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

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

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

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:
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

6. Derivatives Derivative instruments include: Forwards Futures 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. Financial Risks Defined
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)

8. Derivatives Used by 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

9. Recognition and Measurement of 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

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

13. A 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

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 31st is $120 per share
Option settled in cash on April 1, 2011

15. Accounting for Derivatives
Option Price Formula
Option
Premium =
Intrinsic
Value +
Time
Market Price less
Strike (Exercise)
Price
Option Value
Less
Intrinsic Value
Option
Premium =
($100 - $100) +
($400 - $0)
Journal Entries

16. Accounting for Derivatives
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

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. 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
Gain

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

20. Debt, Equity or Both? Hybrid/combined instruments:
Have characteristics of both debt and equity (e.g. convertible 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. 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. 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. Measurement Issues Hybrid/Combined instruments:
Economic value stems from both the debt component and the equity component
Two measurement tools:
Residual value method (or incremental method)
Relative fair value method (or proportional method)
IFRS requires the use of residual method (with debt valued first)
PE GAAP allows
equity component to be valued at zero, or
the use of residual method (with component that is easier to measure being valued first)

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. Convertible Debt 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 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

26. Convertible Debt – Accounting Issues
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

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. 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 $ 75,939
Journal entry at issuance:
Cash 1,000,000
Bonds Payable 924,061
Contributed Surplus –
Conversion Rights 75,939

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 ,942
Contributed Surplus - Conversion Rights 75,939
Common Shares 1,061,881

30. 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)

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 ,476
Expense – Debt Retirement ,986
Contributed Surplus – Conversion Rights 75,939*
Retained Earnings (15,000 – 8,986) ,014
Common Shares 1,048,415
Cash ,000
* Calculated previously using Incremental Method

32. Reporting at the Time of Retirement
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

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 ,476
Expense – Debt Retirement ,986
Contributed Surplus – Conversion Rights 75,939
Retained Earnings ,599
Cash ,070,000

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

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

37. Stock Compensation Plans
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
Determination of compensation expense
Periods of allocation for compensation expense amounts

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

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

40. 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)

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 ,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

42. Stock Options - 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

43. Options: Allocating Compensation Expense
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

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 Expense 110,000
Contributed Surplus – Stock Options ,000
($220,000 / 2)

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) ,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)

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

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. COPYRIGHT
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