Contents
What You Really Need to Know ....................................................................................................................................... 4
CHAPTER 12: Financial Liabilities and Provisions ........................................................................................................... 4
WHAT IS A LIABILITY? ................................................................................................................................................ 4
CATEGORIES OF LIABLITIES ........................................................................................................................................ 4
FINANCIAL LIABILITIES ............................................................................................................................................... 4
EXAMPLES OF PROVISIONS ........................................................................................................................................ 6
Classifying Liabilities, Disclosure and Statement of Cash Flow .................................................................................. 8
ACCOUNTING STANDARDS FOR PRIVATE ENTERPRISES (ASPE) ................................................................................ 8
What You Really Need to Know ....................................................................................................................................... 9
CHAPTER 13: Financial Instruments: Long Term Debt ............................................................................................... 9
SOURCES OF FINANCING .................................................................................................................................... 9
SHORT TERM FINANCING (LO1) ........................................................................................................................ 9
LONG TERM FINANCING (LO2) .......................................................................................................................... 9
COVENANTS (LO3) ................................................................................................................................................ 9
LONG TERM DEBT (LO4) ...................................................................................................................................... 9
FOREIGN EXCHANGE ISSUES (LO5) .................................................................................................................10
CAPITALIZATION OF BORROWING COSTS (LO6) .........................................................................................10
DEBT RETIREMENT (LO7) ...................................................................................................................................10
CASH FLOW STATEMENT AND DISCLOSURES FOR LONG-TERM LIABILITIES (LO8) ..........................11
ACCOUNTING STANDARDS FOR PRIVATE ENTERPRISES (ASPE) (LO9) .................................................11
What You Really Need to Know ......................................................................................................................................12
CHAPTER 14: SHAREHOLDERS’ EQUITY ............................................................................................................12
LO-1 Distinguish the various types of share capital issued by private and public companies and descriptive terms
used ...........................................................................................................................................................................12
LO-2 Explain the recognition and measurement requirements for share capital issues and subscriptions ...............13
LO-3 Identify reasons for share retirements and illustrate the related measurement and recognition requirements 13
LO-4 Explain the recognition. Measurement and disclosure requirements for treasury stock transactions .............14
LO-5 Distinguish the various components of retained earnings. ..............................................................................14
LO-6 Classify the various types of dividend payments and illustrate the appropriate accounting treatment ...........15
LO-7 Describe the presentation and disclosure of stock splits, contributed capital and accumulated other
comprehensive income .............................................................................................................................................16
LO-8 Illustrate the presentation of the statement of equity and the related note disclosure .....................................17
LO-9 Compare the recognition, measurement and presentation of share capital transactions under ASPE and IFRS
..................................................................................................................................................................................17
What You Really Need to Know ......................................................................................................................................18
CHAPTER 15: COMPLEX DEBT AND EQUITY INSTRUMENTS ........................................................................18
LO-1 Classify complex financial instruments as debt or equity using classification factors. ...................................18
LO-2 Identify, classify and describe the measurement and disclosure requirements for different types of complex
financial instruments. ................................................................................................................................................18
LO-3 Illustrate the recognition, measurement and disclosure of convertible debt converted at the investor’s option
..................................................................................................................................................................................19
LO-4 Illustrate the recognition, measurement and disclosure of convertible debt when conversion is mandatory ..19
LO-5 Classify stock options and rights and describe the related reporting and disclosure requirements .................20
LO-6 Summarize the characteristics of share based arrangements and describe the various accounting patterns
related to the share based arrangements for employees ............................................................................................21
LO-7 Describe the nature of derivatives and hedges and the related accounting implications .................................22
LO-8 Explain the presentation of financial instruments on the cash flow statement and the related note disclosure
related to risks ...........................................................................................................................................................23
LO-9 Compare and contrast the accounting requirements for complex financial instruments under ASPE and IFRS
under ASPE (different treatment than under IFRS): .................................................................................................23
What You Really Need to Know ......................................................................................................................................24
CHAPTER 16: ACCOUNTING FOR CORPORATE INCOME TAX........................................................................24
1
LO-1 Explain the difference between the income tax provision and expense and permanent and temporary
differences ................................................................................................................................................................24
LO-2 Describe the various approaches to interperiod tax allocation and the related conceptual issues and prepare
the appropriate accounting entries ............................................................................................................................24
LO-3 Classify the various tax related elements on the statement of financial position ............................................25
LO-4 Illustrate the disclosure requirements related to income taxes ........................................................................26
LO-5 Apply the short cut approach if tax rates have not changed ............................................................................26
LO-6 Describe the presentation of income taxes on the cash flow statement ...........................................................27
LO-7 Describe the conceptual issues of defining deferred taxes as a liability..........................................................27
LO-8 Describe the recognition, measurement and disclosure requirements for income taxes under ASPE .............27
What You Really Need to Know ......................................................................................................................................29
CHAPTER 17: ACCOUNTING FOR TAX LOSSES .................................................................................................29
LO-1 Distinguish between a tax loss and tax benefit, tax loss carryforwards and temporary and permanent
differences in the year of loss ...................................................................................................................................29
LO-2 Explain the recognition and measurement of tax loss carryforwards and two approaches for recording the
accounting entries .....................................................................................................................................................29
LO-3 Illustrate the use of a valuation allowance to report tax loss benefits and recognize the appropriate tax rate to
be used ......................................................................................................................................................................30
LO-4 Compare the reporting requirements for tax loss carryforwards under various scenarios with changing
probabilities of realization ........................................................................................................................................30
LO-5 Explain the disclosure requirements for income taxes ...................................................................................31
LO-6 Describe the recognition and measurement of tax loss benefits under ASPE .................................................32
Appendix 1 ...............................................................................................................................................................32
LO-3 Illustrate the use of a valuation allowance to report tax loss benefits and recognize the appropriate tax rate to
be used ......................................................................................................................................................................32
What You Really Need to Know ......................................................................................................................................33
CHAPTER 18: LEASES ..............................................................................................................................................33
UNDERSTAND THE ELEMENTS, DEFINITIONS, AND IDENTIFICATION CRITERIA OF A LEASE (LO 1)
..................................................................................................................................................................................33
EXPLAIN THE ACCOUNTING METHODS FOR LEASES FROM THE LESSEE’S PERSPECTIVE (LO 2) ..34
PREPARE THE APPROPRIATE JOURNAL ENTRIES AND SCHEDULES FROM THE LESSEE’S
PERSPECTIVE (LO 3) ............................................................................................................................................36
DESCRIBE AND ACCOUNT FOR A SALE LEASEBACK TRANSACTION AND OTHER LEASE RELATED
ISSUES (LO 4) .........................................................................................................................................................36
UNDERSTAND HOW TO ACCOUNT FOR OPERATING AND CAPITAL LEASES UNDER ASPE (LO 5) ..37
EXPLAIN THE RECOGNITION, MEASUREMENT, AND DISCLOSURE REQUIREMENTS FOR LEASES
FROM THE LESSOR’S PERSPECTIVE (LO 6) ....................................................................................................38
EXPLAIN THE FINANCIAL STATEMENT IMPACT AND DISCLOSURE REQUIREMENTS FOR LEASES
UNDER IFRS AND ASPE (LO 7) ...........................................................................................................................39
IDENTIFY SIMILARITIES AND DIFFERENCES BETWEEN THE ACCOUNTING FOR LEASES UNDER
IFRS AND ASPE (LO 8) .........................................................................................................................................41
What You Really Need to Know ......................................................................................................................................42
CHAPTER 19: POST-EMPLOYMENT BENEFITS ...................................................................................................42
LO-1 Describe the two types of pension plans and their related variables ...............................................................42
LO-2 Describe the recognition, measurement and disclosure requirements for defined contribution plans ............43
LO-3 Describe the three actuarial cost methods for defined benefit pension plans and explain the difference be
funding and accounting amounts ..............................................................................................................................43
LO-4 Define the various components for defined benefit pension plan. ..................................................................44
LO-5 Describe the components in the pension expense for defined benefit pension plans and reconcile the net
funding status to the accrued pension liability recognized for accounting purposes ................................................45
LO-6 Prepare a pension plan spreadsheet showing the memorandum accounts and the reported accounts for
defined benefit pension plans over numerous years and the related accounting adjustments ...................................45
LO-7 Explain the differences between other post-employment benefit plans and pension plans and prepare the
spreadsheet and accounting entries for the post employment benefit plans..............................................................47
LO-8 Identify the disclosure requirements in the statements and the notes required for pensions and other post
employment benefits. ................................................................................................................................................47
2
LO-10 Compare the accounting treatment for pension plans under ASPE with IFRS and the proposals for change
..................................................................................................................................................................................47
What You Really Need to Know ......................................................................................................................................49
CHAPTER 20: EARNINGS PER SHARE...................................................................................................................49
LO-1 Explain basic and diluted EPS and interpret what the numbers mean ............................................................49
LO-2 Calculate basic EPS adjusting for weighted average number of shares, contingently issuable and complex
dividends...................................................................................................................................................................49
LO-3 Itemize the steps required in calculating diluted EPS and identify appropriate adjustments to be made for
conversions ...............................................................................................................................................................50
LO-4 Identify and describe the impact of the numerous factors that complicate the calculation of diluted EPS .....51
LO-5 Prepare the calculation of basic and diluted EPS under a comprehensive scenario ........................................52
LO-6 Describe the disclosure requirements related to EPS and the impact of restatements and changes in share
capital .......................................................................................................................................................................52
What You Really Need to Know ......................................................................................................................................53
CHAPTER 21: ACCOUNTING CHANGES ..............................................................................................................53
LO-1 Provide examples of changes in estimates and describe the related accounting and disclosure requirements 53
LO-2 Identify changes in accounting policies as either mandatory or voluntary and illustrate the retrospective
application with full or partial restatement and the related disclosures ....................................................................53
LO-3 Identify when prospective application can be used for accounting policy changes and demonstrates its use
and the related disclosures ........................................................................................................................................55
LO-4 Identify prior period errors and illustrate their correction in the accounting records ......................................55
LO-5 Describe the impact of accounting changes on the cash flow statements and related ethical issues ...............56
LO-6 Identify similarities and differences between the accounting for accounting changes under IFRS and ASPE.
..................................................................................................................................................................................56
3
What You Really Need to Know
CHAPTER 12: Financial Liabilities and Provisions
WHAT IS A LIABILITY?
The liabilities of a business are its obligations (debts). A liability is defined as a present obligation arising
from past events, the settlement of which is expected to result in an outflow of economic benefits (future
sacrifice of assets or services).
Legal obligation – arise from contract or legislation and examples include: accounts payable and
borrowings. Constructive obligations are liabilities that exist because there is pattern of past practice or
established policy, creating an expectation by the public.
CATEGORIES OF LIABLITIES
A financial liability is a financial instrument where the liability is a contract that gives rise to a financial
liability of one part and a financial asset of another party. Examples would be accounts payables or bank
loans.
FINANCIAL LIABILITIES
Financial liabilities are classified into:
1. Fair value through profit or loss (FVTPL) if the liability will be sold in the short term or if management
wishes to avoid an accounting mismatch. In this case, the liability is recorded at fair value at each reporting
period with gains and losses recognized in profit or loss in the period they arise.
2. Other is does meet the criteria to be classified as FVTPL. In this case, the liability is recorded at fair value
on initial valuation and then at amortized cost for each subsequent reporting period.
Common Financial Liabilities
Current liabilities are amounts payable within one year from the date of the balance sheet, or the normal
operating cycle where this is longer than a year. Most current liabilities are monetary items (e.g., accounts
payable), but they can also include some non-monetary items (e.g., unearned revenues).
Accounting problems for monetary current liabilities are discussed in the following section.
Accounts payable
(trade accounts
payable
Accounts payable (trade accounts payable) are obligations arising from the firm's
normal business operations. To determine the amount of the liability, adjustments
are made for purchase discounts, allowances, and returns as discussed for accounts
receivable.
4
Notes Payable
Loan Guarantees
Cash dividends
payable
Monetary accrued
liabilities
Advances and
returnable deposits
Taxes
Conditional
Notes payable often result from borrowing from a lender. Notes may be
categorized as interest-bearing or non-interest-bearing notes. Notes payable are
initially valued at fair value, which is often simply the loan amount. If the note
carries a stated interest rate equal to market interest rates, or has a very short
term, then valuation issues are immaterial and stated values are used. If the stated
and market interest rates are different, and term is more than a year (i.e., not
short), then present value— discounting—must be used to establish initial fair
value.
A loan guarantee requires the guarantor to pay the loan principal and interest if the
borrower defaults. This is a financial liability of the guarantor. The financial
instruments rules require that loan guarantees be recorded at their fair value.
Cash dividends payable are dividends declared but not yet paid; these are reported
as a current liability if it is payable within the coming year/operating cycle.
Declaration of dividends gives rise to an enforceable contract.
Dividends in arrears for preferred shares are only reported in a note to the financial
statements.
Monetary accrued liabilities are recorded by adjusting journal entries at year end
(e.g., wages earned by employees). This is consistent with the definition of a liability
and the matching principle.
Advances and returnable deposits are provided as guarantees for payment or
future obligations (i.e., to guarantee performance on a contract or to ensure
against noncollection or possible damage of property.
Taxes are liabilities until the funds are remitted to the designated party. Common
examples of these taxes are:
* Sales taxes. These arise when retail businesses are required to collect taxes from
customers and remit them to the appropriate government agency. Examples are
the goods and services tax (GST), provincial sales taxes (PST), and harmonized sales
tax (HST). Purchases should be recorded net of GST recoverable. The net amount of
GST should be carried as a liability or asset. Any GST not recoverable should be
accounted for as a component of the cost of the goods or services to which it
relates. PST paid is part of inventory cost.
* Payroll taxes. These arise when employers act as a collection agent for certain
taxes and payments by withholding amounts from employee paycheques. Common
withholdings include the following:
— Personal income taxes
— Canada pension plan (CPP)
— Employment insurance (EI)
— Union dues
— Insurance premiums
— Pension plan payments
— Other deductions (e.g., charitable, parking)
* Property taxes are paid directly by the company based on the assessed value of
property. Property taxes are usually set part way through the fiscal year by taxing
authorities; therefore, estimates must be made prior to the final assessment, at
which point the tax rates are known.
Conditional payments are liabilities established on the basis of the firm's periodic
5
payments
income. Estimates of this liability must be made for interim statements. Two
examples are:
* Income tax payable for federal and provincial taxes, which are not known until
after year end, when the tax return is prepared.
* Bonuses, which are paid by companies to their employees based on earnings.
FOREIGN CURRENCY PAYABLES
If the company has accounts or notes payable, they must be restated at the current exchange rate at the
balance sheet date. The difference between the Canadian equivalent of the amount and any cash receipt is
charged to a gain or loss account. Any changes in the exchange rate following the initial transaction affect
only the monetary balance and are recognized directly and immediately in the income statement if the
balance is classified as current.
Non-Financial Liabilities – Provisions
A provision is a category of non-financial liabilities and is defined as a liability of uncertain timing or
amount. Provisions can be caused by both legal and constructive obligations.
Degree of uncertainty
Certain
Probable
Not probable
Classification
Payables, accruals recorded
Provision - recorded
Contingency – disclosed only
Where there is uncertainty involved with a provision, then a reasonable estimate of the amount must be
determined. Provisions are recorded at the best estimate. If there is a range of outcomes, the expected
value (he sum of the outcomes multiplied by their probability distribution) is used. The most likely
outcome (highest probability alternative) should also be considered. If there is a small population, then the
most likely outcome may be the best estimate.
In cases where the time value of money is material, the liability is recorded at its discounted amount. The
discount rate should reflect the current market interest rates for risk level specific to the liability. Interest
expense on a discounted liability is recorded as time passes.
Contingencies exist when:
 The obligation is possible but not probable;
 There is a present obligation but no economic resources are attached;
 There is a present obligation but rate circumstances dictate that an estimate cannot be
established.
EXAMPLES OF PROVISIONS
Lawsuits – Based on the certainty of payout, an unsettled lawsuit may result in a provision (if probable) or
a contingency (if not probable). Only a provision will be recorded.
6
Onerous contracts – If the unavoidable costs of meeting a contract exceed the economic benefits under
the contract, and then the contract is classified as an onerous contract. A provision is required for this
onerous contract for the net loss associated with the contract.
Restructuring – Restructuring is a program, planned and controlled by management, which materially
changes the scope of the business or the manner in which the business is conducted. When an entity has a
detailed formal plan for the restructuring that it has started to implement and has been announced to
those affected, then a provision for the costs must be recorded.
Warranty - Warranty rights may be legal or constructive and an amount must be estimated based on
expected value, and recorded as a provision at each reporting period.
Restoration and environmental obligations – may be legal or constructive obligations – and must be
estimated and recorded as provisions. If legislative requirements are pending, the provision is accrued only
if there is virtual certainty that the legislation will be enacted.
Coupons, refunds and gift cards – If retailers or customers are reimbursed in cash for coupons, or if
products are sold at a loss, then a provision is appropriate. The coupon offer must result in a transfer of
economic benefits in order to be recognized.
Loyalty programs- Some allocation of the original sale price must be made to the loyalty (points) program.
The sale transaction has multiple parts and the value of the award credits (points) are one such part. The
provision is measured according to the value of the awards to the customer (not the cost of goods to the
company).
Self-insurance – A provision for estimated losses must be determined for events taking place prior to the
reporting date but also for loss events that have happened during the year but are not yet known such as
undiscovered damage. The provision must be justified based on a loss event.
Loan guarantees – A loan guarantee requires the guarantor to pay loan principal and interest if the
borrower defaults. Loan guarantees are recorded at their fair value which would be estimated using the
probability that default will occur multiplied by the amount of the guarantee.
Compensated-Absence Liabilities- When employees can carry over unused time for vacation or holidays to
future years, any expense due to compensated absences must be recognized (accrued) in the year in which
it is earned. The accrual is based on the additional amount that the entity expects to pay as a result of the
unused entitlement accumulated at the year-end date.
The Impact of Discounting
Liabilities must be discounted where the time value of money is material. This will affect multiyear liabilities that
bear no interest rate (i.e., are interest-free), or low interest rates.
Calculation of Present Value
P = [I × (P/A, i, n)] + [F × (P/F, i, n)], where
P = fair value of the loan; issuance proceeds on issuance date
I = dollar amount of each period’s interest payment, if any, or
= nominal rate, if any, times the loan face value,
7
F = maturity value of the loan
n = the number of periods to maturity
i = the market interest rate
The text book provides four examples of the calculation of discounted values and subsequent accounting
using the effective interest method for:
No-Interest Note Payable
Note Payable with Different Market and Stated Rate.
Provision for Lawsuit
Provision with Estimate Change
Classifying Liabilities, Disclosure and Statement of Cash Flow
A current liability is one that is due within the next operating cycle of the next fiscal year, whichever period
is longer. A long –term liability is due beyond this period.
On the statement of financial position, provisions must be shown separately from payables and accruals
and the nature of each provision explained in the notes. Disclosure of these obligations includes a
reconciliation of the opening and closing balances for each obligation.
ACCOUNTING STANDARDS FOR PRIVATE ENTERPRISES (ASPE)
There are no specific standards for non-financial liabilities under ASPE. Liabilities are recognized when they
meet the definition of a liability, are measureable and if future sacrifices are probable. Constructive
liabilities are not recognized under ASPE. And the term “provision” is not used, as ASPE refers to these
types of obligations as liabilities.
The definition of a contingent liability is also different under ASPE and IFRS. ASPE defines a contingent
liability as a liability that will result in the outflow of resources only if a future event happens. A contingent
liability is recorded if the probability is likely; and requires disclosure only if the probability is not
determinable or not likely (unless immaterial). So a contingent liability may be recognized or only
disclosed. (Under IFRS, if the liability is recognized it is now a “provision”; if it is only disclosed it is a
“contingent liability”)
ASPE has no standards specific to loyalty point programs. Under ASPE, the loyalty program liability can be
recorded as a part of the sale transaction (as described earlier in the chapter under IFRS) or an accrual for
the estimated costs can be determined (similar to a warranty accrual).
Either the straight-line method or the effective interest rate method may be used under ASPE.
Under ASPE, if renegotiation of long term debt that is coming due has been completed prior to release of
the financial statements, then the long term debt can be classified as long term, pursuant to the new
agreement. Under IFRS, this renegotiation must be put in place prior to the report date; otherwise the
long term debt coming due must be reported as current.
8
What You Really Need to Know
CHAPTER 13: Financial Instruments: Long Term Debt
SOURCES OF FINANCING
SHORT TERM FINANCING (LO1)
The most obvious source of short-term financing is through trade credit extended by suppliers. Some
purchases are made by signing a promissory note which obligates the company to pay the supplier.
Short-term bank loans to businesses are usually operating lines of credit which are typically secured
by a lien or charge on accounts receivable and inventory. These are usually due on demand but in
practice is often a permanent fixture on a company's balance sheet.
Remember if a company's account frequently changes from positive to negative the overdraft is part of
the cash and cash equivalents.
LONG TERM FINANCING (LO2)
Leverage is risky. Debt payments are obligations that the company must make regardless of how much
cash flow it has earned. Business failures are frequently caused from the entity having too much debt.
However, if an entity can earn a return on the borrowed funds which is more than the interest rate
having to be paid, then it is said to be using debt to its advantage is therefore successfully leveraged.
Term loans and commercial mortgages are common forms of long term bank financing. Repayment
can be through blended payments or principal plus interest. Rates may be fixed or floating. The rate
may be fixed for the term of the loan but the amortization period may be longer.
A bond or debenture is a debt security issued to secure large amounts of capital on a long term basis.
COVENANTS (LO3)
Covenants are conditions placed on a company as a condition of maintaining the loan. They can be
accounting-based (e.g. maximum debt-to-equity ratio), or restricted actions (e.g. restrictions on
dividend payments).
Some debt agreements require the establishment of a sinking fund, cash restricted to retire the debt.
LONG TERM DEBT (LO4)
Long term debt is recognized initially at its discounted present value using the market rate at the time
of issue. If the nominal interest rate is different from the market rate, the loan is issued above or
below par, or at a premium or a discount. The long term debt is amortized to its face value over the
time to maturity, using the effective interest rate. See exhibits 13-2, 13-3 and 12-4 for examples of the
amortization of these bonds.
9
Interest is accrued at each period end date when the payment date for the interest is different from
the report date. This is also true for bonds sold at some date later than their issue date and between
interest payment dates. See example in text book of these calculations.
Debt issue costs (legal costs, accounting, underwriting, commission, engraving, printing, registration
and promotion costs and upfront fees) reduce the net proceeds from the debt issue and therefore
increase the overall cost or the effective interest rate for the issuer.
FOREIGN EXCHANGE ISSUES (LO5)
Many long-term loans are from foreign lenders. This adds an additional form of risk to the borrowing
and causes gains or losses when exchange rates fluctuate. Some companies hedge the loans by
arranging equal and offsetting cash flows in the desired currency. This can be done through operating
hedges or use of derivative contracts and is studied further in chapter 15.
Foreign currency monetary liabilities are reported on the statement of financial position at the spot
rate on the report date. Any exchange gain or loss (unrealized) is reported in profit or loss for the
period in which is arises. See exhibit 13-5 for a numerical example.
CAPITALIZATION OF BORROWING COSTS (LO6)
Any borrowing costs that are directly attributable to the acquisition, construction or production of a
qualifying asset are capitalized as part of the cost of the asset. A qualifying asset is a non-financial
asset and may be inventory, intangible assets, machinery and office and manufacturing facilities.
Borrowing costs are capitalized if the asset takes a substantial amount of time to ready for sale or use.
The capitalized borrowing costs are those specific to the acquisition and may include: interest paid on
a specific loan in place to finance the acquisition and/or if general borrowings are used, then the
average borrowing rate is applied to the specific expenditures. See capitalization calculation example
in the text book.
DEBT RETIREMENT (LO7)
Debt can be derecognized through payment on maturity, or early extinguishment before the maturity
date. On early retirement, the retirement price reflects the current market price. A gain (or loss) on
extinguishment will result when the retirement price is lower (or higher) than the current net book
value of the loan. See exhibit 13-6 for example.
Defeasance is a transaction where the bond will be derecognized from accounting purposes, but
repayment has not been made to the investor. In this case, the bond indenture will allow the company
to transfer investments into an irrevocable trusteed fund. The trustee is then responsible for interest
and principal payments on the debt. When such a trust is set up and fully funded, accounting
standards allow for the debt to be derecognized. In this case, the issuer no longer has the
responsibility to make payments as these have now been assumed by the trust.
Substitution or modification of debt, a company may repay and borrow in one transaction replacing
the existing debt with a new one. If the present value of the new debt is at least 10% different than the
present value of the old loan, then the old loan is extinguished and the new loan is recorded and any
10
resulting gain or loss is recorded. In cases where the difference is less than 10%, no gain or loss on
retirement is recognized.
CASH FLOW STATEMENT AND DISCLOSURES FOR LONG-TERM
LIABILITIES (LO8)
The textbook provides an example of the impact of a bond payable on the cash flow statement where
there is a discount.
A current liability is one that is due within the next operating cycle of the next fiscal year, whichever
period is longer. A long term liability is due beyond this period.
Disclosures for long term debt include details of terms and conditions; interest rate, credit and
liquidity risks; and fair values. In addition, companies must disclose their objectives, policies and
processes for managing its capital. See the reporting example at exhibit 13-7.
ACCOUNTING STANDARDS FOR PRIVATE ENTERPRISES (ASPE) (LO9)
Long term liabilities have similar treatment under ASPE and IFRS. However, either the straight-line
method or the effective interest rate method may be used under ASPE.
Under ASPE, if renegotiation of long term debt that is coming due has been completed prior to release
of the financial statements, then the long term debt can be classified as long term, pursuant to the new
agreement. Under IFRS, this renegotiation must be put in place prior to the report date; otherwise the
long term debt coming due must be reported as current.
Under ASPE, private enterprises have a choice to capitalize borrowing costs or not on assets being
constructed, although there are no guidelines on the amount that can be capitalized.
Disclosure for provisions, long term debt and risks is less onerous under ASPE than in comparison to
IFRS.
11
What You Really Need to Know
CHAPTER 14: SHAREHOLDERS’ EQUITY
LO-1 Distinguish the various types of share capital issued by private and
public companies and descriptive terms used
Shareholders' equity can be defined as "the net contributions to the firm by the owners, plus the firm's
cumulative earnings retained in the business, less any adjustments, payments, or requisition of the
company's own shares."
Shareholders' equity is the second part of the balance sheet equation:
Assets - Liabilities = Shareholders' equity.
This chapter deals with various aspects of shareholders' equity; focusing on the accounting
implications of share capital, issuance, and retirement, and the accounting for and disclosure of
retained earnings and dividends. It also discusses other components of shareholders' equity with
emphasis on Other Comprehensive Income (OCI).
Shareholders' equity applies only to corporations. Partnerships and proprietorships have ownership
interests but not share capital.
Private versus Public Corporations
Private corporations have a limited number of shareholders and the shares cannot be publicly traded.
Private companies may adopt differential disclosure with unanimous shareholder consent. They can
raise share capital through private placements. Public corporations have debt or equity trading on the
stock exchanges.
Share Capital
Share certificates represent ownership in a corporation. Shares can be bought, sold, or transferred by
shareholders without the consent of the corporation.
A corporation has at least one class of shares: common shares. Common shares normally carry the
rights to vote, share in profits and share in distribution of assets in the event of liquidation or
dissolution. Common shares are often called residual ownership shares, since they get whatever is left
after the creditors and the other investors have had their share in earnings and net assets.
Preferred shares have a priority claim on dividends at a specified dollar amount or rate, as well as
priority claim on assets upon liquidation but often do not have voting rights.. Dividends may be
cumulative or participating. The shares may be convertible to other securities.
Terms and conditions
Shares are sometimes issued with special terms and conditions. Preferred shares are sometimes
structured to look a lot like debt - this is discussed in chapter 15.
Par Value Shares versus No-par Value Shares
12
Par value shares have a designated dollar amount per share, as stated in the articles of incorporation
and as printed on the face of the share certificates. No-par value shares do not carry a designated or
assigned value per share. If a corporation is incorporated under the CBCA (Canadian Business
Corporations Act), it is prohibited from using par value shares. No-par value shares are common in the
United States.
LO-2 Explain the recognition and measurement requirements for share
capital issues and subscriptions
Shares issued for cash: Dr. Cash and Cr. The appropriate share capital class.
Subscriptions:
Prospective shareholders sign a contract to purchase a specified number of shares at a specified price
to be paid in installments. Then:
 On date of subscription-The stock subscriptions receivable account is debited and share
capital subscribed is credited.
 On date of collection-Cash is debited and stock subscriptions receivable is credited.
 On date of issuance of shares-Share capital subscribed is debited and common shares is
credited.
The preferred approach is to classify the receivable as a contra account in the equity section.
If the subscriber defaults after a partial fulfillment of the subscription, the corporation may decide to:
(a) return all payments received to the subscriber,(b) issue shares equivalent to the number paid in
full, or
(c) Keep the money received.
Non-cash Sale of Share Capital
Record at the fair value of the assets received, as long as reliably determinable. In rare cases where
the fair value of assets received cannot be determined, then record at fair value of equity shares
issued.
Basket sale of share capital - When selling two or more classes for one lump sum amount, we must use
either the proportional method (the preferred method) or the incremental method to allocate the
proceeds or board may arbitrarily split the proceeds.
Share Issue Costs are recorded in equity as either a reduction of the amount received from the sale of
shares, or against retained earnings.
LO-3 Identify reasons for share retirements and illustrate the related
measurement and recognition requirements
Retractable shares - At the option of the shareholder, at a contractually arranged price, a company is
required to buy back its shares.
Callable or Redeemable shares - These involve specific buy-back provisions at the option of the
company.
Reasons for share redemption include:
13
(1) increase EPS; (2) provide cash flow to shareholders in lieu of dividends; (3) acquire shares when
they appear to be undervalued; (4) buy out one or more particular shareholders or thwart a takeover
bid; (5) reduce future dividend payments.
1. When the reacquisition cost is higher than the average price per share issued to date, the cost
should be charged in this sequence:
a. First, to share capital, at the average price per issued share
b. Second, to any contributed surplus that was created by earlier share transactions in the same class
of shares, and then,
c. if any remaining amount, to retained earnings.
2.
When the reacquisition cost is lower than the average price per share issued to date, the cost
should lie charged in this sequence:
a. First, to share capital, at the average price per issued share
b. any remaining amount, to contributed surplus.
LO-4 Explain the recognition. Measurement and disclosure requirements for
treasury stock transactions
Treasury stock arises when a company buys its own shares and holds them for resale. Treasury shares
do not have voting rights and are not entitled to dividends. The CBCA provides that if a company
reacquires its own shares, it must retire those shares immediately.
Condition
When resale price
if higher than the
average price of
shares
When resale price
if lower than the
average price of
shares
First, debit
Treasury stock, at
the average price
of share
Treasury stock, at
the average price
of share
Then, either/or
Credit
Other contributed
capital from
treasury
transactions
N/A
Debit
N/A
1. Other
contributed
capital from
treasury stock
transactions, if
any, then
2. retained
earnings
LO-5 Distinguish the various components of retained earnings.
RETAINED EARNINGS
Decreased by (debits)
Increased by (credits)
Net losses
Net earnings
Cash or other dividends. Stock dividends.
Removal of deficit in a financial reorganization
Share retirement and treasury stock
transactions.
Share issue costs.
14
Effect of an accounting policy change
applied retroactively.
Error corrections
Effects an accounting policy change applied
retroactively.
Error corrections
Appropriations and restrictions are made (a) to fulfill a contractual agreement, (b) to comply with
corporate legislation, or (c) to indicate a specific purpose for a specified portion of retained earnings.
Appropriations are the result of discretionary management action; restrictions are the result of legal
contract or corporate law.
LO-6 Classify the various types of dividend payments and illustrate the
appropriate accounting treatment
The four relevant dividend dates are: declaration date; record date; ex-dividend date and payment
date.
To record cash dividends: Dr. Retained earnings Cr. Dividends payable
Cumulative dividends on preferred shares - Any dividends not declared in a given year, accumulate at
the specified rate of such shares. The accumulated amount must be paid in full if and when dividends
are declared in a later year before any dividends can be paid on the common shares. Dividends in
arrears are not liabilities but must be disclosed in the notes to the financial statements.
Participating preferred shares provide that the preferred shareholders participate above the stated
preferential rate on a pro rata basis in dividend declarations with the common shareholders, as
follows:
1. First, the preferred shareholders receive their preference rate.
2. Second, common shareholders receive a specified matching dividend.
3. If the total is larger than the two amounts, the excess is divided on a pro rata basis between the two
share classes.
Non-cash (Property) dividends – are recorded at the fair value of the assets distributed and a gain or
loss is recorded for the difference between book value and fair value of the asset.
Liquidating dividends occur when the dividend is paid out of equity other than retained earnings.
Shareholders must be informed of the portion of any dividend that represents a return of capital.
Scrip dividends arise when a corporation declares dividends and issues promissory notes (scripts) to
the shareholders.
Stock dividends – is a proportional distribution to shareholders of additional common or preferred
shares of the corporation. They increase the number of shares outstanding but have no effect on total
shareholders' equity. There are no specific accounting standards on how to record stock dividends, so
there are three possible alternatives:
1. Market value method (required by CBCA); 2. Stated value method; 3. Memo entry.
When a small stock dividend is issued, not all shareholders will own exactly the number of shares
needed to receive whole shares. Fractional shares may be issued or a cash distribution can be made.
Summary: Dividends and distributions are summarized as follows:
15
Type
Cash
Shareholder receives
Cash
Recorded at
Exchange amount;
cash
Property
Some company asset
as designated by the
Board: inventory,
investments, etc.
Shares of subsidiary
Fair value; gain or loss
recorded on
declaration
Liquidating
Usually cash but may
be other assets
Exchange amount; fair
value
Scrip
Promissory note
Exchange amount; as
stated
Stock
Shares
May be recorded at
fair value, book value,
or an arbitrary value
as decided by the
Board
Spinoff
Book value
Watch out for
Amount allocated to
common versus
preferred shares
Distribution of shares
of subsidiary could be
a spinoff instead
Market value not
recorded
Debit to other
contributed capital or
share capital, not
retained earnings
Shareholders get a
receivable; company
sets up a liability
May be fractional
shares for part shares
or cash for part shares
LO-7 Describe the presentation and disclosure of stock splits, contributed
capital and accumulated other comprehensive income
A stock split is a change in the number of shares outstanding and no change in recorded capital
accounts. A memo entry is made only, since there is no consideration received.
Additional contributed capital can include:
1. Donated capital – The donated asset is recorded at fair market value, with a corresponding credit to
donated capital which is part of equity.
2. Retirement of shares at a price less than (or greater than) average issue price to date
3. Issue of par value shares at a price higher than par
4. Treasury stock transactions and share reissued costs
5. Stock option transactions
6. Financial restructuring
Accumulated other comprehensive income are the accumulated unrealized gains and losses that are
part of other comprehensive income and include the following sources:
 Gains and losses on FVTOCI financial instruments
 Revaluation reserves caused by using the revaluation model for property, plant and
equipment
 Gains and losses on certain hedging instruments
 Translation gains and losses on foreign operations whose functional currency is not the
presentation currency.
16
LO-8 Illustrate the presentation of the statement of equity and the related
note disclosure
The statement of changes in equity includes a reconciliation of opening and closing balances for each
equity component. Note disclosure is required to describe each class of share capital including the
legal rights, preferences, restrictions and number authorized. Disclosure is also required for the
number of shares issued, repurchased and retired during the year. The entity’s objectives, definition,
policies and process for managing its capital is also required.
LO-9 Compare the recognition, measurement and presentation of share
capital transactions under ASPE and IFRS
Private companies are required to follow the standards governing share retirement and treasury
stock transactions (IASB has no standards in this area).
Shares issued for non-cash consideration are valued at the fair value of the shares given up, unless the
valuation of the shares is problematic. If the fair value of the assets received is more clearly
determinable, then this value is used for the shares issued. (IASB requires that the fair value of the
assets received be used to value the shares issued.)
There is no comprehensive income for private companies, so all the reserves arising due to OCI items
is non-existent. ASPE classifies foreign subsidiaries as either self-sustaining or integrated. Unrealized
foreign exchange gains and losses on a self-sustaining foreign subsidiary are reported as a separate
line item in equity.
There is no statement of changes in equity required under ASPE. Only a statement of retained
earnings is required. Changes in the other equity accounts are disclosed in the notes.
17
What You Really Need to Know
CHAPTER 15: COMPLEX DEBT AND EQUITY INSTRUMENTS
LO-1 Classify complex financial instruments as debt or equity using
classification factors.
Financial instruments must be classified as a liability or equity based on the substance of the contractual
agreement. A compound instrument (hybrid instrument) has a liability and an equity component. Payments
that are associated with instruments classified as liabilities will be shown in net earnings; payments
associated with instruments classified as equity will be shown in the statement of changes in equity. Gains
and losses associated with debt retirement are shown in net earnings; gains and losses associated with equity
are shown in the equity accounts. The tax status of the instrument does not change based on the accounting
classification.
Classification generally depends on whether or not the investor has an enforceable legal right to receive
payments. The following five questions should be addressed to determine if the instrument is in substance
debt or equity.
1. Is the periodic return on capital (cash interest or dividend payment) mandatory?
Any payment that is mandatory or at the investor’s option, is classified as debt.
2. Is the debtor legally required to repay the principal in cash, either at a fixed pre-determined date, or at
the option of the creditor?
Any payment that is mandatory or at the investor’s option, is classified as debt.
3. Does the issuer have the unconditional right to defer payments indefinitely?
If the payments can be deferred forever, then the instrument is equity. If deferral is only for a period
of time, then it is debt.
4. If cash payment is dependent on the outcome of an uncertain future event beyond the control of both
the investor and the issuer, is the future event extremely rate/very unlikely to occur?
If the future event is highly unlikely and uncontrollable, then the element is equity.
5. If the annual periodic return and/or principal can be settled in the company’s own shares, is the number
of shares fixed by contract, or does it vary based on the market value of shares at the time of
distribution?
If the share price is fixed, then the risk of price fluctuation is with the investor, and this is equity.
LO-2 Identify, classify and describe the measurement and disclosure
requirements for different types of complex financial instruments.
Retractable shares provide the investor with an option to redeem the preference shares. Term-preferred
shares have a provision that the shares must be redeemed on or before a specified date. In either case, when
a preferred share has a redemption that is required or at the investor’s option, then there is a mandatory
18
obligation to pay cash at some future date, making this type of preferred share a liability. The key is that the
redemption is out of the issuer’s control– it is either mandatory or at the investor’s option.
Shares redeemable at the issuer’s option are equity since the company cannot be forced to pay cash.
Perpetual debt is a loan that (1) never has to be repaid; (2) has to repaid only in the indefinite future or; (3) is
highly unlikely ever to be repaid. There is a stated interest rate for the perpetual debt, and the corporation is
obligated to pay the interest regularly. The perpetual debt is reported entirely as a liability. Although its
present value of the principal is equity, the present value of this payment in the infinite future is zero.
The debt is recorded as the present value of the future interest payments.
A convertible bond is a compound instrument – classified partly as debt and partly as equity.
Convertible bonds often have a cash redemption option that allows management to force conversion before
maturity if the market share price is higher than the conversion price of the shares. The company calls the
bonds for cash redemption knowing that the investor will convert to shares since the share price is higher
than the conversion price.
Floating conversion price per share - Convertible debt may be issued where the number of shares to be
issued on conversion is not fixed by contract, but is based on the market value of the shares at the conversion
date. This type of bond is all debt, since the value of the conversion option is nil.
LO-3 Illustrate the recognition, measurement and disclosure of convertible
debt converted at the investor’s option
Convertible debt that is convertible at the investor’s option at a fixed conversion price has both a liability
and equity component on initial recognition. This type of convertible bond has: (1) a promise to pay
interest and principal and (2) an option that gives the investor the right to use the principal to buy a certain
number of common shares. At the date of issuance, the component for the liability is determined first by
calculating the present value of the cash obligations of interest and principal, discounted using the market
interest rate for a comparable non-convertible bond (Level 2 hierarchy). The conversion option - the equity
portion - is the residual and represents the fair value of the bond at issuance date less the liability component.
This is the incremental method of valuation.
The interest expense is affected by this allocation. The higher the amount allocated to the conversion option,
the higher the discount rate that has been used to determine the liability component. This means that the
effective rate of interest will be higher, causing the recognized interest expense to be higher, and lowering
net earnings. The conversion option stays in equity, does not change throughout the term of the bond and
does not impact earnings. If the bond is converted to shares, then this conversion option will be folded into
the common shares account. If the bond is redeemed for cash, then the conversion option becomes part of
other contributed capital.
When the bonds are submitted for conversion, the accrued interest to date and any foreign exchange gains or
losses are first recorded. Then, using the book value method, the book value of the liability and the book
value of the conversion option are transferred to the share capital account. The market value is not used to
report this conversion.
LO-4 Illustrate the recognition, measurement and disclosure of convertible
debt when conversion is mandatory
Convertible bonds with mandatory conversion require interest be paid in cash, but the principal be settled by
issuing a specific number of shares at maturity. In this case, the liability is the cash requirement for the
interest payments, but the principal is all equity since the shares can be forced onto the investor at a fixed
19
price (price set in advance). If the issuer (the company) has the right to repay principal in either cash or
shares, the bond is still classified as “conversion mandatory”.
Using the incremental method, the liability portion is calculated first by determining the present value of the
interest payments, discounted at an appropriate market yield (based on a comparable non-convertible bondLevel 2 hierarchy). The equity or conversion option is determined as the residual between the issuance
proceeds and the liability component. Over the life of the bond, interest is recorded on the interest portion
only, and the cash payments are applied against the interest liability only, reducing it to zero by the maturity
date. At maturity, the conversion option is transferred to share capital when the shares are issued.
Settlement of interest in shares at fair value - If the company may settle the interest by issuing shares at fair
value, the interest is still a liability.
Settlement of interest in shares at a fixed share price or a fixed number of shares - If the bond agreement
stated that the interest could be settled by issuing shares at a fixed price, then this portion of the debt is
equity. In this case, the risk falls on the investor when the price per share is set, because the ultimate value
of the interest payments will depend on the market price of the shares and not on a fixed monetary amount.
LO-5 Classify stock options and rights and describe the related reporting and
disclosure requirements
Stock options or stock rights are financial instruments that provide the holder with an option to acquire a
specified number of shares in a corporation at a fixed price (exercise price) within a certain period of time
(exercise date). They are a derivative instrument since they derive their value from the underlying equity
instruments.
The stock option has an intrinsic value when the exercise price is less than the market price of the share.
The fair value of the stock option depends on the market expectations about the eventual price on the
exercise date which considers the time to expiry and the volatility of the price of the underlying share. Fair
values of options are determined using option pricing models such as Black Schole’s, Monte Carlo or
binomial pricing models. These models price an option giving consideration to the exercise price, the term of
the option, the current market share price, the volatility of the share price, expected dividends and the
prevailing risk-free interest rates. (These would represent Level 2 and Level 3 hierarchy in fair value
determinations.)
When the stock options or rights are issued, they are recorded at fair market value as equity in an account
called contributed capital – stock rights outstanding for the value of the cash proceeds received. When the
stock options are exercised, the share capital is increased with the value of the cash and the closing out of the
contributed capital - stock rights.
Example:
1. Announcement date: only a memorandum entry.
2. Issuance date or grant date:
Cash
Stock rights outstanding
10,000
10,000
3. If exercised: with an exercise price of $40 per share and the market price is $58 per share
Cash (20,000 x $40)
800,000
Stock rights outstanding
10,000
Common shares
810,000
Note that the market value of the shares is not used to determine the value of the share capital issued.
20
4. at expiration: Assuming that the current market price of the common shares was $38 and all rights
expired:
Stock rights outstanding
10,000
Contributed capital, lapse of stock rights
10,000
Warrants are detachable stock rights that are attached to another security – usually bonds. Warrants will
trade separately from the bond and therefore have a Level 1 fair value. Warrants may be exercised to
acquire additional shares or be allowed to expire if the share price does not rise above the exercise price. On
issuance, the bond with the warrants must be split between
(1) the liability component - the present value of the required cash outlay for interest and principal
discounted at the market interest rate for comparable debt with no warrants attached; and
(2) the equity component - the market value of the warrants based on their trading values.
The proportional method is used based on the relative market values of these two components.
On exercise, the contributed capital account rolls into the share capital account along with any cash recieved.
If the warrants expire, then the contributed capital – warrants is rolled into another contributed capital
account.
LO-6 Summarize the characteristics of share based arrangements and
describe the various accounting patterns related to the share based
arrangements for employees
Share based payments result from transactions where the entity uses consideration that is shares or
referenced to the price of a share to acquire or receive goods or services. These may be cash-settled or
equity-settled plans. Or the recipient may be able to choose whether to receive shares or cash settlement.
Share-based payments to non-employees – For transactions with non-employees, the transaction are
recorded when the goods are received or services are rendered. The value of the transaction is the fair value
of the goods received or services rendered. Only in rare circumstances where this fair value cannot be
determined, would the fair value of the share rights issued be used. (In this case, the fair value may move to
Level 2 or Level 3 in the hierarchy.) If share rights are issued, then a stock rights outstanding equity account
is used. If the rights are exercised, the share capital account will increase with the cash received and the
closing out of the stock rights account. If the stock rights expire, then the account is closed out to another
contributed capital account in the equity section. In some cases, the non-employee may also be entitled to
cash settled plans, which would require a liability to be recorded rather than an equity account.
Share based payments to employees- These plans may be cash settled or equity-settled and include plans
that relate to stock options, SARS (stock appreciation rights), phantom stock plans and restricted share units.
Vesting is achieved when the employee is entitled to the compensation, regardless of other conditions.
Forfeiting – During the vesting period, the share based consideration may be forfeited or given up, if the
employee leaves.
Accounting patterns for share based arrangements with employees can take several different forms:
1. Equity- settled plans – the fair value is determined on the date of grant and does not change. The
value is accrued over the vesting period. Forfeitures are initially estimated and then adjusted to
actual each period and at maturity. The entry is to increase contributed capital and to increase an
expense account as the arrangement is accrued.
o Stock options – the fair value (based on option pricing models) is determined at the date of
the grant and recorded over the vesting period. Only actual forfeitures are adjusted for
during this period; the fair value is not changed for subsequent changes in the option pricing
21
variables. When the options are exercised, the contributed capital account is moved to the
share capital account along with the cash received on exercise. If the options lapse, then the
amount remains as contributed capital in the equity section (classification to another
contributed capital account occurs).
2. Cash-settled plans – the fair value are determined based on pricing models and is re-calculated
annually. The value is accrued over the vesting period. The yearly accrual is equal to the current
year’s amount, plus a correction of prior year`s estimates. Forfeitures are initially estimated and
then adjusted to actual each period and at maturity. The accrual increases a liability account and the
related expense account.
o Cash-settled SAR’s – a SAR entitles the employee to a cash payment equal to the
appreciation of the stock price over a reference price over the life of the SAR’s contract.
The fair value of the SAR is the expected time adjusted value of the SAR at maturity, which
will include the intrinsic value (market share price less the reference price times the number
of units). SARs are adjusted each year throughout the contract for both fair value
adjustments and actual forfeitures.
3. If the plan allows the employees to have a choice between cash or equity settlement at maturity, the
equity component is determined as in #1 above and the liability portion is determined as in #2
above.
o Phantom stock plan with employee option – An employee may be provided with a phantom
stock option plan and the choice to receive either shares or cash after two years of
employment. Both the fair value of the equity component and the fair value of the liability
component are recorded at the time of the grant and accrued over the vesting period. The
liability will be re-adjusted annually to its fair value, whereas the equity component will not
change. At the end of the plan, the equity component will either be folded into common
shares (if shares are taken) or closed out to contributed capital if the cash is taken as
settlement.
LO-7 Describe the nature of derivatives and hedges and the related
accounting implications
A derivative financial instrument is one whose value is tied to a primary financial instrument or a
commodity, has no initial net investment (or a small investment) required, and is settled at a future date.
They are either options (right to buy or sell something in future) or forward contracts or futures contracts
(obligation to buy or sell something in the future). The derivative is recognized on the SFP at fair value
when the contract is initiated (generally equal to zero) , and then re-measured at fair value at each reporting
date. Gains and losses arising from the change in fair value, or on settlement are recognized in net earnings,
unless the derivative is a hedge.
Hedge – Derivatives used as hedges are a way to offset the risk to which the company would otherwise be
exposed. For the derivative to be a hedge, the company must first have a risk (in the hedged item) that is
being countered with the risk in the derivative (the hedging item). The substance of a hedge is that the
company is protected from gains or losses on the risk being hedged. In this case, a loss on the hedged item
will then be offset by a gain in the hedging item or vice versa. Hedge accounting is voluntary. Hedges may
be classified as cash flow hedges or fair value hedges. A financial statement element is a hedge when the
company has:
1. an established strategy for risk management that involves hedging;
2. the hedging relationship is formally documented and designated; and
3. the expectation is that the hedge is highly effective and is assessed each period for this effectiveness.
22
Accounting – Once designated as a hedge, then the gains and losses on the hedged item and the hedging item
are to be recorded at the same time into earnings so that they can be offset and substance of the hedge is
reflected in the statements. In cases where there is a temporary mismatch, the gain or loss that is recognized
is reported in OCI and flows to an equity reserve until gains and losses on the other side of the hedging
transaction can be also be recognized into the accounts. Once this occurs, the item is transferred from OCI
to net earnings to now be matched and offset.
Interest rate swaps are a hedge of interest rates as the company agrees with another company to pay each
other’s interest costs. One company will have a floating rate debt but prefer a fixed rate, whereas the other
party will have a fixed rate debt but prefer to have a flowing rate debt. The interest expense will reflect the
result of the interest rate swap. If the interest rate swap is a hedge on a variable rate loan, then the hedge is
on future payments of interest that will vary based on the current interest rates. The interest rate swap is a
derivative and must be recorded at fair value at each reporting date, with changes in the fair value normally
reported in net earnings for the period. In this case, the hedged item - the change in the future variable
interest payments - is not yet recognized on the SFP and so there would be an accounting mismatch. With
hedge accounting, the changes in the fair value of the interest rate swap would be shown as OCI and
accumulated in equity. Once the variable interest payments are made then gains and losses in OCI would be
transferred to net earnings to be appropriately matched.
LO-8 Explain the presentation of financial instruments on the cash flow
statement and the related note disclosure related to risks
The cash flows related to complex financial instruments must be reported based on their substance. Net
proceeds on issuance is a financing activity (regardless if whether debt or equity or both), with appropriate
note disclosure. Conversions do not involve cash and will not be shown on the SCF. Interest and dividend
payments may be shown as either operating or financing activities.
Extensive disclosure is required with respect to the accounting policies used for each type of financial
instrument; fair values of each class and the methods used to determine fair value; and the nature and extent
of risks arising from the financial instruments, including objectives, policies and processes for managing the
risk.
LO-9 Compare and contrast the accounting requirements for complex
financial instruments under ASPE and IFRS under ASPE (different treatment
than under IFRS):






Redeemable preferred shares issued as part of tax planning structures are classified as equity;
shareholders’ loans are classified as liabilities.
The conversion option related to convertible bonds is zero so that the entire convertible bond is
treated as a liability.
Stock based compensation accounting is generally the same, and companies must use an estimate of
volatility for the pricing option model based on the sector values, since the shares are not publicly
traded. Forfeiture does not need to be estimated, but recorded as they occur.
Measurement of share based payments has a narrower scope and may impact supplier and nonemployee consideration. Measurement is based on consideration given up or fair value received,
whichever is more reliable. (IFRS only uses fair value of goods and services received, except in rare
circumstances.)
Hedge accounting is different. Since OCI does not exist, cash flow hedges do not resist – only fair
hedges in net income exist.
Disclosures under ASPE are far less onerous.
23
What You Really Need to Know
CHAPTER 16: ACCOUNTING FOR CORPORATE INCOME TAX
This area is complicated by the fact that the income taxes payable by a corporation is determined as a
single amount, but the revenues, expenses, gains and losses that give rise to taxable income are
reported in different sections of the income statement (intraperiod income tax allocation). A second
complication arises when the income tax expense differs from the income tax payable which results in
deferred tax liabilities or assets (interperiod income tax allocation). A third complication arises when
a corporation has an operating loss for tax purposes. Tax benefits of accounting losses will be covered
in Chapter 17.
LO-1 Explain the difference between the income tax provision and expense
and permanent and temporary differences
Intraperiod tax allocation deals with allocating taxes between different lines on the statement of
comprehensive income.
lnterperiod tax allocation deals with allocating taxes between different reporting periods regardless of
when it is actually paid.
Accounting income and taxable income for a year will be different due to:
 Permanent differences – arise when a revenue, expense, gain or loss is included in the
calculation of either taxable income or pre-tax accounting income but never the other.
Examples include:
o Intercorporate dividends which are included in accounting income but are tax exempt
and will never be included in taxable income.
o 50% of capital gains is never taxed
o Certain expenses – golf dues are non-deductible expenses
o And many others – see exhibit 15-1 for further examples
 Temporary differences – arise when the tax basis of an asset or liability differs from its
accounting carrying value. A temporary difference originates in the period when it is first
included in either accounting income or taxable income, and then reverses in a subsequent
period when it is then included in taxable income or accounting income, respectively.
Examples include:
o CCA and depreciation expenses
o Write downs of inventories and other tangible assets
o And many others – see exhibit 16-1 for further examples
LO-2 Describe the various approaches to interperiod tax allocation and the
related conceptual issues and prepare the appropriate accounting entries
Conceptually, there are three basic underlying issues:
1.
The extent of allocation.
2.
The measurement method.
3.
Discounting.
24
APPROACH TO INCOME TAX QUESTIONS – LIABILITY METHOD
1. Calculate taxable income and taxes payable – see example in text; see exhibit 16-2
 Start with accounting income and adjust for permanent differences to get accounting income
subject to tax.
 Then adjust for temporary differences to arrive at taxable income.
 Multiply taxable income by the tax rate to obtain income taxes payable
If the taxes payable method is used, the analysis stops at this point since the tax expense equals the tax
payable.
2. Determine the change in deferred income taxes – see example in text - exhibit 16-3
 Identify the tax carrying value and accounting carrying value for each asset and liability with
differences and calculate the difference.
o Determining the accounting basis - Think about the common sources of temporary
differences and identify the SFP account that could give rise to a different.
o Determining the tax basis - with respect to:
Tax basis
equals:
ASSETS
LIABILITIES
MONETARY
NON-MONETARY
Accounting carrying value less any
amount that will enter tax in the future
Tax deductible amount less all amounts already
deducted in determining taxable income in
current and prior periods
Carrying amount less any amounts that will not
be taxable in future periods
Accounting carrying value less any
amount that will be deductible for income
tax in the future.
o For SFP accounts that relate to permanent differences, the tax basis is equal to the
accounting basis.
 Calculate the deferred tax liability/asset as the difference in values calculated above times the
enacted tax rate expected in the year of reversal.
 Calculate the difference between the deferred tax liability/asset calculated above and the
opening balance. This is the adjustment required.
3. Combine income taxes payable with the change in deferred income tax to determine the tax expense
for the year – see example – Exhibit 16-4
 Credit taxes payable (from step 1).
 Debit/credit future taxes (from step 2).
 Debit income tax expense to balance.
LO-3 Classify the various tax related elements on the statement of financial
position
DEFERRED INCOME TAX ASSET
(DEBIT BALANCE)
DEFERRED INCOME TAX LIABILITY
(CREDIT BALANCE)
Tax paid is more than accrual based accounting
expense
 Revenue is recognized for accounting
purposes after it is taxable
 Expenses are deducted for tax after it is
Tax paid is less than accrual based accounting
expense
 Revenue is recognized for accounting
purposes before it is taxable
 Expenses are deducted for tax before it is
25
deducted for accounting purposes
 Limited to the amount that is probable
(greater than 50% likelihood) to be
realized
deducted for accounting purposes
Classification is non-current and does not relate to the nature of the related asset or liability or its
expected timing for reversal.
Netting of deferred income tax assets and liabilities is only allowed for the same taxable company and
same taxation authority.
LO-4 Illustrate the disclosure requirements related to income taxes
Total income tax expense must be allocated to the following:
Statement of profit or loss:
 Income from continuing operations;
 Income from discontinued operations (net of tax)
The amount of income tax expense that is attributable to (1) current income taxes and (2) deferred
income taxes should be disclosed, either on the face of the statements or in the notes.
Statement of comprehensive income
 Each component of OCI is reported net of tax – the related income taxes for each OCI item
is disclosed either on face of statement or in the notes
Statement of changes in shareholders’ equity
 Any tax on capital transactions is disclosed
 Any tax on restatements of prior periods
Other disclosure required:
 The change in deferred income taxes due to (1) changes in temporary differences and (2) tax
rate changes should also be disclosed in the notes.
 For each type of temporary difference, require disclosure of: amount of deferred tax recognized
in the deferred tax balance on the SFP.
 A reconciliation between the statutory rate and the company’s effective tax rate – can be in
either percentages or in dollar terms. Differences may arise due to permanent differences,
different rates in different jurisdictions, special levies or deductions permitted, and changing
rates on temporary differences.
Note: the difference in definitions of “effective tax rate”. For accounting standards, the effective tax
rate includes deferred income tax. Financial analysts might ignore the deferred taxes and calculate
the effective tax rate as current tax provision/ accounting income before taxes.
LO-5 Apply the short cut approach if tax rates have not changed
The short cut approach is best suited to situations only where the income tax rate has not changed
from the prior year. The steps are as follows:
1. Calculate taxable income and tax payable.
26
2. Determine the change in deferred income tax through a direct calculation.
3. Combine income tax payable with the change in deferred income tax to determine the tax expense
for the year.
Your text provides an example of this approach.
LO-6 Describe the presentation of income taxes on the cash flow statement
All tax allocation amounts must be reversed out of transactions reported in the cash flow statement.
The cash flow statement must include only the actual taxes paid.
IFRS requires disclosure of the income taxes paid as an operating activity and on the face of the
statement. If the indirect method is used, and the net earnings after taxes is used, then add backs will
be required for the income tax expense and income taxes paid will be shown as a separate item.
(Alternatively, some companies begin with earnings before taxes). If the direct method is used, then
income taxes paid is shown as a disbursement.
LO-7 Describe the conceptual issues of defining deferred taxes as a liability
Do deferred income taxes meet the definition of being liability and represent an existing obligation?
Supporters state that the obligation is real even though the specific parties to whom the liability will
be fulfilled cannot be specifically identified nor the actual amount to be paid in the future. And the
second question relates to how likely it is that the obligation will actually be paid in cash at some
future date. This will depend on two joint occurrences:
(1) the asset basis of the temporary difference must shrink before there can be a net reversal; and
(2) the company must be earning taxable income while the net reversals occur.
LO-8 Describe the recognition, measurement and disclosure requirements for
income taxes under ASPE
Private companies may elect to use either the taxes payable method (no deferred tax balances are
recognized) or the comprehensive allocation method.
Income tax expense must be allocated to: earnings from continuing operations; discontinued
operations; gains and losses recorded directly to retained earnings; and gains and losses recorded
directly to share capital.
If the comprehensive method is used, then deferred taxes (or the term “future” taxes may also be
used) are classified as either current or non-current based on the classification of underlying asset or
liability that gave rise to the temporary differences. For example, a deferred tax balance related to a
current warranty liability would be classified as current. A deferred tax balance related to PP&E
would be classified as long-term.
There is less disclosure required for private enterprises. Disclosure is required of the method used;
significant tax policies related to revenue recognition, CCA rates, deductible pension expenses, etc.
Income tax expense should be reconciled to the average income tax rate, but temporary differences
are excluded. The reconciliation would include: large corporation’s tax, non-deductible expenses,
non-taxable gains (including capital gains), and the amount of deductible temporary differences for
which a future tax asset has not been recorded.
Appendix 1
Conceptually, there are three basic underlying issues:
1.
The extent of allocation.
27
2.
3.
The measurement method.
Discounting.
Extent of allocation refers to the range of temporary differences to which interperiod tax allocation is
applied. There are two options:
1.
No allocation - taxes payable method (also called the flow-through method). The amount of
taxes assessed each year is recognized as income tax expense for that year. This is only permitted as a
choice for private enterprises under ASPE.
2.
Full allocation - Comprehensive tax allocation method. The tax effects of all temporary
differences are allocated, regardless of the timing or likelihood of their reversal. This method ensures
that the related income tax impact of a revenue, expense, gain or loss is recorded in the same period as
the related element gives rise to a deferred tax asset and liability. When a temporary difference
reverses, the related deferred tax asset or liability is drawn down. This is required under IFRS and is a
choice allowed under ASPE.
Your text provides an example that illustrates the impact of the taxes payable method and
comprehensive tax allocation.
The measurement issue relates to which tax rate should be used to measure temporary differences.
 The deferral method records the deferred tax impact by using the company’s average tax rate
in the year the temporary difference initially originates.
 The liability method uses the tax rate in effect in the year of reversal. Under the liability
method, when the tax rate changes, the related deferred tax liability or asset must be adjusted.
The offset to the adjustment goes to income tax expense in the year of adjustment. The
liability method is a SFP focus and is required under IFRS and ASPE (when the comprehensive
method is used).
The liability and deferral methods are illustrated in the text.
Discounting is not done for deferred tax assets and liabilities due to the complexity in the assumptions
that would be required with respect to when the amount would reverse and the appropriate discount
rate to use.
Appendix 2
A1 - Explain investment tax credits and prepare the appropriate accounting entries.
The Canadian Income Tax Act provides for investment tax credits (ITC’s) for (1) qualifying research
and development expenditures and (2) specified types of expenditures for capital investment. The
cost reduction approach is used to recognize an ITC in the same period as the expenditure is
recognized as an expense. Under this approach, the amount of the ITC is deducted from the
expenditure that gave rise to the tax credit. ITC’s related to costs as current expenses may be
recognized as either (1) an item of other income in the profit or loss statement; or (2) as reduction
(offset) against the expense that gave rise to the ITC.
If the ITC relates to a capital asset or are for development costs that have been capitalized, then the
ITC is deducted (1) from the asset itself and the net amount is depreciation, or (2) it is deferred and
amortized on the same basis as the asset.
The notes should disclose: the accounting policy and method of presentation; the nature and extent of
ITC’s and any unfulfilled conditions and contingencies.
28
What You Really Need to Know
CHAPTER 17: ACCOUNTING FOR TAX LOSSES
LO-1 Distinguish between a tax loss and tax benefit, tax loss carryforwards
and temporary and permanent differences in the year of loss
When a corporation prepares its tax return and ends up with a taxable loss instead of taxable income,
the loss may be used against past and/or future taxable income, as follows:
•
•
The loss can be carried back for 3 years.
Any remaining loss can be carried forward for 20 years.
Loss carrybacks entitle a company to recover tax paid in the previous three years. It is normally
carried back to the earliest year first and then applied to subsequent years. Tax is recovered at the
rate that was in effect in the year it was paid.
The taxes recovered from the loss carry-back are recognized on the income statement as a tax
recovery, and this item is shown on the SFP as a current asset. Recognition occurs in the period of the
loss.
Tax Loss versus Tax Benefits
The tax loss is the final number of taxable loss on the income tax return. The tax benefit is the total
present and future benefit that the company will be able to realize from the tax loss through a
reduction of income taxes paid (or payable) to governments. It is calculated as the loss times the
applicable tax rate.
The steps to calculate taxable income, deferred income tax and the journal entries are the same in the
previous chapter.
Tax planning – CCA is an optional deduction; in any year the company can claim anywhere from zero
to the maximum allowable amount. If less CCA is claimed in the current year, then the company will
have higher amounts of UCC and CCA claims available in future years which do not expire. In cases
where the company has a current year’s taxable loss and taxable income in previous carryback years,
the best planning is to maximize the CCA deduction in the current year thereby maximizing the loss
available for carryback. In comparison, if the company had little or no taxable income in the previous
carryback years, the company could consider reducing the current year’s CCA claim, and reduce the
current year’s loss. This results in higher CCA claims available in the future years to help reduce
taxable income.
LO-2 Explain the recognition and measurement of tax loss carryforwards and
two approaches for recording the accounting entries
If the carry-backs do not fully utilize the loss, a recognition problem arises. Income taxes can be
reduced in future periods as a result of the tax loss carry-forward. The benefit can be measured with
reasonable assurance. The issue that arises relates to the likelihood of the benefit being realized. Will
29
sufficient taxable income be earned in the carryforward period to be able to use the benefit of the
carry forward?
The general principle is that the tax benefits of tax losses should be recognized in the period of the loss
when it is probable (greater than 50%) that the benefits will be realized in the future. See exhibit 172 that shows the impact of different recognition assumptions on net income.
Tax planning strategies that could be used to realize a future income tax asset include the following:
•
Reducing or eliminating CCA in the year of the loss and future years.
•
Amending prior years' tax returns to reduce or eliminate CCA.
•
Recognizing taxable revenues in the carry-forward period that might ordinarily be recognized
in later periods.
This assessment of probability is a matter of judgment and should be supported with some objective
evidence such as:
 A strong earnings history;
 Enough accumulated temporary differences to absorb the unrealized loss
 The existence of tax planning opportunities to create taxable profit
Evidence that the probability criterion will not be met would include:
 A history of tax losses expiring without being used;
 A change in the company’s economic prospects;
 Pending circumstances that may not be resolved in the company’s favour.
Each year, the probability of the realization of the deferred tax benefit must be reviewed. The amount
of the deferred tax asset can change accordingly at each reporting period. It may be that in the year of
loss, the probability was less than 50% and therefore the benefit was not recognized. Subsequently,
the probability may increase above 50% allowing the benefit to be recognized in a future year. And
vice versa. The deferred tax benefit might have been recognized in an earlier year when the
probability was estimated to be greater than 50% and subsequently, the probability could be
decreased below 50% requiring the asset to be written down. Exhibit 17-1 provides examples of
reporting the tax loss for carry forward benefits.
LO-3 Illustrate the use of a valuation allowance to report tax loss benefits and
recognize the appropriate tax rate to be used
The substantially enacted rates are used to recognize the deferred tax asset and adjustments are
required as the rates change. When a rate correction is required, the income tax expense in the
current year will be adjusted. If the rate decreases it will result in a debit to income tax expense; if it
increases, tax expense will be credited.
LO-4 Compare the reporting requirements for tax loss carryforwards under
various scenarios with changing probabilities of realization
The textbook provides illustrations of recognition of loss carry forward benefits with more
complications. It compares the results under the assumptions that realization is likely and not likely.
30
Matching is better served when realization is likely. When realization is not likely, in subsequent
periods when the benefit is realized, a swing in income results.
If the realization is not probable, then the benefit of the loss carry forward is not recognized. Only the
recovery of taxes due to a loss carryback will be recognized in the year of the loss. The benefit for the
loss carry forward will be recognized in the year that it is used to reduce the income taxes payable
amount. And the payable will be reduced along with the income tax expense for that year.
In another scenario, if the realization becomes probable at a date subsequent to the year the loss carry
forward arises, then an entry can be made to record the deferred tax benefit at this time, reducing the
income tax expense in that year.
A third scenario looks at refiling past returns eliminating the CCA to minimized tax losses and increase
UCC.
Extended and comprehensive examples are provided in the test see Exhibits 17-3 to 17-8.
LO-5 Explain the disclosure requirements for income taxes
Income tax expense related to continuing operations must be shown on the face of the income
statement. The benefits of either carrybacks or carryforwards are included in the income tax expense,
but information on these losses will most often be in the notes. Note disclosure will focus on
unrecognized tax loss carryforwards. Disclosure is recommended for:
 The amount of the benefit arising from a previously unrecognized tax loss that is used to
either:
1. Reduce current income tax expense by using the carryforward in the current period if
it had not been recognized as a deferred tax asset in prior periods; or
2. Reduce current deferred tax expense such as by reducing the CCA in prior periods and
thereby reducing the amount of temporary differences related to the capital assets
 The amount of the deferred tax expense arising from a write down or reversal of a previous
write down of deferred tax assets;
 The amount and expiry date of unused tax losses for which no deferred tax asset has been
recognized in the SFP.
When the future benefits of a tax loss carryforward are recognized in the year of the loss, the benefits
will be given intraperiod allocation. If the benefits are recognized in a period following the loss, any
income statement impacts will not be given intraperiod allocation. The delay in recognition can move
the benefit from one category to another on the income statement (e.g. from discontinued operations
to operating income).
The IASB's recommendations on accounting for the future benefit of a loss carryforward are
consistent with U.S. practice. Problems with recognition are:
* There has been no transaction to establish the right. The right is contingent on generating future
income.
* Recognition is highly dependent on management judgment.
* When the likelihood is marginal, management may delay recognition to enhance future income.
* When the source of the loss is other than continuing operations management may delay recognition
to move the loss to continuing operations.
31
LO-6 Describe the recognition and measurement of tax loss benefits under
ASPE
ASPE allows either the taxes payable method or the comprehensive allocation method.
Taxes payable method – Loss carry forwards will not be recognized until realized in a future year
when the income tax expense and income taxes payable will be reduced.
Comprehensive allocation – ASPE uses the term “more likely than not” rather than “probable” in
determining if the loss carry forward should be recognized. These terms have the same meaning, a
greater than 50% probability.
ASPE refers to the valuation allowance as a viable alternative to the direct method for recognizing the
realizable amount of the benefit from the loss carry forward.
Appendix 1
LO-3 Illustrate the use of a valuation allowance to report tax loss benefits and
recognize the appropriate tax rate to be used
Rather than adjusting the benefit directly for the realizable future benefit, an alternative approach is
to record the full amount of the future tax benefit and then use a valuation allowance to adjust for the
probability of realization. Although IASB makes not specific mention of this method, it is really only a
bookkeeping alternative since the end result will be the same under the direct method or the
valuation allowance method. Many companies prefer the valuation allowance method since it is easier
to keep track of the full tax loss carryforwards that are available. US accounting standards require this
method be used.
32
What You Really Need to Know
CHAPTER 18: LEASES
UNDERSTAND THE ELEMENTS, DEFINITIONS, AND IDENTIFICATION
CRITERIA OF A LEASE (LO 1)
DEFINITION OF A LEASE
A lease is a rental contract that transfers the right to use an asset in return for the payment of rent.
The lessor owns the asset, and the lessee uses the asset. The lease specifies the terms under which the
lessee has the right to use the lessor’s property and the fee to be paid to the lessor in exchange for use.
ASSET
Lessor
Lessee
(owns the asset)
(uses the asset)
THE LEASE AGREEMENT
Leases are usually standard contracts but may have unique characteristics. Lease contracts may
require a separate negotiation and must be signed by both the lessor and lessee.
In the process of negotiation, the parties reach agreement on many contractual terms, such as the
length of the lease (the lease term); the amount, timing, and type of lease payments; each party’s
responsibility for maintenance, insurance, and property taxes, if any; cancellation terms, renewal
terms, including payouts or the return of the leased asset at the end of the lease term; upgrading
responsibilities; and so on.
A contract contains a lease if:
1. there is a clearly identified asset;
2. the lessee has the right to obtain substantially all the economic benefits derived from use of
the asset throughout the lease term; and
3. the lessee can direct how and for what purpose the asset will be used.
DEFINITIONS
The lease term is the non-cancellable period during which the lessee may use the asset, plus:
1. Any extension option (if reasonably certain it will be exercised); and
2. Periods covered by a termination option (unless reasonably certain lessee will not exercise).
Residual value guarantee: an amount the lessee guarantees to the lessor that the value of the leased
asset at the end of the lease will be at least equal to.
Unguaranteed residual value: the value that the lessor expects to realize on sale of the asset at the end
of the lease term. The lessee has no liability for such an amount.
Short-term lease: a lease that has a maximum term of 12 months.
33
Low-value asset lease: a lease where the underlying asset has a low value when new. In addition, the
underlying asset can only be classified as low-value if:
1. the lessee can benefit from use of the asset on its own or along with other assets that are
readily available; and
2. the asset is not highly dependent on or highly interrelated with other assets.
Initial direct costs: costs incurred when negotiating and arranging a lease. These include legal fees or
commissions for example.
Implicit lease interest rate: interest rate that equates the present value of the lease payments and the
unguaranteed residual value to equal the fair value of the leased property at the beginning of the lease
and any direct costs incurred by the lessor.
Incremental borrowing rate (IBR): the interest rate that the lessee would have to pay to obtain
financing through a financial institution to buy the asset.
SEPARATING COMPONENTS OF A LEASE
A lease contract may require the lessee to make payments not only for the right to use the asset but
also for other costs (e.g., maintenance, service, and security costs). The lease payment is allocated to
each of these components based on the relative stand-alone price of the lease component and the
stand-alone price of the non-lease components. In this case, there are two components to the lease
payment:
(a) a lease component for the right to use the asset; and
(b) a non-lease component for payments included in the lease which do not relate directly to using
the asset but instead represent a cost of service paid to the lessor.
DATES
There are two dates related to a lease. For accounting purposes, the right-of-use asset and lease
liability are recognized on the commencement date.
• The inception date of the lease is generally the date at which the lessor and the lessee commit
to the principal provisional terms of the lease agreement – usually the date of signing of the
lease agreement but could be earlier (i.e., the date of signing a memorandum of agreement).
• The commencement date of the lease term is the date upon which the lessee is entitled to the
use of the asset.
ECONOMIC VERSUS USEFUL LIFE
The economic life of an asset is the maximum number of years that it can be economically productive.
The useful life can never be longer than the economic life.
EXPLAIN THE ACCOUNTING METHODS FOR LEASES FROM THE LESSEE’S
PERSPECTIVE (LO 2)
THE BASIC APPROACH
At the beginning of a lease, the lessee recognizes two elements measured at the present value of the
cash flows stated in the lease agreement:
1. A right-to-use asset (ROU asset); and
34
2.
A lease liability for the lease payments, including any initial direct costs paid by the lessee.
LEASE LIABILITY
The lease liability is measured at the commencement date at the net present value of lease payments
not yet paid. The discount rate is the implicit rate in the lease if determinable. Otherwise, the lessee’s
incremental borrowing rate is used. Discounted payments include:
•
Fixed payments less any lease incentives. If there are non-lease components, these are either
excluded or lessee can elect to include in the lease payment to be discounted.
•
Variable payments that change with an index or rate (e.g., CPI). These are initially measured at
the rate in effect.
•
Expected amounts to be paid under the contract for residual values.
•
The exercise of a purchase option if the lessee is reasonably certain to exercise this option.
•
Payments of penalties to terminate the lease if the term reflects this option will be exercised.
After the commencement date, the lease liability is accounted for using the effective interest method:
•
Interest is accrued for each period; charged to interest expense and credited to the lease liability
account. Interest is based on the discount rate used to present value the payments.
•
Lease payments are debited to the lease liability account, reducing the liability.
Lease accounting specifically provides for the possibility that economic circumstances will change and
either the lease payments or discount rate could change. Changes to the lease liability are reported as
an adjustment to the right-of-use asset. If the carrying value of the right-of-use asset has been reduced
to zero, then the change is recognized in profit or loss.
Lease amounts are re-measured if:
•
The lease term changes; a revised discount rate as of the re-measurement date is applied;
•
The likelihood of exercising a purchase option changes; a revised discount rate is applied in this
case, as well;
•
The expected amount to be paid under a residual guarantee value changes; the discount rate is not
changed in this case; and
•
The indexed amount of payments is reassessed; the discount rate is not changed in this case.
RIGHT-OF-USE ASSET
The initial cost of the right-of-use asset is equal to the present value of the lease payments specified in
the contract. Payments discounted include:
• Initial measurement of the lease liability;
• Any lease payments made by the lessee at or before the commencement date less lease
incentives;
• Any initial costs incurred by the lessee to enter the lease, such as a commission or legal fees;
• Any costs required for site restoration costs or decommissioning liabilities measured at the
present value of the expected payment.
After recognition, the asset is measured using either the cost model, the revaluation model, or the fair
value model. For the purposes of this chapter, the cost model has been used, where the asset is
measured as follows:
• amortized or depreciated as appropriate for that type of asset;
• adjusted for impairment losses or reversal of impairment losses;
• adjusted for re-measurements of the lease liability.
35
The depreciation period is the period the lessee will use the asset—its useful life to the company. This
may be limited by the lease term and conditions such as purchase options or transfer of ownership at
the end of the lease term. The depreciable amount is the initial cost of the asset.
ACCOUNTING FOR SHORT-TERM AND LOW-VALUE ASSET LEASES
Lessees may avoid the requirement to record a right-of-use and the related liability by electing to take
advantage of an optional exemption in IFRS 16 for qualifying short-term leases and low-value asset
leases.
If the election is made, lessees will account for short-term and low-value asset leases by recognizing
the lease payments as an expense, allocated either on a straight-line basis or on another systematic
basis that is based on the pattern of benefit used. No asset or liability is recognized relating to lease
contract of this nature unless the lease payments do not follow a straight-line pattern.
•
For short-term leases, this election is made for an entire class of assets (e.g., all construction
equipment on short-term leases).
•
For low-value asset leases, this election is made on a lease-by-lease basis.
PREPARE THE APPROPRIATE JOURNAL ENTRIES AND SCHEDULES FROM
THE LESSEE’S PERSPECTIVE (LO 3)
At the commencement date:
1. Determine the present value of the lease payments.
2. Record the right-of-use asset at the present value (not to exceed its fair value).
3. Record the lease liability at the same amount.
Each reporting period:
1. Accrue interest by debiting interest expense and crediting interest payable or lease liability
account.
2. Record lease payments as a debit to the lease liability account (and a credit to cash).
3. Depreciate the right-of-use asset using the company's normal depreciation policy for the type
of asset. (Period not to exceed the term of the lease including bargain renewal periods).
End of lease term:
1. Write off the fully depreciated right-of-use asset as a debit to accumulated depreciation and
credit to the right-of-use asset account.
DESCRIBE AND ACCOUNT FOR A SALE LEASEBACK TRANSACTION AND
OTHER LEASE RELATED ISSUES (LO 4)
A sale and leaseback are an arrangement whereby a company sells an asset to a lessor and
simultaneously leases it back from the lessor. This is a linked set of two transactions:
1. The seller transfer title to the asset to the lessor for a certain price, and the lessor pays the
cash proceeds to the seller;
2. Simultaneously, the seller becomes a lessee and leases the exact same asset back, signing a
lease agreement with the series of period payments to the lessor.
36
A transaction will be accounted for as a sale leaseback only if a performance obligation is satisfied
using IFRS 15, Revenue from Contracts with Customers. For a sale to have taken place, control of the
asset must be transferred from the seller (lessee) to the buyer (lessor). If the transaction does not
represent a sale, it is considered a form of financing and the proceeds received are recognized as a
loan payable with any lease payments being applied as loan repayments.
At sale:
•
Record the cash received or amount receivable
•
Record the right-of-use asset received* as a debit
•
Write-off the asset and accumulated depreciation of the asset sold
•
Record the lease liability
•
Record the gain/loss on the sale
* If the transaction is a sale and control is transferred, then the seller (lessee) measures the right-of-use
asset at the percentage of right to use retained (i.e., if after a sale and lease back 30% use of an asset is
retained, then 30% is retained in the books while the 70% is treated as a sale with a gain/loss recognized).
No gain/loss is recorded on the portion retained.
The following calculations are required:
•
Seller-lessee’s proportionate claim = Present value of lease payments/Fair market value of asset
sold
•
Buyer-lessor’s proportionate claim = (Fair market value of asset sold − Present value of lease
payments)/Fair market value of asset sold
•
The initial cost of the right-of-use asset = (Present value of the lease payments/Fair market value
of asset sold) × Book value of asset sold
•
Amount of gain to recognize = Buyer-lessors proportionate claim × (Fair market value of asset
sold – Book value of asset sold)
Subsequent entries to record interest and depreciation follow the same approach as above.
UNDERSTAND HOW TO ACCOUNT FOR OPERATING AND CAPITAL LEASES
UNDER ASPE (LO 5)
CAPITAL LEASES
Capital leases are leases where the lessor transfers substantially all of the risks and rewards of
ownership to the lessee.
For capital leases, an asset and a lease obligation are recognized at the inception of the lease equal to
the present value of the lease payments, excluding executory costs. The accounting treatment is like
IFRS accounting for leases in that the asset is depreciated and the lease obligation is amortized over
the lease term.
If any one of the following criteria are met, the lease must be classified as a capital lease.
1. Is it likely that the lessee will obtain ownership of the leased property at the end of the lease?
(Transfer of title or bargain purchase option)
2. Will the lessee receive substantially all of the economic benefits expected to be derived
through use of the leased property? (Lease term = 75% or more of the asset’s economic life)
37
3. Will the lessor be assured of recovering substantially all of the investment of the leased
property, plus a return on investment, over the lease term? (Present value of minimum net
lease payments, excluding executory costs = 90% or more of the leased asset’s fair value at
inception of the lease).
If none of the criteria are met, the lease is classified as an operating lease.
OPERATING LEASES
Operating leases are leases where the lessor does not transfer substantially all of the risks and
rewards of ownership to the lessee. The lease payments are expensed on a straight-line basis over
time. When the lease payment does not change throughout the lease, the lease payment is expensed as
incurred.
EXPLAIN THE RECOGNITION, MEASUREMENT, AND DISCLOSURE
REQUIREMENTS FOR LEASES FROM THE LESSOR’S PERSPECTIVE (LO 6)
A lease is a finance lease if it transfers substantially all the risks and rewards of ownership related to
ownership of the underlying asset. Otherwise, the lease is an operating lease.
CLASSIFICATION AS A FINANCE LEASE
If any of the following guidelines is satisfied, the lease may be classified as a finance lease:
1. Is there reasonable certainty that the lessee will obtain ownership of the leased property
at the end of the lease term? (Transfer of title at end of lease, lessee entitled to buy
asset at end of lease for price much below expected fair value at that time)
2. Will the lessee receive substantially all of the economic benefits expected to be derived
through use of the leased property? (Lease term covers most of asset’s economic life –
75% or more of useful life)
3. Will the lessor be assured of recovering substantially all of the investment in the leased
property, plus a return on the investment, over the lease term? (PV of lease payments
= 90% or more of the fair value of the leased asset at inception).
4. Is the leased asset so highly specialized that only the lessee can obtain the benefit without
substantial modification? (True for assets fixed in place that cannot be moved without
incurring costs > asset’s remaining benefits).
FINANCE LEASES
If the lease is classified as a finance lease, there are two types of leases for lessors:
1. If the lease is a financing-type lease, the lessor recognizes an asset equal to the net investment
(present value) of the lease and recognizes finance revenue over the life of the lease using the
effective interest method.
a. Net-lease basis: Lessor records the net lease receivable which is the present value of the
lease payments required under the agreement. Each lease payment is then allocated to
interest income or principal which reduces the net lease receivable. Interest is determined
using the effective interest method using the rate implicit in the lease.
38
b. Gross-lease basis: Lease receivable is recorded at the gross receivable equal to the total
undiscounted cash flows for the lease. A contra unearned finance revenue account is also
recognized which represents the interest that the lessor will receive over the term of the
lease. At each reporting date, the lessor calculates the amount of finance income during
the period which is then deducted from the unearned finance revenue.
2. Sales-type leases have distinguishing features including the lessor being a manufacturer or dealer,
and the leased asset having a carrying value (cost) that is different than fair value. It has two
distinct transactions:
i. the sale of the product with recognition of the profit on the sale;
ii. the financing of the sale through a finance lease, with finance income recognized over the
lease term.
The sale is recorded at the fair value of the asset being sold, cost of goods sold is the carrying value
of the asset, and accordingly, gross profit is recorded on the lease/sale. The lease itself is
accounted for by recognizing the present value of the lease payments, either through the gross
method or the net method, as you would see in a finance lease. The lease payments and finance
revenue are then accounted for exactly as for a finance lease.
OPERATING LEASES
A lease is an operating lease if it is not a finance lease. The lessor receives periodic rent payments
and credits an income account. The leased asset is depreciated appropriately based on its nature
and intended life cycles
LESSOR ACCOUNTING UNDER ASPE
For lessor accounting treatment, ASPE uses same guidelines when determining if a lease is
capital or operating from the lessee’s perspective, with an additional two requir ements that
must be met:
1. The lessor’s credit risk relating to the lease and the lessee is normal and is compared
with the collectability of similar receivables; and
2. The lessor’s unreimbursable costs can be reasonably estimated.
If neither of these additional requirements are satisfied, the lease is reported as an operating
lease rather than a capital lease. If the criteria for capitalization are met, then the lessor must
classify the lease as either a direct-finance or sale-type lease. Direct finance lease is essentially
the same as finance-type lease under IFRS.
EXPLAIN THE FINANCIAL STATEMENT IMPACT AND DISCLOSURE
REQUIREMENTS FOR LEASES UNDER IFRS AND ASPE (LO 7)
STATEMENT OF FINANCIAL POSITION
•
•
•
The liability is divided between the short-term portion and the long-term portion. Short-term
portion includes any interest accrual included in the liability balance and principal portion of any
payment made in the next fiscal period.
The lease liability is either presented separately on the face of the SFP or included in other
liabilities with separate note disclosure.
The right-of-use asset (as well as the accumulated depreciation) is shown either separately on the
SFP or as a part of similar assets that are owned with separate disclosure in the notes.
39
STATEMENT OF COMPREHENSIVE INCOME
•
•
•
The profit or loss section of the SCI will include depreciation expense and interest expense. The
expenses relating to leased assets do not need to be reported separately and can be combined with
other similar costs.
The interest expense must be reported with other long-term interest which is reported separately
from interest on short-term obligations.
Short-term lease payments, low-value asset lease payments, and variable lease payments not
included in the lease liability are included as rent expense in the SCI.
STATEMENT OF CASH FLOWS
•
•
•
If indirect approach to operating cash flow is used, depreciation expense will be added back as an
adjustment to earnings. Any interest expense included in income that has not been paid as of yearend is not a cash outflow and the change to the liability for interest will adjust for this.
Amount of principal repayment will be shown as financing outflow. Interest paid is classified as
either operating or financing activities.
Short-term lease payments, low value-added lease payments, and variable lease payments not
included in the lease liability are included as operating activities.
DISCLOSURES & NOTES TO FINANCIAL STATEMENTS
•
•
•
•
•
•
•
•
•
•
Lessee - IFRS
Lease expenses related to short-term leases, low-value asset leases, variable lease payments
Qualitative and quantitative information about leasing activities including the nature of lessee’s
leasing activities, future cash flows for items not reflected in the lease liability such as variable
payments, extension and termination options, residual value guarantees, leases committed to but
not yet commenced, restrictions and covenants imposed by the lessee and any sale leaseback
transactions.
Lessee - ASPE
For operating leases lasting more than one year, disclosure in aggregate (1) the future minimum
lease payments for each of the five succeeding five year and (2) in total.
For capital leases, the total amount of payments estimated to be required under capital leases for
each of the next five years, in aggregate; the interest rate, maturity date, and amount outstanding;
the aggregate amount of interest expense; whether leases are secured; and for the leased asset, the
cost, depreciation method used, and amount of accumulated amortization.
Lessor - IFRS
A general description of the lessor’s leasing arrangements
The aggregate future minimum lease payments receivable (i.e. the gross amount) and the total
amount of unearned finance income
The gross lease payments and PV of future minimum lease payments for the next year, the total for
years two through five and later than the fifth year in total.
Any contingent rentals that have been taken into income
The estimated amount of unguaranteed residual values
The accumulated allowance for uncollectible lease payments
40
IDENTIFY SIMILARITIES AND DIFFERENCES BETWEEN THE ACCOUNTING
FOR LEASES UNDER IFRS AND ASPE (LO 8)
The main differences between IFRS and ASPE in accounting for leases are outlined below.




Asset is called “asset under capital lease” in ASPE and “right-of-use” asset in IFRS.
Lease liability is the present value of the minimum net lease payments, similar to IFRS lease
obligation.
The discount rate used to present value the lease payments is the lower of the implicit rate stated
in the lease and the lessee’s incremental borrowing rate (IFRS – Lessor rate if known, otherwise
lessee’s incremental borrowing rate).
Lease terms used under ASPE (not applicable in IFRS):
Bargain Purchase Option (BPO): a stated or determinable buyout price given in the lease that is
sufficiently lower than the expected fair value of the leased asset at the option’s exercise date
(BPO makes it probable that lessee will exercise option).
Bargain Renewal Term: one or more periods for which the lessee has the option of extending the
lease at lease payments that are substantially less than would normally be expected for an asset of
that age and type.
Guaranteed Residual Value: an amount that the lessee promises the lessor will receive for the asset
by selling it to a third party at the end of the lease term. This amount is decided when the lease
contract is negotiated. A high guaranteed residual value will effectively reduce the periodic lease
payment and a low value will increase the lease payments.
Unguaranteed Residual Value: the value that the lessor expects to realize on sale of the asset at the
end of the lease term not guaranteed by the lessee. Lessee has no obligation and in some cases no
awareness of this amount but it is factored into the calculation of the lease payments by the lessor.
Minimum Net Lease Payments: all payments the lessee is required to make over the lease term
(including bargain renewal terms), net of any operating or executory costs that are implicitly
included in the lease payment, plus any guaranteed residual value. A BPO is also included.
o The guaranteed amount of residual value is included in the minimum lease payments
under ASPE, but not included in the expected payments under IFRS.

Fair value ceiling: Initial measurement of the asset under capital lease cannot exceed its fair value;
the discount rate must be adjusted to equal the fair value. Under IFRS, the right-of-use asset is
tested for impairment and any adjustment required is made as an impairment loss.

ASPE uses the term contingent rent (or contingent lease payments) whereas IFRS uses variable
lease payments. Under ASPE, contingent rent is reported as an operating expense in the period
incurred and not included in the minimum lease payment for the lease liability. Under IFRS, some
variable payments that are based on indices are included in the lease liability payments.

In determining an asset’s depreciable cost, any guaranteed residual amount is deducted from the
initial cost and the net amount is depreciated under ASPE. Under IFRS, the guaranteed residual
amount is not deducted in calculating the depreciation.

Lease modifications and sale and leasebacks are accounted for differently under ASPE and IFRS.
41
What You Really Need to Know
CHAPTER 19: POST-EMPLOYMENT BENEFITS
LO-1 Describe the two types of pension plans and their related variables
There are two types of pension plans:
•
A defined contribution plan is one that specifies the formula used to determine the amount of
employer's contributions. No promise is made concerning the future benefits to be received by
employees.
•
A defined benefit plan is one that specifies either the amount of benefits to be received by
employees upon retirement, or-much more likely-a formula to be used for determining these benefits.
Figuring out how much the employer should contribute to a pension plan is the task of an actuary. An
actuary is a person who calculates statistical risks, life expectancy, pay out probabilities, etc.
Summary of the Two Types of Pension Plans
Type of Plan
Contributions
Benefits
Defined
contribution
Defined benefit
Fixed
Variable
Variable
Fixed
PENSION TERMS
Contributory versus Non-contributory
In a contributory pension plan, the employee makes contributions to the plan, normally in addition to
those made by the employer.
In a non-contributory pension plan, the cost of the pension is borne entirely by the employer.
Vested versus Unvested
Pension plan benefits are vested when the employee is entitled to receive the benefits even though he
or she does not remain an employee of the company until retirement.
Trusteed
An independent trustee receives the pension contributions from the employer, invests the
contributions, and pays the benefits to the employee.
Trustees of pension funds are financial institutions such as trust companies and banks. A pension
trustee is not an individual person. In order for a company to deduct pension plan contributions from
taxable income the plan must be trusted. Registration of the plan also requires it to be trusted. There
is an important accounting implication of trusteeship. If the plan is trusted its assets are not
controlled by the company. Therefore the plan's assets and liabilities are not recorded on the
company's financial statements.
Registered
Normally, pensions are registered with the pension commissioner in the province of jurisdiction.
An important benefit of registration is that it enables the company to deduct the contributions from
taxable income.
42
Actuarial Cost Methods
An actuary is an expert who calculates statistical risks, life expectancy, payout probabilities, etc. There
are several different methods of measuring and allocating the pension amounts, known as actuarial
cost methods. Every actuarial cost method allocates the future estimated cost of such postemployment benefits to the years of an employee’s service in an effort to determine appropriate
funding.
Actuarial Gains and Losses
Actuarial gains and losses exist in defined benefit plans. There are two sources of actuarial gains and
losses:
1. A change in the present value of the defined benefit obligation to employees, resulting from the
experience of the plan to date, as compared to predicted amounts. This is a retrospective
measurement, based on experience to date and is sometimes referred to as an experience gain or loss.
2. Changes in the present value of the defined benefit obligation to employees, resulting from a change
in an assumption about the future.
Plan Settlement and Curtailment
On occasion, an employer may end its legal liability under an existing defined benefit pension plan, or
end a portion of the benefits under a plan. This is called a pension plan settlement; the obligation to
the pensionable group is settled by transferring assets to a trustee, purchasing specified annuities for
employees, or otherwise terminating the financial commitments of the employer.
A pension plan curtailment takes place when there is a significant reduction in the number of
employees covered by a plan, or some significant element of future service that will no longer qualify
for benefits. This may happen when a company closes down a division or otherwise restructures or
downsizes operations. It may also happen when workers agree to a major change in benefits, perhaps
to preserve competitiveness.
LO-2 Describe the recognition, measurement and disclosure requirements for
defined contribution plans
The amount of contribution is treated as an expense on the income statement. The one uncertainty if
the benefits do not fully vest at the start of an individual's entry into the plan is the likelihood of the
person staying until vesting occurs.
If some of the funding for the current service services is to be paid into the plan in future years, the
current service cost is the amount of the current payments plus the present value of future payments.
LO-3 Describe the three actuarial cost methods for defined benefit pension
plans and explain the difference be funding and accounting amounts
A defined benefit plan is a post-retirement benefit plan where the financial risk remains with the
employer. A defined benefit pension plan consists of pension fund assets, placed with a trustee, and
the post-employment defined benefit obligation to employees. The defined benefit obligation of a
pension plan to its members is measured as the present value of expected future payments resulting
from employee service in current and prior periods. The net defined benefit pension liability (asset) is
the net overall funded status of the pension plan; the pension plan assets netted with the defined
benefit obligation. If the pension plan assets are greater than the obligation, companies must evaluate
an asset ceiling before declaring their asset status. If the pension plan assets are greater than the
43
obligation, companies must evaluate an asset ceiling before declaring their asset status. The asset
ceiling is a test to see if the “excess” assets in the plan can be used to benefit the employer in the
future: this benefit must be in the form of a reduction of future contributions, or perhaps a cash
refund.
Variables to be estimated
In defined benefit plans, the future benefit is known but the annual contributions that are necessary to
provide the defined future benefit must be estimated. Major categories of assumptions are as follows:
1. Demographic assumptions—decisions that relate to the characteristics of the employees eligible for
benefits:
• Employee turnover, disability, and early retirement.
• Mortality rates
2. Financial assumptions—decisions that deal with economic variables:
• Future salary increases
• Discount rates
These estimates are made by an actuary. It is not necessary to use the same assumptions for
accounting as are used for funding. For funding purposes actuaries often use conservative estimates.
For accounting purposes 'best estimates' should be used.
Funding versus Accounting
Funding refers to the manner in which the employer calculates the necessary contributions to the
plan. It is important to keep accounting separate from funding.
Funding Approaches
There are three basic methods for calculating the cash contributions a company must make in order to
provide for the defined pension benefits:
•
Accumulated benefit methods calculates the contributions that an employer must make in
order to fund the pension to which the employee currently is entitled, based on years of service to
date and on current salary. This method results in the lowest degree of projections.
•
Projected unit credit (projected benefit) method calculates the required funding based on the
actual years of service to date on a projected estimate of the employee's salary at the retirement date.
This is the method required for accounting purposes to calculate the current service cost.
•
Level contribution method projects both the final salary and the total years of service, and
then allocates the cost evenly over the years of service. This method results in the highest degree of
projections.
LO-4 Define the various components for defined benefit pension plan.
1. Service cost
2. Net Interest
on the Net
Defined Benefit
Pension Liability
(Asset)
3. Re measurement of
The total of current service cost, any past service cost and any gain or loss on plan
settlement. This amount is expensed.
Net interest on the net defined benefit pension liability is a change caused by the
passage of time. It is, in essence, the combination of expected investment earnings
on pension plan assets and accrued interest on the defined benefit obligation, all at
the same discount rate. (If the result of netting is an asset, ensure that the asset
ceiling does not restrict the value of the asset. If it is restricted, reduce the asset
value to the ceiling and recalculate the net balance.)
Re-measurement of the net defined benefit pension liability (asset) is recorded in
OCI. It is not recycled to earnings, but may be reclassified to another equity
44
the Net Defined
Benefit Pension
Liability (Asset)
account, such as retained earnings. Re-measurement has three components:
1. Actuarial gains and losses,
2. The difference between expected earnings on pension plan assets, included in
element 2, above, and actual fund earnings or loss, and
3. Any change dictated by the effect of invoking the asset ceiling rule.
LO-5 Describe the components in the pension expense for defined benefit
pension plans and reconcile the net funding status to the accrued pension
liability recognized for accounting purposes
When all pension adjustments are recorded, the net defined benefit pension liability on the SFP will equal
the difference between the plan assets and the defined benefit obligation. That is, the net overfunded or
underfunded status of the plan will be recorded as an asset (overfunded) or a liability (underfunded)
LO-6 Prepare a pension plan spreadsheet showing the memorandum
accounts and the reported accounts for defined benefit pension plans over
numerous years and the related accounting adjustments
45
46
LO-7 Explain the differences between other post-employment benefit plans
and pension plans and prepare the spreadsheet and accounting entries for
the post employment benefit plans
Accounting standards require the OPEB’s be accounted for in a manner similar to pensions. That is the
annual expense is:
Current service cost
Plus: interest on OPEB obligation;
Minus: expected earnings on segregated fund assets, if any;
Plus: recognition of past service costs
Plus/Minus: recognition of actuarial gains/losses
Use
Beneficiary
Pensions
Regular monthly payments with predictable or
estimable increases until entitlements cease
Funding
Retired employee with usually some survivor
rights
Plans are typically registered; likely to be fully or
mostly funded during the working life of the
employee
Revaluations
Periodic as required by legislation
Other Post-Retirement Benefits
Sporadic use from employee to
employee and unpredictable cost
increases
Retired employee and family
members, as specified in the plan
Likely to be totally unfunded
because contributions to
unregistered plans are not tax
deductible for the employer
Likely more frequent to reflect
changed cost estimates
LO-8 Identify the disclosure requirements in the statements and the notes
required for pensions and other post employment benefits.
The disclosure requirements for post-employment benefits are unusually extensive. The financial
statements themselves include the three elements relating to pensions and other post-employment
benefits:
1. on the statement of comprehensive income, the amount of expense relating to providing postemployment benefits;
2. On the statement of comprehensive income, and the statement of financial position, the amount of
re-measurement recorded (element 3 in our examples);
3. On the statement of financial position, the net defined benefit pension asset or liability that reflects
the funded status of the pension plan; the defined benefit obligation netted with plan assets;
4. On the statement of cash flows, the change in the SFP pension liability.
Further note disclosure is required in three broad areas:
1. The characteristics of and risks associated with, defined benefit plans,
2. Identification and explanation of recognized amounts, and
3. A description of how such plans might affect the amount, timing, and uncertainty of future cash
flows.
LO-10 Compare the accounting treatment for pension plans under ASPE with
IFRS and the proposals for change
Defined contribution plans – same treatment as under IFRS
47
Private companies with defined benefit plans follow a simplified approach, reflecting the absence of
OCI in the ASPE reporting environment. Best estimates must be used in actuarial valuation, and these
estimates must be internally consistent. Effective in 2014, pension expense for a defined benefit
pension plan is equal to an amalgamation of three items: current service cost, finance cost, and remeasurements. Nothing is recorded in accumulated OCI.
Prior to 2014, the ASPE rules allowed a variety of substantial deferrals, which prevented the net status
of the pension plan from being reflected on the balance sheet. This undesirable reporting result has
now been eliminated.
48
What You Really Need to Know
CHAPTER 20: EARNINGS PER SHARE
Earnings per share (EPS) are one of the primary indicators of a company's financial performance, and
a driving force behind common stock market prices.
The earnings per share calculation are conceptually very simple: the earnings of the company divided
by the number of common shares outstanding. EPS accounting has technically complex calculations
because (1) new shares may be issued during the year; (2) there may be several different classes of
shares outstanding; (3) the measure of earnings used may vary; (4) convertible senior securities
affect EPS if they are converted; and (5) outstanding stock options may be present.
The uses and limitations of EPS data is also discussed in this chapter.
LO-1 Explain basic and diluted EPS and interpret what the numbers mean
EPS applies only to public companies, although private companies may do so if relevant to their
shareholders or other stakeholders.
Basic EPS and diluted EPS are calculated based on profit or loss from continuing operations if
presented, and on profit or loss. It is useful in comparing a company’s performance year over year.
Diluted EPS shows the maximum dilution to EPS that could occur if all dilutive potential ordinary
shares were issued.
Interpreting EPS can be as follows:
Basic EPS – compare over the past years and may indicate trends for future forecasting.
Diluted EPS – gives an indication of long-run impact that conversions and options will have on
earnings attributable to ordinary shareholders.
EPS calculations are complex and difficult to evaluate what the numbers mean. The emphasis on EPS
may encourage transactions for the purpose of generating book profits to increase EPS.
LO-2 Calculate basic EPS adjusting for weighted average number of shares,
contingently issuable and complex dividends
The following formula is applied to calculate the "basic" EPS:
Net profit or loss available ordinary shareholders
EPS = Weighted average number of common shares
outstanding
Earnings per share are calculated in order to indicate each common shareholder's proportionate
share in the company's earnings. It is not necessarily related to the amount of dividends paid out. It
shows the residual net income available after preferred shareholders have been allocated their return
on capital.
Numerator: Earnings available to ordinary shares begins with net income or loss available to ordinary
shareholders less claims to earnings that take precedence over the ordinary share claims such as
49
dividend entitlements of senior (preferred) shares on senior share retirement and any adjustments
for preferred share retired at a loss, or a capital charge on convertible bonds - to arrive at income
available to common shareholders only.
For cumulative preferred shares, the prescribed dividend is subtracted from net income whether it
was declared or not. However, for noncumulative preferred shares, only those dividends actually
declared during the period are subtracted in determining the EPS numerator.
There may be other adjustments - the important question is "What are the earnings available to
ordinary shareholders?"
Denominator: Weighted Average Number of Shares
The denominator of the EPS calculation reflects the number of shares, on average, that were
outstanding during the year. There are three methods of calculating the weighted average number of
shares. These are illustrated in the textbook on page 1193. The method used is irrelevant since they
all provide the same answer.
Contingently issuable ordinary shares – are ordinary shares issued for little or no cash upon
satisfaction of specific conditions in a contingent share agreement. Contingently issuable ordinary
shares are included in the calculation WAOS from the date that the necessary conditions are met
which applies even if the shares are not issued until a later date.
Stock splits and stock dividends - When a share dividend, split, or reverse split occurs, the
denominator of the EPS calculation must be adjusted to reflect the shares as though they have been
outstanding since the beginning of the year, even if they are issued after year end. All previous
calculations of EPS are restated (for comparative purposes). This treatment is based on the fact that
stock splits or dividends do not bring new capital into the business.
Multiple Classes of Shares
If the dividend privileges are different, the EPS valuations must be one for each class. If two or more
classes share dividends equally, share for share, then they are all ordinary shares and are lumped
together in the denominator for the EPS calculation. If the sharing of dividends is unequal, more than
one basic EPS will be calculated.
LO-3 Itemize the steps required in calculating diluted EPS and identify
appropriate adjustments to be made for conversions
Diluted EPS reflects a hypothetical earnings dilution if:
•
Dilutive options to purchase shares that are exercised

Dilutive convertible senior securities outstanding are converted to common shares, and
•
Dilutive contingently issuable ordinary shares are issued at the beginning of the fiscal year and
•
Any shares actually issued during the year because of (dilutive) convertible senior securities,
share option contracts or contingently issuable shares are issued at the beginning of the fiscal year
Diluted EPS is a worst case scenario. If conversion of senior securities or exercise of options would
increase EPS, they are called anti-dilutive and are excluded from the calculation.
Diluted EPS Calculation
Options are dilutive if they are in-the-money and adjustments are based on the treasury stock method
where proceeds are assumed to be used to reacquire and retire common shares at the average market
50
price during the period. The denominator is increased by the shares issued and decreased by shares
retired.
Adjustments for contingently issuable shares – If the contingency is resolved during the period, and
the shares become issuable, the shares are included in the WAOS for basic EPS as of the date the
contingency is resolved. If all necessary conditions are not met, the shares are included if the only
unmet condition is that the date of the contingency period has not yet expired. Shares are included
based on the shares issuable if the end of the reporting period were the end of the contingency period.
Bonds and preferred shares are based on if-converted method where the numerator and denominator
are adjusted to reflect if securities were converted at the beginning of the period. For bonds, the
numerator is increased by the after tax interest avoided and for preferred shares increased by the
dividend claim avoided. The denominator for both is increased by the shares issued.
Three technicalities to note:
* If there are a variety of conversion terms the most dilutive must be used.
* If the securities were issued during the year the assumed conversion goes to the issue date not the
beginning of the year.
* If the conversion option lapsed during the year or the security was redeemed or settled during the
year, the conversion is still included for the period it was outstanding.
Steps in Calculating Diluted EPS and Example
The steps are listed in the textbook and an example is provided for diluted EPS.
Reporting Diluted EPS
Basic and diluted EPS must be reported on the SCI with equal prominence.
Diluted EPS Cascade
Adjustments are done from most to least dilutive. Options that are in-the-money are always dilutive
and done first. Next are convertible securities with the lowest individual EPS effect. Remember any
items that would increase EPS (anti-dilutive) are excluded.
Actual Conversions during the Period
Backdating is used to reflect actual conversions and actual options exercised at the beginning of the
fiscal period.
LO-4 Identify and describe the impact of the numerous factors that
complicate the calculation of diluted EPS
Convertible Securities and
Options Issued During the
Year
Convertible Securities and
Options Extinguished During
the Year
Reference Point for Diluted
EPS
If convertible securities or options are issued during the year, the
effect of the hypothetical conversion is backdated in the calculation of
diluted EPS only to the date of issue.
Potential common shares, if dilutive, are included in the calculation of
diluted EPS up to the date of redemption, settlement, or expiry.
In deciding if a potentially dilutive security has an individual effect
that is anti-dilutive or dilutive standard requires the use of earnings
from continuing operations. If an item is included for earnings from
continuing operations, then it is also always included for EPS based on
net earnings.
51
Measuring Interest Expense
Measuring share price
Diluted EPS in a Loss Year
Bonds convertible at issuer’s
option
FVTPL Liabilities
In EPS calculations, when making the adjustment to earnings available
to ordinary shareholders, the adjustment must be made for interest
expense not interest paid.
Average share price for the treasury stock method is determined using
a simple average of weekly or monthly prices over the period.
Diluted EPS is generally equal to basic EPS in a loss year because all
potentially dilutive items are classified as anti-dilutive. This is
because when a loss is reported adding anything positive to the
numerator (the loss) and/or increasing the number of common shares
outstanding will reduce the loss per share.
Bonds are still considered in the diluted EOS calculation.
If convertible bonds are carried at fair value, any gain or loss on the
change in fair value included in profit or loss must also be adjusted on
the numerator, after tax in calculating then dilutive effect on EPS.
LO-5 Prepare the calculation
comprehensive scenario
of
basic
and
diluted
EPS
under
a
A comprehensive illustration of the calculation of fully dilutive EPS is presented in the textbook.
LO-6 Describe the disclosure requirements related to EPS and the impact of
restatements and changes in share capital
RESTATEMENT OF EARNINGS PER SHARE INFORMATION
EPS will be recalculated if:
•
There has been a retroactive change in accounting principle or error correction.
•
There has been a stock dividend or stock split during the fiscal year.
SUBSEQUENT EVENTS
If a subsequent event would significantly change the number of common shares or potential common
shares used in basis or diluted EPS, the transaction must be disclosed and described.
DISCLOSURE PRACTICES
Disclose:

basic and diluted EPS be shown on the face of SCI for net earnings from continuing operations
and for net earnings

Note disclosure that shows reconciliations of the numerator and denominator for both basic
and diluted EPS; details of securities excluded because they were anti-dilutive; details of share
transactions, convertible bonds, options, and other share contracts issued subsequent to report date.

Other per share amounts may be disclosed in the notes.
52
What You Really Need to Know
CHAPTER 21: ACCOUNTING CHANGES
The following requirements are the same for both IFRS and ASPE.
LO-1 Provide examples of changes in estimates and describe the related
accounting and disclosure requirements
TYPES OF ACCOUNTING CHANGES
There are three types of accounting changes:
1. Changes in accounting policy.
a. involuntary, to comply with new CICA Handbook recommendations
b. voluntary, at the option of management or at the request of the user
2. Changes in accounting estimates.
3. Corrections of an error in previous years' financial statements.
CHANGES IN ESTIMATES - is a change in the application of an accounting policy to a specific
transaction or event. Examples include estimates related to: uncollectible accounts, inventory
obsolescence, and fair values of financial assets.
Changes in accounting estimates can occur for several reasons:
* New reliable information is available.
* Experience has provided insight into such things as usage patterns or benefits.
* The company's economic environment has changed.
* Probabilities underlying accounting estimates have changed.
* There has been a shift in the nature of the company's business operations.
Changes in estimates are accounted for prospectively by applying them in the current and future years
only.
Consider a change in the amortization rate for a patent. If the change is due to changed economic
circumstances, it is a change in estimate; but if it is due to different reporting circumstances, it is a
change in policy.
When there is doubt as to whether a change is a change in policy or a change in estimate, the change
should be treated as a change in estimate.
Disclosure requirements – are generally minimal and would be provided for changes in estimates that
are “fixed” for some future period, as for the useful lives used for depreciation and amortization.
LO-2 Identify changes in accounting policies as either mandatory or
voluntary and illustrate the retrospective application with full or partial
restatement and the related disclosures
CHANGES IN ACCOUNTING POLICIES
A change in accounting policy is a change in the way a company accounts for a particular type of
transaction or event, or for the resulting asset or liability. Accounting policy changes may be:
53



Mandatory when a new standard is issued and an existing standard is revised.
Voluntary – when management decides that another acceptable accounting policy is reliable
and more relevant for financial statement users. Circumstances when this may arise would
include:
o Change in reporting objectives;
o A change in the way of doing business such as a shift to higher-risk business strategies
that make the prediction of future outcomes more difficult and less reliable
o A desire to conform to industry practices.
Early Adoption Early adoption means that a company applies a new or revised standard prior
to its mandatory effective date. Some new and revised standards permit early adoption—
others prohibit it. There are two main reasons for prohibiting early adoption:
o To promote comparability. If the change is substantial and may significantly affect
users’ intercompany comparisons, it is best if all companies make the change in the
same year.
o To give time to collect data. Early adoption usually means that a company will not
restate (or not be able to restate) its prior-period data. By prohibiting early adoption,
standard setters remove any excuse for not restating at least the most recent one or
two prior years.
Adopting a new accounting policy must not be confused with a change in accounting policy. The
following are not changes in accounting policy:
1.
Adopting an accounting policy for transactions or other events that differ in substance from
those previously occurring.
2.
Adopting a new accounting policy for transactions or other events that did not occur
previously or were immaterial.
Accounting policy changes are to be accounted for retrospectively. Basic rule: Restate prior period
reported amounts as far back as practicable; if you don’t have the information to enable restatement,
and then apply the new policy in the current and future years.
RESTROSPECTIVE APPLICATION
Retrospective application with full restatement of prior periods: This approach requires that the new
accounting policy is applied to events and transactions from the date of origin of each event or
transaction. Financial statements for each prior year that are presented for comparative purposes are
restated and the opening balance of retained earnings (or other component of equity, as appropriate)
for the year of change is adjusted to reflect the retrospective impact of the change. All summary
financial information for earlier periods, including net income, total assets, EPS, etc are restated as
well. The effect is to report the financial results as if the new policy has always been in effect. This
makes current and future income fully comparable with results from earlier periods. Consistency and
comparability are enhanced.
Retrospective application with partial restatement: If full restatement is impracticable, then restate as
far back as possible with the data available. This would result in restating the opening balances of
prior and current years. The new policy is applied in full for both the current and prior years. Both the
financial position and the earnings are based on the new standard, facilitating comparison.
Impracticable: Retrospective application is impracticable if:
 It is not possible or feasible to determine the effects of the new policy on previous years;
 Application would require assumptions about management’s intent in prior periods; or
54
 It is impossible to reliably know what the appropriate measurements and valuations would
have been in a prior period.
Disclosure: When an accounting policy is changed, disclose:
 Nature of change
 Amount of the adjustment for the current and prior period by financial line item
 Amount of adjustments for periods prior to those present, to the extent practicable;
 If retrospective restatement is not applied or applied fully, the reason
LO-3 Identify when prospective application can be used for accounting policy
changes and demonstrates its use and the related disclosures
PROSPECTIVE APPLICATION – is applied when the company cannot completely restate prior year’
financial results due to lack of information. It can also be used for a change in an accounting standard
when permitted by a new standard. Some new and revised standards allow early adoption and some
prohibit it.
Guidelines for applying accounting policy changes prospectively:
1. The cumulative impact of the change on all of the relevant beginning balances for the current
year is computed and recorded, including the change in retained earnings.
2. The cumulative impact of the change is reported in the financial statements as ad adjustment
to the opening retained earnings for the current year.
3. Prior year’s comparative statements are not changed.
Disclosure required when an accounting policy is applied prospectively:
 The fact that the change has not been applied retrospectively;
 The effect of the change on current and future financial statement;
 The reasons that retrospective application cannot be done.
Adopting a new accounting policy is not a change in an accounting policy. This arises when adopting
an accounting policy for transactions and events that:
 differ in substance from those previously occurring; or
 did not occur previously or were immaterial.
LO-4 Identify prior period errors and illustrate their correction in the
accounting records
Prior period errors are omissions or mistakes that were made in the application of accounting
principles in one or more earlier periods.
Major causes of accounting errors•
Mathematical mistakes.
•
Misapplication of accounting principles.
•
Failure to recognize accruals and/or deferrals.
•
Misclassification of an account.
•
Intentional use of unrealistic accounting estimates (or fraud).
Errors relate to information that:
55
1. was available when the prior period’s financial statements were prepared; and
2. could reasonably be expected to have been obtained and taken into account in the preparation
and presentation of those financial statements.
Error correction is accounted for retrospectively with restatement.
Counterbalancing errors – If and when the impact of the change has “washed through” retained
earnings, then no entry for the change is required. In this case, comparative statements might have to
be adjusted for reporting purposes, but restatement is not required for recording purposes in the
books. Example – inventory errors that self correct in the following period.
If restatement for an error is impracticable, report error prospectively. This may be the case for fair
values incorrectly assigned to biological assets or investment properties.
For errors disclosure includes the fact that an error has occurred, the nature of the error, the amount
of the correction for each period affected, and the fact that the results are restated.
LO-5 Describe the impact of accounting changes on the cash flow statements
and related ethical issues
A change in accounting policy does not affect the net change in cash but can affect the classification of
amounts as reported in the statement of cash flows. Retrospective changes will also impact the prior
year’s comparative statement of cash flows.
Similarly, the correction of accounting errors may affect the amounts shown in prior periods' cash
flow statements if the error affects the amounts previously reported.
Changes in accounting estimates will not affect the classification of cash flows.
LO-6 Identify similarities and differences between the accounting for
accounting changes under IFRS and ASPE.
IFRS requires disclosure of new standards that have been issued but not yet effective; the potential
effect should also be disclosed, even if the disclosure is that the new standard will have no effect. In
contrast, ASPE does not require disclosure of issued but not-yet-effective standards.
Like the IFRS standard, ASPE requires that any voluntary change in accounting policy meet the test of
being reliable and more relevant. However, several changes in accounting policy are permissible
without meeting this test.
56