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TENTH CANADIAN EDITION INTERMEDIATE ACCOUNTING Prepared by: Lisa Harvey, CPA, CA Rotman School of Management, University of Toronto 16 CHAPTER 16 Complex.

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Presentation on theme: "TENTH CANADIAN EDITION INTERMEDIATE ACCOUNTING Prepared by: Lisa Harvey, CPA, CA Rotman School of Management, University of Toronto 16 CHAPTER 16 Complex."— Presentation transcript:

1 TENTH CANADIAN EDITION INTERMEDIATE ACCOUNTING Prepared by: Lisa Harvey, CPA, CA Rotman School of Management, University of Toronto 16 CHAPTER 16 Complex Financial Instruments Kieso Weygandt Warfield Young Wiecek McConomy

2 CHAPTER Copyright © John Wiley & Sons Canada, Ltd. 16 After studying this chapter, you should be able to: Understand what derivatives are and how they are used to manage risks. Understand how to account for derivatives. Analyze whether a hybrid/compound instrument issued for financing purposes represents a liability, equity, or both. Explain the accounting for hybrid/compound instruments. Describe the various types of stock compensation plans. Describe the accounting for share-based compensation. Identify the major differences in accounting between ASPE and IFRS, and what changes are expected in the near future. COMPLEX FINANCIAL INSTRUMENTS 2

3 3 Copyright © John Wiley & Sons Canada, Ltd. Complex Financial Instruments 3 Derivatives Managing risk Accounting for derivatives Share-Based Compensation Types of plans Recognition, measurement, and disclosure of share- based compensation Debt versus Equity – Issuer Perspective Economics of complex financial instruments Presentation and measurement of hybrid/compound instruments IFRS/ASPE Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

4 4 Copyright © John Wiley & Sons Canada, Ltd. Financial Instruments Financial instruments: contracts that create both a financial asset for one party and a financial liability or equity instrument for the other party Financial instruments can be primary or derivative Primary financial instruments: include most basic financial assets and financial liabilities such as receivables and payables, and equity instruments such as shares 4

5 5 Copyright © John Wiley & Sons Canada, Ltd. Derivatives Derivatives are financial instruments that create rights and obligations that transfer financial risk from one party to the another party Derivatives have the following characteristics: 1.Their value changes in response to the underlying instrument (the “underlying”) 2. They require little or no initial investment 3.They are settled at a future date 5

6 6 Copyright © John Wiley & Sons Canada, Ltd. Derivatives Derivative instruments include: 1.Options 2.Forwards 3.Futures Example: Stock Options –The stock is the “underlying” –If the share price goes up, the option is worth more; –If the share price goes down, the option may become worthless 6

7 7 Copyright © John Wiley & Sons Canada, Ltd. Derivatives – Financial Risks Derivatives are used to manage financial risks: 1.Credit Risk –Risk to one party that the other party will fail to meet an obligation 2.Liquidity Risk –Risk of not being able to meet own financial obligation 3.Market Risk –Risk that fair value or future cash flows of a financial instrument will fluctuate due to changes in market price (includes currency risk, interest rate risk, and other price risk) 7

8 8 Copyright © John Wiley & Sons Canada, Ltd. Derivatives Used by 1.Producers and Consumers Lock in future revenues or costs 2.Speculators and Arbitrageurs Generate cash profit from trading Maintain market liquidity Additional motivations to use derivatives –Manage interest rate volatility –Manage foreign exchange rate volatility 8

9 9 Copyright © John Wiley & Sons Canada, Ltd. Accounting for Derivatives Basic principles of accounting for derivatives: 1.Financial instruments (including financial derivatives) and certain non-financial derivatives that meet definitions of assets or liabilities should be reported in financial statements when entity becomes party to the contract 2.Derivatives should be reported at fair value (most relevant) 3.Gains and losses should be recorded through net income Special accounting is used for items that have been designated as being part of a hedging relationship 9

10 10 Copyright © John Wiley & Sons Canada, Ltd. Non-Financial Derivatives and Executory Contracts Example of non-financial derivatives: contract to buy steel at a specified date for a specified price Are purchase commitments (executory contracts) “derivatives”? –Value changes with value of the underlying –No investment up front –Settled in future 10

11 11 Copyright © John Wiley & Sons Canada, Ltd. Executory Contracts Under IFRS –Not accounted for as derivatives, and recognized when goods received if: There are no net settlement features (can settle for cash or other assets instead of taking delivery) There are net settlement features, but company intends to take delivery and therefore designates contracts “expected use” Under ASPE: –Not accounted for as derivatives because difficult to measure –Recognized when goods received 11

12 12 Copyright © John Wiley & Sons Canada, Ltd. Options and Warrants Options 1.Call Option Holder has the right, but not the obligation, to buy the “underlying” at a preset (strike or exercise) price 2.Put Option Holder has the right, but not the obligation, to sell the “underlying” at a preset price 12

13 13 Copyright © John Wiley & Sons Canada, Ltd. Framework for Options Call – right to buyPut – right to sell Written Sell option for $: Transfer rights to buy shares/underlying Sell option for $: Transfer right to sell shares/underlying Purchased Pay $ for option: Obtain right to buy shares/underlying Pay $ for option: Obtain right to sell shares/underlying 13

14 14 Copyright © John Wiley & Sons Canada, Ltd. Options – Example Given: Call option entered into January 2, 2014 Option expires April 30, 2014 Option to purchase 1,000 shares at $100 per share Share market price on January 2, 2014 is $100 per share Option is purchased for $400 (Option Premium) Share price on March 31 st is $120 per share Options traded at $20,100 on March 31, 2014 Option settled in cash on April 1, 2014 Prepare the journal entries 14

15 15 Copyright © John Wiley & Sons Canada, Ltd. Options – Example 15 Option Price Formula Option Premium = = Intrinsic Value + + Time Value Time Value Market Price less Strike (Exercise) Price Option Value Less Intrinsic Value Option Premium = ($100 - $100) + + ($400 - $0)

16 16 Copyright © John Wiley & Sons Canada, Ltd. Options – Example January 2 (acquisition date) Derivatives – Financial Assets 400 Cash 400 March 31 (to record change in value of option) Derivatives – Financial Assets 19,700* Gain 19,700 Assume options are trading at $20,100 *(20,100 – 400) April 1 (cash settlement of option) Cash 20,000 Loss 100 Derivatives - Trading 20,100 Time Value lost through cash settlement before expiry = $20,100 less intrinsic value of $20,000

17 17 Copyright © John Wiley & Sons Canada, Ltd. Forwards Under a forward contract, parties each commit upfront to do something in the future (obligation) –The price and time period are locked in under the contract Therefore, forward contracts are specific to the transacting parties and –Forwards generally do not trade on exchanges –Banks are usually involved in forward contracts Forwards are measured at the present value of any future cash flows 17

18 18 Copyright © John Wiley & Sons Canada, Ltd. Forwards – Example Given: On January 2, 2014, Abalone Inc. agrees to buy $1,000 in U.S. currency for $1,150 in Canadian currency in 30 days from Bond Bank Abalone has the right to any increases in value of the underlying (U.S. dollars), and an obligation exists to pay a fixed amount of $1,150 by a specified date This forward contract transfers the currency risk inherent in the Canada-U.S. exchange rate Upon inception, the value of the contract is zero so no journal entry would be recorded

19 19 Copyright © John Wiley & Sons Canada, Ltd. Forwards – Example The value of the forward contract will vary depending on interest rates as well as on the spot prices (the current value) and forward prices (future value) for the U.S. dollar If the U.S. dollar appreciates in value, in general, this particular contract will have value to Abalone The forward is remeasured at fair value For example, if the fair value of the contract is $50, on January 5, 2014, the journal entry is: Derivatives – Financial Assets/Liabilities 50 Gain50 19

20 20 Copyright © John Wiley & Sons Canada, Ltd. Forwards – Example If the U.S. dollar depreciates, in general, this particular contract would create a loss for Abalone The journal entry to record the loss must also reverse the original gain of $50 For example, if on January 31 the fair value of the contract now creates an overall loss of $30: Loss80 Derivatives – Financial Assets/Liabilities 80

21 21 Copyright © John Wiley & Sons Canada, Ltd. Forwards – Example Forward contracts can be settled on a net basis or in cash Assume that on the settlement date of February 1, the U.S. dollar is worth $1.04 The following journal entry would be required to settle the contract on a net basis: Loss80 Derivatives – Financial Assets/Liabilities 30 Cash110* * $1,000 ( )

22 22 Copyright © John Wiley & Sons Canada, Ltd. Forwards – Example The following journal entry would be required to settle the contract on a cash basis: Cash 1,040* Loss80 Derivatives – Financial Assets/Liabilities 30 Cash 1,150** * $1,000 x 1.04 ** $1,000 x 1.15

23 23 Copyright © John Wiley & Sons Canada, Ltd. Futures Futures are similar to forwards except: –They have standardized amounts and dates –They are exchange traded and have ready market values –They are settled through clearing houses –There is a requirement to put up collateral

24 24 Copyright © John Wiley & Sons Canada, Ltd. Futures – Example Given: Forward Inc. entered into a futures contract to sell grain for $1,000 Initial margin of $100 cash is required This is a non-financial derivative because the underlying is grain (a non-financial commodity) Record the journal entries for this contract

25 25 Copyright © John Wiley & Sons Canada, Ltd. Futures – Example The contract is valued at zero at inception however the margin must be recorded as follows: Deposits100 Cash 100

26 26 Copyright © John Wiley & Sons Canada, Ltd. Futures – Example The value of the grain increased after the contract date therefore the value of the contract decreased Assume that the contract has decreased by $50 This also required an additional margin deposit of $50 The required journal entries would be: Loss50 Derivatives – Financial Assets/Liabilities 50 Deposits50 Cash50

27 27 Copyright © John Wiley & Sons Canada, Ltd. Futures – Example If the contract is closed out on a net basis (no delivery of grain) with no further changes in value, the journal entries would be: Cash100 Derivatives – Financial Assets/Liabilities 50 Deposits150 The loss on the contract has already been recorded in the previous journal entries thus only the net settlement of $50 cash is recorded

28 28 Copyright © John Wiley & Sons Canada, Ltd. Derivatives Involving Entity’s Own Shares Companies can enter into derivative contracts with their own shares: –Options Purchased call or put options Written call or put options –Forwards To buy entity’s own shares To sell the entity’s own shares This creates a presentation issue

29 29 Copyright © John Wiley & Sons Canada, Ltd. Derivatives Involving Entity’s Own Shares Under IFRS, any contracts that are for a fixed number of shares for a fixed amount are generally presented as equity –This is referred to as the “fixed for fixed” principle –There are generally two exceptions: The derivative creates an obligation to settle in cash or other assets The derivative allows a choice in how the instrument is settled ASPE is silent on this matter but general principles support equity presentation

30 30 Copyright © John Wiley & Sons Canada, Ltd. Complex Financial Instruments 30 Derivatives Managing risk Accounting for derivatives Share-Based Compensation Types of plans Recognition, measurement, and disclosure of share- based compensation Debt versus Equity – Issuer Perspective Economics of complex financial instruments Presentation and measurement of hybrid/compound instruments IFRS/ASPE Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

31 31 Copyright © John Wiley & Sons Canada, Ltd. Complex Financial Instruments Over the years, hybrid/compound have been created in order to profit from the best attributes of debt and equity instruments –These instruments have characteristics of both debt and equity –Example: convertible debt 31

32 32 Copyright © John Wiley & Sons Canada, Ltd. Presentation and Measurement of Hybrid/Compound Instruments To determine appropriate presentation, the following must be considered: –Contractual terms –Economic substance –Definitions of financial statement elements

33 33 Copyright © John Wiley & Sons Canada, Ltd. Definitions Revisited Financial liability is any liability that is a contractual obligation to do either of the following: 1. Deliver cash or another financial asset to another party, or 2. Exchange financial instruments with another party under conditions that are potentially unfavourable. IFRS explicitly includes instruments settled using variable number of shares as financial liabilities 33

34 34 Copyright © John Wiley & Sons Canada, Ltd. Definitions Revisited An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities IFRS provides additional guidance when instruments are settled through own shares 34

35 35 Copyright © John Wiley & Sons Canada, Ltd. Presentation and Measurement of Hybrid/Compound Instruments Financial instruments can be shown on a net basis on the statement of financial position if: –There is a legally enforceable right to offset and –The company intends to settle the instruments on a net basis or simultaneously

36 36 Copyright © John Wiley & Sons Canada, Ltd. Measurement of Hybrid/Compound Instruments Economic value stems from both the debt component and the equity component Two general approaches: 1.Residual value method (or incremental method) 2.Relative fair value method (or proportional method) IFRS requires the use of residual method (with debt valued first) ASPE allows 1.equity component to be valued at zero, or 2.the use of residual method (with component that is easier to measure being valued first). 36

37 37 Copyright © John Wiley & Sons Canada, Ltd. Convertible Debt Bonds that are convertible to other forms of securities (e.g. common shares) during a specified period of time Combines the benefits of a bond (interest payments, principal repayment) with the privilege of exchanging the bond for shares at the bondholder’s option Once the bond is converted, all interest and principal no longer payable 37

38 38 Copyright © John Wiley & Sons Canada, Ltd. Convertible Debt Convertible debt is issued for two main reasons: 1.Corporation can raise equity capital without giving up unnecessary ownership control 2.It can also achieve equity financing at a lower cost Conversion feature allows the corporation to offer a lower interest rate because it provides the investor with an opportunity to own equity 38

39 39 Copyright © John Wiley & Sons Canada, Ltd. Convertible Debt The reporting of convertible debt and the conversion feature result in three issues: 1.Reporting at the time of issuance 2.Reporting at the time of conversion 3.Reporting at the time of retirement 39

40 40 Copyright © John Wiley & Sons Canada, Ltd. Convertible Debt — Example 40 Given: 3 year, $1,000,000 par value, 6% convertible bonds Similar bonds (without conversion feature) have a 9% interest rate Each $1,000 bond convertible to 250 common shares (current market price of $3) What portion of the proceeds are allocated to Bond Liability, and what portion to equity?

41 41 Copyright © John Wiley & Sons Canada, Ltd. Convertible Debt — Example 41 Total proceeds at par= $ 1,000,000 Fair value of the liability without the conversion option (PV at 9%) = $ 924,061 Incremental value of option $ 75,939 Journal entry at issuance: Cash1,000,000 Bonds Payable924,061 Contributed Surplus – Conversion Rights 75,939

42 42 Copyright © John Wiley & Sons Canada, Ltd. Convertible Debt — Example Conversion before maturity - assume that the unamortized portion is $14,058 –therefore, book value of Bonds Payable is 1,000,000 – 14,058 = 985,942 The entry to record the conversion using the book value approach would be: 42 Bonds Payable 985,942 Contributed Surplus- Conversion Rights 75,939 Common Shares1,061,881

43 43 Copyright © John Wiley & Sons Canada, Ltd. Convertible Debt – Induced Conversion When the corporation wants to entice or induce the bondholders to convert their bonds into shares Additional consideration – the “sweetener” – offered to the bondholders to convert (cash, common shares, etc.) The inducement is allocated between the debt and equity components using a method consistent with how instrument was first recorded (e.g. incremental method) 43

44 44 Copyright © John Wiley & Sons Canada, Ltd. Convertible Debt — Example Assume Bond Corp. offers an additional cash premium of $15,000, when carrying amount of the debt is $972,476 and bond’s fair value at date of conversion is $981,462 $981,462 - $972,476 = $8,986 (debt retirement cost) 44 Bonds Payable 972,476 Expense – Debt Retirement 8,986 Contributed Surplus – Conversion Rights 75,939* Retained Earnings (15,000 – 8,986) 6,014 Common Shares 1,048,415 Cash 15,000 * Calculated previously using Incremental Method

45 45 Copyright © John Wiley & Sons Canada, Ltd. Convertible Debt – Normal Retirement Normal retirement is treated the same as debt retirement from Chapter 14 for non- convertible bonds –Clear the bonds payable and any outstanding premiums, discounts, bond issue costs, interest accrued to bondholders –Equity component remains in Contributed Surplus 45

46 46 Copyright © John Wiley & Sons Canada, Ltd. Convertible Debt – Early Retirement Early retirement –Clear the bonds payable and any outstanding premiums, discounts, bond issue costs, interest accrued to bondholders –The conversion rights must be zeroed out –The loss on early retirement is allocated between the debt and equity portion

47 47 Copyright © John Wiley & Sons Canada, Ltd. Convertible Debt – Early Retirement Example Assume that Bond Corp. decides to retire the convertible debt early and offers the bondholders $1,070,000 cash 47 Bonds Payable 972,476 Expense – Debt Retirement 8,986 Contributed Surplus – Conversion Rights 75,939 Retained Earnings 12,599 Cash 1,070,000

48 48 Copyright © John Wiley & Sons Canada, Ltd. Interest, Dividends, Gains/Losses The related interest, dividends, gains, and losses must be consistently treated as the financial instrument they relate to Example: term preferred share –presented as a liability –related dividends would be recorded as interest expense (or dividend expense) and charged to the income statement (instead of Retained Earnings) 48

49 49 Copyright © John Wiley & Sons Canada, Ltd. Complex Financial Instruments 49 Derivatives Managing risk Accounting for derivatives Share-Based Compensation Types of plans Recognition, measurement, and disclosure of share- based compensation Debt versus Equity – Issuer Perspective Economics of complex financial instruments Presentation and measurement of hybrid/compound instruments IFRS/ASPE Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

50 50 Copyright © John Wiley & Sons Canada, Ltd. Share-Based Compensation Stock compensation plans are used to remunerate or compensate employees for services provided –This allows a more long-run focus in a company’s compensation plan

51 51 Copyright © John Wiley & Sons Canada, Ltd. Types of Compensation Plans 1.Compensatory stock option plans (CSOPs) 2.Direct awards of stock 3.Stock appreciation rights plans (SARs) (Appendix 16B) 4.Performance-type plans (Appendix 16B) 51

52 52 Copyright © John Wiley & Sons Canada, Ltd. Uses of Stock Options 52 Stock Options Issued by the company Issued by others e.g. financial institutions Options/ Warrants Other ESOP CSOP Not traded on Exchange since must Be employee to hold Not traded on Exchange since Rights usually not transferable Often exchange traded

53 53 Copyright © John Wiley & Sons Canada, Ltd. Compensatory vs. Non- Compensatory Plans Stock Options Non-compensatory ESOP Compensatory CSOP Income Statement Shareholders’ Equity Operating transactions Capital transactions

54 54 Copyright © John Wiley & Sons Canada, Ltd. Compensatory vs. Non-Compensatory Plans Factors to determine if a plan is compensatory: 1.Option terms Non-standard terms implies compensatory 2.Discount from market price Implies compensatory 3.Eligibility If available to only a certain group of employees (i.e. management) 54

55 55 Copyright © John Wiley & Sons Canada, Ltd. Non-Compensatory - Example Fanco Limited set up an ESOP that gives employees the option to purchase shares for $10 per share On January 1, 2013, employees purchase 6,000 options for $6,000: Cash 6,000 Contributed Surplus-Options 6,000 If employees exercise all 6,000 options: Cash (6,000 x $10) 60,000 Contributed Surplus-Options 6,000 Common Shares 66,000 55

56 56 Copyright © John Wiley & Sons Canada, Ltd. Compensatory Stock Option Plans Two accounting issues associated with stock compensation plans 1.Determination of compensation expense 2.Periods of allocation for compensation expense amounts 56

57 57 Copyright © John Wiley & Sons Canada, Ltd. Compensatory Stock Options Plans - Important Dates 57 Grant date Options are granted to employee Work start date Vesting date Date that employee can first exercise options Exercise date Employee exercises options Expiration date Unexercised options expire

58 58 Copyright © John Wiley & Sons Canada, Ltd. Compensatory Stock Options Plans 58 Compensation Expense is determined as of the measurement date and is allocated over the service period The service period is the period benefited by employee’s service It is usually the period between the grant date and the vesting date

59 59 Copyright © John Wiley & Sons Canada, Ltd. Compensatory Stock Options Plans - Example On January 1, 2015, Chen Corp grants five executives the options to purchase 2,000 shares each The option price per share is $60, and the market price is $70 per share when options are granted The fair value, determined by an option pricing model, results in compensation expense of $220,000 Assuming expected period of service is two years, journal entries at year end for 2015 and 2016: Compensation Expense 110,000 Contributed Surplus – Stock Options 110,000 ($220,000 / 2) 59

60 60 Copyright © John Wiley & Sons Canada, Ltd. Compensatory Stock Options Plans - Example If 20% or 2,000 of the 10,000 options were exercised on June 1, 2015, journal entry is: Cash (2,000 x $60) 120,000 Contributed Surplus–Stock Options (20% x $220,000) 44,000 Common Shares 164,000 If the remaining stock options are not exercised before their expiration date, journal entry is: Contributed Surplus–Stock Options 176,000 Contributed Surplus-Expired Options 176,000 (80% x $220,000) 60

61 61 Copyright © John Wiley & Sons Canada, Ltd. Direct Awards of Stock Nonmonetary reciprocal transaction –Little or no cash involved –Two-way transaction the company gives something up (shares) and gets the employee’s services in return Recorded at fair value of the shares (the asset given up) 61

62 62 Copyright © John Wiley & Sons Canada, Ltd. Disclosure of Compensation Plans Following is fully disclosed: –Accounting policy used –Description of the plans and modifications –Details of number and values of options issued, exercised, forfeited, and expired –Description of assumptions and methods used to determine fair values –Total compensation cost included in net income/contributed surplus, and –Other 62

63 63 Copyright © John Wiley & Sons Canada, Ltd. Complex Financial Instruments 63 Derivatives Managing risk Accounting for derivatives Share-Based Compensation Types of plans Recognition, measurement, and disclosure of share- based compensation Debt versus Equity – Issuer Perspective Economics of complex financial instruments Presentation and measurement of hybrid/compound instruments IFRS/ASPE Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

64 64 Copyright © John Wiley & Sons Canada, Ltd. Looking Ahead There are a number of IASB projects that are expected to simplify and promote consistent application of accounting standards for financial instruments 64

65 65 Copyright © John Wiley & Sons Canada, Ltd. COPYRIGHT Copyright © 2013 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.


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