Chapter 5

Question 1

What is a provision, and when must a provision be recognized?

Answer 1

A provision is a liability of uncertain timing or amount. A provision must be recognized when: (1) there is a present obligation, (2) an outflow of resources to settle the obligation is probable, and (3) the obligation can be reliably estimated.

Question 2

What is a contingent liability? What is the financial reporting treatment for contingent liabilities?

Answer 2

A contingent liability is (a) a possible obligation or (b) a present obligation that is not recognized as a provision because (1) an outflow of resources to settle the obligation is not probable or (2) the obligation cannot be reliably estimated. Contingent liabilities are disclosed unless the likelihood of an outflow of resources is remote.

Question 3

What is a constructive obligation?

Answer 3

A constructive obligation exists when an entity, through past actions or current statements, indicates it will accept certain responsibilities and as a result creates a valid expectation on the part of other parties that it will discharge those responsibilities.

Question 4

What is an onerous contract? How are onerous contracts accounted for?

Answer 4

An onerous contract exists when the unavoidable costs of meeting the obligation of the contract exceed the economic benefits expected to be received from it. An onerous contract must be recognized as a provision with an offsetting decrease in net income.

Question 5

How does a company measure the net pension benefit liability (asset) to report on the balance sheet under IFRS and U.S. GAAP?

Answer 5

The net amount recognized as a pension liability (or asset) is measured as:
+ Present value of the defined benefit obligation (PVDBO)
- Fair value of plan assets
+/- Unrecognized actuarial gains (+) and losses (-)
- Unrecognized past service cost

If the resulting amount is negative (net pension asset), the amount of asset to be reported on the balance sheet is limited to sum of the following:
• unrecognized actuarial losses
• past service cost
• present value of any refunds available from the plan
• any available reduction in future employer contributions to the plan.

Under U.S. GAAP, the pension liability or asset is simply measured as:
+ Present value of the defined benefit obligation (PVDBO)
- Fair value of plan assets
There is no limit to the amount recognized as a net pension asset.

Question 6

In accounting for post-employment benefits, when are past service costs and actuarial gains and losses recognized in income?

Answer 6

Past service costs related to:

a. vested and inactive/retired employees are recognized immediately, and
b. non-vested employees are recognized over the remaining vesting period.

Actuarial gains/losses related to:

a. inactive/retired employees are recognized immediately, and
b. active (vested and non-vested) employees are recognized over their remaining working life.

Question 7

At what point in time should a company recognize the liability and expense associated with termination benefits? What is the basis for measuring the amount of termination benefits to recognize?

Answer 7

Termination benefits should be recognized as an expense and a liability when an employer is demonstrably committed to an employee termination plan. The amount recognized should be based on the number of employees expected to accept the offer.

Question 8

What is the basis for determining compensation cost in an equity-settled share-based payment transaction with non-employees? With employees?

Answer 8

Compensation cost in an equity-settled share-based payment (SBP) transaction with non-employees should be based on the fair value of the goods or services received. If this cannot be reliably determined, then the fair value of the equity instruments should be used to determine compensation cost.
Compensation cost in an equity-settled share-based payment (SBP) transaction with employees should be based on the fair value of the equity instruments granted because the fair value of the employee’s services generally is not reliably measurable.

Question 9

What is the difference in measuring compensation expense associated with stock options that vest on a single date (cliff vesting) and in installments (graded vesting)?

Answer 9

Compensation cost associated with stock options that vest on a single date is recognized as expense on a straight-line basis over the vesting period. When stock options vest in installments, the compensation cost associated with each installment is recognized as expense on a straight-line basis over that installment’s vesting period.

Question 10

How does an entity account for a choice-of-settlement share-based payment transaction?

Answer 10

In a choice-of-settlement share-based payment (SBP) transaction in which the supplier of goods and services has the choice, the entity has created a compound financial instrument which must be split into its debt and equity components.

Question 11

Which income tax rates should be used in accounting for income taxes?

Answer 11

Income tax rates that have been enacted or substantively enacted should be used in measuring current and deferred income taxes. In jurisdictions in which distributed profits are taxed at a different rate from undistributed profits, the tax rate on undistributed profits should be used to measure current and deferred income taxes.

Question 12

What are the rules related to the recognition of a deferred tax asset?

Answer 12

A deferred tax asset is recognized only when it is probable that a tax benefit will be realized in the future.

Question 13

What approaches are available for disclosing the relationship between tax expense and accounting profit?

Answer 13

IAS 12 requires an explanation of the relationship between tax expense and accounting profit using one of two approaches: (a) a numerical reconciliation between tax expense and the product of accounting profit multiplied by the applicable tax rate, or (b) a numerical reconciliation between the average effective tax rate and the applicable tax rate.

Question 14

How are deferred taxes classified on the balance sheet?

Answer 14

Deferred taxes are classified as noncurrent items on the balance sheet.

Question 15

What are the criteria that must be met in order to recognize revenue from the sale of goods?

Answer 15

Five criteria must be met to recognize revenue from the sale of goods:

1. The significant risks and rewards of ownership of the goods have been transferred to the buyer.
2. Neither continuing managerial involvement normally associated with ownership nor effective control of the goods sold is retained.
3. The amount of revenue can be measured reliably.
4. It is probable that the economic benefits associated with the sale will flow to the seller.
5. The costs incurred or to be incurred with respect to the sale of goods can be measured reliably.

Question 16

What approaches are used to recognize revenue from the rendering of services? Under what conditions is each of these approaches used?

Answer 16

Revenue from the rendering of services is recognized using either (a) the stage of completion method or (b) the cost recovery method. The stage of completion method is appropriate when the outcome of a service transaction (1) can be estimated reliably and (2) it is probable that economic benefits of the transaction will flow to the enterprise; otherwise, the cost recovery method should be used.

Question 17

How is an exchange of goods that are similar in nature and value accounted for?

Answer 17

There is no gain or loss recognized when assets that are similar in nature and value are exchanged; the asset acquired is measured at the carrying amount of the asset given up.

Question 18

Under what conditions may revenue be recognized on a “bill-and-hold” sale?

Answer 18

Revenue may be recognized on a bill and hold sale when:

a. It is probable that delivery will be made,
b. The item is on hand, identified, and ready for delivery to the buyer at the time the sale is recognized,
c. The buyer specifically acknowledges the deferred delivery instructions, and
d. The usual payment terms apply.

Question 19

What is a customer loyalty program, and how is such a program accounted for?

Answer 19

A customer loyalty program provides customers with “award credits” at the time a purchase is made that the customer can convert into goods and/or services when a sufficient number of credits have been accumulated. Airline frequent flyer programs are an example. The fair value of the consideration received on the sale that provides customers with award credits must be allocated between the award credits and the other components of the sale. The amount allocated to the award credits, based on their fair value, is recognized as a liability (deferred revenue) until the award credits are redeemed.

Question 20

What are the five steps to follow in revenue recognition as proposed in the IASB/FASB exposure draft on revenue from contracts with customers?

Answer 20

The five steps to follow in revenue recognition as proposed in the IASB-FASB exposure draft Revenue from Contracts with Customers are:

1. Identify the contract with a customer.
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 the revenue allocated to each performance obligation when the entity satisfies each performance obligation.

Question 21

What are the four classes of financial assets?

Answer 21

The four classes of financial assets are:
• Financial assets at fair value through profit or loss (FVPL)
• Held-to-maturity investments.
• Loans and receivables.
• Available-for-sale financial assets.

Question 22

Under what conditions should preferred shares be recognized as a liability on the balance sheet?

Answer 22

Preferred shares should be recognized as a liability on the balance sheet when they are redeemable by the shareholder and the issuer cannot avoid the payment of cash to the shareholders if they redeem their shares. Preferred shares that are contingently redeemable based on future events outside the control of the issuer also should be classified as a liability.

Question 23

How are convertible bonds measured initially on the balance sheet?

Answer 23

Convertible bonds are a compound financial instrument subject to “split accounting.” Upon initial recognition and measurement, convertible bonds are split into their debt and equity components using a with-and-without approach.

Question 24

How can use of the “fair value option” solve the problem of an accounting mismatch?

Answer 24

When (1) a financial instrument measured at fair value through profit or loss is hedged with (2) a financial instrument classified as available-for-sale, the gain/loss on (1) will be reported in net income but the gain/loss on (2) will be taken to other comprehensive income. As a result, a net gain/loss in reported in net income that is not economically meaningful. Adopting the fair value option for (2) removes this accounting mismatch.

Question 25

What happens if a significant amount of held-to-maturity investments is reclassified as available-for-sale?

Answer 25

An entity is prohibited from classifying financial instruments as held-to-maturity for two years in this situation.

Question 26

How are costs associated with the issuance of bonds payable accounted for?

Answer 26

Bond issuance costs reduce the fair value of the bonds payable and are subtracted in determining their initial carrying amount.

Question 27

What is the accounting treatment for debt extinguishment costs? Debt modification costs?

Answer 27

Debt extinguishment costs are included in the calculation of the gain/loss on debt extinguishment, resulting in a larger loss or a smaller gain.
Debt modification costs are treated in a similar fashion to debt issuance costs; they reduce the carrying amount of the debt being modified.

Question 28

In a sale of receivables described as a pass through arrangement, under what conditions can receivables be derecognized?

Answer 28

Derecognition of receivables in a so-called pass through arrangement is appropriate only if each of the following criteria is met:

(a) The entity has no obligation to pay cash to the buyer of the receivables unless it collects equivalent amounts from the receivables.
(b) The entity is prohibited by the terms of the transfer contract from selling or pledging the receivables.
(c) The entity has an obligation to remit any cash flows it collects on the receivables to the eventual recipient without material delay. In addition, the entity is not entitled to reinvest such cash flows. An exception exists for investments in cash equivalents during the short settlement period from the collection date to the date of remittance to the eventual recipients, as long as interest earned on such investments also is passed to the eventual recipients.

Question 29

LO1: Describe and apply the requirements of International Financial Reporting Standards (IFRS) related to the financial reporting of current liabilities, provisions, employee benefits, share-based payment, income taxes, revenue, and financial instruments.

Answer 29

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Question 30

LO2: Explain and analyze the effect of major differences between IFRS and U.S. GAAP related to the financial reporting of current liabilities, provisions, employee benefits, share-based payment, income taxes, revenue, and financial instruments.

Answer 30

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