College of Mount Saint Vincent Financial Reporting Concepts Exam Practice

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WEYGANDT – KIESO - KIMMEL – TRENHOLM – WARREN - NOVAK ACCOUNTING PRINCIPLES VOLUME 2 SEVENTH CANADIAN EDITION Prepared by: Debbie Musil, CPA, FCMA Kwantlen Polytechnic University CHAPTER 10: CURRENT LIABILITIES AND PAYROLL Current Liabilities & Payroll • Determinable (Certain) Current Liabilities – – – – – – – • Uncertain Liabilities – – • Provisions Contingencies Payroll – – – • • Accounts payable Unearned revenues Operating line of credit and bank overdraft Short-term notes payable Sales taxes Property taxes Current maturities of long-term debt Employee payroll costs Employer payroll costs Recording the payroll Financial Statement Presentation Payroll Deductions (Appendix 10A) – – Mandatory payroll deductions Using payroll deduction tables 3 Chapter 10: Current Liabilities and Payroll LEARNING OBJECTIVES 1. Account for determinable or certain current liabilities. 2. Account for uncertain liabilities. 3. Determine payroll costs and record payroll transactions. 4. Prepare the current liabilities section of the balance sheet. 5. Calculate mandatory payroll deductions (Appendix 10A). 4 Determinable (Certain) Current Liabilities • Obligations that are expected to be settled: – Within one year of the balance sheet date, or – Within normal operating cycle • Requires existence of a present obligation • Determinable liabilities have known amount, payee, due date 5 Accounts Payable • Often the largest current liability on a company’s balance sheet • Entity buys goods from a supplier with the agreement to pay at a later date – Accounts Payable (trade payable) usually due within 30 days 6 Unearned Revenues • Payment received in advance when customer order is placed – Reported as a current liability • As company provides goods or performs service, revenue is recognized by reclassifying amount from Unearned Revenue to Revenue 7 Operating Line of Credit and Bank Overdraft • Pre-authorized borrowing – Allows the company to borrow up to a preset limit when needed • May require collateral (security) – Such as current assets, investments, or property, plant, and equipment • Used on a short-term basis • Negative (overdrawn) cash balance is called bank indebtedness, bank overdraft, or bank advances 8 Short-Term Notes Payable • Obligations in the form of written promissory notes • Usually require the borrower to pay interest • Used instead of accounts payable – Gives lender proof of obligation in case legal action is needed to collect • Issued for varying periods – If due within one year of the balance sheet date, classified as current liabilities 9 Short-Term Notes Payable (cont’d) • Interest is recorded in the period the loan is outstanding • At maturity, interest must be updated for two additional months 10 Short-Term Notes Payable (cont’d) • Also, at maturity, the face value of the note plus interest must be repaid 11 Sales Taxes • Expressed as a percentage of the sales price of goods sold to customers • Includes goods and service tax (GST), provincial sales tax (PST) or a harmonized sales tax (GST and PST combined into the HST) • Remitted to government monthly, quarterly or annually • Amounts paid by customers for sales tax are not considered revenue, but are credited to Sales Tax Payable 12 Property Taxes • Paid for a calendar year • Upon receipt of the property tax bill, an expense is recorded for the months that have passed: • When paid, expense is recorded for additional months that have passed, and prepaid is set up for remaining months • Prepaid is cleared to expense at the end of year 13 Current Maturities of Long-Term Debt • The portion of long-term debt that is due within the current year – Amount not due within current year is disclosed as a long-term liability • No adjusting entry is required to recognize the current portion of long-term debt – The proper classification is made when the balance sheet is prepared 14 CHAPTER 10: LEARNING OBJECTIVES 1. Account for determinable or certain current liabilities. 2. Account for uncertain liabilities. 3. Determine payroll costs and record payroll transactions. 4. Prepare the current liabilities section of the balance sheet. 5. Calculate mandatory payroll deductions (Appendix 10A). 15 Uncertain Liabilities • Provision is a liability that exists but the amount and timing is uncertain – We owe someone, but not sure how much, when or even who • Liability is recognized when: – Settlement of the liability is likely, and – Amount of the liability can be reasonably estimated 16 Product Warranties • Promises made by seller to buyer to repair or replace a product if it is defective or does not perform as intended • Warranties will lead to future costs for replacement or repair of defective units • Cost of warranty is estimated and accrued based on prior experience 17 Customer Loyalty Programs and Gift Cards • Results in an estimated liability: – Not known if or when rewards will be redeemed • If redemptions are likely, and can be estimated based on past experience: – Record estimated liability as a reduction in revenue (not an expense) 18 Contingent Liabilities • Record liability if both conditions are met: – It is likely (or probable under IFRS) that an obligation exists, and – Amount can be reasonably estimated • If contingent loss is likely, but cannot be reasonably estimated: – No liability is recorded – Disclosed in the notes to the statements • If contingency is unlikely: – Still disclosed if event is substantial, otherwise not disclosed 19 CHAPTER 10: LEARNING OBJECTIVES 1. Account for determinable or certain current liabilities. 2. Account for uncertain liabilities. 3. Determine payroll costs and record payroll transactions. 4. Prepare the current liabilities section of the balance sheet. 5. Calculate mandatory payroll deductions (Appendix 10A). 20 Payroll • More than paying employee salaries and wages • Companies are required by law: – To have payroll records for each employee – To report and remit payroll deductions – To respect federal and provincial laws • Two types of payroll costs: – Employee costs: amounts paid to employees (gross pay) & amounts paid by employees (payroll deductions) – Employer costs: amounts paid by employer on behalf of the employee (employee benefits) 21 Gross Pay (or Earnings) • The total compensation earned by an employee • Consists of: – Wages = hours worked x hourly rate of pay, or – Salaries: based on a weekly, biweekly, monthly or annual rate – Bonuses – Commissions 22 Employee Payroll Costs • The difference between gross pay and the amount actually received (net pay) • Mandatory payroll deductions: – Required by law – Personal income tax, Canada Pension Plan (CPP) and Employment Insurance (EI) – Determined from payroll deduction tables • Voluntary payroll deductions: – For charitable causes, retirement, and other purposes – Should be authorized in writing by the employee – Do not result in a payroll expense to the employer 23 Employer Payroll Costs • Amounts an employer is required to pay – Required by governments: • • • CPP (matching the employee contribution) EI (1.4 x the employee contribution) Workplace health, safety and compensation – Additional employee benefits: • • Paid absences: sick days, vacation, statutory holidays Post-employment benefits: to retired employees • These benefits give rise to liabilities that must be accrued 24 Recording the Payroll • Involves: – – – – Maintaining payroll records Recording payroll expenses and liabilities Paying the payroll, and Filing and remitting payroll deductions • Payroll Records – A separate earnings record is kept for each employee – Payroll register may be used to accumulate gross earnings, deductions & net pay by employee for each period 25 Recording Payroll Expenses and Liabilities • Employee payroll costs: • Entry for the employee portion of a payroll – The company’s expense is equal to total gross pay – Employee payroll deductions become current liabilities of the company until remitted 26 Recording Payroll Expenses and Liabilities (cont’d) • Employer payroll costs: – Recorded when the payroll is journalized – Become current liabilities of the company until remitted 27 Recording Payment of the Payroll • Payment of payroll is either by cheque or electronic funds transfer (EFT) • Entry to record payment of payroll deductions: 28 CHAPTER 10: LEARNING OBJECTIVES 1. Account for determinable or certain current liabilities. 2. Account for uncertain liabilities. 3. Determine payroll costs and record payroll transactions. 4. Prepare the current liabilities section of the balance sheet. 5. Calculate mandatory payroll deductions (Appendix 10A). 29 Financial Statement Presentation • Current liabilities are generally the first category reported in the liabilities section of the balance sheet • Each type of current liability is listed separately • Listed in order of liquidity, usually by maturity date – Also common to show bank loans, notes payable and accounts payable first regardless of size • Terms of operating lines of credit, notes payable, and other information are disclosed in the notes 30 CHAPTER 10: LEARNING OBJECTIVES 1. Account for determinable or certain current liabilities. 2. Account for uncertain liabilities. 3. Determine payroll costs and record payroll transactions. 4. Prepare the current liabilities section of the balance sheet. 5. Calculate mandatory payroll deductions (Appendix 10A). 31 Appendix 10A: Mandatory Payroll Deductions • Canada Pension Plan (CPP) contributions: – Calculated as a percentage of earnings (contribution rate) over a set minimum (basic exemption) to a maximum amount of earnings (maximum pensionable earnings) – Pro-rated per pay period • Employment Insurance (EI) contributions: – Calculated as a percentage of earnings to a maximum amount (maximum insurable earnings) – No basic exemption – Not pro-rated: deducted from pay until maximum is reached 32 Appendix 10A: Mandatory Payroll Deductions (cont’d) • Personal income tax deductions: – Based on tax rates set by federal and provincial governments – Progressive rates: higher percentage rates for higher income levels • Complicated calculations: – Best done using deduction tables or automated tools provided by the Canada Revenue Agency 33 COPYRIGHT Copyright © 2016 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. Chapter 11 FINANCIAL REPORTING CONCEPTS Accounting Principles Eighth Canadian Edition Weygandt Kieso Kimmel Trenholm Warren Novak Prepared by Debbie Musil, FCPA, FCMA Financial Reporting Concepts (1 of 2) • The conceptual framework of accounting • The objective of financial reporting • Elements of financial statements • Qualitative characteristics of useful financial information • Fundamental characteristics • Enhancing qualitative characteristics and their application • Differences under IFRS and ASPE Copyright ©2019 John Wiley & Sons Canada, Ltd. 2 Financial Reporting Concepts (2 of 2) • Recognition and measurement criteria • General, revenue and expense recognition criteria • Measurement of elements • Errors and intentional misstatements • Foundational Concepts, Assumptions and Constraints • Concepts and assumptions • Constraints • Summary of conceptual framework Copyright ©2019 John Wiley & Sons Canada, Ltd. 3 CHAPTER 11: LEARNING OBJECTIVE 1 (1 of 2) 1. Explain the importance of having a conceptual framework of accounting, and list the key components. 2. Explain the objective of financial reporting, and define the elements of the financial statements. 3. Apply the fundamental and enhancing qualitative characteristics of the conceptual framework to financial reporting situations. Copyright ©2019 John Wiley & Sons Canada, Ltd. 4 CHAPTER 11: LEARNING OBJECTIVE 1 (2 of 2) 4. Apply the recognition and measurement criteria of the conceptual framework to financial reporting situations. 5. Apply the foundational concepts, assumptions and constraints of the conceptual framework to financial reporting situations. Copyright ©2019 John Wiley & Sons Canada, Ltd. 5 Conceptual Framework of Accounting • A foundation for accounting: • Ensures existing standards and practices are clear and consistent • Provides guidance in responding to new issues and developing new standards • Assists in the application of standards • Increases users’ understanding and confidence in financial statements • Standards built on general principles, not rules Copyright ©2019 John Wiley & Sons Canada, Ltd. 6 Conceptual Framework 2 • Use professional judgment and framework to determine appropriate accounting treatment • Key components of framework: • 1. Objective of financial reporting and user needs • 2. Elements of financial statements • 3. Qualitative characteristics • 4. Recognition and measurement criteria • 5. Foundational concepts, assumptions, and constraints Copyright ©2019 John Wiley & Sons Canada, Ltd. 7 CHAPTER 11: LEARNING OBJECTIVE 2 (1 of 2) 1. Explain the importance of having a conceptual framework of accounting, and list the key components. 2. Explain the objective of financial reporting, and define the elements of the financial statements. 3. Apply the fundamental and enhancing qualitative characteristics of the conceptual framework to financial reporting situations. Copyright ©2019 John Wiley & Sons Canada, Ltd. 8 CHAPTER 11: LEARNING OBJECTIVE 2 (2 of 2) 4. Apply the recognition and measurement criteria of the conceptual framework to financial reporting situations. 5. Apply the foundational concepts, assumptions and constraints of the conceptual framework to financial reporting situations. Copyright ©2019 John Wiley & Sons Canada, Ltd. 9 Objective of Financial Reporting (1 of 2) • To provide information that is useful for making decisions about a business • To investors and creditors • To give information about: • Economic resources (assets) and claims on those resources (liabilities, equity) • Changes in resources and claims on them • Economic performance Copyright ©2019 John Wiley & Sons Canada, Ltd. 10 Objective of Financial Reporting (2 of 2) • Enables users to decide whether management used company resources in the best way possible • Referred to as stewardship Copyright ©2019 John Wiley & Sons Canada, Ltd. 11 Elements of Financial Statements • Basic categories that are used in financial statements • Assets, liabilities, equity, revenues and expenses • Must be precisely defined and applied in the same way by all reporting entities Copyright ©2019 John Wiley & Sons Canada, Ltd. 12 CHAPTER 11: LEARNING OBJECTIVE 3 (1 of 2) 1. Explain the importance of having a conceptual framework of accounting, and list the key components. 2. Explain the objective of financial reporting, and define the elements of the financial statements. 3. Apply the fundamental and enhancing qualitative characteristics of the conceptual framework to financial reporting situations. Copyright ©2019 John Wiley & Sons Canada, Ltd. 13 CHAPTER 11: LEARNING OBJECTIVE 3 (2 of 2) 4. Apply the recognition and measurement criteria of the conceptual framework to financial reporting situations. 5. Apply the foundational concepts, assumptions and constraints of the conceptual framework to financial reporting situations. Copyright ©2019 John Wiley & Sons Canada, Ltd. 14 Fundamental Characteristics of Useful Financial Information (1 of 2) • To be useful, information should have two fundamental qualitative characteristics: • Relevance • Faithful Representation Copyright ©2019 John Wiley & Sons Canada, Ltd. 15 Fundamental Characteristics of Useful Financial Information (2 of 2) • Other characteristics enhance the usefulness of accounting information: • • • • Comparability Verifiability Timeliness Understandability Copyright ©2019 John Wiley & Sons Canada, Ltd. 16 Fundamental Characteristics: Relevance (1 of 2) • Accounting information has relevance if it makes a difference in a decision • Relevant information has predictive and/or confirmatory value: • Predictive value: helps users forecast future events • Confirmatory value: confirms or corrects prior expectations Copyright ©2019 John Wiley & Sons Canada, Ltd. 17 Fundamental Characteristics: Relevance (2 of 2) • Materiality is an important component of relevance • An item is material if it will influence a decision Copyright ©2019 John Wiley & Sons Canada, Ltd. 18 Fundamental Characteristics: Faithful Representation • Information must be a faithful representation of the economic reality of reported events • Concept known as substance over form • This is achieved when the information is: • Complete: includes all necessary information • Neutral: information is free from bias • Prudence: managing with care, economy, frugality • Free from material error: will not affect decisions by investors and creditors Copyright ©2019 John Wiley & Sons Canada, Ltd. 19 Enhancing Qualitative Characteristics: Comparability • Comparability: Similar companies use the same accounting policies • Consistency: A company uses the same accounting policies from year to year • However, accounting policies can change: • Due to new requirements that have been issued • When management decides that a difference policy gives more relevant information • Accounting changes are disclosed in the financial statements Copyright ©2019 John Wiley & Sons Canada, Ltd. 20 Enhancing Qualitative Characteristics: Verifiability and Timeliness • Verifiable: assures users that the accounting information shows the economic reality of a transaction • Information is verifiable if two knowledgeable and independent people agree that it faithfully represents the economic reality • Timely: accounting information is provided when it is still useful for decision-making • Available to decision makers before it loses its ability to influence their decisions Copyright ©2019 John Wiley & Sons Canada, Ltd. 21 Enhancing Qualitative Characteristics: Understandability • Information must be understandable to users for it to be useful • Enables users to interpret and comprehend the information provided in the financial statements • Users are assumed to have a reasonable knowledge of: • Business, economic and financial activities • Financial reporting Copyright ©2019 John Wiley & Sons Canada, Ltd. 22 Differences in Qualitative Characteristics Under IFRS and ASPE (1 of 2) • ASPE identifies four principal characteristics: • Understandability – higher status under ASPE than IFRS • Relevance – important under both ASPE and IFRS • Reliability – considered reliable if it is a faithful representation • Comparability – higher status under ASPE than IFRS Copyright ©2019 John Wiley & Sons Canada, Ltd. 23 Differences in Qualitative Characteristics Under IFRS and ASPE (2 of 2) • ASPE includes conservatism as a component of reliability • Similar to the prudence concept for IFRS • It is anticipated that ASPE will adopt the IFRS conceptual framework Copyright ©2019 John Wiley & Sons Canada, Ltd. 24 CHAPTER 11: LEARNING OBJECTIVE 4 (1 of 2) 1. Explain the importance of having a conceptual framework of accounting, and list the key components. 2. Explain the objective of financial reporting, and define the elements of the financial statements. 3. Apply the fundamental and enhancing qualitative characteristics of the conceptual framework to financial reporting situations. Copyright ©2019 John Wiley & Sons Canada, Ltd. 25 CHAPTER 11: LEARNING OBJECTIVE 4 (2 of 2) 4. Apply the recognition and measurement criteria of the conceptual framework to financial reporting situations. 5. Apply the foundational concepts, assumptions and constraints of the conceptual framework to financial reporting situations. Copyright ©2019 John Wiley & Sons Canada, Ltd. 26 Recognition & Measurement Criteria (1 of 2) • Accrual basis of accounting – transactions are recorded in the period in which the events occur, rather than when cash is received or paid • Recognition criteria help determine when items should be included in financial statements • Measurement criteria provide guidance on what amount should be recorded Copyright ©2019 John Wiley & Sons Canada, Ltd. 27 Recognition & Measurement Criteria (2 of 2) • An item is usually included in the financial statements if: • It meets the definition of an asset, liability, equity, revenue or expense • It can be measured, and a reasonable estimate of the amount can be made • It meets the fundamental qualitative characteristics of relevance and faithful representation Copyright ©2019 John Wiley & Sons Canada, Ltd. 28 Recognition & Measurement Criteria Two important concepts underlying the general recognition criteria: 1. If an asset is going to be recorded it must be probable that future economic benefit will flow to the business 2. If a liability is going to be recorded it must be probable that future economic benefit will flow from the business to settle present obligations Copyright ©2019 John Wiley & Sons Canada, Ltd. 29 Revenue Recognition Criteria (1 of 2) • Revenue should be recognized at the same time that: • An increase in an asset is recognized, or • A decrease in a liability is recognized for profit-generating activities Copyright ©2019 John Wiley & Sons Canada, Ltd. 30 Revenue Recognition Criteria (2 of 2) • Two approaches: • Contract-based approach • Required for companies that follow IFRS • Also known as the asset-liability approach • Earnings approach • Standard used in ASPE Copyright ©2019 John Wiley & Sons Canada, Ltd. 31 Revenue Recognition – Contract Based Approach • Based on enforceable rights and obligations in a contract with a customer • Seller will recognize revenue when promised goods or services are transferred to customer • Performance obligation is complete • Amount that is recognized reflects consideration expected to be received in exchange • Seller promises to deliver goods or services (performance obligation) and customer agrees to pay some amount of consideration in exchange (enforceable right to receive consideration) Copyright ©2019 John Wiley & Sons Canada, Ltd. 32 Revenue Recognition – Earnings Approach: Sale of Goods • Revenue recognized when all conditions met: • Performance complete and significant risks and rewards of ownership have transferred from seller to buyer • Seller no longer controls or manages goods • Revenue can be reliably measured • Probable increase in economic resources (cash collected) • Costs relating to sale can be reliably measured (critical event) Copyright ©2019 John Wiley & Sons Canada, Ltd. 33 Revenue Recognition: Other Situations (1 of 2) • Right of Return • If revenue is recognized without consideration of potential returns, revenue will be overstated • Under contract-based approach, revenue recorded at the amount expected to be received (net amount) • Under earnings approach, record revenue and adjust revenue for returns Copyright ©2019 John Wiley & Sons Canada, Ltd. 34 Revenue Recognition: Other Situations (2 of 2) • Warranties • Accounting is the same under both contractbased and earnings approach • Assurance warranty: requires a provision for future warranty costs that may be incurred • Service warranty: accounted for as a multiple performance obligation Copyright ©2019 John Wiley & Sons Canada, Ltd. 35 Expense Recognition Criteria • Expenses are recognized when there is: • A decrease in an asset • An increase in a liability • Excludes distributions to owners • Not necessarily when the cash is paid • Can be a direct association between costs incurred and revenue earned (matching concept) • When no direct relationship, another systematic and rational allocation policy may be used Copyright ©2019 John Wiley & Sons Canada, Ltd. 36 Measurement of Elements • Acquired assets are recorded at cost • Cost is used because it is: • Relevant: represents the price paid, assets sacrificed or the commitment made at the date of acquisition • A Faithful Representation: objectively measurable, factual and verifiable • After acquisition, cost is referred to as historical cost Copyright ©2019 John Wiley & Sons Canada, Ltd. 37 Measurement of Elements 2 • Most companies use historical cost model to report property, plant and equipment • Under IFRS can choose revaluation model • Fair value is market value of asset or liability at reporting date • Amount of cash expected to be collected when asset is sold • For some assets, more relevant to use fair value Copyright ©2019 John Wiley & Sons Canada, Ltd. 38 Measurement of Elements 3 Fair Value (1 of 2) • Current Cost • Amount of cash or equivalent that would have to be paid if same or equivalent asset was to be purchased in current period (replacement cost) or amount required to settle obligation currently Copyright ©2019 John Wiley & Sons Canada, Ltd. 39 Measurement of Elements 3 Fair Value (2 of 2) • Realizable Value • Amount that can be reasonably be expected to be collected or cash expected to be paid to satisfy liabilities • Inventory measured in this way • Present Value • Present value of future cash inflows or outflows Copyright ©2019 John Wiley & Sons Canada, Ltd. 40 Errors and Intentional Misstatements • Revenues and expenses may be misstated by: • • • • Recognition in the incorrect accounting period Misstatement of estimates Failure to record a revenue or expense Failure to apply the correct measurement • Important to analyze transactions carefully to ensure that accounting principles are applied correctly and are faithfully represented Copyright ©2019 John Wiley & Sons Canada, Ltd. 41 CHAPTER 11: LEARNING OBJECTIVE 5 (1 of 2) 1. Explain the importance of having a conceptual framework of accounting, and list the key components. 2. Explain the objective of financial reporting, and define the elements of the financial statements. 3. Apply the fundamental and enhancing qualitative characteristics of the conceptual framework to financial reporting situations. Copyright ©2019 John Wiley & Sons Canada, Ltd. 42 CHAPTER 11: LEARNING OBJECTIVE 5 (2 of 2) 4. Apply the recognition and measurement criteria of the conceptual framework to financial reporting situations. 5. Apply the foundational concepts, assumptions and constraints of the conceptual framework to financial reporting situations. Copyright ©2019 John Wiley & Sons Canada, Ltd. 43 Foundational Concepts, Assumptions and Constraints (1 of 4) • Reporting Entity Concept • - The accounting for a reporting entity’s activities must be kept separate and distinct from those of the activities of its owner and all other reporting entities • Going Concern Assumption • Assumes that a company will continue operating for the foreseeable future • Important implications for how financial information is presented Copyright ©2019 John Wiley & Sons Canada, Ltd. 44 Foundational Concepts, Assumptions and Constraints (2 of 4) • Monetary Unit Concept • Money is the common denominator of economic activity • Prevents recognition of elements that cannot be quantified (employee morale, customer loyalty) • Periodicity Concept • Guides businesses in dividing up their economic activities into distinct time periods • Most common periods are months, quarters, years Copyright ©2019 John Wiley & Sons Canada, Ltd. 45 Foundational Concepts, Assumptions and Constraints (3 of 4) • Full Disclosure Concept • Requires disclosure of circumstances and events that make a difference to financial statement users • Accomplished through: • The data in the financial statements • The notes that accompany the statements • A summary of significant accounting policies is usually the first note to the financial statements Copyright ©2019 John Wiley & Sons Canada, Ltd. 46 Foundational Concepts, Assumptions and Constraints (4 of 4) • Cost Constraint • The value of information should be greater than the cost of providing it • Benefits of financial reporting should justify the costs • Also known as benefit versus cost constraint under ASPE Copyright ©2019 John Wiley & Sons Canada, Ltd. 47 Copyright Copyright © 2019 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. Copyright ©2019 John Wiley & Sons Canada, Ltd. 48 Chapter 12 ACCOUNTING FOR PARTNERSHIPS Accounting Principles Eighth Canadian Edition Weygandt Kieso Kimmel Trenholm Warren Novak Prepared by Debbie Musil, FCPA, FCMA Accounting for Partnerships • Partnership form of organization • Characteristics • Advantages and disadvantages • Partnership agreement • Basic partnership accounting • Forming a partnership • Dividing partnership profit or loss • Partnership financial statements • Admission and withdrawal of partners • Liquidation of a partnership • With or without a capital deficiency Copyright ©2019 John Wiley & Sons Canada, Ltd. 2 CHAPTER 12: LEARNING OBJECTIVE 1 1. Describe the characteristics of the partnership form of business organization. 2. Account for the formation of a partnership. 3. Allocate and record profit or loss to partners. 4. Prepare partnership financial statements. 5. Account for the admission of a partner. 6. Account for the withdrawal of a partner. 7. Account for the liquidation of a partnership. Copyright ©2019 John Wiley & Sons Canada, Ltd. 3 Characteristics of Partnerships (1 of 5) Copyright ©2019 John Wiley & Sons Canada, Ltd. 4 Characteristics of Partnerships (2 of 5) • Association of individuals • Usually based on a written agreement • A legal and accounting entity, but not taxed • Co-ownership of property • Assets are jointly owned by partners Copyright ©2019 John Wiley & Sons Canada, Ltd. 5 Characteristics of Partnerships (3 of 5) • Division of profit • Partners determine how profit or loss is to be divided • Otherwise shared equally • Limited life • Partnership ends when change in ownership • New partnership can be formed to continue business Copyright ©2019 John Wiley & Sons Canada, Ltd. 6 Characteristics of Partnerships (4 of 5) • Mutual agency • Each partner acts for (binds) the partnership • Unlimited liability • Each partner is liable for all partnership liabilities • Special types of partnerships created to limit liability • Limited partnership (LP) • Limited liability partnership (LLP) Copyright ©2019 John Wiley & Sons Canada, Ltd. 7 Characteristics of Partnerships (5 of 5) Copyright ©2019 John Wiley & Sons Canada, Ltd. 8 Partnership Agreement (1 of 2) • Written contract between two or more parties to form a partnership • Contains basic information: • Name and main location of firm • Purpose of the business • Date of inception Copyright ©2019 John Wiley & Sons Canada, Ltd. 9 Partnership Agreement (2 of 2) • Specifies relationship of partners: • • • • Names and capital contributions of partners Rights and duties of partners Basis for sharing profit or loss Procedures for admission, withdrawal, death of partner, resolving disputes, liquidation of partnership Copyright ©2019 John Wiley & Sons Canada, Ltd. 10 CHAPTER 12: LEARNING OBJECTIVES 2 1. Describe the characteristics of the partnership form of business organization. 2. Account for the formation of a partnership. 3. Allocate and record profit or loss to partners. 4. Prepare partnership financial statements. 5. Account for the admission of a partner. 6. Account for the withdrawal of a partner. 7. Account for the liquidation of a partnership. Copyright ©2019 John Wiley & Sons Canada, Ltd. 11 Basic Partnership Accounting: ASPE Versus IFRS • Many partnerships are private and therefore follow ASPE • Limited Partnerships are often public enterprises and therefore follow IFRS • International partnerships must also follow IFRS Copyright ©2019 John Wiley & Sons Canada, Ltd. 12 Basic Partnership Accounting: Forming a Partnership • Partner’s initial investment is recorded at fair value of assets contributed • As at date of transfer into partnership • Values assigned are agreed to by all partners • After partnership formed, accounting for transactions is similar to other types of business organizations Copyright ©2019 John Wiley & Sons Canada, Ltd. 13 CHAPTER 12: LEARNING OBJECTIVES 3 1. Describe the characteristics of the partnership form of business organization. 2. Account for the formation of a partnership. 3. Allocate and record profit or loss to partners. 4. Prepare partnership financial statements. 5. Account for the admission of a partner. 6. Account for the withdrawal of a partner. 7. Account for the liquidation of a partnership. Copyright ©2019 John Wiley & Sons Canada, Ltd. 14 Basic Partnership Accounting: Dividing Profit or Loss • Partnership profit/loss is shared equally • Unless partnership agreement indicates otherwise • Called the profit ratio or profit and loss ratio • Each partners’ share of profit or loss is recognized through closing entries Copyright ©2019 John Wiley & Sons Canada, Ltd. 15 Partnership Accounting: Profit and Loss Ratios (1 of 2) • Typical ratios used to share profit or loss: • Fixed ratio: a proportion (2:1), percentage (67%) or fraction (2/3) • A ratio based on capital balances at beginning or end of year or on average capital balances during the year • Salary and interest allowances to partners, remainder in a fixed ratio Copyright ©2019 John Wiley & Sons Canada, Ltd. 16 Partnership Accounting: Profit and Loss Ratios (2 of 2) • Salaries and interest allowances: • Are allocated first even if greater than profit or if partnership incurred a loss for the year • Are NOT expenses of the partnership – only used to divide profit or loss among the partners • Are NOT distributions of cash (or other assets) – drawings by partners are distributions • Partners are neither employees or creditors Copyright ©2019 John Wiley & Sons Canada, Ltd. 17 Partnership Accounting: Closing Entries (1 of 3) • Four closing entries for partnership: 1. Close revenue accounts to income summary 2. Close expense accounts to income summary Copyright ©2019 John Wiley & Sons Canada, Ltd. 18 Partnership Accounting: Closing Entries (2 of 3) • Four closing entries for partnership (continued): 3. Close income summary to partners’ capital accounts • If profit: Dr. Income summary (= total profit) Cr. Each partner’s capital account (= their share of profit) • If loss: Dr. Each partner’s capital account (= their share of loss) Cr. Income summary (= total loss) Copyright ©2019 John Wiley & Sons Canada, Ltd. 19 Partnership Accounting: Closing Entries (3 of 3) • Four closing entries for partnership (continued): 4. Close each partner’s drawings account to their respective capital accounts Copyright ©2019 John Wiley & Sons Canada, Ltd. 20 CHAPTER 12: LEARNING OBJECTIVES 4 1. Describe the characteristics of the partnership form of business organization. 2. Account for the formation of a partnership. 3. Allocate and record profit or loss to partners. 4. Prepare partnership financial statements. 5. Account for the admission of a partner. 6. Account for the withdrawal of a partner. 7. Account for the liquidation of a partnership. Copyright ©2019 John Wiley & Sons Canada, Ltd. 21 Partnership Financial Statements: Statement of Partners’ Equity • The equity statement for a partnership is the statement of partners' equity • Explains changes in each partner’s capital account and in total partnership equity during the year Copyright ©2019 John Wiley & Sons Canada, Ltd. 22 Partnership Financial Statements: Balance Sheet • Capital balances of each partner are shown on the balance sheet in section called partners’ equity: Copyright ©2019 John Wiley & Sons Canada, Ltd. 23 CHAPTER 12: LEARNING OBJECTIVES 5 1. Describe the characteristics of the partnership form of business organization. 2. Account for the formation of a partnership. 3. Allocate and record profit or loss to partners. 4. Prepare partnership financial statements. 5. Account for the admission of a partner. 6. Account for the withdrawal of a partner. 7. Account for the liquidation of a partnership. Copyright ©2019 John Wiley & Sons Canada, Ltd. 24 Admission of a Partner • Causes the legal dissolution of the existing partnership and the beginning of a new partnership • A new partner may be admitted either by: • Purchasing the interest of one or more existing partners • Investing assets in the partnership Copyright ©2019 John Wiley & Sons Canada, Ltd. 25 Admission of a Partner: Purchase of a Partner’s Interest • A personal transaction between one or more existing partners and the new partner • Consideration exchanged is personal property of the partners involved and not property of the partnership • In the partnership, only the transfer of the partnership interest is recorded: • Existing partners’ equity is decreased by the amount of equity given to the new partner • New partner’s equity is increased by same amount Copyright ©2019 John Wiley & Sons Canada, Ltd. 26 Admission of a Partner: Investment of Assets in Partnership (1 of 2) • A transaction between the new partner and the partnership: • Partnership receives assets from new partner in exchange for an interest in the partnership • Both net assets and total partners’ equity of the partnership will increase Copyright ©2019 John Wiley & Sons Canada, Ltd. 27 Admission of a Partner: Investment of Assets in Partnership (2 of 2) • Complications occur when new partner’s investment differs from the capital equity acquired: • The difference is considered a bonus either to the existing (old) partners or to the new partner Copyright ©2019 John Wiley & Sons Canada, Ltd. 28 Admission of a Partner: Bonus to Existing (Old) Partners • Bonus to old partners may be necessary: • Fair value of partnership assets may be greater than their carrying value • Goodwill may exist that has not been recorded • Bonus to old partners occurs when: • New partner’s investment > capital account credit on the date of admission • Amount of bonus = difference Copyright ©2019 John Wiley & Sons Canada, Ltd. 29 Admission of a Partner: Bonus to New Partner • Bonus to new partner may be necessary: • New partner has resources or attributes that the partnership wants (cash, expertise) • Carrying amount of partnership assets is greater than their fair value • Bonus to new partner occurs when: • New partner’s investment < capital account credit on the date of admission to partnership • Amount of bonus = difference Copyright ©2019 John Wiley & Sons Canada, Ltd. 30 Admission of a Partner: Determining Amount of Bonus (1 of 2) 1. Determine the total capital of partnership • = Capital of old partnership + new partner’s investment 2. Determine new partner’s capital credit • = Total capital determined above × new partner’s ownership interest Copyright ©2019 John Wiley & Sons Canada, Ltd. 31 Admission of a Partner: Determining Amount of Bonus (2 of 2) 3. Determine the amount of the bonus • = New partner’s investment ± new partner’s capital credit • If investment > capital credit: bonus to old partners • If investment < capital credit: bonus to new partner 4. Allocate the bonus to/from old partners • Based on income ratios of old partners Copyright ©2019 John Wiley & Sons Canada, Ltd. 32 Admission of a Partner: Example Calculation of Bonus • Old partners’ capital balance = $120,000 • Peart $72,000 and Huang $48,000 • Old partners’ profit ratios: • Peart 60% and Huang 40% • Trent purchases 25% share: • Scenario 1: for $80,000 • Scenario 2: for $20,000 Copyright ©2019 John Wiley & Sons Canada, Ltd. 33 Admission of a Partner: Bonus Calculation – Scenario 1 1. Total capital of new partnership: • $120,000 + $80,000 = $200,000 2. New partner’s capital credit: • $200,000 × 25% = $50,000 3. Amount of bonus to old partners: • $80,000 − $50,000 = $30,000 4. Allocation of bonus to old partners • To Peart: $30,000 × 60% = $18,000 • To Huang: $30,000 × 40% = $12,000 Copyright ©2019 John Wiley & Sons Canada, Ltd. 34 Admission of a Partner: Bonus Calculation – Scenario 2 1. Total capital of new partnership: • $120,000 + $20,000 = $140,000 2. New partner’s capital credit: • $140,000 × 25% = $35,000 3. Amount of bonus to new partner: • $20,000 − $35,000 = $(15,000) 4. Allocate bonus from old partners: • From Peart: $15,000 × 60% = $9,000 • From Huang: $15,000 × 40% = $6,000 Copyright ©2019 John Wiley & Sons Canada, Ltd. 35 CHAPTER 12: LEARNING OBJECTIVES 6 1. Describe the characteristics of the partnership form of business organization. 2. Account for the formation of a partnership. 3. Allocate and record profit or loss to partners. 4. Prepare partnership financial statements. 5. Account for the admission of a partner. 6. Account for the withdrawal of a partner. 7. Account for the liquidation of a partnership. Copyright ©2019 John Wiley & Sons Canada, Ltd. 36 Withdrawal of a Partner • Voluntary withdrawal: Partner sells their equity in the firm • Involuntary withdrawal: Partner reaches mandatory retirement age, dies or is expelled • Withdrawal may be accomplished by: • Payment from remaining partners’ personal assets • Payment from partnership assets Copyright ©2019 John Wiley & Sons Canada, Ltd. 37 Withdrawal of a Partner: Payment from Partners’ Personal Assets (1 of 2) • A personal transaction between partners • Payment is from remaining partners’ personal assets • Partnership assets are not involved and total capital of partnership does not change Copyright ©2019 John Wiley & Sons Canada, Ltd. 38 Withdrawal of a Partner: Payment from Partners’ Personal Assets (2 of 2) • In the partnership, only the transfer of the partnership interest is recorded: • Departing partner’s equity is eliminated • Remaining partners’ equity increased by same amount • Amount is split between remaining parties on same basis as they paid departing party Copyright ©2019 John Wiley & Sons Canada, Ltd. 39 Withdrawal of a Partner: Payment from Partnership Assets (1 of 2) • A transaction between the withdrawing partner and the partnership: • Partnership pays assets in exchange for the withdrawing partner’s interest in the partnership • Both net assets and total partners’ equity of the partnership will decrease Copyright ©2019 John Wiley & Sons Canada, Ltd. 40 Withdrawal of a Partner: Payment from Partnership Assets (2 of 2) • Complications occur when amount paid differs from withdrawing partner’s capital balance: • The difference is considered a bonus either to the departing partner or to the remaining partners Copyright ©2019 John Wiley & Sons Canada, Ltd. 41 Withdrawal of a Partner: Bonus to Withdrawing Partner (1 of 2) • Bonus to withdrawing partner may be necessary: • Fair value of partnership assets may be greater than their carrying amount • Goodwill may exist that has not been recorded • Remaining partners wish to remove partner from firm Copyright ©2019 John Wiley & Sons Canada, Ltd. 42 Withdrawal of a Partner: Bonus to Withdrawing Partner (2 of 2) • Bonus to withdrawing partner occurs when: • Payment to departing partner > departing partner’s capital balance on the date of departure • Amount of bonus = difference Copyright ©2019 John Wiley & Sons Canada, Ltd. 43 Withdrawal of a Partner: Bonus to Remaining Partners • Bonus to remaining partners may be necessary: • Recorded assets are overvalued • Partnership has a poor earnings record • Partner wishes to leave partnership • Bonus to remaining partners occurs when: • Payment to departing partner < departing partner’s capital balance on departure date • Amount of bonus = difference Copyright ©2019 John Wiley & Sons Canada, Ltd. 44 Withdrawal of a Partner: Determining Amount of Bonus 1. Determine the amount of the bonus • = Payment from partnership to departing partner ± departing partner’s capital balance • If payment > capital balance: bonus to departing partner • If payment < capital balance: bonus to remaining partners 2. Allocate payment of bonus to remaining partners based on their profit ratios • Amount allocated to each remaining partner = bonus × profit ratio for each partner Copyright ©2019 John Wiley & Sons Canada, Ltd. 45 Withdrawal of a Partner: Example Calculation of Bonus • Partners’ capital balance: Roman $50,000 Sand $30,000 Terk $20,000 • Partners’ profit ratio: Roman, Sand, Terk: 3:2:1 • Terk retires and is paid: Scenario 1: $25,000 Scenario 2: $16,000 Copyright ©2019 John Wiley & Sons Canada, Ltd. 46 Withdrawal of a Partner: Bonus Calculation (1 of 2) Scenario 1: 1. Amount of bonus to departing partner: • $25,000 - $20,000 = $5,000 2. Allocate payment of bonus by remaining partners: • From Roman: $5,000 × 3/5 = $3,000 • From Sand: $5,000 × 2/5 = $2,000 Copyright ©2019 John Wiley & Sons Canada, Ltd. 47 Withdrawal of a Partner: Bonus Calculation (2 of 2) Scenario 2: 1. Amount of bonus to remaining partners: • $16,000 − $20,000 = $(4,000) 2. Allocate payment of bonus to remaining partners: • To Roman: $4,000 × 3/5 = $2,400 • To Sand: $4,000 × 2/5 = $1,600 Copyright ©2019 John Wiley & Sons Canada, Ltd. 48 CHAPTER 12: LEARNING OBJECTIVES 7 1. Describe the characteristics of the partnership form of business organization. 2. Account for the formation of a partnership. 3. Allocate and record profit or loss to partners. 4. Prepare partnership financial statements. 5. Account for the admission of a partner. 6. Account for the withdrawal of a partner. 7. Account for the liquidation of a partnership. Copyright ©2019 John Wiley & Sons Canada, Ltd. 49 Liquidation of a Partnership • Liquidation ends the business • Steps in liquidating a partnership: 1. Sell non-cash assets for cash 2. Allocate any gain or loss from sale (on realization) to partners’ capital accounts based on profit and loss ratios 3. Pay partnership liabilities in cash 4. Distribute remaining cash to partners based on their capital balances (not their profit ratios) Copyright ©2019 John Wiley & Sons Canada, Ltd. 50 Liquidation of a Partnership: No Capital Deficiency • Capital deficiency: if one or more partners’ capital account is in a debit balance • If no capital deficiency: • Remaining cash after all assets sold and liabilities paid is distributed to partners • Distribution is based on partners’ capital balances • Since this is the final distribution to partners all accounts will have zero balances afterwards Copyright ©2019 John Wiley & Sons Canada, Ltd. 51 Liquidation of Partnership: Capital Deficiency • Capital deficiency may be caused by: • Recurring losses • Excessive drawings by one or more partners • Losses from sale of assets during liquidation • Partners having a capital deficiency immediately before final distribution: • May or may not be able to pay the deficiency from personal funds • This will affect the amount of funds available for distribution to other partners Copyright ©2019 John Wiley & Sons Canada, Ltd. 52 Liquidation of Partnership: Payment of Capital Deficiency • Partnership has a legally enforceable claim against partners with a capital deficiency • If partner repays deficiency to partnership: • Amount repaid is added to cash available for distribution • Total cash after repayment is distributed to partners with credit balances in their capital accounts Copyright ©2019 John Wiley & Sons Canada, Ltd. 53 Liquidation of Partnership: Nonpayment of Deficiency • If partner does not repay deficiency to partnership: • Amount of deficiency is considered a loss • Loss is allocated between partners with credit balances based on their profit ratios • Allocation of loss will affect remaining partners capital accounts • Final distribution of remaining cash is to partners with credit balances in capital accounts Copyright ©2019 John Wiley & Sons Canada, Ltd. 54 Copyright Copyright © 2019 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. Copyright ©2019 John Wiley & Sons Canada, Ltd. 55 Chapter 13 INTRODUCTION TO CORPORATIONS Accounting Principles Eighth Canadian Edition Weygandt Kieso Kimmel Trenholm Warren Novak Prepared by Debbie Musil, FCPA, FCMA Introduction to Corporations • The corporate form of organization • Characteristics • Operating a corporation • Share capital • Issuing shares • Preferred shares • Retained earnings • Corporate income statements • Cash dividends • Reporting retained earnings • Statement presentation and analysis Copyright ©2019 John Wiley & Sons Canada, Ltd. 2 CHAPTER 13: LEARNING OBJECTIVE 1 (1 of 2) 1. Identify and discuss characteristics of the corporate form of organization. 2. Explain share capital and demonstrate the accounting for the issuance of common and preferred shares. 3. Prepare a corporate income statement. Copyright ©2019 John Wiley & Sons Canada, Ltd. 3 CHAPTER 13: LEARNING OBJECTIVE 1 (2 of 2) 4. Explain and demonstrate the accounting for cash dividends. 5. Prepare a statement of retained earnings and closing entries for a corporation. 6. Prepare the shareholders’ equity section of the balance sheet and calculate return on equity. Copyright ©2019 John Wiley & Sons Canada, Ltd. 4 The Corporate Form of Organization • A legal entity separate from its owners (known as shareholders) • Classified by purpose and ownership: • Purpose: for profit or not-for-profit • Ownership: • Public corporation: shares are available for purchase on an organized securities market • Private corporation: shares are held by a few individuals and are not traded Copyright ©2019 John Wiley & Sons Canada, Ltd. 5 Characteristics of a Corporation (1 of 3) • Separate legal existence from its owners • Acts under its own name • Owners do not bind the corporation • Limited liability of shareholders • Limited to the amount of their investment Copyright ©2019 John Wiley & Sons Canada, Ltd. 6 Characteristics of a Corporation (2 of 3) • Transferable ownership rights • Shares may be bought and sold • No effect on operating activities of corporation • Ability to acquire capital • Can raise capital by issuing shares • May be difficult for closely-held corporations Copyright ©2019 John Wiley & Sons Canada, Ltd. 7 Characteristics of a Corporation (3 of 3) • Continuous and unlimited life • Unaffected by change in ownership • Government regulations • Specific laws that govern operations of corporations • Income tax • Taxed as a separate entity Copyright ©2019 John Wiley & Sons Canada, Ltd. 8 Forming a Corporation (1 of 2) • Can incorporate federally or provincially • Done by filing articles of incorporation (the company’s “constitution”): • Provides information such as : • Name and purpose of company • Number of shares and kinds of shares to be authorized • Location of corporation’s head office Copyright ©2019 John Wiley & Sons Canada, Ltd. 9 Forming a Corporation (2 of 2) • By-laws: internal rules and policies • Organization costs: • Costs of forming a corporation • Must be expensed when incurred Copyright ©2019 John Wiley & Sons Canada, Ltd. 10 Ownership Rights of Shareholders • Ownership rights are in the form of shares • Can be divided into different classes • As stated in the articles of incorporation • Each class has rights and privileges • Usually referred to as common and preferred shares • Shareholders have rights: • To vote on certain matters • To dividends: the distribution of profit • To remaining assets in a liquidation Copyright ©2019 John Wiley & Sons Canada, Ltd. 11 Corporation Management • Shareholders manage the corporation indirectly through the Board of Directors that they elect • The board: • Decides on the corporation’s operating policies • Selects officers (such as the Chief Executive Officer or CEO) to execute policy and perform daily management functions Copyright ©2019 John Wiley & Sons Canada, Ltd. 12 Distribution of Profit • Profit can either be reinvested in the company or distributed to shareholders as dividends • Dividend: • Pro-rata distribution of a portion of corporation’s retained earnings to shareholders • Pro-rata: based on the proportion of shares owned Copyright ©2019 John Wiley & Sons Canada, Ltd. 13 CHAPTER 13: LEARNING OBJECTIVE 2 (1 of 2) 1. Identify and discuss characteristics of the corporate form of organization. 2. Explain share capital and demonstrate the accounting for the issuance of common and preferred shares. 3. Prepare a corporate income statement. Copyright ©2019 John Wiley & Sons Canada, Ltd. 14 CHAPTER 13: LEARNING OBJECTIVE 2 (2 of 2) 4. Explain and demonstrate the accounting for cash dividends. 5. Prepare a statement of retained earnings and closing entries for a corporation. 6. Prepare the shareholders’ section of the balance sheet and calculate return on equity. Copyright ©2019 John Wiley & Sons Canada, Ltd. 15 Share Issue Considerations (1 of 2) • Authorized share capital • Total number of each class of shares company is allowed to sell • Many companies have unlimited number of shares • Issue of shares • Issued directly to investors or through an investment dealer • First public sale is called an initial public offering (IPO) Copyright ©2019 John Wiley & Sons Canada, Ltd. 16 Share Issue Considerations (2 of 2) • Market value of shares • Once issued, shares trade on a secondary market • Prices determined by buyers and sellers and other external factors • Legal capital • Share capital is legal capital and cannot be distributed to shareholders • Retained earnings are earned capital and can be distributed as dividends Copyright ©2019 John Wiley & Sons Canada, Ltd. 17 Common Shares: Issuing Shares • Shares are usually issued for cash: • Dr. Cash Cr. Common shares • Shares can be issued in exchange for services or noncash assets • Recorded at fair value of goods/services received: • Dr. Service or asset (e.g. Legal Fees Expense) Cr. Common shares • Under IFRS, if fair value of goods/services not measurable, use fair value of shares given in exchange • Under ASPE, value transaction at amount that can be more reliably measured Copyright ©2019 John Wiley & Sons Canada, Ltd. 18 Preferred Shares • Priority over common shares for dividends and assets in the event of liquidation of the company • Entries to record issue and reacquisition of preferred shares similar to entries for common shares • Transactions for each class of share is recorded in a separate account Copyright ©2019 John Wiley & Sons Canada, Ltd. 19 Dividend Preference • Preferred shareholders have a right to dividends before common shareholders • Cumulative preferred shares have a right to current year’s dividends and any prior years’ dividends owing before dividends are paid on common shares • Any unpaid dividends (in arrears) are not considered a liability • No obligation to pay until dividend is declared Copyright ©2019 John Wiley & Sons Canada, Ltd. 20 Convertible Preferred Shares • Provide option to exchange preferred shares to common shares at a specified ratio • Conversion is recorded by transferring cost from Preferred Shares to Common Shares account Copyright ©2019 John Wiley & Sons Canada, Ltd. 21 Redeemable and Retractable Preferred Shares • Corporation (redeemable) or the shareholder (retractable) can redeem the shares at specified future dates and prices • Similar to debt: offers a repayment of the principal • Considered a financial instrument • These preferred shares usually reported in the liabilities section of the balance sheet Copyright ©2019 John Wiley & Sons Canada, Ltd. 22 CHAPTER 13: LEARNING OBJECTIVE 3 (1 of 2) 1. Identify and discuss characteristics of the corporate form of organization. 2. Explain share capital and demonstrate the accounting for the issuance of common and preferred shares. 3. Prepare a corporate income statement. Copyright ©2019 John Wiley & Sons Canada, Ltd. 23 CHAPTER 13: LEARNING OBJECTIVE 3 (2 of 2) 4. Explain and demonstrate the accounting for cash dividends. 5. Prepare a statement of retained earnings and closing entries for a corporation. 6. Prepare the shareholders’ section of the balance sheet and calculate return on equity. Copyright ©2019 John Wiley & Sons Canada, Ltd. 24 Retained Earnings • The cumulative total of profit less losses and less declared dividends since incorporation • Represents part of shareholder’s claim on total assets of a corporation • Not a claim on any specific asset (including cash) • Two major components: • Profit • Dividends: cash distributions to owners Copyright ©2019 John Wiley & Sons Canada, Ltd. 25 Corporate Income Statements (1 of 2) • Income statement for corporations are similar to proprietorship or partnership statements • One major difference is income taxes • Since corporation is a separate legal entity • Affects income statement (income tax expense) and balance sheet (income tax payable or receivable) Copyright ©2019 John Wiley & Sons Canada, Ltd. 26 Corporate Income Statements (2 of 2) Copyright ©2019 John Wiley & Sons Canada, Ltd. 27 CHAPTER 13: LEARNING OBJECTIVE 4 (1 of 2) 1. Identify and discuss characteristics of the corporate form of organization. 2. Explain share capital and demonstrate the accounting for the issuance of common and preferred shares. 3. Prepare a corporate income statement. Copyright ©2019 John Wiley & Sons Canada, Ltd. 28 CHAPTER 13: LEARNING OBJECTIVE 4 (2 of 2) 4. Explain and demonstrate the accounting for cash dividends. 5. Prepare a statement of retained earnings and closing entries for a corporation. 6. Prepare the shareholders’ section of the balance sheet and calculate return on equity. Copyright ©2019 John Wiley & Sons Canada, Ltd. 29 Dividends • Common types of dividends • Cash dividends • Distribution of cash on a pro rata basis to shareholder • Stock dividends - Distribution of corporation’s own shares to shareholders (normally common shares) Copyright ©2019 John Wiley & Sons Canada, Ltd. 30 Cash Dividends (1 of 2) • To pay dividends, a corporation must: • Have enough retained earnings and cash • Maintain legal capital • Declare a dividend payable • Declaration date: • Board of directors formally declares dividend • Commits corporation to a legal obligation • Declaration is recorded: Copyright ©2019 John Wiley & Sons Canada, Ltd. 31 Cash Dividends (2 of 2) • Record date: • Ownership of shares is determined • Shareholders of record on this date will receive dividend • No journal entry required • Payment date: • Dividend is paid to shareholders and recorded: Copyright ©2019 John Wiley & Sons Canada, Ltd. 32 Preferred Share Cash Dividends • Main difference between common share cash dividends occurs when preferred shares are cumulative • Dividends in arrears are not considered a liability • No obligation to pay dividend until board of directors declares • Amount of dividends in arrears should be disclosed in notes to financial statements Copyright ©2019 John Wiley & Sons Canada, Ltd. 33 CHAPTER 13: LEARNING OBJECTIVE 5 (1 of 2) 1. Identify and discuss characteristics of the corporate form of organization. 2. Explain share capital and demonstrate the accounting for the issuance of common and preferred shares. 3. Prepare a corporate income statement. Copyright ©2019 John Wiley & Sons Canada, Ltd. 34 CHAPTER 13: LEARNING OBJECTIVE 5 (2 of 2) 4. Explain and demonstrate the accounting for cash dividends. 5. Prepare a statement of retained earnings and closing entries for a corporation. 6. Prepare the shareholders’ section of the balance sheet and calculate return on equity. Copyright ©2019 John Wiley & Sons Canada, Ltd. 35 Statement of Retained Earnings • Shows the changes in retained earnings during the year • Required under ASPE • Transactions that affect retained earnings: • Earning a profit (incurring a loss) • Declaring cash and stock dividends • Other transactions Copyright ©2019 John Wiley & Sons Canada, Ltd. 36 Sample Statement of Retained Earnings Copyright ©2019 John Wiley & Sons Canada, Ltd. 37 Closing Entries for a Corporation • All temporary accounts must be closed at the end of the accounting period • Balance in Retained Earnings must be updated Copyright ©2019 John Wiley & Sons Canada, Ltd. 38 CHAPTER 13: LEARNING OBJECTIVE 6 (1 of 2) 1. Identify and discuss characteristics of the corporate form of organization. 2. Explain share capital and demonstrate the accounting for the issuance of common and preferred shares. 3. Prepare a corporate income statement. Copyright ©2019 John Wiley & Sons Canada, Ltd. 39 CHAPTER 13: LEARNING OBJECTIVE 6 (2 of 2) 4. Explain and demonstrate the accounting for cash dividends. 5. Prepare a statement of retained earnings and closing entries for a corporation. 6. Prepare the shareholders’ section of the balance sheet and calculate return on equity. Copyright ©2019 John Wiley & Sons Canada, Ltd. 40 Shareholders’ Equity on the Balance Sheet • Contributed Capital: total amount contributed by shareholders • Share capital: preferred and common shares • Contributed surplus: amounts contributed from acquiring and retiring shares • Retained Earnings: cumulative profit (or loss) since incorporation that has been retained • Annual profit (loss) is added (deducted) • Dividends declared are deducted Copyright ©2019 John Wiley & Sons Canada, Ltd. 41 Sample Shareholders’ Equity Section Copyright ©2019 John Wiley & Sons Canada, Ltd. 42 Return on Equity • Also called return on investment • Considered to be the most important measure of a firm’s profitability • It evaluates how many dollars are earned for each dollar invested by shareholders Copyright ©2019 John Wiley & Sons Canada, Ltd. 43 Copyright Copyright © 2019 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. Copyright ©2019 John Wiley & Sons Canada, Ltd. 44 Chapter 14 Corporations: Additional Topics and IFRS Accounting Principles Eighth Canadian Edition Weygandt Kieso Kimmel Trenholm Warren Novak Prepared by Debbie Musil, FCPA, FCMA Corporations: Additional Topics and IFRS (1 of 2) • Additional Share Transactions • Stock dividends and splits • Reacquisition of shares • Comprehensive Income • Continuing and discontinued operations • Other comprehensive income • Accounting Changes • Changes in accounting policies and estimates • Correction of prior period errors Copyright ©2019 John Wiley & Sons Canada, Ltd. 2 Corporations: Additional Topics and IFRS (2 of 2) • Reporting Changes in Shareholders’ Equity • Summary of transactions • Statement of changes in shareholders’ equity • Analyzing Shareholders’ Equity • Earnings performance; Dividend record Copyright ©2019 John Wiley & Sons Canada, Ltd. 3 CHAPTER 14: LEARNING OBJECTIVE 1 (1 of 2) 1. Explain how to account for stock dividends and splits, and compare their financial impact. 2. Explain how to account for the reacquisition of shares. 3. Prepare an income statement showing continuing and discontinued operations, and prepare a statement of comprehensive income. Copyright ©2019 John Wiley & Sons Canada, Ltd. 4 CHAPTER 14: LEARNING OBJECTIVE 1 (2 of 2) 4. Explain the different types of accounting changes and account for the correction of a prior period error. 5. Prepare a statement of changes in shareholders’ equity. 6. Explain earnings and dividend performance and calculate performance ratios. Copyright ©2019 John Wiley & Sons Canada, Ltd. 5 Stock Dividends • Distribution of corporation’s own shares to its shareholders • Distributed (paid) in shares instead of cash • Does not change assets or shareholders’ equity • Decreases retained earnings and increases share capital by the same amount • Total amount is therefore unchanged Copyright ©2019 John Wiley & Sons Canada, Ltd. 6 Stock Dividends: Purpose and Benefits • Satisfies shareholders' dividend expectations without spending cash • Increases marketability of corporation’s shares • Increasing number of shares will cause market price to decrease and make shares more affordable • Emphasizes that a portion of shareholders’ equity has been permanently reinvested in the business • Therefore unavailable for cash dividends Copyright ©2019 John Wiley & Sons Canada, Ltd. 7 Entries for Stock Dividends • Declaration date: • Record date: no entry required • Distribution date: Copyright ©2019 John Wiley & Sons Canada, Ltd. 8 Stock Splits • Involves the issue of additional shares to shareholders • Similar to a stock dividend • Increases the marketability of shares by lowering market price per share • Effect on share price is generally inversely proportional to size of split • Does not affect shareholders’ equity • Therefore no entries are required Copyright ©2019 John Wiley & Sons Canada, Ltd. 9 Comparison of Dividends and Stock Splits • Cash dividends reduce assets and shareholders’ equity (retained earnings) • Stock dividends increase share capital and decrease retained earnings • Stock splits have no effect (but do increase number of shares issued) Copyright ©2019 John Wiley & Sons Canada, Ltd. 10 CHAPTER 14: LEARNING OBJECTIVE 2 (1 of 2) 1. Explain how to account for stock dividends and splits, and compare their financial impact. 2. Explain how to account for the reacquisition of shares. 3. Prepare an income statement showing continuing and discontinued operations, and prepare a statement of comprehensive income. Copyright ©2019 John Wiley & Sons Canada, Ltd. 11 CHAPTER 14: LEARNING OBJECTIVE 2 (2 of 2) 4. Explain the different types of accounting changes and account for the correction of a prior period error. 5. Prepare a statement of changes in shareholders’ equity. 6. Explain earnings and dividend performance and calculate performance ratios. Copyright ©2019 John Wiley & Sons Canada, Ltd. 12 Common Shares: Reacquisition of Shares (1 of 2) • Companies can reacquire their shares from shareholders in order to: • Increase trading on securities markets (to hopefully increase share value) • Increase earnings per share • Buy out hostile shareholders • Have shares available for compensation or other uses • Reacquired shares are retired and cancelled (in most jurisdictions) Copyright ©2019 John Wiley & Sons Canada, Ltd. 13 Common Shares: Reacquisition of Shares (2 of 2) • Steps to record a reacquisition: • Remove dollar amount of shares from share capital account • Based on average per share amount (must be calculated) • Record cash paid for the shares • Record any difference on reacquisition in shareholders’ equity Copyright ©2019 John Wiley & Sons Canada, Ltd. 14 Reacquisition of Shares: Below Average per Share Amount • If shares reacquired at a price < average per share amount: • Difference is an excess on reacquisition • This excess is credited to a shareholders’ equity account for the contributed capital from the reacquisition: Copyright ©2019 John Wiley & Sons Canada, Ltd. 15 Reacquisition of Shares: Above Average per Share Amount • If shares reacquired at a price > average per share amount: • Difference is a deficiency on reacquisition • Additional cost of shares is first debited to contributed capital from previous reacquisitions (if any) • Remaining difference is debited to Retained Earnings: Copyright ©2019 John Wiley & Sons Canada, Ltd. 16 CHAPTER 14: LEARNING OBJECTIVE 3 (1 of 2) 1. Explain how to account for stock dividends and splits, and compare their financial impact. 2. Explain how to account for the reacquisition of shares. 3. Prepare an income statement showing continuing and discontinued operations, and prepare a statement of comprehensive income. Copyright ©2019 John Wiley & Sons Canada, Ltd. 17 CHAPTER 14: LEARNING OBJECTIVE 3 (2 of 2) 4. Explain the different types of accounting changes and account for the correction of a prior period error. 5. Prepare a statement of changes in shareholders’ equity. 6. Explain earnings and dividend performance and calculate performance ratios. Copyright ©2019 John Wiley & Sons Canada, Ltd. 18 Discontinued Operations (1 of 2) • Disposal or reclassification to “held for sale” of a component of an entity • A separate major business line or geographic area • Reported separately on income statement • Includes allocation of income tax expense or savings (called intraperiod tax allocation) • Profit (loss) from discontinued operations and gain (loss) from disposal Copyright ©2019 John Wiley & Sons Canada, Ltd. 19 Discontinued Operations (2 of 2) Copyright ©2019 John Wiley & Sons Canada, Ltd. 20 Comprehensive Income • Additional statement required under IFRS • All-inclusive format or as a separate statement • No “other comprehensive income” under ASPE • Includes all changes in shareholders’ equity except from sale/repurchase of shares and dividend transactions Copyright ©2019 John Wiley & Sons Canada, Ltd. 21 CHAPTER 14: LEARNING OBJECTIVE 4 (1 of 2) 1. Explain how to account for stock dividends and splits, and compare their financial impact. 2. Explain how to account for the reacquisition of shares. 3. Prepare an income statement showing continuing and discontinued operations, and prepare a statement of comprehensive income. Copyright ©2019 John Wiley & Sons Canada, Ltd. 22 CHAPTER 14: LEARNING OBJECTIVE 4 (2 of 2) 4. Explain the different types of accounting changes and account for the correction of a prior period error. 5. Prepare a statement of changes in shareholders’ equity. 6. Explain earnings and dividend performance and calculate performance ratios. Copyright ©2019 John Wiley & Sons Canada, Ltd. 23 Change in Accounting Estimates • Estimates of future conditions and events are often made in accounting • For example, bad debt expense or warranty expense • These estimates may need to be changed due to: • A change in circumstances • New information becoming available • The new estimate is used from now on (prospective application) • Do not go back and change prior periods Copyright ©2019 John Wiley & Sons Canada, Ltd. 24 Change in Accounting Policy • Occurs when the policy used in current year is different that that used in prior year • Only occurs when change: • Is required by new IFRS or ASPE guidance • Provides more reliable and relevant information • Retrospective application required (prior years restated) unless not practical to do so Copyright ©2019 John Wiley & Sons Canada, Ltd. 25 Correction of Prior Period Errors (1 of 2) • When a material error is discovered after the financial statements have been issued • Correction is made directly to Retained Earnings (retrospective restatement) • Since effect of error is now located there (all revenues and expenses have been closed to retained earnings) • Net of any income tax effect Copyright ©2019 John Wiley & Sons Canada, Ltd. 26 Correction of Prior Period Errors (2 of 2) • Example: overstatement of interest expense • Understatement of profit (now retained earnings), and income tax payable Copyright ©2019 John Wiley & Sons Canada, Ltd. 27 Presentation of Corrections of Prior Period Errors • Correction is added to (or deducted from) opening balance of retained earnings, net of income tax effect • Financial statements of prior years are restated to reflect the change • Details of the change and its impact disclosed in a note to the financial statements Copyright ©2019 John Wiley & Sons Canada, Ltd. 28 CHAPTER 14: LEARNING OBJECTIVE 5 (1 of 2) 1. Explain how to account for stock dividends and splits, and compare their financial impact. 2. Explain how to account for the reacquisition of shares. 3. Prepare an income statement showing continuing and discontinued operations, and prepare a statement of comprehensive income. Copyright ©2019 John Wiley & Sons Canada, Ltd. 29 CHAPTER 14: LEARNING OBJECTIVE 5 (2 of 2) 4. Explain the different types of accounting changes and account for the correction of a prior period error. 5. Prepare a statement of changes in shareholders’ equity. 6. Explain earnings and dividend performance and calculate performance ratios. Copyright ©2019 John Wiley & Sons Canada, Ltd. 30 Statement of Changes in Shareholders’ Equity • Required for companies following IFRS • Shows changes in shareholders’ equity during year • Including Contributed Capital, Retained Earnings, Accumulated Other Comprehensive Income • Companies following ASPE: • Continue to use a Statement of Retained Earnings • Other changes are reported in notes to the statements Copyright ©2019 John Wiley & Sons Canada, Ltd. 31 Summary of Shareholders’ Equity Transactions Copyright ©2019 John Wiley & Sons Canada, Ltd. 32 CHAPTER 14: LEARNING OBJECTIVE 6 (1 of 2) 1. Explain the different types of accounting changes and account for the correction of a prior period error. 2. Prepare a statement of changes in shareholders’ equity. 3. Explain earnings and dividend performance and calculate performance ratios. Copyright ©2019 John Wiley & Sons Canada, Ltd. 33 CHAPTER 14: LEARNING OBJECTIVE 6 (2 of 2) 4. Explain the different types of accounting changes and account for the correction of a prior period error. 5. Prepare a statement of changes in shareholders’ equity. 6. Explain earnings and dividend performance and calculate performance ratios. Copyright ©2019 John Wiley & Sons Canada, Ltd. 34 Earnings Performance: Earnings per Share • Indicates profit earned by each common share • Used under IFRS; not required under ASPE • Formula to calculate: • Weighted average number of common shares = opening balance + (shares issued during the year x the fraction of the year they are outstanding) Copyright ©2019 John Wiley & Sons Canada, Ltd. 35 Earnings per Share: Complex Capital Structure (1 of 2) • When a company has securities that can be converted into common shares • Example: convertible preferred shares • If converted, the additional common shares will result in a reduced (diluted) EPS figure Copyright ©2019 John Wiley & Sons Canada, Ltd. 36 Earnings per Share: Complex Capital Structure (2 of 2) • Two EPS amounts are calculated: • Basic EPS: calculation on preceding page • Fully diluted EPS: calculated as if all securities were converted into common shares • Calculation of weighted average number of shares becomes more complicated Copyright ©2019 John Wiley & Sons Canada, Ltd. 37 Earnings Performance: Price-Earnings Ratio • Helps investors compare earnings of different companies • Formula to calculate: • A high PE ratio is an indicator that investors believe the company has good earnings potential Copyright ©2019 John Wiley & Sons Canada, Ltd. 38 Payout Ratio • Indicates what percentage of profit a company is distributing to its shareholders • Can be calculated for common, preferred and all dividends: • Mature companies may have a higher payout ratio due to limited growth potential • A low payout ratio may indicate company is retaining cash for possible future growth • Payout ratios vary with between industries Copyright ©2019 John Wiley & Sons Canada, Ltd. 39 Copyright Copyright © 2019 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. Copyright ©2019 John Wiley & Sons Canada, Ltd. 40
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Excellent resource! Really helped me get the gist of things.

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