ACCOUNTING INTERMEDIATE

MODULE

Compiled by :
Abigail Elsa Samita Sitakar
1902113687

Study Program – S1 Accounting

Faculty of Economics and Business
University of Riau
2021
 Table of Contents

TABLE OF CONTENTS...........................................................................................................i

CHAPTER 1: Revenue Recognition .........................................................................................2

A. Definition..................................................................................................................2
B. Valuation...................................................................................................................2
C. Recording and Reporting..........................................................................................4
D. Example and Explanation.........................................................................................6

CHAPTER 2: Accounting for Lease..........................................................................................9

A. Definition..................................................................................................................9
B. Valuation...................................................................................................................9
C. Recording and Reporting..........................................................................................9
D. Example and Explanation.........................................................................................14

CHAPTER 3: Accounting Changes and Errors.......................................................................... 17

A. Definition..................................................................................................................17
B. Valuation...................................................................................................................18
C. Recording and Reporting..........................................................................................20
D. Example and Explanation.........................................................................................24

CHAPTER 4: Statement of Cash Flows..................................................................................... 25

A. Definition..................................................................................................................25
B. Valuation...................................................................................................................26
C. Recording and Reporting..........................................................................................26
D. Example and Explanation.........................................................................................28

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 CHAPTER 1

REVENUE RECOGNITION

A. Definition

Revenue recognition is a principle that identifies the specific conditions in which revenue is
recognized and determines how to account for it.

Revenue transactions are prone to error and fraudulent activity. The incomplete and inconsistent
guidelines in previous standard made the possibility for fraudulent behavior even bigger. That is why
IASB provided new standard. The new standard, Revenue from Contracts with Customers, adopts an
asset-liability approach as the basis for revenue recognition. The asset-liability approach recognizes and
measures revenue based on changes in assets and liabilities, arising with contracts from customers. It
provides a set of guidelines to follow in determining when revenue should be recognized, reported and
measured. The objective of this is enhancement of comparability and consistency in reporting revenue.

Revenue recognition principle is recognize revenue in the accounting period when the
performance obligation is satisfied.

B. Valuation

The five-step process for revenue recognition :

1. Identify the contract with customers.

2. Identify the separate performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the separate performance obligations.
5. Recognize revenue when each performance obligation is satisfied.

Brief explanation for each step :

Identify The Contract With Customers–Step 1

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 A contract is an agreement between two or more parties that creates enforceable rights or
obligations. Revenue from a contract with a customer cannot be recognized until a contract exists.
However, a company does not recognize contract assets or liabilities until one or both parties to the
contract perform.

Identify The Separate Performance Obligations in The Contract–Step 2

A performance obligation is a promise in a contract to provide a product or service to a customer.

This promise may be explicit, implicit, or possibly based on customary business practice. To determine
whether a performance obligation exists, the company must provide a distinct product or service.

Determine The Transaction Price–Step 3

The transaction price is the amount of consideration that a company expects to receive from a
customer in exchange for transferring goods and services. The transaction price in a contract is often
easily determined because the customer agrees to pay a fixed amount to the company over a short period
of time. In other contracts, companies must consider the following factors.

 Variable consideration
 Time value of money
 Non-cash consideration
 Consideration paid or payable to customers

Allocate The Ttransaction Price To The Separate Performance Obligations–Step 4

Companies often have to allocate the transaction price to more than one perfor-mance obligation
in a contract. If an allocation is needed, the transaction price allocated to the various performance
obligations is based on their relative fair values. The best measure of fair value is what the company could
sell the good or service for on a standalone basis, referred to as the standalone selling price. If this
information is not available, companies should use their best estimate of what the good or service might
sell for as a standalone unit.

Recognize Revenue When Each Performance Obligation Is Satisfied–Step 5

A company satisfies its performance obligation when the customer obtains control of the good or
service. the indicators that the customer has obtained control.

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 1. The company has a right to payment for the asset.
2. The company has transferred legal title to the asset.
3. The company has transferred physical possession of the asset.
4. The customer has significant risks and rewards of ownership.
5. The customer has accepted the asset.

Companies recognize revenue over a period of time if the customer receives and consumes the
benefits as the seller performs and one of the following two criteria is met.

1. The customer controls the asset as it is created or enhanced (e.g., a builder constructs a
building on a customer’s property).
2. The company does not have an alternative use for the asset created or enhanced (e.g., an
aircraft manufacturer builds specialty jets to a customer’s specifi cations) and either (a) the
customer receives benefi ts as the company performs and therefore the task would not need to
be re-performed, or (b) the company has a right to payment and this right is enforceable.

C. Recording and Reporting

A company satisfies a performance obligation and recognizes revenue over time if at
least one of the following two criteria is met:
1. The company’s performance creates or enhances an asset (e.g., work in process) that the
customer controls as the asset is created or enhanced; or
2. The company’s performance does not create an asset with an alternative use. For
example, the asset cannot be used by another customer. In addition to this alternative-use
element, at least one of the following criteria must be met:
a. The customer simultaneously receives and consumes the benefi ts of the entity’s
performance as the entity performs.
b. Another company would not need to substantially re-perform the work the
company has completed to date if that other company were to fulfi ll the
remaining obligation to the customer.
c. The company has a right to payment for its performance completed to date, and it
expects to fulfi ll the contract as promised.
Therefore, if criterion 1 or 2 is met, then a company recognizes revenue over time if it
can reasonably estimate its progress toward satisfaction of the performance obligations. That is,
the company recognizes revenues and gross profits each period based upon the progress of the
construction—referred to as the percentage-of-completion method.

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 Alternatively, if the criteria for recognition over time are not met, the company
recognizes revenues and gross profit at a point in time, that is, when the contract is completed. In
these cases, contract revenue is recognized only to the extent of costs incurred that are expected
to be recoverable. Once all costs are recognized, profit is recognized. This approach is referred to
as the cost-recovery (zero-profit) method.

Other Revenue Recognition Issues

1. Right of Return
Return of product by customer (e.g., due to dissatisfaction with the product) in exchange
for refunds, a credit against amounts owed or that will be owed, and/or another product in
exchange. Seller may recognize (a) an adjustment to revenue for the products expected to be
returned, (b) a refund liability, and (c) an asset for the right to recover the product.
2. Repurchase Agreements
Seller has an obligation or right to repurchase the asset at a later date. Generally, if the
company has an obligation or right to repurchase the asset for an amount greater than its
selling price, then the transaction is a financing transaction.
3. Bill and Hold
Result when the buyer is not yet ready to take delivery but does take title and accept
billing. Revenue is recognized depending on when the customerobtains control of that
product.
4. Principal-Agent Relationship
Amounts collected on behalf of the principal are not revenue of the agent.
Instead, revenue for the agent is the amount of the commission it receives. The principal
recognizes revenue when the goods or services are sold to a third-party customer.
5. Consignments
The consignor recognizes revenue only after receiving notification of the sale and
the cash remittance from the consignee (consignor carries the merchandise as inventory
throughout the consignment). The consignee records commission revenue (usually some
percentage of the selling price).
6. Warranties
A separate performance obligation is not recorded for assurance-type warranties
(considered part of the product). Service-type warranties are recorded as a separate
performance obligation. Companies should allocate a portion of the transaction price to
service type-warranties, when present.

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 7. Non-Refundable Upfront Fees
The upfront payment should be allocated over the periods benefited.

D. Example and Explanation

In 2018, Abigail Company started a construction job with a contract price of €1,600,000. The job was
completed in 2020. The following information is available:

2018 2019 2020

Costs incurred to date €400,000 €825,000 €1,070,000

Estimated costs to complete 600,000 275,000 –0–

Billings to date 300,000 900,000 1,600,000

Collections to date 270,000 810,000 1,425,000

Instructions

(a) Compute the amount of gross profit to be recognized each year, assuming the percentage-of-
completion method is used.
(b) Prepare all necessary journal entries for 2019.
(c) Compute the amount of gross profit to be recognized each year, assuming the cost-recovery
method is used.

Answer :

Based on the data above, Abigail would compute the percent complete like this. For the percent
complete, like the formula in the book, we need to multiple cost incurred to date with most recent
estimate of total costs.

2018 2019 2020

Contract price 1,600,000 1,600,000 1,600,000

Less estimated cost :
Cost to date 400,000 825,000 1,070,000
Estimated total cost 600,000 275,000 –0–

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Estimated total gross profit. 1,000,000 1,100,000 1,070,000
40% 75% 100%
400,000 825,000 1,070,000
1,000,000 1,100,000 1,070,000

Based on the computation above, Abigail make these entries to record the cost of construction,
progress billings, and collections. As the instructions, we only compute for 2016.
Entries for 2019 :
To record cost of construction
Construction in Process 450,000
Material, Cash, Payable 450,000
To record progress billing
Accounts Receivable 600,000
Billing on Construction in Process 600,000
To record cost of construction
Cash 540,000
Accounts Receivable 540,000
To record cost of construction
Construction in Process 135,000
Construction Expense 425,000
Revenue from long-term contact 560,000

In that data above, the costs incurred to date are a measure of the extent of progress toward
completion. To determine this, Abigail evaluates the costs incurred to date as a proportion of the
estimated total costs to be incurred on the project. The estimated revenue and gross profit for each
year are calculated like below.

To Date Recognize Recognize

2018 In Prior Year In Current Year

Revenue 640,000 640,000

Cost (400,000) (400,000)
Gross profit 240,000 240,000
2019

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Revenue 1,200,000 640,000 560,000
Cost (825,000) (400,000) (425,000)
Gross profit 375,000 240,000 135,000
2020
Revenue 1,600,000 1,200,000 400,000
Cost (1,070,000) (825,000) (245,000)
Gross profit 530,000 375,000 155,000

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 CHAPTER 2

ACCOUNTING FOR LEASE

A. Definition
A lease is a contractual agreement between a lessor and a lessee. This arrangement gives
the lessee the right to use specific property, owned by the lessor, for an agreed period of time. In
return for the use of the property, the lessee makes rental payments over the lease term to the
lessor.
The lessors that own the property :
1. Banks.
2. Captive leasing companies.
3. Independents.
Advantages of leasing :
1. 100% financing at fixed rates.
2. Protection against obsolescence.
3. Flexibility.
4. Less costly financing.
5. Tax advantages.
6. Off-balance-sheet-financing.

B. Valuation
The various views on capitalization of leases are as follows :
1. Do not capitalize any leased assets.
2. Capitalize leases that are similar to installment purchases.
3. Capitalize long-term leases.
4. Capitalize non-cancelable leases where the penalty for non-performance is subtantial.

C. Recording and Reporting

Accounting by The Lessee
If Air France as the lessee capitalizes a lease, and ILFC is the lessor. Here is the entries :
Air France ILFC
Leased Equipment xxx Lease Receivable xxx
Lease Liability xxx Equipment xxx

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Capitalization criteria (lessee) :
1. There is a transfer of ownership.
2. There is a bargain-purchase option.
3. Lease is term for the major part of economic life.
4. The present value of payments substantially all of fair value.
If the lease meets any of the four criteria, it is finance leases. If it does not meet, it is
operating leases.

Finance Lease Method (Lessee)

To illustrate a finance lease, assume that CNH Capital (NLD) (a subsidiary of CNH
Global) and Ivanhoe Mines Ltd. (CAN) sign a lease agreement dated January 1, 2015, that calls
for CNH to lease a front-end loader to Ivanhoe beginning January 1, 2015. The terms and
provisions of the lease agreement and other pertinent data are as follows.
 The term of the lease is five years. The lease agreement is non-cancelable, requiring equal
rental payments of $25,981.62 at the beginning of each year (annuity-due basis).
 The loader has a fair value at the inception of the lease of $100,000, an estimated economic
life of five years, and no residual value.
 Ivanhoe pays all of the executory costs directly to third parties except for the property taxes
of $2,000 per year, which is included as part of its annual payments to CNH.
 The lease contains no renewal options. The loader reverts to CNH at the termination of the
lease.
 Ivanhoe’s incremental borrowing rate is 11 percent per year.
 Ivanhoe depreciates similar equipment that it owns on a straight-line basis.
 CNH sets the annual rental to earn a rate of return on its investment of 10 percent per year;
Ivanhoe knows this fact.
The lease meets the criteria for classification as a finance lease for the following reasons.
1. The lease term of five years, being equal to the equipment’s estimated economic life of five
years, satisfi es the economic life test.
2. The present value of the minimum lease payments ($100,000 as computed below) equals the
fair value of the loader ($100,000).
Capitalized amount = ($25,981.62 - $2,000) x 4.16986 = $100,000
Ivanhoe records the finance lease on January 1, 2015, as follows.
Leased Equipment $100,000
Leased Liability $100,000

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Ivanhoe records the first lease payment on January 1, 2015, as follows.
Property Tax Expenses $2,000.00
Lease Liability $23,981.62
Cash $25,981.62
Table 21-6
Ivanhoe records accrued interest on December 31, 2015, as follows.
Interest Expenses $7,601.84
Interest Payable $7,601.84
Ivanhoe records depreciation (straight-line method) too at the same day.
Depreciation Expense $20,000
Accumulated Depreciation $20,000
Ivanhoe separately identifies the assets recorded under finance leases on its statement of financial
position.
Non-current liabilities
Lease liability ($76,018.38 - $16,379.78) $59,638.60
Current liabilities
Interest payable $ 7,601.84
Lease liability $16,379.78
Ivanhoe records the lease payment of January 1, 2016, as follows.
Property Tax Expenses $2,000.00
Interest Payable $7,601.84
Lease Liability $16,379.78
Cash $25,981.62
Entries through 2017 would follow the pattern above. If Ivanhoe purchases the equipment at
termination of the lease, at a price of $5,000 and the estimated life of the equipment changes from
five to seven years, it makes the following entry.
Equipment ($100,00 + $5,000) $105,000
Accumulated Depreciation–Leased Equipment $100,000
Leased Equipment $100,000
Accumulated Depreciation–Equipment $100,000
Cash $5,000
Operating Method (Lessee)
Under the operating method, rent expense (and the associated liability) accrues day by
day to the lessee as it uses the property. The lessee assigns rent to the periods benefiting from the

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use of the asset and ignores, in the accounting, any commitments to make future payments. The
lessee makes appropriate accruals or deferrals if the accounting period ends between cash
payment dates.For example, assume that the finance lease illustrated in the previous section did
not qualify as a finance lease. Ivanhoe therefore accounts for it as an operating lease. The first-
year charge to operations is now $25,981.62, the amount of the rental payment.
Ivanhoe records this payment on January 1, 2015, as follows.
Rent Expense 25,981.62
Cash 25,981.62

Accounting by The Lessor

Benefits for the lessor :
1. Interest revenue
2. Tax incentives
3. Residual value profits
If asset fair value equals lessor’s book value, it is direct-financing lease. If not, it is sales-type
lease.
Direct-Financing Method (Lessor)
Direct-financing leases are in substance the financing of an asset purchase by the lessee.
In this type of lease, the lessor records a lease receivable instead of a leased asset.
We use the same example as before, Ivanhoe and CNH.
Fair value of leased equipment $100,000.00
Less: Present value of residual value ——0——
Amount to be recovered by lessor through lease payments $100,000.00
Five beginning-of-the-year lease payments to yield
a 10% return ($100,000 : 4.16986ª) $23,981.62
The lease receivable is the present value of the minimum lease payments (excluding executory
costs which are property taxes of $2,000). CNH computes it as follows.
Lease receivable = ($25,981.62 - $2,000) x 4.16986 = $100,000
CNH records the lease of the asset and the resulting receivable on January 1, 2015 (the inception
of the lease), as follows.
Lease Receivable 100,000
Equipment 100,000
Table 21-13
On January 1, 2015, CNH records receipt of the first year’s lease payment as follows.

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 Cash 25,981.62
Lease Receivable 25,981.62
Property Tax Expense/Tax Payable 2,000.00
On December 31, 2015, CNH recognizes the interest revenue earned during the first year through
the following entry.
Interest Receivable 100,000
Interest Revenue 100,000
At December 31, 2015, CNH reports the lease receivable in its statement of financial position.
Non-current asset (investments)
Lease receivable ($76,018.38 - $16,379.78) $59,638.60
Current liabilities
Interest receivable $ 7,601.84
Lease receivable $16,379.78
The following entries record receipt of the second year’s lease payment and recognition of the
interest earned.
January 1, 2016
Cash 25,981.62
Lease Receivable 16,379.78
Interest Receivable 7,601.84
Property Tax Expense/Tax Payable 2,000.00
December 31, 2016
Interest Receivable 5,963.86
Interest Revenue 5,963.86
Journal entries through 2019 follow the same pattern except that CNH records no entry jn 2019
(the last year for interest revenue). If Ivanhoe buys the loader for $5,000 upon expiration of the
lease, CNH recognizes disposition of the equipment as follows.
Cash 5,000
Gain on Disposal of Equipment 5,000
Operating Method (Lessor)
Under the operating method, the lessor records each rental receipt as rental revenue. It
depreciates the leased asset in the normal manner, with the depreciation expense of the period
matched against the rental revenue.

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 To illustrate the operating method, assume that the direct-financing lease illustrated in the
previous section does not qualify as a finance lease. Therefore, CNH accounts for it as an
operating lease. It records the cash rental receipt as follows.
Cash 25,981.62
Rent Revenue 25,981.62
CNH records depreciation as follows (assuming a straight-line method, a cost basis of $100,000,
and a five-year life).
Depreciation Expense 20,000
Accumulated Depreciation—Equipment 20,000

D. Example and Explanation

Glaus Leasing Company agrees to lease machinery to Jensen Corporation on January 1, 2015.
The following information relates to the lease agreement.
1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated
economic life of 9 years.
2. The cost of the machinery is €525,000, and the fair value of the asset on January 1, 2015, is
€700,000.
3. At the end of the lease term, the asset reverts to the lessor. At the end of the lease term, the asset
has a guaranteed residual value of €100,000. Jensen depreciates all of its equipment on a straight-
line basis.
4. The lease agreement requires equal annual rental payments, beginning on January 1, 2015.
5. Glaus desires a 10% rate of return on its investments. Jensen’s incremental borrowing rate is
11%, and it is impracticable to determine the lessor’s implicit rate.
Instructions
(Assume the accounting period ends on December 31.)
a) Discuss the nature of this lease for both the lessee and the lessor.
b) Calculate the amount of the annual rental payment required.
c) Compute the present value of the minimum lease payments.
d) Prepare the journal entries Jensen would make in 2015 and 2016 related to the lease arrangement.
e) Prepare the journal entries Glaus would make in 2015 and 2016.

Answer :
(a) This is a finance lease to Jensen since the lease term is greater than 75% of the economic life of the
leased asset. The lease term is 78% (7 ÷ 9) of the asset’s economic life. This is a finance lease to Glaus
because the lease term is greater than 75% of the asset’s economic life. Since the fair value (€700,000) of
the equipment exceeds the lessor’s cost (€525,000), the lease is a sales-type lease.

(b) Calculation of annual rental payment:

€700,000 – (€100,000 X 0.51316) / 5.35526 = €121,130

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*–Present value of €1 at 10% for 7 periods.
  –Present value of an annuity due at 10% for 7 periods.

(c) Computation of present value of minimum lease payments:

PV of annual payments: €121,130 X 5.23054 = €633,575
PV of guaranteed residual value: €100,000 X 0.4816 =     48,166
€681,741
*–Present value of an annuity due at 11% for 7 periods.
–Present value of €1 at 11% for 7 periods.

(d) 1/1/15 Leased Equipment 681,741

Lease Liability 681,741
Lease Liability 121,130
Cash 121,130

12/31/15 Depreciation Expense   83,106

Accumulated Depreciation—Equipment 83,106
    (€681,741 – €100,000) ÷ 7

Interest Expense   61,667

Interest Payable 61,667
    (€681,741 – €121,130) X 0.11

1/1/16 Lease Liability   59,463

Interest Payable   61,667
Cash 121,130

12/31/16 Depreciation Expense   83,106

Accumulated Depreciation—Leased Equipment   83,106

Interest Expense   55,126

Interest Payable 55,126
  [(€681,741 – €121,130 – €59,463) X 0.11]

(e) 1/1/15 Lease Receivable 700,000

Cost of Goods Sold 525,000
Sales Revenue 700,000
Inventory 525,000

Cash 121,130
Lease Receivable 121,130

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12/31/15 Interest Receivable   57,887
Interest Revenue 57,887
    [(€700,000 – €121,130) X 0.10]

1/1/16 Cash 121,130

Lease Receivable   63,243
Interest Receivable 57,887

12/31/16 Interest Receivable 51,563

Interest Revenue 51,563
  [(€700,000 – €121,130 – €63,243) X .10]

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 CHAPTER 3
ACCOUNTING CHANGES AND ERROR ANALYSIS

A. Definition

ACCOUNTING CHANGES

Accounting alternatives diminish the comparability of financial information between periods and between
companies; they also obscure useful historical trend data. A reporting framework helps preserve
comparability when there is an accounting change.

The IASB has established a reporting framework that involves two types of accounting changes. The two
types of accounting changes are:

1. Change in accounting policy. A change from one accepted accounting policy to another one. For
example, Alcatel-Lucent (FRA) changed its method of accounting for actuarial gains and losses
from using the corridor approach to immediate recognition.
2. Change in accounting estimate. A change that occurs as the result of new information or
additional experience. As an example, Daimler AG (DEU) revised its estimates of the useful lives
of its depreciable property recently due to modifications in its productive processes.

A third category necessitates changes in accounting, though it is not classified as an accounting change.

3. Errors in financial statements. Errors result from mathematical mistakes, mistakes in applying
accounting policies, or oversight or misuse of facts that existed when preparing the financial
statements. For example, a company may incorrectly apply the retail inventory method for
determining its inventory value.

CHANGES IN ACCOUNTING POLICY

By definition, a change in accounting policy involves a change from one accepted accounting policy to
another. Adoption of a new policy in recognition of events that have occurred for the first time or that
were previously immaterial is not a change in accounting policy. If a company previously followed an
accounting policy that was not acceptable or the company applied a policy incorrectly, this type of change
is a correction of an error.

There are three possible approaches for reporting changes in accounting policies:

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 • Report changes currently. In this approach, companies report the cumulative effect of the change
in the current year’s income statement. The cumulative effect is the difference in prior years’
income between the newly adopted and prior accounting policy. Under this approach, the effect
of the change on prior years’ income appears only in the current-year income statement. The
company does not change prior-year financial statements.
• Report changes retrospectively. Retrospective application refers to the application of a different
accounting policy to recast previously issued financial statements—as if the new policy had
always been used. In other words, the company “goes back” and adjusts prior years’ statements
on a basis consistent with the newly adopted policy. The company shows any cumulative effect
of the change as an adjustment to beginning retained earnings of the earliest year presented.
• Report changes prospectively (in the future). In this approach, previously reported results remain.
As a result, companies do not adjust opening balances to reflect the change in policy.

The IASB requires that companies use the retrospective approach. Because it provides financial statement
users with more useful information than the cumulative-effect or prospective approaches.

ACCOUNTING ERRORS

In general, accounting errors include the following types:

1. A change from an accounting policy that is not generally accepted to an accounting policy that is
acceptable. The rationale is that the company incorrectly presented prior periods because of the
application of an improper accounting policy. For ex-ample, a company may change from the
cash (income tax) basis of accounting to the accrual basis.
2. Mathematical mistakes, such as incorrectly totaling the inventory count sheets when computing
the inventory value.
3. Changes in estimates that occur because a company did not prepare the estimates in good faith.
For example, a company may have adopted a clearly unrealistic depreciation rate.
4. An oversight, such as the failure to accrue or defer certain expenses and revenues at the end of the
period.
5. A misuse of facts, such as the failure to use residual value in computing the depreciations base for
the straight-line approach.
6. The incorrect classification of a cost as an expense instead of an asset, and vice versa.

As soon as a company discovers an error, it must correct the error. Companies record corrections of errors
from prior periods as an adjustment to the beginning balance of retained earnings in the current period.
Such corrections are called prior period adjustments.

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B. Valuation

Retrospective Accounting Change Approach

The IASB permits companies to change an accounting policy if:

1. It is required by IFRS (e.g., the new IFRS on financial instruments will be subject to the proper
accounting for changes in accounting policy); or
2. It results in the financial statements providing more reliable and relevant information about a
company’s financial position, financial performance, and cash flows.

When a company changes an accounting policy, it should report the change using retrospective
application. In general terms, here is what the company must do:

1. Adjust (recast) its financial statements for each prior period presented. Thus, financial statement
information about prior periods is on the same basis as the new accounting policy.
2. Adjust the carrying amounts of assets and liabilities as of the beginning of the first year
presented. By doing so, these accounts reflect the cumulative effect on periods prior to those
presented of the change to the new accounting policy. The company also makes an offsetting
adjustment to the opening balance of retained earnings or other appropriate component of equity
or net assets as of the beginning of the first year presented.

Direct and Indirect Effects of Changes

Direct Effects

The IASB takes the position that companies should retrospectively apply the direct effects of a change in
accounting policy. An example of a direct effect is an adjustment to an inventory balance as a result of a
change in the inventory valuation method.

Indirect Effects

In addition to direct effects, companies can have indirect effects related to a change in accounting policy.
An indirect effect is any change to current or future cash flows of a company that result from making a
change in accounting policy that is applied retrospectively.

Impracticability

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Retrospective application is considered impracticable if a company cannot determine the prior period
effects using every reasonable effort to do so.

Companies should not use retrospective application if one of the following conditions exists:

1. The company cannot determine the effects of the retrospective application.

2. Retrospective application requires assumptions about management’s intent in a prior period.
3. Retrospective application requires significant estimates for a prior period, and the company
cannot objectively verify the necessary information to develop these estimates.

CHANGES IN ACCOUNTING ESTIMATES

To prepare financial statements, companies must estimate the effects of future conditions and events. A
company cannot perceive future conditions and events and their effects with certainty. Therefore,
estimating requires the exercise of judgment. Accounting estimates will change as new events occur, as a
company acquires more experience, or as it obtains additional information.

Prospective Reporting

Companies report prospectively changes in accounting estimates. That is, companies should not adjust
previously reported results for changes in estimates. Instead, they ac-count for the effects of all changes in
estimates in (1) the period of change if the change affects that period only (e.g., a change in the estimate
of the amount of bad debts affects only the current period’s income), or (2) the period of change and
future periods if the change affects both (e.g., a change in the estimated useful life of a depreciable asset
affects depreciation expense in the current and future periods). The IASB views changes in estimates as
normal recurring corrections and adjustments, the natural result of the accounting process. It prohibits
retrospective treatment.

Disclosures

A company should disclose the nature and amount of a change in an accounting estimate that has an
effect in the current period or is expected to have an effect in future periods (unless it is impracticable to
estimate that effect).

C. Recording and Reporting

Retrospective Accounting Change: Long-Term Contracts
To illustrate the retrospective approach, assume that Denson Company has accounted for its income from
long-term construction contracts using the cost-recovery (zero-profit) method. In 2015, the company

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changed to the percentage-of-completion method. Management believes this approach provides a more
appropriate measure of the income earned. For tax purposes, the company uses the cost-recovery method
and plans to continue doing so in the future. (We assume a 40 percent enacted tax rate.)

COST-RECOVERY METHOD
DENSON COMPANY
INCOME STATEMENT (PARTIAL)
FOR THE YEAR ENDED DECEMBER 31

2013 2014 2015

Income BIT €400,0000 €160,000 €190,000

Inckme tax (40%) 160,000 64,000 76,000

Net income €240,000 €96,000 €114,000

PERCENTAGE-OF-COMPLETION METHOD
DENSON COMPANY
INCOME STATEMENT (PARTIAL)
FOR THE YEAR ENDED DECEMBER 31

2013 2014 2015

Income BIT €600,0000 €180,000 €200,000

Inckme tax (40%) 240,000 72,000 80,000

Net income €360,000 €108,000 €120,000

Identify various effects on the data :

Pretax Income from Difference in Income
Percentage-of- Cost- Tax Effect Income Effect
Year Completion Recovery Difference. 40% (net of tax)
Prior to 2014 €600,000 €400,000 €200,000 €80,000 €120,000
In 2014 180,000 160,000 20,000 8,000 12,000
Total at beginning
of 2015 €780,000 €560,000 €220,000 €88,000 €132,000

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Total in 2015 €200,000 €190,000 € 10,000 € 4,000 € 6,000

To record the change at the beginning of 2015 :

Construction in Process 220,000
Deferred Tax Liability 220,000
Retained Earnings 220,000

Reporting a Change in Policy :

DENSON COMPANY
INCOME STATEMENT (PARTIAL)
FOR THE YEAR ENDED
2015 2014
Income before income tax 200,000 180,000
Income tax (40%) 80,000 72,000
Net income 120,000 108,000
Note A : Change in Method of Accounting for Long-Term Contacts.

Retained Earnings Adjustment :

DENSON COMPANY
INCOME STATEMENT (PARTIAL)
FOR THE YEAR ENDED
2015 2014 2013
Income before income tax 1,696,000 1,600,000 1,360,000
Income tax (40%) 114,000 96,000 240,000
Net income 1,810,000 1,696,000 1,600,000

The difference between the retained earnings balances is computed as follows.

Retained earnings, January 1, 2014 (percentage-of-completion) €1,720,000
Retained earnings, January 1, 2014 (cost-recovery) 1,600,000
Cumulative-effect difference € 120,000

Comparative retained earnings statement for 2014 and 2015 :

DENSON COMPANY
RETAINED EARNINGS STATEMENT

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 FOR THE YEAR ENDED
2015 2014
Retained earnings, January 1, as reported 200,000 180,000
Add : Adjustment for the cumulative effect
prior years of applying retrospectively
the new method of accounting for
construction contracts 120,000
Retained earnings, January 1, as adjus 1,828,000 1,720,000
Net income 120,000 108,000
Retained earnings, December 31 1,948,000 1,828,000

For the Inventory Method can be seen on the book.

Error Corretion :
To illustrate, in 2016 the bookkeeper for Selectro Company discovered an error: In 2015, the
company failed to record £20,000 of depreciation expense on a newly constructed building. This
building is the only depreciable asset Selectro owns. The company correctly included the depreciation
expense in its tax return and correctly reported its income taxes payable. Illustration 22-17 (on page
1142) presents Selectro’s income statement for 2015 (starting with income before depreciation
expense) with and without the error

SELECTRO COMPANY
INCOME STATEMENT
FOR THE YEAR ENDED, DECEMBER 31, 2015
Without Error With Error
Income before depreciation expense £100,000 £100,000
Depreciation expense 20,000 0
Income before income tax 80,000 100,000
Current £32,000 £32,000
Deferred –0– 32,000 8,000 40,000
Net income £ 48,000 £ 60,000

These are the entries that Selectro should have made and did make for recording depreciation expense
and income taxes.

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 Entries Company Should Have Made Entries Company Did Make
(Without Error) (With Error)
Depreciation Expense 20,000 No entry made for depreciation
Accumulated
Depreciation—Buildings 20,000
Income Tax Expense 32,000 Income Tax Expense 40,000
Income Taxes Payable 32,000 Deferred Tax Liability 8,000
Income Taxes Payable 32,000

The £20,000 omission error in 2015 results in the following effects.

Income Statement Effects
Depreciation expense (2015) is understated £20,000.
Income tax expense (2015) is overstated £8,000 (£20,000 3 40%).
Net income (2015) is overstated £12,000 (£20,000 2 £8,000).
Statement of Financial Position Effects
Accumulated depreciation—buildings is understated £20,000.
Deferred tax liability is overstated £8,000 (£20,000 3 40%).

To make the proper correcting entry in 2016, Selectro should recognize that net income in 2015 is
overstated by £12,000, the Deferred Tax Liability is overstated by £8,000, and Accumulated
Depreciation—Buildings is understated by £20,000. The entry to correct this error in 2016 is as
follows.
Retained Earnings 12,000
Deferred Tax Liability 8,000
Accumulated Depreciation—Buildings 20,000
D. Example and Explanation

For example, $1000 worth of salaries payable wasn’t recorded (an error of omission). To make the
correction, a journal entry of $1000 must be added under “salary expense” (debit) and $1000 added as
“salary payable” (credit).

Errors from the previous year can affect your current books. The way around this is to add backdated
correcting entries.

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 For example, the mistake in the previous example was made in 2017. To make the correction, add the
$1000 debit and credit dated December 31, 2017.

CHAPTER 4

STATEMENT OF CASH FLOWS

A. Definition
Statement of cash flows is a financial statement that reports cash receipts, cash payments,
and net change in cash resulting from a company’s operating, investing, and financing activities
during a period. Its primary purpose is to provide information about company’s cash receipt and
cash payments during a period. Its secondary purpose is to provide cash-basis information about the
company’s operating, investing, and financing activities.
Usefulness of the statement of cash flows :
 The entity’s ability to generate future cash flows.
 The entity’s ability to pay dividends and meet obligations.
 The reasons for the difference between net income and net cash flow from operating.
 The cash and non-cash investing and financing transaction during a period.

B. Valuation

Classification of cash flows :

 Operating activities
The cash effects of transactions that enter into the determination of net income, such
as cash receipts from sales of goods and services, and cash payments to suppliers and employees
for acquisitions of inventory and expenses.
 Investing activities
Generally involve non-current assets and include making/collecting loans, and
acquiring and disposing of investments and productive long-lived assets.
 Financing activities
Involve liability and equity items and include obtaining cash from creditors and
repaying the amounts borrowed, and obtaining capital from owners and providing them with a
return on, and a return of, their investment.

C. Recording and Reporting

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Steps in Preparation :
Illustration—Tax Consultant Inc.
The company started on January 1, 2015, when it issued 60,000 ordinary shares of $1 par value for
$60,000 cash. The company rented its office space, furniture, and equipment, and performed tax
consulting services throughout the first year. The comparative statements of financial position at the
beginning and end of the year 2015.

TAX CONSULTANTS INC.

COMPARATIVE STATEMENTS OF FINANCIAL POSITION
Change
Assets Dec. 31, 2015 Jan. 1, 2015 Increase/Decrease
Accounts receivable . $36,000 $–0– $36,000 Increase
Cash 49,000 –0– 49,000 Increase
Total $85,000 $–0–

Equity and Liabilities

Ordinary shares ($1 par) $60,000 $–0– $60,000 Increase
Retained earnings 20,000 –0– 20,000 Increase
Accounts payable 5,000 –0– 5,000 Increase
Total $85,000 $–0–

This shows an income statement and additional information for Tax Consultants.

TAX CONSULTANTS INC.

INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2015
Revenues $125,000
Operating expenses 85,000
Income before income taxes 40,000
Income tax expense 6,000
Net income $ 34,000
Additional Information:

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 Examination of selected data indicates that a dividend of $14,000 was declared and paid during
the year.

Step 1: Determine the Change in Cash

Tax Consultant had no cash on hand at the beginning of the year 2015. It had $49,000 on hand at the
end of 2015. Thus, cash changed (increased) in 2015 by $49,000.

Step 2: Determine Net Cash from Operating Activities

Increase in Accounts Receivable—Indirect Method
Accounts Receivable
1/1/15 Balance –0– Receipts from customer 89,000
Revenues 125,000
12/31/15 Balance 36,000
Increase in Accounts Payable—Indirect Method
Net income $34,000
Adjustments to reconcile net income to net
cash provided by operating activities:
Increase in accounts receivable $(36,000)
Increase in accounts payable 5,000 (31,000)
Net cash provided by operating activities $ 3,000

Step 3: Determine Net Cash Flows from Investing and Financing Activities
Two items caused of $34,000 increased retained earnings.
 Net income of $34,000 increased retained earnings.
 Declaration of $14,000 of dividends decreased retained earnings.

Statement of Cash Flows—2015

TAX CONSULTANTS INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2015
INCREASE (DECREASE) IN CASH
Cash flows from operating activities
Net income $ 34,000
Adjustments to reconcile net income to net

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 cash provided by operating activities:
Increase in accounts receivable $(36,000)
Increase in accounts payable 5,000 (31,000)
Net cash provided by operating activities 3,000
Cash flows from financing activities
Issuance of ordinary shares 60,000
Payment of cash dividends (14,000)
Net cash provided by financing activities 46,000
Net increase in cash 49,000
Cash, January 1, 2015 –0–
Cash, December 31, 2015 $ 49,000

D. Example and Explanation

All the explanation above related to recording and reporting is quite clear. But here will be explained
a little about the identification of each transaction to operating, investing, or financing.
Each of the following items must be considered in preparing a statement of cash flows (indirect
method) for Granderson Inc. For the year ended December 31, 2015.
a. Plant assets that had cost $20,000 6 years before and were being depreciated on a straight-line
basis over 10 years with no estimated scrap value were sold for $5,300. (increases cash flows
from investing activities)
b. During the year, 10,000 shares of common stock with a stated value of $10 a share were issued
for $43 a share. (increases cash flows from financing activities)
c. Uncollectible accounts receivable in the amount of $27,000 were written off against Allowance
for Doubtful Accounts. (this corresponds to bad debt expense which is included in the income
statement)
d. The company sustained a net loss for the year of $50,000. Depreciation amounted to $22,000, and
a gain of $9,000 was realized on the sale of land for $39,000 cash. (the net loss and the gain on
the sale of land decreases the cash flows from operating activities, while the depreciation
expense increases it, the $39,000 received will increase cash flow from investing activities)
e. A 3-month U.S. Treasury bill was purchased for $100,000. The company uses a cash and cash
equivalent basis for its cash flow statement. (not included in teh cash flow statements)
f. Patent amortization for the year was $20,000. (increases cash flow from operating activities (in
a similar way than depreciation)

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g. The company exchanged common stock for a 70% interest in Tabasco Co. for $900,000. (this is a
non-cash financing and investing activity)
h. During the year, treasury stock costing $47,000 was purchased. (decreases cash flow from
financing activities)

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