Financial Accounting: Assets Assignment
Question 1 (15 marks)
Evergreen Inc. operates a tree farming business. It plants, maintains, and harvests
evergreen trees. It sells the trees for cash, primarily during the Christmas season in
parking lots at select locations in major urban areas. It normally takes about 15 years for
a tree to grow to a suitable size. The biggest cost of this business is the cost of fertilizing,
pruning and maintaining the trees over the 15-year period.
Required
1. (10 marks)
Use the criteria for revenue recognition to explain when revenue should be recognized
for this tree farming business.
2. (5 marks)
How should the annual cost of fertilizing, pruning and maintaining the trees be accounted
for?
Question 2 (27 marks)
Multiple choice (1 mark each)
a. In general, in what period should costs be expensed?
1)
2)
3)
4)
The same period in which they are incurred
The period in which they are paid for
The same period in which the related revenue is recognized
The period after the related revenue is recognized
b. When is revenue recognized under the percentage-of-completion method of
recognizing revenue from long-term construction contracts?
1)
2)
3)
4)
Revenue is recognized as soon as the contract price is known.
Revenue is recognized in each period based on an estimate of the amount of
work completed in that period.
Revenue is recognized when the construction project is completed and all
costs are known with certainty.
Revenue is recognized as the progress payments are received from the
customer.
c. In selecting an accounting method for a newly contracted long-term construction
project, what is the principal factor that should be considered?
1)
2)
3)
4)
The terms of payment in the contract
The methods used by other contractors in the industry
The reliability of the estimate of the progress toward contract completion
The method usually used by the contractor to account for other long-term
construction contracts
d. Revenue is recognized earliest using which of the following revenue recognition
methods?
1)
At date of sale
2)
3)
4)
Instalment sales method
Completion-of-production method
At delivery
e. In general, revenue is recognized when the earning process is substantially complete
and also which of the following?
1)
2)
3)
4)
The sales price is measurable and collectible.
The sales price has been collected.
Production is completed.
A purchase order has been received.
f. Why do most retail enterprises recognize revenue at the point of sale?
1)
2)
3)
4)
The price is known.
Collectibilty of any amounts owing is reasonably assured.
Future costs associated with the sale such as warranty costs and returns can be
reasonably estimated.
All of the above
g. What is the accounting definition of losses?
1)
2)
3)
4)
Decreases in net assets from regular operating activities
Decreases in net assets from activities outside the enterprise’s normal business
activities
Expenses
Increases in net assets from activities outside the enterprise’s normal business
activities
h. The process of recognizing depreciation expense by allocating the cost of an asset to
depreciation expense over its useful life is an example of what accounting principle?
1)
2)
3)
4)
The revenue recognition principle
The matching principle
The reliability principle
The historic cost principle
i. Which financial statements are affected when revenue is recognized?
1)
2)
3)
4)
Balance sheet only
Income statement only
Both Balance sheet and Income statement
Depends on the type of revenue
j. Which of the following is true with respect to depreciation?
1)
2)
3)
4)
Depreciation is an allocation of the cost of property, plant, and equipment in a
rational and systematic manner to the periods in which such items are used.
Depreciation is a process of recognizing the decreasing value of an asset over
time.
Depreciation is a cash expense.
Depreciation of €4,000 reflects a €4,000 increase in liquid assets.
k. When inventory items are not ordinarily interchangeable, what inventory costing
method should be used to compute ending inventory and cost of goods sold?
1)
2)
3)
4)
Moving weighted average
FIFO
Specific identification
Weighted average
l. In a period of declining prices, which inventory costing method will normally
produce the lowest ending inventory figure?
1)
2)
3)
4)
Weighted average
Specific identification
Moving weighted average
FIFO
m. How should development costs be accounted for according to IAS 38?
1)
2)
3)
4)
They must be capitalized when incurred and then depreciated over their useful
lives.
They must be expensed in the period incurred.
They must be capitalized when incurred and then expensed over a period not
exceeding five years.
They must be expensed in the period incurred unless it is reasonably certain
that the expenditures will provide future benefits.
n. How should research costs be accounted for according to IAS 38?
1)
2)
3)
4)
They must be capitalized when incurred and then depreciated over their useful
lives.
They must be expensed in the period incurred.
They must be capitalized when incurred and then expensed over a period not
exceeding five years.
They must be expensed in the period incurred unless it is reasonably certain
that the expenditures will provide future benefits.
o. The straight-line method of depreciation is based on what assumption?
1)
2)
3)
4)
The calculation of depreciation expense should be as simple as possible.
Revenue is generated from the asset at a constant rate over time.
Proportionately more revenue is generated in the early years of the asset’s
useful life than in the later years.
The asset has an indefinite useful life.
p. Which depreciation method would, in theory, provide for the best matching of cost to
the related revenue?
1)
2)
3)
4)
Straight-line
Double declining balance
Sum-of-the-units
Compound interest
q. If a company constructs a laboratory building to be used as a research and
development facility, how should the cost of the laboratory building be expensed?
1)
2)
3)
Research and development expense in the period(s) of construction
Depreciation deducted as part of research and development costs
Depreciation or immediate write-off depending on company policy
4)
An expense at such time as productive research and development has been
obtained from the facility
r. What is the similarity between deferred charges and prepaid expenses?
1)
2)
3)
4)
They are both reported as current assets on a classified balance sheet.
They will both be debited to expense in some subsequent period in accordance
with the matching principle.
They are both reported as non-current assets on a classified balance sheet.
They are both expensed in the period immediately following the balance sheet
on which they appear.
s. Mango Inc. went to court this year and successfully defended the brand name of its
product, “EnviroPack,” from infringement by a competitor. The cost of this defence
should be charged to?
1)
2)
3)
4)
Patents and amortized over the legal life of the patent
Legal fees and amortized over five years or less
Expenses of the period
Trademarks and amortized over a given period
(2 marks each)
Note: The following information should be used to answer part (t) and part (u)
BC Construction Limited contracted to build an office building for XYZ Holdings Inc.
for €2,000,000. Construction began in January 20X6 and was completed in
December 20X7. Details of the activities related to this contract are summarized as
follows (in €000s):
Costs incurred to date
Estimated costs to complete
Progress billings to date
Collections on progress billings to date
20X6
20X7
400
1,200
300
250
1,700
2,000
2,000
t. How much gross profit can BC recognize for this contract in 20X6 under the
percentage-of-completion method of revenue recognition?
1)
2)
3)
4)
Zero
€100,000
€133,333
€266,667
u. Assuming BC is unable to estimate costs to complete the project at the end of 20X6,
how much gross profit would BC recognize on this contract in 20X7?
1)
2)
3)
4)
Zero
€50,000
€300,000
€450,000
v. Vermil Inc. began operations on January 1, 20X6, and uses the FIFO method of
inventory costing. Management is contemplating a change to the average costing
method to be consistent with Vermil’s parent company and is interested in
determining what effect such a change will have on 20X7 profit. Accordingly, the
following information has been developed (in €000s):
Ending Inventory: FIFO
Average cost
Profit (computed under the FIFO method)
20X6
20X7
€ 96
80
580
€ 108
84
780
Based on the above information, what will the 20X7 profit be after a change to the
average cost method of inventory costing?
1)
2)
3)
4)
€740
€756
€772
€780
w. Zenon Ltd. sells products with a two-year warranty period. During the current year
Zenon has sales of €600,000. Based on many years of experience, Zenon is able to
reliably estimate warranty costs at 6% of the original sales amount. During the
current year, Zenon incurs €30,000 of warranty costs related to products sold the
prior year and also incurs €14,000 of warranty costs related to products sold this year.
Assuming Zenon records revenue at the time of sale, what is warranty expense for the
current year?
1)
2)
3)
4)
€44,000
€14,000
€36,000
€12,000
Question 3 (26 marks)
Caragana Construction Ltd. contracted to build an office building for €6,600,000.
Construction began in September 20X5 and is scheduled to be completed in May 20X7.
Data related to this contract are summarized as follows (in €000s):
Costs incurred during the year
Estimated additional costs to complete
Billings during the year
Cash collections during the year
20X5
20X6
20X7
€ 1,000
5,000
900
850
€ 3,600
2,200
2,600
2,200
€ 2,100
—
3,100
3,550
The balance sheet presentation for this contract for 20X5 and 20X6 was as follows:
20X5
20X6
Assets:
Accounts receivable
Construction in process
Less: Progress billings
Required
1. (3 marks)
€ 50
€ 1,000
(900)
100
€ 450
€ 4,400
(3,500)
900
Which method of accounting for revenue recognition (percentage-of-completion or
completed contract) did Caragana use for the long-term construction contract for 20X5
and 20X6? Explain.
2. (9 marks)
Prepare the income statement presentation for this contract for 20X5 and 20X6 under the
other method of accounting for revenue recognition. Show your supporting calculations.
3. (2 marks)
Which method would you recommend for Caragana? Explain.
4. (12 marks)
Prepare journal entries for each of the three years under each of the alternative revenue
recognition methods.
Question 4 (14 marks)
Air Plain Ltd. is a regional airline. Individual travellers typically reserve their flights at
least three weeks prior to departure, and pay for the flights two weeks prior to departure.
Corporate travelers typically book their flights through a travel agent and do not pay for
their flights until 30 days after the flights have been taken and the invoice rendered.
Occasionally, travellers make reservations but do not take the reserved flight and do not
bother cancelling their reservations. These passengers receive a refund of amounts paid
less a €75 administration fee. If they did not pay for the reserved flight, they are billed a
€75 administration fee for not using the flight. However, more than 50% of these €75
billings are never collected and are eventually written off by the company
Required
1. (6 marks)
Based on the information provided and using the criteria for revenue recognition, state
why revenue should or should not be recognized:
a. at the time of reservation
b. when cash is collected (prior to taking the flight)
c. at the completion of the flight
2. (8 marks)
Now assume that all revenue is recognized at the completion of the flight.
a. How should cash received for flights reserved but not yet taken be accounted for?
b. How should the unused but unpaid flights (reservations made, flight not taken, and
reservations not cancelled) be accounted for?
Question 5 (18 marks)
Global Aircraft Manufacturers Ltd. is a manufacturer and seller of a wide range of
commercial and military aircraft for markets around the world. During the year it has
incurred expenditures of €32,000,000 on its RX7 project. The RX7 is a stretch version of
its popular RX6 aircraft that has been in service for a number of years. During the year, a
prototype was completed and a number of test flights were successfully completed.
Major airlines around the world have been impressed with the plane and have signed firm
orders for 50 of the aircraft, expected to be in commercial production in three years.
Global expects that it will need to sell 150 of the planes to break even on its investment
and is comfortable it will be able to do so.
During the year, Global also incurred expenditures of €2,500,000 on its Personal Jet (PJ)
project. The PJ project is dedicated to designing and building a commercially viable
personal jet about the size of a car that can fly at speeds up to 900 kilometres per hour.
Most of the €2,500,000 in expenditures incurred in the current year was for salaries for a
team of aeronautical engineers working on the project. To date, a number of computer
models of the PJ have been developed, but no prototypes have been developed. Global
thinks there will be a market for these personal jets but, at this time, has no idea what the
total development costs will be and what an estimated sales price might be. No orders for
the PJ have been taken by Global.
Required
1. (6 marks)
How should Global account for the expenditures incurred during the year on its
RX7 project? Carefully support your answer with specific reference to the appropriate
criteria.
2. (6 marks)
How should Global account for the expenditures incurred during the year on its
PJ project? Carefully support your answer with specific reference to the appropriate
criteria.
3. (6 marks)
Using inventory held for resale as an example, explain when costs incurred should be
expensed.
100
Suggested solutions
Question 1 (15 marks)
Requirement 1 (10 marks)
Revenue should be recognized when the trees are sold to the customer during each of the
Christmas seasons because that is when the benefits and risks of ownership pass from the
company to the customer. Until then, the company does not know whether any customers
will buy their trees or how much the customer will pay for the trees (measurement of
amount). There is so much competition and one never knows how many trees will be
sold. Some trees may have to be discarded if they do not sell. Also, at the time of the
sale, cash is collected so there is no uncertainty as to collectibility. The company has
little or no risk once the tree is sold because it is very unlikely that the tree will be
returned.
Requirement 2 (5 marks)
The annual cost of fertilizing, pruning, and maintaining the trees should be capitalized as
a cost of inventory. In effect, the trees are like work-in-process inventory. Then, when the
trees are sold, all of these costs will be expensed as cost of goods sold. This is an
example of the matching principle and the point of sale recognition method.
Question 2 (27 marks)
Multiple choice (1 mark each)
a. 3)
Under the matching principle, costs should be expensed in the same period as the related
revenues are recognized.
b. 2)
The percentage-of-completion method of revenue recognition is an example of
recognizing revenue as effort is expended, or as the work is done. If a reliable estimate of
the percentage of the total work completed in a period can be made, then that proportion
of total revenue from the project will be recognized.
c. 3)
If the percentage-of-completion can be reliably estimated, then revenue will be
recognized based on the amount of work done. If it is not possible to estimate the stage of
completion, then revenue will only be recognized to the extent of costs incurred in the
period.
d. 3)
The completion-of-production method of revenue recognition recognizes revenue as soon
as production is complete. The other three methods recognize revenue only at date of sale
to customer, or later.
e. 1)
Generally, the conditions that are required before revenue can be recognized are that the
earnings process is substantially complete and the sales price is measurable and
collectible.
f. 4)
The revenue recognition criteria of performance, measurability, and collectibility are
generally all met at the time of sale.
g. 2)
Losses are defined as decreases in net assets from activities outside the enterprise’s
normal operating activities. Expenses are decreases in net assets from an enterprise’s
normal business activities.
h. 2)
Under the matching principle, expenses (cost of efforts) are matched to revenues
(accomplishments).
i. 3)
Since revenue is defined as an increase in net assets from normal operating activities,
both Income statement accounts (Revenue) and Balance sheet accounts (assets or
liabilities) must be impacted.
j. 1)
Depreciation is a method of transferring the cost of an asset to expense over the period
that the asset produces revenue in accordance with the matching principle. There is no
cash involved in the allocation process.
k. 3)
IAS 2 specifies that the specific identification method of inventory costing should be
used when inventory items are not ordinarily interchangeable.
l. 4)
Under FIFO, the newest costs (which will be the lowest in a period of declining prices)
will be assigned to ending inventory.
m. 4)
Development costs must be expensed as incurred unless the six criteria for capitalization
are met.
n. 2)
Since it is difficult to link research efforts with specific future benefits, IAS 38
recommends that they be expensed as incurred.
o. 2)
Since the same amount of depreciation expense will be recognized each year, we must be
assuming that the related revenue from the asset is constant from year to year.
p. 3)
Under the sum-of-the-units method, depreciation expense is based on units produced in
the period compared to total units expected to be produced over the life of the asset. This
is a direct matching of expense with the related revenue.
q. 2)
The normal depreciation on the building would be calculated. Then, it would be
apportioned to research activities or development activities and capitalized or expensed
as appropriate.
r. 2)
Both prepaid expenses and deferred charges represent costs that have not yet been
expensed. Prepaid expenses will become expenses in the next period while deferred
charges will become expenses in the next or future periods.
s. 3)
IAS 38 requires that legal fees be expensed when incurred. However, it can be argued
that the successful defence of the trademark ensures that it continues to produce future
benefits. Therefore, it could be capitalized and amortized over the shorter of the
trademark’s useful and legal life. Note that this latter approach is very uncommon.
(2 marks each)
t. 2)
(€400,000  €1,600,000) × €400,000 = €100,000
At the end of 2004, €400,000 of the estimated total costs to complete of €1,600,000 had
been incurred. This indicates that 25% of the work has been done. The estimated total
profit is €400,000 (€2,000,000 – €1,600,000) of which 25% (€100,000) will be
recognized this year.
u. 3)
€2,000,000  €1,700,000
Since reliable estimates of degree of completion cannot be made, revenue would be
recognized in 2004 only to the extent of costs incurred (no profit). In 2005, when the
final results are known (Contract price of €2,000,000 and total costs incurred of
€1,700,000), the full profit of €300,000 is recognized.
v. 3)
€780 + €16 – €24
The change in accounting method must be applied retroactively. Therefore, opening
inventory for 2007 would be decreased by €16 (€96 – €80) and closing inventory for
2007 would be decreased by €24 (€108 – €84). The decrease in opening inventory would
cause 2007 profit to increase by €16 and the decrease in closing inventory would cause
2007 profit to decrease by €24.
w. 3)
€600,000 × 6%
Question 3 (26 marks)
Requirement 1 (3 marks)
Caragana is using the completed contract method of revenue recognition because the
Construction in process account contains the actual costs and no profit in 2005, and
actual costs less the expected loss of €200,000 in 2006 (See Note 1 to Part 2).
Requirement 2 (9 marks)
Under the percentage-of-completion method of revenue recognition, profit would be
recognized as follows:
CARAGANA CONSTRUCTION LTD.
Partial Income Statement
for the year ended December 31
(in €000s)
Revenue from construction contracts (Note 1)
Costs of construction contract (Note 2)
Gross margin on construction contract
20X5
20X6
€ 1,100
1,000
€ 100
€ 3,364.9
3,664.9
€ (300.0)
Notes:
1.
(in €000s)
20X5
20X6
Actual costs to date
Estimated costs to complete
Total expected costs
Total expected revenue
Total expected profit (loss)
€ 1,000
5,000
6,000
6,600
€ 600
€ 4,600
2,200
6,800
6,600
€ (200)
Percentage complete
Revenue earned to date
Less revenue recognized in prior years
Revenue recognized in current year
16.67%
*1,100
—
€ 1,100
67.65
**4,464.9
(1,100)
€ 3,364.9
2. Amount required to produce a gross margin of €100 to end of 20X5 and a cumulative
loss of €200 to the end of 20X6.
* 16.67% of €6,600
** 67.65% of €6,600
Requirement 3 (2 marks)
Either method could be selected. However, the percentage-of-completion method
matches expenses and revenues on a more timely basis when reliable estimates of
progress and costs to complete the contract can be made. The completed contract method
is driven by the conservatism constraint and should be used only when reliable estimates
cannot be made. The rationale for the choice should be evaluated accordingly.
Requirement 4 (12 marks)
Following are the journal entries for the three years using the percentage-of-completion
method of revenue recognition (in €000s):
20X5
Construction in progress ..............................................................
Cash/AP .................................................................................
To record construction cost incurred
1,000
Accounts receivable .....................................................................
900
1,000
Progress billings ....................................................................
To record contract billings during year
900
Cash .............................................................................................
Accounts receivable ...............................................................
To record cash collections during year
850
Construction in progress ..............................................................
Construction expenses .................................................................
Contract revenue ....................................................................
To record revenue recognized on contract during year
100
1,000
850
1,100
20X6
Construction in progress ..............................................................
Cash/AP .................................................................................
To record construction cost incurred
3,600
Accounts receivable .....................................................................
Progress billings ....................................................................
To record contract billings during year
2,600
Cash .............................................................................................
Accounts receivable ...............................................................
To record cash collections during year
2,200
Construction expenses .................................................................
Construction in progress ........................................................
Contract revenue ....................................................................
To record revenue recognized on contract during year
3,664.9
3,600
2,600
2,200
300
3,364.9
20X7
Construction in progress ..............................................................
Cash/AP .................................................................................
To record construction cost incurred
2,100
Accounts receivable .....................................................................
Progress billings ....................................................................
To record contract billings during year
3,100
Cash .............................................................................................
Accounts receivable ...............................................................
To record cash collections during year
3,550
Construction in progress ..............................................................
Construction expenses .................................................................
Contract revenue ....................................................................
100
2,035.1
2,100
3,100
3,550
2,135.1
To record revenue recognized on contract during year. The contract is now complete for
a total cost of €6,700. Therefore, there is a total loss on the contract of €100 (€6,600 –
€6,700). Since a cumulative loss of €200 (€100 – €300) has been recognized to the end of
2006, a profit of €100 must be recognized in 20X7. Revenue in 20X7 must be €6,600
minus the amount previously recognized. Therefore 2007 revenue equals €2,135.1
(€6,600 – €1,100 – €3,364.9). Construction expense in 20X7 of €2,035.1 is the expense
needed to produce the 20X7 gross profit of €100.
Progress billings ..........................................................................
6,600
Construction in progress ........................................................
6,600
To close the progress billings account against the construction in progress account
Following are the journal entries for the three years using the completed contract method
of revenue recognition (in €000s):
20X5
Construction in progress ..............................................................
Cash/AP .................................................................................
To record construction cost incurred
1,000
Accounts receivable .....................................................................
Progress billings ....................................................................
To record contract billings during year
900
Cash .............................................................................................
Accounts receivable ...............................................................
To record cash collections during year
850
Construction expenses .................................................................
Contract revenue ....................................................................
To record contract revenue equal to construction costs incurred
1,000
1,000
900
850
1,000
20X6
Construction in progress ..............................................................
Cash/AP .................................................................................
To record construction cost incurred
3,600
Accounts receivable .....................................................................
Progress billings ....................................................................
To record contract billings during year
2,600
Cash .............................................................................................
Accounts receivable ...............................................................
To record cash collections during year
2,200
3,600
2,600
2,200
Construction expenses .................................................................
3,600
Construction in progress ........................................................
200
Contract revenue ....................................................................
3,400
To record loss as soon as it is known. Under the completed contract method, revenue is
recognized to the extent of costs incurred. If a loss on the project is predicted, as it is here
of €200, it is recorded as soon as the loss is predicted. By recording contract revenue of
€3,400 and construction expense of €3,600, the loss of €200 is recorded in year 2.
20X7
Construction in progress ..............................................................
Cash/AP .................................................................................
To record construction cost incurred
2,100
Accounts receivable .....................................................................
Progress billings ....................................................................
To record contract billings during year
3,100
Cash .............................................................................................
Accounts receivable ...............................................................
To record cash collections during year
3,550
2,100
3,100
3,550
Construction expenses .................................................................
2,100
Construction in progress ..............................................................
100
Contract revenue ....................................................................
2,200
Overall, there is a loss on the contract of €100 (€6,600 – €6,700). To date, a cumulative
loss of €200 has been recorded. A profit of €100 must be recorded in 20X7 to get the
cumulative loss of €100.
Progress billings ..........................................................................
6,600
Construction in progress ........................................................
6,600
To close the progress billings account against the construction in progress account
Question 4 (14 marks)
Requirement 1 (6 marks)
a. At the time of reservation, the price of the flight is known; therefore, the amount of
revenue is known (measurability). However, collectibility is unknown at this point
because it is not known whether the passenger will ever take the flight. The service of
providing the flight (performance) has not yet been provided.
b. When the cash has been collected (prior to taking the flight), collectibility is now
reasonably assured and the amount of revenue is measurable. However, the main
service of completing the flight has not been provided (performance).
c. At the completion of the flight, revenue has been earned because all criteria for
revenue recognition have been fulfilled — service has been rendered (performance),
revenue is measurable, and collectibility is reasonably assured, since most individuals
will have already paid and the corporate accounts are likely to be collectable or a
reasonable estimate of the allowance for doubtful accounts can be estimated.
Requirement 2 (8 marks)
a. The cash received for flights reserved but not yet taken should be recorded as a debit
to cash and a credit to deposits on flights, which is presented as a current liability (the
obligation of the airline to provide the flight).
b. Once the flight for which the reservation was made is completed, the €75 fee should
be recorded as revenue with a corresponding reduction in deposits on flights for those
passengers who paid for the flight or a corresponding debit to accounts receivable for
those travellers who have not yet paid for the flight. In turn, an allowance for
doubtful accounts should be established for those travellers who are not likely to pay
the €75 fee.
Question 5 (18 marks)
Requirement 1 (6 marks)
The expenditures on the RX7 project would appear to fall under the IAS 38 definition of
development. That is, the new jet that is being worked on qualifies as a plan for the
production of a new or improved product. The next question is whether or not the
development costs qualify for capitalization and subsequent amortization. If it is
relatively certain that the expenditures will lead to future economic benefits from the sale
of new products, then the costs should be capitalized. IAS 38 requires six criteria be met
before development costs be capitalized. The following is an analysis of this project in
terms of those six criteria:
a. Technical feasibility: Since a prototype has been completed and successfully flown,
technical feasibility would seem to be satisfied.
b. Intention to complete and sell product: The project seems to be successful so far.
There is no indication that Global does not intend to complete. It has already received
orders for the new plane.
c. Ability to sell the product: The existence of firm orders from customers suggests
Global has the ability to sell the product.
d. Will it generate probable future economic benefits: The existence of the firm orders
and a successful prototype suggest the plane will be completed and sold, thus
generating future economic benefits through sale of the products.
e. Availability of adequate financial and technical resources to complete the project:
There is nothing to suggest that Global does not have the necessary resources to
complete the project.
f. Ability to measure the expenditures attributable to the RX7 project: The fact that
Global estimates it will need to sell 150 planes to break even suggests that Global is
able to track the costs of the project.
It appears that the six criteria for capitalization of development costs have been met in
the case of Global’s RX7 project. Therefore, these costs should be capitalized and
depreciated to expense as the new planes are sold.
Requirement 2 (6 marks)
The expenditures on the PJ project would initially appear to fall under the IAS 38
definition of development. That is, the personal jet that is being worked on qualifies as a
design for the production of a new product. The next question is whether or not the
development costs qualify for capitalization and subsequent depreciation. If it is
relatively certain that the expenditures will lead to future economic benefits from the sale
of new products, then the costs should be capitalized. IAS 38 requires six criteria be met
before development costs be capitalized. The following is an analysis of this project in
terms of those six criteria:
a. Technical feasibility: Technical feasibility is still not confirmed. No prototype has yet
been built.
b. Intention to complete and sell product: They seem to have the intention to complete,
but without an actual product it is difficult to confirm.
c. Ability to sell the product: No attempt has been made at gaining orders and it appears
Global has no firm evidence of potential market size.
d. Will it generate probable future economic benefits: Without any orders and no clear
idea of what the development costs will be it is hard to argue that there will be
positive future economic benefits.
e. Availability of adequate financial and technical resources to complete the project:
Without knowing the cost of development, the adequacy of financial resources is
suspect.
f. Ability to measure the expenditures associated with the PJ project: There is nothing
to suggest that costs attributable to the project cannot be tracked.
Since not all six criteria for capitalization appear to have been met, then the development
costs incurred this year should be expensed. There is not enough evidence that the
expenditures on the PJ project will lead to future economic benefits.
Requirement 3 (6 marks)
When a cost is incurred, it must be either capitalized as an asset or expensed when
incurred. The general rule is that if the cost is expected to provide future economic
benefits, then it should be initially capitalized and then transferred to expense as those
future economic benefits are realized. If it is not likely that the expenditure will produce
any future economic benefits, then the expenditure should be expensed immediately
when it is incurred.
For inventory specifically, the acquisition of inventory for resale usually results in
capitalization of the cost on the balance sheet. This is because it is expected that the
inventory will be sold in some future period, thus providing an economic benefit (the
sale). In the subsequent period when the inventory is sold, the original cost is transferred
from the balance sheet to the income statement as Cost of goods sold expense. This
accomplishes the proper matching of the revenue (sale of inventory) and expense (cost of
inventory). If inventory becomes unsaleable (through obsolescence, for example) then the
inventory would be written off to expense (Cost of goods sold) as soon as that becomes
known. This is recognizing that there is no future economic benefit to come from the
inventory.
100