Accounting For Private Busness

GUIDE TO ACCOUNTING STANDARDS FOR PRIVATE ENTERPRISES
CHAPTER 45 FINANCIAL INSTRUMENTS
DISCLAIMER This publication was prepared by the Guidance and Support Group of the Canadian Institute of Chartered Accountants (CICA). It has not been approved by any Board of Committee of the CICA or any Provincial Institute/Ordre. The CICA and the authors do not accept any responsibility or liability that might occur directly or indirectly as a consequence of the use, application or reliance on this material. For information regarding permission, please contact permissions@cica.ca
Financial Instruments
TABLE OF CONTENTS
Paragraph Introduction Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Overview of Section 3856 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Scope. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Trade date accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Classication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liability or equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preferred shares issued in a tax planning arrangement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Examples Liability vs. equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compound instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Measurement Initial measurement of arms length transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financing fees and transaction costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Costs related to investment in equity instrument . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Demand loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Loan fees and costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans at non-market interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Off-market loan related to asset purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Indexed nancial liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Convertible nancial liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residual method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Relative fair value method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Initial measurement of convertible liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Initial measurement of related party transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Initial measurement of loan to manager . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Subsequent measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost/amortized cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Equity instrument measured at cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Interest-bearing investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of original purchase premium or discount, nancing fees and transaction costs . . . . . . . . . . . . . Example Investment in debt instrument issued at a discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Amortization of discount on off-market loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Amortization of discount on employee interest-free loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decision tree Impairment process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Identify assets to assess for impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Indications of impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Measurement of impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Present value of future cash ows of a loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Cash ow estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Impairment of groups of assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reversals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Impairment reversal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Fair value sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Calculating the change in fair value of a forward contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Calculating the change in fair value of an interest rate swap . . . . . . . . . . . . . . . . . . . . . . . . . . . Indexed nancial liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Indexed nancial liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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1-3 4-5 6-7 8-9 9 10-23 12-23 20 21 22-23 24-30 25-26 26 27-29 29 30-31 31 32 33-37 35 36 37 38-39 39 40-76 40 41-68 42 43 44 45 46 47 48-68 49 50 55 56-64 60 64 65 66-68 68 69-73 71 72 73 74-76 76
The Canadian Institute of Chartered Accountants
Presentation Offsetting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest, dividends, gains, losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Derecognition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial assets Securitization transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Illustration Typical securitization transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Measurement of interest held after a transfer of receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Recording transfers with proceeds of cash, derivatives, and other liabilities . . . . . . . . . . . . . . . Example Recording transfers of partial interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Servicing assets and liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Recognizing a servicing liability in a transfer of receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Sale of receivables with servicing retained . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Recording transfers of partial interests with proceeds of cash, derivatives, other liabilities, and servicing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair value Example Recording transfers if it is not practicable to estimate a fair value . . . . . . . . . . . . . . . . . . . . . . . Sales-type and direct nancing lease receivables Example Recording transfers of lease nancing receivables with residual values. . . . . . . . . . . . . . . . . . . Financial liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Investment banker acting as agent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Modication of line of credit or other revolving debt arrangement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Determining whether borrowing capacity exceeds that of the old arrangement and related accounting implications of fees and costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Extinguishing nancial liabilities with equity instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Convertible liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Accounting on extinguishment of compound nancial instrument . . . . . . . . . . . . . . . . . . . . . . . Hedge accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hedged item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hedging item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commodity hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Hedge of anticipated purchase of a commodity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Currency hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Foreign currency hedge of anticipated purchase of a commodity . . . . . . . . . . . . . . . . . . . . . . . . Example Hedge of anticipated foreign currency transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hedge of interest rate risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Interest rate swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cross-currency interest rate swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example - Cross-currency interest rate swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hedge of the net investment in a self-sustaining foreign operation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mechanics of hedge accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Example Effect of hedge accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Examples Hedge of foreign currency anticipated transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional examples Hedge of foreign currency anticipated transaction . . . . . . . . . . . . . . . . . . . . . . . . . . Example Hedge of interest rate risk with interest rate swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Appendix Denitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
77-83 84-85 86-119 87-102 91 93-94 93 94 95-100 97 98 100 101 102 103-119 112 113-114 114 115-117 118-119 119 120-147 120-125 126-128 129 130-131 131 132-136 133 136 137-140 138 139-140 140 141 142-147 144 145 146 147 148-159 A1
INTRODUCTION This publication has been produced in response to requests for guidance on the application of Section 3856, Financial Instruments, in the CICA Handbook Accounting, Part II, Accounting Standards for Private Enterprises. The CICA expresses its appreciation to the principal author of the publication, Jo-Ann Lempert, CA, and to Kate Ward, CA, for her technical review. The guidance and illustrative examples provided are not authoritative. All decisions on the application of any accounting standard need to be made based on a thorough understanding of the facts and circumstances of each transaction and through the application of professional judgment. The guidance in this publication is current as of the date of publication. Judgment will need to be applied as practice evolves or Section 3856 is updated.
Gordon Beal, CA, M.Ed Director, Guidance and Support
BACKGROUND 1. The nancial instrument standards previously contained in Part V of the CICA Handbook were highly criticized for being complex and often requiring resources that are beyond those cost-effectively available to many private enterprises. In some situations, these standards required the use of fair value measurements for nancial instruments that sometimes involved sophisticated nancial modelling and access to a variety of market price sources that many private companies did not have. Also, private companies struggled with determining impairment losses on nancial instruments due to multiple models existing in previous standards. Lastly, the hedge accounting model, designed mainly for publicly accountable enterprises, increased the number of fair value measurements and imposed extensive documentation and analytical requirements which private companies found to be very complex and onerous. In response to these criticisms, the Canadian Accounting Standards Board (AcSB) decided to start afresh and so developed the new CICA Handbook section, FINANCIAL INSTRUMENTS, Section 3856. This Standard simplies the accounting for nancial instruments by providing a single accounting standard that applies to all nancial assets and nancial liabilities. Section 3856 replaced several standards previously found in Part V of the CICA Handbook Accounting including TEMPORARY INVESTMENTS, Section 3010; ACCOUNTS AND NOTES RECEIVABLE, Section 3020; IMPAIRED LOANS, Section 3025; LONG-TERM DEBT, Section 3210; FINANCIAL INSTRUMENTS RECOGNITION AND MEASUREMENT, Section 3855; FINANCIAL INSTRUMENTS DISCLOSURE AND PRESENTATION, Section 3860; FINANCIAL INSTRUMENTS DISCLOSURE AND PRESENTATION, Section 3861; FINANCIAL INSTRUMENTS DISCLOSURES, Section 3862; FINANCIAL INSTRUMENTS PRESENTATION, Section 3863; and HEDGES, Section 3865. In developing the new Standard, the AcSB maintained that the previously existing principles should continue to apply. However, in order to ensure that the costs of applying these principles would not exceed the benets of applying them, the AcSB modied the application of these principles. The underlying principles guiding Section 3856 are as follows: (a) Financial Instruments represent rights or obligations that meet the denitions of assets or liabilities and should be reported in nancial statements. (b) Fair value is the most relevant measure for nancial instruments and the only relevant measure for derivative instruments. (c) Only items that are assets or liabilities should be reported as such in nancial statements. (d) Special accounting for items designated as being hedged should be provided only for qualifying items. OVERVIEW OF SECTION 3856 4. Section 3856 provides guidance on the accounting treatment of nancial instruments. It answers the following questions: (a) What is a nancial instrument? (i) The Standard lists several examples of common nancial instruments. It also describes transactions that resemble or may be nancial instruments but that are not dealt with in the Scope of the Standard (paragraph 6 of this chapter). The Standard requires that nancial instruments be recognized when an entity becomes a party to a contract involving nancial instruments, i.e., immediately (paragraph 8). The Standard requires that a nancial instrument be initially measured at its fair value plus, when it will be subsequently measured at cost or amortized cost, any related transaction costs and nancing fees (paragraphs 24-25).
2.
3.
(b) When should a nancial instrument be recognized in the nancial statements? (i)
(c) How should a nancial instrument be measured when it is initially recognized and thereafter? (i)
(ii) For subsequent measurement, the Standard requires the nancial instrument to be classied into one of the two following categories: Fair value (paragraphs 10 and 40) Cost/Amortized cost (paragraphs 40-41).
The classication decision will be primarily based on the instruments characteristics but the entity may elect to classify an instrument to the fair value category on initial recognition. (iii) All nancial instruments classied into the cost/amortized cost category, must be assessed for impairment at the end of each reporting period (paragraph 48). (d) How should a nancial instrument be presented? (i) The Standard provides guidance on classifying a nancial instrument, or its component parts, as a liability or part of equity based on the substance of the arrangement (paragraph 12).
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(ii) The equity component of a nancial liability that is convertible to equity must be recognized separately. Section 3856 permits measuring the equity component as zero. If this measurement option is not chosen, the equity component may be measured using any rational method including the residual method and the relative fair value method (paragraph 33). (iii) Section 3856 requires that preferred shares issued in a tax planning arrangement under specied sections of the Canadian Income Tax Act be presented at par, stated or assigned value as a separate line item in the equity section of the balance sheet, with a description indicating that they are redeemable at the option of the holder (paragraph 20). (iv) A nancial asset may be offset with a nancial liability only when both of the following criteria are met: (i) The entity currently has a legally enforceable right of offset; and The entity intends to settle on a net basis, or, to realize the items simultaneously (paragraph 80).
(e) When is a nancial instrument derecognized? For transferred receivables, only when control has been surrendered (paragraph 86); (ii) For a nancial liability, when it is extinguished (paragraph 103). (f) When and how can hedge accounting be applied (paragraph 120)? (i) Hedge accounting is optional. (ii) Hedging is only permitted in specic circumstances. (iii) Hedge accounting will only be allowed when the critical terms of the hedging item and hedged item match. (iv) Specic details of the hedging relationship must be documented. (v) When hedge accounting is achieved, accounting for the hedging item is modied. (vi) Hedge accounting cannot be electively discontinued, but is discontinued when the critical terms of the hedged item and the hedging item no longer match. (g) What is required to be disclosed regarding nancial instruments? (i) In general, information that enables users to evaluate the signicance of nancial instruments on the nancial position and performance of an entity must be disclosed (paragraph 148).
5.
The following chart illustrates the application of Section 3856 to nancial instrument transactions. General application of Section 3856, Financial Instruments
Has the entity become a party to the contractual provisions of a nancial instrument? Yes Is the nancial instrument excluded from the scope of Section 3856 as set out in paragraph 3856.03? No Is the transaction with a related party? Yes Is the relationship solely in the capacity of management (paragraph 3856.09)? Yes No The transaction is measured in accordance with RELATED PARTY TRANSACTIONS, Section 3840 Yes Other standards may apply Not sure Go to paragraph 6 of this chapter
No
Will the instrument be measured at fair value or amortized cost subsequent to initial recognition?
Fair value Investments in quoted equity instruments Derivative contracts other than those linked to another private entity and those in qualifying hedging relationships Other nancial instruments if fair value measurement is elected at initial recognition (election is irrevocable)
Cost or amortized cost Investments in unquoted equity instruments Derivatives that are not measured at fair value All other nancial assets and nancial liabilities not measured at fair value
Initial measurement
Measure initially at fair value Transaction costs are expensed in the period incurred Measure initially at fair value plus or minus transaction costs and nancing fees, if applicable
Subsequent measurement
Fair value Financial assets and liabilities other than hedging instruments or indexed liabilities Hedging instruments Indexed nancial liabilities
Amortize any initial premium or discount and any transaction costs or nancing fees to net income over the expected life of the instrument
Derivative hedging instruments are recognized at the earlier of: Date a payment is received or made; and Date the hedged instrument is recognized (i.e., hedging instrument receipt or payment is accrued)
At each reporting date measure at the higher of: the amortized cost of the debt; and the amount that would be payable if the indexing formula was applied on the reporting date The adjustment for changes in value due to the indexing feature, if any, is recognized immediately in net income as a separate component of interest expense
Assess all nancial assets for indications of impairment at each reporting date
Record the asset at the highest of: Is there a signicant change in the expected timing or amount of future cash ows? PV of cash ows expected from holding the asset Selling price at balance sheet date Expected net proceeds from liquidating collateral held
If previously impaired, assess for reversal of condition causing impairment in earlier period
SCOPE 6. What is a nancial instrument? Denitions of nancial asset and nancial liability are in paragraph 3856.05: Examples of items that are not accounted for in the scope of Section 3856 The cost incurred by an entity to purchase a right to reacquire its own equity instruments from another party; this is a deduction from equity (paragraph 3856.05(h)) Prepaid expenses Inventories Property, plant and equipment Leased rights and assets (paragraph 3856.03(b)) Intangible assets such as patents and trademarks Income taxes Investments in subsidiaries, variable interest entities, entities subject to signicant inuence or joint ventures (paragraph 3856.03(a)*
Denitions A nancial asset is any asset that is: cash
Examples of nancial instruments cash demand and xed-term deposits commercial paper bankers acceptances treasury notes and bills
a contractual right to receive cash or another nancial asset from another party a contractual right to exchange nancial instruments with another party under conditions that are potentially favourable
an equity instrument of another entity (paragraph 3856.05(h))
accounts, notes and loans receivable bonds and similar debt instruments held as investments common and preferred shares and similar equity instruments held as investments options, warrants, futures contracts, forward contracts, and swaps (these items also meet the denition of a derivative see below) (paragraph 3856.02) accounts, notes and loans payable (3856.02(d)) bonds and similar debt instruments issued (paragraph 3856.02(e)) perpetual debt instruments preferred shares, shares in co-operative organizations and interests in partnerships, and similar equity instruments issued (paragraph 3856.02(f))
A nancial liability is any liability that is a contractual obligation: to deliver cash or another nancial asset to another party; or to exchange nancial instruments with another party under conditions that are potentially unfavourable to the entity
* 7.
options, warrants, futures contracts, forward contracts, and swaps (these items also meet the denition of a derivative see below) (paragraph 3856.02(g)) See Sections 3051, 3055, 1590 and AcG-15 as appropriate.
Section 3856 applies to items that are created by contracts so payables and receivables that result from statutory requirements, such as income or excise taxes, are not in the scope. RECOGNITION
8.
Financial instruments are initially recognized in nancial statements when the entity becomes a party to the contractual provisions of the nancial instruments. This will normally happen when an entity commits to purchase or sell a nancial instrument (otherwise referred to as the trade date). This approach accurately reects the economic effects of transactions and is the only recognition date that provides transparency for derivatives.
9.
Example Trade date accounting On December 30, 20X1, Buy Co. purchases 100 shares of a company for its fair value of an aggregate amount of $100. The transaction settles on January 2, 20X2 at which time, Buy Co. receives and pays for the shares. On December 31, 20X the fair value of the shares has increased to $115 in aggregate, and by the time the transaction settles on January 2, 20X2 the fair value of the shares has increased to $125. Journal Entries Subsequent measurement at amortized cost Subsequent measurement at fair value (i.e., investment in private company shares) (i.e., investment in public company shares) December 30, 20X1 Dr. Investment in shares $100 Dr. Investment in shares $100 Cr. Payable $100 Cr. Payable $100 December 31, 20X1 No Entry Dr. Investment in shares $15 Cr. Unrealised fair value increase* $15 January 2, 20X2 Dr. Payable $100 Dr. Investment in shares $10 Cr. Cash $100 Dr. Payable 100 Cr. Unrealised fair value increase* $ 10 Cr. Cash 100 * This description is not a required title, it is used simply to describe the change in fair value that is recognized in net income.
CLASSIFICATION 10. Section 3856 requires few classication decisions. Freestanding derivatives (other than those in qualifying hedging relationships and those that are linked to and settle with delivery of the equity instruments whose fair value cannot be readily determined) and investments in equities that are quoted in an active market must be measured at fair value subsequent to their initial recognition (paragraph 3856.12). On initial recognition, any nancial asset or nancial liability may be designated as measured at fair value. Also, fair value measurement may be elected for an equity instrument that ceases to be quoted in an active market. Fair value measurement may be useful when the asset or liability will be hedged with a derivative but hedge accounting would or could not be applied. These elective applications of fair value measurement are irrevocable (paragraph 3856.13). It might make sense to use the irrevocable election to measure nancial instruments at fair value in the following situations: (a) When investments that are eligible for amortized cost measurement are managed on a fair value basis. For example, when surplus cash is invested in a portfolio containing both interest-bearing and equity securities, it is often easier to assess the performance of the portfolio when all of the securities are measured on the same basis. (b) Accounting for all investments on a fair value basis may simplify bookkeeping. Maintaining amortization schedules for interest-bearing items is operationally more challenging than recording fair values and cash transactions. (c) When it is unclear whether the nancial instrument is traded in an active market. It is important to understand the nature of the investment. For example, some mutual fund units are not redeemable daily so are not considered actively traded. However, it is usually easier and more useful to measure these investments at fair value. (d) When fair value is more relevant for the users. (e) To simplify the accounting for transaction costs. Transaction costs must be amortized over the life of any nancial instrument measured at amortized cost. Liability or equity 12. Guidance on the classication of an issued nancing instrument between a nancial liability and an equity instrument is included under the heading Presentation in paragraphs 3856.20-.23.
11.
13.
In some cases, it may be difcult to determine whether a nancial instrument should be considered a liability or equity. For example, some nancial instruments take the legal form of equity but are liabilities in substance because they require payment to the holder of a xed or determinable amount. Others may combine features associated with equity instruments and features associated with nancial liabilities, therefore making it difcult to distinguish whether it is an equity or liability instrument in its entirety.
14. In distinguishing whether a nancial instrument should be classied as a liability or equity instrument, the denitions of these instruments should be considered as follows: Paragraph 3856.05(e) An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Paragraph 3856.05(j) A nancial liability is any liability that is a contractual obligation: (i) to deliver cash or another nancial asset to another party; or (ii) to exchange nancial instruments with another party under conditions that are potentially unfavourable to the entity. 15. The substance of the contractual terms of a nancial instrument, rather than its legal form, governs its classication on the issuers balance sheet. This determination is made on initial recognition of the instrument, disregarding any non-substantive or minimal features, and this classication is not revised unless the terms of the instrument change or it is removed from the balance sheet. When considering whether the nancial instrument, or its component parts, meets the denition of a nancial liability, the existence of a restriction on the ability of the issuer to satisfy an obligation, such as lack of access to foreign currency or the need to obtain approval for payment from a regulatory authority, does not negate the issuers obligation or the holders rights under the instrument. When an issuer has a contractual obligation to deliver a xed amount or an amount that varies either partially or fully in response to changes in a variable, other than the market price of the entitys own equity instruments, and the issuer is required to or is able to settle the contractual obligation by delivering enough of its own equity instruments to satisfy the obligation, this would be considered a nancial liability because the counterparty is guaranteed a xed value and is not subject to the residual risk of the issuer. When an issuer does not have a contractual obligation to deliver cash or another nancial asset or to exchange another nancial instrument under conditions that are potentially unfavourable, the instrument is equity. When the issuer is not contractually obligated to distribute a pro rata share of any dividends or other distributions out of equity, even when the holder may be entitled to such distributions, it is considered an equity instrument. The classication of a nancial instrument between liability and equity is not changed based on a change in estimate of the probability of a future event occurring. If the future event passes, and the nancial instrument still exists, it is derecognized, and a new nancial liability or equity instrument is recognized based on the remaining terms. Similarly, the classication would not be impacted by historical experience or intentions but would be based on the actual substance of the contractual arrangements themselves.
Preferred shares issued in a tax planning arrangement
16.
17.
18.
19.
20.
The only exception to the above guidance applies to preferred shares issued in a tax planning arrangement under Sections 51, 85, 85.1, 86, 87 or 88 of the Canadian Income Tax Act that are redeemable at the option of the holder. These shares should be presented at par, stated or assigned value as a separate line item in the equity section of the balance sheet, with a suitable description indicating that they are redeemable at the option of the holder. When redemption is demanded, the shares are reclassied as liabilities and measured at the redemption amount. Any adjustment is recognized in retained earnings.
21.
Examples Instruments that would be considered a nancial liability vs. an equity instrument Financial liability An entity receives $10,000 and promises to deliver the $10,000 or shares equal in value to $10,000 in 3 years time. An entity receives $10,000 and promises to deliver shares in 3 years time equal to the value of gold at that time. Preferred shares* issued in the amount of $10,000 to be redeemed at a xed date (as per the contractual arrangement) for a xed price and paying mandatory scheduled dividends. Preferred shares* issued in the amount of $10,000 to be redeemed at a xed date for a xed price without mandatory dividend payment, when declared. A retractable or mandatorily redeemable share that does not meet the criteria to be classied as an equity instrument. Equity instrument An entity receives $10,000 and promises to deliver 10,000 shares in 3 years time. An entity receives $10,000 and promises to deliver a xed number of shares at a xed date. Preferred shares* issued in the amount of $10,000 with no specied repayment date, redeemable at the option of the issuer, with no stipulated dividend payments, when declared. Preferred shares* issued in the amount of $10,000 with no specied repayment date, redeemable at the option of the issuer, paying mandatory scheduled dividends. A retractable or mandatorily redeemable share that: Is the most subordinated of all equity instruments issued by the entity and participates on a pro rata basis in the residual equity; The redemption feature is extended to 100% of the common shares (and/or in-substance common shares), and the basis for determination of the redemption price is the same for all shares; All of the redeemable shares include substantially similar characteristics to the enterprises common shares; for example, they do not include any substantive liquidation preferences or dividend distribution preferences.
The redemption event is the same for all the shares subject to the redemption feature, for example, redemption on the resignation, termination, retirement or death of the shareholder. These shares are not subject to the exception above, i.e., they are not issued in a tax planning arrangement under Sections 51, 85, 85.1, 86, 87 or 88 of the Canadian Income Tax Act.
Compound nancial instruments 22. When a nancial instrument contains both liability and equity elements, each element should be classied in accordance with its substance, taking into consideration the denitions of a nancial liability and equity instrument. A nancial position is more faithfully represented by separate presentation of the liability and equity components contained in a single instrument according to their nature. For example, when a nancial liability includes detachable warrants or options, it is more a matter of form than substance that both liabilities and equity interests are created by a single nancial instrument rather than two or more separate instruments. The separate classication based on the substance of the contractual terms of the arrangement discussed above would still apply when a nancial instrument contains components that are neither nancial liabilities nor equity instruments of the issuer. For example, an instrument that gives the holder the right to receive a non-nancial asset such as an amount of gold (i.e., a commodity) on settlement and an option to exchange that right for shares of the issuer contains both liability and equity elements. The issuer recognizes and presents the equity instrument (the exchange option) separately from the liability components of the compound instrument, whether the liabilities are nancial or non-nancial. MEASUREMENT Initial Measurement Arms length transactions 24. Financial instruments issued or acquired in arms length transactions are measured initially at fair value. Given that fair value is the price that an arms length market participant would pay or receive in a routine transaction under the market conditions at the time of initial recognition, a nancial instruments initial fair value will normally be the transaction price, that is, the fair value of the consideration given or received.
23.
10
Financing Fees & Transaction Costs
25.
The treatment of any nancing fees and transaction costs directly attributable to the origination, acquisition, issuance or assumption of nancial instruments depends on the subsequent measurement of the instrument. When the instrument will be measured at fair value, transaction costs and nancing fees are recorded in income in the period incurred because they are not part of the fair value of the nancial instrument and they do not meet the denition of an asset necessary for separate recognition (paragraph 3856.12). When the instrument will be measured at cost or amortized cost, nancing fees and transaction costs are included in the initial measurement of the instrument. Transaction costs included in the initial measurement of an interest-bearing instrument are amortized over the life of the instrument (paragraphs 3856.07 and .A3). Standby fees and transaction costs associated with a line of credit or revolving debt arrangement are recognized as a prepaid expense and amortized over the life of the commitment because they are, in substance, analogous to an insurance premium. The fee is the cost associated with having the ability to draw down the loan over the term of the arrangement (paragraph 3856.A57). Example Investment in equity instruments at cost On February 14, 20X1, Investor Corporation invests $10,000 in 10,000 common shares of Private Corporation, giving Investor Corp. a 10% voting interest in the company. Investor Corp. and Private Corp. are unrelated, and the price paid for the acquisition of the common shares represented fair value of the shares at the purchase date. Investor Corp. also incurred $500 in legal fees to register the title of the shares in their name. Date Entry February 14, 20X1 Dr. Investment in Private Corporation $10,500 Cr. Cash $10,500
Demand Loans
26.
27.
The fair value of a nancial liability with a demand feature is not less than the amount payable on demand, discounted from the rst date that the amount could be required to be paid. The maturity date of an item with no contractual repayment terms cannot be later than the earliest date on which payment can be demanded. The initial fair value for such nancial liabilities is usually the price at which they are originated between the customer and the lender, that is, the demand amount. However, the effect of discounting would need to be considered in a high interest rate environment for a loan payable on 30 days notice (paragraph 3856.A12). The interest rate used to discount a nancial instrument payable on demand should be the rate available to the entity on a similar nancial instrument maturing on, or as close as possible to, the rst date that the instrument could be required to be paid. It incorporates any risk premium that a third party would charge for a nancial instrument of comparable credit quality and terms (paragraph 3856.A13).
28.
11
29.
Examples Accounting for demand loans and revolving debt fees and costs Example 1 Term loan Bank of Lenders agrees to lend Borrowing Corporation $100,000 for 5 years, bearing annual interest at 6%, payable monthly, with principal repayable in full at maturity. Bank of Lenders is able to demand repayment of the loan at anytime if specied conditions are not met. On issuance of the loan, Bank of Lenders charges Borrowing Corporation transaction costs in the amount of $1,250 to write the loan and register collateral on it. Dr. Cash $98,750 Cr. Loan payable Example 2 Demand loan with no terms of repayment Borrowing Corporation arranges a demand loan with Bank of Lenders in the amount of $100,000. Bank of Lenders is able to demand repayment of the loan at anytime. The loan carries an annual interest rate of 6%. On issuance of the loan, the bank charges Borrowing Corporation a $1,250 origination fee. Example 3 Revolving line of credit Borrowing Corporation arranges with Bank of Lenders to enter into a revolving line of credit with a limit of $100,000. Bank of Lenders is able to demand repayment of the line at anytime. The line carries an annual interest rate of 6%. On issuance of the line, the bank charges Borrowing Corporation a $1,250 annual standby fee.
Dr. Cash
$98,750
Cr. Loan payable $98,750 End of year 1 entry Dr. Interest Dr. Interest expense* $250 expense* $1,250 Cr. Loan Cr. Loan payable $250 payable $1,250 This example uses the straight-line * This account can also be called amortization method but the effective Amortization of Loan Fee or someinterest method can alternatively be thing similar and can be presented as a used. separate component of interest expense * This account can be presented as a in the income statement. separate component of interest expense in the income statement: Interest on bank loan $6,000 $98,750 Amortization of loan fee Total interest expense
Loans at non-market interest rates
Dr. Prepaid expenses Cr. Cash
$1,250 $1,250
Dr. Interest expense* $1,250 Cr. Prepaid expenses $1,250 * This account can also be as called Amortization of Prepaid Fee or something similar and can be presented as a separate component of interest expense in the income statement.
250 $6,250
30.
A loan with an interest rate that is signicantly less than a market rate of interest indicates that there is more to the transaction than a pure lending/borrowing relationship. The present value of the difference between the rate on the loan and a fair market lending rate may represent part of the price of an asset nanced by the loan, a government grant to incent the borrower to undertake certain commercial transactions, or compensation to an employee (see paragraph 47 below). Example - Loan with a non-market rate of interest related to asset purchase On February 14, 20X1, Seller Corporation nances Customer Co.s purchase of a $1,000 machine by extending payment for 3 years. Interest is payable annually at 3%. The market rate of interest for a similar loan to an entity with Customers credit rating is 5%. The loan is initially measured at its fair value of $946 (net present value of $30 of interest for 3 years and principal repayment of $1,000 discounted at 5%). The transaction is accounted for as follows: Date Sellers books Customers books February 14, 20X1 Dr. Loan receivable $946 Dr. Machine $946 Cr. Revenue $946 Cr. Loan payable $946
31.
12
Indexed Financial Liabilities
32.
Private enterprises often issue debt that requires payments to be determined by reference to factors such as the value of the enterprises equity or performance measures such as earnings before interest, taxes, depreciation and amortization. These instruments are initially measured at fair value, usually the proceeds of the issue, unless they are related party transactions that are outside the scope of Section 3856.
Convertible Financial Liabilities
33.
Private enterprises also often issue debt that includes an option for the holder to acquire equity of the issuer under specied circumstances (compound instrument). These options are similar in nature to options or warrants that are issued with the liability but detachable thereafter. The equity component may be measured as zero or based on fair value measurements as explained below. It is especially important to disclose the terms of the instrument when the zero measurement alternative is chosen to ensure that readers of the nancial statements are aware of the terms of the conversion option. Acceptable methods for initially measuring the separate liability and equity elements of an instrument include the following: (a) The equity component is measured as zero; the entire proceeds of the issue are allocated to the liability component. (b) Residual method the more easily measurable component is measured rst, and the residual amount is allocated to the remaining component. (c) Relative fair value method the total proceeds of the instrument is allocated to the components in proportion to their relative fair values. The sum of the carrying amounts assigned to all the components in an arrangement on initial recognition is always equal to the carrying amount of the instrument as a whole. No gain or loss is realized from recognizing and presenting the components of the instrument separately.
Residual value method
34.
35.
Using the residual method, the more easily measurable component is measured rst, and the residual amount (after deducting from the entire proceeds of the issue the amount separately determined for the component that is more easily measurable) is allocated to the less easily measurable component. Note that IFRSs require use of the residual value method but the equity portion must be calculated as the residual after deducting the fair value of the liability from the proceeds of the issue.
Relative fair value method
36.
When the issuer can reliably estimate the fair value of each of the liability and equity components, the proceeds may be allocated proportionately. This method is used infrequently because of the difculty of establishing fair value measurements for private enterprises.
13
37.
Example Initial measurement of convertible liability Capital Corporation (Capital) needs to raise $10,000 to fund its operations and is having difculty nding nancing. It issues bonds in the aggregate amount of $10,000 repayable in 5 years and with an annual interest rate of 6%. The bonds are convertible on a one-for-one basis into common shares of the Corporation in the event of default of the bonds terms. The conversion feature was measured using the Black-Scholes Model at $250 on initial issuance of the bond. Conversion feature is measured at zero Dr. Cash $10,000 Cr. Liability $10,000 Cr. Conversion feature (equity) 0 Conversion feature is measured at fair value residual method Dr. Cash $10,000 Cr. Liability $9,750 Cr. Conversion feature (equity) 250 Liability and conversion feature are measured pro rata relative fair value method Dr. Cash $10,000 Cr. Liability $9,754 Cr. Conversion feature (equity) 246 From Capitals perspective, the bond comprises two components: a nancial liability (a contractual arrangement to deliver cash or other nancial assets) and an equity instrument (a conversion option granting the holder the right, for a specied period of time and upon satisfaction of certain conditions, to convert into common shares of Capital). Capital presents the liability and equity components separately on its balance sheet when the equity component is allocated a value. See paragraph 155 below for examples of the disclosures required for convertible liabilities. Initial Measurement Related party transactions
38.
Related party transactions are measured in accordance with RELATED PARTY TRANSACTIONS, Section 3840 except for those that involve parties whose sole relationship with an entity is in the capacity of management. Management is dened in paragraph 3840.04(d) as follows: Paragraph 3840.04(d) Management: any person(s) having authority and responsibility for planning, directing and controlling the activities of the reporting enterprise. (In the case of a company, management includes the directors, ofcers and other persons fullling a senior management function. When an independent committee of the board of directors is established in accordance with regulatory requirements, to represent the non-controlling interests of an enterprise, the directors serving on that committee are deemed not to be related parties for the transaction under consideration.)
39.
Example Non-interest bearing loan to manager Mr. Manager receives a non-interest-bearing, ve-year housing loan in the amount of $25,000 on January 1, 20X1 from his employer, Bonus Corporation. The loan is due in full on January 1, 20X6. Because Mr. Managers only association with the Company is in his capacity as a manager, i.e., he does not own shares of Bonus Corporation, Bonus would have to measure this transaction on January 1, 20X1 at its fair value in accordance with Section 3856.07. Assuming the prevailing market interest rate for a similar loan for ve years with a similar credit rating were 5%, Bonus Corporation would record the following entry on initial recognition of the loan: Dr. Loan receivable $19,588.15 Dr. Compensation expense 5,411.85 Cr. Cash $25,000.00
14
Subsequent measurement
Overview
40.
Most measurements in Section 3856 can be applied on an instrument-by-instrument basis, i.e., most are not policy choices. The following chart summarizes the subsequent measurement requirements. Cost/Amortized cost (paragraph 41 below) Measurement at cost/amortized cost (when not designated at fair value) Investments in equity instruments not quoted in an active market Derivatives designated in a qualifying hedging relationship Derivatives that are linked to, and must be settled by delivery of, equity instruments of another entity whose fair value cannot be readily determined All other nancial assets not measured at fair value Financial liabilities Fair value (paragraph 69 below) Mandatory fair value measurement Optional fair value measurement Investments in equity instruments quoted in an active Any nancial asset or nancial liability designated on market initial recognition Derivatives not designated in a qualifying hedging relationship Equity instruments that cease to be quoted in an active market
Derivatives that are linked to, and must be settled by delivery of, equity instruments of another entity whose fair value can be readily determined Indexed nancial liabilities (paragraph 74 below) At each reporting date, indexed nancial liabilities are measured at the higher of: the amortized cost of the debt; and the amount that would be payable if the indexing formula was applied at that date. Adjustments for changes in the value of the embedded feature are recognized immediately in net income as a separate component of interest expense.
Cost/Amortized cost
41.
Amortized cost is dened in paragraph 3856.05(a) as follows: Paragraph 3856.05(a) Amortized cost is the amount at which a nancial asset or nancial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortization of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment (see paragraphs 3856.A3-.A6). The term cost is not specically dened in Section 3856. A laymans denition describes cost as the amount paid to acquire the nancial instrument.
42.
Example Investment in equity instruments at cost (continued from paragraph 26 below) On December 31, 20X1, Investor Corp.s year-end, the fair value of this investment has increased to $12,500. Investor Corp. would record the following entries throughout the 2011 year related to this investment: Date Entry December 31, 20X1 No entry because the investment is classied by Investor Corp. to be measured at cost, no adjustment is required for the change in fair value.
15
43.
Example Investment in Guaranteed Investment Certicates (GICs) On February 14, 20X1, Investor Corporation decides to invest $10,000 in a 30-month Bank of Canadiana non-redeemable GIC which guarantees a return of 2.40%. Investor Corp. did not pay any fees or transaction costs associated with this investment. At December 31, 20X1, the interest rates on similar GICs have decreased to 2.05%, thereby increasing the fair value of this investment by year-end. Investor Corp. would record the following entries throughout the 20X1 year related to this investment: Date Entry February 14, 20X1 Dr. Investment in GIC $10,000 Cr. Cash $10,000 December 31, 20X1 Dr. Interest receivable $ 210 Cr. Interest income $ 210 The increase in fair value of the investment is ignored because the investment is measured at amortized cost.
Amortization of initial purchase premium or discount, nancing fees and transaction costs
44.
Any systematic amortization of premiums/discounts, fees and/or costs to net income may be used. The effective interest method is theoretically preferred but Section 3856 permits use of alternative methods such as the straight-line method. In many situations, the difference between the effective interest method and straight-line amortization will not be material. Example Investment in Government of Canada Treasury Bill On January 1, 20X1, Investor Corporation decides to invest in a one-year $10,000 GOC treasury bill to yield 1.45%: Principal amount of T-bill $10,000 Initial investment ($10,000 discounted at 1.45%) $ 9,857 Interest income recognized over the year $ 143 For interim reporting purposes, the interest may be recognized using any systematic and rational method including straightline amortization (approximately $12 per month).
45.
46.
Example Loan at non-market rate of interest (continued from paragraph 31 above) The net amount of the loan of $946 accretes to $1,000 over its three-year term. The accretion can be determined using any systematic method, including the effective interest method at 5%, or the straight-line method, and can either be shown in net income as part of interest income (Sellers perspective, interest expense for Customer) or on a separate line within interest income/expense. Sellers entries are as follows: Date Effective interest method Straight-line amortization December 31, 20X1 Dr. Loan receivable $41 Dr. Loan receivable $42 Cr. Interest income $41 Cr. Interest income $42 February 14, 20X2 Dr. Cash $30 Dr. Cash $30 Cr. Loan receivable $24 Cr. Loan receivable $24 Cr. Interest income 6 Cr. Interest income 6 December 31, 20X2 Dr. Loan receivable $42 Dr. Loan receivable $42 Cr. Interest income $42 Cr. Interest income $42 February 14, 20X3 Dr. Cash $30 Dr. Cash $30 Cr. Loan receivable $24 Cr. Loan receivable $24 Cr. Interest income 6 Cr. Interest income 6 December 31, 20X3 Dr. Loan receivable $43 Dr. Loan receivable $42 Cr. Interest expense $43 Cr. Interest income $42 February 14, 20X4 Dr. Cash $1,030 Dr. Cash $1,030 Cr. Loan receivable $1,024 Cr. Loan receivable $1,024 Cr. Interest expense 6 Cr. Interest expense 6 (Customers entries would mirror those of Sellers.)
16
47.
Example Interest-free loan to manager (continued from paragraph 39 above) Entries to be made over the term of the loan are as follows. Both the straight-line amortization method and the effective interest method are illustrated: Straight-line Amortization Method Effective Interest Amortization Method January 1, 20X1 Dr. Loan receivable $19,588.15 Dr. Compensation expense 5,411.85 Cr. Cash $25,000.00 December 31, 20X1 Dr. Loan receivable $1,082.37 Dr. Loan receivable $979.41 Cr. Interest income $1,082.37 Cr. Interest income $979.41 December 31, 20X2 Dr. Loan receivable $1,082.37 Dr. Loan receivable $1,028.38 Cr. Interest income $1,082.37 Cr. Interest income $1,028.38 December 31, 20X3 Dr. Loan receivable $1,082.37 Dr. Loan receivable $1,079.80 Cr. Interest income $1,082.37 Cr. Interest income $1,079.80 December 31, 20X4 Dr. Loan receivable $1,082.37 Dr. Loan receivable $1,133.79 Cr. Interest income $1,082.37 Cr. Interest income $1,133.79 December 31, 20X5 Dr. Loan receivable $1,082.37 Dr. Loan receivable $1,190.48 Cr. Interest income $1,082.37 Cr. Interest income $1,190.48 January 1, 20X6 Dr. Cash $25,000.00 Dr. Cash $25,000.00 Cr. Loan receivable $25,000.00 Cr. Loan receivable $25,000.00
Impairment
48.
The carrying amount of any nancial asset measured at cost or amortized cost must be reduced if there is a decline in value that is specic to the issuer of the instrument. A decline in value of a stock or group of stocks generally does not give rise to an impairment loss if it relates to an overall decline in equity markets. Similarly, a decline in the value of interest-bearing nancial instruments that related to an increase in interest rates does not create an impairment loss. Section 3856 species one impairment model applicable to all nancial assets measured at cost or amortized cost. This model requires the impairment loss to be determined on the basis of the difference between the current carrying amount of the asset and the cash ows the enterprise could expect to receive in the most favourable outcome. The reduction may be recognized directly or through the use of an allowance account with the offset recognized directly in net income. Losses recognized in previous periods may be reversed if the circumstances related to the original write-down improve.
17
49.
Decision tree Process for assessing impairment Step 1: Identify assets to be assessed for impairment Investments in private equity instruments measured at cost Investments in interest-bearing instruments measured at amortized cost that are individually signicant, e.g., bonds, loans, etc. Financial assets measured at amortized cost that share similar characteristics, e.g., accounts receivable No No action
Step 2: Are there indications that the asset or group of similar assets is impaired? Yes Step 3: Has there been a signicant adverse change during the period in the expected timing or amount of future cash ows from the asset(s)? Yes Step 4: Is carrying amount higher than highest of: Present value of cash ows expected to be generated by holding the asset(s) Expected net proceeds from selling the asset(s) at the balance sheet date Expected net value of collateral held Yes Action: Reduce carrying amount to highest of three amounts In subsequent periods Step 5: Has the situation identied in Step 2 improved? Yes Step 6: Is the carrying amount lower than the highest of: Present value of cash ows expected to be generated by holding the asset(s) Expected net proceeds from selling the asset(s) at the balance sheet date Expected net value of collateral held Yes Action: Increase carrying amount to lower of: the amount calculated in Step 6; and the carrying amount that would have been recorded had the asset not been previously impaired
No
No action
No action No
No
No action
No action No
18
50.
Example Impairment assessment Investor Corporation holds a portfolio of debt and equity securities amounting to $25,000. This portfolio is comprised of $15,000 of investments in equity securities of three private companies, and $10,000 in debt securities. Investor Corp. has determined the following for its impairment review: Equity instruments to be reviewed individually: $5,000 investment in preferred shares of Company A $3,000 investment in common shares of Company B $7,000 investment in special shares of Company C Debt securities to be reviewed individually due to their signicance: $6,000 investment in bonds of Company D Debt securities to be reviewed individually due to their shared industry characteristic: $3,000 aggregate investment in bonds of various companies in the utilities sector The remaining $1,000 are individually insignicant and would be reviewed only when information comes to the attention of Investors management.
51.
A nancial asset is impaired when the holder expects a signicant adverse change in either the amount or timing of future cash ows. For an investment in an equity instrument, the most signicant potential decrease in future cash ows arises from the inability to sell the shares at a price that recovers the initial investment. Uncertainty about an entitys future cashgenerating ability generally results in a decline in the fair value of the entity. Indications that the investment might be at risk include: (a) It becomes probable that the issuer will enter bankruptcy or other nancial reorganization; (b) The issuer experiences a signicant adverse change in the technological, market, economic or legal environment in which it operates. The effect of possible changes in the industry in which the issuer operates needs to be assessed. This includes changes in: (i) the technology used to produce the entitys product; (ii) the competitive environment in which it operates, including changes in the way the product is distributed that increase the number of suppliers with reasonable access to the entitys customers; (iii) national or local economic conditions; (iv) environmental sensitivities or laws; or (v) tax laws.
52.
Accounts receivable are similar in nature to interest-bearing assets such as loans, bankers acceptances, guaranteed investment certicates, term notes and bonds. Although the same process for recognizing and measuring impairment applies to accounts receivable as to other nancial assets, the model should not result in a change in process from existing practice. Indications that an interest-bearing asset is impaired include: (a) The customer or issuer appears to be experiencing signicant nancial difculty. This may be evident by: (i) late payments or defaults in either the instrument held by the creditor or investor or in debts owed to other creditors or investors;
(ii) a breach of a non-nancial contract; or (iii) concessions granted to the customer. (b) It becomes probable that the customer or issuer will enter bankruptcy or other nancial reorganization. (c) The market for nancial instruments issued by the obligor disappears. (d) Liquidity for the type of instrument decreases due to a lack of popularity for that type of investment. (e) A signicant adverse change in the technological, market, economic or legal environment in which the customer or issuer operates (see paragraph 51 above). 53. The following events or circumstances do not necessarily indicate impairment: (a) An active market disappears because an entitys nancial instruments are no longer publicly traded. (b) The issuers credit rating is downgraded. However, any downgrade should be evaluated to determine whether the amounts or timing of cash ows from the nancial instrument held are at risk of signicant change.
19 The Canadian Institute of Chartered Accountants
(c) A decrease in the fair value of a nancial asset below its cost or amortized cost may be due to changes in the risk-free interest rate or other exogenous factors. 54. Section 3856 does not dene signicant; judgment is required. The assessment should consider the cash ows that are expected to be derived over the period of time that the entity expects to hold the nancial asset, including any applicable proceeds of disposal. Examples of situations that might be considered a signicant adverse change include a change in expectation of collection of a receivable from 60 days to 180 days or receiving notice that a past due receivable will be settled for $0.80 on the dollar. Example Indications of impairment Lendor Corporation has lent one of its customers, Big Box Incorporated (Big Box), $10,000 on February 14, 20X1. By December 31, 20X1, it is clear that customer trends have changed and one of Big Boxs competitors has introduced a new product to the market that is really taking off, leaving Big Boxs product out of date and not nearly as popular as it once was. Big Box has also approached Lendor Corporation to renegotiate and extend its repayment terms because it has been having difculty with its cash ow considering recent events. Lendor Corp. should consider the fact that Big Box has asked to extend its repayment terms as well as the downturn in Big Boxs economic situation to be indications of a signicant adverse change in the expected timing or amount of future cash ows associated with its loan receivable.
Measurement of impairment
55.
56.
When a signicant adverse change in future cash ows from the asset is expected, any impairment loss is calculated in accordance with paragraph 3856.17. The write-down, if any, is to the highest of three possible amounts: (a) The present value of the cash ows expected to be generated by holding the asset(s), discounted using a current market rate of interest appropriate to the asset(s); (b) The amount that could be realized by selling the asset(s) at the balance sheet date; and (c) The amount expected to be realized by exercising rights to collateral held to secure the repayment of the asset(s), net of all costs necessary to exercise the rights.
57.
Section 3856 assumes the holder of the asset will take whatever action is necessary to maximize cash ows from impaired nancial assets. However, it does not presume a course of action. This means that the reporting entity may manage an asset in a different manner from that corresponding to the measurement. For example, collateral backing an asset may be worth more than either the present value of the assets future cash ows or the amount that could be realized on sale of the asset. The value of the collateral would be used even if the reporting entity does not intend foreclosing on the asset and realizing the collateral. Even though, conceptually, the net realizable amount from a hypothetical sale of the asset should be equal to the higher of the net realizable value of the collateral and the net present value of the future cash ows, Section 3856 does not presume that markets for these assets are liquid or perfect. The interest rate to be used to discount future cash ows is determined based on judgment. The rate should reect the type of asset under consideration. For example, a loan should be remeasured using the rate that would be charged for a loan with comparable term, conditions and quality at the balance sheet date. Cash ows from other interest-bearing assets should be discounted using current yields for the asset, if observable, or a comparable asset. If the reporting entity has granted concessions to a borrower by reducing the interest rate below the current market rate, the amount of the loss reported will include a component for foregone interest. This is illustrated in the example in paragraph 60.
58.
59.
20
60.
Example Present value of future cash ows of a loan Richco extended a $120,000, three-year loan to Sadco in 20X0. Sadco is required to pay interest only at 10% with principal due in full June 30, 20X3. Sadco lost its most signicant customer to bankruptcy shortly after the loan was extended. Sadco made all required payments in 20X0. In January 20X1, Sadco asked for a reduction in the interest rate to 5% and an extension in the nal payment to June 30, 20X4. The loan is not collateralized. Depending on market rates of interest, the impairment loss Richco calculates is: Market interest rate 5% 10% 12% Present value of renegotiated cash ows $121,040 $103,703 $104,330 Carrying amount of loan 120,000 120,000 120,000 Impairment loss recognized $ 0 $ 11,297 $ 15,670 The impairment loss The impairment loss represents the difference represents the difference between the new interest between the new interest rate and the market rate. rate and the market rate. If the term of the loan had not been extended, the loss would have been $9,917. Subsequent to recognizing the write-down, Richco recognizes interest at 5%. If Sadco rebuilds its customer base, all or part of the loss might be reversed. (See paragraph 66 below.) Because the loan has been renegotiated to a market rate of interest, no impairment loss is recognized.
61.
Impairment losses realized on unquoted equity instruments or derivative assets that are linked to, and must be settled by delivery of, unquoted equity instruments are more difcult to measure than interest-bearing investments. Estimates of the fair value of the shares and cash ows that might reasonably be expected over the anticipated hold period are required. Future cash ows might be discounted using the required yield for an investment with comparable terms and risk or possibly using an estimate of the entitys weighted average cost of capital. It is not always necessary to perform the three calculations in paragraph 3856.17. The best estimate of a selling price for an asset may be equivalent to the present value of its cash ows and there may be no collateral backing the asset. Estimates of the amount and timing of expected future cash ows from impaired nancial assets should reect managements best judgment, based on reasonable and supportable assumptions, taking into account the range of possible outcomes. Although making reliable estimates of the amounts and timing of expected future cash ows from a group of assets is constrained by limitations on the availability of information as well as the inability to assess the effect on individual accounts, there is a presumption that reasonable assumptions can still be made.
62. 63.
21
64.
Example Cash ow estimates (continued from paragraph 55 above) Lendor Corporations loan to Big Box Incorporated has a carrying amount of $100,000 on December 31, 20X1. After much discussion with Big Boxs management, Lendor Corp. has agreed to extend the repayment period to mature February 14, 20X6 instead of the original maturity date of February 14, 20X4. Assume that the loan is priced at 3.25%, paid monthly and that a current market rate of interest appropriate to Big Box is 4.5%. Probability weighted Probability Outcome gross cash ows Present value 5% No payments $ 0 $ 0 5% $30,000 principal plus interest until Feb. 20X4 1,852 1,572 10% $50,000 and interest until Feb. 20X5 6,029 5,097 20% $70,000 and all interest 16,708 14,079 60% $100,000 principal and all interest 68,125 57,220 $92,714 $77,968 The amount that Big Box expects to realize by exercising its right to collateral net of all costs necessary to exercise those rights is $70,000. Lendor Corp. records an impairment in the amount of $22,032 through net income at December 31, 20X1 as follows: Dr. Credit loss $22,032 Cr. Loan receivable (or allowance for loan loss) $22,032 By December 31, 20X2, the present value of the cash ows expected to be generated by holding the loan is estimated at $78,700, while the amount expected to be realized by exercising their rights to collateral (net of all costs necessary to exercise those rights) is $72,000. However, Lendor does not record the increase because there is no indication that the conditions that caused it to evaluate the loan for impairment have improved (see paragraph 66 below).
Impairment of groups of assets
65.
When history suggests that bad debt losses will be experienced on some assets in a group but it is not yet apparent which assets will default, an allowance for impairment is calculated, e.g., an allowance for doubtful accounts receivable. When information becomes available about the impairment of specic assets in the group, those assets are removed from the group and assessed for impairment on an individual basis.
Reversals
66.
At each reporting date all assets previously identied as impaired are reviewed to determine whether all or part of the impairment loss should be reversed. When an increase in value of the asset can be related to an improvement in the condition(s) that caused the loss, a gain is recognized. The carrying amount of the asset may not be increased above the amount that would have been reported at the reporting date had an impairment loss not been previously recorded. (Refer to paragraph 49 above, steps 5 and 6.) The amount of the reversal is recognized in net income in the period the reversal occurs. Examples of circumstances that might indicate that an impairment reversal may be possible include: (a) The customer or issuer previously experiencing signicant nancial difculty seems to be doing better. This may be evident by faster payments, the absence or cure of events of default, or a commitment to resume interest or principal payments. (b) Renegotiation of a contract to incorporate commercial terms appropriate to a party free from liquidity, solvency, or profitability concerns, or reinstatement of dividend payments. (c) Emergence from receivership or bankruptcy protection. (d) An improvement in the technological, market, economic or legal environment in which the customer or issuer operates. A recovery in the fair value of an investment in an equity instrument above its cost might be indicative of improvement, but the reporting entity should consider whether the improvement is specic to the issuer and sustainable through its intended holding period. Other indicators might include: (i) Increased popularity of the issuer or customers product (ii) Structural changes in the customer or issuers industry such as new technology or a change in the number of competitors (iii) Changes in external variables such as environmental or tax laws.
22
67.
68.
Example Impairment reversal (continued from paragraph 64 above) By December 31, 20X2, it is clear that the new product introduced by Big Boxs competitor is faulty and receives signicant negative exposure in the media. As a result, the market now has renewed interest in Big Boxs products noting their stable reputation for high quality and reliability. Big Boxs management recently contacted Lendor Corp. to conrm their intention to repay the loan in full over the next ve years. Lendor is cautiously optimistic and revises its estimate of expected cash ows as follows: Probability Probability Outcome weighted outcome Present value 0% No further payments $ 0 $ 0 5% $40,000 principal and all interest 2,515 2,207 5% $60,000 principal and all interest 3,515 3,077 10% $80,000 principal and all interest 9,029 7,894 80% $100,000 principal and all interest 88,233 77,074 $103,292 $90,253 The value of the collateral has increased to $75,000. Lendor increases the carrying amount of the loan to Big Box from $77,968 to $90,253 and records the following entry: Dr. Loan receivable (or allowance for loan losses) $12,285 Cr. Credit loss $12,285
Fair value
69.
Fair value is dened in paragraph 3856.05(f) as follows: Paragraph 3856.05(f) Fair value is the amount of the consideration that would be agreed upon in an arms length transaction between knowledgeable, willing parties who are under no compulsion to act. (Paragraph 3856.A7 provides related application guidance.)
70.
In practice, this denition can be difcult to apply. As such, there are a few things to keep in mind when trying to determine fair value for a particular instrument: (a) Fair value measurement presumes the going concern assumption applies. This means that fair value is not an amount an entity would pay in a forced transaction, involuntary liquidation or distressed sale. (b) Fair value reects the credit quality of the instrument, including any collateral or other credit enhancements. (c) Quoted prices in an active market are the best evidence of fair value so long as they reect actual and regularly occurring market transactions on an arms length basis, which will be the case when prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency. (d) When current rates or prices are unavailable, the price of the most recent transaction may provide evidence of the current fair value considering whether there have been any signicant changes in the economic circumstances since the time that the most recent transaction took place. (e) In the absence of a recent transaction for the instrument that is being measured, fair value may be based on a recent price for a similar proxy instrument. (f) In some cases, it may be prudent to consider engaging the use of a specialist or valuator in determining fair value.
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71.
Example Fair value sources by instrument Instrument Equity instrument quoted in an active market Non-option derivatives Fair value or proxy Latest closing price Mid-market prices or rates consistent with prices that would be supplied by banks Quote from a derivatives dealer Bid prices for purchased options and ask prices for issued options (mid-market prices may be used) Quote from a derivatives dealer Software packages Present value of all future cash receipts discounted using the prevailing market rates of interest for a similar instrument (as to currency, term, type of interest rate, or other relevant factors) with a similar credit rating
Option derivatives
Interest-free or low interest loans
72.
Example Calculating the change in fair value of a forward contract ABC Corporation (ABC), purchases a forward contract (a derivative) on January 15, 20X1 to purchase $100,000 USD on August 1, 20X1 at a rate of 1.045. ABC will receive $100,000 USD in exchange for $104,500 CAD on August 1, 20X1. The spot rate on January 15, 20X1 was 1.05. On March 31, 20X1. ABCs year-end, the forward rates for US dollars, as published in the local newspaper or reputable website, are as follows: 1-Month 2-Months 3-Months 4-Months 5-Months 6-Months Forward rate 1.049 1.048 1.046 1.047 1.046 1.045 The change in the fair value of the foreign currency forward contract at March 31, 20X1 is calculated as follows: f(t) = (F(t) K)e rf(T t) dened as follows: f(t) = forward contract value at time t F(t) = forward exchange rate at time t K = price per contract at inception rf = Canadian risk free interest rate T-t = duration of the contract in years. When the effect of time value is not material, the change in the intrinsic value of the contract may be used as a proxy for the change in its fair value. The effect of time value is small when the interest rates are low, when the contract is of short duration or when the change in the intrinsic value of the forward contract is not material. The change in intrinsic value is calculated as follows: Foreign currency forward contract x (contract rate contract rate in effect at the period-ended) Using the example above, the change in fair value of the foreign currency forward contract is estimated as follows: $100,000 * (1.047 forward rate in 4 months time 1.045 contracted rate) = $200. The Company would record the following entry to record the change in fair value of the forward contract: Dr. Derivative asset $200 Cr. Unrealised gain on derivative (net income) $200 Alternatively, the providing nancial institution might provide an estimated fair value for the forward contract.
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73.
Example Calculating the change in fair value of an interest-rate swap On January 1, 20X1, Coverage Corporation borrowed $5,000,000 repayable in ve years at prime plus 1.5%. On June 1, 20X1, Coverage Corporation decides to enter into an interest rate swap to minimize its exposure to uctuations in the prime rate. Under the swaps terms, Bank of Lenders pays Coverage Corporation prime plus 1.5% and Coverage pays Bank of Lenders 3.5% xed for the remaining term of the loan. If Coverage Corporation does not want to apply hedge accounting, Coverage Corporation is required to measure the swap at fair value at each reporting period. The fair value of the swap can be estimated with the use of commercially available software and prices or by requesting an approximate fair value of the swap from Bank of Lenders. To verify whether the estimate received from the bank is reasonable, the following technique can be used: Notional amount $5,000,000 Number of months remaining in swap agreement 54 months Prime Rate Current 1.30% Expected average High end of range 3.80% Expected average Low end of range 3.30% Interest rate of the debt Variable 2.80% Interest rate of the swap Fixed 3.50% Discount rate risk-free rate based on remaining term swap 2.00% Discounted cash ows High/Low estimate High Fixed rate $5,000,000 x 3.50% = $(175,000) Variable $5,000,000 x 3.80% = $190,000 Difference per year $15,000 Difference per month $ 1,250 Present value of future cash ows $64,500 Low Fixed rate $5,000,000 x 3.50% = $(175,000) Variable $5,000,000 x 3.30% = $165,000 Difference per year $(10,000) Difference per month $ (833) Present value of future cash ows $(43,000) External valuation Mark-to-market from bank $ 52,000 Conclusion: Because the banks valuation is within the high/low range, the value provided by the bank is reasonable. Note: If the swap value is material to the overall nancial statements, a more precise technique should be considered to estimate the reliability of the banks estimate, such as determining points along the interest rate curve over the remaining term of the swap.
Indexed nancial liabilities
74.
Section 3856 requires that the readers of an entitys nancial statements are alerted to any terms of a liability that might cause unusual future cash ows. When a liability is indexed to a measure of the entitys performance, it must be measured using an estimate of the intrinsic value of the indexing feature at the reporting date. Examples of indexing features are payments that are based on actual or average net income or earnings before interest, taxes, depreciation and amortization (EBITDA), the increase in net income or EBITDA above a specied baseline and the increase in share price or value above a specied baseline. Any amount recognized at a reporting date as an additional amount payable is reported as a separate component of interest expense. If at a subsequent reporting date the additional payment would not be required, the carrying amount of the liability is revised and the adjustment is recognized as a deduction from interest expense. In applying a formula that ultimately measures the payment based on performance over a number of periods, some of which have yet to occur, the formula is applied as if the formula applies only to periods ending with the reporting date.
75.
76.
Example Indexed nancial liability On July 1, 20X1, Private Corporation issues a $100,000 ve-year note bearing interest at 8% plus 10% of the average earnings before interest, taxes, depreciation and amortization (EBITDA) for the ve years ending June 30, 20X6. The note is measured as follows: Date Entries required Reported balances July 1, 20X1 Dr. Cash $100,000 Note payable $100,000 Cr. Notes payable $100,000 June 30, 20X2 Dr. Interest expense $13,300 EBITDA $ 53,000 Cr. Cash $8,000 Note payable 105,300 Cr. Note payable 5,300 (10% x $53,000) June 30, 20X3 Dr. Interest expense $2,700 EBITDA(loss) $(65,000) Dr. Note payable 5,300 Note payable 100,000 Cr. Cash $8,000 June 30, 20X4 Dr. Interest expense $9,200 EBITDA $48,000 Cr. Cash $8,000 Note payable 101,200 Cr. Note payable $1,200 (10% x (53,000 65,000 + 48,000)/3) June 30, 20X5 Dr. Interest expense $9,800 EBITDA $84,000 Cr. Cash $8,000 Note payable 103,000 Cr. Note payable 1,800 (10% x (53,000 65,000 + 48,000 + 84,000)/4) 1,200 June 30, 20X6 Dr. Interest expense $9,500 EBITDA $105,000 Cr. Cash $8,000 Note payable 104,500 Cr. Note payable 1,500 (10% x (53,000 65,000 + 48,000 + 84,000 + 105,000)/5) 3,000 PRESENTATION Offsetting
77.
Offsetting refers to the presentation of a recognized nancial asset and a recognized nancial liability as a single net asset or liability on the face of the balance sheet. Neither instrument is actually derecognized. (See paragraph 86 below for discussion of derecognition.) Offsetting differs from derecognition in the following ways: (a) No gain or loss is recognized. (b) Unlike a transfer of assets that results in sale treatment because the entity surrenders control (a derecognition transaction), nancial assets that are offset by nancial liabilities continue to be controlled by their owner. (c) Unlike an extinguishment of debt, where the debtor is legally released from its obligation (a derecognition transaction), the debtor remains obligated to repay the debt that is offset against one or more assets.
78.
79.
The determination of whether nancial assets should be offset with nancial liabilities is important because gross or net presentation can have a signicant impact on the following key ratios (among others) that are sometimes used to measure liquidity and protability: (a) Current ratio (b) Return on assets (c) Debt to equity or other leverage measures.
80.
From a risk perspective, entering into contracts with the legally enforceable right of offset may help manage an entitys exposure to credit and settlement risk with counterparties. The two conditions that must be present in order to offset are: (a) An entity has a legally enforceable right to set off the recognized amounts; and (b) An entity intends either to settle on a net basis, or to realize the asset and settle the liability simultaneously.
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Legal right of offset
81.
A legally enforceable right of offset is a function of both the facts and circumstances of the transaction and its governing laws and regulations. In some cases, laws or regulations, or the operation of common law may contradict rights otherwise provided by contract. A right of offset that is legally enforceable only in the event of the default of one of the parties to the contract does not satisfy the requirement that the right of set-off be currently enforceable. Further, such a contract does not meet the intent requirement of the standard.
Intent to settle net
82.
83.
The intention condition is necessary to faithfully represent the entitys expected sources and uses of cash. Intent to settle net must be documented or supported by the entitys history of set-off in similar situations. In the absence of an explicit settlement mechanism and date, an entity cannot assert that it intends to net settle two or more transactions. Interest, dividends, losses and gains
84.
The presentation of any interest, dividends, losses and gains relating to nancial instruments in either income (or expenses) or equity will be dictated by the classication of the nancial instrument on the balance sheet. Distributions to holders of a nancial liability are presented in net income as expense, e.g., interest. Distributions on equity instruments are presented directly in equity, e.g., dividends. Similarly, gains and losses associated with redemptions or renancings of instruments classied as liabilities are reported in net income, and redemptions or renancings of instruments classied as equity are reported as changes in equity. Amortization of nancing fees and transaction costs, debt premiums or discounts may be presented as a separate component of interest income or expense. DERECOGNITION Financial assets
85.
86.
Derecognition refers to the process of removing a previously recognized nancial asset or nancial liability from an entitys balance sheet. Section 3856 provides guidance on securitization of receivables formerly in ACCOUNTING GUIDELINE AcG 12, Transfers of Receivables, and derecognition of nancial liabilities. The focus of the guidance on transfers of assets focuses on transactions that result in the transferor retaining some continuing interest in the transferred assets.
Securitization transactions
87.
Receivables such as mortgage loans, automobile loans, trade receivables, credit card receivables, and other revolving charge accounts are assets commonly transferred in securitizations. Securitizations of mortgage loans may include pools of singlefamily residential mortgages or other types of real estate mortgage loans (for example, multi-family residential mortgages and commercial property mortgages). Securitizations of loans secured by chattel mortgages on automotive vehicles as well as other equipment (including direct nancing or sales-type leases) are also common. Both nancial and non-nancial assets can be securitized. Life insurance policy loans, patent and copyright royalties, and even taxi medallions have been securitized but securitizations of non-nancial assets are outside the scope of Section 3856. An originator of a typical securitization (the transferor) transfers a portfolio of receivables to a special purpose entity (SPE), commonly a trust or co-ownership pool. In certain pass-through and pay-through securitizations, receivables are transferred to the SPE at the inception of the securitization, and no further transfers are made; all cash collections are paid to the holders of benecial interests in the SPE. In certain revolving-period securitizations, receivables are transferred at the inception and also periodically (daily or monthly) thereafter for a dened period (commonly three to eight years), referred to as the revolving period. During the revolving period, the SPE uses most of the cash collections to purchase additional receivables from the transferor on prearranged terms. In these structures, benecial interests in the SPE are sold to investors and the proceeds are used to pay the transferor for the assets transferred. Those benecial interests may comprise either a single class having equity characteristics or multiple classes of interests, some having debt characteristics and others having equity characteristics. The cash collected from the portfolio is distributed to the investors and others as specied by the legal documents that established the SPE. Pass-through, pay-through, and revolving-period securitizations that meet the criteria in paragraph 3856.B5 qualify for sale accounting. All nancial assets obtained or retained and liabilities incurred by the originator of a securitization that qualies as a sale are recognized and measured as provided in paragraph 3856.B39. This includes the implicit forward contract to sell
88.
89.
90.
new receivables during a revolving period, which may become valuable or onerous to the transferor as interest rates and other market conditions change. 91. Illustration Typical securitization transaction
Transferor of receivables Trust or SPE
interest holders (investors)
92.
Receivables are derecognized only when control has been surrendered. The conditions necessary to achieve transfer of control are set out in paragraphs 3856.B5-3856.B37. Paragraphs 3856.B38-B40 set out the accounting steps to derecognize the transferred assets, to recognize assets obtained or retained in the transfer transaction and liabilities incurred or assumed. Measurement requirements for the items incurred and retained are set out in paragraphs 3856.B41-3956.B47.
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Measurement of interest held after a transfer of receivables
93.
Example Recording transfers with proceeds of cash, derivatives, and other liabilities Company A sells loans with a fair value of $1,100 and a carrying amount of $1,000. Company A retains no servicing responsibilities but obtains an option to purchase loans from the transferee similar to the loans sold (which are readily obtainable in the marketplace) and assumes a limited recourse obligation to repurchase delinquent loans. Company A agrees to provide the transferee a return at a oating rate of interest even though the contractual terms of the loan are xed rate in nature (that provision is effectively an interest rate swap). Fair values Cash proceeds $1,050 Interest rate swap 40 Call option 70 Recourse obligation 60 Net proceeds Cash received Plus: Call option Interest rate swap Less: Recourse obligation Net proceeds Gain on sale Net proceeds Carrying amount of loans sold Gain on sale Journal entry Dr. Cash Dr. Interest rate swap Dr. Call option Cr. Loans Cr. Recourse obligation Cr. Gain on sale To record transfer
$1,050 70 40 (60) $1,100
$1,100 1,000 $ 100
$1,050 40 70 $1,000 60 100
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94.
Example Recording transfers of partial interests Company B sells a pro rata 90% interest in loans with a fair value of $1,100 and a carrying amount of $1,000. There is no servicing asset or liability, because Company B estimates that the benets of servicing are just adequate to compensate it for its servicing responsibilities (note: servicing assets and liabilities are discussed in further detail immediately following this example). Fair values Cash proceeds for 90% interest sold $ 990 10% interest retained [($990 9/10) x 1/10] 110 Percentage of Allocated total fair value carrying amount $ 90 $ 900 10 100 $100 $1,000
Carrying amount based on relative fair values Nine-tenths interest sold One-tenth interest retained Total Gain on sale Net proceeds Carrying amount of loans sold Gain on sale Journal entry Dr. Cash Cr. Loans Cr. Gain on sale To record transfer
Servicing assets and liabilities
Fair value $ 990 110 $1,100
$990 900 $ 90
$990 $900 90
95.
Transferors sometimes agree to take on servicing responsibilities for transferred assets. Servicing activities include the following: (a) collecting principal, interest, and escrow payments from borrowers; (b) paying taxes and insurance from escrowed funds; (c) monitoring delinquencies; (d) executing foreclosure if necessary; (e) temporarily investing funds pending distribution. When an obligation is undertaken to service receivables, a servicing asset or a servicing liability is recognized, unless: the assets are securitized all of the resulting securities are retained the securities are classied and measured on an amortized cost basis.
96.
When the future benets of servicing the assets are not expected to compensate the transferor adequately for performing that work, the result is a servicing liability rather than a servicing asset. For example, if in the transaction illustrated in paragraph 93 above the transferor had agreed to service the loans without explicit compensation and it estimated the fair value of that servicing obligation at $50, net proceeds would be reduced to $1,050, the gain on sale would be reduced to $50, and the transferor would report a servicing liability of $50. These revised facts are illustrated in paragraph 97 below. Servicing becomes a distinct asset or liability only when contractually separated from the underlying assets by sale, or securitization of the assets with servicing retained, or separately purchased or assumption of the servicing responsibility.
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97.
Example Recognizing a servicing liability in a transfer of receivables (continued from paragraph 93 above) Company C sells loans with a fair value of $1,100 and a carrying amount of $1,000. Company C has agreed to service the loans without explicit compensation and it estimates the fair value of that servicing obligation at $50. Company C obtains an option to purchase from the transferee loans similar to the loans sold (which are readily obtainable in the marketplace) and assumes a limited recourse obligation to repurchase delinquent loans. Company C agrees to provide the transferee a return at a oating rate of interest even though the contractual terms of the loan are xed rate in nature (that provision is effectively an interest rate swap). Fair values Cash proceeds $1,050 Interest rate swap 40 Call option 70 Recourse obligation 60 Servicing liability (50) Net proceeds Cash received Plus: Call option Interest rate swap Less: Recourse obligation Additional recourse obligation Net proceeds Gain on sale Net proceeds Carrying amount of loans sold Gain on sale Journal entry Dr. Cash Dr. Interest rate swap Dr. Call option Cr. Loans Cr. Recourse obligation Cr. Servicing liability Cr. Gain on sale To record transfer
$1,050 70 40 (60) (50) $1,050
$1,050 1,000 $ 50
$1,050 40 70 $1,000 60 50 50
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98.
Example Sale of receivables with servicing retained Company D originates $1,000 of loans that yield 10% interest income for their estimated lives of nine years. Company D sells the $1,000 principal plus the right to receive interest income of 8% to another entity for $1,000. Company D will continue to service the loans, and the contract stipulates that its compensation for performing the servicing is the right to receive half of the interest income not sold. The remaining half of the interest income not sold is considered an interest-only strip receivable. At the date of the transfer, the fair value of the loans, including servicing, is $1,100. The fair value of the servicing asset is $40. Fair values Cash proceeds $1,000 Servicing asset 40 60 Interest-only strip receivable Percentage of Allocated total fair value carrying amount 91.0 $ 910 3.6 36 5.4 54 100.0 $1,000
Carrying amount based on relative fair values Loans sold Servicing asset Interest-only strip receivable Total Gain on sale Net proceeds Carrying amount of loans sold Gain on sale Journal entries Dr. Cash Cr. Loans Cr. Gain on sale To record transfer Dr. Servicing asset Dr. Interest-only strip receivable Cr. Loans To record servicing asset and interest-only strip receivable 99.
Fair value $1,000 40 60 $1,100
$1,000 910 $ 90
$1,000 $910 90
$36 54 $90
The example in paragraph 97 demonstrates how a transferor would account for a simple securitization in which servicing is retained. Company D might instead transfer the receivables to a corporation or a trust that is a qualifying SPE. The qualifying SPE then securitizes the loans by selling benecial interests to the public. The qualifying SPE pays the cash proceeds to the original transferor, which accounts for the transfer as a sale and derecognizes the receivables assuming that the criteria in paragraph 3856.B5 are met. Securitizations often combine the elements shown in all of the previous examples, as illustrated below.
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100. Example Recording transfers of partial interests with proceeds of cash, derivatives, other liabilities, and servicing Company E originates $1,000 of prepayable loans that yield 10% interest income for their nine-year expected lives. Company E sells nine-tenths of the principal plus interest of eight% to another entity. Company E will continue to service the loans, and the contract stipulates that its compensation for performing the servicing is the two% of the interest income not sold. Company E retains an option to purchase from the transferee loans similar to the loans sold (which are readily obtainable in the marketplace) and incurs a limited recourse obligation to repurchase delinquent loans. Fair values Cash proceeds $900 Call option 70 Recourse obligation 60 Servicing asset 90 One-tenth interest retained 100 Net proceeds Cash received Plus: Call option Less: Recourse obligation Net proceeds
$900 70 (60) $910 Percentage of Allocated total fair value carrying amount 83 $ 830 8 80 9 90 100 $1,000
Carrying amount based on relative fair values Interest sold Servicing asset One-tenth interest retained Total Gain on sale Net proceeds Carrying amount of loans sold Gain on sale Journal entries Dr. Cash Dr. Call option Cr. Loans Cr. Recourse obligation Cr. Gain on sale To record transfer
Fair value $910 90 100 $1,100
$910 830 $ 80
$900 70 $830 60 80
Dr. Servicing asset $80 Cr. Loans $80 To record servicing asset At the time of the transfer, Company E reports its one-tenth retained interest in the loans at its allocated carrying amount of $90.
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Fair value
101. Example Recording transfers if it is not practicable to estimate a fair value Company F sells loans with a carrying amount of $1,000 to another entity for cash plus a call option to purchase loans similar to the loans sold (which are readily obtainable in the marketplace) and incurs a limited recourse obligation to repurchase any delinquent loans. Company F undertakes to service the transferred assets for the other entity. In Situation I, Company F nds it impracticable to estimate the fair value of the servicing contract, although it is condent that servicing revenues will be more than adequate compensation for performing the servicing. In Situation II, Company F nds it impracticable to estimate the fair value of the recourse obligation. Situation I Situation II Cash proceeds $ 1,050 $ 1,050 Servicing asset (a) 40 Call option 70 70 Recourse obligation 60 (a) Fair value of loans transferred 1,100 1,100 Net proceeds Cash received Plus: Call option Less: Recourse obligation Net proceeds Carrying amount based on relative fair values (Situation I) Fair value $1,060 $1,060 Percentage of total fair value 100 100 Allocated carrying amount $1,000 $1,000 Situation I $1,050 70 (60) $1,060 Situation II $1,050 70 (a) $1,120
Loans sold Servicing asset Total Carrying amount based on relative fair values (Situation II)
Loans sold Servicing asset Total Journal entries Dr. Cash Dr. Servicing asset Dr. Call option Cr. Loans Cr. Recourse obligation Cr. Gain on sale To record transfer (a) Not practicable to estimate fair value. Situation I $1,050 (b) 70
Fair value $1,120 40 $1,160
Percentage of total fair value 97 3 100
Allocated carrying amount $ 970 30 $1,000
Situation II $1,050 30 70 $1,000 60 60 $1,000 150 (c)
(b) Assets are recorded at zero if an estimate of the fair value of the assets is not practicable. (c) The amount recorded as a liability in this example equals the sum of the known assets less the fair value of the known liabilities, that is, the amount that results in no gain or loss.
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Sales-type and direct nancing lease receivables
102. Example Recording transfers of lease nancing receivables with residual values At the beginning of the second year in a 10-year sales-type lease, Company G sells for $505 a nine-tenths interest in the minimum lease payments and retains a one-tenth interest in the minimum lease payments and a 100% interest in the unguaranteed residual value of leased equipment. Company G receives no explicit compensation for servicing, but it estimates that the other benets of servicing are just adequate to compensate it for its servicing responsibilities and, hence, initially records no servicing asset or liability. The carrying amounts and related gain computation are as follows: Carrying amounts Minimum lease payments $ 540 Unearned income related to minimum lease payments 370 Gross investment in minimum lease payments 910 Unguaranteed residual value 30 Unearned income related to residual value 60 Gross investment in residual value 90 Total gross investment in nancing lease receivable $ 1,000 Gain on sale Cash received Nine-tenths of carrying amount of gross investment in minimum lease payments Nine-tenths of carrying amount of unearned income related to minimum lease payments Net carrying amount of minimum lease payments sold Gain on sale Journal entry Dr. Cash Dr. Unearned income Cr. Lease receivable Cr. Gain on sale To record sale of nine-tenths of the minimum lease payments at the beginning of year two Financial liabilities
Extinguishment of nancial liabilities
505 819 (333) 486 $ 19
$505 333 $819 19
103. A nancial liability (or a part of a nancial liability) that is extinguished should be derecognized. Previous standards referred to an extinguishment as a settlement. A liability is extinguished when the obligation is discharged or cancelled, or expires. Section 3856 provides guidance on distinguishing between an extinguishment and a modication of a nancial liability. A renegotiation of a nancial liability is considered to be an extinguishment when the new terms of the instrument differ substantially from the original. Paragraph 3856.A52 sets out the two circumstances when a renegotiated liability is considered to differ substantially from the original: (a) the present value of the cash ows under the new terms differs by at least 10% from the present value of the remaining cash ows of the original liability; or (b) there is a change in creditor and the original debt is legally discharged. 104. Cash ows can be affected by changes in principal amounts, interest rates, or maturity. They can also be affected by fees exchanged between the debtor and creditor to effect changes in such attributes as: (a) Recourse or non-recourse features (b) Priority of the obligation (c) Collateral (d) Debt covenants and/or waivers (e) The guarantor (f) Call or redemption features.
If the terms of a debt instrument are changed or modied, such as in any of the ways described above, and the resulting cash ow effect on a present value basis is at least 10%, the changes are substantial and should be accounted for as a settlement of the original debt. 105. The following scenarios do not result in a settlement and would not result in gain or loss recognition: (a) An announcement of intent by the debtor to call a debt instrument at the rst call date. (b) An agreement with a creditor that a debt instrument issued by the debtor and held by a different party will be redeemed. 106. To determine whether a transaction meets the conditions in paragraph 3856.A52(a), the following should be considered: (a) The cash ows to be discounted include: all cash ows specied by the terms of the new debt instrument; plus any amounts (including fees) paid by the debtor to the creditor and allocated to the debt instrument; less any amounts (including fees) received by the debtor from the creditor as part of the modication or exchange.
(b) If the original debt instrument and/or the new debt instrument have a oating interest rate, then the variable rate in effect at the date of the modication or exchange is to be used to calculate the cash ows of the variable rate instrument. (c) If either the new debt instrument or the original debt instrument is callable or puttable, then separate cash ow analyses are to be performed assuming exercise and non-exercise of the call or put. The cash ow assumptions that generate the smaller change would be the basis for determining whether the 10 % threshold is met. (d) If the debt instruments contain contingent payment terms or unusual interest rate terms, judgment should be used to determine the appropriate cash ows. (e) The discount rate to be used to calculate the present value of the cash ows is the effective interest rate, for accounting purposes, of the original debt instrument. (f) If within a year of the current transaction the debt has been modied or exchanged without being deemed to be a settlement, then the original debt terms that existed a year ago should be used to determine whether the current modication or exchange is a settlement. 107. If the present values of the cash ows of the original and new debt instruments differ by at least 10%, then: (a) the new debt instrument is initially recorded at its fair value adjusted by any fees or transaction costs incurred to renegotiate the debt; and (b) the difference between the fair value of the new liability and the carrying amount of the original liability, including all fees and transaction costs originally included in that carrying amount, is recognized as a gain or loss on extinguishment of the original liability. 108. The fair value is also used to determine the effective interest rate of the new instrument if the effective interest method is used. If the effective interest method is not used, the difference between the principal amount of the new debt and its carrying amount must be amortized over the life of the new debt on a systematic basis. 109. If the present values of the cash ows of the original and new debt instruments differ by less than 10%, any fees or costs associated with the renegotiation are added to the carrying amount of the instrument and amortized over the remaining life of the instrument together with the fees or costs previously capitalized. If the fees and costs previously capitalized are being amortized using the effective interest method, a new effective interest rate must be calculated based on the revised carrying amount and cash ows. 110. Sub-participation of a debt instrument by the lead creditor to other lenders does not affect the treatment of the instrument by the obligor unless the cash ows are also altered because the borrowers obligation to the lead bank is not discharged. However, if the debt has been syndicated, and the borrowers obligations are to each syndicate member, it is possible that a renegotiation effectively creates more than liability if individual syndicate members agree to different new terms. 111. When an intermediary is involved in securing nancing or renegotiating debt for a borrower, it may be necessary to assess whether the intermediary acts as a principal or an agent to determine whether the original debt has been discharged (paragraph 3856.A51). The following examples are indicative, not denitive, and the entity may need to evaluate whether the transaction causes the entity to become publicly accountable: (a) When the intermediarys role is restricted to placing or reacquiring debt for the debtor without placing its own funds at risk, the intermediary is an agent. When the intermediary places or reacquires debt for the debtor by committing its funds and is subject to the risk of loss of those funds, the intermediary is acting as principal.
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(b) When an intermediary places notes issued by the debtor, and the placement is done under a best-efforts agreement, the intermediary is acting as agent. Under a best-efforts agreement, an agent agrees to buy only those securities that it is able to sell to others; if the agent is unable to remarket the debt, the issuer is obligated to pay off the debt. The intermediary may be acting as principal if the placement is done on a rmly committed basis, which requires the intermediary to hold any debt that it is unable to sell to others. (c) When the debtor directs the intermediary and the intermediary cannot independently initiate an exchange or modication of the debt instrument, the intermediary is an agent. The intermediary may be a principal if it acquires debt from or exchanges debt with another debt holder in the market and is subject to loss as a result of the transaction. (d) When the only compensation derived by an intermediary from its arrangement with the debtor is a pre-established fee, the intermediary is an agent. When the intermediary derives gains based on the value of the security issued by the debtor, the intermediary is a principal. 112. Example Investment banker acting as agent When a third party investment banker acts as agent on behalf of the debtor, its activities are treated as actions of the debtor. When the investment banker acquires debt instruments from holders for cash, the transaction is a settlement even if the investment banker subsequently transfers a debt instrument with the same or different terms to the same or different investors. When the investment banker acquires debt instruments from holders for cash and contemporaneously issues new debt instruments for cash, a settlement has occurred only if the two debt instruments have substantially different terms, as dened above. In transactions involving a third party investment banker acting as principal, the investment banker is considered a debt holder like other debt holders. Thus, if the investment banker acting as principal acquires debt instruments from other parties, the acquisition by the investment banker does not impact the accounting by the debtor, and exchanges or modications between the debtor and the investment banker would follow the requirements discussed above.
Modication of line of credit or other revolving debt arrangement
113. Paragraph 3856.A56 provides guidance to help determine whether changes to a revolving credit facility constitute replacement of one facility with another or a modication of the original instrument. Because future cash ows are not known, the extent of the modication is evaluated by comparing the capacity of the facility before and after the change. Capacity is estimated as the product of the maximum available amount of the debt and the maximum term.
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114. Example Determining whether borrowing capacity exceeds that of the old arrangement and related accounting implications of fees and costs Terms of original revolving debt: 5-year term (3 years remaining) $1 million commitment amount. The borrowing capacity under the original arrangement at the time of the change is $3 million, the product of the remaining term (3 years) and the commitment amount ($1 million). The following changes are made (with the same creditor) to the original terms: Scenario A: The commitment amount is increased to $1.5 million, the term of the new arrangement remains at 3 years (borrowing capacity is $4.5 million). Scenario B: The commitment amount is decreased to $200,000, the term of the new arrangement is 5.5 years (borrowing capacity is $1.1 million). Scenario C: The original revolver is replaced with a 3-year $750,000 term loan, with principal due at the end of 3 years (borrowing capacity is $2.25 million). Scenario D: The original revolver is replaced with a 3-year $1 million term loan, with principal due at the end of 3 years (borrowing capacity is $3 million). In all of the examples, at the time the change is made to the original arrangement, $15,000 of unamortized costs relating to the original arrangement remain on the debtors balance sheet; the debtor pays a fee of $10,000 to the creditor, and the debtor incurs third-party costs of $20,000. Old New borrowing borrowing Accounting treatment Accounting treatment of fees and Scenario capacity capacity of unamortized costs third-party costs incurred A $3 million $4.5 million $15,000 is amortized over 3 years $30,000 is amortized over 3 years B $3 million $1.1 million 63% of the unamortized costs $30,000 is amortized over 5.5 years ($9,450) are written off; the remaining costs ($5,550) are amortized over 5.5 years C $3 million $2.25 million 25% of the unamortized costs $30,000 is amortized over 3 years ($3,750) are written off; the remaining costs ($11,250) are amortized over 3 years. D $3 million $3 million $15,000 is amortized over 3 years $30,000 is amortized over 3 years
Extinguishing nancial liabilities with equity instruments
115. When a debtor settles all or part of a liability by issuing shares to the creditor in a debt for equity swap, the equity instruments are considered to be consideration paid. The equity instruments are measured at the more reliably measurable of the fair value of the equity or the fair value of the liability at the date of extinguishment. Any difference between the carrying amount of the nancial liability (or part of a nancial liability) extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, is recognized in prot or loss. 116. Fair value of the equity issued best reects the total amount of consideration paid in the transaction, which may include a premium that the creditor requires to renegotiate the terms of the nancial liability. However, when it is not practicable to determine the fair value of the shares issued, the fair value of the liability should be used. Because debt for equity swaps often take place in situations when the terms of the nancial liability have been breached rendering the liability payable on demand, and because shares would not be issued if the entity was able to repay the debt, the guidance in paragraph 3856.A12 is not applied in measuring the fair value of all or part of the extinguished nancial liability. 117. When the issue of an entitys equity shares reects consideration paid for both the extinguishment of part of a nancial liability and the modication of the terms of a remaining part of the liability, the consideration paid should be allocated between the part of the liability extinguished and the part of the liability that remains outstanding. The entity would consider this allocation in determining the prot or loss to be recognized on the part of the liability extinguished and in its assessment of whether the terms of the remaining liability have been substantially modied.
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Convertible liabilities
118. On extinguishment of a convertible debt instrument: When one or both components are measured at fair value Consideration allocation The consideration paid is allocated to: Each component on the same basis that was used for the original allocation of the proceeds received on issuance (paragraph Any residual amount is allocated to the 3856.A36(b)). equity component. (paragraph 3856.A36(a)) Conversion is in When the conversion option is exercised in accordance with the original terms of the accordance with the instrument, the carrying amount of the equity element (conversion feature), if any, plus the original terms (no cash) carrying amount of the liability element (including any accrued but unpaid interest), are transferred to share capital. No gain or loss is recognized. (Paragraph 3856.A34) Conversion is settled in When the conversion option is exercised and the issuer settles the obligation in cash, a gain cash or loss on extinguishment of the liability element is recognized in net income. The settlement of the equity element (i.e., the conversion feature) is treated as a capital transaction, with any gain credited to contributed surplus and any loss applied rst against contributed surplus to the extent of prior gains, and then against retained earnings. (Paragraph 3856.A35) When the issuer offers a more favourable conversion ratio than that originally specied as per Conversion is not in the debt agreement, or offers additional shares to entice the holder to convert by a specied accordance with the original terms (favourable time, the number of shares converted under the original terms are measured at the original contract price (as per the original conversion ratio), and any additional shares issued are conversion ratio) measured at fair value. Any gain or loss recognized on the liability component is reected in income, whereas any difference between the carrying amount and amount considered to be settled on the conversion option is treated as a capital transaction. (Paragraph 3856.A37) Conversion option expires The settlement is accounted for at its redemption value which is also the stated principal amount of the instrument. The liability component is derecognized, and any carrying amount of the equity component is transferred to contributed surplus. (Paragraph 3856.A38) When the conversion feature was initially measured at zero The consideration paid is allocated to: The liability up to its carrying amount plus any accrued interest; then
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119. Example Accounting on extinguishment of a compound nancial instrument Capital Corporation (Capital) needed to raise $10,000 to fund its operations and had difculty nding nancing. As a result, it issued bonds in the aggregate amount of $10,000 which were repayable in 5 years time and carried an annual interest rate of 6%. The bonds were convertible on a one-for-one basis into common shares of the Capital upon default of the terms. The conversion feature was measured using the Black-Scholes Model at $250 on initial issuance of the bond. Capital could have initially recorded the issuance of the bonds using one of the following two alternatives: Conversion feature is measured at zero Conversion feature is measured at fair value Dr. Cash $10,000 Dr. Cash $10,000 Cr. Liability $10,000 Cr. Liability $9,750 Cr. Conversion feature 250 The following table illustrates the accounting treatment that would follow various different extinguishment scenarios (the illustrations assume that all interest is paid as due): Scenario Conversion feature was measured at zero Conversion feature was measured at fair value Conversion in year 3 Dr. Liability $10,000 Dr. Liability $9,000* is in accordance with Cr. Share capital $10,000 Dr. Conversion feature 250 the original terms (no Cr. Share capital $10,150 cash) Conversion in year 3 Dr. Liability is settled in cash Cr. Cash Cr. Gain $10,000 Dr. Liability $9,500 Dr. Conversion feature 500 Cr. Cash Cr. Gain Cr. Contributed surplus $9,900* 250 $9,500 634 16
Extinguishment is not in accordance with the original terms (favourable conversion ratio)
To entice conversion in year 3, Capital offers an additional 2,000 shares over and above the original one-for-one ratio. The additional 2,000 shares have a fair value of $2 each on issuance. Dr. Liability $10,000 Dr. Liability $9,900* Dr. Loss 4,000 Dr. Conversion feature 250 Cr. Share capital $14,000 Dr. Loss 3,755 Dr. Equity 95 Cr. Share capital $14,000 Dr. Liability Cr. Cash $10,000 $10,000 Dr. Liability Cr. Cash Dr. Conversion feature Cr. Contributed surplus $10,000 $10,000 $250 $250
Settlement upon expiry or maturity of conversion option and payment in cash
Settlement upon Dr. Liability $10,000 Dr. Liability $10,000 expiry or maturity Cr. Share capital $10,000 Cr. Share capital $10,000 of conversion option Dr. Conversion feature $250 and payment in Cr. Contributed surplus $250 shares * The liability component will have been amortized over 5 years to its maturity amount, in this example the straight-line method of amortization is being used, but the effective interest method can equally be applied. HEDGE ACCOUNTING Introduction 120. Hedging is an activity intended to modify an entitys exposure to one or more risks. Hedging involves creating an offset to one or more characteristics of a contract or group of contracts with another contract. Many hedges occur naturally when features of a contract creating rights for the entity are offset by features of a contract creating obligations. For example, the foreign exchange risk created by selling goods or services in US dollars might be offset by purchases in US dollars. To the extent that natural offsets do not occur within the entitys business model, an entity can use derivative contracts to create
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offsets. For example, an interest rate swap can be used to effectively convert oating rate debt to a xed rate, making it easier to predict and manage cash ows. 121. Hedge accounting refers to a process whereby the normal accounting for the revenue or expense, gains or losses from a contract is modied to offset the timing of income recognition on another contract. Over the life of the contracts designated in a hedging relationship, the total amount of income is unchanged. Hedge accounting removes volatility from earnings that might be confusing to a nancial statement reader for situations where the entity has taken steps to pre-determine a desired economic result. 122. Because hedge accounting changes the normal accounting treatment of one or more components of a hedging relationship, the choice must be designated and documented at the inception of the relationship. The documentation must specify: (a) the hedged item; (b) the related hedging item; (c) the nature of the specic risk exposure or exposures being hedged; and (d) the intended term of the hedging relationship. 123. The entity must ensure that the critical terms of the hedging item and the hedged item are the same, both at the inception of the relationship and throughout its term. Section 3856 denes the conditions that must be met to meet the required degree of offset and these are discussed further in the following paragraphs. When an entity designates an anticipated transaction as the hedged item, it must be probable that the transaction will occur in the amount and at the time expected. Probable should be interpreted in its normal use of the word, i.e., more likely than not. However, the entity needs to be realistic about its expectations and should not designate transactions that are marginally probable. 124. It is very important to understand that hedge accounting cannot be designated in arrears, other than as permitted by the special transition paragraph added in 2011 (see paragraph 3856.56). A transaction can be designated as the hedged item after its initial recognition, but a derivative hedging item can only be designated at inception and the accrual treatment of the hedging derivative cannot be applied retroactively. 125. Section 3856 also does not permit an entity to change the designation; hedge accounting may not be discontinued unless: (a) one of the components ceases to exist; (b) a hedged anticipated transaction is no longer probable to occur; or (c) something happens that alters the offset between the two contracts. Hedged item 126. The hedged item is the contract or anticipated contract or group of contracts that creates the risk exposure. For example, a company is exposed to foreign currency risk when it agrees to purchase machinery from a foreign supplier that requires payment in its own currency. The assets cost would be the hedged item if it were designated in a qualifying hedging relationship. To modify the exposure to the risk that the exchange rate in effect when the company settles the payable is less favourable than the rate in effect when the purchase decision is made, management may enter into a forward foreign exchange contract to buy the amount of foreign currency necessary to x the price of the machine. 127. Section 3856 only permits the following contracts to be designated as hedged items: (a) anticipated commodity purchases or sales for the risk that the price of the commodity will change unfavourably; (b) anticipated foreign currency cash ows for the risk of unfavourable movements in the exchange rate; (c) interest receipts or payments on an interest-bearing asset or liability to either protect the fair value of the asset or liability or to effectively lock in (or x) its interest rate; (d) both the interest rate and foreign currency risk in a foreign currency denominated interest-bearing asset or liability when hedged with a cross-currency interest rate swap; and (e) the foreign exchange risk associated with the net investment in a self-sustaining foreign operation. 128. More than one contract may be hedged by a single derivative contract as long as each transaction meets the requirements for hedge accounting and the aggregate amount of the designated contracts matches the amount of the hedging contract.
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Hedging item 129. The documentation also identies the hedging item. Hedge accounting in Section 3856 always alters the accounting treatment of the hedging item in contrast to the accounting standards for publicly accountable enterprises where the mechanics of hedge accounting may affect either the hedged or hedging item, depending on the type of hedging relationship. In Section 3856, permissible hedging instruments are limited to: (a) commodity or foreign exchange forward contracts; (b) basic interest rate swaps; (c) basic cross-currency interest rate swaps; (d) a foreign currency-denominated nancial asset, but only when designated as a hedge of the net investment in a selfsustaining foreign operation. Commodity hedge 130. The terms of the hedging instrument must match most of those of the hedged item. This ensures that any gains or losses on the hedging instrument will be offset by the effect of the hedged risk on the hedged item. When hedging commodity price risk, (a) the quantity must match; (b) the grade or purity must be similar;1 (c) each hedged anticipated purchase or sale must occur within 30 days2 of the maturity date of the hedging forward; (d) it must be probable that the anticipated purchase or sale will occur at the time and in the amount expected; and (e) the fair value of the forward contract at the inception of the relationship must be zero. This means that the forward contract must be designated at the time it is created. 131. Example Hedge of an anticipated purchase of a commodity Jules Jewels (JJ) is a successful jewellery designer and manufacturer located in Toronto. Its products are sold nationally in boutiques and major department stores. JJ has rm orders from customers for products requiring approximately 1,000 ounces of pure gold to be manufactured in June and July 20X1 and committed its prices when the June 20X1 forward price of gold was US$1,400 per ounce based on the CBOT June contract. JJ purchases gold alloys from a rener who invoices at the spot price on the shipping date. Although these alloys are of differing purities, their prices vary directly with changes in the spot price of pure gold and JJ has calculated its 1,000 ounce requirement based on the purities of these alloys. To ensure it achieves its target gross margin on its anticipated sales, JJ buys 10 contracts in June 20X1 (100 ounces per contract) on the CBOT at US$1,400. Because the Canadian dollar had been trading near par with the US dollar and expected to remain near par throughout the period until these orders are produced and shipped, JJ initially decided against taking any action to ensure it is not affected by changes in the Canada-U.S. exchange rate. Without hedge accounting, changes in the price of the June contract would be recognized immediately in JJs net income. JJ designates anticipated June and July inventory purchases equating to 1,000 ounces of gold as the hedged item, and the June 20X1 contracts as the hedging item. Currency hedge 132. The 2011 amendments permit a commodity hedger to also hedge currency risk encountered when either the anticipated purchase or sale or the hedging contract is not denominated in the currency in which the entity measures its transactions for nancial reporting purposes (see paragraph 3856.A63A). 133. Example Foreign currency hedge of an anticipated purchase of a commodity (continued from paragraph 131 above) In April 20X1, Jules Jewels (JJ) becomes nervous that the near par relationship between the Canadian and U.S. dollars will not continue through to the maturity of the futures contracts. Accordingly, JJ purchases a forward foreign exchange contract to buy $1,400,000 USD, maturing June 28, 20X1 (the last trading day of the June gold contract), and designates it as hedging the currency risk of the futures contracts.
Section 3856 originally required that the location parameter of the hedging contract match that of the hedged item. At the date of writing, the AcSB approved, subject to redeliberation following public exposure, changes to Section 3856, including replacing the requirement to match location with a requirement that the grade or purity of the commodity be similar. This minimizes basis risk but facilitates hedging when it is not practical to match the location parameter. Revised from 14 days in the May 2011 Exposure Draft. 42
134. When hedging currency risk, the following conditions apply: (a) the amount and currency of the forward contract must match that of the anticipated transaction or group of transactions; (b) the forward contract must mature within 30 days of the settlement date of the anticipated transaction or transactions; (c) it must be probable that each anticipated transaction will settle at the time and in the amount expected; and (d) the fair value of the forward contract must be zero when designated. 135. Note that documentation of the hedging relationship also identies the term of the relationship. In the example in paragraph 126 above, although the entity is hedging the anticipated purchase of the machine, and designates the purchase as the hedged item, the best economic protection occurs when the contract matures at the time the payable will be settled. Section 3856 permits designation of a forward contract maturing after the expected delivery date. In the 2011 ASPE improvements, the AcSB extended the maximum period of time between the occurrence of the hedged item and the maturity of the hedging contract to 30 days from the 14 days originally in Section 3856. 136. Example Hedge of anticipated foreign currency transaction A Western Wire (WW) purchases inventory for US$100,000 for delivery on February 7th. It intends to pay the account 30 days later, on March 7th. It designates a foreign exchange forward contract maturing on March 7th to purchase US$100,000 for C$105,000 as a hedge of the purchase. This relationship qualies for hedge accounting because the designated amounts, currencies and dates exactly match. Eastern Elements (EE) purchases inventory for US$100,000 for delivery on February 7th. It intends to pay the account 30 days later, on March 7th. It designates a contract to purchase US$100,000 for C$105,000 on March 31st as a hedge of the purchase. This relationship qualies for hedge accounting because the contract matures within 30 days of the settlement of the resulting account payable. Central Connectors (CC) purchases inventory for US$100,000 for delivery on February 7th. It intends to pay the account 60 days later, on April 7th. It hedges the purchase with a foreign exchange forward contract maturing on April 15th. This relationship qualies for hedge accounting once the amendments to Section 3856, proposed in the May 2011 Exposure Draft, are approved because the forward contract settles within 30 days of the settlement of the anticipated inventory purchase.
Hedge of interest rate risk 137. Interest rate swaps can be used to effectively convert either a oating rate asset or liability to a xed rate or a xed rate asset or liability to oating. Hedge accounting may be designated when: (a) The notional amount of the swap matches the principal amount of the interest-bearing asset or liability that is designated as the hedged item. (b) At the inception of the hedging relationship, the fair value of the swap is zero. (c) The formula for computing net settlements under the interest rate swap is the same for each net settlement. This means that the xed rate is the same throughout the term, and the variable rate is based on the same index and includes the same constant adjustment or no adjustment. (d) It is probable that the interest-bearing asset or liability will not be prepaid. (e) The index on which the variable leg of the swap is based matches the interest rate designated as the interest rate risk being hedged for that hedging relationship. (f) The swap matures within two weeks of the maturity date of the designated nancial asset or liability. (g) There is no oor or ceiling on the variable interest rate of the swap. (h) In the case of a hedge of a xed rate asset or liability, the interval between repricings of the variable interest rate in the swap is frequent enough (generally three to six months or less) to justify an assumption that the variable payment or receipt is at a market rate. (i) In the case of a hedge of a variable rate asset or liability, the repricing dates are within two weeks of those of the variable rate asset or liability.
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138. Example Interest rate swap Southern Semiconductors (SS) borrows $1,000,000 repayable in three years with interest oating at prime plus 5% payable quarterly. SS does not have the ability to prepay the debt. SS simultaneously enters into a three-year interest rate swap with a notional amount of $1,000,000 to pay xed at 4% and receive interest at the average prime rate. The combination of the interest rate swap and the debt obligation result in SS paying xed interest at 9%. Both the debt obligation and the interest rate swap require payments to be made or received quarterly. The variable rate on the interest rate swap resets quarterly. SS designates the interest rate swap as a hedge of the oating rate debt obligation attributable to changes in the interest rates.
Cross-currency interest rate swap
139. All of the requirements for designating an interest rate swap as a hedging instrument also apply to designating a crosscurrency interest rate swap as a hedge of both the interest rate and currency risk of an interest-bearing asset or liability with the following modications: (a) When settlements of a cross-currency interest rate swap are not on a net basis, the formula for computing the gross settlement amounts are the same for each settlement. This means that the xed rate is the same throughout the term, and the variable rate is based on the same index and includes the same constant adjustment or no adjustment. (b) The currency of one leg of the swap is the same as the currency in which the underlying hedged asset or liability is denominated and the currency of the other leg of the swap is the same as the currency in which the reporting entity measures the underlying hedged asset or liability in its nancial statements. (c) When multiple swaps are used, the combined effect of all of the swaps should result in the same effect as for a single swap. 140. Example Cross-currency interest rate swap Northern Networks (NN) measures and reports in Canadian dollars. It agreed to nance an American customers purchase of its product by extending a ve-year $1,000,000 USD loan at LIBOR + 3%. At the same time, it arranges a cross-currency interest rate swap that guarantees the Canadian dollar repayment of the loan and provides a xed rate of return on the loan. NN designates the swap as a hedge of the currency and interest rate risk of the loan. Hedge of the net investment in a self-sustaining foreign operation 141. Section 1651 permits an entity to designate either a derivative or a foreign currency-denominated cash instrument as a hedge of the currency uctuations created by translation of the net investment in a self-sustaining foreign operation. Electing hedge accounting for this relationship results in presentation of the foreign currency gains or losses on the hedging instrument in the separate component of shareholders equity to offset gains or losses on the investment. Mechanics of hedge accounting 142. Applying hedge accounting under Section 3856 results in cash or accrual accounting for derivatives used to hedge nancial assets and liabilities or anticipated transactions, such as expected purchases and sales, rather than the fair value accounting normally required. To qualify, the key features of the derivative must be close enough to those of the item it hedges so that the gain or loss on the derivative will offset the loss or gain on the hedged item. In most cases, rolling strategies may not be designated for hedge accounting because gains or losses on earlier contracts cannot be reinvested in subsequent contracts without altering the hedge ratio such that the amount of the forward contract matches the designated hedged item. This does not mean that hedge strategies using rolling forwards do not reduce risk. However, Section 3856 is not designed to offer accounting relief for more sophisticated hedging strategies. 143. When a derivative qualies as a hedge of an anticipated transaction, the derivative is not recognized on the balance sheet until the earlier of the date it matures and the date the anticipated transaction occurs. When the anticipated transaction occurs rst, the derivative is recognized at its intrinsic value and the gain or loss is recognized as an adjustment of the carrying amount of the hedged item. If the hedged item is recognized directly as revenue or expense, the gain or loss on the hedging derivative adjusts the amount of revenue or expense recognized. The difference between the gain or loss recorded when the hedged item is recognized and the amount realized at its maturity is recognized in net income. This amount will offset the gain or loss on the receivable or payable resulting from the hedged item. If the maturity of the derivative exactly matches the date the payable or receivable is settled, no net gain or loss will be recognized in net income.
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144. Example Effect of hedge accounting Downward Developments (DD) purchases a machine on January 2nd to be delivered on March 2, 20X1 for $100,000 USD when the Canadian-U.S. exchange rate is $1.10. To minimize the foreign currency risk exposure, on the same day, management enters into a forward contract to buy $100,000 USD on March 2 for $112,000 CAD. DD would be required to make the following accounting entries to account for these transactions. Without hedge accounting With hedge accounting January 2 No entry No entry required. The fair value of the forward contract at inception is $0. January 31 Exchange rate = 1.05 Dr. Loss on forward (I/S) $7,000 No entry Cr. Forward contract (B/S) $7,000 To record change in fair value of forward contract February 28 Exchange rate = 1.11 Dr. Forward contract (B/S) $7,000 No entry Cr. Loss on forward (I/S) $7,000 To reverse January entry Dr. Loss on forward (I/S) $1,000 Cr. Forward contract (B/S) $1,000 To record change in fair value of forward contract March 2 Exchange rate = 1.13 Dr. Forward contract (B/S) $1,000 Dr. Machine $113,000 Cr. Loss on forward (I/S) $1,000 Cr. Accounts payable $113,000 To reverse February entry To record receipt of machine Dr. Machine $113,000 Dr. Cash $113,000 Cr. Accounts payable $113,000 Cr. Cash $112,000 To record receipt of machine Cr. Machine 1,000 To record settlement of forward contract Dr. Cash (Cdn equivalent of Dr. Accounts payable $113,000 US$100,000 received) $113,000 Cr. Cash (Cdn$ paid) $112,000 Cr. Cash $113,000 Cr. Foreign exchange gain (I/S) 1,000 To record payment of payable To record settlement of forward contract Dr. Accounts payable $113,000 Cr. Cash $113,000 To record settlement of payable Net effect Balance sheet Machine $113,000 Machine $112,000 Income statement Foreign exchange gain $1,000 No effect Note that without hedge accounting, CC would report a $7,000 loss in January that would subsequently reverse. This might not be a problem if CC is not required to produce nancial statements as at the end of January, but might be misleading otherwise.
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145. Examples Hedge of foreign currency anticipated transaction (continued from paragraph 136 above) A. Western Wire (WW) receives the inventory on February 7th when the spot exchange rate is $1 USD = $ .98 CAD. The deemed value of the forward contract at that time is $7,000. It settles the payable on March 8th when the spot exchange rate is $1 USD = $1.01 CAD. WW records: February 7 Dr. Inventory $98,000 Cr. Accounts payable $98,000 Dr. Inventory $7,000 Cr. Forward contract $7,000 To record the receipt of inventory March 7 Dr. Accounts payable $98,000 Dr. Foreign currency loss 3,000 Cr. Cash $101,000 Dr. Forward contract $7,000 Dr. US cash received in C$ 101,000 Cr. Foreign exchange gain $3,000 Cr. C$ cash paid 105,000 To record settlement of the payable and the foreign exchange forward contract Summary: the inventory is recorded at $105,000 and entity does not record any foreign currency gain or loss. B. Eastern Elements (EE) receives its inventory on February 7th when the spot exchange rate is $1 USD = $ .98 CAD. EE settles the payable on March 7th when the spot exchange rate is $1 USD = $1.01 CAD. The foreign exchange forward contract matures on March 31 when the spot rate is $1 USD = $1.03 CAD. EE records: February 7 Dr. Inventory $98,000 Cr. Accounts payable $98,000 Dr. Inventory $7,000 Cr. Forward contract $7,000 March 7 Dr. Accounts payable $98,000 Dr. Foreign currency loss 3,000 Cr. Cash $101,000 March 31 Dr. US cash received in C$ $103,000 Dr. Forward Contract 7,000 Cr. C$ cash paid $105,000 Cr. Foreign exchange gain 5,000 To record settlement of the payable and the foreign exchange forward contract Summary: the inventory is recorded at $105,000. A net foreign exchange gain of $2,000 is recorded, representing the ineffective portion arising from exchange rate uctuations between the settlement of the account payable and the settlement of the forward contract.
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146. Additional examples Hedge of foreign currency anticipated transaction C. Mountain Movers (MM) purchases inventory for $100,000 USD for delivery on May 3rd. It intends to pay the account 30 days later, on June 3rd. It designates a contract maturing June 3rd to purchase $100,000 USD for $103,000 CAD as a hedge of the purchase. The goods are received on May 3rd when the spot exchange rate is $1 USD = $1.05 CAD. On June 3rd, the spot exchange rate is $1 USD = $1.04 CAD. MM records: May 3 Dr. Inventory $103,000 Cr. Accounts payable $103,000 Dr. Forward contract $2,000 Cr. Inventory $2,000 To record the receipt of inventory June 3 Dr. Accounts payable $105,000 Cr. Cash $104,000 Cr. Foreign exchange gain 1,000 To record settlement of the payable Dr. US cash received in C$ $104,000 Dr. Foreign exchange loss 1,000 Cr. C$ cash paid $103,000 Cr. Forward contract 2,000 To record settlement of the foreign exchange forward contract Summary: the inventory is recorded at $103,000 and the entity records no foreign exchange gain or loss. D. Prairie Planters (PP) purchases inventory for $100,000 USD for delivery on May 3rd. It intends to pay the account 30 days later, on June 3rd. PP designates a contract to purchase $100,000 USD for $103,000 CAD on June 30th as a hedge of the purchase. The goods are received on May 3rd when the spot exchange rate is $1 USD = $1.05 CAD. On June 3rd, the spot exchange rate is $1 USD = $1.04 CAD and the exchange rate on June 30th when the forward contract matures is $1 USD = $1.06 CAD. PP records: May 3 Dr. Inventory $103,000 Cr. Accounts payable $103,000 Dr. Forward contract $2,000 Cr. Inventory $2,000 To record the receipt of inventory June 3 Dr. Accounts payable $105,000 Cr. Cash $104,000 Cr. Foreign exchange gain 1,000 To record settlement of the payable June 30 Dr. US cash received in C$ $106,000 Cr. C$ cash paid $103,000 Cr. Forward contract 2,000 Cr. Foreign exchange gain 1,000 To record settlement of the foreign exchange forward contract Summary: the inventory is recorded at $103,000 and a net foreign exchange gain of $2,000 is recorded, representing the ineffective portion arising from exchange rate uctuations between the settlement of the account payable and the settlement of the forward contract.
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147. Example Hedge of interest rate risk with interest rate swap (continued from paragraph 138 above) Southern Semiconductors (SS) borrows $1,000,000 repayable in three years with interest oating at prime plus 5% payable quarterly. SS does not have the ability to prepay the debt. SS simultaneously enters into a three-year interest rate swap with a notional amount of $1,000,000 to pay xed at 4% and receive interest at the average prime rate. The combination of the interest rate swap and the debt obligation results in SS paying xed interest at 9%. Both the debt obligation and the interest rate swap require payments to be made or received quarterly. The variable rate on the interest rate swap resets quarterly. SS designates the interest rate swap as a hedge of the oating rate debt obligation attributable to changes in the interest rates. Average prime rates for each quarter are in the rst column. For simplicity, interest is calculated as if each quarter contains an equal number of days (i.e., annual amount divided by 4). Year 1 Dr. Cash $1,000,000 Cr. Loan payable $1,000,000 To record the receipt of loan 3% Dr. Interest expense (loan payment) $20,000 Cr. Cash $20,000 Dr. Interest expense (swap payment) $2,500 Cr. Cash $2,500 3.5% Dr. Interest expense (loan payment) $21,250 Cr. Cash $21,250 Dr. Interest expense (swap payment) $1,250 Cr. Cash $1,250 4% Dr. Interest expense (loan payment) Cr. Cash No swap payment required oating rate = xed Dr. Interest expense (loan payment) Cr. Cash Dr. Cash Cr. Interest expense (swap payment) Year 2 Dr. Interest expense (loan payment) Cr. Cash Dr. Cash Cr. Interest expense (swap payment) Dr. Interest expense (loan payment) Cr. Cash Dr. Cash Cr. Interest expense (swap payment) Dr. Interest expense (loan payment) Cr. Cash Dr. Cash Cr. Interest expense (swap payment) Dr. Interest expense (loan payment) Cr. Cash Dr. Cash Cr. Interest expense (swap payment) $22,500 $22,500 $23,750 $23,750 $1,250 $1,250 $25,000 $25,000 $2,500 $2,500 $26,250 $26,250 $3,750 $3,750 $27,500 $27,500 $5,000 $5,000 $25,000 $25,000 $2,500 $2,500
4.5%
5%
5.5%
6%
5%
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4%
3%
2.5%
3%
Year 3 Dr. Interest expense (loan payment) Cr. Cash No swap payment required oating rate = xed Dr. Interest expense (loan payment) Cr. Cash Dr. Interest expense (swap payment) Cr. Cash Dr. Interest expense (loan payment) Cr. Cash Dr. Interest expense (swap payment) Cr. Cash Dr. Interest expense (loan payment) Cr. Cash Dr. Interest expense (swap payment) Cr. Cash
$22,500 $22,500 $20,000 $20,000 $2,500 $2,500 $18,750 $18,750 $3,750 $3,750 $20,000 $20,000 $2,500 $2,500
Dr. Loan payable $1,000,000 Cr. Cash $1,000,000 To record the repayment of loan Summary: SS makes payments totalling $272,500 to its lender but receives $2,500 net over the life of the swap from the swap counterparty. The swap payments x the effective interest rate on the loan at 9%. DISCLOSURE 148. This section includes illustrations of notes that might meet the disclosure requirements of Section 3856. It is important to remember that the examples in this section are illustrative only; notes should always reect relevant facts and circumstances and meet the overall requirement for fair presentation detailed in GENERAL STANDARDS OF FINANCIAL STATEMENT PRESENTATION, paragraph 1400.04: Paragraph 1400.04 A fair presentation in accordance with generally accepted accounting principles is achieved by: (a) applying GENERALLY ACCEPTED ACCOUNTING PRINCIPLES, Section 1100; (b) providing sufcient information about transactions or events having an effect on the entitys nancial position, results of operations and cash ows for the periods presented that are of such size, nature and incidence that their disclosure is necessary to understand that effect; and providing information in a manner that is clear and understandable.
(c)
149. The goal of the required disclosures is to ensure that enough information is provided for users to understand the nancial statements and to be able to make informed inquiries regarding nancial statement items or transactions when they require further details. Although the standard imposes a minimum level of disclosure which is reected in the illustrative examples below, the preparer must always consider whether additional information should be provided to ensure that users have enough information to make informed decisions. The general disclosure requirement in paragraph 3856.37 is designed in this light: Paragraph 3856.37 An entity shall disclose information that enables users of its nancial statements to evaluate the signicance of nancial instruments to its nancial position and performance. Financial assets (paragraph 3856.38) 150. Paragraph 3856.38 An entity shall disclose the carrying amounts of each of the following categories of nancial instruments, either on the face of the balance sheet or in the notes: (a) nancial assets measured at amortized cost; (b) nancial assets measured at fair value; and (c) investments in equity instruments measured at cost less any reduction for impairment.
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Note X Financial assets The classication and carrying amounts of the Companys nancial assets other than cash and accounts receivable are as follows: December 31, 20X1 December 31, 20X0 At amortized cost $17,500 $12,500 At cost 8,000 8,000 At fair value 4,100 3,600 $29,600 $24,100 -ORNote Y Investments The carrying amounts of investments are comprised of the following: December 31, 20X1 December 31, 20X0 At amortized cost: Rocky Bank of Canada Guaranteed Investment Certicates, 2 years, 2%, maturing on June 30, 20X2 $10,000 $ 5,000 TeleCanada, 3-year bond, 2.25%, maturing August 15, 20X3 7,500 7,500 $17,500 $12,500 At cost: 10% interest in common shares of Private Company, Ltd. $ 8,000 $ 8,000 At fair value: Portfolio of marketable securities 4,100 3,600 $29,600 $24,100 Accounts and notes receivable (paragraph 3856.39) 151. Paragraph 3856.39 Accounts and notes receivable shall be segregated so as to show separately trade accounts, amounts owing by related parties and other unusual items of signicant amount. The amounts and, when practicable, maturity dates of accounts maturing beyond one year shall be disclosed separately. Note Z Accounts and Notes Receivable Accounts receivable, trade Accounts receivable, trade, related parties Account receivable, government assistance Notes receivable, employees, bearing interest at 4% per annum, repayable on January 31, 20X5 Notes receivable, directors, non-interest bearing, payable on demand Allowance for doubtful accounts December 31, 20X1 December 31, 20X0 $50,000 $45,000 25,000 26,000 5,000 4,500 8,000 5,000 (2,500) $90,500 8,500 5,000 (2,200) $86,800
Transfers of receivables (paragraphs 3856.40-.41) 152. The disclosures required for securitization activities are reduced from those in Accounting Guideline AcG-12: Paragraph 3856.40 If an entity has transferred nancial assets during the period and accounts for the transfer as a sale (see Appendix B), it shall disclose: (a) the gain or loss from all sales during the period; (b) the accounting policies for: (i) (c) initially measuring any retained interest (including the methodology used in determining its fair value); and (ii) subsequently measuring the retained interest; and a description of the transferors continuing involvement with the transferred assets, including, but not limited to, servicing, recourse and restrictions on retained interests.
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Paragraph 3856.41 If an entity has transferred nancial assets in a way that does not qualify for derecognition (see Appendix B), it shall disclose: (a) the nature and carrying amount of the assets; (b) (c) the nature of the risks and rewards of ownership to which the entity remains exposed; and the carrying amount of the liabilities assumed in the transfer.
Note 1 Summary of signicant accounting policies Securitizations To increase liquidity, the Company securitizes automobile loans, credit card loans and residential mortgage loans by selling them to an independent entity that issues securities to investors. It accounts for these transactions as sales when it transfers control of the assets for consideration other than a benecial interest in the transferred assets. The Company may retain servicing rights or other retained interests in the securitized assets. Gains or losses on the sale of the assets depend on their previous carrying amounts and the allocation of those amounts between the portion sold and any retained interest based on their relative estimated fair values at the date of transfer. Quoted market prices are used to estimate fair values, if available. However, quotes are generally not available for retained interests, so the Company generally estimates fair value based on the present value of future expected cash ows estimated using managements best estimates of credit losses, prepayments, discount rates and other factors appropriate to the nature of the retained interest. Servicing assets are amortized in proportion to and over the period of estimated net servicing income. Note D Sales of receivables During the year, the Company sold automobile loans, residential mortgage loans, and credit card loans in securitization transactions. In all those securitizations, the Company retained servicing responsibilities and subordinated interests. The Company receives annual servicing fees approximating 0.5% (for mortgage loans), 2.0% (for credit card loans), and 1.5% (for automobile loans) of the outstanding balance and rights to future cash ows arising after the investors in the securitization trust have received the return for which they contracted. The investors and the securitization trusts have no recourse to the Companys other assets for failure of debtors to pay when due. The Companys retained interests are subordinate to investors interests. Their value is subject to credit, prepayment and interest rate risks on the transferred receivables. In 20X1, the Company recognized pre-tax gains of $2.23 million (20X0 $1.69 million) on the securitization of the automobile loans, $3.02 million ($2.14 million) on the securitization of credit card loans, and $2.56 million ($1.5 million) on the securitization of residential mortgage loans. Impairment (paragraph 3856.42) 153. The illustration in paragraph 151 above also demonstrates the application of the following disclosure requirement with respect to impairment. Paragraph 3856.42 An entity shall disclose the carrying amount of impaired nancial assets, by type of asset, and the amount of any related allowance for impairment. Note G Impairment As at December 31, 20X1, the carrying amount of trade accounts receivable included an allowance for impairment recognized during the year in the amount of $3,500 (20X0 $2,200). $1,200 of the previous years allowance balance was reversed during the year because of a recovery in demand among the companys industrial customers (20X0 reversals NIL). -ORAccounts receivable are presented net of the allowance for doubtful accounts of $3,500 (20X0 $2,200). Financial liabilities (paragraphs 3856.43-.46) 154. Paragraph 3856.43 For bonds, debentures and similar securities, mortgages and other long-term debt, an entity shall disclose: (a) the title or description of the liability; (b) the interest rate; (c) the maturity date; (d) the amount outstanding, separated between principal and accrued interest;
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(e) the currency in which the debt is payable if it is not repayable in the currency in which the entity measures items in its nancial statements; and (f) the repayment terms, including the existence of sinking fund, redemption and conversion provisions. Paragraph 3856.44 An entity shall disclose the carrying amount of any nancial liabilities that are secured. An entity shall also disclose: (a) the carrying amount of assets it has pledged as collateral for liabilities; and (b) the terms and conditions relating to its pledge. Paragraph 3856.45 An entity shall disclose the aggregate amount of payments estimated to be required in each of the next ve years to meet repayment, sinking fund or retirement provisions of nancial liabilities. Paragraph 3856.46 For nancial liabilities recognized at the balance sheet date, an entity shall disclose: (a) whether any nancial liabilities were in default or in breach of any term or covenant during the period that would permit a lender to demand accelerated repayment; and (b) whether the default was remedied, or the terms of the liability were renegotiated, before the nancial statements were completed. Note M Long-Term Debt 20X1 Mortgage loan, principal repayable at $600 per month, plus interest at 4.25% compounded semi-annually, maturing May 31, 20X7, secured by land and building having an aggregate carrying amount of $150,000 Loan payable to shareholder, non-interest bearing, not due before January 1, 20X3 Current portion 20X0
$ 75,000 25,000 $100,000 7,200 $ 92,800
$ 82,200 26,000 $108,200 7,200 $101,000
The terms of the mortgage loan agreement require that the Company maintain a specied working capital and debt-equity ratio. It also imposes restrictions on capital expenditures and distributions to shareholders. At the balance sheet date, the Company was not in conformity with the requirements of the mortgage loan agreement. The covenant violation provided the lender with the right to demand repayment of the full amount of the debt. However, subsequent to its year-end and prior to the completion of the nancial statements, the Company renegotiated the terms of its mortgage loan to ensure compliance with its covenants. Accordingly, the Company has continued to classify the mortgage loan as a long-term liability instead of a current liability. Principal payments due in each of the next ve years are as follows: 20X2 $7,200 20X3 $7,200 20X4 $7,200 20X5 $7,200 20X6 $7,200 Financial liabilities (paragraph 3856.47) 155. Paragraph 3856.47 An entity that issues any of the following nancial liabilities or equity instruments shall disclose information to enable users of the nancial statements to understand the effects of features of the instrument, as follows: (a) For a nancial liability that contains both a liability and an equity element (see paragraph 3856.21), an entity shall disclose the following information about the equity element including, when relevant: (i) the exercise date or dates of the conversion option; (ii) the maturity or expiry date of the option; (iii) the conversion ratio or the strike price; (iv) conditions precedent to exercising the option; and (v) any other terms that could affect the exercise of the option, such as the existence of covenants that, if contravened, would alter the timing or price of the option.
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(b) For a nancial instrument that is indexed to the entitys equity or an identied factor, as described in paragraph 3856.14, an entity shall disclose information that enables users of the nancial statements to understand the nature, terms and effects of the indexing feature, the conditions under which a payment will be made and the expected timing of any payment. (c) For a preferred share issued in a tax planning arrangement as specied in paragraph 3856.23, an entity shall disclose: (i) on the face of the balance sheet, the total redemption amount for all classes of such shares outstanding; (ii) the aggregate redemption amount for each class of such shares; and (iii) the aggregate amount of any scheduled redemptions required in each of the next ve years. Note N Convertible Debenture During the year, the Company issued convertible debentures for $100,000. These debentures bear interest at 5% payable annually and mature December 31, 20X6. The debenture holders have the option to convert the principal amount of the debentures into common shares at a price of $1,000 per share at any time after March 31, 20X3. The Companys obligation to the convertible debenture holders for future interest and principal payments has been recorded as a liability at their entire issuance proceeds of $100,000. The conversion option associated with the convertible debenture was thereby allocated a value of $0 on the date of issuance. -ORDuring the year, the Company issued convertible debentures for $100,000. These debentures bear interest at 5% payable annually and mature December 31, 20X6. The debenture holders have the option to convert the principal amount of the debentures into common shares at a price of $1,000 per share at any time after March 31, 20X3. The Companys obligation to the convertible debenture holders for future interest and principal payments has been recorded as a liability at its fair value of $90,000. The conversion option associated with the convertible debenture was recorded in equity at $10,000 calculated as the difference between the consideration received and the fair value of the liability on the issue date. Note D Loan payable The loan payable bears interest at 1.5% above the Canadiana Banks prime rate, payable monthly. Principal is repayable in annual instalments of $1,200 at the end of each year in which the Companys total equity exceeds $2,000,000. The remaining principal is due on December 31, 20X6. Excerpt from the Companys Balance Sheet Shareholders Equity Common shares 1,000 Class A preferred shares, redeemable at the option of the holder for an aggregate amount of $1,000,000 Retained earnings
20X1 100
20X0 100
100 100,000 $100,200
100 80,000 $80,200
Note S Share Capital Issued share capital 100 common shares 1,000 Class A preferred shares, redeemable (at $1,000 per share) at the option of the holder with the right to a non-cumulative dividend as determined by the directors
20X1 $100 100 $200
20X0 $100 100 $200
Derivatives (paragraphs 3856.48-.50) 156. Paragraph 3856.48 An entity shall disclose: (a) the notional and carrying amounts of all derivative assets measured at fair value; (b) the notional and carrying amounts of all derivative liabilities measured at fair value; (c) the method used to determine the fair value of all derivatives measured at fair value; and (d) the notional and accrued amounts of all interest rate and cross-currency interest rate swaps in designated hedging relationships.
Paragraph 3856.49 When an entity measures the fair value of a derivative asset or liability using a quote from a derivatives dealer, it discloses that fact and the nature and terms of the instrument. Paragraph 3856.50 An entity shall disclose sufcient information about derivatives that are linked to, and must be settled by delivery of, equity instruments of another entity whose fair value cannot be readily determined (see paragraph 3856.12(b) (ii)) to permit the reader to assess the potential implications of the contract. This information shall include: (a) the name of the issuer of the equity instrument; (b) a description of the equity instrument; and (c) the terms under which settlement will take place. Note K Derivatives As at December 31, 20X1, the Company had foreign currency exchange contracts to sell $100,000 USD at each month end until June 30, 20X2. These contracts are measured at fair value using quoted rates and prices. The aggregate carrying amount of these contracts is an asset of $9,350. (Liability of $3,700 as at December 31, 20X0.) The Company has an interest rate swap with a notional amount of $500,000 maturing September 30, 20X5. Under the terms of the swap, the Company pays xed interest quarterly at 7% p.a. and receives the 90-day BA rate. At December 31, 20X1, the swap is a liability with a carrying amount of $17,230, provided by the Companys counterparty (asset of $2,220 as at December 31, 20X0). An interest rate swap with a notional amount of $150,000 maturing June 30, 20X2 is designated as a hedge of the Companys term loan maturing on the same day. Under the terms of the swap, the Company pays xed interest monthly at 5% p.a. and receives the banks prime rate + 3%. The accrual at December 31 is NIL. Hedge accounting (paragraph 3856.51) 157. Paragraph 3856.51 An entity that designates derivatives as hedging items shall disclose information that enables users of the nancial statements to understand the effect of hedge accounting, as follows: (a) For a hedge of an anticipated transaction in accordance with paragraph 3856.33, during the term of the hedging relationship, the entity discloses the terms of the anticipated transaction including the nature and timing of the hedged item, the terms of the forward contract, the fact that hedge accounting applies and the net effect of the relationship. (b) For a hedge of an interest-bearing asset or liability in accordance with paragraph 3856.34, the entity discloses the nature and terms of the hedged item, the nature and terms of the hedging interest rate or cross-currency interest rate swap, the fact that hedge accounting applies and the net effect of the relationship. Note H Hedge accounting The Company has designated wheat futures contracts as hedges of the price risk of its expected wheat purchases as follows: Hedged item Hedging item First 50,000 bushels of expected February and 100 contracts for delivery March 20X2 March 20X2 purchases 100 contracts for delivery May 20X2 First 50,000 bushels of expected April and May 20X2 purchases First 25,000 bushels of expected June and 50 contracts for delivery July 20X2 July 20X2 purchases The effect of the hedges is to guarantee the price for the designated wheat purchases. Margin posted with the broker is recorded in Other Assets. An interest rate swap is designated as a hedge of the interest rate risk in the Companys 5-year oating rate debt issue. The swap matures on the maturity date of the debt and requires the Company to pay 6%. The oating rate side of the swap exactly matches the interest payments on the debt. Because all payments are due on the last day of each month, no amounts are accrued at the reporting date.
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Items of income (paragraph 3856.52) 158. Paragraph 3856.52 An entity shall disclose the following items of income, expense, gains or losses either on the face of the statements or in the notes to the nancial statements: (a) net gains or net losses recognized on nancial instruments; (b) total interest income; (c) total interest expense on current nancial liabilities; (d) interest expense on long-term nancial liabilities, separately identifying amortization of premiums, discounts and nancing fees; and (e) the amount of any impairment loss or reversal of a previously recognized loss. Risks and uncertainties (paragraphs 3856.53-.54) 159. Paragraph 3856.53 For each signicant risk (see paragraph 3856.A66) arising from nancial instruments, and separately for derivatives, an entity shall disclose: (a) the exposures to risk and how they arise; and (b) any change in risk exposures from the previous period. Paragraph 3856.54 For each type of risk arising from nancial instruments, an entity shall disclose concentrations of risk. Concentrations of risk arise from nancial instruments that have similar characteristics and are affected similarly by changes in economic or other conditions (see paragraph 3856.A67). Note R Risks and uncertainties The Company is exposed to the effect of changes in oil prices on its inventory purchases. It uses over-the-counter and exchange-traded derivative contracts to mitigate some of this risk but is unable to perfectly hedge this risk. The exposure to oil prices was unchanged from the previous year-end, but the Company incurred losses due to price uctuations of $8,160 in 20X1 (gains of $3,500 in 20X0).
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APPENDIX Denitions (paragraphs 3856.05, A1-A7, A9, A12 and A66) A1. Amortized cost is the amount at which a nancial asset or nancial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortization of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment. When a nancial instrument is issued or purchased at a premium or discount relative to its face amount, the difference represents a prepaid adjustment of interest. This amount is a component of the initial carrying amount of the nancial instrument. When the nancial instrument is measured at amortized cost, any premium or discount is amortized over the expected life of the item and recognized in net income as interest income or expense. Similarly, when a lender charges a borrower a fee in lieu of interest, either when a nancial instrument is initially recognized or periodically throughout its term, the amounts paid represent adjustments of interest. Any such nancing fee is recognized as an adjustment to the carrying amount of the nancial instrument and amortized over the expected life of the nancial instrument or the period to which the fee relates, if shorter. Amortization of prepaid interest in accordance with paragraphs 3856.A3-.A4 may be presented as a separate component of interest income or expense. If a nancial asset or a group of similar interest-bearing nancial assets has been written down as a result of an impairment loss, interest income is thereafter recognized using the rate of interest used to discount the future cash ows for the purpose of measuring the impairment loss. An anticipated transaction is any transaction expected to occur in the future that has not yet given rise to a recognized asset or liability. Derecognition is the removal of a previously recognized nancial asset or nancial liability from an entitys balance sheet. A derivative is a contract with all three of the following characteristics: (i) its value changes in response to the change in a specied interest rate, nancial instrument price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or other variable (sometimes called the underlying), provided in the case of a non-nancial variable that the variable is not specic to a party to the contract; (ii) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and (iii) it is settled at a future date. Financial instruments include primary instruments, such as receivables, payables and equity instruments, and derivative nancial instruments, such as futures, forward, swap and option contracts. Derivative nancial instruments meet the denition of a nancial instrument and, accordingly, are within the scope of this Section. The denition of a derivative in this Section includes contracts that are settled gross by delivery of the underlying item (for example, a forward contract to purchase a xed-rate debt instrument). However, contracts to buy or sell non-nancial items do not meet the denition of a nancial instrument because the contractual right of one party to receive a non-nancial asset or service and the corresponding obligation of the other party do not establish a present right or obligation to receive, deliver or exchange a nancial asset. An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Fair value is the amount of the consideration that would be agreed upon in an arms length transaction between knowledgeable, willing parties who are under no compulsion to act. Fair value is dened as a price agreed upon by a willing buyer and a willing seller in an arms length transaction. Underlying the denition of fair value is a presumption that an entity is a going concern. Therefore, fair value is not the amount that an entity would receive or pay in a forced transaction, involuntary liquidation, or distress sale. Fair value reects the credit quality of the instrument, including collateral or other credit enhancements. The existence of published price quotations in an active market is the best evidence of fair value. A nancial instrument is regarded as quoted in an active market when quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency, and those prices reect actual and regularly occurring market transactions on an arms length basis.
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The fair value of a nancial liability with a demand feature (for example, a demand deposit) is not less than the amount payable on demand, discounted from the rst date that the amount could be required to be paid. A debt instrument with no stated repayment terms is deemed to be payable on demand. When the payment of a debt instrument is subordinated to the interest of another party, the earliest date at which payment could be demanded is the day following the maturity of the instrument to which it is subordinated. Financing fees are amounts that compensate the lender for the risk of providing funds to the borrower. Financing fees, sometimes referred to as fees in lieu of interest, loan fees or nancing costs, include: (i) fees charged to originate, arrange or syndicate a loan or debt nancing; (ii) commitment, standby and guarantee fees; and (iii) renancing, restructuring and renegotiation fees. Financing fees may be refundable or non-refundable. Financing fees do not include transaction costs. A nancial asset is any asset that is: (i) cash; (ii) a contractual right to receive cash or another nancial asset from another party; (iii) a contractual right to exchange nancial instruments with another party under conditions that are potentially favourable; or (iv) an equity instrument of another entity. The cost incurred by an entity to purchase a right to reacquire its own equity instruments from another party is a deduction from its equity, not a nancial asset. A nancial instrument is a contract that creates a nancial asset for one entity and a nancial liability or equity instrument of another entity. A nancial liability is any liability that is a contractual obligation: (i) to deliver cash or another nancial asset to another party; or (ii) to exchange nancial instruments with another party under conditions that are potentially unfavourable to the entity. Financial risk: transactions in nancial instruments may result in an entity assuming or transferring to another party one or more of the nancial risks described below. The required disclosures provide information that assists users of nancial statements in assessing the extent of risk related to nancial instruments. (a) Credit risk is the risk that one party to a nancial instrument will cause a nancial loss for the other party by failing to discharge an obligation. (b) Currency risk is the risk that the fair value or future cash ows of a nancial instrument will uctuate because of changes in foreign exchange rates. (c) Interest rate risk is the risk that the fair value or future cash ows of a nancial instrument will uctuate because of changes in market interest rates. (d) Liquidity risk is the risk that an entity will encounter difculty in meeting obligations associated with nancial liabilities. (e) Market risk is the risk that the fair value or future cash ows of a nancial instrument will uctuate because of changes in market prices. Market risk comprises three types of risk: currency risk, interest rate risk and other price risk. (f) Other price risk is the risk that the fair value or future cash ows of a nancial instrument will uctuate because of changes in market prices (other than those arising from interest rate risk or currency risk), whether those changes are caused by factors specic to the individual nancial instrument or its issuer, or factors affecting all similar nancial instruments traded in the market. Hedge accounting is a method of recognizing the gains, losses, revenues and expenses associated with the items in a hedging relationship such that those gains, losses, revenues and expenses are recognized in net income in the same period when they would otherwise be recognized in different periods. A hedged item is a recognized asset, a recognized liability, an anticipated transaction or a net investment in a self-sustaining foreign operation having an identied risk exposure that an entity has taken steps to modify. A hedging item is: (i) a derivative offsetting a risk exposure identied in the hedged item; or
(ii) a non-derivative nancial asset or a non-derivative nancial liability offsetting the foreign currency risk exposure in the net investment in a self-sustaining foreign operation. A hedging relationship is a relationship established by an entitys management between a hedged item and a hedging item that satises all of the conditions in this Section. An insurance contract is a contract under which one party (the insurer) accepts signicant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specied uncertain future event (the insured event) adversely affects the policyholder. Insurance contracts include any contract based on climatic, geological or other physical variables. Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a nancial asset or nancial liability. An incremental cost is one that would not have been incurred if the entity had not acquired, issued or disposed of the nancial instrument. Transaction costs include expenditures such as legal fees, reimbursement of the lenders administrative costs and appraisal costs associated with a loan. Transaction costs do not include nancing fees, debt premiums or discounts. Transaction costs are not a characteristic of an asset or a liability; rather, they are specic to a transaction and will differ depending on how an entity enters into a transaction for the asset or liability.
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Accounting For Private Busness

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Accounting For Private Busness

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GUIDE TO ACCOUNTING STANDARDS FOR PRIVATE ENTERPRISES

CHAPTER 45 FINANCIAL INSTRUMENTS

The Canadian Institute of Chartered Accountants

Gordon Beal, CA, M.Ed Director, Guidance and Support

The Canadian Institute of Chartered Accountants

The Canadian Institute of Chartered Accountants

Denitions A nancial asset is any asset that is: cash

an equity instrument of another entity (paragraph 3856.05(h))

The Canadian Institute of Chartered Accountants

The Canadian Institute of Chartered Accountants

The Canadian Institute of Chartered Accountants

Dr. Prepaid expenses Cr. Cash

The Canadian Institute of Chartered Accountants

The Canadian Institute of Chartered Accountants

The Canadian Institute of Chartered Accountants

The Canadian Institute of Chartered Accountants

The Canadian Institute of Chartered Accountants

Interest-free or low interest loans

Transferor of receivables Trust or SPE

interest holders (investors)

$1,050 70 40 (60) $1,100

$1,100 1,000 $ 100

$1,050 40 70 $1,000 60 100

The Canadian Institute of Chartered Accountants

Fair value $ 990 110 $1,100

$1,050 70 40 (60) (50) $1,050

The Canadian Institute of Chartered Accountants

Fair value $1,000 40 60 $1,100

Fair value $910 90 100 $1,100

The Canadian Institute of Chartered Accountants

Fair value $1,120 40 $1,160

Percentage of total fair value 97 3 100

Allocated carrying amount $ 970 30 $1,000

Situation II $1,050 30 70 $1,000 60 60 $1,000 150 (c)

505 819 (333) 486 $ 19

$505 333 $819 19

The Canadian Institute of Chartered Accountants

The Canadian Institute of Chartered Accountants

Settlement upon expiry or maturity of conversion option and payment in cash

The Canadian Institute of Chartered Accountants

The Canadian Institute of Chartered Accountants

The Canadian Institute of Chartered Accountants

The Canadian Institute of Chartered Accountants

The Canadian Institute of Chartered Accountants

The Canadian Institute of Chartered Accountants

$ 75,000 25,000 $100,000 7,200 $ 92,800

$ 82,200 26,000 $108,200 7,200 $101,000

100 100,000 $100,200

100 80,000 $80,200

20X1 $100 100 $200

20X0 $100 100 $200

The Canadian Institute of Chartered Accountants

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