Chapter 4: Statements of Financial Position and Changes in Equity; Disclosure Notes
Suggested Time
Case4-1Wonder Amusements Limited
4-2WPB Limited
4-3BrownLtd.
Assignment4-1SFP classification...... 10
4-2SFP classification...... 20
4-3SFP classification...... 15
4-4SFP classification...... 15
4-5Determining values in the SFP (*W)...... 20
4-6Financial statement classification...... 15
4-7Prepare a statement of financial position (*W)25
4-8Analyzing data and reporting on theSFP....20
4-9Redraft a deficient SFP...... 30
4-10Criticize and redraft a deficient SFP (*W).60
4-11removed
4-12Full set of statements—comprehensive income45
4-13Income statement and SFP...... 60
4-14Error correction...... 20
4-15Change in accounting policy...... 15
4-16Error correction...... 25
4-17Change in accounting policy—private company30
4-18Financial statement classification...... 20
4-19Correction of income and retained earnings
statements—private company...... 35
4-20Note disclosures ...... 10
4-21Contingencies...... 30
4-22Subsequent events...... 25
4-23Subsequent events...... 20
4-24Contingencies, subsequent events...... 15
4-25Special disclosures...... 20
4-26Special disclosures...... 20
4-27Segment disclosure...... 15
4-28SFP interpretation...... 40
4-29SFP interpretation...... 45
4-30Comprehensive...... 40
*W The solution to this exercise/problem is on the text Web site and in
the Study ...Guide. This solution is marked WEB.
Questions
1.The limitations of the SFP include:
- The statement reflects the results of reporting policies, which affects carrying value of assets and liabilities.
- The SFP reflects estimated amounts, which may be reasonably reliable but still may reflect management’s perceptions and may turn out to be incorrect when the amounts are realized.
- The SFP is a “mixed valuation” model thatreflects both historic costs and market values, and therefore may not adequately portray the true “financial position” of the enterprise.
- Certain assets and liabilities that fail the recognition criteria are not on the balance sheet, and thus the SFP is incomplete.
- Aggregated numbers may disguise relationships or hide significant items of interest to some readers.
- Consolidated statements represent a fictional accounting entity and don’t show the assets and liabilities of any specific legal entity, which can mislead lenders as to the security of their loans.
2. In North America, current asset accounts are typically ordered from the most liquid to the least liquid, as follows:
Cash and cash equivalents
Short-term investments
Short-term notes receivable
Accounts receivable
Accrued receivables
Inventories
Prepaid expenses
3.SFPs in other countries may appear quite different from those in North America, even when they follow IFRS. For example, the listing of asset and liabilities may be from least liquid to most liquid instead of the North American custom of listing them from most liquid to least liquid. Also,the positioning of assets vs. liabilities and shareholder’s equity may be reversed.
4.Capital assets are those used in the revenue-generating operations of an entity over more than one year. They are not held for resale. Tangible capital assets are characterized by physical existence (i.e., land, buildings, equipment, etc.). Intangible capital assets have no physical existence, but have value because of the rights their ownership confers (e.g., patents, franchises, etc.).
5.Many intangible assets do not appear on the balance sheet because they have been self-developed (i.e., not purchased). Self-developed intangible assets are reported at cost, which may be a minor amount in relation to their value (e.g., legal costs for patents vs. the future cash flow generated by the patented item). Also, some intangibles have a significant cost that is expensed, rather than capitalized (e.g., research). Thus, firms whose major assets are intangible may have balance sheets that materially understate their net asset position. This makes key return statistics, etc., misleading.
6.Deferred income taxes are either a liability or an asset on the balance sheet, and indicate that income tax will have to be paid – or received – in the future. The amount is not currently due or receivable. Deferred income tax amounts arise when accounting and taxable measures of various revenues and expenses are different, although they will be the same over time. The classification is sometimes questioned because the amount is not one that is presently owed (or receivable), but instead is the result of an interperiod allocation of cost (i.e., income tax expense).
7.A non-controlling interest is the portion of the net assets of a consolidated subsidiary included in the balance sheet that the non-controlling interest owns (e.g., if an 80%-owned subsidiary is consolidated, then 20% of net assets of the subsidiary belong to the non-controlling interest).
8.Shareholders’ equity is the residual interest in the assets of an entity after deducting liabilities. In a business, the main components are (a) contributed, or paid-in, capital (share capital and other contributed capital), (b) retained earnings and (c) items of other comprehensive income.
9.The format is usually columnar, with each item of shareholders’ equity reconciled from the opening to ending balance. Items should not be combined into an “other” category.
10.The primary disclosure note classifications are:
a.Statement of compliance with accounting standards, citing the basis of presentation
Examples —IFRS
—ASPE
b.Accounting policy disclosures
Examples—general basis of presentation; GAAP used
—revenue recognition policy
—new accounting standards
c.Identify major underlying assumptions and estimates
Examples—depreciation rates and useful life estimates
—sensitivity to estimates such as exchange rate changes or interest
c.Provide additional information about specific financial statement line items
Examples—amount of cumulative dividends in arrears
—reconciliation of beginning and ending balances of capital assets
d.Provide information not disclosed elsewhere but useful for users
Examples—five year cash flows for long-term debt
—contingent liabilities
11.A contingent cost or loss is a potential amount that will become a liability in the future if some specific event or events occur but either is not measurable or not probable.
A provision is a probable and reliably measurable present obligation that has arisenfrom actions taken by management in the current (or previous) period.
12.Segment disclosures are designed to desegregate the aggregated and/or consolidated information in the financial statements. This allows analysis of key operating statistics by geographical location and industry, permitting more effective risk assessment.
13.Related party transactions may not be recorded at fair market value. If they are pervasive, the true economics of an entity’s operations may not be obvious from the financial statements.
14.Measurement uncertainty is uncertainty as to the amount to record for a transaction and/or balance. It must be disclosed to alert financial statement users to the risk of misstatement.
15.Understatement of Year 1 income ($21,000 – $2,000) $19,000 cr.
Overstatement of Year 2, 3 and 4 income ($2,000 × 3) (6,000)dr.
Restatement of retained earnings required in Year 5 $13,000 cr.
Note that Year 5 depreciation is directly adjusted on the income statement.
Annual depreciation ($21,000 – $1,000) ÷ 10 = $2,000 per year
16.A change in accounting policy is reflected in the financial statements retrospectively. Comparative figures are restated, and the cumulative effect of the change, net of tax, is recorded as an adjustment to opening retained earnings in each year.
If new accounting standards permit, or if information is unavailable to allow complete retrospective restatement, a change may be recorded:
a)prospectively, affecting current and future years only.
b)in the current year, with the cumulative effect adjusted to opening retained earnings. There is no retrospective restatement of comparative data.
These methods are less desirable, due to the loss of consistency.
17.Restrictions on retained earnings are imposed by contract and by law. Appropriations are established by management choice. Restrictions and appropriations limit retained earnings availability for dividends to the unrestricted balance.
Restrictions and appropriations usually are reported in a disclosure note or parenthetically. Occasionally, separate “appropriated retained earnings” accounts are set up and reported in the statement of changes in shareholders’ equity.
Cases
Case 4-1 — Wonder Amusements Limited
REPORT TO PARTNER
Fabio & Fox, Chartered Accountants
For The Year Ending September 30, 20X7
As requested, I have prepared a report that can be used for your next meeting with Leo Titan, Chief Executive Officer of Wonder Amusements Limited (“WAL”). The report deals with the accounting, audit, and tax implications of the matters discussed with Leo.
WAL is a private corporation; all of the shareholders are family members of Howard Smith, the majority and controlling shareholder. Over the past year, the business of WAL has changed—it now owns a sports franchise and is currently building a sports arena. A number of transactions have taken place in connection with the construction of the arena. You have asked me to comment on the various issues related to these transactions.
Users of WAL’s financial statements
There are many users of WAL’s financial statements and the objectives of each user may conflict. The users include WAL’s:
- Creditors. WAL’s creditors look to the financial statements to predict future cash flows and determine whether their loans will be repaid. Further, they look to the financial statements to ensure that the loan covenants are not violated and assist in determining the value of their security. The financial statements may not be appropriate for this use.
- Minority shareholders. The minority shareholders are not active in the business and need the financial statements to assess and monitor their investment and to assess Leo’s performance. They are also interested in being able to predict cash flow and in minimizing cash outflows in the form of taxes and unwarranted bonus payments.
- Management. Management bases its bonus on the financial statements and uses them to report the financial results of the company to shareholders. As a result, management may have a bias towards selecting accounting policies that tend to increase income and delay recognition of expenses, thus maximizing bonuses.
Other users of the financial statements include Revenue Canada for income tax purposes. However, our engagement is with the directors of WAL and its management, and they must be our primary concern. As a result, the recommendations presented below must be consistent with their objectives, must fairly disclose the financial results of WAL, and must enable all users to monitor their investment.
As noted, the company uses Canadian Accounting Standards for Private Enterprise (“ASPE”). Some flexibility may exist in the choice of accounting policies. New policies can be selected to reflect the changing business.
Overall, the accounting policies recommended must balance management’s objective of maximizing its bonus and the shareholders’ and creditors’ need to predict future cash flows using financial statements they can rely on.
Golf course relocation costs
We must decide whether the golf-course relocation costs should be capitalized as part of the golf course lands or whether they should be expensed for accounting purposes. Generally, the decision depends on whether the expenditure represents an improvement to the course or a repair to the current property.
The argument that the relocation cost improves the course and potentially increases the future revenue that WAL could earn suggests that the amount should be capitalized. On the other hand, one could argue that the cost does not increase the value of the course itself or the potential for increased revenues in the future.
Another argument might be that the golf course relocation costs are actually costs of getting the road into its intended state and therefore that these costs should be capitalized as part of the road costs. The relocation costs are arguably directly attributable to the cost of the road.
I recommend that the golf course relocation costs be capitalized as part of the road costs for accounting purposes. Management maximizes its bonus, and the other users of the financial statements will be able to predict future cash flows.
Ride relocation
Again, we must decide whether the costs should be capitalized or expensed for accounting purposes. Does the expenditure represent an improvement to the rides and increase their useful life and future benefits, or is the amount strictly a moving cost or repair-type expenditure?
In order to capitalize this amount, the cost would have to improve the useful life of the rides or increase the amount of future income that can be earned from the rides. This does not seem to be the case, even though the relocation is expected to improve the overall profitability of WAL. These costs do not improve the rides or lengthen their useful life.
Therefore, the amount should be expensed in the current period. It is difficult to argue that the useful life of the rides has been increased. As well, this treatment allows for better predictability of cash flows given that the amount was incurred in the current period.
Amusement park acquisition
WAL acquired the amusement park solely in order to obtain the company’s assets, including its equipment and rides. The cost of the acquisition was $4.6 million, including the shipping cost. This cost should be capitalized as the laid-down cost of the acquired assets. The total cost should be allocated to the individual assets in the group on the basis of fair values for those assets for which a fair value can be reliably estimated.
The net asset value (including the deduction for related liabilities) is higher than the acquisition cost; no impairment is obvious on the surface. However, an impairment test cannot be applied for the asset group as a whole. Instead, each component must be evaluated individually. Since the acquisition cost will be allocated on the basis of estimated fair values in the first place, there should be no impairments afterwards.
The $900,000 estimated costs for new foundations and repairs have not yet been incurred. When they are incurred, they should be added to the laid-down cost of the rides because they are necessary to get the rides in productive use. The new rides (and other equipment) should be carried at their acquisition cost and—depreciation should commence when the new assets are ready and available for use.
Sale of land
Management intends to report the sale of the excess land in fiscal 20X7. We must decide whether it should be reported in the 20X7 or the 20X8 fiscal period. The sale has been agreed to, the sales contract has been signed, and a 25% deposit has been received. These facts support recognition in fiscal 20X7. However, the sale does not close until the 20X8 fiscal period and the land title will not transfer to the developers until then. As well, although a sustantial deposit has been paid, the collectibility of the balance may not be assured.
The gain on sale should be reported in 20X8, not in 20X7. Note disclosure of the sale in the 20X7 statements will help provide the financial statementusers with the relevant information. In 20X8, after the sale has closed, the gain on sale will be recognized. The gainmay be presented as a separate line item on the income statement if such presentation is relevant to an understanding of the company’s financial performance.
However, another possibility that can be considered is whether this excess land could have been classified as investment property up to and including the date of the sale.An investment property is one that is held by the owner to earn rentals or for capital appreciation. If it is possible to consider the excess land as investment property, WAL would have the option of reporting the land at fair value rather than cost. If the fair value option were chosen, in effect the sale price would be recognized in 20X7 regardless of conditions surrounding the sale, as fair value changes are recognized in income statement.
Contingent profit on the sale of excess land
Management wants to disclose the probability that a contingent gain will be earned on the sale of the excess land in a note to the financial statements. Disclosure is possible. However, it is important that disclosures for contingent assets avoid giving misleading indications of the likelihood of income arising. If the likelihood that a future benefit will be received is probable, then disclosure should be made in a note to the financial statements, including a brief description of the nature of the contingent asset and, where practicable, an estimate of its financial effect.
In this case, however, the amount and timing of these potential amounts is unlikely to be reliably measurable. If so, then the fact of this agreement exists can be disclosed, but the note should contain no estimated amounts.
Golf membership fees
We must determine whether the revenue from the non-refundable golf membership fees can be recognized in income immediately or deferred and recognized in income over time, as members use the course. The accounting depends on the nature of the services provided.
The justification for recognizing the amount in income is that the fee is non-refundable and there is no future service that must be provided. Indeed, members must pay a separate monthly fee of $100 to maintain their membership and use the club.
Conversely, the support available for deferring the income is that the amount has not yet been earned, that is, the member would not have paid the $2,000 entrance fee in absence of the right it provides for membership over the subsequent membership period. If deferred, the income should be recognized over a 5-year period—the length of the contract.