MIdterm 1

Kieso, Weygandt, Warfield, Young, Wiecek Intermediate Accounting, Eighth Canadian Edition

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CURRENT LIABILITIES AND CONTINGENCIES

CHAPTER 13

CHAPTER TOPICS CROSS-REFERENCED WITH CICA HANDBOOK Financial Statement Concepts Section 1000 Current Assets and Liabilities Section 1510 Asset Retirement Obligations Section 3110 Contractual Obligations Section 3280 Contingencies Section 3290 Financial Instruments—recognition and measurement Section 3855 Disclosure of guarantees AcG-14

LEARNING OBJECTIVES 1. Define liabilities and distinguish financial liabilities from other liabilities. 2. Define current liabilities and identify and account for common types of current

liabilities. 3. Explain the classification issues for short-term debt that is expected to be refinanced. 4. Identify and account for the major types of employee-related liabilities. 5. Identify the accounting for common estimated liabilities. 6. Explain the recognition, measurement, and disclosure requirements for asset retirement

obligations. 7. Identify the accounting and reporting requirements for contingent liabilities. 8. Identify the accounting and reporting requirements for guarantees and commitments 9. Indicate how current liabilities and related items are presented and analyzed. 10. Compare current Canadian and international GAAP.


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CHAPTER REVIEW 1. Chapter 13 explains the basic principles regarding accounting and reporting for current

liabilities, asset retirement obligations, and contingent liabilities and commitments. Current Liabilities 2. In general, liabilities involve future disbursements of assets or other future economic

benefits (HB Section 1000). A liability is said to have three essential characteristics: a) It is an obligation to others that entails settlement by future transfer or use of cash or other assets, provision of goods or services on a determinable date, or on the occurrence of some specified event; b) the entity has little or no discretion to avoid the obligation; and c) the transaction or other event creating the obligation has already occurred.

3. A distinction is made between financial liabilities and those that are not financial in

nature. Financial liabilities are contractual obligations to deliver cash or other financial assets to another party, or to exchange financial instruments with another party that are potentially unfavourable. For example, unearned revenue is not a financial liability because it does not require the delivery of cash or another financial asset. Legislated liabilities such as income taxes payable are not created by a contract so they do not qualify as financial liabilities either.

4. Liabilities are classified on the balance sheet as current obligations or long-term

obligations. Current liabilities are those obligations whose liquidation is reasonably expected to require use of existing resources classified as current assets, or the creation of other current liabilities.

5. The relationship between current assets and current liabilities is an important factor in the

analysis of a company's financial condition. Thus, the definition of current liabilities for a particular industry will depend upon the time period (operating cycle or one year, whichever is longer) used in defining current assets in that industry.

6. Financial liabilities are initially measured and recorded at their fair value and then

subsequently at their amortized cost using the effective interest method. Non-financial liabilities are measured depending on their nature—for example unearned revenue is measured at the fair value of the goods or services to be given up in the future whereas warranty liabilities are measured based on management’s estimate of the cost of goods or services that will be provided in the future.


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Bank Indebtedness and Credit Facilities 7. The cash position of a company is closely related to its bank indebtedness for current

operating purposes and its associated line-of-credit or revolving debt arrangements. Instead of having to negotiate a new loan every time the company needs funds, it generally enters into an agreement with its bank to make multiple borrowings up to a negotiated limit. The company draws on the fund as needed and is normally required to make pre-negotiated repayments.

Accounts Payable

8. Accounts payable represent obligations owed to others for goods, supplies, and services

purchased on open account. These obligations, commonly known as trade accounts payable, should be recorded to coincide with the receipt of the goods or at the time title passes to the purchaser. Attention must be paid to transactions occurring near the end of one accounting period and at the beginning of the next to ascertain that the goods received (inventory) are in agreement with the liability (accounts payable) and that both are recorded in the proper period.

Notes Payable

9. Notes payable are written promises to pay a certain sum of money on a specified future

date and may arise from sales, financing, or other transactions. Notes may be classified as short-term or long-term, depending on the payment due date.

10. Short-term notes payable resulting from borrowing funds from a lending institution may

be interest-bearing or non-interest-bearing (i.e., zero-interest-bearing). Interest-bearing notes payable are reported as a liability at the face amount of the note along with any accrued interest payable. A zero-interest-bearing note does not explicitly state an interest rate on the face of the note. Interest is the difference between the present value of the note and the face value of the note at maturity. For example, Landscape Corp. issues a $104,000, four month, zero-interest bearing note to the Provincial Bank. The present value of the note is $100,000. The entry to record this transaction for Landscape Corp. would be as follows:

Cash 100,000 Discount on Notes Payable 4,000

Notes Payable 104,000

The balance in the discount on notes payable account would be deducted from the notes payable account on the balance sheet.


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11. The currently maturing portion of long-term debts may be classified as a current liability. When a portion of long-term debt is so classified, it is assumed that the amount will be paid within the next 12 months out of funds classified as current assets.

Refinancing

12. Certain short-term obligations expected to be refinanced on a long-term basis should be excluded from current liabilities. Under CICA Handbook Section 1510, a short-term obligation is excluded from current liabilities if contractual arrangements have been made for settlement from other than current assets. Emerging Issues Committee Abstract (EIC 122) requires that both of the following criteria be met in order to be classified as non-current: a) the entity must intend to refinance; and b) the entity must demonstrate an ability to consummate the refinancing.

In comparison, International Accounting Standards require that liabilities that are being refinanced be reported as current liabilities unless other arrangements have been completed by the balance sheet date.

Dividends Payable 13. Cash dividends payable are classified as current liabilities during the period subsequent

to declaration and prior to payment. Once declared, a cash dividend is a binding obligation of a corporate entity, payable to its shareholders. Stock dividends payable are reported in the shareholders' equity section when declared, and dividends payable in the form of additional shares are not recognized as a liability.

Rents and royalties payable 14. Rents and royalties are contractual agreements covering rent or royalty payments which

are conditional on the amount of revenues earned or the quantity of product produced or extracted. As each additional unit of product is produced or extracted, an additional obligation, usually a current liability, is created.

Returnable Deposits 15. When returnable deposits are received from customers or employees, a liability

corresponding to the asset received is recorded. The classification of these items as current or non-current liabilities is dependent on the time involved between the date of the deposit and the termination of the relationship that required the deposit.

Unearned Revenues


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16. A company sometimes receives cash in advance of the performance of services or issuance of merchandise. Such transactions result in a credit to a deferred or unearned revenue account classified as a current liability on the balance sheet. As claims of this nature are redeemed, the liability is reduced and a revenue account is credited.

Taxes Payable 17. Current tax laws require most business enterprises to collect sales taxes from customers

and income taxes from employees during the year and periodically remit these collections to the appropriate governmental unit. In such instances, the enterprise is acting as a collection agency for a third party. If tax amounts due to governmental units are on hand at the financial statement date, they are reported as current liabilities.

18. Sales Taxes Payable: To illustrate the collection and remittance of sales tax by a company,

assume that Bentham Company recorded sales for the period of $230,000. Further assume that Bentham is subject to a 7% sales tax collection that must be remitted to the provincial government. The entry to record the sales tax liability is:

Accounts Receivable 246,100

Sales 230,000 Sales Tax Payable 16,100

When payment is made, the sales tax payable would be debited and cash could be credited.

19. Goods and Services Tax: Most businesses in Canada are subject to a goods and services

tax (GST). Because companies are permitted to offset the recoverable and payable amounts, only the net balance of the two accounts is reported on the balance sheet. Until net credit balances are remitted to the Canada Customs and Revenue Agency, they are reported as current liability. A net debit balance is reported as a current asset.

20. Income Taxes Payable: A corporation should estimate and record the amount of income

tax liability as computed per its income tax return. Chapter 18 discusses in detail the complexities involved in accounting for the difference between taxable income under the tax laws and accounting income under generally accepted accounting principles.

Employee-Related Liabilities 21. Amounts owed to employees for salaries or wages of an accounting period are reported as

a current liability. The following items are related to employee compensation and are often reported as current liabilities: a. Payroll deduction.


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b. Compensated absences. c. Bonuses.

21. The following illustrates the concept of accrued liabilities related to payroll deductions.

Assume a weekly payroll of $10,000 that is entirely subject to Canada Pension (4.95%) and Employment Insurance (1.8%) deductions. Also, income tax withholding amounts to $1,320, and union dues to $88. Two entries are necessary to record the payroll, the first for the wages paid to employees and the second for the employer's payroll taxes. The two entries are as follows:

Wages and Salaries 10,000.00 Employee Income Taxes Payable 1,320.00 CPP Contributions Payable 495.00 EI Premiums Payable 180.00 Union Dues Payable 88.00 Cash 7,917.00 Payroll Tax Expense 747.00

CPP Contributions Payable ($495 x 1.0) 495.00 EI Premiums Payable ($180 x 1.4) 252.00

22. Compensated absences are absences from employment, such as vacation, illness, and

holidays, for which it is expected that employees will be paid. In connection with compensated absences, vested rights exist when an employer has an obligation to make payment to an employee even if that employee terminates. Accumulated rights are those rights that can be carried forward to future periods if not used in the period in which earned.

23. The expense and related liability for compensated absences should be recognized in the

year in which they are earned by the employees, whenever a reasonable estimate can be made of the amounts expected to be paid out in the future. To determine the cost of compensated absences, companies are more likely to use the current wage rate rather than a future rate, which is less certain and raises issues concerning the discounting of the future amount.

24. The accounting and reporting standards for post-retirement benefit payments are complex

and are discussed extensively in Chapter 19. 25. Bonus agreements are common incentives established by companies for certain key

executives or employees. In many cases, the bonus is dependent upon the amount of income earned by the company. However, because the bonus in an expense used in determining net income, it must be deducted before net income can be computed. Thus, we end up with the need to solve an algebraic formula to compute the bonus. In addition,


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when the concept of income taxes is added to the formula, calculation of the bonus requires solving simultaneous equations.

Estimated Liabilities Warranties 26. A warranty (product guarantee) represents a promise by a seller to a buyer to make good

on any deficiency in quantity, quality, or performance specifications in a product. Product warranty costs may be accounted for by using the cash basis method or the accrual method. The cash basis method must be used for income tax purposes and for financial accounting purposes when a reasonable estimate of warranty costs cannot be made at the time of sale. The accrual method includes two different accounting treatments: a) expense warranty approach, and b) sales warranty approach.

27. The expense warranty treatment is the generally accepted method for financial accounting

purposes and should be used whenever the warranty is an integral and inseparable part of the sale and is viewed as a loss contingency. The sales warranty treatment defers a certain percentage of the original sales price until some future time when actual costs are incurred or the warranty expires. Under the expense warranty method the estimated warranty expense is recorded in the year in which the item subject to the warranty is sold. When the warranty is honoured in a subsequent period the liability is reduced by the amount of the expenditure to repair the item. For example, if 200 units are sold and the estimated warranty cost is $300 per unit, the following entry would be made for the warranty:

Warranty Expense 60,000

Estimated Liability Under Warranties 60,000

Actual expenditures made to honour the warranty would debit the liability account and credit cash.

Premiums, Coupons, Rebates, and Loyalty Programs 28. If a company offers premiums to customers in return for coupons, a liability should

normally be recognized at year-end for outstanding premium offers expected to be redeemed. The liability should be recorded along with a charge to a premium expense account. The premiums, coupon offers, air miles, rebates, and prizes are made to stimulate sales, and their costs should be charged to expense in the period that benefits from the premium plan, i.e., the period of the sale. The cost of outstanding promotional offers that will be presented for redemption must be estimated in order to reflect the existing current liability and to match costs with revenues.


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Asset Retirement Obligations 29. In industries such as mining or oil drilling, the construction and operation of long-lived

assets often involves obligations at the time of retirement of those assets. A company must recognize an asset retirement obligation (ARO), an existing legal obligation associated with the retirement of a tangible long-lived asset that results from its acquisition, construction, development, or normal operation in the period in which it is incurred, if its fair value can be reasonably estimated. If a fair value cannot be reasonably estimated, the details must be reported in the notes.

30. Obligating Event. Existing legal obligation that requires the recognition of a liability

and asset cost such as the cost of restoring or reclaiming oil and gas properties. 31. Measurement. An ARO is initially measured at its fair value, which is defined as the

amount that the company would be required to pay. 32. Recognition and Allocation. The estimated costs of the ARO are included in the carrying

amount of the related long-lived asset in the same amount as the liability recognized. An asset retirement cost is recorded as part of the related asset because these costs are considered a cost of operating the asset. Therefore, the specific asset, e.g., mine, drilling platform, nuclear power plant, should be increased and should not be recorded as a separate account.

33. Reporting and Disclosure Requirements. Most of the AROs are long-term in nature and

should be shown outside current liabilities, providing details of the AROs and associated long-lived assets.

Contingencies and Commitments

34. A contingency is an existing condition or situation involving uncertainty as to possible

gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Gain contingencies are not recorded and are disclosed in the notes only when it is likely that a gain contingency will be realized.

35. A contingent liability is an obligation that is dependent upon the occurrence or non-

occurrence of one or more future events to resolve its status. When a loss contingency exists, the likelihood that the future event or events will confirm the incurrence of a liability is characterized as likely, unlikely or undeterminable.

36. An estimated loss from a loss contingency should be accrued by a charge to expense and a

liability recorded only if both the following conditions are met:


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a. Information available prior to the issuance of the financial statements indicates that

it is likely that a future event will confirm that an asset has been impaired or a liability incurred as of the date of the financial statements, and

b. The amount of the loss can be reasonably estimated.

Neither the exact payee nor the exact date payable need be known to record a liability. What must be known is whether it is likely that a liability has been incurred.

Litigation, Claims, and Assessments 37. When a company is threatened by legal action (litigation, claims, and assessments), the

recording of a liability will depend upon certain factors. Among the more prevalent are a) the time period in which the underlying cause for action occurred, b) the probability of an unfavourable outcome, and c) the ability to make a reasonable estimate of the amount of loss.

Guarantees 38. CICA Handbook Guideline AcG-14 “Disclosure of Guarantees” (effective 2003) requires

expanded disclosure by all guarantors about obligations and particularly about the risks that are assumed as a result of issuing guarantees.

Contractual Obligations

39. CICA Handbook Section 3280 on Contractual Obligations as a result of agreements with customers, suppliers, employees and other parties requires disclosure of significant commitment.

Self-Insurance Risks 40. A company cannot accrue a liability for the cost of potential and probable losses resulting from a decision to self insure because no liability exists until damage occurs. Presentation & Disclosure 41. Current liabilities are reported in the financial statements at their maturity value. Present

value techniques are not normally used in measuring current liabilities, because of the short time periods involved. Current liabilities are normally listed at the beginning of the liabilities and shareholders' equity section of the balance sheet. Within the current liability section the accounts may be listed in order of maturity, in descending order of amount, or in order of liquidation preference.


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42. Contingent liabilities are disclosed if:

• it is likely that a future event will confirm the existence of a loss but the loss cannot be reasonably estimated.

• a loss has been recognized, but there is an exposure to loss that is higher than the amount that was recorded.

• it is not possible to determine the likelihood of there being a future event that confirms the liability.

43. Contractual commitments are disclosed if they will result in future obligations that are

unusual in nature or material in amount. Analysis 44. Analysts are interested in the liquidity of a company. Part of this analysis requires an

assessment of the ability to pay current obligations as they come due. These obligations arise from both financing activities (such as notes payable) and operations (such as accounts and salaries payable). Ratios that focus on current liabilities in this analysis include the current ratio, the acid-test ratio, and the days payables outstanding ratio.

International Perspectives 45. Canadian accounting standards on current liabilities, contingencies, and commitments are

largely converged with those of the IASB though there are some differences in classification, terms, and the comprehensiveness of requirements in classification, measurement, and disclosure.


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LECTURE OUTLINE This chapter can be covered in two or three class sessions. Students should be familiar with trade and payroll liabilities. Short-term obligations expected to be refinanced and the accounting for loss contingencies are the conceptually challenging areas for many students.

Section 1: Current Liabilities A. The Concept of Liabilities

1. The question of what is a liability is not a simple issue to resolve. This can be seen if the example of preferred shares is analyzed.

2. The CICA has provided a definition of a liability as part of the CICA Handbook

Section 1000. (Chapter 2 may be reviewed for the definition.) B. Current Liabilities

1. Nature of current liabilities: Obligations whose liquidation is reasonably expected to require use of existing resources classified as current assets, or the creation of other current liabilities.

2. Current liabilities can be either financial or non-financial. Financial liabilities are

contractual obligations to deliver cash or other financial assets to another party, or to exchange financial instruments with another party that are potentially unfavourable.

3. Financial liabilities are initially measured and recorded at their fair value and then

subsequently at their amortized cost using the effective interest method. Non-financial liabilities are measured depending on their nature such as the fair value of the goods or services to be given up in the future

Financial liabilities do not include obligations resulting from legislation. For

example, the income tax payable on corporate income would be a non-financial liability.

4. Current liabilities can be classified as either determinable or contingent.

C. Determinable Current Liabilities: Such liabilities can be measured precisely, and the

amount and timing of the cash outflows are reasonably certain.


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1. Bank Indebtedness and Credit Facilities: a line-of-credit or revolving debt arrangement. The company draws on the fund as soon as needed when the previous amount is repaid.

2. Accounts Payable: Trade accounts payable should be recorded when the goods are

received, or the legal title passes to the purchaser.

3. Notes Payable:

a. Trade notes

b. Short-term loan notes: Interest bearing notes are presented at their face value, zero-interest bearing notes are presented at amortized cost.

c. Current maturity of long term debt. That portion of long-term indebtedness

that matures within the next fiscal year is reported as a current liability if it is to be paid out of current assets, and if it is not going to be refinanced by a new debt issue or by conversion into shares.

4. Short-term Obligations Expected to Be Refinanced.

a. HB Section 1510 requires the exclusion of short-term obligations from current

liabilities “to the extent that contractual arrangements have been made for settlement from other than current assets.” Emerging Issues Committee Abstract (EIC 122) requires that both of the following criteria be met in order to be excluded from the current category: a) the entity must intend to refinance, and b) the entity must demonstrate an ability to consummate the refinancing.

b. In comparison, International Accounting Standards require that liabilities

being refinanced be reported as current liabilities unless other arrangements have been completed by the balance sheet date.

c. Disclosure is recommended.

5. Dividends Payable: At the date of declaration of a cash dividend payable the

corporation assumes a liability. Preferred dividends in arrears are not a legal obligation until a distribution is formally authorized. Stock dividends payable are part of shareholders' equity (not a liability).

6. Other liabilities include returnable deposits and rents and royalties payable.

7. Unearned Revenues: Non-financial liabilities that are measured at the fair value

of the goods or services to be given up in the future.


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8. Collections for Third Parties:

a. Sales taxes

b. Income tax and other payroll deductions, such as Canada Pension Plan premium, employment insurance, and union dues.

9. Accrued Expenses or Liabilities:

a. Accrued payroll taxes: These would include the employer's share of CPP and

employment insurance premiums. b. Accrued property taxes: The accounting questions involved here are when the

property owner should record the liability, and to which periods the cost should be charged.

10. Compensated Absences: These are absences such as vacations, illnesses, or holidays

for which employees are normally paid. When benefits vest, accrual of the estimated liability is recommended.

11. Conditional Payments: These are liabilities that depend on annual income and

therefore cannot be known for certain until the end of the period.

a. Income taxes payable

b. Bonus agreements

D. Estimated Liabilities

1. Guarantee and Warranty Costs: The amount of the liability is an estimate of all the costs that will be incurred after sale and delivery.

a. Cash basis method

b. Accrual methods:

(1) Expense warranty treatment. This method should be used whenever the warranty is an integral and inseparable part of the product sale and requires warranty costs to be charged to operating expense in the year of sale.

(2) Sales warranty treatment. This method should be used when the

warranty is sold separately from the product and requires that revenues from the sale of the warranty be deferred and subsequently recognised as income over the life of the warranty contract.

2. Premiums, coupons, loyalty programs, and other bonuses offered to customers:

result in the likely existence of a liability at the date of the financial statements.


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E. Asset Retirement Obligation

1. Obligating Events: Examples include decommissioning nuclear facilities, dismantling, restoring, and reclamation of oil and gas properties, closure and post-closure cost of landfills, and others.

2. Measurement: An ARO is initially measured at its fair value, which is defined as

the amount that the company would be required to pay.

3. Recognition and Allocation: The estimated costs of the ARO are included in the carrying amount of the related long-lived asset in the same amount as the liability recognized.

4. Reporting and Disclosure Requirements: As most of the AROs are long-term in

nature, they should be shown outside current liabilities, providing details of the AROs and associated long-lived assets.

F. Contingencies and Commitment

These are liabilities that are dependent upon the occurrence or non-occurrence of one or more future events to confirm either the amount payable or the payee or the date payable or its existence. The condition had to exist at the balance sheet date. Information has to be available prior to issuing financial statements.

1. Probability that the future event or events will confirm the incurrence of a liability

can be classified as:

a. Unlikely. b. Likely. A liability is recorded if the information indicates that it is likely that

a liability had been incurred at the balance sheet date, and the amount of the resulting loss can be reasonably estimated.

c. Not determinable.

2. If a loss contingency is either likely or estimable but not both, and if there is a

reasonable possibility that a liability may have been incurred, the following disclosure is suggested.

a. The nature of the contingency.

b. An estimate of the possible loss or range of loss or a statement that an

estimate cannot be made.


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3. Litigations, Claims, and Assessments. The following factors should be considered:

a. The period in which the underlying cause for action occurred.

b. The degree of probability of an unfavourable outcome.

c. The ability to make a reasonable estimate of the amount of the loss.

4. Companies are required under Section 3060.39 of the CICA Handbook to accrue

future removal and site restoration costs. This accrual is subject to the measurability of the estimated future costs.

5. Risk of loss due to lack of insurance coverage. The absence of insurance does not mean

that a liability has been incurred at the date of the financial statements. 6. Guarantees: CICA Handbook Guideline AcG-14 “Disclosure of Guarantees” (effective

2003) requires expanded disclosure by all guarantors about obligations and particularly about the risks that are assumed as a result of issuing guarantees.

TEACHING TIP The accounting treatment of loss contingencies can be summarized with the aid

of Illustration 13-1.

G. Financial Statement Disclosure of Current Liabilities

1. The current liability accounts are generally the first classification in the equity section of the balance sheet.

2. Current liabilities are frequently listed in order of maturity, according to amount, or

in order of liquidation preference. 3. Areas that warrant additional disclosure are:

a. Assets pledged as collateral for secured liabilities.

b. Purchase commitments.

c. Short-term obligations expected to be refinanced.

d. Loss contingencies for which a liability has not been recorded.


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G. Analysis

Ratios used to measure the liquidity of a company to determine its ability to meet its current financing and operating obligations include:

a. Current ratio b. Acid-test ratio c. Days payables outstanding

H. International Perspectives Canadian accounting standards on current liabilities, contingencies, and commitments are largely converged with those of the IASB with some differences in classification, comprehensiveness, and terminology.


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ILLUSTRATION 13-1

ACCOUNTING TREATMENT OF LOSS CONTINGENCIES Not May be

Loss Related to: Accrued Accrued* 1. Risk of loss or damage of enterprise property by fire, explosion, or other hazards X 2. General or unspecified business risks X 3. Risk of loss from catastrophes assumed by property and casualty insurance companies including re- insurance companies X 4. Threat of expropriation of assets X 5. Pending or threatened litigation X 6. Actual or possible claims and assessments X

7. Guarantees of indebtedness of others** X 8. Agreements to repurchase receivables (or the related property) that have been sold X

* Should be accrued when both criteria are met (likely and reasonably estimable). ** Estimated amounts of losses incurred prior to the balance sheet date but settled

subsequently should be accrued as of the balance sheet date. Source: Kieso, Weygandt, Intermediate Accounting, Eighth Edition.


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CHAPTER 14

LONG-TERM FINANCIAL LIABILITIES

CHAPTER TOPICS CROSS REFERENCED WITH CICA HANDBOOK Long-Term Debt Section 3210 Financial Instruments—recognition and measurement Section 3855 Financial Instruments—presentation Section 3863 Financial Instruments—disclosure Section 3862

LEARNING OBJECTIVES 1. Describe the procedures for issuing long-term debt. 2. Identify various types of long-term debt. 3. Explain the initial measurement of bonds/notes at date of issuance. 4. Apply the methods of bond discount and premium amortization. 5. Value bonds and consideration in special situations. 6. Describe the accounting procedures for the extinguishment of debt. 7. Explain the issues surrounding off-balance sheet financing arrangements. 8. Indicate how long-term debt is presented and analyzed. 9. Compare current Canadian and international GAAP and understand which direction

international GAAP is headed. 10. Account for impairments on notes and loans receivable. (Appendix 14A) 11. Distinguish between and account for debt restructurings that result in extinguishment or in

debt continuation (Appendix 14A).


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CHAPTER REVIEW 1. Chapter 14 presents a discussion of the issues related to long-term liabilities. Long-term

debt consists of probable future sacrifices of economic benefits. These benefits are payable in the future, normally beyond one year or operating cycle, whichever is longer. Coverage in this chapter includes bonds payable, long-term notes payable, mortgage notes payable, issues related to the extinguishment of debt and issues surrounding off-balance sheet financing. The accounting and disclosure issues related to long-term liabilities includes a great deal of detail due to the potentially complicated nature of debt instruments.

Long-Term Financial Liabilities 2. Long-term debt consists of obligations of an entity arising from past transactions or events

that are not payable within the next year or operating cycle, whichever is longer. These obligations normally require a formal agreement between the parties involved that often includes certain covenants and restrictions for the protection of both lenders and borrowers. These covenants and restrictions are found in the bond indenture or note agreement, and include information related to amounts authorized to be issued, interest rates, due dates, call provisions, security for the debt, sinking fund requirements, etc. The important issues related to long-term debt should always be disclosed in the financial statements or the notes thereto.

3. Long-term liabilities include bonds payable, mortgage notes payable, long-term notes

payable, lease obligations, and pension obligations.

Bonds Payable 4. Bonds payable represent an obligation of the issuing corporation to pay a sum of money

at a designated maturity date plus periodic interest at a specified rate on the face value. The following terms are commonly used in discussing the various aspects of corporate bond issues.

a. Bond Indenture. Describes the contractual agreement between the corporation

issuing the bonds and the bondholders. b. Face Value. Amount stated on the face of the bond which serves as the basis for

periodic interest computations, and represents the amount due at maturity (also known as maturity value or par value).

c. Term Bonds. Issues that mature on a single date.


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d. Serial Bonds. Issues that mature in periodic instalments.

e. Mortgage Bonds. Secured bonds having a claim on real estate.

f. Junk Bonds. Term used to describe bonds that are unsecured and pay a high rate of interest because of the high risk associated with the bonds.

g. Debenture Bonds. Unsecured bonds. h. Convertible Bonds. Bonds that may be exchanged for other securities of the

corporation. i. Commodity-Backed Bonds. Bonds that are redeemable in measures of a

commodity such as barrels of oil, bushels of wheat, or ounces of a rare metal (also called asset-linked bonds).

j. Deep Discount Bonds. Bonds sold at a discount that provides the buyer's total

interest payoff at maturity (in Canada, zero-coupon bonds, or stripped bonds, are a form of deep-discount bond).

k. Income Bonds. Interest payments depend on the existence of operating income.

Revenue bonds are bonds on which the interest is paid from specified revenue sources.

l. Callable Bonds. Issuer reserves the right to call and retire the bonds prior to

maturity. m. Registered Bonds. Bonds issued in the name of the owner. n. Bearer or Coupon Bonds. Bonds not recorded in the name of the owner,

transferred by mere delivery.

5. Bonds are debt instruments of the issuing corporation used by that corporation to borrow funds from the general public or institutional investors. The use of bonds provides the issuer an opportunity to divide a large amount of long-term indebtedness among many small investing units. Bonds may be sold through an underwriter who either a) guarantees a certain sum to the corporation and assumes the risk of sale, or b) agrees to sell the bond issue on the basis of a commission. Alternatively, a corporation may sell the bonds directly to a large financial institution without the aid of an underwriter.

6. If an entire bond issue is not sold at one time, both the amount of the bonds authorized

and the bonds issued should be disclosed on the balance sheet or in a note. This discloses the potential indebtedness represented by the unissued bonds.


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7. Bonds are issued with a stated rate of interest expressed as a percentage of the face value of the bonds. When bonds are sold for more than face value (at a premium) or less than face value (at a discount), the interest rate actually earned by the bondholder is different from the stated rate. This is known as the effective yield or market rate of interest and is set by economic conditions in the investment market. The effective yield exceeds the stated rate when the bonds sell at a discount, and the effective yield is less than the stated rate when the bonds sell at a premium.

8. To compute the effective interest rate of a bond issue, the present value of future cash

flows from interest and principal must be computed.

Discounts and Premiums 9. Premiums and discounts resulting from a bond issue are recorded at the time the bonds are

sold. These items are amortized each time bond interest is paid. The time period over which discounts and premiums are amortized is equal to the period of time the bonds are outstanding (date of sale to maturity date). Amortization of bond premiums decreases the recorded amount of bond interest expense, while the amortization of bond discounts increases the recorded amount of bond interest expense.

10. To illustrate the recording of bonds sold at a discount or premium the following examples

are presented. If Aretha Company issued $100,000 of bonds dated January 1, 2004, at 98, on January 1, 2004, the entry would be as follows:

Cash ($100,000 x .98) 98,000

Bonds Payable 98,000

If the same bonds noted above were sold for 102, the entry to record the issuance would be as follows:

Cash ($100,000 x 1.02) 102,000

Bonds Payable 102,000

(Note that the examples in this chapter journal entries are shown on a “net” basis, meaning that discount and premium accounts are not used as they were in chapters 7, 10, 1and 13. For bookkeeping purposes, either method can be used, however when receivables or payables have discounts or premiums, they must be shown on the financial statements on a net bases, regardless of the bookkeeping method used.)

11. To illustrate the amortization of the bond discount or premium, assuming a simplified

straight line method is used, the bonds sold in the example in paragraph 10 above are five-year bonds. Since the bonds are sold on the issue date (January 1, 2004) they will be outstanding for the full five years. Thus, the discount or premium would be amortized


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over the entire life of the bonds. The entry to amortize the bond discount at the end of 2004 would be:

Bond Interest Expense 400

Bonds Payable 400

The entry to amortize the premium would be:

Bonds Payable 400 Bond Interest Expense 400

Note that the amortization of the discount increases the bond interest expense for the period and the amortization of the premium reduces bond interest expense for the period.

12. When bonds are issued between interest dates, the issuer must receive the purchase price

plus an amount equal to the interest earned on the bonds since the last interest payment date. On the next interest payment date, the bondholder receives the entire semi-annual (if payable semi-annually) interest payment. However, the amount of interest expense to the issuing corporation is the difference between the semi-annual interest payment and the amount of the interest prepaid by the purchaser. For example, assume a 10-year bond issue in the amount of $300,000 bearing 9% interest payable semi-annually is dated January 1, 2004. If the entire bond issue is sold at par on March 1, 2004, the following journal entry would be made by the seller:

Cash 304,500

Bonds Payable 300,000 Bond Interest Expense 4,500* *($300,000 x .09 x 1/6)

The entry for the semi-annual interest payment on July 1, 2004, would be as follows:

Bond Interest Expense 13,500

Cash 13,500

The total bond interest expense for the six-month period is $9,000 ($13,500 - $4,500), which represents the correct interest expense for the four month period the bonds were outstanding.

13. Bond premiums and discounts may be amortized using the straight-line method as

illustrated in paragraph 11. However, the preferred method is the effective interest method. This method computes bond interest using the effective yield at which the bonds are issued. More specifically, interest cost for each period is the effective interest rate multiplied by the carrying value (book value) of the bonds at the start of that period. The effective interest method is best accomplished by preparing a Schedule of Bond Interest


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Amortization. This schedule provides the information necessary for each semi-annual entry for interest and discount or premium amortization. The spreadsheet softwares available from Excel, Lotus or QuattroPro are capable of applying the effective interest method.

14. Unamortized premiums/discounts are added/deducted from bonds payable and presented

net in the liability section of the balance sheet. Premiums are added to bonds payable and discounts are deducted from bonds payable.

15. If the interest payment date does not coincide with the financial statement date, the

amortized premium or discount should be prorated by the appropriate number of months to arrive at the proper interest expense.

16. Some of the costs associated with issuing bonds include engraving and printing costs,

legal and accounting fees, commissions, and promotion expenses. These costs, can be either recognized in net income or added to the carrying value of the debt and amortized over the life of the debt in a way that is similar to what is done for bond discounts.

Notes Payable 17. The difference between current notes payable and long-term notes payable is the maturity

date. Accounting for notes and bonds is quite similar. 18. Interest-bearing notes are treated the same as bonds—a discount or premium is recognized

if the stated rate is different than the effective yield. Zero-interest-bearing notes represent a discount on the note and the discount is amortized similar to the manner on interest-bearing notes.

19. When a long-term note is issued solely for cash, the interest factor is assumed to be the

stated or coupon rate plus or minus the amortization of the discount or premium. In special situations where a note is exchanged for cash and some additional privilege, the difference between the present value of the payable and the amount of cash loaned should be recorded as a discount on the note and as unearned revenue. This discount should be amortized by a charge to interest expense over the term of the note using the effective interest method. The unearned revenue is prorated on the same basis as the privilege that gave rise to the unearned revenue is realised by the lender/customer. For example, the privilege may be a favourable merchandise purchase agreement. In this case, the unearned revenue is prorated on the same basis that each period's sales to the lender/customer bear to the total sales to that customer for the term of the note.

20. When a debt instrument is exchanged for non-cash consideration, such as property,

goods, or services, the stated rate of interest is presumed fair unless a) no interest rate is stated, b) the stated rate is unreasonable, or c) the face amount of the debt is materially


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different from the current cash price of the consideration or the current market value of the debt. In these circumstances, the present value of the debt instrument is measured by the imputed interest rate.

21. The imputed interest rate used for valuation purposes will normally be at least equal to the

rate at which the debtor can obtain financing of a similar nature from other sources at the date of the transaction. The object is to approximate the rate that would have resulted if an independent borrower and an independent lender had negotiated a similar transaction under comparable terms and conditions. Any difference between the cash received and the discounted amount (fair value of the loan) is recognized in net income unless it qualifies for recognition as some other asset or liability.

22. Mortgage notes are a common means of financing the acquisition of property, plant, and

equipment in a proprietorship or partnership form of business organization and in smaller corporations. Normally, the title to specific property is pledged as security for a mortgage note. If a mortgage note is paid on an instalment basis, the interest accrued to the balance sheet date and the principal portion of the instalment payments coming due within the next year should be classified as a current liability.

Extinguishment of Debt/Derecognition 23. The extinguishment, or payment, of long-term liabilities can be a relatively

straightforward process when the debt is held to maturity—no gain or loss is calculated. The process can also be a complicated one when the debt is extinguished prior to maturity. CICA Handbook Section 3855.46 states that extinguishment of debt occurs when: 1. The debtor discharges the liability by paying the creditor 2. The debtor is legally released from primary responsibility for the liability by law or by

the creditor. 24. The reacquisition of debt can occur either by payment to the creditor or by reacquisition in

the market. At the time of reacquisition, any unamortized premium or discount related to the bonds, must be amortized up to the reacquisition date. If this is not done, any resulting gain or loss on the extinguishment would be misstated. The difference between the reacquisition price and the net carrying amount of the debt is a gain or loss from extinguishment.

25. Gains or losses from debt extinguishment would be reported in the income statement and

could be an extraordinary item if the criteria of being unusual, infrequent, and not dependent on management decisions and determinations are met. This situation would be rare. Differences between the carrying value of any new bonds issued and the old bonds redeemed is treated as a gain or loss in the current year's income statement.


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26. The following terms are important to an understanding of the accounting for early extinguishment of debt securities.

a. Extinguishment of Debt/Derecognition. When debt is repaid or extinguished, i.e.,

when an obligation is discharged, cancelled or expires, it is derecognized from the financial statements.

b. Reacquisition Price. The amount paid on early extinguishment. Includes any call

premium and expense of reacquisition.

c. Net Carrying Amount. Amount of bonds payable at maturity, adjusted for unamortized premium or discount.

d. Gain or Loss from Extinguishment. Difference between reacquisition price and

net carrying amount of bonds, recognized in income of the period of redemption. If reacquisition price exceeds net carrying amount, a loss results.

e. Refunding is the exchange of an existing debt instrument with a new one. At the

time of redemption, professional judgement must be used to determine whether the transaction represents an extinguishment of the old debt, or a renegotiation or modification of the old debt.

f. Defeasance is the setting aside of money in a trust or other arrangement that allows

the trust to repay a debt as it becomes due according to the original agreement. Companies enter into this type of arrangement when they want to extinguish or pay off debt before its due date but factors such as early repayment penalties would discourage them from doing so.

Off-Balance Sheet Financing 27. A significant issue in accounting today is the question of off-balance sheet financing. Off-

balance sheet financing is an attempt to borrow monies in such a way that the obligations are not recorded. Several examples of off-balance sheet financing are discussed in the chapter:

28. A non-consolidated subsidiary may have considerable debt, for which the parent is

ultimately liable. Proposed Section 3855 will require that any exposure under guarantees be recognized on the parent’s balance sheet.

29. Special Purpose Entities (SPE) or Variable Purpose Entities (VIE) are entities created

by a company to perform a special purpose, such as to access financing, or to segregate certain assets from other company assets, which may allow for certain tax advantages.


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30. Another way companies keep debt off the balance sheet is by leasing assets instead of buying them with debt.

Presentations and Disclosure 31. Long-term debt that matures within one year should be reported as a current liability

unless retirement is to be accomplished with other than current assets. 32. Companies that have large amounts and numerous issues of long-term debt frequently

report only one amount in the balance sheet and support this with comments and schedules in the accompanying notes to the financial statements. These note disclosures generally indicate the nature of the liabilities, maturity dates, interest rates, call provisions, conversion privileges, restrictions imposed by the borrower, and assets pledged as security.

Analysis 33. Ratios helpful in analysing a company’s solvency include those that help determine a

company’s ability to pay interest and to repay long-term debt as it becomes due. Two of these ratios are the debt-to-total-assets ratio that measures the percentage of the total assets provided by creditors and times interest earned which indicates a company’s ability to meet interest payments as they become due.

International Perspective

34. Current Canadian GAAP for long-term debt are quite similar to IAS standards. Canadian GAAP allows transaction costs to be either expensed or included in the initial recognition cost of the debt, whereas IAS standards require the latter approach. The IASB and the FASB are working to simplify accounting for financial instruments that will see all financial instruments valued at fair value with gains and losses recognized in net income.

Accounting for Troubled Debt—Appendix 14A

35. A loan is considered impaired when the lender no longer has reasonable assurance of timely collection of the full amount of the principal and interest. Once loans are determined to be impaired, they should be measured at estimated realisable amounts—which generally means discounting the expected future cash flows at the effective interest rate inherent in the loans (the historical rate).

36. Troubled debt restructuring occurs when the creditor, for economic or legal reasons related

to the debtor's financial difficulties, grants a concession to the debtor that it would not


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otherwise consider. Such restructuring could be through settlement of the debt at less than its carrying amount or continuation of the debt with a modification of terms.

37. Once loans are determined to be impaired, they should be measured at estimated net

realizable amounts, which means discounting the expected future cash flows at the effective interest rate inherent in the loans (the historical rate is recommended over the market rate by HB Section 3025.

LECTURE OUTLINE Students are generally familiar with the accounting for bonds payable from elementary accounting. Students, however, may be unfamiliar with the effective interest method of amortization of bond discount and premium. New for many students may also be the treatment of discounts and premiums on a net basis when presented on financial statements. A. Nature of Long-Term Debt

1. Consists of present obligations not payable within the operating cycles of the business, or within a year if there are several cycles within a year.

2. Long-term creditors normally have no vote in management affairs and only receive

a stated rate of interest regardless of the level of earnings. 3. Covenants or restrictions on the borrower for the protection of the lenders are stated

in the bond indenture or note agreement. B. Bonds Payable

1. Discuss the different types of bonds such as term bonds, serial bonds, secured and unsecured bonds, convertible bonds, commodity backed bonds, deep discount bonds, guaranteed and income bonds, registered and coupon bonds.

2. Accounting for the issuance of bonds 3. Discount and premium on bonds

a. Stated, coupon, or nominal rate of interest: the interest rate written in the

terms of the bond indenture. b. Effective yield, or market rate: the interest rate actually earned by the

bondholders. c. A premium (discount) exists when the market rate is lower (higher) than the

stated rate.


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TEACHING TIP Illustration 14-1 can be used to demonstrate how bond prices are affected by the stated rate of interest. A numerical example is given that calculates the selling price of bonds issued at a premium, at par, and at a discount.

d. The amortization period is the period of time that the bonds are outstanding.

e. On the balance sheet the bonds are shown net of any premium or discount,

though for bookkeeping purposes a bond discount or bond premium account can be used.

4. The effective interest method must be used to calculate the periodic interest expense

if GAAP is a constraint. The carrying amount of the bonds at the start of the period is multiplied by the effective interest rate. If GAAP is not a constraint, or for illustration purposes, the straight-line method is often used because of its simplicity.

TEACHING TIP

Illustration 14-2 compares the calculation of bond discount or premium amortization under straight-line and effective interest methods.

Effective Interest Method. In teaching this part of the chapter the following relationships may be emphasized:

a. Carrying Value of Bonds = Face Value Plus Premium or Less Discount

b. Interest Expense = Market Interest Rate x Carrying Value of Bonds

c. Interest Payable = Stated Interest Rate x Face Value of Bonds

d. If a premium exists: Interest expense will be less than interest paid or payable.

e. If a discount exists: Interest expense will be greater than interest paid or

payable.

f. Difference between interest expense and interest paid or payable is the amount of amortization of the discount or premium.

5. Review accounting for bonds issued between interest dates

6. Issuance expenses may be treated as an immediate expense or as a reduction of the

related liability and amortized. Treatment as a deferred charge is no longer an acceptable method under GAAP.


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TEACHING TIP Illustration 14-3 provides a review problem of accounting for bonds. The numerical example requires calculating bond discount, recording issuance of bonds, preparing an effective interest method amortization schedule, and preparing journal entries to record interest expense, amortization of bond discount and bond issuance costs.

C. Long-Term Notes Payable

1. The following categories of transactions are considered:

a. Zero interest-bearing notes issued for cash: The implicit interest rate is the rate that equates the cash received (present value) with the amounts received in the future. The difference between the face amount and the present value of the note is the discount or premium and it is amortized over the life of the note.

b. Interest-bearing notes with an effective yield different than the stated

rate: If a stated interest rate is unreasonable, an imputed interest rate must be used to determine the present value of the note. Any discount or premium must be recognized and amortized over the life of the note.

c. Notes exchanged for cash and some right or privilege: The difference

between the present value of the payable and the amount of cash loaned should be regarded as a discount on the note. Also, an unearned income account should be credited for the same amount. The unearned income is recognized as revenue each period as the right or privilege is exercised. Example: the right to purchase merchandise at low prices.

d. Non-cash transactions: the present value of the debt is measured by the fair

value of the property, goods, or services changing hands, or by an amount that reasonably approximates the market value of the note.

2. Imputing an interest rate: Approximate the rate that would have resulted if an

independent borrower and lender had negotiated a similar transaction. When interest is imputed, the effective interest method must be used. Any difference between the cash received and the discounted amount (fair value of the loan) is recognized in net income unless it qualifies for recognition as some other asset or liability

3. Journal entries are similar to entries for bonds payable issued at a discount.


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D. Extinguishment of Debt/Derecognition

1. Reacquisition of debt before maturity

a. The difference between the net carrying amount and the reacquisition price (the amount paid including any call premium and reacquisition expense) is the gain or loss.

b. The net carrying amount is the amount payable at maturity, adjusted for any

unamortized premium or discount.

c. The gain or loss is reflected in income in the period of redemption. This may be considered extraordinary if the criteria of unusual, infrequent, and not depending on management determinations are met. Usually, however, it is shown before extraordinary items.

TEACHING TIP

Illustration 14-3 provides a scenario for the reacquisition of debt prior to maturity. Debt is extinguished two years after issuance and a loss is recognized.

E Off-balance Sheet Financing

1. Examples:

a. Non-consolidated subsidiaries

b. Special purpose entities or variable interest entities

c. Operating versus capital leases

2. Rationale for off-balance sheet financing:

a. Attempt to "enhance the quality" of the balance sheet.

b. Conform to loan covenants.

c. "Balance" understatement of assets. F. Reporting Long-Term Debt

1. Disclosures generally indicate the nature of the liabilities, maturity dates, interest rates, call provisions, conversion privileges, restrictions imposed by borrowers, and assets pledged as security.


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2. Future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years should be disclosed.

G. Troubled Debt Restructuring (Appendix 14A)

1. Discuss the reasons for troubled debt restructuring. 2. Accounting issues

a. Recognition—losses should be recognized immediately if it is likely that the

loss will occur.

b. Measurement: i. Aggregate cash flows ii. Present value— historical rate iii. Present value—market rate


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ILLUSTRATION 14-1 INTEREST RATES AND BOND PRICES Market Interest Bonds Sold Rate At Bond (1) 10% Premium Stated Issued Interest Rate (2) 12% Face Value 12% (3) 15% Discount EXAMPLE: Three-year bonds are issued at face value of $100.000 and a stated rate of interest of 12 %. (1) Bonds are issued to yield 10%. Present value of principal = $100,000 x (PVIF 10%, 3yrs) = $100,000 x .75132 = $75,132 Present value of interest payments = $12,000 x (PVIFA 10%,3yrs) $12,000 x 2.48685 = 29,842 Selling price of bonds (premium) $104.974 (2) Bonds are issued to yield 12%. Present value of principal = $100,000 x (PVIF 12%, 3yrs) = $100,000 x .71178 = $71,178 Present value of interest payments = $12,000 x (PVIFA 12%,3yrs) $12,000 x 2.40183 = 28,822 Selling price of bonds (par) $100.000 (3) Bonds are issued to yield 15%. Present value of principal = $100,000 x (PVIF 15%, 3yrs) = $100,000 x .65752 $65,752 Present value of interest payments = $12,000 x (PVIFA 15%,3yrs) $12,000 x 2.28323 = 27,399 Selling price of bonds (discount) $93,151


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ILLUSTRATION 14-2 BOND AMORTIZATION METHODS

Computation of Amortization—Straight-Line Method Bond Discount Number of Bond or Premium ÷ Interest = Amortization Periods Interest Payable + Discount Interest - Premium Expense Amortization = Constant Amount Constant Amount Constant Amount

Computation of Amortization—Effective Interest Method

Bond Interest Payable Bond Interest Expense Face Stated Carrying Value Effective Amortization Amount × Interest − of bonds × Interest = Amount of Bonds Rate Beginning of Period Constant Amount Premium-Decreasing Amount Decreasing Amt. Discount-Increasing Amount Increasing Amt.


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ILLUSTRATION 14-3 BONDS PAYABLE—REVIEW PROBLEM

Three-year bond with an 8% coupon rate sold to yield 10% on January 1, 2005. Interest payable annually. Callable at 105. Face value: $100,000. Bond issue costs: $5,000. 1. Calculation of premium or discount

$100,000(0.75132) = $75,132.00 $ 8,000(2.48685) = 19,894.80

$95,026.80

Discount = $100,000 - $95,026.80 = $4,973.20 2. Recording of bond issuance

Cash 90,026.80 Bond Issue Expenses 5,000.00

Bonds Payable 95,026.80 3. Bond Discount Amortization

Interest Interest Face Carrying Payable Expense Discount Bond Value of Value of (8%) (10%) Amortization Discount Bonds Bonds

01/01/05 4,973.20 100,000 95,026.80 12/31/05 8,000 9,502.68 1,502.68 3,470.52 100,000 96,529.48

12/31/06 8,000 9,652.95 1,652.95 1,817.57 100,000 98,182.43 12/31/07 8,000 9,818.24 1,818.24 -0- 100,000 100,000.00

4. Accounting Entries

12/31/05 12/31/06 12/31/07 Interest Expense 9,502.68 9,652.95 9,818.24 Bonds payable 1,502.68 1,652.95 1,818.24 Cash 8,000.00 8,000.00 8,000.00 Bonds Payable 100,000.00 Cash 100,000.00


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ILLUSTRATION 14-3 (continued) 5. Entries, if bonds recalled on 12/31/06. Expenses of recall: $2,000

Cash paid = (1.05 x $100,000) + $2,000 = $107,000

Net carrying amount of bond = $100,000 - $1,817.57= $98,182.43

Loss on extinguishment = $107,000 - $98,182.43 = $8,817.57 Journal entry:

Bonds Payable 98,182.43 Loss on Extinguishment 8,817.57

Cash 107,000.00


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SHAREHOLDERS' EQUITY CHAPTER 15

CHAPTER TOPICS CROSS-REFERENCED WITH CICA HANDBOOK Share Capital Section 3240 Share Capital: Treasury Shares (Acquisition of Shares) Section 3240 Share Capital: Redemption or Cancellation of Shares Section 3240 Capital Transactions Section 3610 Equity Section 3251 Comprehensive Income Section 1530 Financial Instruments—disclosure Section 3862 Financial Instruments—presentation Section 3863 Financial Reorganization Section 1625 LEARNING OBJECTIVES 1. Discuss the characteristics of the corporate form of organization. 2. Identify the rights of shareholders. 3. Describe the major features of preferred shares. 4. Explain the accounting procedure for issuing shares. 5. Identify the major reasons for repurchasing shares. 6. Explain the accounting for reacquisition and retirement of shares. 7. Explain the accounting for various forms of dividend distributions. 8. Explain the effect of different types of dividend preferences. 9. Distinguish between stock dividends and stock splits. 10. Understand the nature of other components of shareholders’ equity. 11. Indicate how shareholders’ equity is presented. 12. Analyze shareholders’ equity.


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13. Compare current Canadian and international GAAP and understand which direction

international GAAP is headed. 14. Explain the accounting for par value shares (Appendix 15A). 15. Explain the accounting for treasury shares (Appendix 15A). 16. Describe the accounting for a financial reorganization (Appendix 15B)


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CHAPTER REVIEW 1. Chapter 15 focuses on the shareholders' equity section of the corporate form of business

organization. Shareholders' equity represents the amount that was contributed by the shareholders and the portion that was earned and retained by the enterprise. This chapter addresses the accounting issues related primarily to capital contributed by owners of a business organization.

2. Given that the CBCA and most provincial incorporation acts allow only for shares without

par value, the chapter concentrates on the accounting for such shares. Appendix 15A is provided to cover the basic aspects of accounting for par value shares that are permitted in some Canadian jurisdictions, the U.S., and many other countries.

The Nature of Shareholders' Equity 3. In a corporate form of business organization the shareholders are said to possess a residual

interest in the business. This means that the shareholders (owners) bear the ultimate risks and rewards of ownership. If a business is profitable, the owners benefit through increased share prices and perhaps the receipt of dividends. If a business is not profitable, it is the owners who stand to lose their investment in the business. The shareholders' interest in a business enterprise is measured by the difference between assets and liabilities and is recorded in the shareholders' equity section of the balance sheet. Shareholders' equity is not a claim to specific assets but a claim against a portion of the total assets.

4. The two primary sources from which shareholders' equity is derived are a) contributions

by shareholders (paid-in capital) and b) income (earnings) retained by the corporation. When accountants refer to a corporation's capital, they mean contributed capital and earned capital, which make up the shareholders' equity section of the balance sheet. Contributed capital is the amount advanced by shareholders to the corporation for use in the business (price originally paid for shares). Earned capital is the capital that develops if the business operates profitably (retained earnings and accumulated other comprehensive income).

The Corporate Form of Entity 5. In Canada, a business organization may incorporate either federally or provincially by

submitting the necessary documents to the appropriate governmental office.

a. Federally incorporated companies are created and operate under the provisions of the Canada Business Corporations Act (CBCA). To create and operate one, articles of incorporation are submitted to the Corporations Directorate of Industry Canada, who will issue a certificate of incorporation after ensuring that the incorporation


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documents are appropriately completed. Once the certificate of incorporation is issued, the corporation is recognized as a separate legal entity bound by the laws of the country and the provisions of the CBCA. The entity’s owners have greater legal protection against lawsuits. An added advantage is that incorporation involves the issue of shares, which allows access to capital markets.

Corporations may be classified by the nature of ownership as follows: public sector corporations (government units such as municipalities, cities; government business enterprises such as Canada Post) and private sector corporations.

b. Provincially incorporated companies would be subject to the requirements and

provisions of the respective province's business corporations act. 6. Within a given class of shares, each share is exactly equal to every other share. A person's

percent of ownership in a corporation is determined by the number of shares he or she possesses in relation to the total number of shares owned by all shareholders. In the absence of restrictive provisions, each share carries the right to participate proportionately in (a profits and losses, b) management (right to vote for directors), and c) corporate assets upon liquidation.

In addition to these three rights, the CBCA allows a corporation to assign a pre-emptive right to any or all classes of shares through appropriate specification in the articles of incorporation.

7. The transfer of ownership between individuals in the corporate form of organization is

accomplished by one individual selling or transferring his or her shares to another individual. The only requirement in terms of the corporation involved is that it be made aware of the name of the individual owning the shares. A subsidiary ledger of shareholders is maintained by the corporation (or its registrar and transfer agent) for the purpose of dividend payments, issuance of stock rights, and voting proxies.

8. Common shares represent the residual interest in the company and bear the ultimate risks

of loss and receive the benefits of success. Common shares are guaranteed neither dividends nor assets upon dissolution of the corporation. Thus, common shareholders are considered to hold a residual interest in the corporation. However, common shareholders generally control the management of the corporation and tend to profit most if the company is successful. In the event that a corporation has only one authorized issue of shares, that issue is by definition common shares, whether or not it is so designated in the charter.

9. The amount an individual pays for shares in a corporation represents the maximum amount that individual can lose in the event of corporate liquidation. This is known as the concept of limited liability. The property or service invested in the enterprise is the extent of a shareholder’s possible loss.


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10. Profits of a corporation distributed to shareholders are referred to as dividends. In general,

dividends can only be paid if the company's capital will be maintained intact. Also, dividends must be formally approved by the board of directors and be in full agreement with share capital contracts.

11. When special classes of shares are created with certain preferential rights, they are usually

called preferred shares. A common type of preference is a prior claim on earnings and priority claim on assets upon dissolution. Preferred shares can be cumulative, convertible, callable/redeemable, retractable, and/or participating. Preferred shares are often issued instead of debt to keep the company’s debt-to-equity ratio within a certain range. However, if the characteristics of the preferred shares are such that the instrument resembles debt more than equity, reclassification as debt may be required.

Accounting for the Issuance of Shares 12. Under the CBCA, shares must be without a nominal or par value. This means that all the

proceeds from the issuance of the shares must be credited to the share capital account. Par value establishes the nominal value per share and is the minimum amount that must be paid in by each shareholder.

13. When no-par shares are issued, the share capital account is credited for an amount equal

to the value of the consideration received. 14. When shares are sold on a subscription basis, the full price is not received initially.

Normally,only a partial payment is made originally, and the shares are not issued and rights associated with them are not received until the issuing company receives the full subscription price. When an individual subscribes to a common share issue, the corporation debits subscriptions receivable and credits common shares subscribed.

15. More than one class of shares is sometimes issued for a single payment. Such a transaction

requires allocation of the proceeds between the classes of securities involved. The two methods of allocation used are a) the proportional method and b) the incremental method. The former method is used when the fair market value of each class of security is readily determinable. If no fair market value is determinable for any of the classes of shares, the allocation may have to be arbitrary.

16. Shares issued for consideration other than cash should be recorded using the fair market

value of the consideration received or the fair market value of the shares issued, whichever is more clearly determinable. In cases where the fair market value of both items is not clearly determinable, the board of directors has the authority to establish a value for the transaction.


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17. Where an entity advances money to its employees or officers for the purpose of purchasing shares of company stock, it is common practice to deduct the remaining loan balances from the share capital reported within shareholders' equity.

18. The costs associated with issuing share capital may be written off against amounts paid in,

capitalized as organization costs and amortized against future earnings, or charged directly against retained earnings. Share issue costs are identified as capital transactions (as opposed to operating transactions) in Handbook Section 3610, which recommends that these charges be excluded from the determination of net income.

19. The CBCA and various provincial acts permit a corporation to redeem its shares, provided

such an action would not render the company insolvent. The CBCA then requires that such shares be cancelled and restored to the status of authorized but unissued shares if appropriate.

20. When shares are repurchased, or reacquired and retired, shareholders' equity accounts are

adjusted. CICA Handbook Section 3240 specifies how the accounts are to be adjusted.

a. If the cost of the reacquired shares is equal to or greater than their par, stated, or assigned value, the allocation is as follows:

− To share capital in an amount equal to the par, stated, or assigned value of the

shares; − Any excess to contributed surplus to the extent that contributed surplus was

previously created by the cancellation or resale of shares of the same class; − Any excess to contributed surplus in an amount equal to the pro rata share of

contributed surplus that arose from transactions in the same class of shares; − Any excess to retained earnings.

b. If the cost of the reacquired shares is less than the par, stated, or assigned value, the

cost would be allocated as follows:

− To share capital in an amount equal to par, stated, or assigned value of the shares;

− The difference to contributed surplus. Formality of Profit Distribution: Dividend Policy

21. The applicable laws of incorporation normally provide information concerning legal

restrictions related to the payment of dividends. The CBCA prohibits the declaration or payment of dividends if such an action would render the corporation insolvent. At any rate, corporations rarely pay dividends in an amount equal to the legal limit. This is due, in part, to the fact that assets represented by undistributed earnings are invested in a variety of operating assets and are, therefore, used to finance future operations of the business.


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22. While the unencumbered credit balance in retained earnings is normally considered to provide the basis for dividend distributions, very few companies pay dividends in amounts equal to this legally available amount. The major reasons may include a) agreements with creditors, b) the need to finance growth and expansion, c) the need to provide for continuous dividends in good or bad years, and d) the need to build a cushion. If funds are unavailable for the payment of dividends, the extent of the credit balance in retained earnings is of little significance. Thus, management must ask two questions before declaring a dividend: Is it legally permissible? and, Is the paying out of company assets economically sound?

23. Dividends may be paid in cash (most common means), shares, scrip, or some other asset.

Dividends, other than a stock dividend, reduce the shareholders' equity in a corporation through an immediate or promised distribution of assets. Stock dividends merely transfer a portion of the retained earnings account to capital accounts in shareholders' equity; no assets are distributed.

Cash Dividend 24. The accounting for a cash dividend requires information concerning three dates: a) date

of declaration, b) date of record, and c) date of payment. A liability is established by a charge to retained earnings on the declaration date for the amount of the dividend declared. No accounting entry is required on the date of record. The liability is liquidated on the payment date through a distribution of cash. The following journal entries would be made by a corporation that declared a $50,000 cash dividend on March 10, payable on April 6 to shareholders of record on March 25.

Declaration date - March 10

Retained Earnings 50,000 Dividends Payable 50,000

Record date - March 25

No entry

Payment date - April 6 Dividends Payable 50,000

Cash 50,000 Property Dividends 25. Property dividends (or dividends in kind) represent distributions of corporate assets other

than cash. A property dividend may be viewed as a non-reciprocal transfer of non-monetary assets between an enterprise and its owners (see Handbook Section 3831. Such transfers should be recorded at the fair value of the assets transferred. Fair value is measured by the amount that would be realized in an outright sale near the time of


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distribution. When a property dividend is declared, fair market value should be recognized in the accounts with the appropriate gain or loss recorded. The fair market value then serves as the basis used in accounting for the property dividend. For example, if a corporation held shares of another company that it intended to distribute to its shareholders as a property dividend, it would first be required to make sure the carrying amount reflected current market value. If on the date the dividend was declared the difference between the cost and market value of the shares to be distributed was $75,000, the following additional entry would be made.

Investment in Securities 75,000 Gain on Appreciation of Securities 75,000

Scrip Dividends 26. Scrip dividends are normally declared when the corporation has a sufficient credit

balance in retained earnings but is short of cash. When a scrip dividend is declared, a special form of note is issued to shareholders, payable on some future date. Because of the delayed payment, interest may be paid as well.

Stock Dividends 27. A stock dividend occurs when the board of directors declares that a dividend will be paid

to shareholders in the form of the company's own shares (of the same or different class). Accounting for a stock dividend results in a capitalization of retained earnings (a reduction in retained earnings and a corresponding increase in the appropriate share capital account). As such, total shareholders' equity remains unchanged when a stock dividend is distributed. Also, all shareholders retain their same proportionate share of ownership in the corporation.

28. The CICA Handbook makes no recommendations regarding the amount of retained

earnings that should be capitalized when a stock dividend is declared. The CBCA states "the declared amount of the dividend stated as an amount of money shall be added to the stated capital account maintained or to be maintained for the shares of the class or series issued in payment of the dividend" (Section 41 [2]). The CBCA does not allow shares to be issued until they are fully paid for in an amount not less than the fair equivalent of money that the corporation would have received if the shares had been issued for cash; therefore, the fair market value must be used for companies incorporated under the CBCA. Throughout the text, the amount to be capitalized is the fair market value of the shares issued.

29. When a stock dividend is declared, retained earnings is debited for the fair market value

(assumed deemed amount) of the shares to be distributed. The credit is to common stock dividend distributable, which would be shown in the shareholders' equity as an addition


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to share capital. When the stock dividend is "paid," the appropriate share capital account is credited, and the common stock dividend distributable account is debited.

Liquidating Dividends 30. Some companies’ use contributed surplus as a basis for dividends. Dividends based on

other than retained earnings are described as liquidating dividends. This implies that they are a return of the shareholder’s investment rather than of profits.

Stock Split 31. A stock split results in an increase (or decrease if a reverse split) in the number of shares

outstanding. No accounting entry is required for a stock split, as the total dollar amount of all shareholders' equity accounts remains unchanged. A stock split is usually intended to improve the marketability of the shares by reducing the market price of the stock being split. In general, the difference between a stock split and a stock dividend is based upon the size of the distribution. If the number of shares issued exceeds 20 to 25% of the shares outstanding, treatment as a stock split may be judged to be warranted.

32. A stock split is distinguished from a stock dividend because a stock split results in an increase in the number of shares outstanding with no change in the share capital or the retained earnings amount.

33. On the other hand, the stock dividend may result in an increase in both the number of

shares outstanding and the share capital while reducing the retained earnings. A stock split may be used to increase the share’s marketability. If the stock dividend is large, it has the same effect on the market as a stock split.

34. A stock dividend of more than 20-25% of the number of shares previously outstanding is

called a large stock dividend

35. Preferred Shares

Preferred shares is the term used to describe a share class which has sacrificed one of the previously mentioned rights in return for other special rights or privileges. The most common type of preference given to preferred shareholders is a prior claim on earnings.

Certain terms are used to describe various features of preferred shares. These terms

include the following:


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a. Cumulative. Dividends not paid in any year must be made up in a later year before any profits can be distributed to common shareholders. Unpaid annual dividends on cumulative preferred shares are referred to as dividends in arrears and, if they exist, must be disclosed in a note to the financial statements.

b. Participating. Preferred shares that are participating share proportionately with the

common shareholders in any profit distribution beyond a prescribed amount.

c. Convertible. Preferred shareholders may, at their option, exchange their preferred shares for common shares based on a predetermined ratio.

d. Callable. At the option of the issuing corporation, preferred shares can be redeemed

at specified future dates and at stipulated prices.

e. Retractable. The holder, at his or her option, may sell the shares back to the issuing company, usually at specified prices at specified times.

36. Sometimes, under the right combination of features, preferred shares have most of the

characteristics of debt (e.g., term-preferred shares). When equity instruments meet the definition of a financial liability, Handbook Section 3863 requires that they be accounted for like debt, in all respects.

Preferred Share Preferences to Dividends 37. The amount of dividends available for distribution to common shareholders is dependent

upon the terms of the preferred shares. The amount can vary, depending upon whether the preferred shares are cumulative and/or participating and whether preferred dividends are in arrears. The text material includes numerical examples of these features in various combinations showing their impact on dividend distributions when both common and preferred shares are involved.

Contributed Surplus

38. Contributed surplus results from a wide variety of transactions. The basic transactions that

result in increases and decreases in contributed surplus are described below:

Transactions that may affect contributed surplus a. Par value shares issue, retirement (Appendix 15A) b. No par shares—repurchase/retirement (Appendix 15A) c. Liquidating dividends


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d. Financial reorganizations (Appendix 15B) e. Stock rights and warrants (Chapter 16) f. Issue of convertible debt (Chapter 16) g. Share subscriptions forfeited

39. Accumulated Other Comprehensive Income. Accumulated other comprehensive income

results because of treatment of revenues, expenses, gains, and losses that result from nonshareholder transactions, which are not included in the calculation of net income.

Presentation and Disclosure 40. Required disclosure, usually through notes to the financial statements, covers information

on the terms and rights attached to each equity instrument, and changes in share capital over the fiscal year. The following would normally be disclosed:

a. Authorized number of shares b. Existence of unique rights (e.g., dividend preferences) c. Number of shares issued and amounts received d. Whether par value or no par value e. Amount of dividends in arrears f. Details of changes during the year g. Restrictions on retained earnings

Section 3862 f the Handbook requires additional disclosures of any significant terms and conditions of equity instruments that might affect the amount, timing, and uncertainty of future cash flows.

Analyze Shareholders’ Equity 41. A number of ratios are used to evaluate a company’s profitability and long-term solvency.

Common ratios used are:

a. Rate of return on common shareholders’ equity: This ratio measures profitability from the common shareholders’ perspective. This ratio shows how many dollars of net income were earned from each dollar invested by the investors. It is calculated as: net income-preferred dividends/average common shareholders’ equity.

b. Payout ratio: This is the ratio of cash dividends to net income. This is an important

ratio to some investors who are looking for good yield on the shares. It is calculated as: cash dividends/net income-preferred dividends.


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c. Price earnings ratio: The analyst, in discussing the investment possibility of a given enterprise, mostly uses this ratio. It is calculated as follows: market price per share/earnings per share.

d. Book value per share: The book value per share is the amount each share would

receive if the company were liquidated on the basis of amounts reported on the balance sheet. This is calculated as follows: common shareholders’ equity/number of outstanding shares.

International Perspective 42. Canadian standards related to shareholders’ equity are largely converged with those

of the IASB.

Par Value Shares-Appendix 15A 43. Par value is an amount stated as such on each share certificate. This establishes the

nominal value per share and is the minimum amount that must be paid by each shareholder if the share is to be fully paid when issued. Shares issued for more than par value are said to be issued at a premium. Conversely, shares issued for less than par value are said to be issued at a discount. When the corporation issues shares at a discount, the holders are contingently liable to corporate creditors for the amount of the discount. This contingency is realized only in the event of a liquidation where creditors' claims remain unsatisfied. Canadian jurisdictions, which permit par value shares generally, do not permit the issuing of shares below par.

43. When par value shares are issued, the share capital (common or preferred) account is

credited for an amount equal to par value times the number of shares issued. Any amount received in excess of par value is credited to contributed surplus.

44. Treasury shares are a corporation's own shares that a) were outstanding, b) have been

reacquired by the corporation, and c) are not retired. Treasury shares are not an asset and should be shown in the balance sheet as a reduction in shareholders' equity, following the single-transaction method.

45. The CBCA does not sanction the holding of a company's own shares as treasury shares;

however it is allowed in the United States and in certain provincial jurisdictions in Canada.

46. In Canada, the CICA Handbook recommends that the single-transaction method be used

to account for treasury shares. Under this method, the reacquired shares' cost are held in a treasury shares account and reported as a deduction from the total of the components of shareholders' equity in the balance sheet. When the shares are reissued, the treasury shares account is credited for the acquisition cost. If treasury shares are reissued for more than their acquisition cost, the excess is credited to a contributed surplus account. If the


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treasury shares are reissued for less than acquisition cost, the difference should be debited to any contributed capital from previous treasury share, or repurchase share transactions. If the balance in this account(s) is insufficient, the remaining difference is charged to retained earnings.

APPENDIX 15B Financial Reorganization: Accounting for a Financial Reorganization 47. A corporation that has accumulated a large debit balance in retained earnings (deficit) may

be permitted (depending on the laws and due process) to enter into a process known as a financial reorganization. When there is a change in control of the corporation and new accounting values can be reasonably determined, the accounting procedure for the financial reorganization will consist of the following steps:

a. The balance in the retained earnings (deficit) account is brought up to the date of the

reorganization. In addition to closing any open income statement accounts, any asset write-downs related to circumstances that existed prior to the reorganization must be accounted for.

b. The updated deficit is reclassified to share capital, contributed surplus, or a

separately identified account in shareholders' equity, giving retained earnings a zero balance.

c. When a financial reorganization occurs, and where the same party does not control

the company both before and after the reorganization, and, if the new costs are reasonably determinable, the assets and liabilities are comprehensively revalued. New values are determined in negotiations among equity and non-equity interests. The difference between the old and new carrying values is accounted for as a revaluation adjustment, and any costs directly incurred to carry out the reorganization are then recorded as share capital, contributed surplus, or a separately identified account within shareholders' equity.

As well, the date of the reorganization, description, and amount of change in each major class of assets, liabilities and shareholders' equity must be disclosed. The date of reorganization, revaluation adjustment amount and the shareholders' equity account in which it was recorded, and the retained earnings deficit account into which it was reclassified must be disclosed for at least three years.

48. When there has not been a change in control of the organization, Handbook Section 1625

does not permit the comprehensive revaluation of the entity's assets and liabilities. However, the writing down of assets that are overvalued and the recognition of the revised terms with creditors and owners are equally appropriate.


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LECTURE OUTLINE The material in this chapter is relatively straightforward and can be covered in one or two class sessions. A. Nature of Shareholders' Equity

1. The shareholders' interest in a firm is a residual interest. It can be derived from the following basic accounting equation: assets less liabilities equals shareholders' equity.

2. The two primary sources of equity are:

a. Capital contributed by shareholders—share capital and contributed surplus

b. Earned—Retained earnings and accumulated other comprehensive income

TEACHING TIP

Illustration 15-1 can be used to provide an overview of the major components of shareholders' equity that are described in the chapter.

3. The corporate form of entity.

a. The primary forms of business organization are the proprietorship, the

partnership, and the corporation. b. Corporations may be classified as:

(1) public sector (2) private sector

(a) non-share, e.g., churches, charities, colleges (b) stock (operate for profit and issue shares)

(i) private—closely held (ii) public—shares widely held

1) listed on stock exchange (TSE, NYSE) 2) unlisted or over-the-counter (OTC)

4. Influence of Corporate Law. Federally incorporated companies operate under the

provisions of the Canada Business Corporations Act (CBCA). Provincially incorporated companies operate under the provision of the relevant province's business corporations act, and requirements may vary from province to province.


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5. Share Capital or Capital Stock System. Each share represents an ownership right with the following privileges:

a. To share proportionately in profits and losses. b. To share proportionately in management. c. To share proportionately in corporate assets upon liquidation. d. The CBCA also allows for a fourth right, the pre-emptive right, to be

assigned. This pre-emptive right allows a shareholder to share proportionately in any new issues of shares in the same class, thus protecting an existing shareholder against dilution of ownership interest.

The share system provides easy transferability of ownership interests.

6. Variety of ownership interests.

a. Common Shares: The residual corporate interest that bears the ultimate risk of

loss and receives the benefits.

b. Preferred Shares: In return for certain preferences to earnings, a preferred shareholder may sacrifice a voice in management or the right to share in profits above a stated amount.

c. Many classes of shares, which vary in terms of rights and privileges, are

possible. One share class, however, must represent the basic ownership interest (referred to as common shares).

7. Limited Liability: Shareholders cannot lose more than their investment.

8. Formality of Profit Distribution:

a. No amounts may be distributed among the owners unless corporate capital is

maintained intact.

b. The board of directors must formally approve distributions to shareholders.

c. Dividends must be in full agreement with the capital share provisions as to preferences, participation and the like.

B. Characteristics of Preferred Shares

The most common features are:

1. Dividend preferences 2. Preference to assets on liquidation

3. Convertible into common shares


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4. Callable at the option of the corporation

5. Retractable at the option of the shareholder

6. Nonvoting

7. Cumulative

8. Participating

Preferred shares sometimes have more of the characteristics of debt than equity. When an issue meets the definition of a financial liability (Section 3863), it must be accounted for in all respects as if it were debt.

C. Accounting for the Issuance of Shares

1. With few exceptions, the CBCA requires that all shares issued by companies incorporated under it be without a par or nominal value. The full amount received is credited to the appropriate share capital account.

2. Sales on a Subscription Basis. Under this purchase (sale) process, only a partial

payment is made originally, and the shares are not issued and the rights associated with them are not received until the issuing company receives the full subscription price.

3. Lump-Sum Sales. Either the proportional or the incremental method can be used to

allocate proceeds among the different securities.

4. Noncash Share Transactions. When shares are issued for services or property other than cash, the property or services should be recorded at either their fair market value or the fair market value of the shares issued, whichever is more clearly determinable.

5. Costs of Issuing Shares. These costs are treated as a reduction of the amounts paid

in, as an organization cost, or charged directly against retained earnings. Share issue costs are identified as capital transactions in Handbook Section 3610, which recommends that these charges be excluded from the determination of net income.

D. Reacquisition of Shares Corporations may buy their own shares for a variety of reasons, including meeting

employee stock option contracts, increasing earnings per share, meeting the share needs of a merger, buying out a particular interest, or satisfying claims of a dissenting shareholder.


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1. Such reacquired shares may be retired (cancelled) or, where permitted, held as treasury shares. With rare exceptions, the CBCA does not allow a corporation to hold its own shares as treasury shares.

2. CICA Handbook Section 3240 specifies the allocation of the purchase price of the

reacquired shares among the share capital account, contributed surplus, and retained earnings.

E. Contributed Surplus

1. Several transactions can affect the balance of contributed surplus as shown below in T-account form:

Contributed Surplus

Decreases (debits) Increases (credits)

1. Discounts on capital shares issued.* 1. Premiums on capital shares issued.* 2. Sale of treasury shares below cost

under the circumstances and to the extent described in Chapter 16.

2. Sale of treasury shares above cost.

3. Absorption of a deficit in a financial reorganization

3. Additional capital arising in a financial reorganization.

4. Distribution of a liquidating dividend.

4. Additional assessments on shareholders.

5. Retirement of shares at a cost in excess of par* or assigned value.

5. Issue of convertible bonds or preferred shares.

6. Capital donations from non-

shareholders.

7. Retirement of shares acquired by purchase at a cost less than par* or assigned value or through donations.

* Items relate to shares having a par value (See Appendix 16A for further explanation).

2. Analyze shareholders’ equity: Several ratios use shareholders’ equity to evaluate a company’s profitability and long-term solvency. The chapter discusses four ratios: a) rate of return on common shareholders’ equity, b) payout ratio, c) price earnings ration, and d) book value per share.

F. Accounting for Par Value Shares (Appendix 15A)—Where Permitted by Law

Par value establishes the nominal value per share and is the minimum amount that must be paid by each shareholder.


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G. Treasury Shares

Treasury shares are not an asset. A corporation cannot own a part of itself.

1. In Canada, the CICA Handbook recommends that treasury shares, if they exist, be accounted for using the single-transaction method. This results in debiting the treasury shares account for the reacquisition cost and reporting this amount as a deduction from the total of contributed capital and retained earnings on the balance sheet.

TEACHING TIP

Illustration 15-2 can be used to provide an illustration of the entries required in accounting for the purchase and subsequent reissue of treasury shares.

2. Disclosure of treasury shares: Under the single-transaction method, treasury shares

are shown as an unallocated reduction of shareholders' equity. H. Financial Reorganization

The accounting procedure for the financial reorganization will consist of the following steps:

1. The balance in the retained earnings (deficit) account is brought up to the date of the

reorganization. In addition to closing any open income statement accounts, any asset write-downs related to circumstances that existed prior to the reorganization must be accounted for.

2. The updated deficit is reclassified to share capital, contributed surplus, or a

separately identified account in shareholders' equity, giving retained earnings a zero balance.

3. The assets and liabilities are comprehensively revalued. New values are determined

in negotiations among equity and non-equity interests. The difference between the old and new carrying values is accounted for as a revaluation adjustment and any costs directly incurred to carry out the reorganization are then recorded as share capital, contributed surplus, or a separately identified account within shareholders' equity.


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ILLUSTRATION 15-1 COMPONENTS OF SHAREHOLDERS' EQUITY

Preferred Shares

Common Shares

Shareholders' Unappropriated

Equity Retained Earnings

Appropriated

Accumulated Other Comprehensive Income


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ILLUSTRATION 15-2 ACCOUNTING FOR TREASURY SHARE TRANSACTIONS HTM Limited has the following shareholders' equity at September 30, 2004:

Common shares, no par value, 100,000 shares authorized, 72,000 shares issued and outstanding $675,000 Contributed surplus from cancellation of shares 6,000

Contributed capital 681,000 Retained earnings 247,500

Total Shareholders' Equity $928,500 The following transactions took place in the last quarter of 2004: October 12 Purchased 10,000 shares from the estate of a deceased shareholder at a total cost

of $100,000, or $10 per share. The shares were not cancelled, but were held as treasury shares.

October 29 Sold 3,000 of the treasury shares for $30,900. November 19 Sold 1,000 of the treasury shares for $9,000. December 27 Sold the remainder of the treasury shares for $50,000. Required: (a) Prepare journal entries to record the transactions indicated. (b) Prepare the shareholders' equity section of the October 31, 2004 balance sheet, assuming the company earned income of $2,500 during October.


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ILLUSTRATION 15-2–SOLUTION: (a)

October 12 Treasury Shares 100,000

Cash 100,000

October 29 Cash 30,900

Contributed Surplus (T/S Transactions) 900 Treasury Shares (3,000 x $10) 30,000

November 19

Cash 9,000 Contributed Surplus (T/S Transactions) 900 Contributed Surplus from Cancellation of Shares 100

Treasury Shares (1,000 x $10) 10,000

December 27

Cash 50,000 Contributed Surplus from Cancellation of Shares 5,900 Retained Earnings 4,100

Treasury Shares (6,000 x $10) 60,000

(a) SHAREHOLDERS' EQUITY

OCTOBER 31, 2004

Common shares, no par value, 100,000 shares authorized, 72,000 shares issued of which 7,000 are held in treasury $675,000 Contributed surplus from treasury share transactions 900 Contributed surplus from cancellation of shares 6,000

Contributed capital 681,900 Retained earnings 250,000

931,900 Less cost of 7,000 treasury shares (70,000)

Total Shareholders' Equity $861,900


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CHAPTER 16

COMPLEX FINANCIAL INSTRUMENTS CHAPTER TOPICS CROSS-REFERENCED WITH CICA HANDBOOK Financial Instruments—recognition and measurement Section 3855 Financial Instruments—disclosure Section 3862 Financial Instruments—presentation Section 3863 Hedging Section 3865 Specific Items—Stock-Based Compensation and Other Stock-Based Payments Section 3870 Comprehensive Income Section 1530 LEARNING OBJECTIVES 1. Describe whether an instrument issued for financing purposes represents a liability,

equity, or both 2. Explain the accounting for issuance, conversion, and retirement of convertible

securities. 3. Understand what derivatives are and why they exist. 4. Explain the various types of financial risks, including how they arise. 5. Understand what options, forwards, and futures are. 6. Describe the recognition, measurement, and presentation issues for options, forwards,

and futures. 7. Describe the various types of stock compensation plans. 8. Explain the differences between employee and compensatory option plans and other

options. 9. Describe the accounting for compensatory stock option plans. 10. Compare current Canadian and international GAAP, and understand which direction

international GAAP is going. After studying the appendices students should be able to:


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11. Understand how derivatives are used in hedging. 12. Explain what hedge accounting is and identify the qualifying hedge criteria. 13. Explain the difference between a fair value and cash flow hedge. 14. Calculate the impact on net income using hedge accounting for both types of hedges. 15. Account for stock appreciation rights plans. 16. Explain what performance-type plans are. 17. Understand the different fair value measurement options and models.


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CHAPTER REVIEW Introduction Complex financial instruments, once uncommon, are now widely used by companies in an effort to manage risk, access pools of financing, and minimize cost of capital and taxes. In response to this trend, the accounting profession has developed a new framework for dealing with these instruments in the financial statements Chapter 16 focuses on complex financial instruments, including derivatives, which are discussed separately. Since employee compensation plans often include the issuance of derivatives such as stock options, this topic is also discussed. Presentation and Measurement Issues 1. Compound financial instruments have attributes of both equity and debt. They are

sometimes referred to as hybrid instruments because of these dual attributes. Convertible and perpetual debt are examples. With these instruments, the main accounting complexity lies in determining how to classify them on the balance sheet. Users rely on the classification between debt and equity to assess a company’s liquidity and solvency; thus, the classification issue is significant. As these types of complex instruments proliferate, financial statement preparers and analysts are faced with the increasingly difficult task of classifying instruments that do not fit neatly into either the debt or equity category.

2. Determining the presentation and classification of an instrument as a financial liability or

an equity instrument is dealt with in Handbook Section 3863. Section 3855 gives guidance on how to recognize and measure financial liabilities. The following definitions are critical in determining how to present the hybrid instruments:

a. A financial liability is any liability that is a contractual obligation:

i. to deliver cash or another financial asset to another party, or ii. to exchange financial instruments with another party under conditions that

are potentially unfavourable.

b. An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

3. Perpetual debt is debt that will never be repaid; therefore, it is similar to equity in that it

represents permanent capital for the company. However, since it is perpetual, the interest gradually becomes equal to the value of the debt. Therefore, a perpetual bond’s value is driven solely by the contractual obligation to pay interest. As such it is classified as a


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liability. 4. Mandatorily redeemable or term preferred shares (although legally equity), meet the

definition of a liability since there is an obligation for the company to pay cash. When the term expires, the company is obligated to buy back the shares from the holder. This is also the case when the terms are such that it is highly probable that the company will redeem the shares. Retractable preferred shares are shares where the holder has the right to require the issuer to redeem the shares for a fixed or determinable amount. This contractual obligation also meets the definition of a financial liability.

5. Measurement of hybrid financial instruments may also be made more complicated when

the economic value is attributable to both the debt and equity components of the instrument. Two measurement tools are possible: the incremental or residual method and the proportional method. These tools may be used to allocate the value of an instrument between its debt and equity components.

a. Proportional method: Determine the market values of similar straight debt (i.e.,

with no warrants) and tradeable options or warrants. Measurement of the debt portion may also be done by a PV calculation, discounting at the market rate for similar debt. (Measurement of the option portion may be done using an options pricing model.) The components are then assigned these values; any difference is prorated based on respective market or fair values and allocated to the components.

b. Incremental or residual method: Value only one component (the one that is easier

to value—often the debt component). The other component is valued at whatever is left.

6. Debt may be issued with detachable stock warrants. The warrants give the holder the

right to buy common shares at a fixed price—the exercise or strike price—for a specified period of time: the exercise period. Because a market often exists to buy and sell these instruments, the warrants are equity instruments and, therefore, the instrument is part debt and part equity. The proceeds from the sale of debt with detachable stock warrants should be allocated between the two securities.

Triggering Events 7. Common shares or in-substance common shares that require redemption when some likely

event occurs should be treated as debt unless: • The instruments are the most subordinated of all equity securities, • The redemption feature must apply to all common shares and in-substance common

shares, • The shares must not have any preferential rights, AND • The redemption event must be the same for all shares that the redemption feature

applies to


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Convertible Securities 8. A convertible bond combines the benefits of a bond with the privilege of exchanging it

for common shares at the holder’s option. Corporations issue convertible debt for two main reasons: One is the desire to raise equity capital without giving up more ownership control than necessary; the other is to obtain debt financing at cheaper rates. The embedded option to convert to common shares is an equity instrument; therefore, that part of the instrument is presented as equity. The remaining component is presented as a liability.

9. When bonds are converted prior to maturity, the book value method of recording the

bond conversion is the method most commonly used in practice, even though there is no GAAP that specifically deals with measurement of the transaction. The book value method indicates that the transaction should be measured in accordance with the agreement that was established at the date of the issuance, either to pay a stated amount of cash at maturity or to issue a stated number of shares of equity securities. Therefore, when the debt is converted to equity in accordance with the pre-existing contract terms, no gain or loss would be recognized upon conversion. Under the book value method, the unamortized portion of any discount or premium is reversed, bonds payable and contributed surplus—conversion rights are zeroed out, and any difference represents the value of the shares issued in the transaction.

10. An alternative approach that has some conceptual merit uses the market value to record

the conversion. Under this method, the common shares would be recorded at market value (their market value or the market value of the bonds);the contributed surplus—stock options, bonds payable, and unamortized discount or premium amounts would be zeroed out; and a gain/credit or loss/debit would result.

11. Sometimes a company may wish to induce conversion of outstanding bonds in order to

keep interest expense down, or to improve its debt-to-equity ratio. Investors receive a “sweetener,” usually a cash inducement. This additional premium should be allocated between the debt and equity components based on their fair values at the time of the transaction.

12. Some debentures may be settled with assets other than cash, for example with shares of

another company. These instruments are known as exchangeable debentures. The issue here is a measurement one, since the economic value of the debt changes as the value of the underlying shares changes. Therefore, the debt must be re-measured continually; the carrying value of the debt must reflect the changing value; and the gains or losses would be recognized in the income statement. It should be noted that, under the proposed Handbook Section 3855, the shares would be revalued to market, and thus the gains and losses of both the debt and the investments would offset.


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Derivatives 13. Financial instruments may be primary or derivative. Primary financial instruments

include most basic financial assets and financial liabilities such as receivables and payables as well as equity instruments such as shares. Derivative instruments on the other hand, are more complex, deriving their value from an underlying primary instrument. Derivatives are defined as financial instruments, which create rights and obligations that have the effect of transferring between parties to the instrument one or more of the financial risks inherent in an underlying primary instrument. They transfer risks that are inherent in the underlying primary instrument without the holder having to necessarily hold the underlying instrument. They have three characteristics:

a. Their value changes in response to the underlying instrument. b. They require little or no initial investment, and c. They are settled at future date.

14. The use of derivatives both for speculation and risk management, particularly financial

risk, has grown extensively. Companies use derivatives to manage:

a. Credit risk—the risk that one of the parties to the contract will fail to fulfil its obligation under the contract and cause the other party loss; e.g., credit risk is usually associated with collection.

b. Liquidity risk—the risk that the company itself will not be able to honour the

contract and fulfil its obligation. The more debt a company has, the greater the risk that it will not be able to repay the debt and the higher the liquidity risk.

c. Market risk—the risk that the fair value or future cash flows of a financial

instrument will fluctuate because of changes in market prices. The three types of market risk are: • change in currency (currency risk), • change in interest rate (interest rate risk), or • other capital market forces (market price risk).

15. In Canada, up until 2003, there were no recognition and measurement principles for

derivatives. As a result, many derivatives were not recognized in the financial statements. In March 2003, the CICA issued three exposure drafts on financial instruments, comprehensive incomes, and hedging. These exposure drafts became the new Handbook sections 3855, 1530, and 3865, respectively. The basic principles established in these standards, are as follows:


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a. Financial instruments and all derivatives (financial and non-financial) that meet the definition of assets or liabilities should be recognized on the balance sheet;

b. Fair value is the most relevant measure for financial instruments and the only

relevant measure for derivative financial instruments;

c. Only items that meet the definition of assets or liabilities should be reported as such;

d. Special accounting for items designated as part of a hedging relationship should

only be provided if those items are qualifying items. Options, Forwards, and Futures 16. An option gives the holder the right to acquire (call option) or to sell (put option) an

underlying instrument at a fixed price within a defined time period. A stock option derives its value from the share price of the underlying shares. It allows the holder to participate in the share value without actually holding the shares, and therefore the investment is much lower than if the shares had been purchased.

17. The option premium can be viewed as comprising two amounts: Option Premium = Intrinsic Value + Time Value

The intrinsic value is the difference between the market price of the underlying and the preset strike or exercise price at any point in time. It represents the amount realized by the option holder if the option were exercised immediately. On the date of issuance, the intrinsic value is zero, because the market price is equal to the preset strike price. Time value refers to the option’s value over and above its intrinsic value. Time value reflects the possibility that the option has a fair value greater than zero, because there is some expectation that the price of the underlying shares will increase above the strike price during the option term.

18. Under Handbook sections 3855 and 1530, a gain or loss is recognized when there is a

change in the value of the option. 19. Under a forward contract, the parties to the contract each commit upfront to do

something in the future, e.g., one party to buy and the other to sell the underlying at a certain fixed price at a certain date. A forward contract is different from an option contract in that it not only transfers to the holder the rights to increases in value of the underlying primary instrument, it also creates an obligation to pay a fixed amount at a certain date. The purchased option, on the other hand, creates a right but not an obligation; the holder may choose to exercise the option but need not.


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20. Assume that on January 1, 2007, Company A agrees to buy $1000 US for $1,150

Canadian in 60 days from National Investment Corp. On the date the transaction is entered into, $1US = $1.10. No journal entry is recorded at this point. The value of the forward contract considers both the intrinsic value and the time value component and the difference between the spot rate and the forward rate is the present value of the future net cash flows of the contract.

In subsequent periods, until settled, the forward is re-measured at fair value depending on interest rates as well as what is happening with the spot rates. If the U.S. dollar appreciates in value, the forward contract now has value because the company has agreed to pay only the $1,150. If the fair value of the contract on January 31, 2007 was $1,120, the following journal entry would be prepared as the forward contract has declined in value: Loss 30 Derivative—trading 30

21. If on the settlement date, the US dollar has weakened further, Company A must

nevertheless pay $1,150 Canadian, and it will receive fewer US dollars than expected. Assuming that on March 2, 2007, the settlement date, $1.00 US = $1.04 Cdn, and Company A actually took delivery of the U.S. dollars, the following entry would be made:

Cash (U.S.) 1,040 (current spot rate) Loss 80 Derivative—trading 30 (carrying value)

Cash (Cdn) 1,150 22. Forward contracts are not normally traded publicly. In the example above, the forward

contract transferred the currency risk regarding the US dollars to Company A. There is also a credit risk and liquidity risk, that at the culmination of the contract, the counterparty to the contract—in this example, National Investment Corp—will not deliver, or will not be able to deliver, the underlying contract value.

23. The forward contract meets the definition of a financial liability and so the Derivative—

trading account would be presented as a liability at the balance sheet date (or an asset, depending on its fair value).

24. Futures contracts, another popular type of derivative, are the same as forwards except for

the following:

a. they are standardized and trade on stock markets and exchanges, thus providing ready market values;

b. they are settled through clearing houses, which removes the credit risk;


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c. there is a requirement to put up collateral in the form of a "margin" account. The

margin account represents a percentage of the value of the contract. Stock Compensation Plans 25. Recently, there has been extensive growth in the use of stock option plans by employers in

an attempt to develop strong company loyalty in their executives. An effective way to accomplish this goal is to give the employees an equity interest based on changes in long-term measures such as increases in earnings per share, revenues, share price, or market share. These plans, come in many different forms. Usually, they provide the executive with the opportunity to receive shares or cash in the future if the company’s performance is satisfactory. Stock-based compensation plans also help companies conserve cash, and often to obtain financing when the employees exercise the options/rights.

26. Four common types of stock compensation plans are:

a. Direct awards of stock—are more broadly known as non-monetary transactions and are recorded at the fair value of the item given up.

b. Compensatory and employee stock option plans—give employees (ESOP) and

management (CSOP) an opportunity to own part of the company.

c. Stock appreciation rights plans (SAR)—covered in Appendix 16B.

d. Performance-type plans—covered in Appendix 16B. 27. The main difference between ESOPs and CSOPs is that in the ESOP, the employee

usually pays for the options, either fully or partially. Thus, these transactions are seen as capital transactions, because the employee is investing in the company. On the other hand, CSOPs, which are related to management, are primarily seen as an alternative way to compensate the manager for services rendered—like a barter transaction. The services are rendered by the employee in the act of producing revenues. Thus, these transactions are seen as operating transactions and must be recognized in the income statement.

28. Under an ESOP, when an option or share right is sold to an employee, the cash account is

debited and contributed surplus account credited for the amount of the premium (i.e., the cost of option). When the right or option is exercised, the cash account is again debited for the exercise price, along with contributed surplus account (to reverse the earlier entry), and the common shares account is credited to reflect the issuance of the shares.


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29. CSOPs must be measured at fair value. Total compensation expense is calculated based

on the fair value of the options expected to vest on the date the options are granted to the employee(s) (the grant date). The grant date is the date that the employee and company agree on the value of what is to be exchanged. Fair value is estimated using an option pricing model, such as the Black-Scholes model, with some adjustments for the unique factors of employee stock options. The fair value is recognized as an expense in the periods in which the employee performs services.

30. Required disclosure for compensation plans includes:

a. the accounting policy used, b. a description of the plan, c. details relating to the number and value of outstanding options or rights, d. a description of assumptions and methods used to determine fair value, and e. total compensation cost included in net income/contributed surplus.

International Perspective 31. The standards are basically converged except that IAS 39 does not allow compound

instruments using the relative fair value method. Section 3870 and IFRS 2 deal with compensation plans and are converged except for a few issues beyond the scope of this course.

Appendix 16A 32. Appendix 16A focuses on the use of derivatives for hedging as opposed to speculation.

Companies that are already exposed to financial risks, because of existing business transactions that arise from their business models, may choose to protect themselves or manage and reduce those risks. Most public companies who borrow and lend substantial amounts in credit markets are exposed to significant financial risks. They face substantial risk that the fair values or cash flows of interest-sensitive assets or liabilities will change if interest rates increase or decrease—interest rate risk. These same companies often also have significant international operations and are exposed to exchange rate risk. The borrowing activity creates liquidity risk for the company and the lending activity—credit risk.

33. Because the value and cash flows of derivative financial instruments can also vary

according to changes in interest rates, foreign currency rates, or other external factors, derivatives may be used to offset the risks that a firm’s fair values or future cash flows will be impacted by these market forces. This use of derivatives to offset risks is referred to as hedging.

34. Hedge accounting is optional and is designed to ensure that the timing of recognition of

gains/losses in net income is the same for both the hedged item and the hedging item.


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Hedges may qualify for optional hedge accounting when the following criteria are met:

a. At the inception of the hedge, the entity must: i. identify the exposure; ii. designate that hedge accounting will be applied; iii. document risk management objectives and strategies, the hedging

relationship, items hedges and used to hedge, methods of assessing effectiveness of hedge, and the method of accounting for the hedge.

b. At the inception and throughout the term, the entity should have reasonable

assurance that the relationship is effective and consistent with the risk management policy. Therefore: i. the effectiveness of the hedge should be reliably measurable, and ii. the hedging relationship should be reassessed regularly.

35. A fair value hedge protects the company against an existing exposure that results

because of an existing asset or liability, which is recognized on the balance sheet, for example a US dollar receivable. A properly hedged position should result in no loss to the company and may result in no gain either if the intent is to reduce cash flow uncertainty.

36. Assume that Company A purchases an equity investment for $1,000, which it designates

as available for sale. At the same time, it enters into a derivative contract, say a put option—to sell those same shares at $1,000, to protect itself against losses in value of the security. There would be no journal entry to record this derivative on acquisition assuming it has no cost. The journal entries to record these transactions are as follows:

January 1, 2005

Investment – Available for sale 1,000 Cash 1,000

If at December 31, 2005, the fair value of the investment increased by $50, the derivative would decrease in value by $50.

Investment – Available for sale 50 Gain on investment 50 Loss on investment 50 Investment – Derivative 50

37. The derivative is always valued at fair value, with the gains/losses being booked to net

income. However, normally, the gain on the available for sale investment would be booked to other comprehensive income (under the proposed standards on financial instruments). Thus, there is a mismatch. Hedge accounting allows the gain on the hedged item to be booked through net income so that it may be offset by the loss on the derivative.


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38. A cash flow hedge protects a company against a future transaction that has not yet been

recognized on the balance sheet, for example, cash flows related to future interest payments on variable rate debt. Thus, future cash flows are uncertain. Since the hedged position is not yet recognized on the balance sheet, the gains/losses related to changes in value (and hence cash flows) are not captured. Thus, under hedge accounting, any gains/losses on the hedging item should not be included in net income either. Therefore, they are recognized in other comprehensive income.

39. The most common form of a cash flow hedge is an interest rate swap, in which one party

makes payments based on a fixed or floating rate and the second party does just the opposite. Swap contracts are entered into because one party prefers the terms of another party’s existing contract and so they agree to swap or trade the terms.

40. An interest rate swap is an effective risk-management tool, because its value is related to

the same underlying item (interest rates) that will affect the value of the floating-rate bond payable. Thus, if the swap’s value goes up, it offsets the loss related to the debt obligation. The swap contract is reported in the balance sheet, and the gain on the hedging transaction is reported in comprehensive income.

Appendix 16B Two common plans (beyond the stock option plans discussed in the chapter) that illustrate different accounting issues are: 41. Stock appreciation rights plans (SARS): In this type of plan, the executive is given the

right to receive compensation equal to the share appreciation, which is defined as the excess of the market price of the shares at the date of exercise over a pre-established price. This share appreciation may be paid in cash, shares, or a combination of both.

41. SARs are popular, because the employee can share in increases in value of the shares

without having to purchase them. The increases in value over a certain amount are paid to the employee as cash or shares. Obligations to pay cash represent a liability which must be continually re-measured. The cost is therefore continually adjusted with the measurement date being the exercise date. The related expense is spread over the service period. If the SARs are not exercised at the end of the service period, the liability must continue to be re-measured.

42. Performance-type plans: whereby executives receive common shares (or cash) if

specified performance criteria are attained during the performance period (generally three to five years). The performance criteria employed usually are increases in return on assets or equity, growth in sales, growth in earnings per share (EPS), or a combination of these factors.


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Appendix 16C 43. Fair value is easily determined when there is an active market with published prices. When

this is not available, valuation techniques are used by incorporating both known and estimated inputs such as risk-free interest rates, credit risk, foreign currency prices, equity prices, marketability, volatility, prepayment/surrender risk, and servicing costs.

44. Two valuation techniques used are option pricing models and discounted cash flows.

The latter method includes more traditional approaches such as the discount rate adjustment approach and the cash flow adjustment approach.


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LECTURE OUTLINE The material in this chapter is relatively complex and should require two to three class periods. students are often not familiar with the nature of derivative transactions, and therefore some time should be spent explaining how these transactions are conducted. A. Compound Financial Instruments

1. The key issues are the classification and measurement of the debt and equity

components. Examples include:

a. perpetual debt b. mandatorily redeemable or term preferred shares c. debt with detachable stock warrants d. retractable preferred shares

2. Two measurement tools are possible :

a. Proportional method: Determine the market values of similar straight debt

with no warrants and tradeable options or warrants. Measurement of the debt portion may also be done by a PV calculation, discounting at the market rate for similar debt. Measurement of the option portion may be done using an options pricing model.

b. Incremental or residual method: Value only one component (the one that is

easier to value, often the debt component). The other component is valued at whatever is left.

TEACHING TIP

Refer to Illustration 16-1 to demonstrate the classification and measurement of a perpetual bond.

B. Convertible Securities

1. Book value method of recording the bond conversion is the method most commonly used in practice even though there is no specific GAAP that deals with measurement of the transaction.


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2. Example of convertible bond issue:

Using the incremental method, the issuance of three year, 6% convertible bonds (par $1,000) would be recorded as follows:

Each $1,000 bond may be converted into 250 common shares, which are currently trading at $3. Similar straight bonds carry an interest rate of 9%.

Total proceeds at par $1,000,000 Less: Value of bonds (PV annuity 3 years, 9%, 60,000 + PV $1,000,000, in 3 years, 9%) (924,061)

Incremental value of option 75,939

3. Accounting for convertible debt involves reporting issues at the time of:

a. Issuance—compound instruments must be split into their components and presented separately in the financial statements.

b. Conversion—when the debt is converted to equity in accordance with the pre-

existing contract terms, no gain or loss would be recognized upon conversion.

c. Retirement—The retirement of the liability component of convertible debt is treated the same way as non-convertible bonds as explained in Chapter 15. The equity component would remain in contributed surplus.

TEACHING TIP

Refer to Illustration 16-2 to demonstrate the accounting for convertible debt using the proportional or options pricing model method.

C. Derivative Instruments

1. Derivative instruments derive their value from an underlying primary instrument.

2. They have three characteristics:

a. Their value changes in response to the underlying instrument,

b. They require little or no initial investment, and

c. They are settled at future date.


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3. Derivatives are used to manage:

a. credit risk c. liquidity risk d. market risk (which includes currency rate risk, market rate risk, and interest

rate risk)

4. Options:

a. An option gives the holder the right to acquire (call option) or to sell (put option) an underlying instrument at a fixed price within a defined time period.

b. Stock options derive their value from the share price of the underlying

shares.

c. The value of an option may be measured using the following formula:

Option Premium = Intrinsic Value + Time Value

5. According to Handbook Sections 3855 and 1530, a gain or loss is recognized when there is a change in the value of the option.

6. Forward Contracts:

a. The parties to the contract each commit upfront to do something in the future.

b. Different from an option contract in that it also creates an obligation to pay a

fixed amount at a certain date and so the Derivative – Trading account is presented on the balance sheet as either an asset or liability depending on its current fair value.

c. Forward contracts are not normally publicly traded.

7. Futures:

a. are standardized and trade on stock markets and exchanges.

b. are settled through clearing houses which removes the credit risk.

c. collateral in the form of a “margin” account is required.

TEACHING TIP

Refer to Illustration 16-3 to demonstrate the accounting for stock options.


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D. Stock Compensation Plans

1. Effective compensation programs are ones that:

a. motivate employees to high levels of performance,

b. help retain executives and allow for recruitment of new talent,

c. base compensation on employee and company performance,

d. maximize the employee’s after-tax benefit and minimize the employer’s after-tax cost, and

e. use performance criteria over which the employee has control.

2. Four common types of stock compensation plans are:

a. Direct awards of stock: considered a non-monetary transaction and are

recorded at the fair value of the item given up.

b. Compensatory and employee stock option plans: gives employees (ESOP) and management (CSOP) an opportunity to own part of the company.

c. Stock appreciation rights plans (SAR): covered in Appendix 17B.

d. Performance-type plans: covered in Appendix 17B.

E. Hedging

1. Defined as the use of derivatives to offset the risks that a firm’s fair values or future cash flows will be affected by market forces such as interest rate, exchange rate, liquidity, or credit risk.

2. Fair value hedge:

a. protects the company against an existing exposure that results because of an

existing asset or liability which is recognized on the balance sheet.

b. Optional hedge accounting allows the gain on the hedged item to be booked through net income so it may be offset by the loss on the derivative.

3. Cash flow hedge:

a. protects a company against a future transaction that has not yet been

recognized on the balance sheet, most commonly an interest rate swap.

b. Since the hedged position is not yet recognized on the balance sheet, the gains/losses related to changes in value (and hence cash flows) are not captured.


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c. Under hedge accounting, any gains/losses on the hedging item are not included in net income; they are recognized in other comprehensive income.

F. Disclosure

Current disclosure provisions for all financial instruments are significant and focus on risks, including:

1. terms and conditions of instrument, 2. interest rate risk, 3. credit risk including significant concentrations, 4. fair value of all financial instruments both recognized and unrecognized, 5. hedges of anticipated future transactions, and

6. description of hedge and instruments.

G. Fair Value

Fair value is easily determined when there is an active market with published prices. When this is not available, valuation techniques are used by incorporating both known and estimated inputs such as risk-free interest rates, credit risk, foreign currency prices, equity prices, marketability, volatility, prepayment/surrender risk, and servicing costs.

Valuation techniques used include:

1. Option pricing models 2. Discounted cash flows, such as the discount rate adjustment approach and the cash

flow adjustment approach.


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ILLUSTRATION 16-1 Accounting for Perpetual Bonds

Economic value of a 3-year, 10% bond

Value of bond:

PV annuity 3 years, 10%, $100 = $249

PV $1,000, in 3 years, 10% = 751

Aggregate fair market value $ 1,000

Economic value of a 40-year bond

Value of bonds:

PV annuity 40 years, 10%, $100 = $978

PV $1,000, in 40 years, 10% = 22

Aggregate fair market value $ 1,000

The value of the bond stems primarily from the interest, and as the life of the bond increases,

the economic value attributed to the repayment of principal decreases significantly. A

perpetual bond’s interest component would theoretically be equal to the value of the bond

itself.


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ILLUSTRATION 16-2 Proportional Allocation of Proceeds Between Liability and Equity Components of Convertible Bond Issue Bond Corp. offers three year 6% convertible bonds (par $1,000). Each $1,000 bond may be converted into 250 common shares, which are currently trading at $3. Similar straight bonds carry an interest rate of 9%.

Value of bonds (PV annuity 3 years, 9%,

60,000 + PV $1,000,000, in 3 years, 9%) = $ 924,061 92.7%

Fair value of option using an option pricing model = 72,341 7.3%

Aggregate fair market value $ 996,402 100.0%

The difference between the proceeds and the calculated fair value is then allocated back to the components based on their respective percentage values. The liability component would be valued at $1 million x 92.7% = 927,000 and the equity component would be valued at $1 million x 7.3% = $73,000. The journal entry to record the issuance would be as follows:

Cash 1,000,000 Bonds Payable 927,000 Contributed Surplus—Stock Options 73,000


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ILLUSTRATION 16-3 ACCOUNTING FOR STOCK OPTIONS Step 1—Acquisition Armstrong Inc. purchases a call option contract on January 2, 2004, from Griffin Investment Corp., which gives Armstrong the option to purchase 1,000 Investco shares (the underlying) at $100 per share (the exercise/strike price). The option expires April 30, 2004. Armstrong pays an option cost/premium of $400. The following journal entry would be made at the acquisition date: January 2, 2004 Investments—trading 400

Cash 400 At point of issuance, the intrinsic value of the option is zero. The amount paid is related solely to the time value and the likelihood that the intrinsic value will be greater than zero during that time period. Step 2—Increase in Intrinsic Value On March 31, 2004, the price of Investco shares has increased to $120 per share, and the intrinsic value of the call option contract is now $20,000. That is, Armstrong could exercise the call option and purchase 1,000 shares from Griffin for $100 per share and then sell the shares in the market for $120 per share. This gives Armstrong a gain of $20,000 ($120,000 - $100,000) on the option contract. The entry to record the increase in the option’s intrinsic value is as follows: March 31, 2004 Investments—trading 20,000

Gain 20,000 Note that the entire increase in intrinsic value is recorded and recognized as a gain in the income statement. This method is consistent with HB Sections 3855 and 1530.


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ILLUSTRATION 16-3 (continued) Step 3—Market Value The increase in intrinsic value is expected to continue, and therefore, on March 31, 2004, the options are trading at $20,100. The additional $100 represents the time value associated with the remaining month until the options expire. The entry to record the change in value is:

March 31, 2004 Gain/Loss 300 Investments—trading ($400 - $100) 300 Step 4—Contract Settlement On April 1, 2004, assuming the options are again trading at $20,000, the entry to record the settlement of the contract is:

April 1, 2004

Cash 20,000 Loss 100

Investment—trading 20,100 The effect on net income over the entire period: Date Transaction Income (Loss) Effect

March 31, 2004 Net increase in value of call option $19,700 ($20,000 - $300) April 1, 2004 Settle call option (100) Net income effect $19,600


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ILLUSTRATION 16-4 COMPENSATION PLANS—KEY CHARACTERISTICS

Stock options

Issued by the company Issued by others, i.e., financial institutions

CSOP

Not traded on exchange since must be employee to hold

Often exchange traded

Warrants ESOP

Used for hedging, speculation and to access

capital funds

Used for motivating and remunerating

employees

Other

Not traded on exchange since

rights usually not transferable

Used as compensation in a

buy or sell transaction

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