intermediate accounting

The liabilities of a business are its obligations (debts). A liability is defined as a present obligation arising from past events, the settlement of which is expected to result in an outflow of economic benefits (future sacrifice of assets or services).Legal obligation– arise from contract or legislation and examples include: accounts payable and borrowings. Constructive obligations are liabilities that exist because there is pattern of past practice or established policy, creating an expectation by the liability is a financial instrument where the liability is a contract that gives rise to a financial liability of one part and a financial asset of another party. Examples would be accounts payables or bank loans.

Financial liabilities are classified into:Fair value through profit or loss (FVTPL)if the liability will be sold in the short term or if management wishes to avoid an accounting mismatch. In this case, the liability is recorded at fair value at each reporting period with gains and losses recognized in profit or loss in the period they arise.Otheris does meet the criteria to be classified as FVTPL. In this case, the liability is recorded at fair value on initial valuation and then at amortized cost for each subsequent reporting period.

Common Financial Liabilities;Current liabilities are amounts payable within one year from the date of the balance sheet, or the normal operating cycle where this is longer than a year. Most current liabilities are monetary items (e.g., accounts payable), but they can also include some non-monetary items (e.g., unearned revenues). 
Accounting problems for monetary current liabilities are discussed in the following section.

Accounts payable (trade accounts payable

Accounts payable (trade accounts payable) are obligations arising from the firm’s normal business operations. To determine the amount of the liability, adjustments are made for purchase discounts, allowances, and returns as discussed for accounts receivable.

Notes Payable

Notes payable often result from borrowing from a lender. Notes may be categorized as interest-bearing or non-interest-bearing notes. Notes payable are initially valued at fair value, which is often simply the loan amount. If the note carries a stated interest rate equal to market interest rates, or has a very short term, then valuation issues are immaterial and stated values are used. If the stated and market interest rates are different, and term is more than a year (i.e., not short), then present value— discounting—must be used to establish initial fair value.

Cash dividends payable

Cash dividends payable are dividends declared but not yet paid; these are reported as a current liability if it is payable within the coming year/operating cycle.
Declaration of dividends gives rise to an enforceable contract.
Dividends in arrears for preferred shares are only reported in a note to the financial statements.

Monetary accrued liabilities

Monetary accrued liabilities are recorded by adjusting journal entries at year end (e.g., wages earned by employees). This is consistent with the definition of a liability and the matching principle.

Advances and returnable deposits

Advances and returnable deposits are provided as guarantees for payment or future obligations (i.e., to guarantee performance on a contract or to ensure against noncollection or possible damage of property.


Taxes are liabilities until the funds are remitted to the designated party. Common examples of these taxes are:

  • Sales taxes. These arise when retail businesses are required to collect taxes from customers and remit them to the appropriate government agency. Examples are the goods and services tax (GST), provincial sales taxes (PST), and harmonized sales tax (HST). Purchases should be recorded net of GST recoverable. The net amount of GST should be carried as a liability or asset. Any GST not recoverable should be accounted for as a component of the cost of the goods or services to which it relates. PST paid is part of inventory cost.
  • Payroll taxes. These arise when employers act as a collection agent for certain taxes and payments by withholding amounts from employee paycheques. Common withholdings include the following:
    — Personal income taxes
    — Canada pension plan (CPP) 
    — Employment insurance (EI) 
    — Union dues
    — Insurance premiums
    — Pension plan payments
    — Other deductions (e.g., charitable, parking) 
  • Property taxes are paid directly by the company based on the assessed value of property. Property taxes are usually set part way through the fiscal year by taxing authorities; therefore, estimates must be made prior to the final assessment, at which point the tax rates are known.

Conditional payments

Conditional payments are liabilities established on the basis of the firm’s periodic income. Estimates of this liability must be made for interim statements. Two examples are:

  • Income tax payable for federal and provincial taxes, which are not known until after year end, when the tax return is prepared.
  • Bonuses, which are paid by companies to their employees based on earnings.


If the company has accounts or notes payable, they must be restated at the current exchange rate at the balance sheet date. The difference between the Canadian equivalent of the amount and any cash receipt is charged to a gain or loss account. Any changes in the exchange rate following the initial transaction affect only the monetary balance and are recognized directly and immediately in the income statement if the balance is classified as current.

Non-Financial Liabilities – Provisions

A provision is a category of non-financial liabilities and is defined as a liability of uncertain timing or amount. Provisions can be caused by both legal and constructive obligations.

Degree of uncertainty



Payables, accruals recorded


Provision – recorded

Not probable

Contingency – disclosed only

Where there is uncertainty involved with a provision, then a reasonable estimate of the amount must be determined. Provisions are recorded at the best estimate. If there is a range of outcomes, the expected value (he sum of the outcomes multiplied by their probability distribution) is used. The most likely outcome (highest probability alternative) should also be considered. If there is a small population, then the most likely outcome may be the best estimate.

In cases where the time value of money is material, the liability is recorded at its discounted amount. The discount rate should reflect the current market interest rates for risk level specific to the liability. Interest expense on a discounted liability is recorded as time passes.

Contingenciesexist when:

  • The obligation is possible but not probable;
  • There is a present obligation but no economic resources are attached;
  • There is a present obligation but rate circumstances dictate that an estimate cannot be established.


Lawsuits– Based on the certainty of payout, an unsettled lawsuit may result in a provision (if probable) or a contingency (if not probable). Only a provision will be recorded.

Onerous contracts– If the unavoidable costs of meeting a contract exceed the economic benefits under the contract, and then the contract is classified as an onerous contract. A provision is required for this onerous contract for the net loss associated with the contract.

Restructuring– Restructuring is a program, planned and controlled by management, which materially changes the scope of the business or the manner in which the business is conducted. When an entity has a detailed formal plan for the restructuring that it has started to implement and has been announced to those affected, then a provision for the costs must be recorded.

Warranty– Warranty rights may be legal or constructive and an amount must be estimated based on expected value, and recorded as a provision at each reporting period.

Restoration and environmental obligations– may be legal or constructive obligations – and must be estimated and recorded as provisions. If legislative requirements are pending, the provision is accrued only if there is virtual certainty that the legislation will be enacted.

Coupons, refunds and gift cards– If retailers or customers are reimbursed in cash for coupons, or if products are sold at a loss, then a provision is appropriate. The coupon offer must result in a transfer of economic benefits in order to be recognized.

Loyalty programs– Some allocation of the original sale price must be made to the loyalty (points) program. The sale transaction has multiple parts and the value of the award credits (points) are one such part. The provision is measured according to the value of the awards to the customer (not the cost of goods to the company).

Self-insurance– A provision for estimated losses must be determined for events taking place prior to the reporting date but also for loss events that have happened during the year but are not yet known such as undiscovered damage. The provision must be justified based on a loss event.

Loan guarantees– A loan guarantee requires the guarantor to pay loan principal and interest if the borrower defaults. Loan guarantees are recorded at their fair value which would be estimated using the probability that default will occur multiplied by the amount of the guarantee.

Compensated-Absence Liabilities– When employees can carry over unused time for vacation or holidays to future years, any expense due to compensated absences must be recognized (accrued) in the year in which it is earned. The accrual is based on the additional amount that the entity expects to pay as a result of the unused entitlement accumulated at the year-end date.

Calculation of Present Value

P = [I × (P/A, i, n)] + [F × (P/F, i, n)], where
P = fair value of the loan; issuance proceeds on issuance date
I = dollar amount of each period’s interest payment, if any, or
= nominal rate, if any, times the loan face value,
F = maturity value of the loan
n = the number of periods to maturity
i = the market interest rate

The text book provides four examples of the calculation of discounted values and subsequent accounting using the effective interest method for:

– No-Interest Note Payable
– Note Payable with Different Market and Stated Rate.
– Provision for Lawsuit
– Provision with Estimate Change

Classifying Liabilities, Disclosure and Statement of Cash Flow

A current liability is one that is due within the next operating cycle of the next fiscal year, whichever period is longer. A long –term liability is due beyond this period.

On the statement of financial position, provisions must be shown separately from payables and accruals and the nature of each provision explained in the notes. Disclosure of these obligations includes a reconciliation of the opening and closing balances for each obligation.


There are no specific standards for non-financial liabilities under ASPE. Liabilities are recognized when they meet the definition of a liability, are measureable and if future sacrifices are probable. Constructive liabilities are not recognized under ASPE. And the term “provision” is not used, as ASPE refers to these types of obligations as liabilities.

The definition of a contingent liability is also different under ASPE and IFRS. ASPE defines a contingent liability as a liability that will result in the outflow of resources only if a future event happens. A contingent liability is recorded if the probability is likely; and requires disclosure only if the probability is not determinable or not likely (unless immaterial). So a contingent liability may be recognized or only disclosed. (Under IFRS, if the liability is recognized it is now a “provision”; if it is only disclosed it is a “contingent liability”)

ASPE has no standards specific to loyalty point programs. Under ASPE, the loyalty program liability can be recorded as a part of the sale transaction (as described earlier in the chapter under IFRS) or an accrual for the estimated costs can be determined (similar to a warranty accrual).

Either the straight-line method or the effective interest rate method may be used under ASPE.

Under ASPE, if renegotiation of long term debt that is coming due has been completed prior to release of the financial statements, then the long term debt can be classified as long term, pursuant to the new agreement. Under IFRS, this renegotiation must be put in place prior to the report date; otherwise the long term debt coming due must be reported as current.

CHAPTER 13: Financial Instruments: Long Term Debt



The most obvious source of short-term financing is through trade credit extended by suppliers. Some purchases are made by signing a promissory note which obligates the company to pay the supplier.

Short-term bank loans to businesses are usually operating lines of credit which are typically secured by a lien or charge on accounts receivable and inventory. These are usually due on demand but in practice is often a permanent fixture on a company’s balance sheet.

Remember if a company’s account frequently changes from positive to negative the overdraft is part of the cash and cash equivalents.


Leverage is risky. Debt payments are obligations that the company must make regardless of how much cash flow it has earned. Business failures are frequently caused from the entity having too much debt. However, if an entity can earn a return on the borrowed funds which is more than the interest rate having to be paid, then it is said to be using debt to its advantage is therefore successfully leveraged.

Term loans and commercial mortgages are common forms of long term bank financing. Repayment can be through blended payments or principal plus interest. Rates may be fixed or floating. The rate may be fixed for the term of the loan but the amortization period may be longer.

A bond or debenture is a debt security issued to secure large amounts of capital on a long term basis.


Covenants are conditions placed on a company as a condition of maintaining the loan. They can be accounting-based (e.g. maximum debt-to-equity ratio), or restricted actions (e.g. restrictions on dividend payments).

Some debt agreements require the establishment of a sinking fund, cash restricted to retire the debt.


Long term debt is recognized initially at its discounted present value using the market rate at the time of issue. If the nominal interest rate is different from the market rate, the loan is issued above or below par, or at a premium or a discount. The long term debt is amortized to its face value over the time to maturity, using the effective interest rate. See exhibits 13-2, 13-3 and 12-4 for examples of the amortization of these bonds.

Interest is accrued at each period end date when the payment date for the interest is different from the report date. This is also true for bonds sold at some date later than their issue date and between interest payment dates. See example in text book of these calculations.

Debt issue costs (legal costs, accounting, underwriting, commission, engraving, printing, registration and promotion costs and upfront fees) reduce the net proceeds from the debt issue and therefore increase the overall cost or the effective interest rate for the issuer.


Many long-term loans are from foreign lenders. This adds an additional form of risk to the borrowing and causes gains or losses when exchange rates fluctuate. Some companies hedge the loans by arranging equal and offsetting cash flows in the desired currency. This can be done through operating hedges or use of derivative contracts and is studied further in chapter 15.

Foreign currency monetary liabilities are reported on the statement of financial position at the spot rate on the report date. Any exchange gain or loss (unrealized) is reported in profit or loss for the period in which is arises. See exhibit 13-5 for a numerical example.


Any borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset are capitalized as part of the cost of the asset. A qualifying asset is a non-financial asset and may be inventory, intangible assets, machinery and office and manufacturing facilities. Borrowing costs are capitalized if the asset takes a substantial amount of time to ready for sale or use. The capitalized borrowing costs are those specific to the acquisition and may include: interest paid on a specific loan in place to finance the acquisition and/or if general borrowings are used, then the average borrowing rate is applied to the specific expenditures. See capitalization calculation example in the text book.


Debt can be derecognized through payment on maturity, or early extinguishment before the maturity date. On early retirement, the retirement price reflects the current market price. A gain (or loss) on extinguishment will result when the retirement price is lower (or higher) than the current net book value of the loan. See exhibit 13-6 for example.

Defeasance is a transaction where the bond will be derecognized from accounting purposes, but repayment has not been made to the investor. In this case, the bond indenture will allow the company to transfer investments into an irrevocable trusteed fund. The trustee is then responsible for interest and principal payments on the debt. When such a trust is set up and fully funded, accounting standards allow for the debt to be derecognized. In this case, the issuer no longer has the responsibility to make payments as these have now been assumed by the trust.

Substitution or modification of debt, a company may repay and borrow in one transaction replacing the existing debt with a new one. If the present value of the new debt is at least 10% different than the present value of the old loan, then the old loan is extinguished and the new loan is recorded and any resulting gain or loss is recorded. In cases where the difference is less than 10%, no gain or loss on retirement is recognized.


The textbook provides an example of the impact of a bond payable on the cash flow statement where there is a discount.

A current liability is one that is due within the next operating cycle of the next fiscal year, whichever period is longer. A long term liability is due beyond this period.

Disclosures for long term debt include details of terms and conditions; interest rate, credit and liquidity risks; and fair values. In addition, companies must disclose their objectives, policies and processes for managing its capital. See the reporting example at exhibit 13-7.


Long term liabilities have similar treatment under ASPE and IFRS. However, either the straight-line method or the effective interest rate method may be used under ASPE.

Under ASPE, if renegotiation of long term debt that is coming due has been completed prior to release of the financial statements, then the long term debt can be classified as long term, pursuant to the new agreement. Under IFRS, this renegotiation must be put in place prior to the report date; otherwise the long term debt coming due must be reported as current.

Under ASPE, private enterprises have a choice to capitalize borrowing costs or not on assets being constructed, although there are no guidelines on the amount that can be capitalized.

Disclosure for provisions, long term debt and risks is less onerous under ASPE than in comparison to IFRS.


LO-1 Distinguish the various types of share capital issued by private and public companies and descriptive terms used

Shareholders’ equity can be defined as “the net contributions to the firm by the owners, plus the firm’s cumulative earnings retained in the business, less any adjustments, payments, or requisition of the company’s own shares.”

 Shareholders’ equity is the second part of the balance sheet equation:

Assets – Liabilities = Shareholders’ equity.

 This chapter deals with various aspects of shareholders’ equity; focusing on the accounting implications of share capital, issuance, and retirement, and the accounting for and disclosure of retained earnings and dividends. It also discusses other components of shareholders’ equity with emphasis on Other Comprehensive Income (OCI).

 Shareholders’ equity applies only to corporations. Partnerships and proprietorships have ownership interests but not share capital.

 Private versus Public Corporations

Private corporations have a limited number of shareholders and the shares cannot be publicly traded. Private companies may adopt differential disclosure with unanimous shareholder consent. They can raise share capital through private placements. Public corporations have debt or equity trading on the stock exchanges.

 Share Capital

Share certificates represent ownership in a corporation. Shares can be bought, sold, or transferred by shareholders without the consent of the corporation.

 A corporation has at least one class of shares: common shares. Common shares normally carry the rights to vote, share in profits and share in distribution of assets in the event of liquidation or dissolution. Common shares are often called residual ownership shares, since they get whatever is left after the creditors and the other investors have had their share in earnings and net assets.

 Preferred shares have a priority claim on dividends at a specified dollar amount or rate, as well as priority claim on assets upon liquidation but often do not have voting rights.. Dividends may be cumulative or participating. The shares may be convertible to other securities.

 Terms and conditions

Shares are sometimes issued with special terms and conditions. Preferred shares are sometimes structured to look a lot like debt – this is discussed in chapter 15.

Par Value Shares versus No-par Value Shares

Par value shares have a designated dollar amount per share, as stated in the articles of incorporation and as printed on the face of the share certificates. No-par value shares do not carry a designated or assigned value per share. If a corporation is incorporated under the CBCA (Canadian Business Corporations Act), it is prohibited from using par value shares. No-par value shares are common in the United States.

LO-2 Explain the recognition and measurement requirements for share capital issues and subscriptions

Shares issued for cash: Dr. Cash and Cr. The appropriate share capital class.


Prospective shareholders sign a contract to purchase a specified number of shares at a specified price to be paid in installments. Then:

  • On date of subscription-The stock subscriptions receivable account is debited and share capital subscribed is credited.
  • On date of collection-Cash is debited and stock subscriptions receivable is credited.
  • On date of issuance of shares-Share capital subscribed is debited and common shares is credited.

The preferred approach is to classify the receivable as a contra account in the equity section.

If the subscriber defaults after a partial fulfillment of the subscription, the corporation may decide to:

(a) return all payments received to the subscriber,(b) issue shares equivalent to the number paid in full, or

(c) Keep the money received.

 Non-cash Sale of Share Capital

Record at the fair value of the assets received, as long as reliably determinable. In rare cases where the fair value of assets received cannot be determined, then record at fair value of equity shares issued.

 Basket sale of share capital – When selling two or more classes for one lump sum amount, we must use either the proportional method (the preferred method) or the incremental method to allocate the proceeds or board may arbitrarily split the proceeds.

 Share Issue Costs are recorded in equity as either a reduction of the amount received from the sale of shares, or against retained earnings.

LO-3 Identify reasons for share retirements and illustrate the related measurement and recognition requirements

Retractable shares – At the option of the shareholder, at a contractually arranged price, a company is required to buy back its shares.

 Callable or Redeemable shares – These involve specific buy-back provisions at the option of the company. 

Reasons for share redemption include:

(1) increase EPS; (2) provide cash flow to shareholders in lieu of dividends; (3) acquire shares when they appear to be undervalued; (4) buy out one or more particular shareholders or thwart a takeover bid; (5) reduce future dividend payments.

1. When the reacquisition cost is higher than the average price per share issued to date, the cost should be charged in this sequence:

a. First, to share capital, at the average price per issued share

b. Second, to any contributed surplus that was created by earlier share transactions in the same class of shares, and then,

c. if any remaining amount, to retained earnings.

2. When the reacquisition cost is lower than the average price per share issued to date, the cost should lie charged in this sequence:

a. First, to share capital, at the average price per issued share

b. any remaining amount, to contributed surplus.

LO-4 Explain the recognition. Measurement and disclosure requirements for treasury stock transactions

Treasury stock arises when a company buys its own shares and holds them for resale. Treasury shares do not have voting rights and are not entitled to dividends.The CBCA provides that if a company reacquires its own shares, it must retire those shares immediately.


First, debit

Then, either/or



When resale price if higher than the average price of shares

Treasury stock, at the average price of share

Other contributed capital from treasury transactions


When resale price if lower than the average price of shares

Treasury stock, at the average price of share


1. Other contributed capital from treasury stock transactions, if any, then

2. retained earnings

LO-5 Distinguish the various components of retained earnings.


Decreased by (debits)

Increased by (credits)

Net losses

Net earnings

Cash or other dividends. Stock dividends.

Removal of deficit in a financial reorganization

Share retirement and treasury stock transactions.

Share issue costs.

Effect of an accounting policy change applied retroactively.

Effects an accounting policy change applied retroactively.

Error corrections

Error corrections

Appropriations and restrictions are made (a) to fulfill a contractual agreement, (b) to comply with corporate legislation, or (c) to indicate a specific purpose for a specified portion of retained earnings.

Appropriations are the result of discretionary management action; restrictions are the result of legal contract or corporate law.

LO-6 Classify the various types of dividend payments and illustrate the appropriate accounting treatment

The four relevant dividend dates are: declaration date; record date; ex-dividend date and payment date.

To record cash dividends: Dr. Retained earnings Cr. Dividends payable

Cumulative dividends on preferred shares – Any dividends not declared in a given year, accumulate at the specified rate of such shares. The accumulated amount must be paid in full if and when dividends are declared in a later year before any dividends can be paid on the common shares. Dividends in arrears are not liabilities but must be disclosed in the notes to the financial statements.

Participating preferred shares provide that the preferred shareholders participate above the stated preferential rate on a pro rata basis in dividend declarations with the common shareholders, as follows:

1. First, the preferred shareholders receive their preference rate.

2. Second, common shareholders receive a specified matching dividend.

3. If the total is larger than the two amounts, the excess is divided on a pro rata basis between the two share classes.

Non-cash (Property) dividends are recorded at the fair value of the assets distributed and a gain or loss is recorded for the difference between book value and fair value of the asset.

Liquidating dividends occur when the dividend is paid out of equity other than retained earnings. Shareholders must be informed of the portion of any dividend that represents a return of capital.

Scrip dividends arise when a corporation declares dividends and issues promissory notes (scripts) to the shareholders.

Stock dividends is a proportional distribution to shareholders of additional common or preferred shares of the corporation. They increase the number of shares outstanding but have no effect on total shareholders’ equity. There are no specific accounting standards on how to record stock dividends, so there are three possible alternatives:

1. Market value method (required by CBCA); 2. Stated value method; 3. Memo entry.

When a small stock dividend is issued, not all shareholders will own exactly the number of shares needed to receive whole shares. Fractional shares may be issued or a cash distribution can be made.

Summary: Dividends and distributions are summarized as follows:


Shareholder receives

Recorded at

Watch out for



Exchange amount; cash

Amount allocated to common versus preferred shares


Some company asset as designated by the Board: inventory, investments, etc.

Fair value; gain or loss recorded on declaration

Distribution of shares of subsidiary could be a spinoff instead


Shares of subsidiary

Book value

Market value not recorded


Usually cash but may be other assets

Exchange amount; fair value

Debit to other contributed capital or share capital,not retained earnings


Promissory note

Exchange amount; as stated

Shareholders get a receivable; company sets up a liability



May be recorded at fair value, book value, or an arbitrary value as decided by the Board

May be fractional shares for part shares or cash for part shares

LO-7 Describe the presentation and disclosure of stock splits, contributed capital and other reserves

A stock split is a change in the number of shares outstanding and no change in recorded capital accounts. A memo entry is made only, since there is no consideration received.
Additional contributed capital can include:

1. Donated capital The donated asset is recorded at fair market value, with a corresponding credit to donated capital which is part of equity.

2. Retirement of shares at a price less than (or greater than ) average issue price to date

3. Issue of par value shares at a price higher than par

4. Treasury stock transactions and share reissued costs

5. Stock option transactions

6. Financial restructuring

 Reserves are the accumulated unrealized gains and losses that are part of other comprehensive income and include the following sources:

Gains and losses on FVTOCI financial instruments

Revaluation reserves caused by using the revaluation model for property, plant and equipment

Gains and losses on certain hedging instruments

Translation gains and losses on foreign operations whose functional currency is not the presentation currency.

LO-8 Illustrate the presentation of the statement of equity and the related note disclosure

The statement of changes in equity includes a reconciliation of opening and closing balances for each equity component. Note disclosure is required to describe each class of share capital including the legal rights, preferences, restrictions and number authorized. Disclosure is also required for the number of shares issued, repurchased and retired during the year. The entitys objectives, definition, policies and process for managing its capital is also required.

LO-9 Compare the recognition, measurement and presentation of share capital transactions under ASPE and IFRS

Private companies are required to follow the standards governing share retirement and treasury stock transactions (IASB has no standards in this area).

Shares issued for non-cash consideration are valued at the fair value of the shares given up, unless the valuation of the shares is problematic. If the fair value of the assets received is more clearly determinable, then this value is used for the shares issued. (IASB requires that the fair value of the assets received be used to value the shares issued.)

There is no comprehensive income for private companies, so all the reserves arising due to OCI items is non-existent. ASPE classifies foreign subsidiaries as either self-sustaining or integrated. Unrealized foreign exchange gains and losses on a self-sustaining foreign subsidiary are reported as a separate line item in equity.

There is no statement of changes in equity required under ASPE. Only a statement of retained earnings is required. Changes in the other equity accounts are disclosed in the notes.


LO-1 Classify complex financial instruments as debt or equity using classification factors.

Financial instruments must be classified as a liability or equity based on the substance of the contractual agreement. A compound instrument (hybrid instrument) has a liability and an equity component. Payments that are associated with instruments classified as liabilities will be shown in net earnings; payments associated with instruments classified as equity will be shown in the statement of changes in equity. Gains and losses associated with debt retirement are shown in net earnings; gains and losses associated with equity are shown in the equity accounts. The tax status of the instrument does not change based on the accounting classification.

Classification generally depends on whether or not the investor has an enforceable legal right to receive payments. The following five questions should be addressed to determine if the instrument is in substance debt or equity.

1. Is the periodic return on capital (cash interest or dividend payment) mandatory?

Any payment that is mandatory or at the investors option, is classified as debt.

2. Is the debtor legally required to repay the principal in cash, either at a fixed pre-determined date, or at the option of the creditor?

Any payment that is mandatory or at the investors option, is classified as debt.

3. Does the issuer have the unconditional right to defer payments indefinitely?

If the payments can be deferred forever, then the instrument is equity. If deferral is only for a period of time, then it is debt.

4. If cash payment is dependent on the outcome of an uncertain future event beyond the control of both the investor and the issuer, is the future event extremely rate/very unlikely to occur?

If the future event is highly unlikely and uncontrollable, then the element is equity.

5. If the annual periodic return and/or principal can be settled in the companys own shares, is the number of shares fixed by contract, or does it vary based on the market value of shares at the time of distribution?

If the share price is fixed, then the risk of price fluctuation is with the investor, and this is equity.

LO-2 Identify, classify and describe the measurement and disclosure requirements for different types of complex financial instruments.

Retractable shares provide the investor with an option to redeem the preference shares. Term-preferred shares have a provision that the shares must be redeemed on or before a specified date. In either case, when a preferred share has a redemption that is required or at the investors option, then there is a mandatory obligation to pay cash at some future date, making this type of preferred share a liability. The key is that the redemption is out of the issuers control it is either mandatory or at the investors option.

Shares redeemable at the issuers option are equity since the company cannot be forced to pay cash.

Perpetual debt is a loan that (1) never has to be repaid; (2) has to repaid only in the indefinite future or; (3) is highly unlikely ever to be repaid. There is a stated interest rate for the perpetual debt, and the corporation is obligated to pay the interest regularly. The perpetual debt is reported entirely as a liability. Although its present value of the principal is equity, the present value of this payment in the infinite future is zero.

The debt is recorded as the present value of the future interest payments.

A convertible bond is a compound instrument classified partly as debt and partly as equity.

Convertible bonds often have a cash redemption option that allows management to force conversion before maturity if the market share price is higher than the conversion price of the shares. The company calls the bonds for cash redemption knowing that the investor will convert to shares since the share price is higher than the conversion price.
Floating conversion price per share – Convertible debt may be issued where the number of shares to be issued on conversion is not fixed by contract, but is based on the market value of the shares at the conversion date. This type of bond is all debt, since the value of the conversion option is nil.

LO-3 Illustrate the recognition, measurement and disclosure of convertible debt converted at the investors option

Convertible debt that is convertible at the investors option at a fixed conversion price has both a liability and equity component on initial recognition. This type of convertible bond has: (1) a promise to pay interest and principal and (2) an option that gives the investor the right to use the principal to buy a certain number of common shares. At the date of issuance, the component for the liability is determined first by calculating the present value of the cash obligations of interest and principal, discounted using the market interest rate for a comparable non-convertible bond (Level 2 hierarchy). The conversion option – the equity portion – is the residual and represents the fair value of the bond at issuance date less the liability component. This is the incremental method of valuation.

The interest expense is affected by this allocation. The higher the amount allocated to the conversion option, the higher the discount rate that has been used to determine the liability component. This means that the effective rate of interest will be higher, causing the recognized interest expense to be higher, and lowering net earnings. The conversion option stays in equity, does not change throughout the term of the bond and does not impact earnings. If the bond is converted to shares, then this conversion option will be folded into the common shares account. If the bond is redeemed for cash, then the conversion option becomes part of other contributed capital.

When the bonds are submitted for conversion, the accrued interest to date and any foreign exchange gains or losses are first recorded. Then, using the book value method, the book value of the liability and the book value of the conversion option are transferred to the share capital account. The market value is not used to report this conversion.

LO-4 Illustrate the recognition, measurement and disclosure of convertible debt when conversion is mandatory

Convertible bonds with mandatory conversion require interest be paid in cash, but the principal be settled by issuing a specific number of shares at maturity. In this case, the liability is the cash requirement for the interest payments, but the principal is all equity since the shares can be forced onto the investor at a fixed price (price set in advance). If the issuer (the company) has the right to repay principal in either cash or shares, the bond is still classified as conversion mandatory.

Using the incremental method, the liability portion is calculated first by determining the present value of the interest payments, discounted at an appropriate market yield (based on a comparable non-convertible bond- Level 2 hierarchy). The equity or conversion option is determined as the residual between the issuance proceeds and the liability component. Over the life of the bond, interest is recorded on the interest portion only, and the cash payments are applied against the interest liability only, reducing it to zero by the maturity date. At maturity, the conversion option is transferred to share capital when the shares are issued.

Settlement of interest in shares at fair value – If the company may settle the interest by issuing shares at fair value, the interest is still a liability.

Settlement of interest in shares at a fixed share price or a fixed number of shares – If the bond agreement stated that the interest could be settled by issuing shares at a fixed price, then this portion of the debt is equity. In this case, the risk falls on the investor when the price per share is set, because the ultimate value of the interest payments will depend on the market price of the shares and not on a fixed monetary amount.

LO-5 Classify stock options and rights and describe the related reporting and disclosure requirements

Stock options or stock rights are financial instruments that provide the holder with an option to acquire a specified number of shares in a corporation at a fixed price (exercise price) within a certain period of time (exercise date). They are a derivative instrument since they derive their value from the underlying equity instruments.

The stock option has an intrinsic value when the exercise price is less than the market price of the share. The fair value of the stock option depends on the market expectations about the eventual price on the exercise date which considers the time to expiry and the volatility of the price of the underlying share. Fair values of options are determined using option pricing models such as Black Scholes, Monte Carlo or binomial pricing models. These models price an option giving consideration to the exercise price, the term of the option, the current market share price, the volatility of the share price, expected dividends and the prevailing risk-free interest rates. (These would represent Level 2 and Level 3 hierarchy in fair value determinations.)

When the stock options or rights are issued, they are recorded at fair market value as equity in an account called contributed capital stock rights outstanding for the value of the cash proceeds received. When the stock options are exercised, the share capital is increased with the value of the cash and the closing out of the contributed capital – stock rights.


1. Announcement date: only a memorandum entry.

2. Issuance date or grant date:



Stock rights outstanding


3. If exercised: with an exercise price of $40 per share and the market price is $58 per share

Cash (20,000 x $40)


Stock rights outstanding


Common shares


Note that the market value of the shares is not used to determine the value of the share capital issued.

4. at expiration: Assuming that the current market price of the common shares was $38 and all rights expired:

Stock rights outstanding


Contributed capital, lapse of stock rights


Warrants are detachable stock rights that are attached to another security usually bonds. Warrants will trade separately from the bond and therefore have a Level 1 fair value. Warrants may be exercised to acquire additional shares or be allowed to expire if the share price does not rise above the exercise price. On issuance, the bond with the warrants must be split between

(1) the liability component – the present value of the required cash outlay for interest and principal discounted at the market interest rate for comparable debt with no warrants attached; and

(2) the equity component – the market value of the warrants based on their trading values.

The proportional method is used based on the relative market values of these two components.

On exercise, the contributed capital account rolls into the share capital account along with any cash recieved. If the warrants expire, then the contributed capital warrants is rolled into another contributed capital account.

LO-6 Summarize the characteristics of share based arrangements and describe the various accounting patterns related to the share based arrangements for employees

Share based payments result from transactions where the entity uses consideration that is shares or referenced to the price of a share to acquire or receive goods or services. These may be cash-settled or equity-settled plans. Or the recipient may be able to choose whether to receive shares or cash settlement.

Share-based payments to non-employees For transactions with non-employees, the transaction are recorded when the goods are received or services are rendered. The value of the transaction is the fair value of the goods received or services rendered. Only in rare circumstances where this fair value cannot be determined, would the fair value of the share rights issued be used. (In this case, the fair value may move to Level 2 or Level 3 in the hierarchy.) If share rights are issued, then a stock rights outstanding equity account is used. If the rights are exercised, the share capital account will increase with the cash received and the closing out of the stock rights account. If the stock rights expire, then the account is closed out to another contributed capital account in the equity section. In some cases, the non-employee may also be entitled to cash settled plans, which would require a liability to be recorded rather than an equity account.

Share based payments to employees– These plans may be cash settled or equity-settled and include plans that relate to stock options, SARS (stock appreciation rights), phantom stock plans and restricted share units.

Vesting is achieved when the employee is entitled to the compensation, regardless of other conditions.

Forfeiting During the vesting period, the share based consideration may be forfeited or given up, if the employee leaves.

Accounting patterns for share based arrangements with employees can take several different forms:

  1. Equity- settled plans the fair value is determined on the date of grant and does not change. The value is accrued over the vesting period. Forfeitures are initially estimated and then adjusted to actual each period and at maturity. The entry is to increase contributed capital and to increase an expense account as the arrangement is accrued.
  • Stock options the fair value (based on option pricing models) is determined at the date of the grant and recorded over the vesting period. Only actual forfeitures are adjusted for during this period; the fair value is not changed for subsequent changes in the option pricing variables. When the options are exercised, the contributed capital account is moved to the share capital account along with the cash received on exercise. If the options lapse, then the amount remains as contributed capital in the equity section (classification to another contributed capital account occurs).
  1. Cash-settled plans the fair value are determined based on pricing models and is re-calculated annually. The value is accrued over the vesting period. The yearly accrual is equal to the current years amount, plus a correction of prior year`s estimates. Forfeitures are initially estimated and then adjusted to actual each period and at maturity. The accrual increases a liability account and the related expense account.
  • Cash-settled SARs a SAR entitles the employee to a cash payment equal to the appreciation of the stock price over a reference price over the life of the SARs contract. The fair value of the SAR is the expected time adjusted value of the SAR at maturity, which will include the intrinsic value (market share price less the reference price times the number of units). SARs are adjusted each year throughout the contract for both fair value adjustments and actual forfeitures.
  1. If the plan allows the employees to have a choice between cash or equity settlement at maturity, the equity component is determined as in #1 above and the liability portion is determined as in #2 above.
  • Phantom stock plan with employee option An employee may be provided with a phantom stock option plan and the choice to receive either shares or cash after two years of employment. Both the fair value of the equity component and the fair value of the liability component are recorded at the time of the grant and accrued over the vesting period. The liability will be re-adjusted annually to its fair value, whereas the equity component will not change.At the end of the plan, the equity component will either be folded into common shares (if shares are taken) or closed out to contributed capital if the cash is taken as settlement.

LO-7 Describe the nature of derivatives and hedges and the related accounting implications

A derivative financial instrument is one whose value is tied to a primary financial instrument or a commodity, has no initial net investment (or a small investment) required, and is settled at a future date. They are either options (right to buy or sell something in future) or forward contracts or futures contracts (obligation to buy or sell something in the future). The derivative is recognized on the SFP at fair value when the contract is initiated (generally equal to zero) , and then re-measured at fair value at each reporting date. Gains and losses arising from the change in fair value, or on settlement are recognized in net earnings, unless the derivative is a hedge.

Hedge Derivatives used as hedges are a way to offset the risk to which the company would otherwise be exposed. For the derivative to be a hedge, the company must first have a risk (in the hedged item) that is being countered with the risk in the derivative (the hedging item). The substance of a hedge is that the company is protected from gains or losses on the risk being hedged. In this case, a loss on the hedged item will then be offset by a gain in the hedging item or vice versa.Hedge accounting is voluntary. Hedges may be classified as cash flow hedges or fair value hedges. A financial statement element is a hedge when the company has:

1. an established strategy for risk management that involves hedging;

2. the hedging relationship is formally documented and designated; and

3. the expectation is that the hedge is highly effective and is assessed each period for this effectiveness.

Accounting Once designated as a hedge, then the gains and losses on the hedged item and the hedging item are to be recorded at the same time into earnings so that they can be offset and substance of the hedge is reflected in the statements. In cases where there is a temporary mismatch, the gain or loss that is recognized is reported in OCI and flows to an equity reserve until gains and losses on the other side of the hedging transaction can be also be recognized into the accounts.Once this occurs, the item is transferred from OCI to net earnings to now be matched and offset.

Interest rate swaps are a hedge of interest rates as the company agrees with another company to pay each others interest costs. One company will have a floating rate debt but prefer a fixed rate, whereas the other party will have a fixed rate debt but prefer to have a flowing rate debt. The interest expense will reflect the result of the interest rate swap. If the interest rate swap is a hedge on a variable rate loan, then the hedge is on future payments of interest that will vary based on the current interest rates. The interest rate swap is a derivative and must be recorded at fair value at each reporting date, with changes in the fair value normally reported in net earnings for the period. In this case, the hedged item – the change in the future variable interest payments – is not yet recognized on the SFP and so there would be an accounting mismatch. With hedge accounting, the changes in the fair value of the interest rate swap would be shown as OCI and accumulated in equity. Once the variable interest payments are made then gains and losses in OCI would be transferred to net earnings to be appropriately matched.

LO-8 Explain the presentation of financial instruments on the cash flow statement and the related note disclosure related to risks

The cash flows related to complex financial instruments must be reported based on their substance. Net proceeds on issuance is a financing activity (regardless if whether debt or equity or both), with appropriate note disclosure. Conversions do not involve cash and will not be shown on the SCF. Interest and dividend payments may be shown as either operating or financing activities. 
Extensive disclosure is required with respect to the accounting policies used for each type of financial instrument; fair values of each class and the methods used to determine fair value; and the nature and extent of risks arising from the financial instruments, including objectives, policies and processes for managing the risk.

LO-9 Compare and contrast the accounting requirements for complex financial instruments under ASPE and IFRS under ASPE (different treatment than under IFRS):

  • Redeemable preferred shares issued as part of tax planning structures are classified as equity; shareholders loans are classified as liabilities.
  • The conversion option related to convertible bonds is zero so that the entire convertible bond is treated as a liability.
  • Stock based compensation accounting is generally the same, and companies must use an estimate of volatility for the pricing option model based on the sector values, since the shares are not publicly traded. Forfeiture does not need to be estimated, but recorded as they occur.
  • Measurement of share based payments has a narrower scope and may impact supplier and non-employee consideration. Measurement is based on consideration given up or fair value received, whichever is more reliable. (IFRS only uses fair value of goods and services received, except in rare circumstances.)
  • Hedge accounting is different. Since OCI does not exist, cash flow hedges do not resist only fair hedges in net income exist.
  • Disclosures under ASPE are far less onerous.


This area is complicated by the fact that the income taxes payable by a corporation is determined as a single amount, but the revenues, expenses, gains and losses that give rise to taxable income are reported in different sections of the income statement (intraperiod income tax allocation). A second complication arises when the income tax expense differs from the income tax payable which results in deferred tax liabilities or assets (interperiod income tax allocation). A third complication arises when a corporation has an operating loss for tax purposes. Tax benefits of accounting losses will be covered in Chapter 17.

LO-1 Explain the difference between the income tax provision and expense and permanent and temporary differences

Intraperiod tax allocation deals with allocating taxes between different lines on the statement of comprehensive income.

lnterperiod tax allocation deals with allocating taxes between different reporting periods regardless of when it is actually paid.

Accounting income and taxable income for a year will be different due to:

  • Permanent differences arise when a revenue, expense, gain or loss is included in the calculation of either taxable income or pre-tax accounting income but never the other. Examples include:
    • Intercorporate dividends which are included in accounting income but are tax exempt and will never be included in taxable income.
    • 50% of capital gains is never taxed
    • Certain expenses golf dues are non-deductible expenses
    • And many others see exhibit 15-1 for further examples
  • Temporary differences arise when the tax basis of an asset or liability differs from its accounting carrying value. A temporary difference originates in the period when it is first included in either accounting income or taxable income, and then reverses in a subsequent period when it is then included in taxable income or accounting income, respectively. Examples include:
    • CCA and depreciation expenses
    • Write downs of inventories and other tangible assets
    • And many others see exhibit 16-1 for further examples

LO-2 Describe the various approaches to interperiod tax allocation and the related conceptual issues and prepare the appropriate accounting entries

Conceptually, there are three basic underlying issues:

1. The extent of allocation.

2. The measurement method.

3. Discounting.

Extent of allocation refers to the range of temporary differences to which interperiod tax allocation is applied. There are two options:

1. No allocation – taxes payable method (also called the flow-through method). The amount of taxes assessed each year is recognized as income tax expense for that year. This is only permitted as a choice for private enterprises under ASPE.

2. Full allocation – Comprehensive tax allocation method. The tax effects of all temporary differences are allocated, regardless of the timing or likelihood of their reversal. This method ensures that the related income tax impact of a revenue, expense, gain or loss is recorded in the same period as the related element gives rise to a deferred tax asset and liability. When a temporary difference reverses, the related deferred tax asset or liability is drawn down. This is required under IFRS and is a choice allowed under ASPE.

Your text provides an example that illustrates the impact of the taxes payable method and comprehensive tax allocation.

The measurement issue relates to which tax rate should be used to measure temporary differences.

  • The deferral method records the deferred tax impact by using the companys average tax rate in the year the temporary difference initially originates.
  • The liability method uses the tax rate in effect in the year of reversal. Under the liability method, when the tax rate changes, the related deferred tax liability or asset must be adjusted. The offset to the adjustment goes to income tax expense in the year of adjustment. The liability method is a SFP focus and is required under IFRS and ASPE (when the comprehensive method is used).

The liability and deferral methods are illustrated in the text.

Discounting is not done for deferred tax assets and liabilities due to the complexity in the assumptions that would be required with respect to when the amount would reverse and the appropriate discount rate to use.


1. Calculate taxable income and taxes payable see example in text; see exhibit 16-2

Start with accounting income and adjust for permanent differences to get accounting income subject to tax.

Then adjust for temporary differences to arrive at taxable income.

Multiply taxable income by the tax rate to obtain income taxes payable

If the taxes payable method is used, the analysis stops at this point since the tax expense equals the tax payable.

2. Determine the change in deferred income taxes see example in text – exhibit 16-3

Identify the tax carrying value and accounting carrying value for each asset and liability with differences and calculate the difference.

oDetermining the accounting basis – Think about the common sources of temporary differences and identify the SFP account that could give rise to a different.

oDetermining the tax basis – with respect to:

Tax basisequals:




Accounting carrying value less any amount that will enter tax in the future

Tax deductible amount less all amounts already deducted in determining taxable income in current and prior periods


Accounting carrying value less any amount that will be deductible for income tax in the future.

Carrying amount less any amounts that will not be taxable in future periods

oFor SFP accounts that relate to permanent differences, the tax basis is equal to the accounting basis.

Calculate the deferred tax liability/asset as the difference in values calculated above times the enacted tax rate expected in the year of reversal.

Calculate the difference between the deferred tax liability/asset calculated above and the opening balance. This is the adjustment required.

3. Combine income taxes payable with the change in deferred income tax to determine the tax expense for the year see example Exhibit 16-4

Credit taxes payable (from step 1).

Debit/credit future taxes (from step 2).

Debit income tax expense to balance.

LO-3 Classify the various tax related elements on the statement of financial position





Tax paid is more than accrual based accounting expense

Tax paid is less than accrual based accounting expense

Revenue is recognized for accounting purposesafter it is taxable

Revenue is recognized for accounting purposesbefore it is taxable

Expenses are deducted for tax after it is deducted for accounting purposes

Expenses are deducted for tax before it is deducted for accounting purposes

Limited to the amount that is probable (greater than 50% likelihood) to be realized

Classification is non-current and does not relate to the nature of the related asset or liability or its expected timing for reversal.

Netting of deferred income tax assets and liabilities is only allowed for the same taxable company and same taxation authority.

LO-4 Illustrate the disclosure requirements related to income taxes

Total income tax expense must be allocated to the following:

Statement of profit or loss:

Income from continuing operations;

Income from discontinued operations (net of tax)

The amount of income tax expense that is attributable to (1) current income taxes and (2) deferred income taxes should be disclosed, either on the face of the statements or in the notes.

Statement of comprehensive income

Each component of OCI is reported net of tax the related income taxes for each OCI item is disclosed either on face of statement or in the notes

Statement of changes in shareholders equity

Any tax on capital transactions is disclosed

Any tax on restatements of prior periods

Other disclosure required:

The change in deferred income taxes due to (1) changes in temporary differences and (2) tax rate changes should also be disclosed in the notes.

For each type of temporary difference, require disclosure of: amount of deferred tax recognized in the deferred tax balance on the SFP.

A reconciliation between the statutory rate and the companys effective tax rate can be in either percentages or in dollar terms. Differences may arise due to permanent differences, different rates in different jurisdictions, special levies or deductions permitted, and changing rates on temporary differences.

Note: the difference in definitions of effective tax rate. For accounting standards, the effective tax rate includes deferred income tax. Financial analysts might ignore the deferred taxes and calculate the effective tax rate as current tax provision/ accounting income before taxes.

LO-5 Apply the short cut approach if tax rates have not changed

The short cut approach is best suited to situations only where the income tax rate has not changed from the prior year. The steps are as follows:

1. Calculate taxable income and tax payable.

2. Determine the change in deferred income tax through a direct calculation.

3. Combine income tax payable with the change in deferred income tax to determine the tax expense for the year.

Your text provides an example of this approach.

LO-6 Describe the presentation of income taxes on the cash flow statement

All tax allocation amounts must be reversed out of transactions reported in the cash flow statement. The cash flow statement must include only the actual taxes paid.

IFRS requires disclosure of the income taxes paid as an operating activity and on the face of the statement. If the indirect method is used, and the net earnings after taxes is used, then add backs will be required for the income tax expense and income taxes paid will be shown as a separate item. (Alternatively, some companies begin with earnings before taxes). If the direct method is used, then income taxes paid is shown as a disbursement.

LO-7 Describe the conceptual issues of defining deferred taxes as a liability

Do deferred income taxes meet the definition of being liability and represent an existing obligation? Supporters state that the obligation is real even though the specific parties to whom the liability will be fulfilled cannot be specifically identified nor the actual amount to be paid in the future. And the second question relates to how likely it is that the obligation will actually be paid in cash at some future date. This will depend on two joint occurrences:

(1) the asset basis of the temporary difference must shrink before there can be a net reversal; and

(2) the company must be earning taxable income while the net reversals occur.

LO-8 Describe the recognition, measurement and disclosure requirements for income taxes under ASPE

Private companies may elect to use either the taxes payable method (no deferred tax balances are recognized) or the comprehensive allocation method.

Income tax expense must be allocated to: earnings from continuing operations; discontinued operations; gains and losses recorded directly to retained earnings; and gains and losses recorded directly to share capital.

If the comprehensive method is used, then deferred taxes (or the term future taxes may also be used) are classified as either current or non-current based on the classification of underlying asset or liability that gave rise to the temporary differences. For example, a deferred tax balance related to a current warranty liability would be classified as current. A deferred tax balance related to PP&E would be classified as long-term.

There is less disclosure required for private enterprises. Disclosure is required of the method used; significant tax policies related to revenue recognition, CCA rates, deductible pension expenses, etc. Income tax expense should be reconciled to the average income tax rate, but temporary differences are excluded. The reconciliation would include: large corporations tax, non-deductible expenses, non-taxable gains (including capital gains), and the amount of deductible temporary differences for which a future tax asset has not been recorded.


A1 – Explain investment tax credits and prepare the appropriate accounting entries.

The Canadian Income Tax Act provides for investment tax credits (ITCs) for (1) qualifying research and development expenditures and (2) specified types of expenditures for capital investment. The cost reduction approach is used to recognize an ITC in the same period as the expenditure is recognized as an expense.Under this approach, the amount of the ITC is deducted from the expenditure that gave rise to the tax credit. ITCs related to costs as current expenses may be recognized as either (1) an item of other income in the profit or loss statement; or (2) as reduction (offset) against the expense that gave rise to the ITC.

If the ITC relates to a capital asset or are for development costs that have been capitalized, then the ITC is deducted (1) from the asset itself and the net amount is depreciation, or (2) it is deferred and amortized on the same basis as the asset. 
The notes should disclose: the accounting policy and method of presentation; the nature and extent of ITCs and any unfulfilled conditions and contingencies.