USER GUIDE. PS 3380 Contractual Rights

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1 USER GUIDE PS 3380 Contractual Rights Effective for Fiscal Years Beginning on or after April 1, 2017

2 What are contractual rights? Contractual rights are defined as: rights to economic resources arising from contracts or agreements that will result in both an asset and revenue in the future, when the terms of those contracts or agreements are met. Economic resources are resources that embody value. Resources embody value if they are capable of being used in achieving objectives or generating cash inflows or reducing cash outflows (i.e. they provide future economic benefits); and resources embody value if there is control over the resource and there is restriction to access the future economic benefits. Economic resources can be financial in nature (i.e. cash) or non-financial in nature (i.e. tangible capital assets). The Public Sector Accounting Board deliberately limited the definition of contractual rights to those rights that will become assets and will result in revenue in the future when the terms of the contracts or agreements are met. Thus disclosure of contractual rights is required only when the contract/agreement results in additional resources becoming available for the organization. Disclosure is not required when there is simply an exchange of one resource for another because this would not meet the definition of a contractual right. For example, Company A has an agreement to sell a truck at its carrying value in the future to Company B. This would not meet the definition of a contractual right because the sale would not result in additional resources to Company A. It is just an exchange of one economic resource (i.e. cash) for another economic resource (i.e. the truck). The limited definition of contractual rights provides a practical limit on the types of contractual rights that will have to be disclosed. This disclosure will provide relevant and useful information about economic resources available to the government in future years to finance operations or to meet obligations. It is important to note that contractual rights are governed by contract law and separate from certain public sector entity rights, such as the right to license or the right to tax. For example, the government has the right to collect taxes from individuals in the future. In the future, there will be both an asset (i.e. cash) and revenue (i.e. tax revenue). However, since the right to collect taxes arises from legislation and does not arise from contracts with each individual owing tax, future tax revenue would not be considered a contractual right for the government. Additionally, the Public Sector Accounting Standard indicates contractual rights do not include derivatives. Derivatives are covered in PS 3450 Financial Instruments of the CPA Canada Public Sector Accounting Handbook which requires recognition of financial instruments when a public sector entity becomes a party to the contractual provisions of a financial instrument. Thus, a public sector entity recognizes all of its contractual rights and obligations under derivatives as assets and liabilities (i.e. derivatives are existing assets, unlike contractual rights). How are contractual rights different than assets? Contractual rights differ from assets in that no past transaction or event has given rise to an asset at the financial statement date. Only when the terms of the contract or agreement are met in the future will Page 2 of 12

3 the past transaction have occurred. Thus, until a transaction or event occurs under the terms of the contract or agreement in the future, an entity only has a contractual right. The act of entering into a contract or agreement does not constitute as the past transaction or event giving rise to an asset. Once an entity receives the asset, the contractual right no longer exists. How are contractual rights different than contingent assets? Contingent assets are possible assets arising from existing conditions or situations involving uncertainty at the financial statement date. The uncertainty will be resolved when one or more future events occur or fail to occur and resolution of the uncertainty will confirm whether or not an asset exists. With contractual rights, there is no uncertainty regarding the existence of the contractual right. What needs to be disclosed? The Public Sector Accounting Standard states that information about a public sector entity s contractual rights should be disclosed in notes or schedules to the financial statements and should include descriptions about their nature, extent, and timing. The Public Sector Accounting Standard also provides factors to consider when determining what contractual rights should be disclosed. Those factors are: 1) contractual rights to revenue that are abnormal in relation to financial position or are abnormal in relation to usual business operations; or 2) contractual rights that will govern the level of a certain type of revenue for a considerable period into the future. The above factors should be considered but should not necessarily limit what is reported on/disclosed. Professional judgement needs to be exercised when determining whether or not a contractual right should be disclosed. Page 3 of 12

4 Example 1 Company 123 entered into an operating lease agreement with Company ABC allowing Company ABC to utilize Company 123 s building. The terms of the lease are as follows: Inception of Lease: April 1, 2017; Contract/Agreement signed January 2, 2017 Term of Lease: 10 years, ending March 31, 2027, or 120 months Amount of Lease: $25,000 per month Termination of Agreement: Either party can terminate the agreement if 120 days written notice is provided to the other party. Other Details: Company 123 owns the building; there is no bargain purchase option at the end of the lease term; the lease payments are comparable to market rates for a similar property; Company 123 can increase the price it charges to company ABC to account for market adjustments any time during the lease period by providing 60 days written notice to Company ABC; and Company 123 recognizes revenue on a monthly basis. Company 123 s normal business operations do not include developing or leasing property. Company 123 asks itself the following questions in the attached document to determine if it has a contractual right. Page 4 of 12

5 Example 1 Walkthrough 1. Is there a contract/agreement? YES If the answer was no, Company 123 would not proceed further as there would be no contractual right. This is because there must be a contract/agreement in place that gives rise to both an asset and revenue in the future in order to meet the definition of a contractual right. 2. Will the contract/agreement give rise to economic resources to Company 123 in the future? YES Economic resources are resources that embody value. Resources embody value if they are capable of being used in achieving objectives or generating cash inflows or reducing cash outflows (i.e. they provide future economic benefits); and resources embody value if there is control over the resource and there is restriction to access the future economic benefits. Economic resources can be financial in nature (i.e. cash) or non-financial in nature (i.e. tangible capital property). Company 123 expects to obtain cash (i.e. the economic resource) in the future (as long as Company 123 makes its building available to Company ABC). Also, Company 123 owns the building and there is a contract/agreement in place with Company ABC to make payments to Company 123. Lastly, the cash that Company 123 receives in the future will be controlled by Company 123 and Company 123 can restrict access to this cash. 3. Does Company 123 control the economic resource as a result of a past transaction or event? If yes, there would be no contractual right because there would be an asset already. If no, determine if the definition of a contractual right been met. First scenario It is March 31, 2018 Company 123 expects to receive $25,000 from Company ABC sometime during the month of April 2018 for rent for the month of April 2018 (as well as $25,000 each month for the remainder of the contract/agreement). As of March 31, 2018, there has been no past transaction/event giving rise to an asset for Company 123 (i.e. there is no accounts receivable or cash receipt). This past transaction/event does not occur until April 30, 2018 when Company 123 has successfully made its building available to Company ABC for the month. However, a contract/agreement exists as of March 31, 2018 (there is no uncertainty about this). As of March 31, 2018 the definition of a contractual right has been met because Company 123 has a right to $25,000 from Company ABC for April s rent (as well as $25,000 each month for the remainder of the contract/agreement) and this right arises from an agreement. Also, this right will result in both an asset (i.e. cash) and revenue (i.e. lease revenue) in the future when Company 123 makes its building available to Company ABC in the future. As of March 31, 2018, Company 123 would disclose a contractual right in the amount of $2,700,000 (calculated as 108 months remaining at $25,000 per month). Page 5 of 12

6 Year-end Information Request (for illustrative purposes only): Second scenario It is March 31, 2018 Company 123 received $300,000 ($25,000 X 12 months) on March 25, 2018 from Company ABC as prepaid rent for the year April 1, 2018 to March 31, As of March 31, 2018, an asset (i.e. cash) has been received in advance of earning revenue (i.e. Company 123 debits cash for $300K and credits deferred lease revenue for $300K). This means Company 123 controls the cash as a result of receiving the prepaid rent. In regards to the $300K prepaid rent that Company 123 received related to the April 1, 2018 to March 31, 2019 period, there is no contractual right to disclose. This is because there needs to be an expected asset and revenue in the future to meet the definition of a contractual right. In this case, there is no expected asset in the future because the cash has been received in advance already. However, a contract/agreement does exist as of March 31, 2018 (there is no uncertainty about this) and the agreement is for a ten year period (starting April 1, 2017). There would be a contractual right for the remainder of the agreement from April 1, 2019 to March 31, 2027 that would need to be disclosed as of March 31, The amount disclosed would be $2,400,000 (calculated as 96 months remaining at $25,000 per month). The definition of a contractual right has been met because Company 123 has a right to this $2,400,000 in the future and this right arises from an agreement. Also, the right will result in both an asset (i.e. cash of $2.4M) and revenue (i.e. lease revenue) in the future (as long as Company 123 makes its building available to Company ABC for the remainder of the contract). Page 6 of 12

7 Year-end Information Request (for illustrative purposes only): 4. Company 123 asks itself: a) Is this lease revenue abnormal in relation to Company 123 s usual business operations? YES, the lease revenue would be considered abnormal because Company 123 s normal business operations do not include developing or leasing property. b) Does the agreement with Company ABC dictate the level of lease revenue for a considerable period into the future for Company 123? YES, the lease agreement with Company ABC is for 10 years thus the agreement governs the level of lease revenue that Company 123 will receive for a considerable period into the future. Note: it only takes one of these factors to support a decision to provide disclosure. Conclusion: The Public Sector Accounting Standard provides factors that should be considered when determining what contractual rights should be disclosed. Company 123 went through the factors (see #4 above) and determined a contractual right for $2.7M should be disclosed under the first scenario; and a contractual right for $2.4M should be disclosed under the second scenario. Page 7 of 12

8 Example 2 The Federal Government of Canada has signed a cost-sharing agreement with Entity X. Terms of the agreement are as follows: -Entity X will perform well site reclamation work on a specific site called Land Z. The Federal Government of Canada has agreed to provide 50% of the costs. Entity X must incur eligible costs to qualify for the reimbursement from the Federal Government of Canada. -The total costs are estimated to be $4 million ($2 million of which will be from the Federal Government of Canada). -The agreement was signed January 1, 2018, with reclamation work expected to begin April 1, 2018 and to be completed by the end March 31, Entity X s normal business operations do not include well site reclamation work. Entity X asks itself the following questions in the attached document to determine if it has a contractual right. Page 8 of 12

9 Example 2 Walkthrough 1. Is there a contract/agreement? YES If the answer was no, Entity X would not proceed further as there would be no contractual right. This is because there must be a contract/agreement in place that gives rise to both an asset and revenue in the future in order to meet the definition of a contractual right. 2. Will the contract/agreement give rise to economic resources to Entity X in the future? YES Economic resources are resources that embody value. Resources embody value if they are capable of being used in achieving objectives or generating cash inflows or reducing cash outflows (i.e. they provide future economic benefits); and resources embody value if there is control over the resource and there is restriction to access the future economic benefits. Economic resources can be financial in nature (i.e. cash) or non-financial in nature (i.e. tangible capital assets). Entity X expects to obtain cash (i.e. the economic resource) in the future when it performs and completes the well site reclamation work on Land Z, in which point the Federal Government of Canada will reimburse Entity X $2M. Lastly, the cash that Entity X receives in the future will be controlled by Entity X and Entity X can restrict access to this cash. 3. Does Entity X control the economic resource as a result of a past transaction or event? If yes, there would be no contractual right because there would be an asset already. If no, determine if the definition of a contractual right been met. It is March 31, 2018 an agreement has been signed between the Government of Canada and Entity X. This agreement was signed and dated January 1, This means the transfer from the Government of Canada has been authorized. However, as of March 31, 2018 there has been no past transaction/event giving rise to an asset. This past transaction/event does not occur until Entity X performs reclamation work on Land Z (i.e. when Entity X incurs eligible costs). However, a contract/agreement exists as of March 31, 2018 (there is no uncertainty about this). As of March 31, 2018, the definition of a contractual right has been met because Entity X has a right to the $2 million in the future when it incurs eligible costs and this right arises from an agreement. Also, the right will result in both an asset (i.e. cash) and revenue (i.e. transfer revenue) in the future when Entity X completes the well site reclamation work on Land Z. 4. Entity X asks itself: a) Is this transfer revenue abnormal in relation to Entity X s usual business operations? YES, the transfer revenue would be considered abnormal because Entity X s normal business operations do not include well site reclamation work. b) Does the agreement with Federal Government of Canada govern the level of specific revenue for a considerable period into the future for Entity X? NO, the reclamation work is expected to begin on April 1, 2018 and the work is expected to be completed within one year. Note: it only takes one of these factors to support a decision to provide disclosure. Page 9 of 12

10 Conclusion: The Public Sector Accounting Standard provides factors that should be considered when determining what contractual rights should be disclosed. Entity X went through the factors (see #4 above). Although the agreement does not govern the level of specific revenue for a considerable period into the future, Entity X uses professional judgment and concludes the contractual right should be disclosed as it is for a significant amount of $2M. Year-end Information Request (for illustrative purposes only): Page 10 of 12

11 Questionnaire Contractual Rights 1) Does your organization currently have or expect to have contracts or agreements that will result in both an asset and revenue in the future, when the terms of those contracts/agreements are met? Yes/No 2) If the answer to number 1 is yes, please fill out the below table for each contract/agreement that you currently have or expect to have: Contract/Agreement #1: a) Which parties are involved in the contract/agreement? b) What is the nature of the contract/agreement? Give a description. c) When was the contract/agreement signed? AND When does/did the contract/agreement start? d) When does the contract/agreement expire? e) What is the asset that will be received in the future? f) What is the revenue that will be received in the future? g) Does the contract/agreement state the dollar amount and timing of the asset and revenue? If YES: please answer h) and i) below. If NO: please provide details of what the terms are and provide the reason as to why the amount and/or timing cannot be determined? h) What dollar amounts are involved in the contract/agreement? i) What transaction/event has to occur under the contract/agreement to give rise to both an asset and revenue? AND when does this occur? j) Does the contract/agreement in question give rise to revenue that is abnormal in relation to the organization s financial position or the organization s usual business operations? k) Does the contract/agreement in question govern the level of a certain type of revenue for the organization for a considerable period into the future? Page 11 of 12

12 Example of Questionnaire using Example 1 (Second Scenario) 1) Does your organization currently have or expect to have contracts or agreements that will result in both an asset and revenue in the future, when the terms of those contracts/agreements are met? Yes 2) If the answer to number 1 is yes, please fill out the below table for each contract/agreement that you currently have or expect to have: Contract/Agreement #1: a) Which parties are involved in the contract/agreement? Company 123 (Lessor) and Company ABC (Lessee) b) What is the nature of the contract/agreement? Give a description. Operating Lease Agreement Lease of building on 123 Main Street to Company ABC c) When was the contract/agreement signed? AND When does/did the contract/agreement start? January 2, 2017 April 1, 2017 d) When does the contract/agreement expire? Ends March 31, 2027 e) What is the asset that will be received in the Cash future? f) What is the revenue that will be received in the Lease revenue future? g) Does the contract/agreement state the dollar Yes amount and timing of the asset and revenue? If YES: please answer h) and i) below. If NO: please provide details of what the terms are and provide the reason as to why the amount and/or timing cannot be determined? h) What dollar amounts are involved in the $25,000 per month contract/agreement? i) What transaction/event has to occur under the contract/agreement to give rise to both an asset and revenue? AND when does this occur? We need to make the building available to Company ABC till the end of the contract. We recognize revenue on a monthly basis (last day j) Does the contract/agreement in question give rise to revenue that is abnormal in relation to the organization s financial position or the organization s usual business operations? k) Does the contract/agreement in question govern the level of a certain type of revenue for the organization for a considerable period into the future? of each month). Yes, Company 123 is not in the business of developing or leasing property. Yes, the contract/agreement with Company ABC governs our lease revenue for 10 years. Page 12 of 12