1、Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto,Chapter 16 Complex Financial Instruments,2,Complex Financial Instruments,Derivatives Understanding derivatives: managing risk Recognition and measurement Derivatives involving the entitys own shares,Share-Based Com
2、pensation 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 a
3、nd private enterprise GAAP Looking ahead,3,Complex Financial Instruments,Derivatives Understanding derivatives: managing risk Recognition and measurement Derivatives involving the entitys own shares,Share-Based Compensation Types of plans Special issues Disclosure of compensation plans,Debt versus E
4、quity 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,Financial Instruments,Financial instruments
5、: 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 pay
6、ables, 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 und
7、erlying 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 OptionsExample: Stock Options The stock is the “underlying” If the share price goes up, the option is worth more; If
8、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 R
9、isk 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 cas
10、h 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 de
11、rivatives) 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 Spe
12、cial 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 t
13、he 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 a
14、re 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 obl
15、igation, to purchase the “underlying” at a preset (strike or exercise) pricePut Option Holder has the right, but not the obligation, to sell the “underlying” at a preset price,13,A Framework for Options,14,Derivative Accounting - Example,Given: Call option entered into January 2, 2011 Option expires
16、 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,16,Accounting for
17、Derivatives,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 incre
18、ases 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
19、 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
20、$50, on January 5, 2011, the journal entry is:Derivatives Financial Assets/Liabilities 50Gain 50,19,Complex Financial Instruments,Derivatives Understanding derivatives: managing risk Recognition and measurement Derivatives involving the entitys own shares,Share-Based Compensation Types of plans Spec
21、ial 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 Lo
22、oking 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 statemen
23、t 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 unfavour
24、able 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 guida
25、nce 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 compo
26、nent 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
27、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 th
28、e bondholders option Once the bond is converted, all interest and principal no longer payable,25,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 corpora
29、tion 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,The reporting of convertible debt and the conversion feature resu
30、lt in three issues: Reporting at the time of issuance Reporting at the time of conversion Reporting at the time of retirement,Convertible Debt Accounting Issues,27,Convertible Debt Example,Given: 3 year, $1,000,000 par value, 6% convertible bonds Similar bonds (without conversion feature) have a 9%
31、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 op
32、tion (PV at 9%) = $ 924,061 Incremental value of option $ 75,939,Journal entry at issuance: Cash 1,000,000Bonds Payable 924,061Contributed Surplus Conversion Rights 75,939,29,Convertible Debt Example,Conversion before maturity - assume that the unamortized portion is $14,058 therefore, book value of
33、 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 75,939Common Shares 1,061,881,30,When the corporation wants to entice or induce the bondholders to convert their bonds into shares Additi
34、onal 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,Convertible Debt Ex
35、ample,Assume Bond Corp. offers an additional cash premium of $15,000, when carrying amount of the debt is $972,476 and bonds 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 Conver
36、sion Rights 75,939* Retained Earnings (15,000 8,986) 6,014Common Shares 1,048,415Cash 15,000 * Calculated previously using Incremental Method,32,Treated the same as debt retirement from Chapter 14 for non-convertible bonds Clear any outstanding premiums, discounts, bond issue costs, interest accrued
37、 to bondholders The conversion rights account must be reallocated Equity components remains in Contributed Surplus,Reporting at the Time of Retirement,33,Convertible Debt Example,Assume that Bond Corp. decides to retire the convertible debt early and offers the bondholders $1,070,000 cash,Bonds Paya
38、ble 972,476 Expense Debt Retirement 8,986 Contributed Surplus Conversion Rights 75,939 Retained Earnings 12,599Cash 1,070,000,34,Interest, Dividends, Gains/Losses,The related interest, dividends, gains, and losses must be consistently treated as the financial instrument they relate to Example: term
39、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
40、Derivatives involving the entitys 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
41、 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,A form of stock warrant a stock option Pro
42、vides 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,Stock Compensation Plans,38,Uses o
43、f Stock Options,Stock Options,Issued by the company,Issued by other 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,39,Compensatory vs. Non-Compensat
44、ory Plans,Stock Options,Non-compensatory ESOP,Compensatory CSOP,Income Statement,Shareholders Equity,Operating transactions,Capital transactions,40,Compensatory vs. Non-Compensatory Plans,Factors to determine if a plan is compensatory Option terms Non-standard terms implies compensatory Discount fro
45、m 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
46、 $6,000:Cash 6,000Contributed Surplus-Options 6,000 If employees exercise all 6,000 options:Cash (6,000 x $10) 60,000Contributed Surplus-Options 6,000Common Shares 66,000,42,Stock Options - Important Dates,43,Options: Allocating Compensation Expense,Compensation Expense,The service period is the per
47、iod benefited by employees serviceIt 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 s
48、hare 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 110,000Contributed Surplus Stock Options 110,000($220,
49、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) 120,000Contributed SurplusStock Options (20% x $220,000) 44,000Common Shares 164,000 If the remaining stock options are not exercised before their expiration date, journal entry is:Contributed SurplusStock Options 176,000Contributed Surplus-Expired Options 176,000(80% x $220,000),
