Presentation Transcript

1. BU397: Intermediate Accounting IIMidterm Exam-AID Session

   Tutor: Regan Cairns Coordinator: KarliMazzer
2. Agenda Part 1: Non-Financial and Current Liabilities Part 2: Long-Term Liabilities Part 3: Equity Part 4: Complex Financial Instruments Part 5: Income Taxes

3. -Provisions, Contingent Liabilities, and Contingent Assets-Non-Financial and Current Liabilities

   Part 1
4. Liability: Defined IFRS: A present obligation, arising from past events, the settlement of which is expected to require an outflow of economic resources ASPE: An obligation that arises from past transactions or events, which may result in a transfer of assets. Embody a duty or responsibility Entity has little or no discretion to avoid the duty Transaction or event that obliges the entity has occurred
5. Legal vs. Constructive Obligation Legal Obligation Derives from: A contract Legislation Other operation of law Constructive Obligation Arises if past practice creates a valid expectation on the part of a third party Result of an “obligating event”
6. Provisions- IAS 37 “A liability of uncertain timing or amount” Must be recognized if, and only if: Present obligation (legal or constructive) has arisen as a consequence of a past event Payment is probable (“more likely than not”) The amount can be estimated reliably Use “Best Estimate” The amount the entity would rationally pay Re-measurement: Review and adjust provisions at each balance sheet date If outflow no longer probable, reverse the provision to income
7. Contingent Liabilities- IAS 37 A possible obligation depending on whether some uncertain future event occurs, OR a present obligation, but payment is not probable OR the amount cannot be measured reliably Entities should not recognize contingent liabilities - but should disclose them, unless the possibility of an outflow of economic resources is remote
8. Provisions & Contingent Liabilities
9. Contingent Assets- IAS 37 A possible asset that arises from past events, and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity. Should not be recognized - but should be disclosed where an inflow of economic benefits is probable
10. Additional Disclosures- IAS 37 For each class of provision: Description of nature, timing, uncertainties, assumptions, reimbursement Current-year reconciliation: opening balance additions used (amounts charged against the provision) unused balances reversed closing balance
11. Contingencies- ASPE An existing condition or situation involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur Accrue when it is likely that a future event will confirm that an asset had been impaired or a liability incurred at the date of the financial statements; AND the amount of the loss can be reasonably estimated. When no amount within the range is indicated as a better estimate than any other, the minimum amount in the range would be accrued
12. Current Liabilities Under IFRS, liabilities are classified as current when they meet any one of the following conditions: Expected to be settled within normal operating cycle Held primarily for trading Due within 12 months from balance sheet date No unconditional right to defer settlement for at least 12 months after balance sheet date PE GAAP has no specific definition, but has same intent
13. Notes Payable Written promise to pay a specified sum at a future date Whether interest-bearing or zero-interest-bearing, we need to take interest expense whenever financial statements are prepared Can be current or long-term liabilities, depending on timeframe for repayment
14. Example: Interest-Bearing Note $6,000 note, 2-month term, 12% interest rate Issued on Oct 1, 2010 Interest expense for the term: (6,000 × 12%) × (2/12 months) = $120 Journal entries required: Issue of note Interest accrual Repayment of note
15. Example: Interest-Bearing Note Journal Entries Oct 1 Cash 6,000 Note Payable 6,000 Dec 1 Interest Expense 120 Interest Payable 120 Dec 1 Note Payable 6,000 Interest Payable 120 Cash 6,120
16. Zero-Interest-Bearing Note Payable The bearer receives less money than indicated by the face value of the note The discount is written down over the life of the note Example: Issue a $100,000 6-month note Present value of the note is 90,000 Receive 90,000 at time 0 & have to pay back $100,000 after 6 months “Discount”= 10,000 & will be charged to interest
17. Example 2: Zero-Interest-Bearing Note $100,000 note, 4-month term, issued Jan 1 Present value of note is 96,154 Discount: 100,000 – 96,154 = 3,846 Assume a Dec 31 year-end Record issue of note: Jan 1 Cash 96,154 Note Payable 96,154
18. Example: Zero-Interest-Bearing Note Record interest at term of note: May 1 Interest Expense 3,846 Note Payable 3,846 Balance in “Note Payable” = $100,000 (face value) Record repayment of note: May 1 Note Payable 100,000 Cash 100,000
19. Some Other Current Liabilities Any liability due on demand Portion of long-term debt that is due within the year (unless the contract dictates that the debt is to be retired by a non-current asset) Rents and Royalties Payable Employee-Related Liabilities Salaries/wages, payroll deductions, short-term compensated absences, bonuses
20. Some Other Current Liabilities Short-term debt expected to be refinanced is omitted from current liabilities, provided: Intent to refinance on long-term basis, and Ability to complete refinancing is demonstrated Customer Advances and Returnable Cash Deposits Either current or non-current, depending on attached conditions
21. Dividends Payable Cash Dividends: recognize when declared Legal obligation Preferred Dividends in Arrears: should be disclosed if not yet declared Stock Dividend: not reflected as a liability; is a transfer through equity accounts Increase to Share capital Decrease to Retained earnings
22. Taxes Payable Income Tax Payable HST Payable: amount collected on eligible sales HST Recoverable: amount paid on eligible purchases NET amount is remitted to the CRA If HST Recoverable > HST Payable, then receive a refund from the CRA
23. Example: Taxes Payable Store makes a sale of $100 on credit HST at 13% is equal to $13 Accounts Receivable 113 Sales 100 HST Payable 13
24. Non-Financial Liabilities Contractual obligation not involving transfer of cash, other financial asset, or financial instrument Under IFRS, valued at best estimate of payment required to settle at the balance sheet date ASPE: measurement varies based on nature of liability
25. Asset Retirement Obligation Obligation to restore a property to its original condition before retirement Discount the amount of future obligation to its present value Capitalize this amount to the underlying asset account Recognize as interest on a straight-line basis over the term of use of the asset Obligation is eventually written up to full value (under ASPE, referred to as “accretion”)
26. Example: ARO Coal mine-> required to restore at end of 5-year period Cost of restoration will be $800,000 Assume a 10% discount rate
27. Example: ARO Present value of ARO: (800,000) ÷ (1.10)5 = 496,737 Record to the asset account: Coal Mine 496,737 Asset Retirement Obligation 496,737
28. Example: ARO End of First Year-> Record interest 496,737 × 10% = 49,674 Interest Expense 49,674 Asset Retirement Obligation 49,674 Balance in ARO is 546,411 (496,737 + 49,674) (Interest after year 2 is 54,641)
29. Example: ARO Asset Retirement Obligation has carrying value of the full $800,000 at end of year 5
30. Unearned Revenues Example- receive $250 for a service to be provided in the future Cash received: Cash 250 Unearned Revenue 250 Service provided: Unearned Revenue 250 Revenue 250
31. Warranty Obligations Require entity to provide goods/services after initial product/service delivered 2 Scenarios: Warranty included in cost of product -> Expense Approach Warranty sold separately -> Revenue Approach
32. Warranty- Expense Approach Record provision if: Future costs likely to be incurred Amount reasonably estimated (& outflow probable) Expense warranty costs in year of sale Recognize a warranty liability
33. Warranty- Expense Approach Warranty costs charged to the expense as incurred Adjusting entry required at period end to accrue remaining estimated liability and expense on current period sales Warranty liability reported for the estimated amount of outstanding claims -Total estimated warranty expense and liability recognized and recorded at the point of sale -Warranty costs charged against liability as incurred -Warranty liability reported for the estimated amount of outstanding claims Method B Method A
34. Example: Warranty- Expense Approach A car dealership provides warranty work on all vehicles sold. The entity’s past experience has indicated the following: 60% of cars sold have 0 defects 25% of cars sold have normal defects -> incur $3,000 in costs 15% of cars sold have significant defects -> incur $12,000 in costs During the year, the dealership sold 80 vehicles and incurred $70,000 in actual costs. There was an opening balance of $40,000 in the warranty provision account.
35. Example: Warranty- Expense Approach Under Method A, $70,000 would be expensed over the year (as costs were incurred) Remaining estimated liability on sale of 80 cars: -expected warranty cost per car sold is: (60% * $0) + (25% * 3,000) + (15% * 12,000) = $2,550 So, on the sale of 80 cars we would have expected expenses of $204,000 ($2,550 * 80) Adjust the provision account: (204,000 – 70,000) = 134,000 Warranty Expense 134,000 Warranty Provision 134,000
36. Example: Warranty- Expense Approach Under Method B, $204,000 would be expensed & provided for over the year ($2,550 at point of sale for each car) Warranty Expense 204,000 Warranty Provision 204,000 $70,000 would be charged against the liability over the year Warranty Provision 70,000 Cash 70,000 Balance in Warranty Provision = 174,000
37. Warranty- Revenue Approach Extended product warranties/ warranties sold as separate product “Sales warranty method” Defer the revenue from sale of warranty Recognize over the life of the warranty ->Straight-line method
38. Example: Warranty- Revenue Approach ABC ComputerWare sells a laptop on Jan 1, 2009 for $4,000 and the buyer purchases a warranty separately for $400. It is good for 2 years. Cash 4,400 Sales 4,000 Unearned Warranty Revenue 400
39. Example: Warranty- Revenue Approach Jan 1, 2010 Warranty Revenue 200 Unearned Warranty Revenue 200 Jan 1, 2011 Warranty Revenue 200 Unearned Warranty Revenue 200
40. Premiums, Coupons, Rebates, Loyalty Points Examples: frequent flyer miles, customer point cards, prizes, mail-in rebates ASPE: Costs expensed in period of underlying sale Costs of outstanding offers are estimated & recorded IFRS (IFRIC 13): Benefit is measured at fair value of the incentive Allocate this amount of the consideration received to the incentive; the remainder to other component(s) of sale Revenue is deferred at time of sale & recognized when benefit is redeemed

41. Long-Term Financial Liabilities

    Part 2
42. Long-Term Debt Obligations not payable within one year, or normal operating cycle- whichever is longer Often have restrictive covenants attached Contract terms requiring company to do, or refrain from doing, something in the future (should be disclosed in notes)
43. Notes Payable Recall: A written promise to pay a specified sum at a future date Interest-bearing Zero-interest-bearing Interest expense is recorded under both types The liability is often classified as Long-Term, but we take the current portion under Current Liabilities (i.e. the amount to be repaid within 1 year, or normal operating cycle)
44. Example: Interest-Bearing Note $22,000 note, 2-year term, 12% interest rate The market interest rate is 9% Today is March 31 Assume a Dec. 31 year end Interest expense for current year: (22,000 × 12%) × (9/12 months) = 1,980 Journal entries required: Issue of note Interest accrual Repayment of note
45. Example: Interest-Bearing Note Year-1 Journal Entries: Mar 31 Cash 22,000 Note Payable 22,000 Dec 31 Interest Expense 1,980 Interest Payable 1,980 Dec 31 Interest Payable 1,980 Cash 1,980
46. Example: Interest-Bearing Note Year-2 Journal Entries: Dec 31 Interest Expense 2,640 Interest Payable 2,640 Dec 31 Interest Payable 2,640 Cash 2,640
47. Example: Interest-Bearing Note Year-3 Journal Entries Mar 31 Interest Expense 660 Interest Payable 660 Mar 31 Interest Payable 660 Note Payable 22,000 Cash 22,660
48. Zero-Interest-Bearing Note Payable The bearer receives less money than indicated by the face value of the note The discount is written down over the life of the note Ex. $100,000 4-year note & market interest rate is 6% Discount to current value: (100,000) ÷ (1.06)4 = 79,209 Receive 79,209 at time 0 & have to pay back $100,000 after 4 years “Discount”= 20,791 & will be charged to interest
49. Example 2: Zero-Interest-Bearing Note $80,000 note, 2-year term, issued Jan 1 Market interest rate is 9% (80,000) ÷ (1.09)2 = 67,334 Discount is (80,000 – 67,334) = 12,666 At the end of year 1, carrying value of note is: (80,000) ÷ (1.09) = 73,394 Charge to interest for year 1: 9% × 67,334 = 6,060 OR (73,394 – 67,334) = 6,060
50. Example 2: Zero-Interest-Bearing Note Year-1 Journal Entries: Jan 1 Cash 67,334 Discount on Note 12,666 Note Payable 80,000 Dec 31 Interest Expense 6,060 Discount on Note 6,060
51. Example 2: Zero-Interest-Bearing Note Year-2 Journal Entries: Dec 31 Interest Expense 6,606 Discount on Note 6,606 Dec 31 Note Payable 80,000 Cash 80,000 Balance in “Discount on Note” = 0
52. Bonds Underlying contract is called a bond indenture A promise (by the lender to the borrower) to pay: a sum of money at the designated date, and periodic interest (usually paid semi-annually) at a stipulated rate on the face value Types of bonds: Bearer (coupon) bonds: are freely transferable by current owner Secured and unsecured debt: secured by collateral (real estate, stocks) Serial bonds: mature in installments Callable bonds: give issuer right to call and retire debt prior to maturity Income and Revenue bonds: interest payments tied to some form of performance Deep-discount bonds: little or no interest payments; sold at substantial discount *Convertible bonds: can be converted into other corporate securities for a specified time after issue
53. Valuation of a Bond Valued at the present value Include present value of Redemption value (=face value) Interest payments (annuity, *often semi-annual) Discount using the market (yield) rate of interest at issue date
54. Valuation of a Bond Sold at discount: market rate > coupon rate Bondholder could earn a greater interest rate in the market, so the bond is issued for less Sold at premium: market rate < coupon rate Bondholder wouldn’t make as much in the market, so charge a higher price for the bond
55. Amortization of Bond Premium We amortize the premium/discount of the bond to equate the carrying value to the face value by the time of maturity Issued at premium-> this decreases the interest expense (it is lower than the interest that is actually paid each year) Issued at discount-> this increases the interest expense (greater than amount paid) Straight-line method: permitted by ASPE Effective Interest method: required under IFRS, optional under ASPE
56. Example: Straight-Line Method Bonds with $100,000 face value are issued at a price of $92,000 on Jan 1. Maturity is in 8 years. Assume a Dec 31 year-end. Discount = $8,000 Annual interest: $8,000 ÷ 8 = $1,000 Record on Dec 31 of all 8 years: Interest Expense 1,000 Bonds Payable 1,000
57. Example 2: Straight-Line Method Bonds with $600,000 face value are issued on March 1 with a $95,000 premium. Maturity is in 10 years. Assume a Dec 31 year-end. Annual Interest = $95,000 ÷ 10 = $9,500 Interest will need to be recorded at Dec 31 of each year. 1st year: $9,500 × 10/12 months = 7,917
58. Example 2: Straight-Line Method Record on Dec 31 of 1st year: Bonds Payable 7,917 Interest Expense 7,917 Record on Dec 31 of the next 9 years: Bonds Payable 9,500 Interest Expense 9,500 Record on March 1 of the 10th year: Bonds Payable 1,583 Interest Expense 1,583
59. Example: Effective Interest Method
60. Effective Interest Method The journal entry to record the bond issuance is: Cash 108,530 Bonds Payable 108,530
61. Effective Interest Method The journal entry for first semi-annual payment is: Bond Interest Expense 3,256 Bonds Payable 744 Cash 4,000
62. Example: Effective Interest Method Refer to the previous table. What is the journal entry for the 6th semi-annual interest payment? Bond Interest Expense 3,137 Bonds Payable 863 Cash 4,000
63. Effective Interest Method A bond with face value $60,000 is issued for $53,104 and has an 8 year term. The coupon rate is 6%. The market rate of interest is 8%. (we see the discount is $6,896)
64. Example: Effective Interest Method Refer to the table on the previous slide. What would be the journal entry in year 3? Interest Expense 4,356 Bonds Payable 756 Cash (Interest Payable) 3,600
65. Transaction Costs Bond issue costs may included: costs paid to broker, legal costs, commissions These are added to the amortized cost
66. Extinguishment of Debt Amortize to date Take gain/loss from settlement Net carrying amount > settlement price  record a gain (“Gain on Redemption”) Net carrying amount < settlement price  record a loss (“Loss on Redemption”)

67. Equity

    Part 3
68. Equity Definition: the residual interest in the assets of an entity after deducting its liabilities Assets = Liabilities + Equity Equity = Assets - Liabilities
69. Components of Equity Share Capital Legal/Stated Capital = full price received for shares Shares Authorized vs. Shares Issued Contributed Surplus Affected by equity transactions not included elsewhere Retained Earnings Accumulated Other Comprehensive Income Includes revenue, expenses, gains, losses arising from transactions that are not included in Net Income
70. Share Capital System Grouped by Class -> all shares in a given class are equal & carry the same rights Basic/ Inherent Rights: Share proportionately in profits & losses Right to vote for directors Share proportionately in corporate assets upon liquidation 4th optional right: Preemptive right: to share proportionately in any new share issues (in the same class) Limited liability: only risk losing the amount invested
71. Share Capital Common/Ordinary Shares Ultimate risk of loss & benefits of success No guarantee of dividends/ assets Control corporation through voting rights Preferred Shares Priority claim on: Dividends Assets upon dissolution May have features attached: Cumulative Convertible Callable/redeemable Retractable Participating
72. Preferred Share Features Cumulative: “dividends in arrears”-> must be paid in a later year Convertible: convert to common shares at predetermined ratio Callable: corporation has right to call shares for redemption-> dates & prices specified Retractable: shareholder has right to sell shares back to company Participating: share in profit distributions higher than prescribed dividend (share proportionately to common shareholders)
73. Example: Issuance of Shares- Basic A Corp. sells 2,000 ordinary shares for $10 each Cash 20,000 Ordinary Shares 20,000
74. Example 2: Issuance of Shares- Basic B Corp. issues 2,000 ordinary shares for $10 each Also being issued are 500 Class A Preferred Shares, and 450 Class B Preferred Shares. They sell for $9 and $8 respectively. Cash 28,100 Ordinary Shares 20,000 Preferred Shares- Class A 4,500 Preferred Shares- Class B 3,600
75. Issuance of Shares- By Subscription Only partial payment received initially Payments are made in “installments” Shares not actually issued until subscription price received in full New accounts: Subscriptions Receivable (normally current asset) Shares Subscribed (equity account-> open different account for each class)
76. Example: Shares Issued By Subscription C Corp offers shares by subscription Can purchase 10 ordinary shares at $22 per share 60% due at subscription date; remaining 40% after 6 months 50 individuals subscribe on March 1
77. Example: Shares Issued By Subscription March 1: subscriptions recorded & 1st installment received Journal Entries: Subscriptions Receivable 11,000 Ord. Shares Subscribed 11,000 Cash 6,600 Subscriptions Receivable 6,600
78. Example: Shares Issued By Subscription Sep 1: 2nd installment received; payment has been received in full, so shares are issued Journal Entries: Cash 4,400 Subscriptions Receivable 4,400 Ordinary Sh. Subscribed 11,000 Ordinary Shares 11,000
79. Shares Issued By Subscription What if the subscriber defaults? 3 scenarios: Amount paid to date is refunded Amount paid to date is considered forfeited (no shares issued) Issue shares equivalent to amount already paid (remaining amount is forgiven)
80. Example: Defaulted Subscription Consider the previous example On Sep 1st, all 50 subscribers default on their subscription
81. Example: Defaulted Subscription Scenario A: corp. refunds the amount paid Sep 1 Ordinary Sh. Subscribed 11,000 Subscriptions Receivable 4,400 Cash 6,600
82. Example: Defaulted Subscription Scenario B: amount paid is considered forfeited no shares are issued Sep 1 Ordinary Sh. Subscribed 11,000 Subscriptions Receivable 4,400 Contributed Surplus 6,600
83. Example: Dividends On Dec 31, YYZ Corp’s Board of Directors decide that a cash dividend in the amount of $40,000 is to be paid on April 1 of the following year. At the same meeting, a 30% stock dividend is declared & shall be distributed May 1. Shares are currently trading for $98 Current outstanding Share Capital = $100,000 1,000 shares are authorized & issued The date of record is February 28
84. Example: Dividends 30% stock dividend 1,000 shares outstanding × 30% = 300 shares Fair value of shares at declaration date: $98 $98 × 300 shares = $29,400
85. Example: Dividends Dec 31 is the Date of declaration 2 ways to do the journal entry: Cash Dividend Declared 40,000 Stock Dividend Declared 29,400 Cash Dividend Payable 40,000 Stock Dividend Payable 29,400 Retained Earnings 69,400 Cash Dividend Payable 40,000 Stock Dividend Payable 29,400 Note: if there are balances in any “dividends declared” accounts at year-end (i.e. financial statement date), the amounts are closed out to Retained Earnings
86. Example: Dividends Payment of the dividends: Apr 1 Cash Dividend Payable 40,000 Cash 40,000 May 1 Stock Dividend Payable 29,400 Ordinary Shares 29,400
87. Example: Dividends How has the price per share changed due to the stock dividend? BEFORE: $100,000 share capital = $100/share 1,000 shares outstanding AFTER: $129,400 share capital = $99.538/share 1,300 shares outstanding -Each shareholder maintains the same proportionate interest
88. Dividend Preferences Implications on Dividend payments Cumulative feature: When a dividend is declared, all dividends in arrears AND current year prescribed dividends must be paid to preferred shareholders before common shareholders receive anything Participating feature: Cumulative & current year dividends have already been paid to preferred Ordinary shareholders are paid an amount to match return rate earned by preferred shareholders (return from current year dividends only) *Any remaining dividend amount is shared proportionately between all shareholders, based on carrying value of each share class
89. Share-Based Payments: IFRS 2 Share-based payments to employees are measured at the fair value of the equity instrument Vesting period: when is the employee permitted to exercise the option? If immediate vesting, recognize the expense immediately If vesting is in the future, recognize the expense over the vesting period Considerations: How many employees are predicted to exercise? Forfeiture of options
90. Example: IFRS 2 Bama Rama Inc. has a stock option plan for its key senior executives. Each of the top 50 executives has been granted 500 options effective January 1, 2009. Each option has a 3 year vesting period and was issued at a strike price of $12. Using an appropriate measurement model, each option was determined to have a fair value of $8 at the grant date.
91. Example: IFRS 2 Key Facts: 25,000 options 50 executives × 500 options 3 year vesting period Fair value $8 per option $8 × 25,000 = $200,000 total fair value
92. Example: IFRS 2 At the end of the first year, it is anticipated that ten executives will leave before the end of the vesting period. Calculate the expense for the current year $200,000 × (40/50 executives) × (1/3 yrs) = $53,333 Dec 31/09 Compensation Expense 53,333 Contributed Surplus- Options 53,333
93. Example: IFRS 2 At the end of the second year it was estimated that a total of 20 executives would leave by the end of the vesting period $200,000 × (30/50 executives) × (2/3 yrs) = $80,000 Subtract amount already expensed (80,000 – 53,333 = 26,667) Dec 31/10 Compensation Expense 26,667 Contributed Surplus- Options 26,667
94. Example: IFRS 2 At Dec 31, 2011 a total of 12 executives had actually left. $200,000 × (38/50 executives) × (3/3 yrs) = $152,000 Subtract amount already expensed (152,000 – 80,000 = 72,000) Dec 31/11 Compensation Expense 72,000 Contributed Surplus- Options 72,000
95. Example: IFRS 2 Assume that 30 of the 38 employees actually exercised their 500 options. 30 × 500 × $12 strike = $180,000 received in cash Balance in related Contributed Surplus account is $152,000 $152,000 × (30/38 employees exercising) = $120,000 Dec 31/11 Cash 180,000 Contrib. Surplus- Options 120,000 Ordinary Shares 300,000
96. Example: IFRS 2 For the remaining options that expired, transfer the balance in “Contributed Surplus- Options” so that it is no longer restricted $152,000 × (8/38 employees not exercising) = $32,000 Dec 31/11 Contrib. Surplus- Options 32,000 Contributed Surplus 32,000

97. Complex Financial Instruments

    Part 4
98. Hybrid/Combined Instruments Contain elements of both debt & equity Classification: Debt or Equity? Must examine economic substance to determine appropriate classification Does the instrument contain equity-like features that need to be separated out? Bifurcation Consider: Obligation to deliver cash/financial asset? Investor exposed to risks/rewards of share ownership?
99. Definitions Revisited Financial liability: any liability that is a contractual obligation to 1. Deliver cash or another financial asset to another party, OR 2. Exchange financial instruments with another party under conditions that are potentially unfavourable Equity instrument: any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities
100. Financial Liabilities Measured initially at fair value Can be subsequently re-measured: Fair value, or Amortized cost Perpetual debt is a financial liability Value flows from payments of interest (obligation to deliver cash) Callable/Redeemable Preferred Shares Although shares are legally equity, they will be called at some point-> entity obligated to pay cash for shares
101. IAS 32 Instrument is classified when initially recognized Hybrid/combined instruments Measured at time of recognition Value the debt component & apply residual (remaining) value to equity  the Incremental Method No subsequent revision to classification or measurement
102. Debt With Detachable Stock Warrants Detachable warrant: Option to buy fixed # common shares at fixed price Only available for specified period Separable from the host contract Warrant is an equity instrument -> bifurcation is required *Value the debt & allocate remainder to warrant (equity)
103. Convertible Debt Bond that can be converted into other forms of securities (usually common shares of the company) Benefits of bond: interest, principal repayment AND Privilege of exchange at holder’s option
104. Convertible Debt Time of Issuance Allocate amounts to liability & equity using the Incremental Method ASPE requires bifurcation, but zero allocation to equity is acceptable Time of Conversion Value at: carrying value of debt + the equity balance in Contributed Surplus Induced Conversion Retirement Settlement Early redemption
105. Example: Time of Issuance Issue 400 three-year, 5% convertible bonds Face value of $400,000 ($1,000/bond) Each bond can be converted into 100 shares (currently trading at $7/share) Similar bonds without the conversion feature have an 11% interest rate Find the fair value of the debt Use formulas or present-value tables
106. Example: Time of Issuance PV of principal: $400,000 * 0.7312 = 292,480 PV of interest payments (annuity): Each payment is $20,000 (400,000 * 5%) $20,000 * 2.4437 = 48,874 So total PV of debt = 292,480 + 48,874 = 341,354
107. Example: Time of Issuance Face value of bonds (cash received): $400,000 Present value without conversion rights:$341,354 Difference of $58,646 is allocated to equity component (This is equivalent to the “Bond discount”) Cash 400,000 Bonds Payable 341,354 Contrib. Surplus- Conversion Rights 58,646
108. Example: Time of Conversion Over the bonds’ lives, the bond discount amortizes to Bonds Payable, using the Effective Interest method Assume all the bonds are converted at the end of year 2
109. Example: Time of Conversion End of year 2: Carrying value = 378,382 Balance in related Contributed Surplus account = 58,646 378,382 + 58,646 = 437,028 Common shares issued are valued at this amount Bonds Payable 378,382 Contrib. Surplus- Conversion Rights 58,646 Common Shares 437,028
110. Convertible Debt- Retirement Settlement (bonds are never converted) Cash is repaid, contributed surplus becomes unrestricted (no longer allocated solely to Conversion Rights) Assume bonds in prior example reach term & were never converted: Bonds Payable 400,000 Contrib. Surplus- Conv. Rights 58,646 Cash 400,000 Contributed Surplus 58,646
111. Example: Early Retirement Find the carrying amount of the debt $378,382 calculated previously Assume fair value of the bond at this time is $385,000 - Difference between fair value & carrying value of debt: 385,000 – 378,382 = 6,618 - This is the debt retirement cost
112. Example: Early Retirement Journal Entry: Bonds Payable 378,382 Contrib Surplus- Conv Rights 58,646 Exp- Debt Retirement Cost 6,618 Retained Earnings 6,354 Cash 450,000 *Debt Retirement Cost reflects the difference between fair value (without conversion feature) and book value of ONLY THE DEBT PORTION Retained Earnings is a plug to reflect the additional loss from offering a higher amount
113. Induced Conversion Corporation offers an incentive in order to push bondholders toward converting Incentive may be in the form of cash, common shares, etc. Allocated between debt & equity components, based on fair value at time of conversion
114. Example: Induced Conversion Consider again the previous example At the end of the second year, a total inducement of $15,000 is offered to the bondholders Assume they all take advantage of the offer & convert at this time
115. Example: Induced Conversion Debt Retirement Cost already calculated in Early Retirement example 385,000 (given fair value) – 378,382 (carrying value) = 6,618 Calculate the DR to Retained Earnings 15,000 (inducement offered) – 6,618 (above) = 8,382 Bonds Payable 378,382 Contrib Surplus- Conversion Rights 58,646 Retained Earnings 8,382 Cash 15,000 Ordinary Shares 430,410
116. Interest & Dividends Recognition dependent on initial treatment of underlying instrument Following items considered a charge to P&L Interest payments on bond issued by entity Dividend payments on preference shares classed as a financial liability Gains/losses associated with redemption of an instrument classed as debt even thought underlying instrument may take legal form of equity Reclassified dividends may be included in interest expense or reported separately
117. Derivatives Financial instruments that create rights and obligations Transfer financial risk from one party to another Derivatives have the following characteristics: Their value changes in response to the underlying instrument 2. They require little or no initial investment They are settled at a future date IAS 39: derivatives are measured & recorded at fair value Related gains and losses are booked through net income

118. Income Taxes

     Part 5
119. Income Tax: Expense vs. Payable “Income Tax Expense” will seldom be equal to “Income Tax Payable” The CRA dictates different deductions & inclusions for tax purposes We take accounting income and adjust it according to these rules -> gives us taxable income
120. Income Tax: Expense vs. Payable Income Tax Payable = CURRENT Income Tax Expense Calculated by: Taxable Income * Tax Rate The “Tax Provision” takes into account both Current & Deferred Income Tax Expense (Benefit)
121. Taxable Income Accounting (“Book”) Income Add-back: Certain expenses not permitted Deduct: Allowable deductions =Taxable Income We look to the Income Tax Act for the required inclusions & allowable deductions
122. Taxable Income:Permanent Differences Permanent differences: different treatment for accounting & tax; the difference will never be reconciled Therefore do not affect future taxes Examples: Add-back: Club dues, Interest & Penalties paid to CRA, 50% of Meals & Entertainment Include in income: taxable capital gains Exclude from income: dividends received from taxable Canadian corporation
123. Taxable Income: Temporary Differences Temporary differences: different timing of the expenses; will eventually be reconciled Result in a Deferred Tax Asset or Liability More tax paid now -> less in the future Less tax paid now -> more in the future Temporary differences = Σ (timing differences)
124. Timing Differences Examples: Book depreciation vs. Capital Cost Allowance Warranty expense vs. actual warranty costs incurred Pension expense vs. actual contributions made to plan Unrealized gains/losses
125. Deferred Tax Asset If you have paid tax on more than book income Arise from “deductible temporary differences” Benefit in the future; you have already paid the tax Examples: Accrual was greater than actual expenses incurred Book depreciation was greater than CCA permitted on the tax return
126. Example- Deferred Tax Asset Warranty Expense on books = $40,000 Actual Warranty costs incurred = $25,000 Accounting income before taxes = $800,000 Tax Rate = 40% Deferred Tax Asset = (40,000 – 25,000) * 40% = 6,000 We pay more tax now & benefit in future years The Deferred Tax Asset is written down as warranty costs are incurred in the future
127. Deferred Tax Liability Deferred Tax Liability: If you have paid tax on less than book income Obligation in the future; need to pay tax on amount you deducted Examples: Accrual was less than actual expenses incurred Book depreciation was less than CCA taken on the tax return
128. Example- Deferred Tax Liability Depreciation Expense on books = $65,000 Capital Cost Allowance for tax = $70,000 Accounting income before taxes = $770,000 Tax Rate = 40% Deferred Tax Liability = (65,000 – 70,000) * 40% = (2,000) We pay less tax now & take the burden in future years The Deferred Tax Liability is written down as book value & tax value of asset approaches zero (eventually accumulated depreciation will “catch up” with CCA)
129. Example #2- Deferred Tax Liability Pension Expense (an accrual) = $105,000 Actual contributions to plan = $180,000 Accounting income before taxes = $450,000 Current Tax Rate = 40% Substantively enacted tax rate for Jan 1 of next year is 34%
130. Example #2- Deferred Tax Liability Current Tax Expense = 375,000 * 40% = 150,000 Deferred Tax Liability = (105,000 – 180,000) * 34% = (25,500) Income Statement presentation: Income Taxes: Current 150,000 Deferred 25,500 175,500
131. Example #2- Deferred Tax Liability Journal Entries: Current Income Tax Expense 150,000 Income Tax Payable 150,000 Deferred Income Tax Expense 25,500 Deferred Income Tax Liability 25,500
132. Example #2- Deferred Tax Liability In the following year: Pension Expense (an accrual) = $75,000 Actual contributions to plan = $70,000 Accounting income before taxes = $450,000 Current Tax Rate = 34% Substantively enacted tax rate for Jan 1 of next year is 32%
133. Example #2- Deferred Tax Liability Current Tax Expense = 455,000 * 34% = 154,700 *Need to adjust DTL account for new rate! Always useful to track the balance of the timing difference From last year: 105,000-180,000 = (75,000) This year: 75,000 – 70,000 = 5,000 So, the outstanding timing difference is (70,000) DTL account should be (70,000) * 32% = (22,400)
134. Example #2- Deferred Tax Liability Change in DTL = (105,000 – 180,000) * 34% = (25,500) Income Statement presentation: Income Taxes: Current 150,000 Deferred 25,500 175,500
135. Example #3 MLSB Inc. has the following information required for tax purposes for 2001, 2002, 2003:
136. Example #3 Find Current Income Tax Payable for each year
137. Example #3 Determine the Deferred Tax Assets/Liabilities Consider each of the timing differences
138. Example #3
139. Example #3
140. Example #3 Summary of balances in tax accounts ( xx ) indicates a credit balance
141. Example #3 Dec 31/2001 Journal Entries: Current Income Tax Expense 33,200 Current Income Tax Liability 33,200 Deferred Income Tax Expense 6,000 Deferred Tax Asset 800 Deferred Tax Liability 6,800
142. Example #3 Dec 31/2002 Journal Entries: Current Income Tax Expense 40,040 Current Income Tax Liability 40,040 Deferred Income Tax Expense 3,680 Deferred Tax Asset 360 Deferred Tax Liability 3,320
143. Example #3 Dec 31/2003 Journal Entries: Current Income Tax Expense 49,440 Current Income Tax Liability 49,440 Deferred Tax Asset 40 Deferred Tax Liability 1,960 Deferred Income Tax Benefit 2,000
144. Income Statement presentation: Income Taxes section
145. Example #3 Suppose that at the end of 2002, the rate of 48% had already been substantively enacted for the following year? We would apply the rate 48% since it is known; it is the rate that will be applicable once the DTA/DTL are reversed

146. Good luck on your Midterm!!!

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