Presentation is loading. Please wait.

Presentation is loading. Please wait.

Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto Chapter 16 Complex Financial Instruments Chapter 16 Complex Financial.

Similar presentations


Presentation on theme: "Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto Chapter 16 Complex Financial Instruments Chapter 16 Complex Financial."— Presentation transcript:

1 Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto Chapter 16 Complex Financial Instruments Chapter 16 Complex Financial Instruments

2 2 Complex Financial Instruments Derivatives Understanding derivatives: managing risk Recognition and measurement Derivatives involving the entity’s own shares Share-Based Compensation Types of plans Special issues Disclosure of compensation plans Debt versus Equity – Issuer Perspective Understanding the economics of complex financial instruments Presentation Measurement Interest, dividends, gains, and losses IFRS and Private Enterprise GAAP Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

3 3 Complex Financial Instruments Derivatives Understanding derivatives: managing risk Recognition and measurement Derivatives involving the entity’s own shares Share-Based Compensation Types of plans Special issues Disclosure of compensation plans Debt versus Equity – Issuer Perspective Understanding the economics of complex financial instruments Presentation Measurement Interest, dividends, gains, and losses IFRS and Private Enterprise GAAP Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

4 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

5 5 Derivative Instruments 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

6 6 Derivatives Derivative instruments include: 1.Forwards 2.Futures 3.Options 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

7 7 Financial Risks Defined 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)

8 8 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

9 9 Recognition and Measurement of 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

10 10 Non-financial Derivatives Example of non-financial derivatives: contract to buy steel at a specified date for a specified price Are purchase commitments “derivatives”? –Value changes with value of the underlying –No investment up front –Settled in future

11 11 Accounting for purchase commitments Under ASPE / PE GAAP: –Not accounted for as derivatives because difficult to measure –Recognized when goods received 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”

12 12 Derivative Instruments Options 1.Call Option Holder has the right, but not the obligation, to purchase 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

13 13 A 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

14 14 Derivative Accounting - Example Given: Call option entered into January 2, 2011 Option expires April 30, 2011 Option to purchase 1,000 shares at $100 per share Share market price on January 2, 2011 is $100 per share Option is purchased for $400 (Option Premium) Share price on March 31 st is $120 per share Option settled in cash on April 1, 2011

15 15 Accounting for Derivatives 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) Journal Entries

16 16 Accounting for Derivatives 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 Forwards Under a forward contract, parties each commit upfront to do something in the future (obligation) Example: Assume on January 2, 2011, 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

18 18 Forwards 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, 2011, the journal entry is: Derivatives – Financial Assets/Liabilities 50 Gain50

19 19 Complex Financial Instruments Derivatives Understanding derivatives: managing risk Recognition and measurement Derivatives involving the entity’s own shares Share-Based Compensation Types of plans Special issues Disclosure of compensation plans Debt versus Equity – Issuer Perspective Understanding the economics of complex financial instruments Presentation Measurement Interest, dividends, gains, and losses IFRS and Private Enterprise GAAP Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

20 20 Debt, Equity or Both? Hybrid/combined instruments: Have characteristics of both debt and equity (e.g. c onvertible debt) Are they debt, equity, or a bit of both? To determine appropriate presentation, must consider: –Contractual terms –Economic substance –Definitions of financial statement elements

21 21 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

22 22 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 –Treated as equity only if settled by exchanging fixed number of own equity instrument for fixed amount of cash or other assets

23 23 Measurement Issues Hybrid/Combined instruments: –Economic value stems from both the debt component and the equity component –Two measurement tools: 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) –PE GAAP 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)

24 24 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

25 25 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 the bond issue at a lower coupon Conversion feature provides investor with an opportunity to own equity - generally results in the investor accepting a lower coupon rate than with non-convertible debt Convertible Debt

26 26 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 Convertible Debt – Accounting Issues

27 27 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) What portion of the proceeds are allocated to Bond Liability, and what portion to equity?

28 28 Convertible Debt — Example 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

29 29 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 would be as follows: Bonds Payable 985,942 Contributed Surplus- Conversion Rights 75,939 Common Shares1,061,881

30 30 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) Induced Conversion

31 31 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 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

32 32 Treated the same as debt retirement from Chapter 14 for non-convertible bonds –Clear any outstanding premiums, discounts, bond issue costs, interest accrued to bondholders –The conversion rights account must be reallocated –Equity components remains in Contributed Surplus Reporting at the Time of Retirement Reporting at the Time of Retirement

33 33 Convertible Debt — Example Assume that Bond Corp. decides to retire the convertible debt early and offers the bondholders $1,070,000 cash Bonds Payable 972,476 Expense – Debt Retirement 8,986 Contributed Surplus – Conversion Rights 75,939 Retained Earnings 12,599 Cash 1,070,000

34 34 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)

35 35 Complex Financial Instruments Derivatives Understanding derivatives: managing risk Recognition and measurement Derivatives involving the entity’s own shares Share-Based Compensation Types of plans Special issues Disclosure of compensation plans Debt versus Equity – Issuer Perspective Understanding the economics of complex financial instruments Presentation Measurement Interest, dividends, gains, and losses IFRS and Private Enterprise GAAP Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

36 36 Types of Compensation Plans 1.Compensatory stock option plans (CSOP) 2.Direct awards of stock 3.Stock appreciation rights plans (SAR) 4.Performance-type plans

37 37 A form of stock warrant — a stock option Provides the employee with an opportunity to purchase shares at a given price, within a specified period of time Two accounting issues associated with stock compensation plans 1.Determination of compensation expense 2.Periods of allocation for compensation expense amounts Stock Compensation Plans

38 38 Uses of Stock Options Stock Options Issued by the company Issued by other e.g. Financial institutions Options/Warrants Other ESOPCSOP Not traded on Exchange since must Be employee to hold Not traded on Exchange since Rights usually not transferable Often exchange traded

39 39 Compensatory vs. Non- Compensatory Plans Stock Options Non-compensatory ESOP Compensatory CSOP Income Statement Shareholders’ Equity Operating transactions Capital transactions

40 40 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)

41 41 Non-Compensatory - Example Fanco Limited set up an ESOP that gives employees the option to purchase shares for $10 per share On January 1, 2011, 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

42 42 Stock Options - Important Dates Grantdate Optionsare granted to employee Work start date Vestingdate Date that employee can first exerciseoptions Exercisedate Employeeexercisesoptions Expirationdate Unexercisedoptionsexpire

43 43 Options: Allocating Compensation Expense 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

44 44 Compensation Expense - Example On January 1, 2012, 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 2012 and 2013: Compensation Expense110,000 Contributed Surplus – Stock Options 110,000 ($220,000 / 2)

45 45 Compensation Expense - 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)

46 46 Direct Stock Awards Non-monetary 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

47 47 Compensation Plan Disclosure 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

48 48 Complex Financial Instruments Derivatives Understanding derivatives: managing risk Recognition and measurement Derivatives involving the entity’s own shares Share-Based Compensation Types of plans Special issues Disclosure of compensation plans Debt versus Equity – Issuer Perspective Understanding the economics of complex financial instruments Presentation Measurement Interest, dividends, gains, and losses IFRS and Private Enterprise GAAP Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

49 49 Looking Ahead There are a number of IASB projects that are expected to simplify and promote consistent application of accounting standards for financial instruments

50 50 Copyright © 2010 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. COPYRIGHT


Download ppt "Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto Chapter 16 Complex Financial Instruments Chapter 16 Complex Financial."

Similar presentations


Ads by Google