600,000. The entity used the double declining balance method. During January 2020, the management realized that technological advancements had made the computers virtually obsolete and that they would have to be replaced. Management proposed changing the remaining useful life of the computers to 2 years. What is the depreciation expense for 2020? a. 3,000,000 b. 2,400,000 c. 1,500,000 d. 1,200,000 Solution Answer b Fixed Rate (100% / 4 x 2) Cost Depreciation for 2019 (50% x 6,000,000) Carrying amount – January 1, 2020 Residual Value Maximum depreciation in 2020

6,000,000 3,000,000 3,000,000 (600,000) 2,400,000

Fixed rate in 2020 (100% / 2 x 2) 100% This means that the computers should be fully depreciated in 2020. Since there is a residual value of P600,000, the maximum depreciation for 2020 is equal to the carrying amount of P3,000,000 minus the residual value of P600,000 or P2,400,000. Problem 8 On May 1, 2019, Fatty Company purchased a new machinery for P2,700,000. The machinery has an estimated useful life of 7 years and depreciation is computed using the sum of the years’ digits method. Estimated salvage value of the machine is P180,000. What is the total accumulated depreciation on December 31, 2020? a. 900,000 b. 960,000 c. 990,000 d. 1,170,000 Solution Answer c SYD = [7 x (7 + 1)] / 2 = 28 Acquisition cost Less: Estimated salvage value Depreciable cost 05/01/19 to 04/30/20 = (7/28 x 2,520,000) 05/01/20 to 04/31/20 = (6/28 x 2,520,000 x 8/12) Total accumulated depreciation

2,700,000 180,000 2,520,000 630,000 360,000 990,000

Problem 9 On January 2, 2017, Sapporo Company acquired equipment to be used in its manufacturing operations. The equipment has an estimated useful life of ten years and an estimated salvage value of P50,000. The depreciation applicable to this equipment was P240,000 for 2019 computed under the sum of the years’ digits method. What was the acquisition cost of the equipment? a. 1,650,000 b. 1,700,000 c. 2,400,000 d. 2,450,00 Solution Answer b SYD = [10 x (10+1)] / 2 Ratio for 2019 Depreciable cost [240,000 / (8/55)] Add: Estimated salvage value Acquisition cost

55 8/55 1,650,000 50,000 1,700,000

Problem 10 On October 1, 2018, PCC Company purchased machinery for P1,900,000. Salvage value was estimated to be P100,000. The machinery will be depreciated over eight years using the sum of the years’ digits method. If depreciation is computed on the basis of the nearest full month, how much should PCC record depreciation expense for 2019 on this machinery? a. 350,000 b. 362,500 c. 387,500 d. 400,903 Solution Answer c Acquisition cost Less: Estimated salvage value Depreciable cost SYD = [8 X (8+1)] /2 1st year depreciation (10/01/18 to 09/30/19) = (1,800,000 x 8/36) 2nd year depreciation (10/01/19 to 09/30/20) = (1,800,000 x 7/36)

1,900,000 100,000 1,800,000 36 400,000 350,000

Depreciation for 2019 (January 1 to December 31) From 1st year (400,000 x 9/12) From 2nd year (350,000 x 3/12) Total depreciation for 2019

300,000 87,500 387,500

Problem 11

On January 2, 2018, Nick Company purchased factory equipment for P4,000,000. Estimated salvage value was P160,000. Estimated useful life of the equipment is 10 years and will be depreciated using double-declining balance method. What is the amount of depreciation to be recognized in year 2019? a. 384,000 b. 614,400 c. 640,000 d. 768,000 Solution Answer c Straight line rate (100% / 10 years) Double declining rate (10% x 2) 2018 depreciation (4,000,000 x 20%) 2019 depreciation (4,000,000 – 800,000 x 20%)

10% 20% 800,000 640,000

Problem 12 Starla Company purchased on October 1, 2019 an equipment for P800,000. The equipment had an estimated useful life of 8 years. The estimated salvage value was P50,000 at the end of the useful life. The equipment is being depreciated using the double declining balance method. What is the amount of depreciation to be charged against 2020 income? a. 140,625 b. 175,000 c. 175,781 d. 187,500 Solution Answer d Straight line rate Double declining rate 2019 depreciation 2020 depreciation

(100% / 8 years) (12.5% x 2) (800,000 x 25% x 3/12) (800,000 – 50,000 x 25%)

12.5% 25% 50,000 187,500

Problem 13 On march 1, 2018, De Luna Company bought an equipment costing P1,200,000. De Luna’s depreciation policy is to depreciate long-lived assets using the double-declining balance method. The equipment has an estimated useful life of ten years with a minimum amount of salvage value at the end of its useful life. What is the carrying amount of the asset as of December 31, 2020? a. 480,000 b. 614,000 c. 640,000 d. 768,000 Solution Answer c Double declining rate (100/10 x 2) Depreciation in – 2012 (1,200 x 20% x 10/12)

20% 200,000

2013 (1,200,000 – 200,000 x 20%) 2014 (1,200,000 – 200,000 – 200,000 x 20%) Total accumulated depreciation Acquisition cost Less: Accumulated depreciation Carrying value as of December 31, 2020

200,000 160,000 560,000 1,200,000 560,000 640,000

Problem 14 IU Company purchased machinery that was installed and ready for use on January 2, 2019 at a total cost of P960,000. Salvage value was estimated at P160,000. The machinery will be depreciated over 5 years using the double declining balance method. How much should be recorded as depreciation expense on this machinery for the year 2020? a. 100,000 b. 192,000 c. 230,400 d. 384,000 Solution Answer c 2019 (960,000 x 40%) 2020 (960,000 – 384,000 x 40%) Double declining rate (100% / 5 x 2)

Depreciation 384,000 230,400 40%

Problem 15 APC Company purchased a machine for P600,000 on January 2, 2019. The machine has an estimated useful life of 5 years and salvage value of P60,000. Depreciation was computed by the 150% declining balance method. How much should be the accumulated depreciation balance at December 31, 2020? a. 216,000 b. 275,000 c. 294,000 d. 306,000 Solution Answer d 150% declining rate (100%/5 years) x 150% Depreciation in 2019 (600,000 x 30%) Depreciation in 2020 (600,000 – 180,000 x 30%) Total Accumulated Depreciation

30% 180,000 126,000 306,000

Problem 16 Thoughtful Company purchased an equipment on January 2, 2018 for P3,000,000. The equipment had an estimated useful life of 5 years. The company’s policy is o depreciate the asset using the 200%-declining balance method in the first two years of the asset’s life and then switch to the straight-line method for the remaining useful life of the asset. What is the total accumulated depreciation as of December 31, 2020? a. 1,800,000

b. 2,280,000 c. 2,352,000 d. 2,520,000 Solution Answer b Straight-line rate (100%/ 5 years) 200%-declining rate (100%/5 years) x 2 Depreciation in 2018 (3,000,000 x 40%) Depreciation in 2019 (3,000,000 – 1,200,000 x 40%) Total accumulated depreciation as of December 31, 2019 Add: Depreciation in 2020 using straight line method: Cost Less: Accumulated depreciation as of 12/31,2019 Book value Divided by: Remaining useful life Accumulated depreciation as of December 31,2014

20% 40% 1,200,000 720,000 1,920,000 3,000,000 1,920,000 1,080,000 3 years 360,000 2,280,000

Problem 17 On January 1, 2019, the Accumulated Depreciation – Machinery account of a particular company showed a balance of P370,000. At the end of 2019, after the adjusting entries were posted, it showed a balance of P370,000. During 2019, one of the machines which cost P125,000 was sold for P60,500 cash. This resulted in loss of P4,000. Assuming that no other assets were disposed of during the year, how much was depreciation expense for 2019? a. 25,000 b. 60,000 c. 85,500 d. 93,500 Solution Answer c Accumulated Depreciation, 12/31/19 Accumulated Depreciation on asset sold: Cost of asset sold Book value Proceeds Loss on sale Total Less: Accumulated Depreciation, 1/1/19 Depreciation during the year

395,000 125,000 60,500 4,000

64,500

60,500 455,500 370,000 85,500

Problem 18 On March 31, 2019, White, derecognized a machine used in manufacturing designer parts. The machine was acquired on May 1, 2016. Straight-line depreciation method was used. The asset had an estimated salvage value of P20,000 and a five-year life. On December 31, 2018, the balance in the accumulated depreciation is P330,000. The machine was scrapped and the company did not receive a single consideration. How much would be the loss on derecognition?

a. b. c. d.

250,000 270,000 277,812 300,000

Solution Answer c Accumulated Depreciation on 12/31/18 Divided by: Age of the asset Monthly depreciation Multiply by: Life of the asset Depreciable cost Salvage value Cost of asset Accumulated depreciation- from acquisition To retirement (68,750 x 35/60) Loss on derecognition

330,000.00 32 months 10,312.50 60 months 618,750.00 20,000.00 638,750.00 360,938.00 277,812.00

Problem 19 On July 1, 2019, Blue Corporation, a calendar year company received a condemnation award of P3,000,000 as compensation for the forced sale of a plant located on company property that stood in the path of a new highway. On this date, the plant building had a depreciated cost of P1,500,000 and the land cost was P500,000. On October 1, 2019, Blue purchased a parcel of land for a new plant side at a cost of P1,250,000. Ignoring income taxes, how much gain should Blue report in its December 31, 2019 profit or loss? a. None b. 250,000 c. 750,000 d. 1,000,000 Solution Answer d Proceeds from a forced sale Less: Book value-assets condemned: Building Land Gain on condemnation of property

3,000,000 1,500,000 500,000

Problem 20 The following data are available from the book of Black Corporation: Machinery Cost of acquisition 560,000 Estimated salvage value 60,000 Date of acquisition January 1, 2011 Estimated life 10 years

2,000,000 1,000,000

Equipment 140,000 20,000 July 1, 2011 5 years

On October 1, 2014, above machinery was sold for P400,000 while the equipment could no longer be used on March 31,2014 and the company received P50,000 from the insurers in full settlement of the claim. What is the amount of net gain or loss on the disposal of the above assets? a. 3,500 b. 23,500 c. 24,000 d. 27,500 Solution Answer a Gain on sale of machinery Less: Loss on disposal of equipment Net gain

27,500 24,000 3,500

Machinery Selling Price 400,000 Book value (560,000 – 187,500) 372,500 Gain on sale of machinery 27,500

disposal acquisition expired life

Year

Mos. Days

2014 2011 3 X 12

10 01 09 36 45

Year

Mos. Days

Expired life in mos. Cost Salvage value Depreciable cost x Age of asset Accumulated depreciation

Equipment Proceeds from insurance Co. Book Value (140,000-66,000) Loss

Cost Salvage value Depreciable cost x Age of asset Accumulated depreciation

01 01 00

560,000 60,000 500,000 45/120 187,500

50,000 74,000 24,000

140,000 20,000 120,000 33/66 66,000

disposal 2014 acquisition expired life 2 x 12

03 31 2011 07 01 08 30 24 32 + 1 = 33 mos.

Chapter 32

Chapter 33

CHAPTER 34 IMPAIRMENT OF ASSET (Individual Asset) LEARNING OBJECTIVES After finishing this chapter, learners are expected to: 1. 2. 3. 4.

Know the basic principle in accordance with PAS 36 Define the fair value less cost to sell and value in use Master the accounting for impairment Account for the impairment of individual asset

PAS 36 (Impairment of Assets) PAS 36 ensures that assets are carried at no more than their recoverable amount, and to define how recoverable amount is determined. PAS 36 applies to the following assets: 1. 2. 3. 4.

Property, plant and equipment Investment property measured or carried at cost Intangible assets Investments in associates, joint ventures and subsidiaries carried at cost

Assets not subject to impairment: 1. 2. 3. 4. 5. 6. 7. 8.

Inventories Deferred tax assets Assets arising from employee benefits Financial assets within the scope of PFRS 9 Investment property measured at insurance contracts, and non-current assets held for sale Biological assets Some assets arising from insurance contracts Non-current assets held for sale

Basic Principle PAS 36 defined that an asset must not be carried in the financial statements at more than the highest amount to be recovered through its use or sale. Accounting for Impairment 1. 2. 3. 4.

There is an indication of possible impairment Measurement of recoverable amount Recognition of impairment loss Reversal of impairment loss

INDICATION OF POSSIBLE IMPAIRMENT 1. External sources a. Market value of the asset declines b. Negative changes in technology, markets, economy, or laws c. Increases in market interest rates d. Company stock price is below its book value 2. Internal sources a. Obsolescence or physical damage of an asset b. Asset is part of a restructuring or held for disposal c. Worse economic performance than expected

MEASUREMENT OF RECOVERABLE AMOUNT Under PAS 36, the recoverable amount of an asset is the higher of its fair value less cost to sell or cost of disposal and value in use. Fair value less cost to sell (or net selling price) Fair value of an asset is “the price that would be received to sell the asset in an orderly transaction between market participants at the measurement date.” (PAS 36 par. 6) Cost of disposal is an “incremental cost directly attributable to the disposal of an asset of an asset or cash generating unit excluding finance cost and income tax expense.” (PAS 36 par. 6) Composition of cost of disposal: a. b. c. d.

Legal cost Attributable stamp and transfer taxes Cost of removing the asset Any other cost to bring the asset into a “for-sale” condition

Rules in determining Fair Value: 1. If there is a binding sale agreement, use the agreed price or quoted price 2. If there is no binding sale agreement but there is an active market for that type of asset, use the market price. Market price means current bid price, if available, or the price in the most recent transaction. 3. If there's no binding sale agreement and the asset is not traded in an active market, the fair value is the best estimate of price that willing parties might agree. Value in Use (or the discounted future cash flows) Rules in calculating projected cash flows: a. Cash flow projections shall be based on reasonable and supportable assumptions.

b. Projections shall be based on the latest budgets on financial forecast, usually up to maximum period of 5 years, unless a longer period can be justified. c. Projections beyond 5 years shall be estimated by extrapolating the 5-year projections using a steady or declining growth rate each subsequent year, unless an increasing rate can be justified. Composition of estimates of future cash flows: Includes: a. Cash inflows of continuing use of the asset. b. Cash outflows necessary to generate the inflows of cash from continuing use of the asset. c. Net cash flows on the disposal of the asset at the end of its useful life. Excludes: a. b. c. d.

Cash flows relating to restructuring to which the entity is not yet committed Cash flows that arises from enhancing the performance of an asset Cash flows from financing activities, and Related income tax

In measuring value in use, the discount rate used should be the pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the asset. It is (based on priority): 1. The current market rate the entity would pay in financing that specific asset or portfolio; 2. The entity's own weighted average cost of capital 3. The entity's incremental borrowing rate 4. Other market borrowing rates. RECOGNITION OF IMPAIRMENT LOSS  If the carrying amount is greater than recoverable amount, the asset is impaired. The excess between carrying amount and recoverable amount is recognized as impairment loss.  If the carrying amount is equal to or less than the recoverable amount, the asset is not impaired. There will be no accounting issue in this case. Illustration 1: On December 31, 2019, CJ Company determines that its equipment is impaired. The following information is related to the equipment. Equipment

5 000 000

Accumulated depreciation

2 000 000

Fair value less cost to sell (FVLCS)

2 500 000

Value in use (VIU)

2 000 000

Answer: Recoverable amount (higher of FVLCS and VIU)

2 500 000

Less: Carrying amount (5 000 000 - 2 000 000)

3 000 000

Impairment loss

(500 000)

Journal Entry: Impairment loss

500 000

Accumulated depreciation

500 000

Illustration 2. On December 31, 2020, EFG Company that its hotel building with a carrying amount of P800 000 has been impaired. In estimate, EFG Company’s hotel building has P500 000 fair value less cost to sell. In estimating the value in use, EFG Company determined the following information: Year 2021 2022 2023 The discount rate is 10%.

Future cash inflows 700 000 680 000 660 000

Future cash outflows 550 000 400 000 430 000

Compute for the hotel building’s impairment loss. Answer: The future net cash flows are as follows: Year 2021 2022 2023

Cash inflows (a) 700 000 680 000 660 000

The value in use is computed as follows:

Cash outflows (b) 550 000 400 000 430 000

Net cash flows (a-b) 150 000 280 000 230 000

Year 2021 2022 2023

Net cash flows 150 000 280 000 230 000

PV of 1 factors 0.909091 0.826446 0.751315

Present value 136 367 231 405 172 816 540 588

The recoverable amount is determined as follows: Fair value less cost to sell

500 000

Value in use

540 588

Recoverable amount (higher)

540 588

The impairment loss is computed as follows: Recoverable amount

540 588

Less: Carrying amount Impairment loss

800 000 (259 412)

REVERSAL OF IMPAIRMENT LOSS If the recoverable value of previously-impaired asset turns out to be higher than its current carrying value, then the asset shall be increased to its new recoverable amount. However, PAS 36 further provides that the increase in carrying amount of an asset due to a reversal of an impairment loss shall not exceed the carrying amount as if the asset does not suffer from impairment. If the new recoverable amount is higher than the carrying value as if there is no previous impairment recognized, the excess must be credited to revaluation surplus if the company elected to use revaluation model and must be amortized over the remaining life of the asset. Needless to say, the excess must be ignored if the company uses the cost model. The reversal of the impairment loss shall be recognized immediately as income. Determination of Revaluation Surplus: New Recoverable Value

xxx

Less: Carrying Value of an asset as if no previous impairment happened xxx Revaluation Surplus

xxx

Proper Journal Entry Appropriate Asset Account Accumulated depreciation

xxx xxx

Gain on reversal of impairment Revaluation surplus

xxx xxx

THEORIES: Part 1 TRUE OR FALSE 1. Asset shall be carried at above the recoverable amount. 2. Depreciation is a fall in the market value of an asset so that recoverable amount is now less than the carrying amount in the statement of financial position 3. Fair value of an asset is the price that would receive to sell the asset in an orderly transaction between market participants at the measurement date 4. The recoverable amount of an asset is the fair value less cost of disposal or value in use, whichever is lower. 5. Value in use is measured as the present value or discounted value of future net cash flows expected to be derived from an asset. THEORIES: Part 2 MULTIPLE CHOICE 1. Estimates of future cash flows include the following except: a. Projections of cash inflows from the continuing use of the asset. b. Projections of cash outflows necessarily incurred to generate the cash inflows from the continuing use of the asset. c. Cash inflows or outflows from financing activities d. Net cash flows received on the disposal of the asset at the end of the useful life in an arm’s length transaction 2. The market participants are buyers and sellers in the principal market who are the following except one: a. Independent b. Knowledgeable c. Willing d. Relevant 3. The reversal of the impairment loss shall be recognized as a. Outright expense b. Contra-asset account in the balance sheet c. Deduction in the capital of the business d. Immediately as income in the income statement 4. The journal entry to record impairment loss is to a. Debit impairment loss and credit accumulated depreciation b. Debit accumulated depreciation and credit impairment loss c. Debit impairment loss and credit to asset related to the impairment d. Debit to asset related to the impairment and credit to impairment loss 5. In the accounting for impairment the three accounting issues to consider except: a. Indication of possible impairment b. External and internal sources c. Measurement of the recoverable amount d. Recognition of impairment loss

PROBLEM 1 On December 31, 2019, MNL Company has an equipment with the following cost and accumulated depreciation: Equipment

5 000 000

Accumulated depreciation

3 150 000

Due to obsolescence and physical damage, the equipment is found to be impaired. On December 31,2019, MNL Company has determined the following related to the equipment Fair value less cost to sell

1 500 000

Value in use or discounted net cash inflows

1 450 000

What amount should be reported as impairment loss in 2019? A. B. C. D.

350 000 400 000 1 850 000 0

PROBLEM 2 During December 2019, GIGI Company determined that there had been a significant decrease in market value of its equipment used in its manufacturing process. On December 31, 2019, GIGI compiled the following information: Original cost of equipment

5 250 000

Accumulated depreciation

3 950 000

Expected undiscounted net future cash inflows related to the continued use and eventual disposal of the equipment Fair value of the equipment

1 750 000 1 150 000

What is the amount of impairment loss that should be reported in the income statement for the year ended December 31,2019? A. B. C. D.

750 000 250 000 150 000 0

PROBLEM 3 Katie Company purchased four (4) convenience store buildings on January 1, 2015 for a total of P15 000 000. The buildings have been depreciated using the straight line method with a 20-year useful life and 10% residual value. On January 1, 2021, Katie has converted the buildings into a hotel and restaurant. Because of the change in use of the buildings, Katie is evaluating the buildings for possible impairment. Katie estimates that the buildings have a remaining useful life of 10 years, that their residual value will be zero, that net cash inflows from the buildings will total P1 500 000 per year and that the current fair value of the four (4) buildings totals P11 000 000. The appropriate discount rate is 12%. The present value of an ordinary annuity of 1 at 12% for 10 periods is 5.65. 1. What impairment loss should be recognized for 2019? a. 150 000 b. 250 000 c. 350 000 d. 950 000 2. What is the depreciation of the building for 2019? a. 1 000 000 b. 1 200 000 c. 1 300 000 d. 0 PROBLEM 4 PIO Company purchased building on January 1, 2016 for P7 000 000. The building has been depreciated using a straight line method with a 25-year useful life and no residual value. On December 31, 2019, Elsa is evaluating for possible impairment. The building has a remaining useful life of 15 years and is expected to generate cash inflows of P550 000 per year. The applicable discount rate is 8%. Round off present value factor to two decimal places. The fair value of the building on December 31, 2019 is P4 500 000. What amount should be recognized as impairment loss on December 31, 2019? a. b. c. d.

4 000 000 1 120 000 4 700 000 1 172 000

PROBLEM 5 One of the cash generating units of Erika Company is the production of liquor. On December 31, 2019, Erika Company believed that the assets of the cash generating units (CGU) are impaired based on an analysis of economic indicators. The assets and liabilities of the CGU on December 31,2019 are: Cash

4 550 000

Accounts Receivable

5 800 000

Allowance for doubtful account Inventory Property, plant and equipment

2 000 000 6 700 000 24 000 000

Accumulated depreciation

4 000 000

Goodwill

3 600 000

Accounts payable

2 500 000

Loans payable

1 300 000

The entity determined that the value in use of the CGU is P28 200 000. The account receivables are considered collectible, except those considered doubtful. What is the impairment loss to be allocated to property, plant and equipment? a. b. c. d.

1 712 500 5 137 500 850 000 1 850 000

PROBLEM 6 Mich Company has two cash generating units. On December 31, 2019, the carrying amounts of the assets of one cash generating unit are: Inventory

150 000

Accounts receivable

250 000

Plant and equipment

5 000 000

Accumulated depreciation

1 200 000

Patent

1 050 000

Goodwill

120 000

The accounts receivable are regarded as collectible and the inventory’s fair value less cost to sell is equal to the carrying amount. The patent has a fair value less cost to sell of P1 650 000. On December 31,2019, Mich Company undertook impairment testing of the cash generating unit and determined the value in use of the unit at P4 550 000. What is the impairment loss? a. b. c. d.

625 000 700 000 850 000 460 000

PROBLEM 7 Marijean Company acquired a machine for P4 500 000 on August 31, 2017. The machine has a 5-year life, P600 000 residual value and was depreciated using straight-line method. On May 31, 2020, a test for recoverability reveals that the expected net future undiscounted cash inflows related to the continued use and eventual disposal of the machine total P1 800 000. The machine’s fair value on May 31, 2020 is P1 450 000 with no residual value. If a loss on impairment is recognized on May 31, 2020, what is the depreciation for June 2020? a. b. c. d.

53 270 50 050 53 704 65 000

PROBLEM 8 RMG Company had purchased equipment for P2 800 000 on January 1, 2017. The equipment had an 8-year life and residual value of P400 000. RMG depreciated the equipment using straight line method. In August 2020, RMG questioned the recoverability of the carrying amount of this equipment. On August 31, 2020, the undiscounted expected net future cash inflows related to the continued use and eventual disposal of the equipment amounted to P1 600 000. The equipment’s fair value on August 31, 2020 is P1 500 000. After any loss on impairment has been recognized, what is the carrying amount of the equipment? a. 1 500 000 b. 1 800 000 c. 1 550 000

d. 1 700 000 PROBLEM 9 The following calculation refers to an impairment loss suffered by CJ Company on December 31,2019: | Carrying amount Impairment loss Adjusted carrying amount

Goodwill 3 000 000 (3 000 000) 0

Net Assets 9 000 000 (2 000 000) 7 000 000

There has been a favorable change in the estimate of the recoverable amount is now P8 000 000 on December 31, 2020. The carrying amount of the net assets would have been P7 200 000 on December 31, 2020 if there was no impairment loss recognized on December 31, 2019. Assets are depreciated at 20% of reducing balance. What gain on reversal of impairment should be recognized in 2020? a. b. c. d.

1 500 000 5 600 000 1 200 000 1 600 000

PROBLEM 10 ROC company reported an impairment loss of P2 000 000 in its income statement for 2020. This loss was related to an item of property, plant and equipment which was acquired on January 1, 2019 with a cost of P10 000 000, useful life of 10 years and no residual value. On December 31, 2020, ROC reported this asset at P6 000 000 which is the fair value on such date. On December 31, 2021, ROC determined that the fair value of its impaired asset had increased to P7 500 000. The straight line method is used in recording depreciation of this asset. What amount of gain on reversal of impairment should ROC report in its 2021 income statement? Provide solution.

ANSWER KEY TRUE OR FALSE 1. 2. 3. 4. 5.

F F T F T

MULTIPLE CHOICE 1. 2. 3. 4. 5.

C D D A B

PROBLEM 1. A (1 500 000-1 850 000 = 350 000) PROBLEM 2. C 5250 000-3 950 000=1 300 000-1 150 000=150 000 PROBLEM 3. D, A 1. FV= 10 000 000 PV= 1 500 000*5.65= 8 475 000 CA= 15 000 000*10% =1 500 000 =15 000 000-1 500 000 =13 500 000/20 =675 000*6 =4 050 000 =15 000 000-4 050 000= 10 950 000 10 000 000(HIGHER)-10 950 000 =D. 950 000 2. 10 000 000/10 =A. 1 000 000 PROBLEM 4. D. Annual cash inflows

550 000

Multiply by PV of an ordinary annuity of 1 at 8% for 15 periods Value in use

8.56 4 708 000(higher)

Cost - January 1, 2016

7 000 000

Accumulated depreciation - December 31,2019 (7 000 000/25*4)

1 120 000

Carrying amount- December 31,2019

5 880 000

Recoverable amount

4 708 000

Impairment loss

1 172 000

PROBLEM 5. A 4 550 000+3 800 000+6 700 000+20 000 000+3 600 000 = CA 38 650 000-VIU 28 200 000 =10 450 000- 3 600 000 REMAINING IMPAIRMENT LOSS= 6 850 000 Inventory Property, equipment

plant

Carrying amount 6 700 000 and 20 000 000 26 700 000

PROBLEM 6. B 150 000+250 000+3 800 000+1 050 000+120 000 =5 370 000-4 550 000 =820 000-120 000 = 700 000 PROBLEM 7. C 1 450 000/27= 53 704 PROBLEM 8. A

Fraction Loss 67/267*6 850 000 1 712 500 200/267*6 850 5 137 500 000 6 850 000

2 800 000-400 000 =2 400 000/96*44 =1 100 000 2 800 000-1 100 000 =1 700 000 1 700 000-1 500 000 =200 000 1 700 000-200 000 =1 500 000 PROBLEM 9. D 7 000 000- 1 400 000=5 600 000 7 200 000-5 600 000=1 600 000 PROBLEM 10. Fair value- January 1,2021

6 000 000

Depreciation for 2019 (6 000 000/8)

750 000

Carrying amount- 12/31/2021- with impairment

5 250 000

Cost- January 1,2019

10 000 000

Accumulated depreciation- December 31,2021 (10 000 000/10*3)

(3 000 000)

Carrying amount- 12/31/2021-assuming no impairment

7 000 000

Carrying amount-12/31/2021-with impairment

5 250 000

Gain on reversal of impairment

1 750 000

CHAPTER 35 IMPAIRMENT OF ASSETS CASH GENERATING UNIT The standard requires an entity to recognize impairment when its asset are carried at more than their recoverable amount. The standard prescribes procedures that an entity has to apply to ensure assets are carried at no more than their recoverable amount illustrated below.

FAIR VALUE LESS COST TO SELL CARRYING AMOUNT

EXCEEDS

IMPAIRMENT OF CASH-GENERATING UNIT

RECOVERABLE AMOUNT

HIGHER OF

VALUE IN USE

Impairment- A loss in the future economic benefits or service potential of an asset, over and above the systematic recognition of the loss of the asset’s future economic benefits or service potential through depreciation. Impairment loss of cash-generating asset- The amount by which the carrying amount of an asset or cash-generating unit exceeds its recoverable amount. Carrying amount- The amount at which an asset is recognized in the statement of financial position, after deducting any accumulated depreciation and accumulated impairment losses thereon. Recoverable amount (of an asset or cash-generating unit)- The higher of an asset’s fair value less costs of disposal and its value in use. Fair value- The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in arm’s length transaction. Value in use- The present value of the future cash flows expected to be derived from an asset or cash-generating unit.

So how do you apply requirements of IAS 36 to your entity? At the end of each reporting period, an entity is required to assess whether there is an indication that an asset may be impaired. A list of external and internal indicators of impairment are prescribed by the standard. If there’s indication that the entity’s assets may be impaired then the assets recoverable amount must be calculated. The standard prescribes that goodwill acquired in a business combination is tested annually for impairment and recoverable amounts determined whether or not there are any internal or external indications of impairment. The same is true for intangible assets with an indefinite useful life and intangible assets not yet available for use. Fair value less costs of disposal The best evidence of an asset’s fair value less costs to sell is the price in a binding sale agreement in an arm’s length transaction, adjusted for incremental costs that would be directly attributable to the disposal of the asset. If there is no binding sale agreement but an asset is traded in an active market, fair value less costs to sell in the asset’s market price less the costs of disposal. If there is no binding sale agreement or active market for an asset, fair value less costs to sell is based on the best information available that reflects the amount that an entity could obtain, at the reporting date, from the disposal of the asset in an arm’s length transaction between knowledgeable, willing parties, after deducting the costs of disposal. Value in use Estimating the value in use of an asset involves estimating the future cash inflows and outflows to be derived from the continuing use of the asset and its ultimate disposal and applying an appropriate discount rate to those future cash flows. Illustration: An entity has determined that one of its cash generating units is impaired. The calculated value in use of the cash generating unit is P5,500,000 The asset of the cash generating unit at carrying amount are: Building Land Equipment

P2,400,000 2,000,000 1,400,000

Inventory Carrying amount of CGU

200,000 P6,000,000

Mostly, the recoverable amount of a cash-generating units is equal to the value in use because the unit is not to be disposed of.

Carrying amount of CGU Value in use Impairment loss

P6,000,000 5,500,000 P 500,000

Allocation of impairment loss Since there is no goodwill, the impairment loss is allocated across the assets based on carrying amount. Carrying amount

Fraction

Loss Building 200,000 Land 166,667 Equipment 116,667 Inventory 16,666

2,400,000

24/60

2,000,000

20/60

1,400,000

14/60

200,000

2/60

6,000,000 500,000

Journal entry to record the impairment loss Impairment loss Accumulated depreciation-building Land Accumulated depreciation-equipment Inventory

500,000 200,000 166,667 116,667 16,666

Cash generating unit with goodwill Goodwill does not generate cash flows independently from other assets or group of assets, and therefore, the recoverable amount of goodwill as an individual asset cannot be determined. Therefore, if there is an indication that goodwill may be impaired, recoverable amount is determined for the cash generating unit to which goodwill belongs.

Recognition of an impairment Recognizing an impairment asset for an individual asset other than goodwill: 



If, and only if, the recoverable amount of an asset is less than its carrying amount, the carrying amount of the asset shall be reduced to its recoverable amount. That reduction is an impairment loss; and an impairment loss shall be recognized immediately in surplus or deficit.

Illustration: The assets of a cash generating unit at carrying amount at year-end are as follows:

Property, plant and equipment Patent Goodwill Carrying amount of CGU

P4,000,000 1,000,000 1,000,000 6,000,000

Annual impairment review is required as the cash generating unit contains goodwill. The calculated value in use of the cash generating unit is P5,500,000

Carrying amount of CGU Value in use Impairment loss

P6,000,000 4,500,000 P 1,500,000

Allocation of impairment loss Impairment loss Applicable to goodwill Excess impairment loss

P1,500,000 1,000,000 P 500,000

The excess impairment loss is allocated to the other noncash assets prorate based on carrying amount. Carrying amount Loss Property, plant and equipment 400,000 Patent 100,000

Fraction

P4,000,000

4/5

1,000,000

1/5

5,000,000 500,000 Journal Entry Impairment loss Goodwill Accumulated depreciation Patent

1500,000 1,000,000 400,000 100,000

Reversal of an Impairment Loss for a Cash-Generating Unit: The reversal of an impairment loss for cash generating unit shall be allocated to the assets of the unit, except for goodwill, on a pro rata based on the carrying amounts of those assets. These increases in carrying amounts shall be treated as reversals of impairment losses for individual

assets and recognized in profit or loss, unless the assets are carried at revalued amount, that any reversal of impairment on revalued asset or assets shall be treated as revaluation increase and credited directly to equity. In allocating a reversal of an impairment loss for a cash-generating unit, the carrying amount of an asset shall not be increased above the lower of: (a)its recoverable amount(if determinable), (b) the carrying amount that would have been determined (net of accumulated depreciation or amortization) had no impairment loss been recognized for the asset in prior periods. The amount of reversal of the impairment loss that would otherwise have been allocated to the asset shall be allocated pro rata to the other assets of the unit, except for goodwill.

Re-designation of Assets The re-designation of an asset from a cash-generating asset to non-cash generating asset or from a non-cash-generating asset to a cash-generating asset shall only occur when there is clear evidence that such a re-designation is appropriate. A re-designation, by itself, does not necessarily trigger an impairment test or a reversal of an impairment loss. a.

PROBLEMS 1. One of the cash generating units of Ivana Company is the production of liquor. On December 31, 2019, Ivana Company believed that the assets of the cash generating unit (CGU) are impaired based on an analysis of economic indicators. The assets and liabilities of the cash generating unit on December 31, 2019 are: Cash Accounts Receivable Allowance for doubtful accounts Inventory Property, plant and equipment Accumulated depreciation Goodwill Accounts payable Loans payable

4,000,000 6,000,000 1,000,000 7,000,000 22,000,000 4,000,000 3,000,000 2,000,000 1,000,000

The entity determined that the value in use of the cash generating unit is P30,000,000. The accounts receivable are considered collectible, except those considered doubtful. What is the impairment loss to be allocated to property,plant and equipment? Solution: Cash Accounts Receivable-net Inventory Property, plant and equipment-net Goodwill Carrying amount of CGU Value in use Impairment loss Impairment loss allocated to goodwill Remaining impairment loss

Inventory Property, plant and equipment

Carrying amount 7,000,000 18,000,000 25,000,000

4,000,000 5,000,000 7,000,000 18,000,000 3,000,000 P37,000,000 30,000,000 7,000,000 3,000,000 P4,000,000 Fraction 7/25 18/25

Loss 1,120,000 2,880,000 4,000,000

The impairment loss is not allocated to the accounts receivable because the accounts are considered collectible except those doubtful. 2. Mona Company operates a production line which is treated as a cash generating unit for impairment review purposes. On December 31,2019, the carrying amounts of the noncurrent assets allocated to this cash generating unit are as follows: Intangibles-goodwill Tangible-plant and machinery

1,100,000 2,200,000

On December 31,2019,the value in use of the production line is estimated at P2,700,000. What are the revised carrying amounts of the intangible and tangible noncurrent assets within this cash generating cash?

a. b. c. d.

Intangibles 500,000 900,000 1,100,000 800,000

Tangibles 2,200,000 1,800,000 1,600,000 1,900,000

Solution: Carrying amount of cash generating unit

3,300,000

Value in use Impairment loss

2,700,000 600,000

The impairment loss is applied against the goodwill only. Thus, goodwill has an adjusted balance of P500,000 and the balance of the tangible noncurrent asset remains the same. 3. Justinius Company has various cash generating units. On December 31,2019, one cash generating unit has the following carrying amount of assets: Cash Inventory Land Plant and equipment Accumulated depreciation Goodwill

600,000 1,400,000 2,500,000 9,000,000 1,500,000 1,000,000

As part of the impairment testing procedure, the management of Justinius Company determined the value in use of the cash generating unit at P8,500,000. The fair value less cost to sell for the inventory is greater than the carrying amount. What is the impairment loss to be allocated to plant and equipment? Solution: Cash Inventory Land Plant and equipment Goodwill Carrying amount of CGU Value in use Impairment loss Impairment loss allocated to goodwill Remaining impairment loss Carrying amount Land 2,500,000 Plant and equipment 7,500,000 10,000,000

P 600,000 1,400,000 2,500,000 7,500,000 1,000,000 13,000,000 8,500,000 4,500,000 1,000,000 3,500,000 Fraction 25/100 75/100

Loss 875,000 2,625,000 3,500,000

No impairment loss is allocated to inventory because the inventory’s fair value less cost to sell is higher that its carrying amount. 4. Tulfo Company has determined that its electronics division is a cash generating unit. The entity calculated the value in use of the division to be P8,000,000. The assets of the cash generating unit at carrying amount are as follows: Building Equipment Inventory

5,000,000 3,000,000 2,000,000 10,000,000

Tulfo Company has also determined that the fair value less cost to sell the building isP4,500,000. What is the impairment loss to be allocated to the equipment? Solution: Carrying amount of CGU Value in use

10,000,000 8,000,000

Impairment loss

2,000,000

Allocation of impairment loss Building (5/10 x 2,0000,000) Equipment (3/10 x 2,000,000) Inventory (2/10 x 2,000,000)

1,000,000 600,000 400,000 2,000,000

Building Allocated loss Reallocated loss: (3/5 x 500,000) (2/5 x 500,000)

1,000,000 (500,000)

Impairment loss

500,000

Equipment 600,000

Inventory 400,000

300,000 200,000 900,000

600,000

5. On January 1,2019, Duterte Company acquired all the assets and liabilities of another entity.The acquire has a number of operating divisions, including one whose major industry is the manufacture of toy train. The toy train division is regarded as a cash generating unit. In paying P20,000,000 for the net assets of the acquiree, Duterte calculated that it had acquired goodwill of P2,400,000. The goodwill was allocated to each of the divisions, and the assets and liabilities acquired are measured at fair value at acquisition date. On December 31, 2019, the carrying amounts of the assets of the toy train division were: Building Inventory Trademark Goodwill

2,000,000 1,500,000 1,000,000 500,000

There is a declining interest in toy train because of the aggressive marketing of computer-based toys. Management of Duterte Company measured the value in use of the toy train division on December 31, 2019 at P3,600,000. What is the impairment loss to be allocated to the building?

Solution: Carrying amount of cash generating unit Value in use Impairment loss Impairment loss allocated to goodwill Remaining Impairment loss

Carrying amount

5,000,000 3,600,000 1,400,000 500,000 900,000

Fraction

Loss Building Inventory 300,000 Trademark 200,000

2,000,000 1,500,000 1,000,000

20/45

400,000 15/45 10/45

4,500,000 900,000 6. Alex Company has two cash generating units. On December 31,2019, the carrying amount of the assets of one cash generating unit are: Inventory Accounts receivable Plant and equipment Accumulated depreciation Patent Goodwill

200,000 300,000 6,000,000 2,600,000 850,000 100,000

The accounts receivable are regarded as collectible and the inventory’s fair value less cost to sell is equal to the carrying amount. The patent has a fair value less cost to sell of P750,000. On December 31,2019, Brandy Company undertook impairment testing of the cash generating unit and determined the value in use of the unit at P4,050,000. What is the impairment loss to be allocated to the plant and equipment? Solution: Inventory Accounts receivable Plant and equipment-net

200,000 300,000 3,400,000

Patent Goodwill Carrying amount of CGU Value in use Impairment loss 800,000 Impairment loss allocated to goodwill Remaining impairment loss

850,000 100,000 4,850,000 4,050,000

100,000 700,000 Plant

Patent Allocated loss (3,400/4250 x 700,000) (850/4250 x 700,000) 140,000 Reallocated loss ( 40,000)

560,000

40,000 600,000

100,000 7. Zebby Company has two cash-generating units, Gray and Pink. There is no goodwill within the unit’s carrying values. The carrying values are Gray P10,000,000 and Pink P15,000,000. Zebby Company has an office building that has not been included in the above values and can be allocated to the units on the basis of their carrying values. The office building has a carrying value P5,000,000. The recoverable amounts are based on the value-in-use of P9,000,000 for Gray and P19,000,000 for Pink. What amount of impairment loss should Zebby Company recognize on the cash-generating-unit Gray? Solution: Carrying value Office Building(10:15 ratio) Total Fair value Impairment loss

Gray P10,000,000 2,000,000 P12,000,000 9,000,000 P 3,000,000

8. Ginger Company’s cash-generating unit has been assessed for impairment and it has been determined that the unit has incurred an impairment loss of P240,000. The carrying amount of the asset were as follows:

Building Equipment Land Fittings

P6,000,000 2,000,000 3,500,000 2,500,000

What amount of impairment loss should be allocated to the bulding? Solution: Impairment Loss Building P102,857

Carrying Value

Ratio

P6,000,000

6/14

9. When should a reversal of goodwill impairment be recognized? a. Immediately b. At the end of the accounting period c. At management’s discretion d. Never 10. Under IAS 36, when it is not possible to calculate the recoverable amount of a single asset, what should be done? a. A rough estimate should be provided. b. The recoverable amount of its cash generating unit. c. A disclosure should be provided in the notes to the financial statements d. The value should remain unchanged. 11. How often should a cash generating unit to which goodwill has been assigned be tested for impairment? a. At management’s discretion b. Every six months c. Every year d. As often as practicable 12. The present value of expected future cash flows generated by an asset, plus its expected disposal value is called… a. Net present value b. Value in use c. Fair value d. Market value 13. When should a reversal of an impairment loss be recognized? a. Never b. Immediately c. When approved by the board of directors

d. None of these 14. When the recoverable amount of an asset is less than its carrying value in the Statement of Financial Position, the asset is… a. In revaluation deficit b. Impaired c. Flawed d. In negative equity 15. The smallest identifiable group of assets that generate cash inflows that are largely independent of the cash inflows from the other group assets are called… a. Division b. Cash-generating unit c. Department d. Operating Segment 16. The asset is said to be impaired if… a. Its carrying amount exceeds its net discounted cash inflows b. Its recoverable amount exceeds its carrying amount c. Its carrying amount exceeds its recoverable amount d. Its carrying amount is less than its market value 17. Under IAS 36, what is the recoverable amount of an asset? a. The lower of its cost and net realizable value b. The higher of fair value less costs of disposal and value in use c. The lower of net present value and cost d. The higher of net present value and cost 18. The amount, which an asset is recorded in the Statement of Financial Position, less any accumulated depreciation and impairment losses, is called… a. Carrying amount b. Present value c. Fair value d. Net Realizable Value 19. Goodwill and intangible assets with indefinite useful lives must be tested for impairment at least every five years. a. True b. False 20. Which of the following is not permitted as a cost to sell under IAS 36? a. Cost to dismantle machine b. Auctioneers fees c. Standard wages for employees

d. Transport cost for machine

CHAPTER 36: INTANGIBLE ASSETS GOODWILL LEARNING OBJECTIVES After finishing this chapter, learners are expected to: 1. 2. 3. 4. 5.

Know the basic principle of intangible assets in accordance with PAS 38 Define criteria of an intangible asset Master the accounting for intangible asset (goodwill) Understand the nature of goodwill as an intangible asset Know the different approach in accounting goodwill

DEFINITION PAS 38 defines intangible assets as identifiable monetary assets without physical substance. Three essential criteria in determining whether an intangible asset must be recognized or not, namely: 1. Identifiability - the ability of the asset to be separated from the entity and can be sold 2. Control – power of an entity over the future economic benefits to be provided by the intangible assets 3. Future economic benefits- either in the form of revenue or cost savings IDENTIFIABLE INTANGIBLE ASSETS The following are the list of identifiable intangible assets: a. b. c. d. e. f. g. h. i. j.

Patent Copyright Franchise Trademark Customer list Computer software Broadcasting license Airline right Marketing rights Fishing rights

RECOGNITION OF INTANGIBLE ASSET An entity must recognize an intangible asset when: 1. It is probable that future economic benefits related to the intangible asset will flow to the entity 2. The cost of intangible asset can be measured reliably. INITIAL MEASUREMENT 1. Acquired separately- at cost plus any directly attributable cost of preparing the asset on its intended use. (it should be capitalized)  The cost of a separately acquired intangible asset comprises: (a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates; and (b) any directly attributable cost of preparing the asset for its intended use. 2. Part of business combination – fair market value at the date of acquisition  In accordance with IFRS 3 Business Combinations, if an intangible asset is acquired in a business combination, the cost of that intangible asset is its fair value at the acquisition date. If an asset acquired in a business combination is separable or arises from contractual or other legal rights, sufficient information exists to measure reliably the fair value of the asset. 3. By way of government grant – either fair value or nominal amount (zero)  Initially recognition at either fair value or normal value plus direct expenses to prepare for use. 4. From exchange – fair market value  Intangible assets may be acquired in exchange for a non-monetary asset or asset. The cost is measured at fair value. If the acquired asset is not measured at fair value, its cost is measured at the carrying amount of the asset given up. 5. Internally generated – all directly attributable costs necessary to create the asset will be capitalized.  Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognized as intangible assets. MEASUREMENT AFTER RECOGNITION An entity shall choose either the cost model or the revaluation model as its accounting policy. 1. Cost model - After initial recognition, an intangible asset shall be carried at its cost less any accumulated amortization and any accumulated impairment losses. 2. Revaluation model - After initial recognition, an intangible asset shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated amortization and any subsequent accumulated impairment losses. For the

purpose of revaluations under this Standard, fair value shall be measured by reference to an active market.  Revaluations shall be made with such regularity that at the end of the reporting period the carrying amount of the asset does not differ materially from its fair value.  When an intangible asset is revalued, the carrying amount of that asset is adjusted to the revalued amount. At the date of the revaluation, the asset is treated in one of the following ways:  (a) the gross carrying amount is adjusted in a manner that is consistent with the revaluation of the carrying amount of the asset.  (b) the accumulated amortization is eliminated against the gross carrying amount of the asset and the amount of the adjustment of accumulated amortization forms part of the increase or decrease in the carrying amount.  If an intangible asset in a class of revalued intangible assets cannot be revalued because there is no active market for this asset, the asset shall be carried at its cost less any accumulated amortization and impairment losses.  If the fair value of a revalued intangible asset can no longer be measured by reference to an active market, the carrying amount of the asset shall be its revalued amount at the date of the last revaluation by reference to the active market less any subsequent accumulated amortization and any subsequent accumulated impairment losses. PRESENTATION AND DISCLOSURE A. The financial statements shall disclose, for each intangible asset: 1. the whether the useful lives are indefinite or finite and, if finite, the useful lives or the amortization rates used; 2. the amortization methods used for intangible assets with finite useful lives; 3. the gross carrying amount and any accumulated amortization (aggregated with accumulated impairment losses) at the beginning and end of the period; 4. the line item(s) of the statement of comprehensive income in which any amortization of intangible assets is included; 5. a reconciliation of the carrying amount at the beginning and end of the period (b) The financial statements shall also disclose: 6.

7.

for an intangible asset assessed as having an indefinite useful life, the carrying amount of that asset and the reasons supporting the assessment of an indefinite useful life. In giving these reasons, the entity shall describe the factor(s) that played a significant role in determining that the asset has an indefinite useful life. a description, the carrying amount and remaining amortization period of any individual intangible asset that is material to the entity’s financial statements.

8. 9.

10.

for intangible assets acquired by way of a government grant and initially recognized at fair value the existence and carrying amounts of intangible assets whose title is restricted and the carrying amounts of intangible assets pledged as security for liabilities. the amount of contractual commitments for the acquisition of intangible assets.

(c) If intangible assets are accounted for at revalued amounts, an entity shall disclose the following: 11. 12.

by class of intangible assets the amount of the revaluation surplus that relates to intangible assets at the beginning and end of the period, indicating the changes during the period and any restrictions on the distribution of the balance to shareholders.

GOODWILL -

unique asset presented in the financial statements. An intangible asset associated with the purchase of one company by another. Acquire when the purchase price is higher than the net fair value of all assets acquired.

Characteristics of GOODWILL -

Most intangible of all intangible assets. Cannot be bought or sold Can only be identify by the entity as a whole Not specifically identifiable, has indeterminate life and inherent to business

FORMULA and CALCULATION OF GOODWILL Goodwill = P – (A+L) Where: P= Purchase price A= Fair market value of all assets acquired L= Fair market value of all liabilities acquired RECOGNITION OF GOODWILL Developed or internal goodwill – should not be recognized as an asset hence, not recorded

Purchased goodwill – paid goodwill hence should be recognizing as an asset and is recorded to the book of accounts. MEASUREMENT OF GOODWILL There are two approaches in measuring goodwill namely: a. Residual approach b. Direct approach RESIDUAL APPROACH Under this method, goodwill is measured by subtracting the net assets acquired (assets-liabilities) to the purchase price for the entity. Illustration: A Company purchased B Company for P5 000 000 cash. The assets and liabilities are of B Company is as follows: Assets: Cash

P80 000

Merchandise inventory

500 000

Accounts receivable

250 000

Building

1 000 000

Land

1 500 000

Liabilities: Accounts payable

250 000

Notes payable

300 000

Bonds payable

580 000

Net assets at fair value

2 200 000

Purchase price

5 000 000

Net assets at fair value

(2 200 000)

Goodwill

2 800 000

JOURNAL ENTRY Cash

80 000

Merchandise inventory

500 000

Accounts receivable

250 000

Building

1 000 000

Land

1 500 000

Goodwill

2 800 000 Accounts payable

250 000

Notes payable

300 000

Bonds payable

580 000

Cash

5 000 000

DIRECT APPROACH Under this approach, goodwill is measure on the basis of future earnings. The value of the anticipated excess earnings is essential component of goodwill. This approach requires the following information: 1. 2. 3. 4.

Normal rate of return Fair value of tangible assets Estimated future normal earnings Probable duration of any “excess earnings” attributable to goodwill.

Illustration: The following data are available in relation to the computation of goodwill: Shareholder’s equity Normal rate of return in the industry

P6 000 000 12%

Earnings for the past 5 years: 2016

800 000

2017

850 000

2018

980 000

2019

1 150 000

2020

1 175 000 4 955 000

Average earnings of the 5-year period (4 955 000/5) 991 000 Method 1 – Purchase of “average excess earnings” The goodwill is measured at average excess earnings for 5 years. Average earnings

991 000

Normal earnings (6 000 000*12%)

720 000

Average excess earnings

271 000

Goodwill (271 000*5)

1 355 000

The normal rate of 12% applies to the shareholder’s equity. Method 2 – Capitalization of “average excess earnings” The goodwill is measure at the average excess earnings capitalized at 15%. Average excess earnings Divided by capitalization rate Goodwill

271 000 15% 1 806 667

Method 3 – Capitalization of “average earnings” The goodwill is measured at average earnings capitalized at 10%. Average Divided by capitalization rate

991 000 10%

Net assets, including goodwill or purchase price

9 910 000

Less: Net assets excluding goodwill

6 000 000

Goodwill

3 910 000

Method 4 – Present value method

In this method, the goodwill is the present value of the average excess earnings that are expected to become available in future periods. Illustration: In the preceding problem, if the average excess earnings of 271 000 are expected to be received annually is 5 years, the goodwill, assuming a discount rate of 12% is computed as follows: Average excess earnings

271 000

Multiply by PV of an ordinary annuity Goodwill

3.605 976 955

IMPAIRMENT OF GOODWILL PAS 38 mandates that goodwill shall not be amortized because the useful life is indefinite. However, it shall be tested for impairment at least annually and whenever that there is an indication that it may be impaired. NEGATIVE GOODWILL Negative goodwill occurs when the purchase price or consideration received for the entity is less than the net fair value of the identifiable assets acquired and liabilities assumed. Negative goodwill is recognized in the statement of profit or loss as gain on bargain purchase. However, standards already dropped the term negative goodwill. Illustration: C entity purchased an ongoing business for P 5 000 000 cash. The assets and liabilities of the acquired business at fair value is as follows: Cash

2 000 000

Inventory

1 000 000

Building

3 500 000

Accounts payable

500 000

Bonds payable

600 000

Net assets at fair value

5 400 000

Purchase price

5 000 000

Less: Net assets at fair value Negative goodwill

5 400 000 ( 400 000)

Journal Entry Cash

2 000 000

Inventory

1 000 000

Building

3 500 000 Accounts payable

500 000

Bonds payable

600 000

Gain on bargain purchase

400 000

Cash

5 000 000

TRUE OR FALSE 1. In recognition of an intangible asset it should always be probable and can be measure reliably. 2. Judgement is always based on internal evidence 3. An intangible asset must be controllable in order to distinguish it from goodwill. 4. Identifiable means that the asset is capable of being separated from the entity. 5. The intangible asset must be controlled by the entity as a result of past event and from which future economic benefits are expected to flow to the entity. 6. It is possible that the liabilities assumed by the entity will be greater than the asset acquired 7. Amortization of goodwill is measured annually over its useful life.

8. Under residual approach, the net assets acquired must be measured at fair value. 9. In direct approach, goodwill is measured on the basis of future earnings of the entity. 10. Developed or internal goodwill is the goodwill that has been paid for. PROBLEM 1. TIBS Company purchase another entity for P5 000 000 cash at the beginning of the current year. The acquired entity’s assets and liabilities at fair value is as follows: Cash

90 000

Trade and other receivables

680 000

Merchandise inventory

1 500 000

Land

3 000 000

Notes payable

750 000

Bonds Payable

900 000

Net assets at fair value

5 270 000

1 650 000 3 620 000

Required: 1. Determine the amount of goodwill 2. Prepare the journal entries PROBLEM 2. CINDY Company purchased for cash at P105 per share all 20 000 ordinary shares outstanding of TIBS company. TIBS statement of financial position showed its net assets with the carrying amount of P1 800 000 at the date of acquisition. The fair value of its non-current asset on the same date was P150 000 in excess of carrying amount. Required: Determine the amount of goodwill on the date of purchase. PROBLEM 3. RINDO Company purchased an entity for P 900 000 cash during its operating year. Given below are the carrying amount and fair value of the assets: Cash

Fair value 10 000

Trade and other receivables Inventory Patent Furniture and fixtures Notes payable (long term debt) Bonds payable

290 000 1 600 000 260 000 900 000 950 000 1 850 000

Required: Determine the amount of goodwill using residual approach. PROBLEM 4. Rain Company purchased an entity for P2 250 000 cash during its operating year. Given below are the carrying amount and fair value of the assets: Cash Trade and other receivables Inventory Patent Building Notes payable (long term debt) Bonds payable

Fair value 80 000 900 000 1 250 000 500 000 1 500 000 850 000 1 500 000

Required: 1. Determine the amount of goodwill using residual approach. 2. Prepare necessary journal entries. PROBLEM 5. Kurt Company purchased for cash at P65 per share all 100 000 ordinary shares outstanding of Joshua company. Joshua statement of financial position showed its net assets with the carrying amount of P5 000 000 at the date of purchase The fair value of its non-current asset on the same date was P500 000 in excess of carrying amount. Required: Determine the amount of goodwill on the date of purchase.

PROBLEM 6. Cy Company purchase John entity for P7 500 000 cash at the beginning of the current year. The acquired entity’s assets and liabilities at fair value is as follows: Cash

100 000

Trade and other receivables

800 000

In-process research and development

2 000 000

Building

5 000 000

Notes payable

500 000

Bonds Payable

2 000 000

7 900 000

2 500 000

Net assets at fair value

5 400 000

Required: 1. Determine the amount of goodwill 2. Prepare the journal entries PROBLEM 7. On December 31, 2019, Lind Company purchased for P50 per share all 150 000 outstanding ordinary share of Say Company. The following relates to Say company’s assets acquired: Carrying amount of assets acquired Fair value of identifiable assets (excess of CA)

6 350 000 800 000

What amount should be reported as goodwill at year-end? PROBLEM 8. On January 1, 2019, AWARDS Company purchased Honor company at a cost that resulted in recognition of goodwill of P3 250 000. During the first quarter of 2019, AWARDS spent an additional P800 000 on expenditures designed to develop and maintain goodwill by training new employees. Due to these expenditures, on December 31,2019, AWARDS estimated that the benefit period of goodwill was indefinite. In it December 31, 2019 statement of financial position, what amount should AWARDS report as goodwill? PROBLEM 9.

The shareholders of JP Company mind to sell their business to new interest. For the past five years, their cumulative net earnings amounted to P6 670 000 inclusive of expropriation gain of P730 000. JP Company’s fair value of net assets was P8 000 000. If the goodwill is determined by capitalizing average net earnings at 10%, what is the amount to be paid for goodwill? PROBLEM 10. Happy company is interested in computing the goodwill to be recognized in the purchase of Sad Company in January 2020. Sad Company’s information is as follows: Year 2015 2016 2017 2018 2019 Totals

Net Income 400 000 500 000 300 000 800 000 700 000 2 700 000

Net Assets 1 500 000 1 700 000 1 200 000 1 500 000 1 350 000 7 250 000

It is agreed that goodwill is measure by capitalizing excess earnings at 40%, with normal return on average net assets at 10%. What is the “purchase price” of Sad Company?

ANSWER KEY TRUE OR FALSE 1. T 2. F 3. F 4. F 5. T 6. T 7. F 8. T 9. T 10. F PROBLEM 1. ANSWER 1. 5 000 000-3 620 000=1 380 000(Goodwill) 2. Cash

90 000

Trade and other receivables

680 000

Merchandise inventory

1 500 000

Land

3 000 000

Goodwill

1 380 000 Notes payable

750 000

Bonds payable

900 000

Cash

5 000 000

PROBLEM 2. ANSWER 105*20 000 =2 100 000-1 800 000-150 000 =150 000 PROBLEM 3. ANSWER Net assets at fair value = 260 000 Purchase price= 900 000

900 000 – 260 000 =640 000(Goodwill)

PROBLEM 4. ANSWER 1. Net assets at fair value = 1 880 000 Purchase price= 2 250 000

2 250 000-1 880 000 =370 000(Goodwill) 2. Cash Trade and other receivables Inventory Patent Building Goodwill Notes payable Bonds payable Cash

80 000 900 000 1 250 000 500 000 1 500 000 370 000 850 000 1 500 000 2 250 000

PROBLEM 5. ANSWER 65*100 000 = 6 500 000-5 000 000 – 500 000 = 1 000 000(goodwill) PROBLEM 6. ANSWER 1. 7 500 000-5 400 000=2 100 000(Goodwill) 2. Cash

100 000

Trade and other receivables

800 000

In-process research and development

2 000 000

Building

3 000 000

Goodwill

2 100 000 Notes payable

500 000

Bonds payable

2 000 000

Cash

7 500 000

PROBLEM 7. ANSWER 50*150 000 =7 500 000-6 350 000-800 000 =350 000 (goodwill) PROBLEM 8. ANSWER Cost of goodwill- January 1,2019

P3 250 000

PROBLEM 9. ANSWER Cumulative earnings

6 670 000

Less: expropriation gain Adjusted cumulative earnings

730 000 5 940 000

Average earnings (5 940 000/5)

1 188 000

Divide by capitalization rate

10%

Net asset including goodwill

11 880 000

Less: net assets before goodwill Goodwill

_

8 000 000 3 880 000

PROBLEM 10. ANSWER Average net assets (7 250 000/5)

1 450 000

Average Earnings (2 700 000/5)

540 000

Less: Normal Earnings (10%*1 450 000)

145 000

Excess Earnings

395 000

Divide by capitalization rate

40%___

Goodwill

158 000

Net assets-2019

1 350 000

Goodwill

158 000

Total purchase price

1 508 000

IDENTIFIABLE INTANGIBLE ASSETS Identifiable Intangibles – can be identified apart from other assets of the enterprise and can be sold separately. Patent – an exclusive right granted by the government to an inventor enabling him o control the manufacture, sale or other use of his invention for a specified period of time. The cost of a purchased patent which is equal to its fair market value should be amortized over its legal life (20 years) or useful life, whichever is shorter. The cost of the developed patent which include only the licensing and other related legal fees in securing the patent rights should be amortized the shorter of the legal life or useful life. If a competitive patent was acquired to protect the old patent, the cost of the competitive patent should be amortized over the remaining life of the old patent. Legal fees and other costs of successfully prosecuting or defending a patent should be charged outright as an expense. Any cost of unsuccessful litigation on patent should also be charged outright as an expense including the unamortized cost of the patent. If a new patent negates the old patent’s value, the cost of the new patent can be made by adding the unamortized cost of the old patent; however, most business enterprises rely on the conservatism constraint and immediately write-off the unamortized cost of the old patent. Copyright – exclusive right granted by the government to the author, composer or artist enabling to publish, sell or otherwise benefit from his literacy, musical and artistic work. The costs which includes the expenses incurred in the production of the work including those required to establish or obtain the right should be amortized over the period it is expected to provide a revenue or legal life, whichever is shorter. However, if revenues are expected to be received for an indefinite period of time and renewal and registration can be done with minimal effort and cost, it should not be amortized but should however be reviewed for impairment at each reporting date. Franchise – an exclusive right granted by the franchisor (government or private companies) to a franchisee to use the property or the rights (trademark, patent and process of the franchisor). The cost of the franchise should be amortized or reviewed at each reporting period for impairment:  If the franchise has a definite period – it should be amortized over the definite period (not exceeding 20 years) or useful life, whichever is shorter.  If the franchise has an indefinite useful life – it is not amortized but tested for impairment at each reporting date. Trademark/ Tradename/ Brand name – is a symbol, sign, slogan or name used to mark a product to distinguish it from other products. The cost of the intangible should include:

 When purchased – the purchase price or the cash price equivalent  When developed – the expenditures required to establish including filing fees, registry fees, and other expenses incurred in securing the trademark. Under R.A No. 8293, the legal life of a trademark is 10 years and may be renewed for periods of 10 years each. The cost of a trademark is not amortized but tested for impairment at least annually as a result of the almost automatic renewal. Trademark may be properly classified as an intangible asset with an indefinite life. However, if its life is no longer indefinite, it should be amortized over its remaining useful life. Customer List – one of the customer-related assets result from interactions with outside parties.  Cost of purchased customer list – includes the purchase price and any directly attributable cost of preparing the asset for its intended use. The cost is amortized over the asset’s useful life.  Cost of an internally generated customer list – expensed in the period incurred. Subsequent expenditures on customer lists are recognized as expense. Web site costs  Summary Web site’s use 1. Internal use 2. External use (customers can place their orders on the web site) 3. External use (customers cannot place their orders on the web site 

Summary Web site development stage 1. Planning stage 2. Application and infrastructure 3. Graphical design stage 4. Content development stage 5. Operating stage

Accounting treatment Capitalize Capitalize Expensed

Treatment for costs incurred Expensed immediately Intangible asset if all conditions are met Intangible asset if all conditions are met Expensed to the extent that content is developed to advertise products or services Expensed, unless recognition criteria are met

IDENTIFIABLE INTANGIBLE ASSETS PROBLEMS Problem 1 Robin Company incurred P1,600,000 of research and development costs to develop a product for which a patent was granted on January 1, 2019. Legal fees and other costs associated with registration of the patent totaled P300,000. On March 31, 2019, Robin paid P450,000 for legal fees in a successful defense of the patent. What is the total amount that should be capitalized for the patent through March 31,2019? a. 750,000 b. 300,000 c. 2,050,000 d. 2,350,000 Solution Answer b Legal fees and other costs associated with registration 300,000 The cost of litigation whether successful or not, should be treated as outright expense because such cost would only maintain and not enhance the originally assessed future economic benefits. As a rule, expenditure on research and development should be recognized as an expense when it is incurred. Problem 2 On January 1, 2016, Coprade Company purchased a patent for P7,140,000. The patent is being amortized over its remaining legal life of 15 years expiring on January 1, 2031. During 2019, Coprade determined that the economic benefits of the patent would not last longer than ten years from the date of acquisition. What should be reported in the statement if financial position as carrying amoun of patent on December 31, 2019? a. 4,284,000 b. 4,896,000 c. 5,050,000 d. 5,236,000 Solution Answer b Cost – January 1, 2016 Amortization for 2016, 2017, 2018 (7,140,000 / 15 x 3) Carrying amount – December 31, 2018 Amortization for 2019 (5,712,000 / 7)

7,140,000 (1,428,000) 5,712,000 (816,000)

Carrying amount – December 31, 2019

4,896,000

Problem 3 On January 1, 2016, Dilan Company purchased a patent for a new customer product for P900,00. At the time of purchase, the patent was valid for 15 years. However, the patent’s useful life was estimated to be only 10 years due to competitive nature of the product. On December 31, 2019, the product was permanently withdrawn from sale under governmental order because of a potential health hazard in the product. What amount should Dilan charge against income during 2019 if amortization is recorded at the end of each year? a. 90,000 b. 540,000 c. 630,000 d. 720,000 Solution Answer c Acquisition cost Amortization for 2016, 2017, 2018 (900,000 / 10 x 3) Carrying Amount – January 1, 2019

900,000 (270,000) 630,000

The remaining carrying amount on January 1, 2019 is entirely expensed in 2019 and this includes the amortization of P90,000 for 2019. Problem 4 Carmona Company acquired three patents in January 2019. The patents have different lives as indicated in the following schedule: Patent Cost Remaining Useful Remaining legal life life X 1,200,000 10 8 Y 2,000,000 5 10 Z 3,000,000 6 15 Patent Z is believed to be uniquely useful as long as the entity retains the right to use it. in June 2019, the entity successfully defended its right to Patent Y. Legal fees of P450,000 were incurred in this action. The entity’s policy is to amortize intangible assets by the straight line method to the nearest half year. The entity reports on a calendar-year basis. What amount of amortization should be recognized for 2019? a. 1,050,000 b. 1,100,000 c. 1,095,000 d. 1,020,000 Solution Answer a Patent X (1,200,000 / 8) Patent Y (2,000,000 / 5) Patent Z (3,000,000 / 6)

150,000 400,000 500,000

Total Amortization

1,050,000

Problem 5 Pink Company was granted a patent on January 1, 2016, and appropriately capitalized P450,000 of related costs. Pink was amortizing the patent over its estimated life of 15 years. During 2019, Pink paid P150,000 in legal costs in successfully defending an attempted infringement of the patent. After the legal action was completed, Pink sold the patent to the plaintiff for P750,000. Pink’s policy is to take no amortization in the year of disposal. In its 2019 income statement, what amount should Pink report as gain from sale of patent? a. 150,000 b. 240,000 c. 270,000 d. 390,000 Solution Answer d Acquisition cost – January 1, 2016 Amortization for 2016, 2017, 2018 (450,000 / 15 x 3) Carrying amount – January 1, 2019

450,000 (90,000) 360,000

Sales Price Remaining cost of patent Gain from sale of patent

750,000 (360,000) 390,000

Problem 6 On January 1, 2019, Serra Company bought a trademark from Kaba Company for P3,000,000. Serra retained an independent consultant who estimated the trademark’s life to be indefinite. Its carrying amount in Kaba’s accounting records was P1,500,000. On December 31, 2019, what is the carrying amount of trademark? a. 3,000,000 b. 1,500,000 c. 2,850,000 d. 0 Solution Answer a The legal life of trademark is 10 years and may be renewed for periods of 10 years each. Considering the almost automatic renewal of a trademark, the trademark can be classified as an intangible asset with indefinite life. Accordingly, the cost of trademark is not amortized but tested for impairment at least annually. Problem 7 Narra Company has acquired a trademark relating to the introduction of a new manufacturing process. The costs incurred were as follows: Cost of trademark Expenditure on promoting the new product Employee benefits relating to testing of new process

3,500,000 50,000 200,000

What total cost should be capitalized as intangible noncurrent asset in respect of the new process? a. 3,750,000 b. 3,700,000 c. 3,500,000 d. 3,550,000 Solution Answer b Total cost (3,500,000 + 200,000)

3,700,000

Problem 8 On January 1, 2019, Laderas Company showed patent of P1,920,000 with related accumulated amortization of P240,000. The patent was purchased on January 1, 2017 at which date the legal life is 16 years. On January 1, 2019, the useful life of the patent was determined to be only 8 years from the date of acquisition. On January 1, 2019, in connection with the purchased of trademark from Ash Company, the parties entered into a noncompetition agreement and a consulting contract. Laderas Company paid Ash Company P800,000, of which three-fourths was for the trademark, and one-fourth was for Ash Company’s agreement not to compete for a five-year period in the line of business covered by the trademark. Laderas Company considers the life of the trademark to be indefinite. Moreover, Laderas Company agreed to pay Ash Company P50,000 annually on January 1 of each year for 5 years. 1. What is the carrying amount of intangible assets on January 1, 2019? a. 2,280,000 b. 2,480,000 c. 1,880,000 d. 1,680,000 2. What is the total amortization of intangible assets for 2019? a. 280,000 b. 440,000 c. 320,000 d. 160,000 Solution Question 1 Answer b Question 2 Answer c Patent (1,920,000 – 240,000)1,680,000 Trademark (800,000 x ¾) 600,000 Noncompetition agreement (800,000 x 1/4) 200,000 Total intangible assets – January 1, 2019 2,480,000 Amortization of patent (1,680,000 / 6) Amortization of noncompetition agreement (200,000 / 5) Total amortization for 2019

280,000 40,000 320,000

Problem 9 On January 1, 2019, Love signed an agreement to operate as a franchise of Spade Company for an initial franchise fee of P12,000,000. The same date, Love paid P4,000,000 and agreed to pay

the balance in four equal annual payments of P2,000,000 beginning January 1, 2020. The down payment is not refundable and no future services are required of the franchisor. Love can borrow at 14% for a loan of this type. Present and future value factors are as follows: PV of 1 at 14% for 4 periods Future amount of 1 at 14% for 4 periods PV of an ordinary annuity of 1 at 14% for 4 periods What is the acquisition cost of the franchise? a. 13,520,000 b. 12,000,000 c. 9,820,000 d. 8,720,000

0.59 1.69 2.91

Solution Answer c Down payment PV of annual payment of P2,000,000 For 4 years (2,000,000 x 2.91) Cost of franchise The present value factor of an ordinary annuity of 1 is used in value because the balance is payable equally by installment.

4,000,000 5,820,000 9,820,000 computing the present

Problem 10 On January 1, 2017, Yan Company signed an eight-year lease for office space. Yan has the option to renew the lease for an additional four-year period on or before January 1, 2024. During January 2019, two years after occupying the lease premises, Yan made general improvements to the premises costing P3,600,000 and having an estimated useful life of ten years. On December 31, 2019, Yan’s intentions as to exercise of the renewal option are uncertain. What is the depreciation of leasehold improvements for 2019? a. 300,000 b. 360,000 c. 450,000 d. 600,000 Solution Answer d (3,600,000 / 6) 600,000 The leasehold improvements are depreciated over the remaining lease term of 6 years because this is shorter than the life of the improvements of 10 years. Problem 11 On January 1, 2019, Rein Company leased land and building from an unrelated lessor for a tenyear term. The lease has a renewal option for an additional ten years, but Rein has not reached a decision with regard to the renewal option. In early January of 2019, Rein completed the following improvements to the property: Sales office Warehouse Parking lot

10 years 25 years 15 years

470,000 750,000 180,000

What is the depreciation of leasehold improvements for 2019? a. 70,000 b. 89,000 c. 122,000 d. 140,000 Solution Answer d Sales office Warehouse Parking lot Total Leasehold improvements should be lease contract, whichever is shorter.

(470,000 / 10) (750,000 / 10) (180,000 / 10)

47,000 75,000 18,000 140,000 depreciated over the life of the improvement or life of the

Problem 12 Moon Company leases a building for its product showroom. The ten-year nonrenewable lease will expire on December 31, 2024. In January 2019, Moon redecorated its showroom and made leasehold improvement of P480,000. The estimated useful life of the improvement is 8 years. Moon uses the straight line method of depreciation. What is the carrying amount of leasehold improvement on June 30, 2019? a. 456,000 b. 450,000 c. 440,000 d. 432,000 Solution Answer c Leasehold improvement 480,000 Depreciation from January 1 to June 39, 2019 (480,000 / 6 x 6/12) (40,000) Carrying amount – June 30, 2019 440,000 The remaining lease term from January 2019 to December 31, 2024 is six years which is shorter than the life of the improvement of 8 years. Problem 13 On January 1, 2018, Grey Company acquired a land lease for 21 years with no option to renew. The lease required Grey to construct a building in lieu of rent. The building, completed on January 1, 2019, at a cost of P8,400,000, will be depreciated using the straight line method. At the end of the lease, the building’s estimated fair value is P4,200,000. What is the carrying amount of the building in the December 31, 2019 statement of financial position? a. 7,980,000 b. 8,000,000 c. 8,190,000 d. 8,200,000

Solution Answer a Building Depreciation for 2019 (8,400,000 / 20) Carrying amount – December 31, 2019

8,400,000 (420,000) 7,980,000

The building was completed on January 1, 2019, one year from the date of the lease on January 1, 2018. Thus, the remaining term is 20 years. The estimated fair value of the building at the end of the lease is ignored in computing depreciation because legally, the building becomes the property of the lessor when the contract is terminated. Problem 14 On October 1, 2019, Mars, Inc. exchanged 2,000 shares of its P500 par value ordinary shares held in treasury for a patent owned by Saturn Company. The treasury shares were acquired in 2018 at a cost of P800,000. At the time of exchange, Mar’s ordinary share was quoted at P550 per share and the patent had a net carrying value on Saturn’s books of P900,000. At what amount should Mars record the patent? a. 800,000 b. 900,000 c. 1,000,000 d. 1,100,000 Solution Answer d FMV of shares issued (treasury) At the time of exchange (2,000 x P550)

P1,100,000

Problem 15 Constellation Company incurred P198,900 of research and development costs to develop a product for which a patent was granted on January 2, 2016. Legal fees and other costs associated with registration of the patent totaled P44,200. On January 2, 2019, Constellation paid P62,400 for legal fees in a successful defense of the patent. The patent has a useful economic life of 20 years. What amount should Constellation record as amortization expense for 2019? a. 2,210 b. 5,200 c. 7,800 d. 19,500 Solution Answer a Historical cost Divided by its legal life Annual amortization

44,200 20 years 2,210

Cost to develop on intangible is recognized as an outright expense Subsequent cost of defending the patent is charged outright to expense.

Problem 16 Pluto Company spent P288,000 in developing a new product with a patent being granted on January 2, 2017. Due to a competitive nature of the product, the patent was estimated to have a useful life of ten years. Cost of licensing and registering was P36,000. On July 1, 2019, a competitor obtained rights to a patent, which made Pluto’s patent obsolete. How much is the loss from patent obsolescence? a. 6,000 b. 16,200 c. 27,000 d. 36,000 Solution Answer c Cost of patent 36,000 Less: Total amortization from Jan. 2017 to July 1, 2019 9,000 (36,000 x 2.5/10) Book value of patent as of July 1, 2019 27,000 The amount of loss on patent obsolescence is equal to the book value of the patent when it became obsolete. Problem 17 Earth Company bought a patent for P600,000 on January 2, 2016, at which time the patent had an estimated useful life of ten years. On January 2, 2019, it was determined that the patent’s useful life would expire at the end of 2022. How much should Earth record as amortization expense for this patent on December 31, 2019? a. 60,000 b. 105,000 c. 120,000 d. 140,000 Solution Answer b Original cost Less: Amortization from Jan.2, 2016 to Jan. 2, 2019 (600,000 x 3/10) Carrying value of patent- date of change in estimated life Divided by: Remaining new life (Jan.2, 2019 to Dec.31, 2022) Amortization expense, 2019

600,000 180,000 420,000 4 years 105,000

Problem 18 On January 1, 2015, Best Company bought a trademark for P400,000, having an estimated remaining useful life of 16 years. After 16 years, revenues expected from these intangibles will be zero. In January 2019, Best paid P60,000 for legal fees in a successful defense of the trademark. What amount of expense should Best Company recognize and charge against income during 2019? a. 15,000 b. 25,000

c. 30,000 d. 85,000 Solution Answer d Amortization expense – original cost (400,000 / 16 years) Cost of litigation Total expense

25,000 60,000 85,000

Problem 19 Sang Company has a broadcasting license that expires in 5 years. As of January 1, 2016, the license has a carrying amount of P1,800,000. The license is renewable and has already been renewed twice in the past. During the current year 2016, the broadcasting authority has decided that in the future it will auction the licenses when they came up for renewal. As a result of this development the company’s renewal option is no longer assured. The license has a remaining life of three years as of January 1,2016. In the December 31, 2016 statement of financial position, how much should be reported as the carrying value of the broadcasting license? a. None b. 1,200,000 c. 1,600,000 d. 2,000,000 Solution Answer b Carrying value as of January 1, 2016 Amortization – 2016 (1,800,000 / 3 years) Carrying value as of Dec. 31, 2016

1,800,000 (600,000) 1,200,000

Problem 20 On July 1, 2019, Silk signed an agreement to operate as a franchise of Cream Company for an initial franchise fee of P1,200,000. On the same date, Silk paid P400,000 and agreed to pay the balance in four equal payments of P200,000 beginning July 1, 2020. The down payment is not refundable and no future services are required of the franchisor. Silk can borrow at 14% for a loan of this type. Present and future value factors are as follows: PV of 1 at 14% for 4 periods 0.59 Future amount of 1 at 14% for 4 periods 1.69 PV of an ordinary annuity of 1 at 14% for 4 periods 2.91 How much should Silk record as acquisition cost of the franchise on July 1, 2019? a. 872,000 b. 982,000 c. 1,200,000 d. 1,352,000 Solution Answer b Down payment Present value of future payments (200,000 x 2.91) Cost of franchise

400,000 582,000 982,000

CHAPTER 38-Research and Development Research activities are planned search or critical investigation aimed at discovery of new knowledge. Development activities are translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use. Research and development activities do not include routine or periodic alternatives to existing products, production lines, manufacturing processes, and other ongoing operations even though these alterations may represent improvements. Accounting for R&D Costs: 1. Materials, Equipment, and Facilities- expense the entire cost unless the items have alternative future uses, then carry as inventory and allocate as consumed, or capitalize and depreciate as used. 2. Personnel- salaries, wages, and other related costs of personnel engaged research and development should be expensed as incurred. 3. Intangibles- expense the entire cost unless the items have alternative future uses, then capitalize and amortize. 4. Contract Services- cost of services performed by others in connection with the reporting company’s R&D should be expensed as incurred. 5. Indirect costs- a reasonable allocation of indirect costs shall be included in R & D costs, except for general and administrative cost which must be clearly related in order to be included and expensed. 6. Only Development activity –related costs has the potential to be capitalized after a market viability is established. Other costs similar to Research and Development costs Start-up cost Start-up cost are costs incurred for one time activities to start a new operations. It includes organizational costs which are incurred in organizing of a new entity. Start-up costs are expensed as incurred with the expectation that future revenues will occur or increased efficiencies will result. Initial Operating Losses Operating losses should not be capitalized during the early years for FASB concludes that the accounting practices and reporting standards should be no different for an enterprise trying to

establish a new business than they are for other enterprise. The same GAAP that apply to the established operating enterprises shall govern the recognition of revenue by a development stage enterprise and shall determine whether a cost incurred by a development stage enterprise is to be charged to expense when incurred or is to be capitalized or deferred. Advertising Costs These costs could be expensed in various of ways: a. b. c. d. e.

When advertising was completed When first time advertising takes place Over the estimated useful life of the advertising In an appropriate fashion to each of the three periods identified above Over the period revenues are expected to result

PROBLEMS 1. How should research and development costs be accounted for? a. must be capitalized when incurred and then amortized over the useful life b. must be expensed in the period incurred c. may either be capitalized or expensed when incurred depending upon the materiality d. must be expensed in the period incurred unless t can be clearly demonstrated that the expenditure will have alternative future use or unless contractually reimbursable

2. Which of the following would be considered research and development? a. routine effort to refine an existing product b. periodic alteration to existing production lines c. marketing research to promote a new product d. construction of prototype 3. Which of the following costs should not be capitalized? a. acquisition cost of equipment to be used on current and future research projects b. engineering costs incurred to advance the product to the full production stage c. cost incurred to file for patent d. cost of testing prototype before economic feasibility has been demonstrated 4. Which of the following costs should be excluded from research and development expense? a. modification of the design of a product b. acquisition of research and development equipment for use on a current project only c. cost of marketing research for a new product

5.

6.

7.

8.

d. engineering activity required to advance the design of a product to the manufacturing stage Which of the following should not be considered research and development activity? a. adaptation of an existing capability to a particular requirement or customer need b. application of research finding or other knowledge to a plan for a new product c. laboratory research aimed at discovery of new knowledge d. conceptual formulation and design of possible product alteration Research activities include all of the following, except a. search for application of research finding or other knowledge b. search for product or process alternative c. formulation and design of the possible product or process alternative d. design, construction and testing of preproduction prototype and model Development activities include all of the following except a. design of tools, jigs, molds and dies involving new technology b. design, construction and operation of a pilot plant c. design, construction and testing of a chosen alternative for a new or improved product or process d. laboratory activities aimed at obtaining new knowledge Which of the following is not one of the criteria which must be met before development costs can be capitalized? a. the entity has sufficient financial resources to complete the project b. the entity intends to complete the project and either use or sell the intangible asset c. the entity can reliably identify the research costs incurred to bring the project to economic feasibility d. the project has achieved technical feasibility

9. Which of the following costs should be capitalized? a. acquisition cost of equipment to be used on current research project only b. engineering cost incurred to advance the product to the full production stage c. cost of research to determine whether a market for the product exists d. salaries of research staff 10. Which statement is true about development cost? a. development cost must be expensed b. development cost is always deferred and expensed against future revenue c. development cost may be capitalized as an intangible asset in very restrictive situations d. development cost is recorded as component of other comprehensive income 11. Routine on-going effort to refine, enrich or improve quality of existing product is not a considered a research and development activity. TRUE 12. Cost of testing equipment that will also be used in another separate research and development project scheduled to begin next year should be capitalized and amortized over current and future periods. TRUE 13. Internal-use software is considered to be software that is marketed as a separate product or as part of a product or process. FALSE

14. A computer software purchased as an integral part of a computer controlled machine tool that cannot operate without the specific software shall be treated as a. intangible asset b. property, plant, and equipment c. inventory d. expense 15. Preliminary cost should be expensed as incurred for internal-use software cost. TRUE 16. The proper accounting for costs incurred in creating computer software is to charge research and development expense when incurred until technological feasibility has been established for the product. TRUE 17. Design, construction and operation of a pilot plant would not be considered as a research and development activity. FALSE 18. Application and development costs should be capitalized as incurred. TRUE 19. On December 31, year 3, Bit Co. had capitalized costs for a new computer software product with an economic life of five years. Sales for year 4 were 30% of expected total sales of the software. At December 31, year 4, the software had a net realizable value equal to 90% of the capitalized cost. What percentage of the original capitalized cost should be reported as the net amount on Bit’s December 31, year 4 balance sheet? a. 70% b. 72% c. 80% d. 90%

20. Cody Corp. incurred the following costs during year 4: Design of tools, jigs, molds, and dies involving new technology $125,000 Modification of the formulation of a process 160,000 Troubleshooting in connection with breakdowns during commercial production 100,000 Adaptation of an existing capability to a particular customer’s need as part of a continuing commercial activity 110,000 In its year 4 income statement, Cody should report research and development expense of a. $125,000 b. $160,000 c. $235,000 d. $285,000