FA3 – Lesson 4 Complex debt and equity instruments 1.Classification: Debt vs. equity 2.Debt convertible at investor’s option 3.Debt convertible at issuer’s option (NOT EXAMINABLE) 4.Accounting for stock options 5.Cash flow statement

1. Classification: Debt vs. equity Liabilities (Inevitable) obligations arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services, or other yielding of economic benefits in the future Equity Ownership interests in the assets of a profit oriented enterprise after deducting its liabilities

1. Classification: Debt vs. equity (cont’d) Liabilities Payment is inevitable Interest payments, gains and losses on redemption flow through income statement Equity Payment can be avoided Dividend payments, “gains” and “losses” on retirement flow through shareholders’ equity

1. Classification: Debt vs. equity (cont’d) Guiding principle: Accounting should be consistent with the substance of the instrument, not its legal form. If a bond is in substance an equity item, the bond is presented in shareholders’ equity and the interest is reported as dividend. If a type of share is in substance a liability, the shares are presented in the liability section and the dividends are reported as an expense.

1. Classification: Debt vs. equity (cont’d) 1.Is the periodic return on capital (interest, dividends) obligatory? 2.Is the debtor legally obligated to repay the principal, either at some fixed date or at the option of the creditor? YES/YES: liability NO/NO: equity 1 YES/1 NO: hybrid instrument, part debt and part equity Exercise: A15-3

2. Debt convertible at investor’s option The investor acquires two things: (1) a promise to pay debt and interest; and (2) an option to use the principal to buy common shares Correct accounting must record the liability portion (1) and the equity portion (2) separately Valuation at issue: based on liability alone, or both liability and value of option Example: A15-10

3. Debt convertible at issuer’s option Prior to 2004, debt convertible at issuer’s option was considered to be part liability (the present value of the stream of interest payments) and part equity (the present value of the principal) Now, consistent with FASB, debt of this kind is part equity only if the debt is convertible into a fixed number of shares (this is rare); if there is a variable-number-of-shares feature (which is very common), it is all debt This issue is not examinable

4. Accounting for stock options Initial valuation Intrinsic value: Option value = current stock price – exercise price at grant date, if this value is positive; otherwise, option value = 0 (As of January 1, 2004, the instrinsic value method is no longer allowed in Canada) Fair value: Option value = fair value of consideration received, or fair value of option, whichever is more reliably measurable Example: A15-21

5. Cash flow statement Cash flows related to complex instruments are reported in a manner consistent with the economic substance of the instrument. -Interest/dividend payments related to substantially debt instruments are operating cash flows -Interest/dividend payments related to substantially equity instruments are financing cash flows

5. Cash flow statement (cont’d) Other issues Transactions involving bonds, shares and options are reported in the financing section of the cash flow statement Non-cash transactions Conversion from debt to equity Lapse of options Example: A15-28