CHAPTER THREE

CASH AND RECEIVABLES

3.1 Cash and Internal Control
3.1.1 Nature of Cash
Cash, the most liquid of assets, is the standard medium of exchange and the basis for measuring
and accounting for all other items in financial accounting. Cash consists of coin, currency,
available funds on deposit at the bank and negotiable instruments. Companies report it in their
financial statement under current asset as cash and cash equivalent.

Negotiable instruments such as money orders, certified checks, cashier’s checks, personal
checks, and bank drafts are also viewed as cash. Banks do have the legal right to demand notice
before withdrawal. But, because banks rarely demand prior notice, savings accounts are
considered cash.

Some negotiable instruments provide small investors with an opportunity to earn interest. These
items, more appropriately classified as temporary investments than as cash, include money
market funds, money market savings certificates, certificates of deposit (CDs), and similar types
of deposits and ―short-term paper.‖ These securities usually contain restrictions or penalties on
their conversion to cash. Money market funds that provide checking account privileges,
however, are usually classified as cash.

Certain items present classification problems: Companies treat postdated checks and I.O.U.s as
receivables. They also treat travel advances as receivables if collected from employees or
deducted from their salaries. Otherwise, companies classify the travel advance as a prepaid
expense. Postage stamps on hand are classified as part of office supplies inventory or as a
prepaid expense. Because petty cash funds and change funds are used to meet current operating
expenses and liquidate current liabilities, companies include these funds in current assets as cash.

3.2 Types of Main Bank Accounts

Banks as their primary function accept deposit. The bank accepts deposits from those that can
save (individuals, companies, and government). People consider it more rational to deposit their
savings in a bank because by doing so they, earn interest and avoid the danger of theft. To attract
savings from all sorts of individuals, the banks maintain different types of accounts:
 Fixed deposit account
 Current deposit account
 Saving deposit account
i. Fixed deposit Accounts
They are money deposited for a specific period of time. They are also known as time liabilities.
Interest is calculated for the whole amount for the same period. If the depositor withdraws the
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deposit before the expiry date, the depositor will pay penalty rate plus the banker should be
willing to pay before the expiry date.
ii. Current deposit accounts
Current accounts are checkable accounts or demand deposit accounts. Current accounts are
operated through cheques. Here the bank undertakes the obligation of paying all cheques drawn
against it by the customer till it has adequate funds of the customer with it. The main purpose of
current accounts is convenience of payments. Current account is owned by businesspersons and
firms.
iii. Saving Deposit Accounts
Saving deposit accounts are opened by individual savers and small business owners. It is opened
for saving purpose- to keep the money away from oneself and thieves. Those savers with huge
money are advised to open current accounts. Frequent withdrawals are not allowed from saving
accounts. Interest is generally calculated on monthly basis on the minimum balances that remains
in the account.
3.2.1. Cash control
In organizations internal control methods, procedures, rules and policies are adopted; the main
purpose of having internal control systems in organizations is to assure that assets that belong to
business enterprise are received when tendered; protected while in the custody of the enterprise
and used only for authorized business purposes.

Cash is the asset most susceptible to improper diversion and use. Management faces two
problems in accounting for cash transactions: (1) to establish proper controls to prevent any
unauthorized transactions by officers or employees, and (2) to provide information necessary to
properly manage cash on hand and cash transactions. Some of the basic control issues related to
cash are:

Using bank accounts: A company can vary the number and location of banks and the
types of accounts to obtain desired control objectives.
The imprest petty cash system: It may be impractical to require that small amounts of
various expenses be paid by check, yet some control over them is important.
Physical protection of cash balances: Adequate control of receipts and disbursements is a
part of the protection of cash balances. Every effort should be made to minimize the cash
on hand in the office.
Reconciliation of bank balances: Cash on deposit is not available for count and is proved
by preparing a bank reconciliation.
3.2.1.1. Internal control procedures
A system of internal control is not designed primarily to detect errors but rather to reduce the
opportunity of errors or dishonesty to occur. Effective system of internal control procedures
should consider the following points:

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i. Segregation of duties; like separating one that works on custody with record keeper,
purchaser or receiver of purchased item. Here the separation of duties enables to protect
assets against either fraud or error. In addition, the work of one helps to cross check the
other.
ii. Assignment of Responsibilities and Authorities; giving a specific authority to a specific
body helps a company to create responsibility and accountability in the actions of each party,
department or division. For example, to set an internal control procedure for cash payments
on enterprise could set a purchase procedure which gives responsibility to order and acquire
goods to purchase department maintain a record and make payments for invoices to
accounting and finance department and receive the purchased stocks to receiving department.
iii. Using mechanical devices and pre-numbered documents; using cash registers, check
protector holes and pre-numbered business forms are very helpful to ensure the accuracy and
reliability of accounting data.
iv. Maintaining physical safeguarding tools; for example, safe boxes, drawers with lockers,
having daily deposits etc.
v. Implementing periodical performance evaluation methods; evaluating helps to take
periodical corrections and to take sure that regulations are properly implemented.
vi. Hiring competent employee and having computer help, creates to have efficient and
accurate record keeping and report preparation function
vii. Planning (budgeting): - forecasting cash necessary for future operations such as through
preparing periodic cash budgets
3.2.1.2 Control over cash receipts
Control over cash is required to safeguard all cash inflows or assure that all cash receivables by
the enterprise is collected and recorded without loss. It includes: Immediate counting; Daily
recording and intact deposit.

3.2.1.3 Control over cash payments

The main objective of control over cash payments is to ensure no authorized payments are made.
It includes; verifying and approving payments for example by using voucher system; Making
payments by checks and Periodic preparation of Bank reconciliation

3.2.1.4 Elements of internal control

Petty cash fund: A petty cash fund refers to a fund of fixed amount used for small expenditures
that are most conveniently paid in cash such as payments for taxi fare, postage stamps, minor
amount of supplies etc.

Establishment: Estimate the required amount of payment to meet minor expenditures for
specified period. Petty Cash fund xx
Cash xx

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Operation: As each cash payment is made from the petty cash fund, prepare a voucher or other
receipts. No Journal entry needed.

Replenishment: petty cash fund is replenished when it reaches minimum cash balance and at the
end of the accounting period to recognize the periodic expenses paid from the fund and to report
the yearend cash balance correctly. The vouchers or receipts will be reviewed and a check will
be issued on the total amount of the vouchers to restore the petty cash fund to its original
amount. Journal Entries at the time of replenishment will be

Various expenses xx
Cash xx

Illustration: On January 1, 2020 ABC Company established a petty cash fund to make payments
for minor expenditures, for $ 500. During January the petty cash vouchers indicate payments are
made for the following transactions

Postage Expenses 189.60

Office Supplies 112.75
Minor repair Expenses 60.05
Miscellaneous expense 40.00
On January 28, the custodian requested replenishment for items paid to date and the cash
balance in the petty cash box is $ 95.20. Now let us see the record that ABC Company will have
at the establishment of petty cash fund and at the replenishment of the fund respectively.

Petty cash funds 500

Cash 500
Replenishment Entry:

Postage Expenses 189.60

Office Supplies 112.75
Minor repair Expenses 60.05
Miscellaneous expense 40.00
Cash short and over 2.40
Cash 404.80

The cash shortage and overage ledger account is classified as revenue when it has credit balance
and as expense when it has a debit balance.
Cash Change Fund: A change fund is used to facilitate the collection of cash from customers
Establishment: Estimate the required types and amounts denominations.

Cash change fund xx

Cash xx

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Operation: Make the necessary changes and deduct the amount of the change fund from the total
cash money on hand at the close of each business day to determine the daily collections. No
Journal entry will be required.

3.3 Bank Reconciliation

Bank checking account (Reconciliation of bank balances): Enterprises usually open checking
account in a bank to have a daily deposit of all cash collections and to make payments from the
bank by issuing checks. Periodically banks prepare bank statement, which is a summary of cash
deposit and out lays made from each checking account of the depositor. Similarly, the depositor
will have a ledger account to record daily cash transactions in the bank account. Usually, the
cash balance indicated in a bank statement seldom agrees with cash balance indicated by the
depositor’s ledger account for the specific period. Bank reconciliation is a schedule that
analyzes and explains the difference between the ending balance of cash in a bank and bank
statement.
Preparing the above bank reconciliation will have the following three functions.

1. It helps to determine the correct cash balance to be reported in the balance sheet.
2. To disclose errors made in recording cash transactions, either by the bank or by the depositor,
and
3. To provide information necessary to bring the accounting records up to date.

After bank reconciliation statement is made, all items appearing in the reconciliation as additions
to or deductions from the ―balance in the depositor’s record" must be included in the journal
entry.
The possible reasons for the difference between two balances could be
Delay in recording transactions:
 Deposits in transit. End-of-month deposits of cash recorded on the depositor’s books
in one month are received and recorded by the bank in the following month.
 Outstanding checks. Checks written by the depositor are recorded when written but
may not be recorded by (may not ―clear‖) the bank until the next month.
 Bank charges. Charges recorded by the bank against the depositor’s balance for such
items as bank services, printing checks, not-sufficient-funds (NSF) checks, and safe-
deposit box rentals. The depositor may not be aware of these charges until the receipt
of the bank statement.
 Bank credits. Collections or deposits by the bank for the benefit of the depositor that
may be unknown to the depositor until receipt of the bank statement. Examples are

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 note collection for the depositor and interest earned on interest bearing checking
accounts.
Errors or omissions in recording transactions

 Bank or depositor errors. Errors on either the part of the bank or the part of the
depositor cause the bank balance to disagree with the depositor’s book balance.

Note that, adjustment entries are required for transactions and events that are not included in the
depositor record and for the errors, which are made in recording by the depositor. However, for
transactions that is not recorded by bank and for the differences that are self-correcting such as,
deposit in transit, outstanding checks, adjustment entries, will not be required. But for the errors
made by the bank it should be called for correction by writing a memorandum to the bank.
The two commonly used forms of bank reconciliation are:

1. Reconcile both bank balance and depositors balance to correct cash balance (Direct method).
2. Reconcile the bank balance to the balance in the depositor's record (Indirect method)
Illustration:
1. A deposit of $3,680 that Nugget mailed November 30 does not appear on the bank
statement.
2. Checks written in November but not charged to the November bank statement are:
Check
$ 150
#7327
#7348 4,820
#7349 31
3. Nugget has not yet recorded the $600 of interest collected by the bank November 20 on
Sequoia Co. bonds held by the bank for Nugget.
4. Bank service charges of $18 are not yet recorded on Nugget’s books.
5. The bank returned one of Nugget’s customer’s checks for $220 with the bank
statement, marked ―NSF.‖ The bank treated this bad check as a disbursement.
6. Nugget discovered that it incorrectly recorded check #7322, written in November for
$131 in payment of an account payable, as $311.
7. A check for Nugent Oil Co. in the amount of $175 that the bank incorrectly charged to
Nugget accompanied the statement. Required:
i) Prepare bank reconciliation schedule for Awash Company for the month of December.
ii) Make the necessary journal entries.
1. Direct Method
Under this method reconciliation will be made to bring both unadjusted balance in a bank and a
depositor’s record to the adjusted or correct balances.

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 Nugget Mining Company
Bank Reconciliation
Denver National Bank, November 30, 2022
Balance per bank statement (end of period) $22,190
Add: Deposit in transit (1) $3,680
Bank error—incorrect check charged to
(7) 175 3,855
account by bank
Sub total 26,045
Deduct: Outstanding checks (2) 5,001
Correct cash balance $21,044
Balance per books $20,502
Add: Interest collected by the bank (3) $600
Error in recording check #7322 (6) 180 780
Sub total 21,282
Deduct: Bank service charges (4) 18
NSF check returned (5) 220 238
Correct cash balance $21,044
The journal entry on November 30, 2022 to adjust the accounting records of Awash Company is
shown below:
Cash 542
Accounts Receivable 220
Miscellaneous Expenses 18
Interest revenue 600
Accounts Payable 180
2. Indirect method
Steps to use this method;
1st Reconcile the bank balance to the unadjusted cash account balance in the general ledger.

- Include all items that are not included in the bank statement
- Add the items that were deducted in the bank statement but not in the depositor’s cash
account record.
- Deduct the items that were added in the bank statement but not in the depositor’s cash account
record.
nd
2 Enter the required adjustments in the bank reconciliation to the cash account in the
depositor’s record.

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 Nugget Mining Company
Bank Reconciliation
Denver National Bank, November 30, 2022
Balance per bank statement (end of period) $22,190
Add: Deposit in transit (1) $3,680
Bank error—incorrect check charged to account by bank (7) 175
Bank service charges (4) 18
NSF check returned (5) 220 4093
Sub Total 26,283
Deduct: Outstanding checks (2) 5,001
Interest collected by the bank (3) $600
Error in recording check #7322 (6) 180 5,781
Balance per books $20,502
Adjustment 542
Correct cash balance $21,044

3.4 Reporting of Cash and disclosure requirements

3.4.1 Reporting Cash

These issues relate to the reporting of cash:

a) Cash Equivalents
Cash equivalents are short-term, highly liquid investments that are both (a) readily convertible to
known amounts of cash and (b) subject to an insignificant risk of changes in value. IFRS
suggests that only investments with original maturities of three months or less at acquisition
qualify under these definitions. In addition, the cash and cash equivalents should be held for the
purposes of meeting short-term cash commitments and not for investment purposes. Usually,
short term investments are not included as cash equivalent, if included the amount should be
specified either parenthetically or in the notes.

b) Restricted Cash
Restricted cash is a cash set aside for a particular purpose. E.g., petty cash, payroll, and dividend.
If the balance of these items is not material, they will be included as cash, if not they will be
reported in current assets or in the non-current assets section, depending on the date of
availability or disbursement.

c) Bank overdrafts
Bank overdrafts occur when a company writes a check for more than the amount in its cash
account. Companies should report bank overdrafts in the current liabilities (A/P, if the amount is
material it requires disclosure) but if such overdrafts are repayable on demand and are an integral

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part of a company’s cash management (offset able), they will be reported as the component of
cash.

Classification of Cash, Cash Equivalents, and Noncash Items

Item Classification Comment
Cash Cash If unrestricted, report as cash.
If restricted, identify and classify as
current and noncurrent assets.
Petty cash and change Cash Report as cash.
funds
Short-term paper Cash equivalents Investments with maturity of less
(<3m) than 3 months, often combined with
cash.
Short-term paper (3m- Investments with maturity of 3 to 12
Temporary investments
12m) months.
Postdated checks and
Receivables Assumed to be collectible.
IOU’s
Travel advances Receivables Assumed to be collected from
employees or deducted from their
salaries.
Postage on hand (as Prepaid expenses May also be classified as office
stamps or in postage supplies inventory.
meters)
Cash If no offsetting allowed, current
Bank overdrafts
liability
Classify as current or non-current in
the
Cash separately classified as a
Statement of financial position.
Compensating balances deposit maintained as
Disclose
compensating balance
separately in notes details of the
Arrangement.

3.4.2 Disclosure of Restricted Cash

Banks and other lending institutions often require customers to maintain minimum cash balances
in checking or savings accounts. These minimum balances, called compensating balances, are
―that portion of any demand deposit (or any time deposit or certificate of deposit) maintained by
a company which constitutes support for existing borrowing arrangements of the company with a
lending institution. Such arrangements would include both outstanding borrowings and the
assurance of future credit availability.

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To avoid misleading investors about the amount of cash available to meet recurring obligations,
companies should state separately legally restricted deposits held as compensating balances
against short-term borrowing arrangements among the ―Cash and cash equivalent items‖ in
current assets. Companies should classify separately restricted deposits held as compensating
balances against long-term borrowing arrangements as non-current assets in either the
investments or other assets sections, using a caption such as ―Cash on deposit maintained as
compensating balance.‖ In cases where compensating balance arrangements exist without
agreements that restrict the use of cash amounts shown on the statement of financial position,
companies should describe the arrangements and the amounts involved in the notes.

3.5 Recognition and Valuation of Accounts Receivables

3.5.1 Recognition of Account Receivable
In most receivables’ transactions, the amount to be recognized is the exchange price between the
two parties. The exchange price is the amount due from the debtor (a customer or a borrower).
Some type of business document, often an invoice, serves as evidence of the exchange price.
Two factors may complicate the measurement of the exchange price: (1) the availability of
discounts (trade and cash discounts), and (2) the length of time between the sale and the due date
of payments.
Trade Discounts
Prices may be subject to a trade or quantity discount. Companies use such trade discounts to
avoid frequent changes in catalogs, to alter prices for different quantities purchased, or to hide
the true invoice price from competitors. Trade discounts are commonly quoted in percentages.
For example, say your cell phone has a list price of $90, and the manufacturer sells it to Best Buy
for list less a 30 percent trade discount. The manufacturer then records the receivable at $63 per
phone. The manufacturer, per normal practice, simply deducts the trade discount from the list
price and bills the customer net.
Cash Discounts (Sales Discounts)
Companies offer cash discounts (sales discounts) to induce prompt payment. Cash discounts
generally presented in terms such as 2/10, n/30 (2 percent if paid within 10 days, gross amount
due in 30 days), or 2/10, E.O.M., net 30, E.O.M. Companies usually take sales discounts unless
their cash is severely limited.
Gross Method Net Method
Sales of $10,000, terms 2/10, n/30
Accounts Receivable 10,000 Accounts Receivable 9,800
Sales Revenue 10,000 Sales Revenue 9,800
Payment on $4,000 of sales received within discount period
Cash 3,920 Cash 3,920
Sales Discounts 80 Accounts 3,920
Accounts 4,000 Receivable
Receivable

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Payment on $6,000 of sales received after discount period
Cash 6,000 Accounts Receivable 120
Accounts 6,000 Sales Discounts 120
Receivable Forfeited
Cash 6,000
Accounts 6,000
Receivable

Sales Returns and Allowances

As part of the sales agreement, companies include a provision that if customers are dissatisfied
with the product, the company will grant an allowance on the sales price or agree to take the
product back. As a result, companies should record the accounts receivable and related revenue
at the amount of consideration expected to be received. The amount to be recorded will include
an estimate of sales returns.
Example: assume that on January 4, 2022, Max sells $5,000 of inventory on account. At the
time of the sale, Max expects, based on past experience the 8% of sales will be returned.

January 4, 2022
Accounts Receivable 5,000
Sales Revenue 4,600
Return Liability 400

On January 16, 2022, Max grants an allowance of $300 to Oliver because some of the
hurricane glasses are defective. The entry to record this transaction is as follows.

January 16, 2022

Return Liability 300
Accounts Receivable 300
Time Value of Money
Ideally, a company should measure receivables in terms of their present value, that is, the
discounted value of the cash to be received in the future. When expected cash receipts require a
waiting period, the receivable face amount is not worth the amount that the company ultimately
receives.

Assume that a company makes a sale on account for $1,000 with payment due in four months.
The applicable annual rate of interest is 12 percent, and payment is made at the end of four
months. The present value of that receivable is not €1,000 but $961.54 ($1,000 × .96154).

3.5.2 Valuation of Accounts Receivable

Reporting of receivables involves (1) classification and (2) valuation on the balance sheet.
Classification involves determining the length of time each receivable will be outstanding.

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Companies classify receivables intended to be collected within a year or the operating cycle,
whichever is longer, as current. All other receivables are classified as long-term.
Companies value and report short-term receivables at net realizable value—the net amount they
expect to receive in cash. Determining net realizable value requires estimating both uncollectible
receivables and any returns or allowances to be granted.
Uncollectible Accounts Receivable
As one revered accountant aptly noted, the credit manager’s idea of heaven probably would be a
place where everyone (eventually) paid his or her debts. Unfortunately, this situation often does
not occur. For example, a customer may not be able to pay because of a decline in its sales
revenue due to a downturn in the economy. Similarly, individuals may be laid off from their jobs
or faced with unexpected hospital bills. Companies record credit losses as debits to Bad Debt
Expense (or Uncollectible Accounts Expense). Such losses are a normal and necessary risk of
doing business on a credit basis.
Two methods are used in accounting for uncollectible accounts: (1) the direct write-off method
and (2) the allowance method. The following sections explain these methods.
Direct Write-Off Method for Uncollectible Accounts
Under the direct write-off method, when a company determines a particular account to be
uncollectible, it charges the loss to Bad Debt Expense. Assume, for example, that on December
10 Cruz Co. writes off as uncollectible Yusado’s $8,000 balance. The entry is:
Bad Debt Expense 8,000
Accounts Receivable (Yusado) 8,000
(To record write-off of Yusado account)
Under this method, Bad Debt Expense will show only actual losses from uncollectible. The
company will report accounts receivable at its gross amount. Supporters of the direct write-off-
method (which is often used for tax purposes) contend that it records facts, not estimates. It
assumes that a good account receivable resulted from each sale, and that later events revealed
certain accounts to be uncollectible and worthless. From a practical standpoint, this method is
simple and convenient to apply. But the direct write-off method is theoretically deficient: It
usually fails to record expenses in the same period as associated revenues. Nor does it result in
receivables being stated at net realizable value on the statement of financial position. As a result,
using the direct write-off method is not considered appropriate, except when the amount
uncollectible is immaterial.
Allowance Method for Uncollectible Accounts
The allowance method of accounting for bad debts involves estimating uncollectible accounts at
the end of each period. This ensures that companies state receivables on the balance sheet at their
net realizable value. Net realizable value is the net amount the company expects to receive in
cash. Thus, the allowance method is appropriate in situations where it is probable that an asset
has been impaired and that the amount of the loss can be reasonably estimated.

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Although estimates are involved, companies can predict the percentage of uncollectible
receivables from past experiences, present market conditions, and an analysis of the outstanding
balances. Many companies set their credit policies to provide for a certain percentage of
uncollectible accounts. (In fact, many feel that failure to reach that percentage means that they
are losing sales due to overly restrictive credit policies.) Thus, the IASB requires the allowance
method for financial reporting purposes when bad debts are material in amount. This method has
three essential features:
1. Companies estimate uncollectible accounts receivable. They match this estimated expense
against revenues in the same accounting period in which they record the revenues.
2. Companies debit estimated uncollectibles to Bad Debt Expense and credit them to Allowance
for Doubtful Accounts (a contra-asset account) through an adjusting entry at the end of each
period.
3. When companies write off a specific account, they debit actual uncollectibles to Allowance
for Doubtful Accounts and credit that amount to Accounts Receivable.
Recording Estimated Uncollectibles. To illustrate the allowance method, assume that Brown
Furniture has credit sales of $1,800,000 in 2012. Of this amount, $150,000 remains uncollected
at December 31. The credit manager estimates that $10,000 of these sales will be uncollectible.
The adjusting entry to record the estimated uncollectibles is:
Bad Debt Expense 10,000
Allowance for Doubtful Accounts 10,000
(To record estimate of uncollectible accounts)
Brown reports Bad Debt Expense in the income statement as an operating expense. Thus, the
estimated uncollectibles are matched with sales in 2012. Brown records the expense in the same
year it made the sales.
Company’s use a contra account instead of a direct credit to Accounts Receivable because they
do not know which customers will not pay. Companies do not close Allowance for Doubtful
Accounts at the end of the fiscal year.
Recording the Write-Off of an Uncollectible Account. When companies have exhausted all
means of collecting a past-due account and collection appears impossible, the company should
write off the account. In the credit card industry, for example, it is standard practice to write off
accounts that are 210 days past due.
To illustrate a receivables write-off, assume that the financial vice president of Brown Furniture
authorizes a write-off of the $1,000 balance owed by Randall Co. on March 1, 2013. The entry to
record the write-off is:
Allowance for Doubtful Accounts 1,000
Accounts Receivable (Randall Co.) 1,000
(Write-off of Randall Co. account)
Bad Debt Expense does not increase when the write-off occurs. Under the allowance method,
companies debit every bad debt write-off to the allowance account rather than to Bad Debt
Expense. A debit to Bad Debt Expense would be incorrect because the company has already

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recognized the expense when it made the adjusting entry for estimated bad debts. Instead, the
entry to record the write-off of an uncollectible account reduces both Accounts Receivable and
Allowance for Doubtful Accounts.
Recovery of an Uncollectible Account. Occasionally, a company collects from a customer after
it has written off the account as uncollectible. The company makes two entries to record the
recovery of a bad debt: (1) It reverses the entry made in writing off the account. This reinstates
the customer’s account. (2) It journalizes the collection in the usual manner. To illustrate, assume
that on July 1, Randall Co. pays the $1,000 amount that Brown had written off on March 1.
These are the entries:
Accounts Receivable (Randall Co.) 1,000
Allowance for Doubtful Accounts 1,000
(To reverse write-off of account)
Cash 1,000
Accounts Receivable (Randall Co.) 1,000
(Collection of account)
Note that the recovery of a bad debt, like the write-off of a bad debt, affects only balance sheet
accounts. The net effect of the two entries above is a debit to Cash and a credit to Allowance for
Doubtful Accounts for $1,000.
Estimating the Allowance. To simplify the preceding explanation, we assumed we knew the
amount of the expected uncollectibles. In ―real life,‖ companies must estimate that amount when
they use the allowance method.
Percentage-of-receivables (balance sheet) approach. Using past experience, a company can
estimate the percentage of its outstanding receivables that will become uncollectible, without
identifying specific accounts. This procedure provides a reasonably accurate estimate of the
receivables’ realizable value. But it does not fit the concept of matching cost and revenues.
Rather, it simply reports receivables in the statement of financial position at net realizable value.
Companies may apply this method using one composite rate that reflects an estimate of the
uncollectible receivables. Or, companies may set up an aging schedule of accounts receivable,
which applies a different percentage based on past experience to the various age categories. An
aging schedule also identifies which accounts require special attention by indicating the extent to
which certain accounts are past due.

WILSON & CO.

AGING SCHEDULE
Name of Customer Balance Under 60 60–90 91–120 Over 120
Dec. 31 days Days days days
Western Stainless-Steel Corp. $ 98,000 $ 80,000 $18,000
Brockway Steel Company 320,000 320,000
Freeport Sheet & Tube Co. 55,000 $55,000

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Allegheny Iron Works 74,000 60,000 $14,000
$547,000 $460,000 $18,000 $14,000 $55,000
Summary
Percentage Estimated to Be Required
Age Amount Uncollectible Balance in
Allowance
Under 60 days old $460,000 4% $18,400
60–90 days old 18,000 15% 2,700
91–120 days old 14,000 20% 2,800
Over 120 days 55,000 25% 13,750
Year-end balance of allowance for doubtful accounts $37,650
Wilson reports bad debt expense of $37,650 for this year, assuming that no balance existed in the
allowance account. To change the illustration slightly, assume that the allowance account had a
credit balance of $800 before adjustment. In this case, Wilson adds $36,850 ($37,650 – $800) to
the allowance account, and makes the following entry.
Bad Debt Expense 36,850
Allowance for Doubtful Accounts 36,850
3.6 Recognition and Valuation of Notes Receivables
A note receivable is supported by a formal promissory note, a written promise to pay a certain
sum of money at a specific future date. Such a note is a negotiable instrument that a maker signs
in favor of a designated payee who may legally and readily sell or otherwise transfer the note to
others. Although all notes contain an interest element because of the time value of money,
companies classify them as interest-bearing or non-interest-bearing. Interest-bearing notes have a
stated rate of interest. Zero-interest-bearing notes (non-interest-bearing) include interest as part
of their face amount. Notes receivable are considered fairly liquid, even if long-term, because
companies may easily convert them to cash (although they might pay a fee to do so). Companies
frequently accept notes receivable from customers who need to extend the payment period of an
outstanding receivable or they require notes from high-risk or new customers.
3.6.1. Recognition of Notes Receivables
Companies’ record and report long-term notes receivable at the present value of the cash they
expect to collect. When the interest stated on an interest-bearing note equals the effective
(market) rate of interest, the note is recorded at face value. When the stated rate differs from the
market rate, the cash exchanged (present value) differs from the face value of the note.
Companies then record this difference, either a discount or a premium, and amortize it over the
life of a note to approximate the effective (market) interest rate.

Example 1: A company received $10,000 in exchange for $10,000, three-year note bearing
interest at 10 percent annually. The market rate of interest for a note of similar risk is also 10
percent.

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 Face value of the note €10,000
Present value of the principal:
€10,000 (PVF3,10%) = €10,000 × .75132 €7,513
Present value of the interest:
€1,000 (PVF-OA3,10%) = €1,000 × 2.48685 2,487
Present value of the note (10,000)
Difference € –0
The recording will be

Notes Receivable 10,000

Sales 10,000
Bigelow recognizes interest revenue each year as follows.
Cash 1,000
Interest Revenue 1,000
Example 2: A company received present value of cash flow in exchange for $10,000, three-year
note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk
is also 12 percent.

Face value of the note €10,000

Present value of the principal:
€10,000 (PVF3,12%) = €10,000 × .71178 €7,118
Present value of the interest:
€1,000 (PVF-OA3,12%) = €1,000 × 2.40183 2,402
Present value of the note 9,520
Difference (Discount) € 480
The recording will be

Notes Receivable 9520

Sales 9520
The company recognizes interest revenue each year as follows.

Schedule of Note Discount Amortization, Effective-Interest Method, 10% Note Discounted at

12%
z Cash Received Interest Revenue Discount Amortized Carrying Amount of Note
Date of issue € 9,520
End of year 1 €1,000a €1,142b €142c 9,662d
End of year 2 1,000 1,159 159 9,821
End of year 3 1,000 1,179 179 10,000
€ 3,000 € 3,480 € 480

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 a €10,000 × .10 = €1,000 c €1,142 - €1,000 = €142
b €9,520 × .12 = €1,142 d €9,520 + €142 = €9,662

Cash 1,000
Notes Receivable 142
Interest Revenue 1,142
Example 3: A company receives a three-year, $10,000 zero-interest-bearing note, the market rate
of interest for a note of similar risk is also 9 percent.

Notes Receivable 7,721.80

Cash 7,721.80
The company recognizes interest revenue each year as follows.

Schedule of Note Discount Amortization

Effective-Interest Method
0% Note Discounted at 9%
Interest Discount Carrying Amount
Cash Received
Revenue Amortized of Note
Date of issue $7,721.80
End of year 1 $ –0– $ 694.96a $ 694.96b 8,416.76c
End of year 2 –0– 757.51 757.51 9,174.27
End of year 3 –0– 825.73d 825.73 10,000.00
$ –0– $2,278.20 $2,278.20
a$7,721.80 × .09 = $694.96 c$7,721.80 + $694.96 = $8,416.76
b$694.96 - $0 = $694.96 d5¢ adjustment to compensate for rounding

Notes Receivable 694.96

Interest Revenue ($7,721.80 × .09) 694.96
3.6.2. Valuation of Notes receivables
Like accounts receivable, companies record and report short-term notes receivable at their cash
realizable value—that is, at their face amount less all necessary allowances. The primary notes
receivable allowance account is Allowance for Doubtful Accounts. The computations and
estimations involved in valuing short-term notes receivable and in recording bad debt expense
and the related allowance exactly parallel that for trade accounts receivable. Companies estimate
the amount of uncollectible by using either a percentage-of-sales revenue or an analysis of the
receivables.

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Receivable with a significant financing component (such as long-term notes) involve additional
estimation problems. As a result, the IASB has established guidelines for alternative approaches
that could be used to estimate impairments of financial instruments.

3.7 De-recognition of Receivables

De-recognition occurs when the receivable no longer has any value; that is, the contractual rights
to the cash flows of the receivable no longer exist or when transferring the risks and rewards of
ownership to other company. Usually, de-recognition relates to Transfers of Receivables. There
are various reasons for the transfer of receivables to another party. The transfer of receivables to
a third party for cash happens either Sale of receivables or Secured borrowing.

3.7.1 Sales of Receivables

A common type is a sale to a factor. Factors are finance companies or banks that buy receivables
from businesses for a fee and then collect the remittances directly from the customers. The
following diagram shows a typical factoring arrangement.

A recent phenomenon in the sale (transfer) of receivables is securitization. Securitization takes a

pool of assets such as credit card receivables, mortgage receivables, or car loan receivables, and
sells shares in these pools of interest and principal payments. This, in effect, creates securities
backed by these pools of assets.

What are the differences between factoring and securitization? Factoring usually involves sale to
only one company, fees are high, the quality of the receivables is low, and the seller afterward
does not service the receivables. In a securitization, many investors are involved, margins are
tight, the receivables are of generally higher quality, and the seller usually continues to service
the receivables. In either a factoring or a securitization transaction, a company sells receivables
on either a without recourse or a with recourse basis.

Sale without Recourse. When buying receivables without recourse, the purchaser assumes the
risk of collectability and absorbs any credit losses. The transfer of accounts receivable in a
nonrecourse transaction is an outright sale of the receivables both in form (transfer of title) and
substance (transfer of control).

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To illustrate, Crest Textiles, Inc. factors $500,000 of accounts receivable with Commercial
Factors, Inc., on a without recourse basis. Crest Textiles transfers the receivable records to
Commercial Factors, which will receive the collections. Commercial Factors assesses a finance
charge of 3 percent of the amount of accounts receivable and retains an amount equal to 5
percent of the accounts receivable (for probable adjustments). Crest Textiles and Commercial
Factors make the following journal entries for the receivables transferred without recourse.

Crest Textiles, Inc. Commercial Factors, Inc.

Cash 460,000 Accounts (Notes) 500,000
Due from Factor 25,000* Receivable
Loss on Sale of 15,000** Due to Customer 25,000
Receivables 500,000 (Crest Textiles) 15,000
Accounts (Notes) Interest Revenue 460,000
Receivable Cash
*(5% x $500,000)
**(3% x $500,000)
Sale with Recourse. For receivables sold with recourse, the seller guarantees payment to the
purchaser in the event the debtor fails to pay. To record this type of transaction, the seller uses a
financial components approach, because the seller has a continuing involvement with the
receivable. Values are now assigned to such components as the recourse provision, servicing
rights, and agreement to reacquire. In this approach, each party to the sale only recognizes the
assets and liabilities that it controls after the sale.

To illustrate, assume the same information as above for Crest Textiles and for Commercial
Factors, except that Crest Textiles sold the receivables on a with recourse basis. Crest Textiles
determines that this recourse liability has a fair value of $6,000. To determine the loss on the sale
of the receivables, Crest Textiles computes the net proceeds from the sale as follows.

Cash received $460,000

Due from factor 25,000 $485,000
Less: Recourse
liability 6,000
Net proceeds $479,000
Crest Textiles then computes the loss as follows.

Carrying (book) $500,000

value 479,000
Net proceeds $ 21,000
Loss on sale of
receivables

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Below shows the journal entries for both Crest Textiles and Commercial Factors for the
receivables sold with recourse.

Crest Textiles, Inc. Commercial Factors, Inc.

Cash 460,000 Accounts Receivable 500,000
Due from Factor 25,000 Due to Customer 25,000
Loss on Sale of (Crest Textiles)
Receivables 21,000 Interest Revenue 15,000
Accounts (Notes) Cash 460,000
Receivable
Recourse Liability 500,000

6,000
3.7.2 Secured Borrowing
A company often uses receivables as collateral in a borrowing transaction. In fact, a creditor
often requires that the debtor designate (assign) or pledge receivables as security for the loan. If
the loan is not paid when due, the creditor can convert the collateral to cash—that is, collect the
receivables.

To illustrate, on March 1, 2012, Howat Mills, Inc. provides (assigns) $700,000 of its accounts
receivable to Citizens Bank as collateral for a $500,000 note. Howat Mills continues to collect
the accounts receivable; the account debtors are not notified of the arrangement. Citizens Bank
assesses a finance charge of 1 percent of the accounts receivable and interest on the note of 12
percent. Howat Mills makes monthly payments to the bank for all cash it collects on the
receivables. In addition to recording the collection of receivables, Howat Mills must recognize
all discounts, returns and allowances, and bad debts. Each month Howat Mills uses the proceeds
from the collection of the accounts receivable to retire the note obligation. In addition, it pays
interest on the note.

Howat Mills, Inc Citizens Bank

Transfer of accounts receivable and issuance of note on March 1, 2012
Cash 493,000 Notes Receivable 500,000
Interest Expense 7,000* Interest revenue 7,000
Notes 500,000 Cash 493,000
Payable*(1%x$700,000)
Collection in March of $440,000 of accounts less cash discounts of $6,000 plus receipt of
$14,000 sales returns
Cash 434,000
Sales Discounts 6,000
Sales Returns and 14,000 (No entry)

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Allowances
Accounts Receivable 454,000
($440,000 + $14,000 =
$454,000)
3.8 Reporting of Receivables and Disclosure Requirement
The general rules in classifying receivables are:

1. Segregate and report the carrying amounts of the different categories of receivables.
2. Indicate the receivables classified as current and non-current in the statement of financial
position.
3. Appropriately offset the valuation accounts for receivables that are impaired, including a
discussion of individual and collectively determined impairments.
4. Disclose the fair value of receivables in a way that permits comparisons with the carrying
amount of the receivables.
5. Disclose information to assess the credit risk inherent in the receivables by providing
information on:
a) Receivables that are neither past due nor impaired.
b) b. The carrying amount of receivables that would otherwise be past due or
impaired, but whose terms have been renegotiated.
c) c. For receivables that are either past due or impaired, provide an analysis of the
age of the receivables that are past due as of the end of the reporting period.
6. Disclose any receivables pledged as collateral.
7. Disclose all significant concentrations of credit risk arising from receivables.

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 CHAPTER FOUR
INVENTORIES
4.1 Nature and classification of inventory
Inventory refers to the assets a company (1) intends to sell in the normal course of business, (2)
has in production for future sale (work in process), or (3) uses currently in the production of
goods to be sold (raw materials).

Merchandising Inventory: Wholesale and retail companies purchase goods that are primarily in
finished form. These companies are intermediaries in the process of moving goods from the
manufacturer to the end-user. They often are referred to as merchandising companies and their
inventory as merchandise inventory. The cost of merchandise inventory includes the purchase
price plus any other costs necessary to get the goods in condition and location for sale.

Manufacturing Inventories: Manufacturing companies actually produce the goods they sell to
wholesalers, retailers, other manufacturers, or consumers. Inventory for a manufacturer consists
of (1) raw materials, (2) work in process, and (3) finished goods.

Raw materials: represent the cost of components purchased from suppliers that will become part
of the finished product.
Work-in-process inventory: refers to the products that are not yet complete in the manufacturing
process. The cost of work in process includes the cost of raw materials used in production, the
cost of labor that can be directly traced to the goods in process, and an allocated portion of other
manufacturing costs, called manufacturing overhead.
Finished goods: are goods that have been completed in the manufacturing process but have not
yet been sold. They have reached their final stage and now await sale to a customer.

4.2 Physical goods and costs included in inventory

A company recognizes inventory and accounts payable at the time it controls the asset. Control is
therefore the key factor in determining when purchases and sales of a product are recognized.
Companies then look to various indicators to determine whether control has passed. Typically,
determining the physical units that should be included in inventory is a simple matter because it
consists of items in the possession of the company. However, in some situations the
identification of items that should be included in inventory is more difficult. Consider, for
example, goods in transit, goods on consignment, and sales returns.
Goods in transit. At the end of a reporting period, it’s important to ensure a proper inventory
cutoff. This means ownership must be determined for goods that are in transit between the
company and its customers as well as between the company and its suppliers.

For example, in December 2020, the Shangahi Metal Corporation sold goods to the Kospi Steel
Factory.

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1. The goods were shipped from Shangahi on December 29, 2020, but
2. The goods didn’t arrive at Kospi until January 3, 2021.
If both companies have December 31 fiscal year ends, whose inventory is it on December 31,
2020?
The answer depends on who owns the goods on December 31. Ownership depends on the terms
of the agreement between the two companies.

If the goods are shipped f.o.b. (free on board) shipping point, then legal title to the goods
passes from the seller to the buyer at the point of shipment (when the seller hands over the goods
to the delivery company). In this case, the buyer is responsible for shipping costs and transit
insurance. Shangahi records the sale of inventory on December 29, 2020, and Kospi records the
purchase of inventory on that same day. Kospi will include these goods in its 2020 ending
inventory even though the company is not in physical possession of the goods on the last day of
the fiscal year.

On the other hand, if the goods are shipped f.o.b. destination, then legal title to the goods does
not pass from the seller to the buyer until the goods arrive at their destination (the customer’s
location). In this case, the seller is responsible for shipping costs and transit insurance. In our
example, if the goods are shipped f.o.b. destination, Shangahi waits to record the sale until
January 3, 2021, and Kospi records the purchase of inventory on that same day. Shangahi
includes the goods in its 2020 ending inventory even though the inventory has already been
shipped as of the last day of the financial statement reporting period.

Goods on consignment Sometimes a company arranges for another company to sell its product
under consignment. The goods are physically transferred to the other company (the consignee),
but the transferor (consignor) retains legal title. If the consignee can’t find a buyer, the goods are
returned to the consignor. If a buyer is found, the consignee remits the selling price (less
commission and approved expenses) to the consignor.

For example, suppose Addey Ababa Clothing (consignor) ships merchandise to Cottex Outlets
(consignee). The arrangement specifies that Cottex will attempt to sell the merchandise, and in
return, Addey Ababa will pay to Cottex a 10% sales commission on any merchandise sold. Any
inventory not sold within six months will be returned to Addey Ababa. In this arrangement,
Cottex obtains physical possession of the inventory and has responsibility to sell to customers,
but Addey Ababa retains legal title to the inventory and risk of ownership and therefore keeps
this inventory in its own records until the merchandise is sold to a customer.

Sales returns Recall from our discussions when the right of return exists, a seller must be able to
estimate those returns before revenue can be recognized. The adjusting entry for estimated sales
returns includes a debit to sales returns and a credit to refund liability. At the same time, cost of
goods sold is reduced and an estimate of inventory to be returned is made

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As a result, a company includes in ending inventory the cost of merchandise sold that it
anticipates will be returned.

Types of costs associated with those inventory units:

The cost of inventory includes all necessary expenditures to acquire the inventory and bring it to
its desired condition and location for sale or for use in the manufacturing process. Obviously, the
cost includes the purchase price of the goods. Usually, the cost of acquiring inventory also
includes freight charges on incoming goods borne by the buyer; insurance costs incurred by the
buyer while the goods are in transit (if shipped f.o.b. shipping point); and the costs of unloading,
unpacking, and preparing merchandise inventory for sale or raw materials inventory for use. The
costs included in inventory are called product costs. They are associated with products and
expensed as cost of goods sold only when the related products are sold.

Freight-in on purchases. Freight-in on purchases is commonly included in the cost of

inventory. These costs clearly are necessary to get the inventory in location for sale or use and
can generally be associated with particular goods. Freight costs are added to the inventory
account in a perpetual system.

In a periodic system, freight costs generally are recorded in a temporary account called freight-
in or transportation-in, which is added to total purchases in determining net purchases for
inclusion in cost of goods sold. From a control perspective, by recording freight-in as a separate
item, management can more easily track its freight costs.

Shipping charges on outgoing goods (freight-out) are not included in the cost of inventory. They
are reported in the income statement either as part of cost of goods sold or as an operating
expense, usually among selling expenses. If a company adopts a policy of not including shipping
charges in cost of goods sold, both the amounts incurred during the period as well as the income
statement classification of the expense must be disclosed.

Purchase returns. When merchandise is returned, the buyer records a purchase return. In a
perpetual inventory system, the purchase return is recorded directly as a reduction to the
inventory account. In a periodic system, we use a purchase returns account to temporarily
accumulate these amounts. Purchase returns are subtracted from total purchases to calculate net
purchases.

Purchase discounts. Discounts offer incentives to the buyer to make quick payment. The
amount of the discount and the time period within which it’s available are conveyed by terms
like 2/10, n/30 (meaning a 2% discount if paid within 10 days, otherwise full payment within 30
days). As with the seller, the purchaser can record these purchase discounts using either the gross
method or the net method.

Illustration 1: On October 5, Cottex purchases $20,000 of inventory with a term 2/10, n/30.

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 On October 14, paid $13,720 ($14,000 of the invoice less a 2% cash discount on that
amount).
On November 4, paid the remaining $6,000 balance of the invoice.

Record the journal entry by both net method and gross method by assuming:
I. The company uses perpetual inventory system
II. The company uses periodic inventory system
Gross Method Net Method
I. Perpetual Inventory System
October 5: Inventory* 20,000 Inventory* 19,600
Account payable 20,000 Account Payable 19,600
October 14: Account Payable 14,000 Account Payable 13,720
Inventory** 280 Cash 13,720
Cash 13,720
November 4: Account payable 6,000 Accounts Payable 5,880
Cash 6,000 Purchase discount lost 120
Cash 6,000
II. Periodic Inventory System
*The purchases account is used in a periodic inventory system.
**The purchase discounts account is used in a periodic inventory system.

Illustration 2: A schedule to demonstrate the calculation of cost of goods sold is provided at the
end.

The Meskel Flower Wholesale Beverage Company purchases soft drinks from producers and
then sells them to retailers. The company began the year with merchandise inventory of
$120,000 on hand. During the year, additional inventory transactions include:
 Purchases of merchandise on account totaled $620,000, with terms 2/10, n/30.
 Freight charges paid by Lothridge were $16,000.
 Merchandise with a cost of $20,000 was returned to suppliers for credit.
 All purchases on account were paid within the discount period.
 Sales on account totaled $830,000. The cost of soft drinks sold was $550,000.
 Inventory remaining on hand at the end of the year totaled $174,000.

Record the above transactions according to both the perpetual and periodic inventory systems
using the gross method.
($ in thousands)
Perpetual System Periodic System
Inventory 620 Purchase 620
Account payable 620 Account payable 620
Inventory 16 Freight-in 16
Cash 16 Cash 16
Account payable 20 Account payable 20

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 Inventory 20 Purchase return and 20
allowance
Account payable 600 Account payable 600
Inventory (600*2%) 12 Purchase discounts 12
Cash 588 Cash 588
Accounts receivable 830 Accounts receivable 830
Sales revenue 830 Sales revenue 830
Cost of goods sold 550
Inventory 550
No entry Cost of goods sold* 550
Inventory (ending) 174
Purchase returns 20
Purchase discounts 12
Inventory (beginning) 120
Purchases 620
Freight-in 16
Supporting Schedule
*Cost of goods sold:
Beginning Inventory $120
Net purchases:
Purchases $620
Plus: Freight-in 16
Less: Returns (20)
Less: Discounts (12)
Cost of good available 604
Less: Ending inventory 724
Cost of goods sold (174)
$550

4.3 Valuation of inventories: A cost-basis approach

Regardless of whether the perpetual or periodic system is used, it’s necessary to assign dollar
amounts to the physical quantities of goods sold and goods remaining in ending inventory. The
inventory costing methods that can be used to achieve the allocation of costs to ending inventory
and cost of goods sold are:

Specific Identification: for each unit sold during the period or each unit on hand at the end of
the period to be matched with its actual cost. It is used frequently by companies selling unique,
expensive products with low sales volume which makes it relatively easy and economically
feasible to associate each item with its actual cost.

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Average Cost: assumes that cost of goods sold and ending inventory consist of a mixture of all
the goods available for sale.
FIFO: assumes that the first units purchased are the first ones sold. Beginning inventory is sold
first, followed by purchases during the period in the chronological order of their acquisition.

Illustration 3: The Glorious Company has the following inventory information for 2021:
Beginning Inventory and Purchases During 2021
Date Units Unit Cost* Total Cost
Jan. 1 (Beginning Inventory) 4,000 $5.50 $22,000
Purchases:
Jan. 17 1,000 6.00 6,000
Mar. 22 3,000 7.00 21,000
Oct. 15 3,000 7.50 22,500
Goods available for sale 11,000 $71,500
Sales
Date of Sale Units
Jan. 10 2,000
Apr. 15 1,500
Nov. 20 3,000
Total sales 6,500
*Includes purchase price and cost of freight.

Soln: I. Specific identification: Suppose the actual units sold include 4,000 units of beginning
inventory, 800 units of the January 17 purchase, 1,400 units from the March 22 purchase, and
300 units of the October 15 purchase.

Cost of goods sold = 4000(5.50)+800(6)+1400(7)+300(7.5)=38,850

Ending inventory = 200(6)+1600(7)+2700(7.5)=32,650

II. Average cost method

In a periodic inventory system: Weighted-average unit cost =
Beginning inventory (4,000 units @ $5.50) $ 22,000
Plus: Purchases (7,000 units @ various prices) 49,500
Cost of goods available for sale (11,000 units) 71,500
Less: Ending inventory* (determined below) (29,250)
Cost of goods sold (6,500 units) $ 42,250
*Cost of Ending Inventory:
Weighted-average unit cost = =
$6.50
4,500 units × $6.50 = $29,250

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In a perpetual inventory system:
Date Purchased Sold Balance
Beginning 4000 @ $5.5 = 4,000 @ $5.5 =$22,000
inventory $22,200
Jan. 10 2000@$5.5=11,000 2,000@ $5.5 =$11,000
Jan. 17 1000 @ $6 = $11,000 + $6,000 =
$6,000 $17,000
Average 2,000 + 1,000 = 3,000
cost per unit
unit
Mar.22 3000 @ $7 = $17,000 + $21,000 =
$21,000 $38,000
Average 3,000 + 3,000 = 6,000
cost per unit
unit
Apr.15 1,500@$6.333= 4,500@ $6.333 =
$9,500 $28,500
Oct. 15 3,000 @ $7.50= $28,500 + $22,500 =
$22,500 $51,000
Average 4,500 + 3,000 = 7,500
cost per unit
unit
Nov. 20 3,000@$6.8 = 4,500@ $6.80 =
$20,400 $30,600
Total cost of goods sold =$40,900

III. FIFO
In a periodic inventory system:
Beginning inventory (4,000 units @ $5.50) $ 22,000
Plus: Purchases (7,000 units @ various 49,500
prices)
Cost of goods available for sale (11,000 units) 71,500
Less: Ending inventory* (determined below) (33,000)
Cost of goods sold (6,500 units) $38,500
*Cost of Ending
Inventory: Date of Units Unit Cost Total Cost
Purchase
Mar. 22 1,500 $7.00 $ 10,500
Oct. 15 3,000 7.50 22,500
Total ending 4,500 $33,000
inventory

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In a perpetual inventory system:
Date Purchased Sold Balance
Beginning 4,000 @ $5.50 4,000 @ $5.50 = $22,000
inventory =$22,000
Jan. 10 2,000@$5.50=$11,000 2,000 @ $5.50 = $11,000
Jan. 17 1,000 @ $6.00 = 2,000 @ $5.50 $17,000
$6,000 1,000 @ $6.00
Mar. 22 3,000 @ $7.00 = 2,000@ $5.50
$21,000 1,000@ $6.00 $38,000
3,000@ $7.00
Apr. 15 1,500@$5.50=$8,250 500@ $5.50
1,000@ $6.00 $29,750
3,000@ $7.00
Oct. 15 3,000@ $7.50 = 500@ $5.50
$22,500 1,000@ $6.00 $52,250
3,000@ $7.00
3,000@ $7.50
Nov. 20 500@ $5.50 + 1,500@ $7.00 $33,000
1,000@ $6.00 + 3,000@ $7.50
1,500@$7.00 =
$19,250
Total cost of goods sold = $38,500

4.4 Special inventory valuation methods

4.4.1. Lower-of-cost-or-net realizable value (LCNRV) method
Sometimes circumstances arise after (or subsequent to) the purchase or production of inventory
that indicate the company will have to sell its inventory for less than its cost. This might happen
because of inventory damage, physical deterioration, obsolescence, changes in price levels, or
any situation that lessens demand for the inventory. Consider, for example, the value of unsold
electronics inventory when the next generation comes out, or the leftover clothing inventory at
the end of the selling season. Usually, the only way these items can be sold is at deeply
discounted prices (well-below their purchase cost). On this case, report inventory at the lower of
cost or net realizable value.

NRV is the estimated selling price of the inventory in the ordinary course of business reduced by
reasonably predictable costs of completion, disposal, and transportation (such as sales
commissions and shipping costs). Another way to think about NRV is that it’s the net amount a
company expects to realize (or collect in cash) from the sale of the inventory.

After comparing cost and NRV, a company reports inventory at the lower of the two amounts.

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1. If NRV is lower than cost, we need an adjusting entry to reduce inventory from its already
recorded purchase cost to the lower NRV. NRV then becomes the new carrying value of
inventory reported in the balance sheet.
2. If cost is lower than NRV, no adjusting entry is needed. Inventory already is recorded at cost
at the time it was purchased, and this cost is lower than total NRV at the end of the period.

For financial reporting purposes, LCNRV can be applied (a) to individual inventory items, (b) to
major categories of inventory, or (c) to the entire inventory. Whichever method a company
selects, it should apply the method consistently from one period to another.

Illustration 4: The Collins Company has five inventory items on hand at the end of the year.
The yearend cost (determined by applying the FIFO cost method) and net realizable value
(current selling prices less costs of completion, disposal, and transportation) for each of the items
are presented below. Items A and B are a collection of similar items, and items C, D, and E are
another collection of similar items. Each collection can be considered a category of inventory.
Lower of Cost or NRV
Item Cost NRV By Individual By Category By Total
Items Inventory
A $ 50,000 $ 85,000 $ 50,000
B 100,000 90,000 90,000
Total A and B $150,000 $175,000 $ 150,000
C $ 80,000 $ 75,000 75,000
D 90,000 85,000 85,000
E 95,000 96,000 95,000
Total C, D, $265,000 $256,000 256,000
and E
Total $415,000 $431,000 $395,000 $406,000 $415,000

Journal entry for adjusting inventory

Cost of goods sold* 20,000
Inventory 20,000
*In situations when a write-down is substantial and unusual, the write-down should be recorded
in a loss on inventory write-down account as follows:
Loss Due to Decline of 20,000
Inventory to NRV
Inventory 20,000

4.4.2. Gross profit method

Companies take a physical inventory to verify the accuracy of the perpetual inventory records or,
if no records exist, to arrive at an inventory amount. Sometimes, however, taking a physical

9|Page
inventory is impractical. In such cases, companies use substitute measures to approximate
inventory on hand.

One substitute method of verifying or determining the inventory amount is the gross profit
method (also called the gross margin method). Auditors widely use this method in situations
where they need only an estimate of the company’s inventory (e.g., interim reports). Companies
also use this method when fire or other catastrophe destroys either inventory or inventory
records. The gross profit method relies on three assumptions:
1. The beginning inventory plus purchases equal total goods to be accounted for.
2. Goods not sold must be on hand.
3. The sales, reduced to cost, deducted from the sum of the opening inventory plus purchases,
equal ending inventory.
To illustrate, assume that Centuries has a beginning inventory of €60,000 and purchases of
€200,000, both at cost. Sales at selling price amount to €280,000. The gross profit on selling
price is 30 percent. Centuries applies the gross profit method as shown below:
Beginning inventory (at cost) € 60,000
Purchases (at cost) 200,000
Goods available (at cost) 260,000
Sales (at selling price) €280,000
Less: Gross profit (.30 x 84,000
€280,000)
Sales (at cost) 196,000
Approximate inventory € 64,000
(at cost)

4.4.3. Retail-inventory method

There is an observable pattern between costs and selling price exists. The retailer can then use
a formula to convert retail prices to cost. This method is called the retail inventory method. It
requires that the retailer keep a record of (1) the total cost and retail value of goods purchased,
(2) the total cost and retail value of the goods available for sale, and (3) the sales for the period.
Use of the retail inventory method is very common.

To illustrate, by using the following data lets see the retail inventory method calculations:

Cost Retail
Beginning inventory £14,000 £ 20,000
Purchases 63,000 90,000
Goods available for sale £77,000 110,000
Deduct: Sales 85,000
Ending inventory, at retail £ 25,000
Ratio of cost to retail (£77,000 ÷ £110,000)

10 | P a g e
 = 70%
Ending inventory at cost (.70 x £25,000)
= £17,500

4.5. Presentation of Inventories

Accounting standards require financial statement disclosure of the following items related to
inventories:

1. The accounting policies adopted in measuring inventories, including the cost formula used
(eg. FIFO).
2. The total carrying amount of inventories and the carrying amount in classifications (common
classifications of inventories are merchandise, production supplies, raw materials, work-in-
process, and finished goods).
3. The carrying amount of inventories carried at fair value less costs to sell.
4. The amount of inventories recognized as an expense during the period (cost of goods sold).
5. The amount of any write-down of inventories recognized as an expense in the period and the
amount of any reversal of write-downs recognized as a reduction of expense in the period.
6. The circumstances or events that led to the reversal of a write-down of inventories.
7. The carrying amount of inventories pledged as security for liabilities, if any.
This information can be disclosed in the statement of financial position or in a separate schedule
in the notes.

11 | P a g e
 CHAPTER FIVE
PROPERTY, PLANT, AND EQUIPMENT
5.1. Acquisition and Disposition of Property, Plant, and Equipment
Assets which have durable nature are called property, plant, and equipment. Other terms
commonly used are plant assets and fixed assets. Property, plant, and equipment is defined as
tangible assets that are held for use in production or supply of goods and services, for rentals to
others, or for administrative purposes; they are expected to be used during more than one
period. Property, plant, and equipment therefore includes land, building structures (offices,
factories, warehouses), and equipment (machinery, furniture, tools).
5.1.1. Characteristics of property, plant, and equipment
The major characteristics of property, plant, and equipment are as follows.
1. They are acquired for use in operations and not for resale. Only assets used in normal
business operations are classified as property, plant, and equipment. For example, an idle
building is more appropriately classified separately as an investment.
2. They are long-term in nature and usually depreciated. Property, plant, and equipment
yield services over a number of years. Companies allocate the cost of the investment in
these assets to future periods through periodic depreciation charges. The exception is land.
3. They possess physical substance. Property, plant, and equipment are tangible assets
characterized by physical existence or substance.

5.1.2. Acquisition of property, plant and equipment

Most companies use historical cost as the basis for valuing property, plant, and equipment. The
following table summarizes the acquisition cost of property, plant and equipment:

Asset Description Typical Acquisition Costs

Property, Productive assets that derive their All expenditures necessary to get the
plant, & value from long-term use in asset in condition and location for its
equipment operations rather than from resale. intended use.

Equipment Broad term that includes machinery, Purchase price (less discounts),
computers and other office taxes, transportation, installation,
equipment, vehicles, furniture, and testing, trial runs, and
fixtures. reconditioning.
Land Real property used in operations Purchase price, attorney’s fees, title,
(land held for speculative recording fees, commissions, back
investment or future use is reported taxes, mortgages, liens, clearing,
as investments or other assets). filling, draining, and removing old
buildings.
Land Enhancements to property such as Separately identifiable costs.
improvements parking lots, driveways, private
 roads, fences, landscaping, and
sprinkler systems
Buildings Structures that include warehouses, Purchase price, attorney’s fees,
plant facilities, and office buildings. commissions, and reconditioning.

Self-Constructed Assets
Occasionally, companies construct their own assets. Determining the cost of such assets can be
a problem. Without a purchase price or contract price, the company must allocate costs and
expenses to arrive at the cost of the self-constructed asset. Materials and direct labor used in
construction pose no problem. However, the assignment of indirect costs of manufacturing
creates special problems. These indirect costs, called overhead, include power, heat, light,
insurance, and so on. Companies can handle overhead in one of two ways:

1. Assign no fixed overhead to the cost of the constructed asset. The major argument for
this treatment is that overhead is generally fixed in nature. As a result, this approach
assumes that the company will have the same costs regardless of whether or not it
constructs the asset. Therefore, to charge a portion of the fixed overhead costs to the
equipment will normally reduce current expenses and consequently overstate income of the
current period. However, the company would assign to the cost of the constructed asset
variable overhead costs that increase as a result of the construction.
2. Assign a portion of all overhead to the construction process. This approach, called a
full-costing approach. Under this approach, a company assigns a portion of all overhead to
the construction process, as it would to normal production. Advocates say that failure to
allocate overhead costs understates the initial cost of the asset and results in an inaccurate
future allocation.
If the allocated overhead results in recording construction costs in excess of the costs that an
outside independent producer would charge, the company should record the excess overhead as
a period loss rather than capitalize it. This avoids capitalizing the asset at more than its fair
value. Under no circumstances should a company record a ―profit on self-construction.‖

Borrowing Costs during Construction

The proper accounting for borrowing costs has been a long-standing controversy. Three
approaches have been suggested to account for the interest incurred in financing the
construction:
1. Capitalize no borrowing costs during construction. Under this approach, interest is
considered a cost of financing and not a cost of construction. Some contend that if a
company had used equity financing rather than debt, it would not incur this cost. The major
argument against this approach is that the use of cash, whatever its source, has an
associated implicit interest cost, which should not be ignored.
2. Charge construction with all borrowing costs of funds employed, whether identifiable
or not. This method maintains that the cost of construction should include the cost of
 financing, whether by cash, debt, or equity. Its advocates say that all costs necessary to get
an asset ready for its intended use, including borrowing costs, are part of the asset’s cost.
Interest, whether actual or imputed, is a cost, just as are labor and materials. A major
criticism of this approach is that imputing the cost of equity capital is subjective and
outside the framework of an historical cost system.
3. Capitalize only the actual borrowing costs incurred during construction. This
approach agrees in part with the logic of the second approach—that interest is just as much
a cost as are labor and materials. But, this approach capitalizes only borrowing costs
incurred through debt financing. (That is, it does not try to determine the cost of equity
financing.) Under this approach, a company that uses debt financing will have an asset of
higher cost than a company that uses equity financing. Some consider this approach
unsatisfactory because they believe the cost of an asset should be the same whether it is
financed with cash, debt, or equity.
IFRS requires the third approach—capitalizing actual interest (with modifications). This
method follows the concept that the historical cost of acquiring an asset includes all costs
(including borrowing costs) incurred to bring the asset to the condition and location necessary
for its intended use. The rationale for this approach is that during construction, the asset is not
generating revenues. Therefore, a company should defer (capitalize) borrowing costs. Once
construction is complete, a company can utilize the asset in its operations. At this point, the
company should report borrowing as an expense in the determination of net income. It follows
that the company should expense any borrowing cost incurred in purchasing an asset that is
ready for its intended use.
To implement the capitalization approach for borrowing costs, companies consider three items:

 Qualifying assets.
To qualify for the capitalization of borrowing costs, assets must require a substantial period of
time to get them ready for their intended use or sale. A company capitalizes borrowing costs
starting at the beginning of the capitalization period (described in the next section).
Capitalization continues until the company substantially readies the asset for its intended use.
Assets that qualify for borrowing cost capitalization include assets under construction for a
company’s own use (including buildings, plants, and large machinery) and assets intended for
sale or lease that require a substantial period of time to produce (e.g., ships or real estate
developments). Examples of assets that do not qualify for interest capitalization are (1) assets
that are in use or ready for their intended use, and (2) inventories that are produced over a short
period of time.

 Capitalization period.
The capitalization period is the period of time during which a company capitalizes borrowing
costs. It begins with the presence of three conditions:
 1. Expenditures for the asset are being incurred.
2. Activities that are necessary to get the asset ready for its intended use or sale are in
progress.
3. Borrowing cost is being incurred.
Capitalization continues as long as these three conditions are present. The capitalization period
ends when the asset is substantially complete and ready for its intended use.

 Amount to capitalize.
The amount of borrowing cost to be capitalized varies depending on whether there is specific
debt that has been incurred to fund the project or whether the project is being funded from the
general debt obligations of the company. When the project is funded by specific debt, the
amount capitalized is the actual borrowing costs incurred during the capitalization period offset
by any investment income on temporary investments of funds made available from the
borrowings.
Illustration: Capitalization of borrowing costs funded by specific debt
Assume that on November 1, 2021, Medroc Company contracted Ahadu Construction Co. to
construct a building for $1,400,000 on land costing $100,000 (purchased from the contractor
and included in the first payment). Medroc made the following payments to the construction
company during 2022.

January 1 March 1 May 1 December 31 Total

$210,000 $300,000 $540,000 $450,000 $1,500,000
Ahadu Construction completed the building, ready for occupancy, on December 31, 2022.
Medroc had a 15 percent, three-year, $1,500,000, note to finance purchase of land and
construction of the building, dated December 31, 2021, with interest payable annually on
December 31. During 2021, a portion of the proceeds from the borrowing that had not yet been
expended in the project were invested and earned $60,000 in interest income.
The project began on January 1 and was completed on December 31, so the capitalization
period was the full year of 2022. The amount of borrowing costs to be capitalized for 2022
would be computed as shown below:

Borrowing costs ($1,500,000 × .15) $225,000

Investment income 60,000
Borrowing costs to be capitalized $165,000
Medroc would make the following entries during the year.

January 1 Land 100,000

Buildings (or Construction in Process) 110,000
Cash 210,000
March 1 Buildings 300,000
 Cash 300,000
May 1 Buildings 540,000
Cash 540,000
December 31 Buildings 450,000
Cash 450,000
Buildings (Capitalized Borrowing Cost) 225,000
Cash 225,000
Cash 60,000
Buildings (Capitalized Borrowing Cost) 60,000
When the project is funded by general debt, some additional calculations and step are included
in the process. To illustrate, assume the same facts as the previous illustration, but, instead of
any specific debt, the project is funded by the general debt of the company. Assume that
Medroc had the following two debt obligations outstanding during 2022:
1. 10 percent, $1,000,000, 5-year note payable, dated December 31, 2018, with interest
payable annually on December 31.
2. 12 percent, $1,500,000, 10-year bonds issued December 31, 2017, with interest payable
annually on December 31.
When a project is funded by general debt, the company will need to determine the average
carrying amount of the project during the period. This can be computed as shown below:

Expenditures
Date Amount Capitalization Period* Average Carrying
Amount
January 1 $ 210,000 12/12 $210,000
March 1 300,000 10/12 250,000
May 1 540,000 8/12 360,000
December 31 450,000 0/12 0
Totals $1,500,000 $820,000
* The capitalization period is the number of months between when the expenditure is made and
the end of the year or the end of the project, whichever occurs first.
The second amount that is needed when borrowing costs from general debt are being used, and
there is more than one general debt obligation, is the weighted average borrowing cost. This
amount is called the capitalization rate and is computed as follows.
[.10 × ($1,000,000 ÷ $2,500,000)] + [.12 × ($1,500,000 ÷ $2,500,000)] = 11.2%

By combining these two amounts, the amount of borrowing cost available for capitalization is
now computed.
$820,000 × .112 = $91,840
The final step when the borrowing cost of general debt is used is to apply the constraint that
the amount capitalized cannot exceed the actual borrowing costs incurred during the period. In
2022, total borrowing costs were $280,000 [($1,000,000 × .10) + ($1,500,000 × .12)]. The
amount capitalized will be lower of actual, or the amount computed by multiplying the average
carrying amount by the capitalization rate. In this case, Medroc will capitalize $91,840. All of
the other entries presented above would be the same except for the interest entries on
December 31, which would be as follows.
December 31
Buildings (Capitalized Borrowing Cost) 91,840
Interest Expense ($280,000 − $91,840) 188,160
Cash 280,000
The final possibility is that the project is funded by a blend of specific debt and general debt.
To illustrate this case, assume that Medroc has the following debt outstanding during 2022.

Specific Construction Debt

1. 15 percent, $750,000, 3-year note to finance purchase of land and construction of the
building, dated December 31, 2021, with interest payable annually on December 31. Idle
funds from this borrowing were invested during early 2022 and earned $40,000 in
investment income.
Other Debt
2. 10 percent, $500,000, 5-year note payable, dated December 31, 2018, with interest payable
annually on December 31.
3. 12 percent, $1,500,000, 10-year bonds issued December 31, 2017, with interest payable
annually on December 31.
In this case, the expenditures are first allocated to the specific debt to the extent possible. Then,
the remainders of the expenditures are allocated to the general debt, as shown below:

Date Expenditure Amount Amount Capitalization Average

Allocated to Allocated to Period Carrying
Specific General Amount
Borrowings Borrowings
January 1 $ 210,000 $210,000 $0
March 1 300,000 300,000 0
May 1 540,000 240,000 300,000 8/12 $200,000
December 450,000 0 450,000 0/12 0
31
Totals $1,500,000 $750,000 $750,000 $200,000
The borrowing costs of the specific debt for this project is $72,500 based on the borrowing
costs of $112,500 ($750,000 × .15) less the investment income of $40,000.
The capitalization rate on the general debt is 11.5 percent {[(.10 × $500,000 ÷ $2,000,000)] +
[.12 × ($1,500,000 ÷ $2,000,000)]}. This results in a potential amount of borrowing costs to be
capitalized of $23,000 ($200,000 × .115). Since this amount is lower than the actual borrowing
costs of the general debt of $230,000 [($500,000 × .10) + ($1,500,000 × .12)], $23,000 will be
capitalized from the general borrowings. The total amount to be capitalized is shown below:

Interest costs from specific debt $112,500

Investment income from specific debt funds (40,000)
Interest costs from general debt 23,000
Total borrowing costs capitalized for 2022 $ 95,500
At December 31, the following entry would be made:

December 31
Buildings (Capitalized Borrowing Cost) ($112,500 135,500
+ $23,000)
Interest Expense ($230,000 − $23,000) 207,000
Cash ($112,500 + $230,000) 342,500
Cash 40,000
Buildings (Capitalized Borrowing Cost) 40,000
Disclosures
For each period, an entity will disclose both the amount of borrowing costs capitalized during
the period and the capitalization rate used to determine the amount of borrowing costs eligible
for capitalization.

5.1.3. Valuation of property, plant and equipment

As with other assets, companies should record property, plant, and equipment at the fair value
of what they give up or at the fair value of the asset received, whichever is more clearly
evident. However, the process of asset acquisition sometimes obscures fair value. For example,
if a company buys land and buildings together for one price, how does it determine separate
values for the land and buildings?

Cash Discounts
When a company purchases plant assets subject to cash discounts for prompt payment, how
should it report the discount? If it takes the discount, the company should consider the discount
as a reduction in the purchase price of the asset. But should the company reduce the asset cost
even if it does not take the discount? Two points of view exist on this question.

One approach considers the discount— whether taken or not—as a reduction in the cost
of the asset. The rationale for this approach is that the real cost of the asset is the cash or cash
equivalent price of the asset. In addition, some argue that the terms of cash discounts are so
attractive that failure to take them indicates management error or inefficiency.

With respect to the second approach, its proponents argue that failure to take the
discount should not always be considered a loss. The terms may be unfavorable, or it might
not be prudent for the company to take the discount. At present, companies use both methods,
though most prefer the former method.

Deferred-Payment Contracts
Companies frequently purchase plant assets on long-term credit contracts, using notes,
mortgages, bonds, or equipment obligations. To properly reflect cost, companies account for
assets purchased on long-term credit contracts at the present value of the consideration
exchanged between the contracting parties at the date of the transaction.

To illustrate, Aberus purchases a specially built robot spray painter for its production line. The
company issues a Br. 100,000, five-year, zero-interest-bearing note to Semon Robotics for the
new equipment. The prevailing market rate of interest for obligations of this nature is 10
percent. Aberus is to pay off the note in five Br. 20,000 installments, made at the end of each
year. Aberus cannot readily determine the fair value of this specially built robot. Therefore,
Aberus approximates the robot’s value by establishing the fair value (present value) of the
note. Entries for the date of purchase and dates of payments, plus computation of the present
value of the note, are as follows.

Date of Purchase
Equipment 75,816*
Notes Payable 75,816

*Present value of note = Br. 20,000 (PVF-OA5,10%)

= Br. 20,000 (3.79079);
= Br. 75,816

End of First Year

Interest Expense 7,582
Notes Payable 12,418
Cash 20,000
Interest expense in the first year under the effective-interest approach is Br. 7,582 (Br.75,816 ×
.10). The entry at the end of the second year to record interest and principal payment is as
follows.

End of Second Year

Interest Expense 6,340
Notes Payable 13,660
 Cash 20,000
Interest expense in the second year under the effective-interest approach is Br. 6,340 [(Br.
75,816 – Br. 12,418) × .10].

If Aberus did not impute an interest rate for the deferred-payment contract, it would record the
asset at an amount greater than its fair value. In addition, Aberus would understate interest
expense in the income statement for all periods involved.

Lump-Sum Purchases
A common challenge in valuing fixed assets arises when a company purchases a group of
assets at a single lump-sum price. When this occurs, the company allocates the total cost
among the various assets on the basis of their relative fair values. The assumption is that costs
will vary in direct proportion to fair value. This is the same principle that companies apply to
allocate a lump-sum cost among different inventory items.

To illustrate, Ayat Homes, Inc. decides to purchase several assets of a small heating concern,
Comfort Heating, for Br.80, 000. Comfort heating is in the process of liquidation. Its assets
sold are as follows.

Book Value Fair Value

Inventory Br.30,000 Br. 25,000
Land 20,000 25,000
Building 35,000 50,000
Total Br.85,000 Br.100,000
Ayat Homes allocates the Br.80, 000 purchase price on the basis of the relative fair values
(assuming specific identification of costs is impracticable), shown bellow

Inventory × Br.80,000 = Br.20,000

Land × Br.80,000 = Br.20,000
Building × Br.80,000 = Br.40,000

Issuance of Shares
When companies acquire property by issuing securities, such as ordinary shares, the par or
stated value of such shares fails to properly measure the property cost. If trading of the shares
is active, the market price of the shares issued is a fair indication of the cost of the property
acquired.

For example, Upgrade Living Co. decides to purchase some adjacent land for expansion of its
carpeting and cabinet operation. In lieu of paying cash for the land, the company issues to
Deed land Company 5,000 ordinary shares (par value $10) that have a market price of $12 per
share. Upgrade Living Co. records the following entry.

Land (5,000 × $12) 60,000

Share Capital—Ordinary 50,000
Share Premium—Ordinary 10,000
If the company cannot determine the fair value of the ordinary shares exchanged (based on a
market price), it may estimate the fair value of the property. It then uses the value of the
property as the basis for recording the asset and issuance of the ordinary shares.

Exchanges of Non-Monetary Assets

The proper accounting for exchanges of non-monetary asset is controversial. Some argue that
companies should account for these types of exchanges based on the fair value of the asset
given up or the fair value of the asset received, with a gain or loss recognized. Others believe
that they should account for exchanges based on the recorded amount (book value) of the asset
given up, with no gain or loss recognized. Still others favor an approach that recognizes losses
in all cases but defers gains in special situations.

Ordinarily, companies account for the exchange of non-monetary assets on the basis of the fair
value of the asset given up or the fair value of the asset received, whichever is clearly more
evident. Thus, companies should recognize immediately any gains or losses on the exchange.
The rationale for immediate recognition is that most transactions have commercial substance,
and therefore gains and losses should be recognized.

For example, Information Processing SA trades its used machine for a new model at Jerrod
Business Solutions NV. The exchange has commercial substance. The used machine has a
book value of $8,000 (original cost $12,000 less $4,000 accumulated depreciation) and a fair
value of $6,000. The new model lists for $16,000. Jerrod gives Information Processing a trade-
in allowance of $9,000 for the used machine. Information Processing computes the cost of the
new asset as shown below:

List price of new machine $16,000

Less: Trade-in allowance for used machine 9,000
Cash payment due 7,000
Fair value of used machine 6,000
Cost of new machine $13,000
Information Processing records this transaction as follows.

Equipment 13,000
Accumulated Depreciation—Equipment 4,000
Loss on Disposal of Equipment 2,000
Equipment 12,000
 Cash 7,000
Computation of loss on Disposal

Fair value of used machine $6,000

Less: Book value of used machine 8,000
Loss on disposal of used machine $2,000
Government Grants
Government grants are assistance received from a government in the form of transfers of
resources to a company in return for past or future compliance with certain conditions relating
to the operating activities of the company. When companies acquire an asset through a
government grant, a strict cost concept dictates that the valuation of the asset should be zero.
However, a departure from the historical cost principle seems justified. Therefore, most
companies use the fair value of the asset to establish its value on the books. In recognizing the
credit balance, two approaches are suggested—the capital (equity) approach and the income
approach.

 Supporters of the equity approach believe the credit should go directly to equity
because often no repayment of the grant is expected. In addition, these grants are an
incentive by the government—they are not earned as part of normal operations.
 Supporters of the income approach disagree—they believe that the credit should be
reported as revenue in the income statement. Government grants should not go directly
to equity because the government is not a shareholder. In addition, most government
grants have conditions attached to them which likely affect future expenses. They
should, therefore, be reported as grant revenue.
IFRS requires the income approach. The general rule is that grants should be recognized in
income on a systematic basis that matches them with the related costs that they are intended to
compensate. This is accomplished in one of two ways for an asset such as property, plant, and
equipment:

1. Recording the grant as deferred grant revenue, which is recognized as income on a

systematic basis over the useful life of the asset, or
2. Deducting the grant from the carrying amount of the assets received from the grant, in
which case the grant is recognized in income as a reduction of depreciation expense.
Illustration: Spectrum AG received a €500,000 subsidy from the government to purchase lab
equipment on January 2, 2022. The lab equipment costs €2,000,000, has a useful life of five
years, and is depreciated on the straight-line basis.

Soln: (1) Credit Deferred Grant Revenue for the subsidy and amortize the deferred grant
revenue over the five-year period. If Spectrum chooses to record deferred revenue of €500,000,
it amortizes this amount over the five-year period to income (€100,000 per year).
(2) Credit the lab equipment for the subsidy and depreciate this amount over the five-year
period. If Spectrum chooses to reduce the cost of the lab equipment, Spectrum reports the
equipment at €1,500,000 (€2,000,000 − €500,000) and depreciates this amount over the five-
year period.

5.1.4. Costs subsequent to acquisition

Type of Expenditure Normal Accounting Treatment
Additions Capitalize cost of addition to asset account.
Improvements and Remove cost of and accumulated depreciation on old asset,
replacements recognizing any gain or loss. Capitalize cost of
improvement/replacement.
Rearrangement and Expense costs of rearrangement and reorganization costs as
reorganization expense.
Repairs (a) Ordinary: Expense cost of repairs when incurred.
(b) Major: Remove cost and accumulated depreciation of
old asset, recognizing any gain or loss. Capitalize cost of
major repair.
5.1.5. Disposition of property, plant and equipment
A company, may retire plant assets voluntarily or dispose of them by sale, exchange,
involuntary conversion (fire, flood), or abandonment. Regardless of the type of disposal,
depreciation must be taken up to the date of disposition. Then, the company should remove all
accounts related to the retired asset. Generally, the book value of the specific plant asset does
not equal its disposal value. As a result, a gain
or loss develops. The reason: Depreciation is an estimate of cost allocation and not a process of
valuation. The gain or loss is really a correction of net income for the years during which
Nokia used the fixed asset.

Illustration 1: Camel Transport had a manufacturing plant located on company property that
stood directly in the path of a tornado. As a result of the tornado, which occurred on May 16,
2022, the plant was completely destroyed. Camel was eventually able to reach a settlement
with its insurance company for the full fair value of the plant. The settlement was reached on
March 18, 2023. At the time of the tornado, the building had a carrying value of $3,500,000
(original cost of $6,000,000 less accumulated depreciation of $2,500,000). The amount of the
settlement with this insurance company was $5,000,000. Camel made the following entries.

May 16, 2022 Loss from Tornado $3,500,000

Accumulated Depreciation—Buildings 2,500,000
Buildings 6,000,000
March 18, 2023 Cash 5,000,000
Gain from Insurance Settlement 5,000,000
Illustration 2: On December 31, 2022, Mitsui Ltd. has a machine with a book value of
¥940,000. The original cost and related accumulated depreciation at this date are as follows (all
amounts in thousands).

Machine ¥1,300,000
Less: Accumulated depreciation 360,000
Book value ¥ 940,000

Depreciation is computed at ¥72,000 per year on a straight-line basis. Presented below is a set
of independent situations. For each independent situation, indicate the journal entry to be made
to record the transaction. Make sure that depreciation entries are made to update the book
value of the machine prior to its disposal.

a. A fire completely destroys the machine on August 31, 2020. An insurance settlement of
¥630,000 was received for this casualty. The insurance company confirmed on September
30 that the claim would be covered and that the amount of the settlement (¥630,000) would
be paid on October 15.
b. On April 1, 2020, Mitsui sold the machine for ¥1,040,000 to Avanti Company.
c. On July 31, 2020, the company donated this machine to the Mountain King City Council.
The fair value of the machine at the time of the donation was estimated to be ¥1,100,000.
 CHAPTER SIX
INVESTMENT PROPERTY

6.1 The Nature of Investment Property

Investment property is defined as property (land or buildings or part of a building or both)

held (by the owner or by the lessee under a finance lease) to earn rentals or for capital
appreciation (or both). Investment property, therefore, is neither:

 held for use in production or supply of goods or services or for administrative purposes,
nor
 Held for sale in the ordinary course of business.

Examples of investment property:

 Land held for long-term capital appreciation is an investment property.

 Land held for an undetermined use is specifically included in investment property.
For example, an entity acquires land upon which it may erect its administrative
headquarters in a few years’ time or it may hold the land for capital appreciation, but
if someone makes an unsolicited offer to purchase the land at a price well in excess
of what the company thinks it is worth, then the entity would dispose of it in the
short term. Such land is investment property.
 A building owned by the entity (or held under a finance lease) and leased out under
one or more operating leases is investment property.
 A building that is vacant, but is held to be leased out under one or more operating
leases, is an investment property.
 A property that is being constructed or developed for future use as investment
property is investment property.

Owner-occupied property

IAS 40 defines owner-occupied property as property held by the owner (including the
lessee under a finance lease) for use in the production or supply of goods or services, or for
administrative purposes. Owner-occupied property is not investment property, and
accordingly is accounted for as property, plant and equipment.

Owner-occupied property includes:

1
  property held for future use as owner-occupied property,
 property held for future development and subsequent use as owner-occupied property,
 property occupied by employees of the reporting entity (even if the employees pay market
related rentals under operating leases), and
 Owner-occupied property awaiting disposal.

6.2 Recognition and Measurement

6.2.1 Initial recognition

Investment properties are recognized as an asset when, and only when:

i. it is probable that the future economic benefits that are associated with the investment
property will flow to the entity; and
ii. The cost of the investment property can be measured reliably.

6.2.2 Initial measurement of investment property

Investment property is initially measured at cost, including:

 the purchase price (or the equivalent cash cost where payment is deferred), and any
 Directly attributable expenditure (e.g., legal fees, transfer duty, and other transaction costs).

The cost of self-constructed investment properties excludes:

 abnormal wastage of material, labour and other resources incurred in constructing the
property;
 start-up costs (unless they are necessary to bring the property to its working condition); and
 initial operating losses incurred before the investment property achieves break-even
occupancy.

Illustrative example 16.1: Initial recognition and measurement

A) On 1 January 2021, ABC Company acquired an investment property for 11 million birr.
The purchase agreement provided for settlement in full on 31 December 2021 (an
appropriate discount factor (MIR) is 10%). 1 million birr transfer duty and 20 000 birr for
legal fees were incurred and paid during January 2021 in respect of the acquisition of this
property. Rates for the year ended 31 December 2021 of 100 000 birr, were paid on 30
November 2021. All amounts given are exclusive of value added tax.
B) During 2021, ABC Company constructed an investment property, expenditure on which

2
 is detailed below:

 Labor: 2 million birr (200 000 of which was incurred to restore faulty work performed
by ‘scab’ laborer’s whilst the company’s employees were on strike and a further 100
000 was in respect of unproductive time whilst waiting for the foundations to dry);
 Materials: 8 million birr (1 million of which was incurred to restore faulty work
performed by ‘scab’ labourers whilst the company’s employees were on strike and
an estimated further 500 000 birr in normal wastage).
 Other resources: 2 million birr.
ABC Company completed the self-constructed building on 30 November 2021 and made an
operating loss on this investment property of 500 000 birr (due to low initial occupancies) for
the month of December 2021. It is anticipated that this investment property will reach break-
even occupancy during August 2022, and the total budgeted operating loss to that date is
estimated to be birr 2 million.
Required:
Calculate the cost of each of the investment properties to be recognized by ABC Company
upon initial recognition of the investment properties.

Solution:
A) Purchased property:
Reasons and Birr
calculations:
Purchase price – cash cost 11 000 000/1.1 10 000 000
discount factor
Transfer duty Given 1 000 000
Legal fees Given 20 000
Rates Operating cost -
therefore excluded
11 020 000
Self-constructed property:
Laborer:
 abnormal reworking Abnormal wastage -
 unproductive time whilst Normal wastage 100 000
foundations drying
 remainder 2 000 000 - 200 000 - 1 700 000
100 000
Materials:
 abnormal reworking Abnormal wastage -
 normal wastage Given 500 000

3
  remainder 8 000 000 – 1 000 000 6 500 000
– 500 000
Other resources Given 2 000 000
Operating loss for December 2001 An operating expense -
10 800 000
Note that budgeted operating losses will also be excluded.

6.2.3 Subsequent Expenditure

Subsequent expenditure on an investment property is evaluated in terms of the initial recognition

criteria.

Replacements are recognized if the recognition criteria are met and the part that is replaced is
derecognized. All other subsequent expenditure (i.e., repairs and maintenance) is expensed in the
period in which it is incurred.

Illustrative example 16.2: Subsequent expenditure

During 2022, ABC Company (see illustrative example above) made the following expenditures
on the investment property that it has constructed itself during 2021:
 1 million birr on erecting shade-cloth covered-parking for its tenants, in respect of
which additional operating lease rentals of 25 birr per month per covered parking bay
will be received;
 3 million birr on tarring parking for an additional 200 customer parking’s for the tenants
customers, no additional rentals are to be received in respect of this expenditure;
 400 000 birr on repairing the roof in respect of hail damage caused during 2022 (as hail
does not usually fall in the location of this building, this expenditure was totally
unanticipated and failure to incur the expenditure would result in a substantial loss of
future rental income);
 2 million birr in property rates; and
 200 000 birr legal fees on debt collection for ‘delinquent’ tenants.
Required:
Determine the amount that in accordance with IAS 40 must be:
 Capitalized to the investment property, and
 Expensed in arriving at operating profit for the year ended 31 December 20.2.

Solution:
Reason: Capitalise Expense
Birr Birr
 Shade-cloth covered Future economic 1 000 000
parking benefits

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 (operating lease
rentals)
 Tarred parking for lessee’s No future economic 3 000 000
customers benefits for
ABC Company
 Repairs to hail The restoration will lead to 400 000
damaged roof future economic benefits
 Property rates Operating 2 000 000
expense
 Legal fees Operating 200 000
expense
1 400 000 5 200 000

6.3 Subsequent Measurement of Investment Property

An entity must choose one of the following accounting policies for accounting for its
investment properties:

 Fair Value Model: Investment property is measured at fair value except in the
exceptional circumstances where there is clear evidence at the date of acquisition that fair
value will not be reliably measurable on a continuing basis in which case such investment
property is carried at depreciated historic cost computed to a nil residual value; or

 Cost Model: Investment property is measured at depreciated historic cost.

Although a free choice is available between the fair value model and the cost model, IAS 40
expresses a preference for the fair value model as it states that it is highly unlikely that the
cost model will result in more relevant presentation. This effectively prohibits a subsequent
change in accounting policy from the fair value model to the cost model.

An entity may choose the fair value model or the cost model for all investment property
backing liabilities that pay a return linked directly to the fair value of, or returns from,
specified assets including that investment property. Choosing the fair value model for this
category of investment property does not preclude the entity from choosing the cost model in
respect of its other investment properties.

5
 A. The Fair Value Model

Subsequent to initial recognition, an entity that uses the fair value model, measures all of its
investment property at fair value. Fair value is the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date. Best evidence is current prices in an active market for similar property in
the same location and condition. If not available, other methods can be used. Changes in the
fair value of investment properties during an accounting period are included in the
determination of the profit (or loss) for that period.

Example: Investment property is acquired August 11, 2008, at a cost of $200. Fair values:
December 31, 2008 - $190, December 31, 2009 - $198 and December 31, 2010 - $205.

Dec.31/08 Loss in value $10

Investment property $10
Dec.31/09 Investment property $ 8
Gain in value $8
Dec.31/10 Investment property $ 7
Gain in value $7

B. The Cost Model

Under the cost model, investment property is measured using IAS 16 – Property, plant and
equipment’s benchmark accounting treatment (i.e., depreciated historic cost). It is
emphasized that owner-occupied property does not constitute investment property and
accordingly, such property is accounted for in its entirety in accordance with IAS 16 –
Property, plant and equipment.

6.4 Presentation and Disclosure

As a general disclosure, firms are required to disclose

 Whether and when any operating leases are classified as investment property
 Criteria used to distinguish between owner-occupied investment property and property
held for sale where judgment is needed
 Methods and assumptions underlying fair value measurements, including extent to which
market-related evidence is used
 Extent to which the fair values were determined by an experienced, professional, and
6
 independent appraiser
 Existence of restrictions and contractual obligations related to the properties
 Amounts and specific types of income and expense recognized in profit or loss

Presentation and Disclosure: Fair value model and Cost model

Set out below are the presentation and disclosure requirements of IAS 40 where the reporting
entity adopts the fair value model and cost model for investment properties.

A reconciliation between the carrying amount at the beginning of the period and end of the period,
separately indicate the following.
Fair Value Cost model
(a) Additions from acquisitions and (a) Additions from acquisitions and subsequent
subsequent expenditure and from business expenditure and from business acquisitions.
acquisitions.
(b) Asset classified as held for sale and other (b) Asset classified as held for sale and other
disposal disposal
(c) Foreign exchange effect on transactions (c) Foreign exchange effect on transactions
(d) Transfer from and to owner occupied (d) Transfer from and to owner occupied
property property
(e) Net gain or loss from fair value adjustment (e) Depreciation and information about
impairment loss
(f) Other changes (f) Other changes
 A reconciliation between the valuation  The depreciation method used and the
received and the adjustment valuation used useful lives or depreciation rates.
on the financial statement, with details.  The carrying amount and the accumulated
 If property is measured using cost model depreciation at the end of each period.
because of inability to reliably measure fair  The fair value of investment property, or if
value, additional description and unable to determine reliably, additional
explanations. description and explanation.

7
 CHAPTER SEVEN

NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED OPERATIONS

Entities sometimes intend to sell their non-current assets (e.g., Property, Plant and Equipment)
and/or their operations. While the intention to sell a small piece of equipment may not affect
investment decisions, the intention to sell off factories and operating units can affect investors‟
choices. Because we must abide by the Financial Reporting Characteristics (specifically
"Relevance") and ensure that we are presenting all relevant information, we must ensure that
readers of the financial statements know whether non-current assets and disposal groups are
being held for sale.

7.1 The Nature of NCAHFS and Discontinued Operations

An entity shall classify a non-current asset (or disposal group) as held for sale if it‟s carrying
amount will be recovered principally through a sale transaction rather than through continuing
use. Which will be the case if the following conditions are met:

 asset/disposal group must be available for immediate sale in its present condition and
 the sale must be highly probable.

Typically, this definition captures individual assets that the entity seeks to dispose of in a sale
transaction, such as:

 Property, plant and equipment;

 Intangible assets;
 Investment property,
 Biological assets; and
 Non-current financial investments, such as interests in associates, or other financial
instruments.

Assets that are to be abandoned or scrapped (rather than sold) are not classified as assets held for
sale. Assets that will be derecognized due to an exchange of non-current assets with a third party
are covered, unless the exchange lacks commercial substance.

Discontinued Operations:
In order for an asset to be considered a discontinued operation, it must have been disposed of or
classified as Held for Sale, and:

 Represents either a major line of business (e.g., a business unit) or a geographical area of
operations (e.g., a key market), OR
 be part of a single coordinated plan to dispose of a separate major line of business or
geographical area of operations OR

 The subsidiary has been acquired exclusively with a view to resale and the disposal
involves a loss of control by the parent organization.

Disposal group concept

A 'disposal group' is a group of assets, possibly with some associated liabilities, which an entity
intends to dispose of in a single transaction. The measurement basis required for non-current
assets classified as held for sale is applied to the group as a whole, and any resulting impairment
loss reduces the carrying amount of the non-current assets in the disposal group in the order of
allocation.

Asset Held for sale, also includes cash-generating units called disposal groups that may include
current and non-current assets and liabilities. A disposal group occurs when an entity disposes of
a group of assets in a single transaction, possibly together with some directly associated
liabilities. This disposal group may be a group of cash generating units, a single cash-generating
unit, or part of a cash-generating unit. Non-current assets or disposal groups that are classified as
held for sale are carried at the lower of carrying amount and fair value less costs to sell. These
assets are not depreciated and are disclosed separately on the face of the statement of financial
position. The accounting for such an asset or disposal group is therefore a process of valuation
rather than allocation. Disposal groups are treated in the same way as a single asset held-for-sale
for reporting purposes.

7.2 Held-For-Sale Classification

In general, the following conditions must be met for an asset (or 'disposal group') to be classified
as held for sale:

 management is committed to a plan to sell

  the asset is available for immediate sale
 an active programme to locate a buyer is initiated
 the sale is highly probable, within 12 months of classification as held for sale (subject to
limited exceptions)
 the asset is being actively marketed for sale at a sales price reasonable in relation to its
fair value
 actions required to complete the plan indicate that it is unlikely that plan will be
significantly changed or withdrawn

The assets need to be disposed of through sale. Therefore, operations that are expected to be
wound down or abandoned would not meet the definition (but may be classified as discontinued
once abandoned).

An entity that is committed to a sale involving loss of control of a subsidiary that qualifies for
held-for-sale classification, classifies all of the assets and liabilities of that subsidiary as held for
sale, even if the entity will retain a non-controlling interest in its former subsidiary after the sale.

7.3 Held for Distribution to Owners’ Classification

The classification, presentation and measurement requirements of held for sale also apply to a
non-current asset (or disposal group) that is classified as held for distribution to owners. The
entity must be committed to the distribution, the assets must be available for immediate
distribution and the distribution must be highly probable.

7.4 The Measurement Principle of NCAHFS

The measurement principle requires an entity to measure a non-current asset (or disposal group)
classified as held for sale at the lower of its carrying amount and fair value less costs to sell.
Costs to sell is the incremental costs directly attributable to the disposal of an asset (or disposal
group), excluding finance costs and income tax expense.

The measurement rules derived from the measurement principle are:

 If a newly acquired asset (or disposal group) meets the criteria to be classified as held for
sale, on initial recognition it is measured at lower of its carrying amount and fair value
 less costs to sell. (This also applies to assets (or disposal groups) acquired as part of a
business combination.)
 If the sale is expected to occur beyond one year (in rare circumstances), the entity shall
measure the costs to sell at their present value.
 Immediately before the initial classification as held for sale, the carrying amounts of the
assets (or liabilities) are measured in accordance with the applicable Standards and
Interpretations.
 On subsequent re-measurement of a disposal group, the carrying amounts of any assets
and liabilities that are not included in the held for sale, but are included in a disposal
group classified as held for sale, shall be remeasured in accordance with the applicable
Standards before the fair value less costs to sell of the disposal group is measured.

Example 1
During December 2015, when the carrying amount of the land was Br.2,000, the reporting
entity‟s board approved its disposal and engaged an estate agent who actively marketed the
land at its fair selling price of Br. 2,000. Selling costs of Br.100 are expected to be incurred in
selling the property.
Prior to classification as held for sale the land was:
• Scenario 1: Investment property carried under the fair value model.
• Scenario 2: Investment property carried under the cost model.
• Scenario 3: Property, plant and equipment carried under the revaluation model.
• Scenario 4: Property, plant and equipment carried under the cost model.
Required: Determine the statement of financial position classification and the amount at
which the reporting entity should carry the land in its statement of financial
position at 31 December 2015.
Solution:
Under all scenarios the land is classified as held for sale and it is carried at Br. 1,900 under
scenarios 2, 3 and 4 (i.e., lower of carrying amount and selling price less costs to
sell (IFRS 5 paragraph 15) and Br. 2,000 under scenario 1.

Example 2: On 1 January 2018, Midroc decided to replace its existing machinery which it had
acquired on 1 January 2015 for $40 million and initiated process for acquisition of new
machinery. Simultaneously, it also initiated efforts to sell of the old machinery. The new
machinery was commissioned on 30 March 2018. The company depreciates machinery assuming
a zero residual value and 5-year total useful life. The carrying value of old machinery as at 1
January 2018 worked out to $16 million. If the fair value of the old machinery is $12 million and
it would cost 10% of the sale proceeds to close the deal, find out when the company should
classify the machinery as held-for-sale and maintain the necessary entry.

Before reclassifying the old machinery as held for sale, MIDROC must recognize the
depreciation expense to update the carrying value:

Annual Depreciation = = = 8,000,000

Depreciation expense (3/12 × 8 million) $2 million

Accumulated depreciation – old machinery $2 million
Accumulated depreciation = (40 million – 16 million+2 million) = 26 million

Carrying value (BV) = cost – accumulated depreciation = 40 million – 26 million = 14 million

Fair Value less cost of sale = 12 million – (10% x 12 million) = 10.8 million

Gain/loss = Fair Value less cost of sale - Carrying value (BV) = 10.8 million - 14 million = 3.2 million

As at 30 March 2018, MIDROC must pass the following journal entry:

Old machinery – held for sale (12 million × (1 – 0.1)) $10.8 million
Accumulated depreciation – old machinery $26 million
Loss on held for sale assets $3.2 million
Old machinery – cost $40 million

7.5 Subsequent Recognition

After the asset(s) or disposal group(s) have been classified as held for sale, they must be
measured at every reporting period, at the lower of: Carrying amount or FV less selling cost.

Impairment. Impairment must be considered both at the time of classification as held for sale
and subsequently:

 At the time of classification as held for sale. Immediately prior to classifying an asset
or disposal group as held for sale, impairment is measured and recognized in accordance
with the applicable IFRSs. Any impairment loss is recognized in profit or loss unless the
asset had been measured at revalued amount, in which case the impairment is treated as a
revaluation decrease.
  After classification as held for sale. Calculate any impairment loss based on the
difference between the adjusted carrying amounts of the asset/disposal group and fair
value less costs to sell. Any impairment loss that arises by using the measurement
principles in held for sale must be recognized in profit or loss, even for assets previously
carried at revalued amounts.
 Assets carried at fair value prior to initial classification. For such assets, the
requirement to deduct costs to sell from fair value may result in an immediate charge to
profit or loss.
 Subsequent increases in fair value. A gain for any subsequent increase in fair value less
costs to sell of an asset can be recognized in the profit or loss to the extent that it is not in
excess of the cumulative impairment loss.
 No depreciation. Non-current assets or disposal groups that are classified as held for sale
are not depreciated.

Subsequent recognition can result in a further impairment loss (if FV less cost to sell < Carrying
Amount), which is reported in Statement of Profit or Loss, as per the Impairment Criteria.
Subsequent recognition can also result in a gain (if FV less cost to sell > Carrying Amount).
Revaluations gains first reverse any prior impairments and then anything more than the
impairment loss becomes a Revaluation Surplus.

The following is a sample journal entry assuming there is a gain after a prior impairment loss.

Sample Journal Entry:

Asset Held for Sale X Increased the value of the asset

Reversal of loss on classification as held for sale X Reverses the prior loss recorded

Revaluation Surplus on Asset held for Sale X Additional gains go to surplus account.

The measurement provisions held for sale do not apply to deferred tax assets, assets arising from
employee benefits, financial assets within the scope of IFRS 9 Financial Instruments, non-current
assets measured at fair value in accordance with IAS 41 Agriculture, and contractual rights under
insurance contracts.

7.6 Presentation and Disclosure of NCAHFS and Discontinued Operations

Non-current assets classified as “held for sale” and the assets of a disposal group classified as
“held for sale” must be disclosed separately from other assets in the statement of financial
position. If those assets comprise a “disposal group” the assets and the liabilities of the group
must be disclosed separately either in the notes or on the face of the statement of financial
position.

Information about discontinued operations (both discontinued and “held for sale”) must be
presented in the statement of comprehensive income or in a note to the financial statements.

There must be a single amount on the face of the statement of comprehensive income (or income
statement) for the total of:
 the post-tax profit or loss for the period from the discontinued operations, and

 the post-tax gain or loss on disposal (based on the fair value minus costs to sell of
the asset or disposal group).
The total amount should be analyzed by:

 the revenue, expenses and pre-tax profit for the period from the discontinued
operations
 the related tax charges

 the gain or loss recognized on the measurement to fair value less costs to sell or
on the disposal of the assets or disposal group constituting the discontinued
operations.
This analysis may be contained in the notes or on the face of the statement of profit or loss and
other comprehensive income.

Discontinued operations should also be shown as a separate line item on the statement of cash
flows.

In addition, an entity should disclose the following information in the notes of the financial
statements in which an asset or disposal group has been sold or classified as “held for sale”:
1. a description of the non-current asset or disposal group
2. a description of the facts and circumstances of the sale
3. in the case of operations and non-current assets „held for sale‟, a description of the
facts and circumstances leading to the expected disposal and the expected manner
and timing of the disposal.
4. Any gain or loss recognized in accordance with IAS 36 – Impairment of Assets
5. The segment in which the assets or disposal group belongs (if applicable)