GUIDE TO ACCOUNTING STANDARDS FOR PRIVATE ENTERPRISES CHAPTER 45 FINANCIAL INSTRUMENTS

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1 GUIDE TO ACCOUNTING STANDARDS FOR PRIVATE ENTERPRISES CHAPTER 45 FINANCIAL INSTRUMENTS

2 DISCLAIMER This publication was prepared by the Chartered Professional Accountants of Canada (CPA Canada). It has not been approved by any Board or Committee of CPA Canada or any Provincial body. Neither CPA Canada nor the authors accept any responsibility or liability that might occur directly or indirectly as a consequence of the use, application or reliance on this material. For information regarding permission, please contact

3 TABLE OF CONTENTS Paragraph Introduction Purpose and Scope Overview of Section What is a Financial Instrument? Contingent Consideration in a Business Combination Definitions Recognition Example Trade Date Accounting Example Settlement Date Accounting Classification Liability or Equity Preferred Shares Issued in a Tax Planning Arrangement Examples Liability vs. Equity Compound Financial Instruments Measurement Initial Measurement Arm s length transactions Financing Fees and Transaction Costs Example Investment in Equity Instruments at Cost Demand Loans Examples Accounting for Dmand Loans and Revolving Debt Fees and Costs Loans at Non-market Interest Rates Example Loan with a Non-market Rate of Interest Related to Asset Purchase Indexed Financial Liabilities Convertible Financial Liabilities Example Initial Measurement of Convertible Liability Related Party Transactions Example Non-interest Bearing Loan to Manager Subsequent Measurement Cost/Amortized Cost v. Fair Value Cost/Amortized Cost Example Investment in Equity Instruments Measured at Cost Example Accounting for an Interest Bearing Investment, an Investment in Guaranteed Investment Certificates (GICs) Measured at Amortized Cost Amortization of Initial Purchase Premium or Discount, Financing Fees and Transaction Costs Example Investment in Government of Canada Treasury Bill Example Loan at Non-market Rate of Interest Example Interest-free Loan to a Manager Impairment Decision Tree Process for Assessing Impairment Example Impairment Assessment Example Indications of Impairment Measurement of Impairment Example Present Value of Future Cash Flows of a Loan Example Cash Flow Estimates Impairment of Groups of Assets Reversals Example Impairment Reversal Fair Value Example Fair Value Sources by Instrument Example Calculating the Change in Fair Value of a Forward Contract Example Calculating the Change in Fair Value of an Interest-rate Swap Chartered Professional Accountants of Canada

4 Indexed Financial Liabilities Example Indexed Financial Liability Presentation Offsetting Legal Right of Offset Intent to Settle Net Interest, Dividends, Losses and Gains Derecognition Financial Assets Securitization Transactions Illustration Typical Securitization Transaction Measurement of Interest Held after a Transfer of Receivables Example Recording Transfers with Proceeds of Cash, Derivatives, and Other Liabilities Example Recording Transfers of Partial Interests Servicing Assets and Liabilities Example Recognizing a Servicing Liability in a Transfer of Receivables Example Sale of Receivables with Servicing Retained Example Recording Transfers of Partial Interests with Proceeds of Cash, Derivatives, Other Liabilities, and Servicing Fair Value Example Recording Transfers if it is not Practicable to Estimate a Fair Value Sales-type and Direct Financing Lease Receivables Example Recording Transfers of Lease Financing Receivables with Residual Values Financial Liabilities Extinguishment of Financial Liabilities Examples Investment Banker Acting as Agent Modification of Line of Credit or Other Revolving Debt Arrangement Example Determining whether Borrowing Capacity Exceeds that of the Old Arrangement and Related Accounting Implications of Fees and Costs Extinguishing Financial Liabilities with Equity Instruments Convertible Liabilities Example Accounting on Extinguishment of a Compound Financial Instrument Hedge Accounting Introduction Hedged Item Hedging Item Accounting for the Hedging of Anticipated Transactions Commodity Hedge Example Hedge of an Anticipated Purchase of a Commodity Currency Hedge Example Foreign Currency Hedge of an Anticipated Purchase of a Commodity Examples Hedge of Anticipated Foreign Currency Transaction Accounting for a Qualifying Hedge of an Interest-bearing Asset/Liability Hedge of Interest Rate Risk Example Interest Rate Swap Cross-currency Interest Rate Swap Example Cross-currency Interest Rate Swap Hedge of the Net Investment in a Self-sustaining Foreign Operation Mechanics of Hedge Accounting Example Effect of Hedge Accounting on the Purchase of Machine Examples Effect of Hedge Accounting on the Hedge of Foreign Currency Anticipated Transaction Additional Examples Hedge of Foreign Currency Anticipated Transaction Example Hedge of Interest Rate Risk with Interest Rate Swap Discontinuance of Hedge Accounting Disclosure

5 Financial Assets Accounts and Notes Receivable Transfers of Receivables Impairment Financial Liabilities Derivatives Hedge Accounting Items of Income Risks and Uncertainties Appendix 3 Chartered Professional Accountants of Canada

6 INTRODUCTION This publication has been produced in response to requests for guidance on the application of Section 3856, Financial Instruments, in the CPA Canada Handbook Accounting, Part II, Accounting Standards for Private Enterprises. CPA Canada expresses its appreciation to the principal author of the publication, Jo-Ann Lempert, CA, and to Kate Ward, CA, for her technical review. The guidance and illustrative examples provided are not authoritative. All decisions on the application of any accounting standard need to be made based on a thorough understanding of the facts and circumstances of each transaction and through the application of professional judgment. The guidance in this publication is current as of the date of publication. Judgment will need to be applied as practice evolves or Section 3856 is updated. Gordon Beal, CA, M.Ed Vice President, Research, Guidance & Support 4

7 PURPOSE AND SCOPE 1. FINANCIAL INSTRUMENTS, Section 3856 is a comprehensive standard that applies to all financial instruments and provides many requirements and guidance as described in the following: Paragraph This Section establishes standards for: (a) recognizing and measuring financial assets, financial liabilities and specified contracts to buy or sell non-financial items; (b) the classification of financial instruments, from the perspective of the issuer, between liabilities and equity; (c) the classification of related interest, dividends, losses and gains; (d) the circumstances in which financial assets and financial liabilities are offset; (e) when and how hedge accounting may be applied; and (f) disclosures about financial assets and financial liabilities. OVERVIEW OF SECTION The underlying principles guiding Section 3856 are as follows: (a) Financial instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements. (b) Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments. (c) Only items that are assets or liabilities should be reported as such in financial statements. (d) Special accounting for items designated as being hedged should be provided only for qualifying items. 3. In applying these principles, Section 3856 provides guidance on the accounting for financial instruments and answers the following questions: (a) What is a financial instrument? (i) Section 3856 lists several examples of common financial instruments. It also describes instruments that resemble or may be financial instruments but are not dealt with in the scope of Section 3856 (paragraph 5 of this chapter). (b) When should a financial instrument be recognized in the financial statements? (i) Section 3856 requires that financial instruments be recognized when an entity becomes a party to a contract involving financial instruments, i.e., immediately (paragraph 10 of this chapter). (c) How should a financial instrument be measured when it is initially recognized and thereafter? (i) Section 3856 requires that a financial instrument be initially measured at its fair value adjusted by, when it will be subsequently measured at cost or amortized cost, any related transaction costs and financing fees (paragraph 34 of this chapter). (ii) For subsequent measurement, Section 3856 requires the financial instrument to be classified into one of the two following categories: Fair value Cost/Amortized cost. (paragraph 51 of this chapter) The classification decision will be primarily based on the instrument s characteristics but the entity may elect to classify an instrument to the fair value category on initial recognition. (iii) All financial assets classified into the cost/amortized cost category, must be assessed for impairment at the end of each reporting period (paragraph 60 of this chapter). (d) How should a financial instrument be presented? (i) Section 3856 provides guidance on classifying a financial instrument, or its component parts, as a liability or part of equity based on the substance of the arrangement (paragraph 14 of this chapter). (ii) The equity component of a financial liability that is convertible to equity must be recognized separately. However, Section 3856 provides a policy choice to permit measuring the equity component as zero. If this measurement option is not chosen, the equity component may be measured using any rational method including the residual method and the relative fair value method (paragraph 32 of this chapter). 5 Chartered Professional Accountants of Canada

8 (iii) Section 3856 requires that preferred shares issued in a tax planning arrangement under specified sections of the Canadian Income Tax Act be presented at par, stated or assigned value as a separate line item in the equity section of the balance sheet, with a description indicating that they are redeemable at the option of the holder (paragraph 27 of this chapter). (iv) A financial asset may be offset with a financial liability only when both of the following criteria are met: The entity currently has a legally enforceable right of offset; and The entity intends to settle on a net basis, or, to realize the items simultaneously (paragraph 92 of this chapter). (e) When is a financial instrument derecognized? (i) For transferred receivables, only when control has been surrendered (paragraph 104 of this chapter); (ii) For a financial liability, when it is extinguished (paragraph 124 of this chapter). (f) When and how can hedge accounting be applied? (i) Hedge accounting is optional. (ii) Hedging is only permitted in specific circumstances. (iii) Hedge accounting will only be allowed when the entity has reasonable assurance that the critical terms of the hedging item and hedged item are the same. (iv) Specific details of the hedging relationship must be documented. (v) When hedge accounting is achieved, accounting for the hedging item is modified. (vi) Hedge accounting cannot be electively discontinued, but is discontinued when the critical terms of the hedged item and the hedging item no longer match. (paragraph 141 of this chapter) (g) What is required to be disclosed regarding financial instruments? (i) In general, information that enables users to evaluate the significance of financial instruments on the financial position and performance of an entity must be disclosed (paragraph 180 of this chapter). 6

9 4. The following chart illustrates the application of Section 3856 to financial instrument transactions: General application of Section 3856, Financial Instruments Has the entity become a party to the contractual provisions of a financial instrument? Yes Not sure Go to paragraph 6 of this chapter Is the financial instrument excluded from the scope of Section 3856 as set out in paragraph ? No Yes Other standards may apply Is the transaction with a related party? Yes Is the relationship solely in the capacity of management (paragraph )? No The transaction is measured in accordance with RELATED PARTY TRANSACTIONS, Section 3840 No Yes Will the instrument be measured at fair value or amortized cost subsequent to initial recognition? Fair value Investments in quoted equity instruments Derivative contracts other than those linked to another private entity and those in qualifying hedging relationships Other financial instruments if fair value measurement is elected at initial recognition (election is irrevocable) Initial measurement Cost or amortized cost Investments in unquoted equity instruments Derivatives that are not measured at fair value All other financial assets and financial liabilities not measured at fair value Measure initially at fair value Transaction costs are expensed in the period incurred Subsequent measurement Measure initially at fair value plus or minus transaction costs and financing fees, if applicable Fair value Financial assets and liabilities other than hedging instruments or indexed liabilities Hedging instruments Indexed financial liabilities Amortize any initial premium or discount and any transaction costs or financing fees to net income over the expected life of the instrument Derivative hedging instruments are recognized at the earlier of: Date a payment is received or made; and Date the hedged instrument is recognized (i.e., hedging instrument receipt or payment is accrued) At each reporting date measure at the higher of: the amortized cost of the debt; and the amount that would be payable if the indexing formula was applied on the reporting date The adjustment for changes in value due to the indexing feature, if any, is recognized immediately in net income as a separate component of interest expense Assess all financial assets for indications of impairment at each reporting date If previously impaired, assess for reversal of condition causing impairment in earlier period Is there a significant change in the expected timing or amount of future cash flows? Record the asset at the highest of: PV of cash flows expected from holding the asset Selling price at balance sheet date Expected net proceeds from liquidating collateral held 7 Chartered Professional Accountants of Canada

10 What is a Financial Instrument? 5. The definitions of a financial asset and financial liability are included in in paragraph and summarized in the following table along with some examples of financial assets, financial liabilities and items that are excluded from the scope of Section 3856: Definitions Examples A financial asset is any asset that is: cash cash demand and fixed-term deposits a contractual right to receive cash or commercial paper another financial asset from another party bankers acceptances a contractual right to exchange treasury notes and bills financial instruments with another accounts, notes and loans receivable party under conditions that are bonds and similar debt instruments potentially favourable held as investments an equity instrument of another common and preferred shares and entity (see paragraph (h)) similar equity instruments held as investments some options, warrants, futures contracts, forward contracts, and swaps if potentially favourable (these items also meet the definition of a derivative see below) (see paragraphs and (h)(iii)) A financial liability is any liability that is a contractual obligation: to deliver cash or another financial asset to another party; or to exchange financial instruments with another party under conditions that are potentially unfavourable to the entity accounts, notes and loans payable ( (d)) bonds and similar debt instruments issued (see paragraph (e)) perpetual debt instruments in some cases preferred shares, shares in co-operative organizations and interests in partnerships, and similar equity instruments issued are in substance financial liabilities (see paragraph and (j)) some options, warrants, futures contracts, forward contracts, and swaps if unfavourable (these items also meet the definition of a derivative see below) (see paragraph (g) and (j)(ii)) Examples of items that are not accounted for in the scope of Section 3856 The cost incurred by an entity to purchase a right to reacquire its own equity instruments from another party; this is a deduction from equity (paragraph (h)) Prepaid expenses Inventories Property, plant and equipment Leased rights and assets (see paragraph (b)) Intangible assets such as patents and trademarks Income taxes** Investments in subsidiaries, variable interest entities, entities subject to significant influence or joint ventures (see paragraph (a)* Contracts issued by an acquirer (not the seller) for contingent consideration in a business combination until such time as the contingency is resolved (see paragraph (k)) * see Sections 3051, 3055, 1590 and AcG-15 as appropriate. In September 2014, a new Section, SUBSIDIARIES, Section 1591, was issued and replaced Section In addition, AcG-15, Consolidation of Variable Interest Entities was withdrawn. A new Section, INTERESTS IN JOINT ARRANGEMENTS, Section 3056, replaced Section 3055, and there were related amendments to INVESTMENTS, Section These changes are effective for annual financial statements relating to fiscal years beginning on or after January 1, Earlier application is permitted, as long as all changes are applied at the same time. These changes would not change the conclusion on the classification of any related financial instruments. ** The definitions of a financial asset and financial liability in Section 3856 refers to items that are created by contracts so payables and receivables that result from statutory requirements, such as income or excise taxes, are not considered to be in the scope of Section 3856 Contingent Consideration in a Business Combination 6. As indicated in the above table contracts issued by an acquirer for contingent consideration in a business combination are not accounted for in the scope of Section 3856 until the contingency is resolved. However, once resolved, the contractual amounts 8

11 would be remeasured in accordance with Section The specific exception for contingent consideration is directed at the acquirer as indicated as follows: Paragraph (k) contracts issued by an acquirer (but not the seller) for contingent consideration in a business combination until such time as the contingency is resolved (see BUSINESS COMBINATIONS, paragraphs ). This exception applies only to the acquirer (the entity that is accounting for the combination) and not to the seller. 7. BUSINESS COMBINATIONS, Section 1582 provides additional guidance on measurement of contingent consideration as follows: Paragraph Some changes in the fair value of contingent consideration that the acquirer recognizes after the acquisition date may be the result of additional information that the acquirer obtained after that date about facts and circumstances that existed at the acquisition date. Such changes are measurement period adjustments in accordance with paragraphs However, changes resulting from events after the acquisition date, such as meeting an earnings target, reaching a specified share price or reaching a milestone on a research and development project, are not measurement period adjustments. The acquirer shall account for changes in the fair value of contingent consideration that are not measurement period adjustments as follows: (a) Contingent consideration classified as equity shall not be remeasured and its subsequent settlement shall be accounted for within equity. (b) Contingent consideration classified as an asset or a liability shall be remeasured at fair value when the contingency is resolved, with any gain or loss recognized in net income. The resulting asset or liability, if a financial instrument shall be accounted for subsequently, in accordance with financial instruments, Section 3856, with any gain or loss recognized in net income. DEFINITIONS 8. Section 3856 provides many definitions in paragraph and within Appendix A and B of the standard, and these definitions are included in the Appendix to this chapter for ease of reference. RECOGNITION 9. Financial instruments are initially recognized in financial statements when the entity becomes a party to the contractual provisions of the financial instruments. This will normally happen when an entity commits to purchase or sell a financial instrument (otherwise referred to as the trade date ). This approach accurately reflects the economic effects of transactions and is the only recognition date that provides transparency for derivatives. 10. Example Trade date accounting On December 30, 20X1, Buy Co. purchases 100 shares of a company for its fair value of an aggregate amount of $100. The transaction settles on January 2, 20X2 at which time, Buy Co. receives and pays for the shares. On December 31, 20X1 the fair value of the shares has increased to $115 in aggregate, and by the time the transaction settles on January 2, 20X2 the fair value of the shares has increased to $125. Journal Entries Subsequent measurement at amortized cost (i.e., investment in private company shares) Subsequent measurement at fair value (i.e., investment in public company shares) December 30, 20X1 Dr. Investment in shares $100 Dr. Investment in shares $100 Cr. Payable $100 Cr. Payable $100 December 31, 20X1 No Entry Dr. Investment in shares $15 Cr. Unrealised fair value increase* $15 January 2, 20X2 Dr. Payable $100 Dr. Investment in shares $10 Cr. Cash $100 Dr. Payable 100 Cr. Unrealised fair value increase* $ 10 Cr. Cash 100 * This description is not a required title, it is used simply to describe the change in fair value that is recognized in net income. 9 Chartered Professional Accountants of Canada

12 11. Example Settlement date accounting Same facts: On December 30, 20X1, Buy Co. purchases 100 shares of a company for its fair value of an aggregate amount of $100. The transaction settles on January 2, 20X2 at which time, Buy Co. receives and pays for the shares. On December 31, 20X1 the fair value of the shares has increased to $115 in aggregate, and by the time the transaction settles on January 2, 20X2 the fair value of the shares has increased to $125. Journal Entries Subsequent measurement at amortized cost (i.e., investment in private company shares) No Entry No Entry Subsequent measurement at fair value (i.e., investment in public company shares) December 30, 20X1 No Entry December 31, 20X1 No Entry January 2, 20X2 Dr. Investment in shares $100 Dr. Investment in shares $100 Cr. Cash $100 No entry Dr. Investment in shares $25 Cr. Unrealised fair value increase* $25 * This description is not a required title, it is used simply to describe the change in fair value that is recognized in net income. 12. In this example, when the investment is subsequently measured at fair value the unrealized gain fully recognized in January 20X2 when the settlement date accounting is applied. If the transaction is settled within the same reporting period the two methods would not result in a difference in reported net income. However, if the fiscal reporting period occurs between the trade date and settlement date, in the balance sheet and net income would be different. The balance sheet would also be different even when the investment is subsequently measured at cost, as the investment and the liability are both recorded at $100. Since the trade order in essence creates the financial liability, the trade date best reflects the economic effects for the transaction. CLASSIFICATION 13. Section 3856 only requires a few classification decisions. Generally, there are no classification issues on derivatives (other than those in qualifying hedging relationships and those that are linked to and settle with the delivery of equity instruments whose fair value cannot be readily determined) and investments in equities that are quoted in an active market, as these must be measured at fair value subsequent to their initial recognition (see paragraph ). 14. One classification decision that can be made is that on initial recognition, any financial asset or financial liability may be designated as measured at fair value. Also, fair value measurement may be elected for an equity instrument that ceases to be quoted in an active market. Fair value measurement may be useful when the asset or liability will be hedged with a derivative but hedge accounting would or could not be applied. These elective applications of fair value measurement are irrevocable (see paragraph ). In addition, it should be noted that this election to use fair value is on an individual financial asset or financial liability at the time of initial recognition, not on a class or group of similar items. Additional record keeping is required to keep track of the financial instruments that are designated to be measured at fair value. 15. The irrevocable election to measure financial instruments at fair value may be suitable in the following situations, if the fair value is readily available or determinable: (a) When investments that are eligible for amortized cost measurement are managed on a fair value basis. For example, when surplus cash is invested in a portfolio containing both interest-bearing and equity securities, it is often easier to assess the performance of the portfolio when all of the securities are measured on the same basis. (b) Accounting for all investments on a fair value basis may simplify bookkeeping. Maintaining amortization schedules for interest-bearing items is operationally more challenging than recording fair values and cash transactions. (c) When it is unclear whether the financial instrument is traded in an active market (see definition of active market paragraph 3856.A9). For example, some mutual fund units are not redeemable daily so are not considered actively traded. However, it is usually easier and more useful to measure these investments at fair value. (d) When fair value is more relevant for the users. 10

13 (e) To simplify the accounting for transaction costs. Transaction costs must be amortized over the life of any financial instrument measured at amortized cost. Liability or Equity 16. Guidance on the classification of an issued financing instrument between a financial liability and an equity instrument is included under the heading Presentation in paragraphs In some cases, it may be difficult to determine whether a financial instrument should be considered a liability or equity. For example, some financial instruments take the legal form of equity but are liabilities in substance because they require payment to the holder of a fixed or determinable amount. Others may combine features associated with equity instruments and features associated with financial liabilities, therefore making it difficult to distinguish whether it is an equity or liability instrument in its entirety. 18. In distinguishing whether a financial instrument should be classified as a liability or equity instrument, the definitions of these instruments should be considered as follows: Paragraph (e) An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Paragraph (j) A financial liability is any liability that is a contractual obligation: (i) to deliver cash or another financial asset to another party; or (ii) to exchange financial instruments with another party under conditions that are potentially unfavourable to the entity. 19. The substance of the contractual terms of a financial instrument, rather than its legal form, governs its classification on the issuer s balance sheet. This determination is made on initial recognition of the instrument, disregarding any non-substantive or minimal features, and this classification is not revised unless the terms of the instrument change or it is removed from the balance sheet. 20. When considering whether the financial instrument, or its component parts, meets the definition of a financial liability, the existence of a restriction on the ability of the issuer to satisfy an obligation, such as lack of access to foreign currency or the need to obtain approval for payment from a regulatory authority, does not negate the issuer s obligation or the holder s rights under the instrument. 21. When an issuer has a contractual obligation to deliver a fixed amount or an amount that varies either partially or fully in response to changes in a variable, other than the market price of the entity s own equity instruments, and the issuer is required to or is able to settle the contractual obligation by delivering enough of its own equity instruments to satisfy the obligation, this would be considered a financial liability because the counterparty is guaranteed a fixed value and is not subject to the residual risk of the issuer. These contractual obligations may be established either explicitly or indirectly through an instrument s terms and conditions. 22. When an issuer does not have a contractual obligation to deliver cash or another financial asset or to exchange another financial instrument under conditions that are potentially unfavourable, the instrument is equity. When the issuer is not contractually obligated to distribute a pro rata share of any dividends or other distributions out of equity, it is considered an equity instrument. The following clarification is provided on such items as partnership interests: Paragraph 3856.A27 Some financial instruments, such as partnership interests and certain types of shares in co-operative organizations, provide for payments to the holder of a pro rata share of the residual equity of the issuer. These financial instruments may require redemption in specified circumstances that are certain to arise, such as the death of the holder, but do not impose an obligation on the issuer to deliver or exchange any specific amount of financial assets in advance of redemption. On issuance, and subject to paragraph 3856.A28, such financial instruments constitute an equity instrument of the issuer. When the holder subsequently chooses to withdraw its equity and is entitled to do so, the issuer may become obliged to make a payment that is fixed or determinable as to amount and timing. This obligation satisfies the definition of a financial liability and is presented as such. 23. The classification of a financial instrument between liability and equity is not changed based on a change in estimate of the probability of a future event occurring. If the future event passes, and the financial instrument still exists, it is derecognized, and a new financial liability or equity instrument is recognized based on the remaining terms. Similarly, the classification would not be impacted by historical experience or intentions but would be based on the actual substance of the contractual arrangements themselves. Furthermore, factors outside the contractual terms are not considered when determining whether an instrument is properly classified as a liability or as equity. 24. It should be noted the possibility of an economic compulsion to settle in cash does not cause the instrument to be classified as a financial liability, if there is no contractual obligation: Paragraph 3856.A26A In the absence of a contractual obligation to redeem a financial instrument, economic compulsion does not cause the instrument to be classified as a financial liability. 11 Chartered Professional Accountants of Canada

14 Paragraph 3856.A26A was added to clarify this point and was effective for annual financial statements relating to fiscal years beginning on or after January 1, Economic compulsion can be described as a situation when an entity will have to take a particular course of action in the future because that action will be so much more economically advantageous than any of the available alternatives. For example, private equity investors often attempt to build a liquidity mechanism into their investments by establishing a right that allows them, after a certain period of time, to have the issuing enterprise sold if a triggering even or circumstance, such as an IPO, has not occurred. 26. This right is a form of a sale right and its objective is to provide the investors with the leverage to recover their investment. The issuing enterprise would then have the option to comply with the mechanisms of the sale right or, within an agreed time frame, to trigger a call right. This call right would be the right, but not the obligation, of the enterprise to avoid the application of the sale right by purchasing the shares of the investors. The investors control the timing of the transaction because the enterprise cannot exercise the call right unless investors have exercised their sale right. In this situation, it might be advantageous to redeem the investors shares to prevent what would amount to the expropriation of the enterprise, or the common shares, by the investors. The issuing enterprise has the right, but not the obligation, to redeem the shares in order to avoid the application of the sale right by the investor. Preferred Shares Issued in a Tax Planning Arrangement 27. The only exception to the above guidance applies to preferred shares issued in a tax planning arrangement under Sections 51, 85, 85.1, 86, 87 or 88 of the Canadian Income Tax Act that are redeemable at the option of the holder. These shares must be presented at par, stated or assigned value as a separate line item in the equity section of the balance sheet, with a suitable description indicating that they are redeemable at the option of the holder. This requirement if provided in the following paragraph: Paragraph An entity that issues preferred shares in a tax planning arrangement under Sections 51, 85, 85.1, 86, 87 or 88 of the Income Tax Act (Canada) shall present the shares at par, stated or assigned value as a separate line item in the equity section of the balance sheet, with a suitable description indicating that they are redeemable at the option of the holder. When redemption is demanded, the issuer shall reclassify the shares as liabilities and measure them at the redemption amount. Any adjustment shall be recognized in retained earnings. 28. The presentation is illustrated in the following example: Shareholders Equity Common Shares 100 Preferred shares 1,000 Class B shares (Redeemable at the option of the holder for $1,000,000) The required disclosures for these preferred shares are provided in Section 3856 as follows: Paragraph (c) For a preferred share issued in a tax planning arrangement as specified in paragraph , an entity shall disclose: (i) on the face of the balance sheet, the total redemption amount for all classes of such shares outstanding; (ii) the aggregate redemption amount for each class of such shares; and (iii) the aggregate amount of any scheduled redemptions required in each of the next five years. 30. When redemption is demanded, the shares are reclassified as liabilities and measured at the redemption amount. Any adjustment is recognized in retained earnings. The continuation of this classification exemption is the subject of an exposure draft and is currently being discussed by the AcSB. Readers should monitor the current projects to identify any changes to the guidance in Section

15 Examples Liability vs. Equity 31. The following financial instruments provide examples of items that would be considered a financial liability vs. an equity instrument: Financial liability An entity receives $10,000 and promises to deliver the $10,000 or shares equal in value to $10,000 in 3 years time. An entity receives $10,000 and promises to deliver shares in 3 years time equal to the value of the original advance adjusted for the change in the market price of gold. Preferred shares* issued in the amount of $10,000 to be redeemed at a fixed date (as per the contractual arrangement) for a fixed price and paying mandatory scheduled dividends. Both the preferred shares and the mandatory dividends meet the definition of a financial liability. Preferred shares* issued in the amount of $10,000 to be redeemed at a fixed date for a fixed price without mandatory dividend payment. A retractable or mandatorily redeemable share that does not meet the exception criteria to be classified as an equity instrument under paragraph for preferred shares issued in certain tax planning arrangements. Equity instrument An entity receives $10,000 and promises to deliver 10,000 shares in 3 years time. This can be described as a Subscription of Shares or similar description in the equity section. An entity receives $10,000 and promises to deliver a fixed number of shares at a fixed date. This can be described as a Subscription of Shares or similar description in the equity section. Preferred shares* issued in the amount of $10,000 with no specified repayment date, redeemable at the option of the issuer, with no dividend payable. A retractable or mandatorily redeemable share that: Is the most subordinated of all equity instruments issued by the entity and participates on a pro rata basis in the residual equity; The redemption feature is extended to 100% of the common shares (and/or in-substance common shares), and the basis for determination of the redemption price is the same for all shares; All of the redeemable shares include substantially similar characteristics to the enterprise s common shares; for example, they do not include any substantive liquidation preferences or dividend distribution preferences. The redemption event is the same for all the shares subject to the redemption feature, for example, redemption on the resignation, termination, retirement or death of the shareholder. * These shares are not subject to the exception above, i.e., they are not issued in a tax planning arrangement under Sections 51, 85, 85.1, 86, 87 or 88 of the Canadian Income Tax Act. Compound Financial Instruments 32. When a financial instrument contains both liability and equity elements, each element should be classified in accordance with its substance, taking into consideration the definitions of a financial liability and equity instrument. An entity s financial position is more faithfully represented by separate presentation of the liability and equity components contained in a single instrument according to their nature. For example, when a financial liability is issued with detachable warrants or options, it is more a matter of form than substance that both liabilities and equity interests are created by more than one separate instrument, rather than in a single instrument, such as convertible debt. 33. The separate classification based on the substance of the contractual terms of the arrangement discussed above would still apply when a financial instrument contains components that are neither financial liabilities nor equity instruments of the issuer. For example, an instrument that gives the holder the right to receive a non-financial asset such as an amount of gold (i.e., a commodity) on settlement and an option to exchange that right for shares of the issuer contains both liability and equity elements. The issuer recognizes and presents the equity instrument (the exchange option) separately from the liability components of the compound instrument, whether the liabilities are financial or non-financial. 13 Chartered Professional Accountants of Canada

16 MEASUREMENT Initial Measurement Arm s length transactions 34. Financial instruments issued or acquired in arm s length transactions are measured initially at fair value. Given that fair value is the price that an arm s length market participant would pay or receive in a routine transaction under the market conditions at the time of initial recognition, a financial instrument s initial fair value will normally be the transaction price, that is, the fair value of the consideration given or received. Financing Fees and Transaction Costs 35. The treatment of any financing fees and transaction costs directly attributable to the origination, acquisition, issuance or assumption of financial instruments depends on the subsequent measurement of the instrument. When the instrument will be measured at fair value, transaction costs and financing fees are recorded in income in the period incurred because they are not part of the fair value of the financial instrument and they do not meet the definition of an asset necessary for separate recognition (see paragraph ). When the instrument will be measured at cost or amortized cost, financing fees and transaction costs are included in the initial measurement of the instrument. Transaction costs included in the initial measurement of an interest-bearing instrument are amortized over the life of the instrument (see paragraphs and.a4). Standby fees and transaction costs associated with a line of credit or revolving debt arrangement are recognized as an asset such as prepaid expense and amortized over the life of the commitment because they are, in substance, analogous to an insurance premium. The fee is the cost associated with having the ability to draw down the loan over the term of the arrangement (see paragraph 3856.A57). 36. Example Investment in equity instruments at cost On February 14, 20X1, Investor Corporation invests $10,000 in 10,000 common shares of Private Corporation, giving Investor Corp. a 10% voting interest in the company. Investor Corp. and Private Corp. are unrelated, and the price paid for the acquisition of the common shares represented fair value of the shares at the purchase date. Investor Corp. also incurred $500 in legal fees to register the title of the shares in their name. Date Entry February 14, 20X1 Dr. Investment in Private Corporation $10,500 Cr. Cash $10,500 Demand Loans 37. The fair value of a financial liability with a demand feature is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid. The maturity date of an item with no contractual repayment terms cannot be later than the earliest date on which payment can be demanded. Often in practice the initial fair value for such financial liabilities is the price at which they are originated between the customer and the lender, that is, the demand amount. However, the effect of discounting needs to be considered if significant, which is more likely when there is a longer time frame to the demand date or when operating in a high interest rate environment. An additional complication covered by paragraph 3856.A12 is... when the payment of a debt instrument is subordinated to the interest of another party, the earliest date payment could be demanded is the day following the maturity of the instrument to which it is subordinated. 14

17 38. The interest rate used to discount a financial instrument payable on demand should be the rate available to the entity on a similar financial instrument maturing on, or as close as possible to, the first date that the instrument could be required to be paid. It incorporates any risk premium that a third party would charge for a financial instrument of comparable credit quality and terms (see paragraph 3856.A13). 39. Examples Accounting for demand loans and revolving debt fees and costs Example 1 Term loan Bank of Lenders agrees to lend Borrowing Corporation $100,000 for 5 years, bearing annual interest at 6%, payable monthly, with principal repayable in full at maturity. Bank of Lenders is able to demand repayment of the loan at any time if specified conditions are not met. On issuance of the loan, Bank of Lenders charges Borrowing Corporation transaction costs in the amount of $1,250 to write the loan and register collateral on it. Dr. Cash ($100,000 $1,250) Example 2 Demand loan with no terms of repayment Borrowing Corporation arranges a demand loan with Bank of Lenders in the amount of $100,000. Bank of Lenders is able to demand repayment of the loan at any time. The loan carries an annual interest rate of 6%. On issuance of the loan, the bank charges Borrowing Corporation a $1,250 origination fee. $98,750 Dr. Cash $98,750 Dr. Prepaid expenses Cr. Loan payable $98,750 Dr. Interest expense* $250 Cr. Loan payable $250 This example uses the straight-line amortization method but the effective interest method can alternatively be used. * This account must be presented as a separate component of interest expense. Interest on bank loan (6% * $100,000) Example 3 Revolving line of credit Borrowing Corporation arranges with Bank of Lenders to enter into a revolving line of credit with a limit of $100,000. Bank of Lenders is able to demand repayment of the line at any time. The line carries an annual interest rate of 6%. On issuance of the line, the bank charges Borrowing Corporation a $1,250 annual standby fee. No amounts have been drawn on the line of credit in the first year. $1,250 Dr. Loan Fees* 1,250 Cr. Cash $1,250 Cr. Loan payable $100,000 End of year 1 entry Dr. Interest expense* $1,250 Cr. Prepaid expenses $1,250 * This account can also be as called Amortization of Prepaid Fee or something similar and can be presented as a separate component of interest expense. Interest on bank loan $6,000 Interest on bank loan $6,000 Interest on bank loan $0 Amortization of loan fee 250 Loan Fee 1,250 Loan Fee 1,250 Total interest expense $6,250 Total interest expense $7,250 Total interest expense $1,250 Loans at Non-market Interest Rates 40. A loan with an interest rate that is significantly less than a market rate of interest indicates that there is more to the transaction than a pure lending/borrowing relationship. The present value of the difference between the rate on the loan and a fair market lending rate may represent part of the price of an asset financed by the loan, a government grant to incent the borrower to undertake certain commercial transactions, or compensation to an employee. 15 Chartered Professional Accountants of Canada

18 41. Example Loan with a non-market rate of interest related to asset purchase On February 14, 20X1, Seller Corporation finances Customer Co. s purchase of a $1,000 machine by extending payment for 3 years. Interest is payable annually at 3%. The market rate of interest for a similar loan to an entity with Customer s credit rating is 5%. The loan is initially measured at its fair value of $946 (net present value of $30 of interest for 3 years and principal repayment of $1,000, both discounted at 5%). The transaction is accounted for as follows: Date Seller s books Customer s books February 14, 20X1 Dr. Loan receivable $946 Dr. Machine $946 Cr. Revenue $946 Cr. Loan payable $946 Indexed Financial Liabilities 42. Private enterprises often issue debt that requires payments to be determined by reference to factors such as the value of the enterprise s equity or performance measures such as earnings before interest, taxes, depreciation and amortization. These instruments are initially measured at fair value, usually the proceeds of the issue, unless they are related party transactions. Section 3856 indicates in paragraph that the initial measurement of financial instruments to or from related parties are to be measured in accordance with RELATED PARTY TRANSACTIONS, Section Convertible Financial Liabilities 43. Private enterprises may issue debt that includes an option for the holder to acquire equity of the issuer under specified circumstances (compound instrument). These options are similar in nature to options or warrants that are issued with the liability but detachable thereafter. Section 3856 provides a policy choice option that the equity component may be measured as zero or based on fair value measurements as explained below. It is especially important to disclose the terms of the instrument when the zero measurement alternative is chosen to ensure that readers of the financial statements are aware of the terms of the conversion option. 44. Acceptable methods for initially measuring the separate liability and equity elements of an instrument include the following: (a) The equity component is measured as zero; the entire proceeds of the issue are allocated to the liability component. (b) Residual method the more easily measurable component is measured first, and the residual amount is allocated to the remaining component. (c) Relative fair value method the total proceeds of the instrument is allocated to the components in proportion to their relative fair values. The sum of the carrying amounts assigned to all the components in an arrangement on initial recognition is always equal to the carrying amount of the instrument as a whole. No gain or loss is realized from recognizing and presenting the components of the instrument separately. 45. Using the residual method, the more easily measurable component is measured first, and the residual amount (after deducting from the entire proceeds of the issue the amount separately determined for the component that is more easily measurable) is allocated to the less easily measurable component. 46. When the issuer can reliably estimate the fair value of each of the liability and equity components, the proceeds may be allocated proportionately. This method is used infrequently because of the difficulty of establishing fair value measurements for private enterprises. In the following example, the fair value of the conversion feature is provided, though this amount is not often available. 16

19 47. Example The following example illustrates the initial measurement of convertible liability: Capital Corporation (Capital) needs to raise $10,000 to fund its operations and is having difficulty finding financing. It issues bonds in the aggregate amount of $10,000 repayable in 5 years and with an annual interest rate of 6%. The bonds are convertible at the option of the holder into a fixed number of common shares of the Corporation. The conversion feature has a fair value of $250 determined using the Black-Scholes Model on initial issuance of the bond. Option 1 Conversion feature is measured at zero Dr. Cash $10,000 Cr. Liability $10,000 Cr. Conversion feature (equity) 0 Option 2 Conversion feature is measured at fair value residual method Dr. Cash $10,000 Cr. Liability ($10,000 FV of conversion feature of $250) $9,750 Cr. Conversion feature (equity) 250 Liability and conversion feature are measured pro rata relative fair value method (Assuming the fair value of the bonds is $10,500) Dr. Cash $10,000 Cr. Liability ($10,000 * $10,500/$10,750) $9,767 Cr. Conversion feature (equity) ($10,000 * $250/$10,750) 233 From Capital s perspective, the bond comprises two components: a financial liability (a contractual arrangement to deliver cash or other financial assets) and an equity instrument (a conversion option granting the holder the right, for a specified period of time and upon satisfaction of certain conditions, to convert into common shares of Capital). Capital presents the liability and equity components separately on its balance sheet when the equity component is allocated a value. (see paragraph of this chapter for examples of the disclosures required for convertible liabilities.) 48. As indicated in Section 1506, ACCOUNTING CHANGES, paragraph (g), the policy chosen can be changed without meeting the requirement that the change would result in the financial statements providing reliable and more relevant information as is normally required in accordance with paragraph However, if the policy was changed it would generally require retrospective application, with restatement. Changes in accounting policies are discussed in Chapter 7 of this Guide. Related Party Transactions 49. Related party transactions are measured in accordance with RELATED PARTY TRANSACTIONS, Section 3840 except for those that involve parties whose sole relationship with an entity is in the capacity of management. Management is defined in paragraph (d) as follows: Paragraph (d) Management: any person(s) having authority and responsibility for planning, directing and controlling the activities of the reporting enterprise. (In the case of a company, management includes the directors, officers and other persons fulfilling a senior management function. When an independent committee of the board of directors is established in accordance with regulatory requirements, to represent the non-controlling interests of an enterprise, the directors serving on that committee are deemed not to be related parties for the transaction under consideration.) 50. Example Non-interest bearing loan to manager Mr. Manager receives a non-interest-bearing, five-year housing loan in the amount of $25,000 on January 1, 20X1 from his employer, Bonus Corporation. The loan is due in full on January 1, 20X6. Because Mr. Manager s only association with the Company is in his capacity as a manager, i.e., he does not own shares of Bonus Corporation, Bonus would have to measure this transaction on January 1, 20X1 at its fair value in accordance with paragraph Assume that the prevailing market interest rate for a similar loan for five years with a similar credit rating were 5%. The continuation of employment is not required as a condition of the loan. Based on these facts and assumptions, Bonus Corporation would record the following entry on initial recognition of the loan: Dr. Loan receivable (PV of $25,000, n = 5, i = 5%) $19,588 Dr. Compensation expense ($25,000 19,588) 5,412 Cr. Cash $25, The substance of this transaction is that Mr. Manager is receiving a non-interest housing loan as compensation for his employment. Therefore, the classification of the amount as compensation expense reflects the nature of the expense. 17 Chartered Professional Accountants of Canada

20 Subsequent Measurement Cost/Amortized Cost v. Fair Value 51. Most measurements in Section 3856 can be applied on an instrument-by-instrument basis, i.e., most are not policy choices. The following chart summarizes the subsequent measurement requirements: Cost/Amortized cost Measurement at cost/amortized cost (when not designated at fair value) Investments in equity instruments not quoted in an active market Derivatives designated in a qualifying hedging relationship Derivatives that are linked to, and must be settled by delivery of, equity instruments of another entity whose fair value cannot be readily determined All other financial assets not measured at fair value Financial liabilities Fair value Mandatory fair value measurement Optional fair value measurement Investments in equity instruments quoted in an active market Derivatives not designated in a qualifying hedging relationship Derivatives that are linked to, and must be settled by delivery of, equity instruments of another entity whose fair value can be readily determined Any financial asset or financial liability designated on initial recognition Equity instruments that cease to be quoted in an active market Indexed financial liabilities At each reporting date, indexed financial liabilities are measured at the higher of: the amortized cost of the debt; and the amount that would be payable if the indexing formula was applied at that date. Adjustments for changes in the value of the embedded feature are recognized immediately in net income as a separate component of interest expense. Cost/Amortized Cost 52. Amortized cost is defined in paragraph (a) as follows: Paragraph (a) Amortized cost is the amount at which a financial asset or financial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortization of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment (see paragraphs 3856.A3-.A6). The term cost is not specifically defined in Section A layman s definition describes cost as the amount paid to acquire the financial instrument. This is consistent with the definition of historical cost provided in paragraph Example This examples continues form the investment in equity instruments measured at cost, introduced in paragraph 36 above On February 14, 20X1, Investor Corporation invests $10,000 in 10,000 common shares of Private Corporation, giving Investor Corp. a 10% voting interest in the company. Investor Corp. and Private Corp. are unrelated, and the price paid for the acquisition of the common shares represented fair value of the shares at the purchase date. Investor Corp. also incurred $500 in legal fees to register the title of the shares in their name. Date Entry December 31, 20X1 No entry because the investment is classified by Investor Corp. to be measured at cost, no adjustment is required for the change in fair value. 18

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