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16 COMPLEX FINANCIAL INSTRUMENTS

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Presentation on theme: "16 COMPLEX FINANCIAL INSTRUMENTS"— Presentation transcript:

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2 16 COMPLEX FINANCIAL INSTRUMENTS
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.

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

4 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 L01

5 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: Their value changes in response to the underlying instrument (the “underlying”) 2. They require little or no initial investment They are settled at a future date L01

6 Derivatives Derivative instruments include: Example: Stock Options
Forwards 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 L01

7 Derivatives – Financial Risks
Derivatives are used to manage financial risks: Credit Risk Risk to one party that the other party will fail to meet an obligation Liquidity Risk Risk of not being able to meet own financial obligation 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) L01

8 Derivatives Used by Additional motivations to use derivatives
Producers and Consumers Lock in future revenues or costs 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 L01

9 Accounting for Derivatives
Basic principles of accounting for derivatives: 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 Derivatives should be reported at fair value (most relevant) 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 L02

10 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 L02

11 Executory Contracts Under IFRS Under ASPE:
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 L02

12 Options and Warrants Options Call Option Put Option
Holder has the right, but not the obligation, to buy the “underlying” at a preset (strike or exercise) price Put Option Holder has the right, but not the obligation, to sell the “underlying” at a preset price L02

13 Framework for Options Call – right to buy Put – right to sell Written
Sell option for $: Transfer rights to buy shares/underlying Transfer right to sell shares/underlying Purchased Pay $ for option: Obtain right to buy shares/underlying Obtain right to sell shares/underlying L02

14 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 31st 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 L02

15 Options – Example = + = + Option Price Formula Option Premium
Intrinsic Value + Time Market Price less Strike (Exercise) Price Option Value Less Intrinsic Value L02 Option Premium = ($100 - $100) + ($400 - $0)

16 Options – Example Derivatives - Trading 20,100
January 2 (acquisition date) Derivatives – Financial Assets Cash March 31 (to record change in value of option) Derivatives – Financial Assets ,700* Gain ,700 Assume options are trading at $20,100 *(20,100 – 400) April 1 (cash settlement of option) Cash ,000 Loss Derivatives - Trading ,100 Time Value lost through cash settlement before expiry = $20,100 less intrinsic value of $20,000 L02

17 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 L02

18 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 L02

19 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 Gain L02

20 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: Loss Derivatives – Financial Assets/Liabilities 80 L02

21 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: Loss Derivatives – Financial Assets/Liabilities 30 Cash * * $1,000 ( ) L02

22 Forwards – Example The following journal entry would be required to settle the contract on a cash basis: Cash ,040* Loss Derivatives – Financial Assets/Liabilities 30 Cash ,150** * $1,000 x 1.04 ** $1,000 x 1.15 L02

23 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 L02

24 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 L02

25 Futures – Example The contract is valued at zero at inception however the margin must be recorded as follows: Deposits Cash L02

26 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: Loss Derivatives – Financial Assets/Liabilities 50 Deposits Cash L02

27 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: Cash Derivatives – Financial Assets/Liabilities Deposits The loss on the contract has already been recorded in the previous journal entries thus only the net settlement of $50 cash is recorded L02

28 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 L02

29 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 L02

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

31 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 L03

32 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 L04

33 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 L04

34 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 L04

35 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 L04

36 Measurement of Hybrid/Compound Instruments
Economic value stems from both the debt component and the equity component Two general approaches: Residual value method (or incremental method) Relative fair value method (or proportional method) IFRS requires the use of residual method (with debt valued first) ASPE allows equity component to be valued at zero, or the use of residual method (with component that is easier to measure being valued first). L04

37 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 L04

38 Convertible Debt Convertible debt is issued for two main reasons:
Corporation can raise equity capital without giving up unnecessary ownership control 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 L04

39 Convertible Debt The reporting of convertible debt and the conversion feature result in three issues: Reporting at the time of issuance Reporting at the time of conversion Reporting at the time of retirement L04

40 Convertible Debt — Example
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) L04 What portion of the proceeds are allocated to Bond Liability, and what portion to equity?

41 Convertible Debt — Example
Total proceeds at par = $ 1,000,000 Fair value of the liability without the conversion option (PV at 9%) = $ ,061 Incremental value of option $ ,939 Journal entry at issuance: Cash 1,000,000 Bonds Payable 924,061 Contributed Surplus – Conversion Rights ,939 L04

42 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: L04 Bonds Payable ,942 Contributed Surplus - Conversion Rights 75,939 Common Shares 1,061,881

43 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) L04

44 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) Bonds Payable ,476 Expense – Debt Retirement ,986 Contributed Surplus – Conversion Rights ,939* Retained Earnings (15,000 – 8,986) ,014 Common Shares 1,048,415 Cash ,000 * Calculated previously using Incremental Method L04

45 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 L04

46 Convertible Debt – 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 L04

47 Convertible Debt – Early Retirement Example
Assume that Bond Corp. decides to retire the convertible debt early and offers the bondholders $1,070,000 cash Bonds Payable ,476 Expense – Debt Retirement ,986 Contributed Surplus – Conversion Rights 75,939 Retained Earnings ,599 Cash ,070,000 L04

48 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) L04

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

50 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 L05

51 Types of Compensation Plans
Compensatory stock option plans (CSOPs) Direct awards of stock Stock appreciation rights plans (SARs) (Appendix 16B) Performance-type plans (Appendix 16B) L05

52 financial institutions
Uses of Stock Options Stock Options Issued by others e.g. financial institutions Issued by the company Options/ Warrants Other CSOP ESOP L05 Not traded on Exchange since Rights usually not transferable Often exchange traded Not traded on Exchange since must Be employee to hold

53 Compensatory vs. Non-Compensatory Plans
Stock Options Compensatory CSOP Non-compensatory ESOP Operating transactions Capital transactions L05 Shareholders’ Equity Income Statement

54 Compensatory vs. Non-Compensatory Plans
Factors to determine if a plan is compensatory: Option terms Non-standard terms implies compensatory Discount from market price Implies compensatory Eligibility If available to only a certain group of employees (i.e. management) L05

55 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 ,000 Contributed Surplus-Options ,000 If employees exercise all 6,000 options: Cash (6,000 x $10) ,000 Contributed Surplus-Options ,000 Common Shares ,000 L06

56 Compensatory Stock Option Plans
Two accounting issues associated with stock compensation plans Determination of compensation expense Periods of allocation for compensation expense amounts L06

57 Compensatory Stock Options Plans - Important Dates
Grant date Options are granted to employee Work start date Vesting Date that can first exercise options Exercise Employee exercises Expiration Unexercised expire L06

58 Compensatory Stock Options Plans
is determined as of the measurement date Compensation Expense 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 L06

59 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 ,000 Contributed Surplus – Stock Options ,000 ($220,000 / 2) L06

60 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) ,000 Contributed Surplus–Stock Options (20% x $220,000) ,000 Common Shares ,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 ,000 (80% x $220,000) L06

61 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) L06

62 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 L06

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

64 Looking Ahead There are a number of IASB projects that are expected to simplify and promote consistent application of accounting standards for financial instruments L07

65 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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