Week4 2012 Lec

192
(9) Liabilities
193
Bonds
face value: redemption value of the bond on its maturity
date
coupon: amount of interest payments made on the bond -
usually semi-annually
coupon rate: annual coupons / face value
yield-to-maturity: actual effective interest% yield paid
by the bond -> market rate
if yield > coupon rate, the bond will sell at a discount;
for less than face value
CMA Accelerated Program 2012/2013 Lecture Student Weekly File - Week 4
1 of 27 CMA Ontario, 2012
194
Bonds - contd
if yield < coupon rate, the bond will sell at a premium; for
more than face value
calculation of value of bond:
N = number of periods (usually the number of years x 2)
I = the yield to maturity per period
PMT = the coupon payment per period
FV = the face value of the bonds
the above can also be used to calculate the book value of the
bonds at any point in time: N is the number of periods
remaining
195
Interest Expense
effective interest rate method is required
under IFRS and optional for ASPE:
the interest expense in a given period is
the net book value of the bonds at the
beginning of that period times the YTM in
effect when the bonds were issued
ASPE also allows the straight-line method (or
any systematic method of allocation)

196
Bond Example 1
On Jan 1, 20x1, you issue $1,000,000 of bonds. Interest
payment dates = June 30, Dec 31. Maturity = 20 years,
coupon = 8%, YTM = 10%.
1. Write all journal entries for 20x1 assuming the
company uses the effective interest rate method.
2. Assume that on July 1, 20x7, we retire 40% of the
bonds on the open market @ 95. Write the journal
entry to record the retirement of the bonds.
3. Repeat the above assuming the company is subject to
ASPE and opts to use the straight line method for
discount/premium amortization.
197
Bond Example 2
On Jan 2, 20x3, you issue $60,000,000 of bonds.
Interest payment dates = June 30, Dec 31.
Maturity = 40 years, coupon = 6.3%, YTM =
5.9%.
1. Write all journal entries for 20x3 assuming
the effective interest rate method is used.
2. Assume that on July 1, 20x16, we retire 100%
of the bonds on the open market @ 101. Write
the journal entry to record the retirement of
the bonds.
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Bonds issued between coupon
payment dates
if a bond is issued between interest payment
dates, bondholders will pay the company a
prorata share of the coupon from the interest
payment date to the date the bonds were
issued
any interest received in advance should be
credited to interest expense if the next coupon
payment date is within the scal period;
otherwise credit interest payable
199
Bond Example 3
On March 1, 20x1, you issue $1,000,000 of bonds.
Interest payment dates = June 30, Dec 31.
Maturity = 15 years, coupon = 10%, YTM = 8%.
Write journal entries for 20x1. Assume the
effective interest rate method is used.
200
Provisions
a provision should be recognized when:
(a) an entity has a present obligation (legal or
constructive) as a result of a past event;
(b) it is probable (i.e. more likely than not)
that an outow of resources embodying
economic benets will be required to settle
the obligation; and
(c) a reliable estimate can be made of the
amount of the obligation.
201
Provisions - contd
a constructive obligation is an obligation that derives
from an entitys actions where:
(a) by an established pattern of past practice,
published policies or a sufciently specic current
statement, the entity has indicated to other parties
that it will accept certain responsibilities; and
(b) as a result, the entity has created a valid
expectation on the part of those other parties that
it will discharge those responsibilities. (IAS 37.10)
example: accepting returns of merchandise
202
Provisions - contd
amount to be recorded = the best estimate or
expected value of the amount required to
settle the obligation
if there is a range of possible outcomes, each
associated with probabilities, then the
expected value can be calculated
if cash outlays are expected over time, they
have to be discounted if the effect of
discounting is material
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Estimated Liabilities - Warranties
two types of warranties:
expense warranty: the warranty is an
integral part of the sale and is viewed as a
provision. The total expected warranty
expense is recorded in the year the related
item is sold:
dr. Warranty Expense
cr. Warranty Liability
sales warranty: the warranty is sold
separately: accrue over the life of the
warranty using the percentage of completion
approach as this is rendering of services
revenues. Record expenses of servicing
warranty as incurred.
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Expense Warranty Example
A rm offers 2 year warranty on its products.
They expect the warranty costs to be 1% of
the selling price in the 1st year and 3% in the
second year. Sales in year 1 = $6,000,000 and
warranty costs incurred = $45,000.
Sales in year 2 are $8,500,000 and warranty
costs incurred are $315,000. Management now
estimates that warranty costs to be 0.8% of
the selling price in the 1st year and 2.6% in
the second year.
Write the journal entries for years 1 and 2.
205
Sale Warranty Example
A product comes with a 1 year warranty, the company sells
an additional 3 years extended warranty for $180.
Assume a sale takes place on Jan 1, 20x1. The company
estimates that warranty costs in the rst year will
amount to $15 per unit.
In 20x1, the product is repaired at a cost of $20.
In 20x2, the product is repaired at a cost of $30 and
expected repair costs in 20x3 and 20x4 are $40.
In 20x3, the product is repaired at a cost of $10 and
expected repair costs in 20x4 are $20.
Actual repair costs in 20x4 are $0.
Write the journal entries for 20x1 - 20x4?
206
Estimated Liabilities - Premiums
coupons, frequent yer points, etc
the premium should be charged as a reduction of revenue
in the same period as the related sale
the amount is at the fair value of the premium
management needs to estimate the % coupon redemption
and accrue the reduction of revenue based on this %
liability should be recognized for outstanding premiums
expected to be redeemed - set up as deferred revenues
ASPE treats premiums as an expense and is measured at
cost
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Premium Example
You sell cereal - each box has a coupon.
Customers redeem 20 coupons and receive a
prize. Cost of prize to the company is $6, the
fair value of each prize is $10. Average
redemption rate = 20%. In year 1, you sell
300,000 boxes and redeem 1,100 prizes. In year
2, you sell 400,000 boxes and redeem 4,500
prizes.
Write the journal entries for the two rst years.
208
Contingent Liabilities
a contingent liability is dened as:
(a) a possible obligation that arises from past events
and whose existence will be conrmed only by the
occurrence or non-occurrence of one or more
uncertain future events not wholly within the control
of the entity; or
(b) a present obligation that arises from past events
but is not recognized because:
(i) it is not probable that an outow of resources
embodying economic benets will be required to
settle the obligation; or
(ii) the amount of the obligation cannot be
measured with sufcient reliability.
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Contingent Liabilities - contd
contingent liabilities are disclosed only - not
accrued
the following information has to be disclosed:
an estimate of the nancial effect,
an indication of the uncertainties arising to
the amount or timing of any outow, and,
the possibility of any reimbursement (i.e.
when some or all of the expenditure
required to settle the obligation is expected
to be reimbursed by another party).
210
Contingent Liabilities - ASPE
what IFRS refers to as provisions and contingencies are
grouped and called contingent liabilities under ASPE
criteria are fundamentally the same: if a liability meets
the criteria for a provision under IFRS, then it is called
a contingent liability that is recorded.
if the liability meets the denition of a contingent
liability as per IFRS, then it is also called a
contingent liability under ASPE and is disclosed.
if you have a range of possible outcomes of a contingent
liability that is to be recorded, ASPE requires you to
record the lower of the range and disclose the remaining
exposure
no discounting is required under ASPE
211
Contingent Liabilities Example
Assume that you are a company selling spinach and that
one of your employees spiked the spinach one day and as
a result 10 people die. At year end, you nd out that you
are being sued for $100M. What do you do? 4
possibilities:
1.legal council says the lawsuit is frivolous and that it
will never get to court
2.legal council believes you will have to pay $50M (no
more, no less)
3.legal council believes that you will have to pay but
cannot estimate how much
4.legal council believes that you will have to pay
between 40 - 80M, with equal probability
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Events after the reporting period
Two types:
adjusting events after the reporting period - those
which provide further evidence of conditions which
existed at the nancial statement date - these will
result in an adjustment to the nancial statements, and
non-adjusting events after the reporting period - those
which are indicative of conditions which arose subsequent
to the nancial statement date that do not provide
further evidence of conditions which existed at the
nancial statement date - if material, these have to be
disclosed in the notes to the nancial statements
213
(10) Shareholders Equity
214
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Common Shares
typical features of common shares:
they provide the right to vote at annual
meetings,
upon liquidation of the company, any cash
remaining after all obligations and preferred
shares have been settled revert back to
common shareholders, and
they are a perpetuity, meaning they never
become due
IFRS standards refer to these as ordinary
shares
216
Preferred Shares
typical features:
they are generally non-voting shares,
they carry a stated dividend per share,
like common shares, they are a perpetuity,
and
they have preference on liquidation
they can be cumulative: if dividends are missed,
any preferred dividends in arrears must be paid
before any dividends can be paid to common
shareholders
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Contributed Surplus
contributed Surplus arises when
shares are repurchased at an amount less
than the average amount of cash that was
raised when they were issued, and
when a share based payment plan is put in
place, and
when subscribed shares are defaulted.
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Retained Earnings
represents the accumulated earnings of the
corporation net of any dividends paid
any premiums paid on retirement of shares are
also charged to retained earnings
some unrealized gains and losses that
accumulate in Accumulated OCI get recycled
directly through Retained Earnings
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Accumulated Other Comprehensive
Income (IFRS Only)
consists of unrealized gains or losses that do not ow to
net income but get placed in accumulated other
comprehensive income until realized, at which time they
ow from accumulated other comprehensive income to
net income. These include:
actuarial gains and losses on dened benet pension
plans,
unrealized gains or losses on investments in fair value
through OCI investments*
unrealized gains or losses on cash ow hedges;
revaluation surpluses*, and
unrealized gains and losses on the translation of the
nancial statements of foreign subsidiaries when the
functional currency is the local currency of the
foreign subsidiary.
* recycled through retained earnings
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Issuance of Shares
non-cash consideration: assets/services are
recorded at their fair market value of the
goods or services received at the date they are
received. If the fair value of the goods or
services cannot be determined, then the value
shall be determined by reference to the fair
value of the equity instruments granted.
issue costs: direct costs are shown as a
reduction of the capital stock account
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Issuance of Shares - Subscription
on issuance of subscription
dr. Subscriptions Receivable (full amount)
cr. Common Shares Subscribed
on payment
dr. Cash
cr. Subscription Receivable
when fully paid:
dr. Common Shares Subscribed
cr. Common Shares
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Re-acquisiton of common shares - example
An entity starts the year with 500,000 common
shares outstanding with a book value of
$2,000,000
On May 1, they issue 100,000 shares @ $6.00
On June 15, they issue 250,000 shares @ $7.50
On Aug 7, they repurchase and cancel 50,000
shares @ $4.60
On Sep 20, they issue 300,000 shares @ $8.00
On Nov 16, they repurchase and cancel 100,000
shares @ $7.00
Write all journal entries to record the above
transactions.
223
Re-acquisiton of common shares
CBCA requires that shares be cancelled
if cost of reacquired shares ! stated value (loss) allocate to:
share capital in an amount equal to the stated value
contributed surplus to the extent it was created by a
similar transaction
to contributed surplus to the extent it was created by
these shares
any remainder to R/E
if cost of reacquired shares < stated value (gain) allocate to:
share capital in an amount equal to the stated value
balance to contributed surplus
224
Dividends and Stock Splits
cash dividends
date of declaration, date of record, date of payment
once declared, the dividend is a legal liability
stock dividends provide for a capitalization of retained
earnings
transfer from retained earnings to common stock at
the market value of stock
stock split: used to reduce the market price of shares;
no entry; shares issued and outstanding change

225
Share Based Payments
equity-settled share-based payment
transactions - when equity instruments are
exchanged for goods/services (i.e. issue of
shares for goods/services, stock option plans)
cash settled share based payment transactions
- when the service/good acquired is based on
the price of an equity instrument (i.e. share
appreciation rights)
226
Equity-Settled Share-Based
Payment Transactions
acquisition of goods: equity is increased with a
corresponding increase in the relevant asset
account
acquisition of services: depends on when the
equity instruments vest
if immediately -recognize as an immediate
expense with a corresponding increase in
equity
if the equity instruments vest until the
services have been rendered, we accrue over
the vesting period
227
Equity Settled Share Based Payments -
Stock Compensation Plans
2 accounting issues:
what is the amount of compensation
expense?
over what period should we allocate the
compensation expense?
how much: determined by the user of an
options valuation model (i.e. Black-Scholes
model or binomial model)
when: over the service or vesting period (will
always be specied)
228
Stock Compensation Expense -
Journal Entries
no entry on date of grant
at year-end, measure the allocated amount of
compensation expense x % of executives the
company estimates will vest the options:
dr. Compensation expense
cr. Contributed Surplus - Stock Options
on exercise:
dr. Cash
dr. Contributed Surplus - Stock Options
cr. Common Shares
229
Stock Option Expiry
- Journal Entries
if they expire (i.e. the executive has not
exercised them by the end of the conversion
period) the Contributed Surplus converts to
unrestricted Contributed Surplus:
dr. Contributed Surplus - Stock Options
cr. Contributed Surplus
230
Stock Compensation Plan Example
On Jan 2, 20x1 a company issues 100,000 options to
executives to purchase stock @ $12 (equal to the market
value of the shares at that date). An option valuation
model puts the value of these options at $600,000.
Vesting period = 3 years. Executives can exercise their
options in 20x4. The company estimates that 80% of the
executives will vest their stock options.
At the end of 20x2, the company now estimates that 85%
of the executives will vest their stock options.
During 20x3, 10,000 options are forfeited due to
employment related reasons.
On Jan 2, 20x4, 40,000 options are exercised when the
market price of the shares is $42. By December 31, 20x4
the remaining options expired.
Write all journal entries related to this plan.
231
Cash Settled Share Based Payment
Transactions
the amount of consideration involved is
determined in relation to an equity instrument,
the consideration itself passes in cash or other
assets
goods/services acquired and liability incurred
are at the fair value the liability incurred
until the liability is settled, the entity
remeasures the fair value of the liability at
each reporting date and at the date of
settlement
any changes in fair value of the liability
ow to prot/loss for the period
232
Share Appreciation Rights
employees become entitled to future cash payments
based on the share price or the increase in the entitys
share price from a specied level over a specied period
of time (or any other formula as determined by
management)
recognize the services received and the corresponding
liability as the services are rendered
the liability is measured, initially and at each reporting
date, until settled, at the fair value of the SARs as
measured by a stock option pricing model
when the liability is actually settled, its fair value is
equal to the cash passing in settlement
233
Share Appreciation Rights Example
(adapted from IFRS 2)
An entity grants 100 cash share appreciation rights (SARs) to each of its 500
employees, on condition that the employees remain in its employ for the next
three years (20x1 20x3)
During 20x1, 35 employees leave and the entity estimates that another 60 will
leave before the end of the vesting period. During 20x2, 40 employees leave and
the entity estimates that a further 25 will leave before the end of the vesting
period. During 20x3, 22 employees leave. At the end of 20x3, 150 employees
exercise their SARs, another 140 exercise their SARs at the end of 20x4 and the
remaining 113 employees exercise their SARs at the end of 20x5.
The fair value of each SAR at year end are as follows:
20x1 - $14.40 20x2 - $15.50 20x3 - $18.20 20x4 21.40
The intrinsic value of each SAR at year-end are as follows:
20x3 - $15.00 20x4 - $20.00 20x5 - $25.00
Problem 17 Shareholders Equity

Excerpts of the shareholders' equity section of P Ltd.'s December 31, 20x5, balance sheet
follow:

Capital Stock
Authorized
500,000 common shares without par value
100,000 10% non-cumulative, non-voting preferred shares

Issued and fully paid
300,000 common shares $ 300,000
50,000 preferred shares 200,000

Retained earnings 1,100,000
Total shareholders' equity $1,600,000

During 20x6, P Ltd. engaged in the following transactions:

1) June 30 - Common share dividend of $1 per share was declared.
2) July 31 - 100,000 common shares were issued for cash consideration totaling
$150,000.
3) Aug. 31 - 10% stock dividend declared on common stock. The per share market
value of common stock on August 31, 20x6, was $1.50. (assume that this
market price is after the announcement of the stock dividend i.e. it has
been adjusted for the dilutive effects of the stock dividend)
4) Sep. 30 - Acquired and cancelled 50,000 P Ltd. common shares for $75,000.
5) Oct. 31 - Annual preferred share dividends were declared and paid.
6) Dec. 30 - Common share dividend of $1 per share was declared.
7) Dec. 31 - The common stock was split 2 for 1. P Ltd. reported 20x6 net income in
the amount of $800,000.

Based solely on the transactions and information above, what is P Ltd.'s closing retained
earnings balance on December 31,20x6?

Problem 11 Notes Receivable/Payable

Assume that Florida Developments Inc., having bought a large tract of land in a swampy
area near an established resort, sold lots for a payment of $1,000 down and the balance
of $30,000 due in 25 years at an interest rate of 5%. Suppose that at the time the imputed
interest rate was 19%. How would Florida Developments Inc. record the sale of such a lot
on January 2, 20x3. How would the first two interest payments be recorded? Assume that
interest is paid annually on December 31.

Week 4
Homework File

Suggested study plan for this week:

Primary List Secondary List

1. Review what we did in class on Saturday.

2. Liabilities
MCQ, Problems 2, 3, 4 Problems 1, 5, 6, 7, 8, 9, 10

3. Shareholders' Equity
MCQ, Problems 1, 2, 6, 10, 7, 8, 9

Problems 3, 4, 5
4. Prepare the following problems - they will be
taken up next week:

IC 15 Pride Music (Liabiities)
IC 16 Klimova (Bonds)

5. Prepare the Week 4 Quiz.

Problem 15 Liabilities

Pride Music Emporium is a publicly accountable entity and carries a wide variety of
musical instruments, sound reproduction equipment, recorded music, and sheet music.
Pride uses two sales promotion techniques - warranties and an incentive program - to
attract customers.

Musical instruments and sound equipment are sold with a one-year warranty for
replacement of parts and labour. The estimated warranty cost, based on past experience,
is 2% of sales.

The incentive program is offered on the recorded and sheet music. Customers receive a
coupon for each dollar spent on recorded music or sheet music. Customers may exchange
200 coupons and $20 for an MP3 player. Pride pays $34 for each MP3 player and
estimates that 60% of the coupons given to customers will be redeemed. The fair value of
each MP3 player is $50.

Prides total sales for 20x2 are $7,200,000. Sales are $5,400,000 from musical
instruments and sound reproduction equipment and $1,800,000 from recorded music and
sheet music. Replacement parts and labour for warranty work total $164,000 during
20x2. A total of 6,500 MP3 players used in the incentive program are purchased
during the year and there are 1,200,000 coupons redeemed in 20x2.

The balances in the accounts related to the warranty and incentive program on January 1,
20x2 are as shown below.

Inventory of MP3 Players $39,950
Deferred Revenues Inventive Program 99,200
Warranty Provision 136,000

Required

Prides Music Emporium is preparing its financial statements for the year ended
December 31, 20x2. Determine the amounts that will be shown on the 20x2 financial
statements for the following:
1. Warranty Expense
2. Warranty Provision
3. Reduction of revenues related to the incentive program
4. Inventory of MP3 Players.
5. Deferred Revenues Incentive Program
6. Net Sales as it would be presented on the statement of income.
Problem 16 Liabilities

On March 1, 20x5 the Klimova Company issued bonds dated January 2, 20x5 with the
following characteristics:

Face value $20,000,000
Coupon rate 7.6%
Yield to maturity 8%
Maturity 20 years
Coupon payment dates June 30, Dec 31
Company year end Dec 31

Required

a) Prepare all journal entries for this bond issue for the year 20x5. Assume the
effective interest method is used.
b) Assume that on July 2, 20x14, the company repurchases 40% of the bond issue on
the open market at 98. Write all journal entries for the year 20x14.
c) Redo parts (a) and (b) on the assumption that Klimova is a private company
subject to ASPE and opts to account for premiums and discounts on bonds
payable using the straight line method.


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