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ACCT 4222 Chapter 16 Complex Financial Instruments: This chapter covers hybrid and compound debt and equity

instruments, derivatives and employee stock option plans. Learning objectives: - Analyze whether a compound instrument is a liability, equity or both. - Explain the accounting for the issuance, conversion and retirement of convertible securities. - Understand what derivatives are and why they exist. - Explain the various types of financial risks and why they arise. - Explain the unique issues associated with derivatives settleable with company's own equity instruments - Describe various types of stock compensation plans - Explain differences between employee and compensatory options plans and other options. - Describe the accounting for compensatory stock options plans. - Identify major differences between ASPE and IFRS. A. Debt vs equity - Issuer Perspective: - e.g., advantages and disadvantages of bonds payable vs common shares: Bonds payable - fixed term - interest - secured, ranks ahead of shares - tax deductible interest - no ownership given up - increases solvency risk - fixed interest payments Common shares - permanent capital - not required to pay dividends - unsecured, no priority on windup - not required to pay interest - no constraints on assets - dilutes shareholder base - missed leverage opportunity.

Term: Return: Seniority: Advantages: Disadvantages:

Issues with compound (hybrid) financial instruments: 1) Presentation: - companies issue securities with features of both debt and equity (compound financial instruments). - this allows flexibility in determining the cost of capital (e.g. debt with warrants has lower interest). - creates problems with how the instruments are presented in the financial statements. - to determine presentation must analyze the instrument contract and economic substance. Generally, if an instrument obligates the company to pay out cash, it is a financial liability. - under both IFRS and ASPE even if a debt instrument is settled with a variable number of shares it is presented as a financial liability (debt) on the balance sheet because the settlement amount is fixed. i.e., the company will retire the debt with a fixed dollar amount of shares. Under IFRS though, if a debt instrument is settled by exchanging a fixed number of equity instruments, it is presented as equity since the value of the final amount paid out will vary with the value of the shares paid out at that time. Examples: Contract - Convertible debt (at option of holder into fixed number of c/s of company) Presentation Part debt, part equity. Conversion is imbedded call option (equity) since fixed number of shares to be issued. Remainder is debt w/fixed interest and principal repayment. Liability since share holder has right to exercise option and this is beyond entity's control. Also entity must pay cash. Part debt, part equity. Warrants are detachable and trade separately. They are equity (exchangeable for common shares). Liability since the economic value is the present value of the interest payments.

- Puttable shares where holder has option to require company to take back shares for cash. - Debt with detachable warrants (giving holder the right to acquire a fixed number of shares). - Perpetual debt.

2) Measurement of compound financial instruments: - need to bifurcate (separate) debt and equity components. a) relative fair value method. Determine the market value of both components independently, then any difference between total fair value of components and the actual fair value of the instrument is prorated based on relative fair values of the two components and then allocated to each. b) Residual method. Value one component and the other component is whatever is left over. IFRS requires the residual value method, valuing the debt component first. ASPE allows the equity to be valued at zero or the residual method to be used with the more easily measurable component being valued first. Exercise BE 16-12, page 1075. Using IFRS and residual method, value the debt component first. Fair value of the bonds = 500 bonds x $1,000/bond x 97% = Fair value of the total issue = 500 bonds x $1,000/bond x 103% = Residual = value of the warrants (equity component) Accounting for the issue: Cash (1,000 bonds x $500 x 103%) Bonds payable Contributed surplus - conversion rights

485,000 515,000 30,000

515,000 485,000 30,000

The value of the warrants is credited to equity (contributed surplus) until such time as the warrants are exercised. When the warrants are exercised the contributed surplus is moved to common equity. To amortize the discount on the bonds payable, you have values for N, PV, PMT and FV, so just need to CPT I/Y and amortize the discount to interest expense over the term of the bond.

E.g., Bonds convertible to common shares at holders option (text pgs 1043 - 1046) - This debt gives the holder the option to convert to common shares. Conversion gives opportunity for growth. Convertible debt is typically issued at a lower interest rate than if it were straight debt without the convertibility feature. (i) For financial accounting, at date of issue, use residual method to allocate proceeds between debt (bond interest and principal repayment) and equity (conversion privilege): e.g., On January 1, 2011 a company issues a $500,000, 5%, 4 year convertible bond. Market interest rate is 8% and interest is payable semi-annually, each January 1 and July 1. Conversion date is January 1, 2012, after the semi-annual interest payment. Total proceeds from the issue is $508,000. The obligation to deliver cash (periodic interest payments and potentially repayment of principal) represents a financial liability, while the right to acquire company common shares represents an equity interest. Therefore, we need to separate the debt and equity components and account for each separately. Using the residual method we value the debt first: PV of interest and principal repayment, N=8, I/Y=4, PMT=-12,500, FV=-500,000, CPT PV = 449,504. Allocate $449,504 to debt and the remainder of the total proceeds (508,000 - 449,504) $58,496 to equity. 1-Jan Cash Bonds payable Contributed surplus - conversion rights Bond amortization table:
Payment Interest (4.0%) Amortization Carrying amount

508,000 449,504 58,496

Jan 1 11 Jul 1 11 Jan 1 12

12,500 12,500

17,980 18,199

5,480 5,699

449,504 454,984 460,684

(ii) At the January 1, 2012 conversion date, the bondholders convert when the bond carrying amount is $460,684. We need to determine the amount at which to record the common shares that are issued for the bond. The method most commonly used in practice is the book value method: Bonds payable 460,684 Contributed surplus - conversion rights 58,496 Common shares (BV of bonds + conversion rights)

519,180

The common shares issued are valued at "book value" by debiting the book value of the bond payable and contributed surplus accounts, then crediting common shares. No gain or loss is recognized on conversion. If there is any outstanding accrued interest that was forfeited, it is netted into the cost of the shares.

(iii) If conversion is "induced", e.g., a $12,000 payment is offered to the bondholders to convert to common shares. The inducement is allocated between debt and equity components based on fair value(s) at the date of the conversion. This approach is consistent with the method used when the debt was initially recorded. Consistent with the residual method initially used, we will calculate the portion of the $12,000 payment that applies to the debt and the remainder is applied to the equity (conversion feature). Assume that the fair value of the bonds (excluding the conversion feature) at conversion date is $470,000. The difference between the fair value of the bonds and their carrying amount is $9,316 (470,000 - 460,684). This $9,316 is related to the "debt" component of the transaction as it is the portion of the $12,000 inducement that compensates the bondholders for the gap between the fair value of the debt and its carrying value. It is treated as a debt retirement cost and is expensed. The $2,684 (12,000 - 9,316) remainder of the inducement relates to the equity component of the transaction, and is treated as capital and charged to retained earnings.

Jan 1/12

Bonds payable Contributed surplus - conversion rights Expense - debt retirement cost Retained earnings (redemption cost) Cash Common shares (460,684 + 58,496)

460,684 58,496 9,316 2,684 12,000 519,180

- If we assume the fair value of the bonds (excluding the conversion feature) at conversion date is equal to or less than the carrying value. How would you allocate the $12,000 inducement? Since the fair value of the bonds is less than their book value, the $12,000 inducement must relate to the equity component, so we would debit retained earnings for the full $12,000. (iv) Assume instead there is early retirement of the instrument on July 1, 2011 when the carrying value of the bond alone is $454,984. Assume the bond fair value is $460,000 and the fair value of the total instrument is $520,000. The company pays the fair value of $520,000 in order to retire the instrument early. Interest has been paid up to date.

Bonds payable Contributed surplus - conversion rights Expense - debt retirement cost Retained earnings (redemption cost) Cash (460,000 - 454,984 = 5,016)

454,984 58,496 5,016 1,504 520,000

The method of allocation of the loss to the debt is the same as previously (difference between the bond fair value and bond carrying value) and the remainder goes against retained earnings (analogous to redeeming shares for more than their average cost). The $520,000 is the fair value of the total instrument (debt plus imbedded option). The option is deemed to be retired.

3) Normal retirement of convertible debt (i.e., the bond holders do not convert): - The equity component remains in contributed surplus. The discount or premium is fully amortized. The convertible bond payable account is debited and cash credited. Exercise E16-10, page 1079: (Bond conversion) a) Jan 1 11 Cash Bond payable Contr. Surplus - conversion rights (plug) 10,800,000 8,500,000 2,300,000

b) Jan 1 13 Bond payable 2,595,000 Contr. Surplus - conversion rights (2,300,000 x 30%) 690,000 Common shares (10,000,000 x 30%) - (1,500,000 x 18/20 x 30%) = 2,595,000 2 years after issue so 2/20 of the discount has been amortized. c) ($3,000,000 / ($1,000 bond)) x 5 shares x 2 (2:1 split) = 30,000 common shares. d) advantages: No dividend obligation No obligation to repay principle Increase in income due to a decrease in interest cost Positive impact on D/E ratio Positive effect on EPS through reduction in interest expense disadvantages: Dilutes earnings for existing shareholders Pressure from existing shareholders not to issue convertible debt Pressure from new shareholders to pay out dividends.

3,285,000

Treatment of interest, dividends, gains and losses: - These must be consistently treated with the classifications of the instruments they are related to. E.g., when a term preferred share is classified as debt, any dividend payments are recorded as interest expense and charged to the income statement (not to retained earnings). If term preferred shares are issued at an amount different from face value, any discount or premium is amortized to interest expense.

B. Derivatives: - Derivatives derive their value from an underlying primary instrument (e.g., stock, index, commodity). For example a call option to purchase a share in a company has value due to the underlying stock in the company. If the company goes bankrupt and the shares become worthless, then so does the option to purchase the shares. If the underlying shares increase in value, so does the value of the option to purchase them. Derivative Characteristics: (i) their value changes in response to the "underlying" (ii) they require little or no initial investment (iii) they are settled at a future date. Derivatives are used to manage a company's financial risks: Financial risks: 1. Credit risk - risk that a party to a financial risk will default on its obligation(s) 2. Liquidity risk - financial risk due to uncertain liquidity (e.g. credit rating drop and cash outflows) 3. Market risk - risk that fair values or future cash flows of a financial instrument or commodity will fluctuate due to currency, interest rate or other changes in prices. Examples of using derivatives to manage market risk: - an oil production company wants to ensure there will be a market for it's oil production in the next 3, 6, 9 and 12 months. It signs forward contracts agreeing to sell it's oil at a future price agreed on today for delivery in the next 3, 6, 9 and 12 months. - a cruise ship company is worried the price of the Euro is going to increase over the next 12 months when it is committed to purchase a newbuild cruise ship. The company enters a forward contract to take delivery of the needed Euros one year from now at a price agreed to today. - a company has mainly variable rate debt but is concerned about expected future interest rate increases. The company signs a contract with an intermediary (bank) agreeing to swap a portion of its variable rate debt with another company willing to swap fixed rate debt for floating rate debt. Recognition, Measurement and Presentation of Derivatives: a) Derivatives represent rights or obligations that meet the definitions of assets or liabilities. They are contractual obligations and may have to be settled in cash. Therefore, they should be reported in financial statements. b) Fair value is the most relevant measure for derivatives. Companies should use their best efforts in determining the fair value of derivatives even though fair value is often difficult to measure. All derivatives should be measured at fair value through net income. c) Only items that are assets or liabilities should be reported as such in financial statements d) Hedge accounting should only be allowed for qualifying items. Companies "hedge" when they take two offsetting positions at the same time so that, regardless of the outcome of an event, the company remains in a neutral position vis a vis the hedged risk.

Types of Derivatives: 1) Options: Purchased option is one purchased by a company/investor (can be a call or a put). The option purchaser has the right but not the obligation to purchase or sell something. Purchased Call option - gives option purchaser the right to buy the underlying (e.g., common shares) Purchased Put option - gives the option purchaser the right to sell the underlying (e,g. common shares). A written option is one written by a company (can be a call or a put). It is riskier than the purchased option since the company has no control whether the purchaser of the option will exercise it or not (or when). "Premium" is the amount paid for an option. "Intrinsic value" portion of the premium is the difference between the "strike" or "exercise" price and the market value of the underlying. "Time value" portion of the premium is the difference between the intrinsic value of the option and the market value of the option. Thus, when an option is purchased and it is "out of the money", it has no intrinsic value and only time value. - Options are written (sold) and bought by individual investors. They are issued and guaranteed by Trans Canada Options Inc., wholly-owned by the ME, TSE & VSE. e.g., a call option with an exercise price of $40 is trading at $13. The underlying stock is trading at $50.
Underlying mkt price Option ex price $50 $40 $10 = Option intrinsic value and $13 - $10 = Option time value

E.g., Exercise E16-1, page 1076: a 2-Jan Derivatives - trading (asset) Cash 350 350

c d e

31-Mar Derivatives - trading (15,500 - 350) 15,150 Gain - income statement 15,150 At this point the intrinsic value of the option is (38 - 25)x1000 = 13,000. The time value of the call option is 15,500 - 13,000 = 2,500. The gain increases net income for the quarter. Speculating. This is not a hedge of a current or future transaction or a cash flow. The company is exposed to market risk. If the underlying shares market price decreases in value, so too will the call option. At most though, the company will lose the cost of the option - $350.

Why buy the option in the first place? Reflow Corporation could have bought 1,000 shares of Walter for cash on January 2 when the shares were trading at $25. Reflow's initial investment would have been $25,000 and Reflow would have recorded a gain at March 31 of $3,000 when the shares reached a value of $38: ($38 - $25) x 1,000 = $13,000. However, the investment in the options was only $350 (rather than $25,000). Also, Reflow could have faced a loss up to $25,000 (worst case) if the shares seriously declined in value. Purchasing an option meant Reflow's loss could not be greater than the cost of the option - $350.

E.g., P16-1, page 1083: a) 7-Jul Derivatives - trading Cash 30-Sep Derivatives - trading (1340 - 240) Gain 31-Dec Loss (1340 - 825) Derivatives - trading 240 240 1,100 1,100 515 515

b)

c)

d)

4-Jan Cash (200 x (76-70)) 1,200 Derivatives - trading (240 + 1100 - 515) Gain Hing Wa's broker sells for $1,200. Assume no brokerage fees.

825 375

E.g., P16-2, page 1083 (homework): 7-Jul a) Cash 240 Derivatives - trading 240 30-Sep b) Loss (240 - 1340) 1,100 Derivatives - trading 1,100 31-Dec c) Derivatives - trading (1340 - 825) 515 Gain 515 4-Jan d) Derivatives - trading 825 Loss (825 - 1200) 375 Cash (200 x (70 - 76) 1,200 Hing Wa buys 200 shares on the market at $76 and sells them to option holder at $70. 2) Forwards: - With a forward contract, the contracting parties contract to do something in the future. For example, one party commits to sell the underlying at a future date at a future price and the other party commits to buying it on that date and at that price. This is different from an option where the option holder has the right (but not the obligation) to exercise his/her option. Here the parties have the right and the obligation to meet their commitments. E.g., exercise BE 16-3, page 1075: 1-Jan No entry - At inception, the forward contract is priced so that its value is zero. It doesn't cost either party anything to enter into the contract. If the US dollar strengthens above $1.056 Canadian, the contract will have value to Ginseng. If the US dollar weakens, the contract will have negative value to Ginseng. 15-Jan Derivative - trading Gain 35 35

The US dollar has strengthened and Ginseng records a gain. It is a gain since the US dollar has appreciated against the Cdn dollar and is worth more than $1.056 Cdn. But Ginseng will only need to pay $1.056 for each US $1.00 (CDN $5,280 in total).

Futures: 3) These are like forwards except: (i) they are standardized in terms of $ amounts and quantities (vs forwards that are tailor made). (ii) they are traded on exchanges and therefore have ready market values (iii) they are settled through clearing houses so credit risk of other party is neglible (iv) daily settlement. Each day, future contracts are "marked to market" and any deficiencies are covered by the participants "margin" account. The initial margin account is accounted for as a deposit (like a bank account), and is increased or decreased as the margin amount changes. E.g., ABC Co.enters into a futures contract to buy 1,000 bbls of oil for $100,000. A 15% margin account is required and deposited by ABC Co. with the broker on January 1. 1-Jan Margin deposit ($100,000 x 15%) Cash 15,000 15,000

On Jan 2, the futures contract is marked to market. The value has declined due to a decrease in the price of oil. This is because ABC has contracted to purchase 1,000 bbls of oil for a price higher than the current market price. Assume the Jan 2 futures price is $85,000 so ABC's margin has been absorbed by the marking to market and ABC must meet it's margin requirement: 2-Jan Loss Margin deposit Margin deposit (85,000 x 15%) Cash 15,000 15,000 12,750 12,750

Assuming no further changes in prices and value and the contract settles Jan 30 without ABC taking delivery of the oil, ABC's entry would be: 30-Jan Cash Deposits 12,750 12,750

Stock Compensation Plans (ESOPs and CSOPs): - All plans are designed to commit employees to a long term commitment to the company and to focus their work efforts in ways that will improve company performance (e.g., EPS increase, growth, higher share value). From an accounting point of view, we want to record the fair market value of the compensation and we want it to go through the income statement as compensation expense. Methods of compensation with company stock are: 1 Direct award of stock: - Does not cost the company cash. Appeals to start-up companies. The awarding of the stock to employees is recorded at the fair market value of the stock in compensation expense on the income statement. Stock option plans (Employee SOPs and Compensatory SOPs): - We have considered stock options as derivatives to manage risk and as debt with detachable warrants (options) with bonds as a sweetener or to reduce the cost of capital. Here we are looking at them as employee stock option plans (ESOPs) where all employees can subscribe to them and as compensatory stock option plans (CSOPs) used as a form of remuneration to management or employees. With ESOPs, the employee generally pays for the options so they are capital transactions. With CSOPs, the employee receives the options as a form of compensation so the transaction should go through the income statement as compensation expense. A plan is compensatory (CSOP) where: a) the employee has an extended time to enrol in the plan and the ability to cancel the option. b) the option is issued at a large discount (typically a larger discount than for ESOPs) c) eligibility for the options is restricted.

ESOP example: E.g., ABC Ltd. sets up an ESOP that gives employees the option to purchase company shares at $15 per share. The option premium (price) is $2 per share and ABC has set aside 7,000 shares. On January 1, 2011 employees purchase 7,000 options for $14,000 and later in August that year, all 7,000 options are exercised: 1 Jan 11 Cash ($2x7,000) Contributed surplus - stock options 14,000 14,000

15 Aug 11

Cash ($15 x 7,000) 105,000 Contributed surplus - stock options 14,000 Common shares 119,000 For any options that are never exercised, any funds received for the options remain in contributed surplus. Compensatory Stock Option Plan (CSOP): - CSOPs are measured at fair value which derives from the option intrinsic value and its time value. Intrinsic is measured as difference between share price and exercise price. To measure the overall compensation value/expense (including the time value) a fair value option pricing model (e.g. Black-Scholes) is used. Once measured, the value of the compensation paid is used to determine the value of the consideration (employee labour) received. CSOPs are not traded on exchanges so a pricing model is used to value them. Total compensation expense is determined on the date of option granting and is based on the fair value of the options that are expected to vest. The compensation expense is recognized in the period in which the employee performs the service. Key dates: Grant date: normally the date to measure the compensation and account for it. No entry. Corporate year-end: normally record compensation expense applicable to the period. Vesting date: date when options are expected to vest (owned by the employee). No entry. Exercise dates: dates options exerciseable. Record any shares issued at their exercise price. Expiry date: date when option expires. Account for any expired options.

E.g., exercise E16-15, page 1080: a) Nov 1 11 Jan 2 12 Dec 31 12 No entry at date of inception of plan. No entry at option grant date but the value of the compensation is measured. Compensation expense (550,000/2 yrs) 275,000 Contributed surplus - stock options 275,000 Recognize half of the compensation measured at the grant date. Contributed surplus - stock options 21,389 Compensation expense (3,500/45,000x275,000) Pro-rate those who have resigned and terminated their options.

Apr 1 12

21,389

Dec 31 13

Compensation expense 253,611 Contributed surplus - stock options 253,611 Recognize other half of compensation less those terminated (550,000/2 yrs) - 21,389 Cash (31,500 x $42) 1,323,000 Contributed surplus - stock options 385,000 Common shares 1,708,000 31,500/45,000 x 550,000=385,000 (market price of shares not relevant) Cash (10,000 x $42) 420,000 Contributed surplus - stock options 122,222 Common shares 542,222 10,000/45,000 x 550,000 = 122,222 (market price of shares not relevant)

Jan 3 14

May 1 14

b) Option pricing model ignores forfeitures as they cannot be reasonably estimated. Forfeitures are treated as a change in estimate when they occur and a benefit of the period (credit to compensation expense). If the forfeitures had been included in the model estimate, the resulting estimate of the fair value of compensation expense would have been less than $550,000. If there were remaining unexercised stock options at expiry date, the balance in contributed surplus would remain. Some companies move the expired balance to a new account by debiting Contributed surplus - stock options and crediting Contributed surplus - expired stock options. c) Compensatory Stock Option Plans - executive retention and treated like compensation. Employee Stock Option Plans - employees pay fully or partially for the options. Performance type plans - award options only if performance criteria are met. Use criteria that employees can influence. Improved stock price as a criteria is difficult to influence directly). However, impact on net income or earnings per share is more measurable). d) CSOPs executives don't pay for options. ESOPs, employees pay for the options. Call options and put options are not related to employee loyalty nor compensation. Note: ASPE: allows estimating forfeitures "up front", or, account for them as they occur. IFRS: requires estimating forfeitures "up front". Disclosure for compensation plans: - a description of the accounting policy and nature of the plan - the amount and movement in the number of options for each plan - methods used to determine the fair value of options (e.g., interest rates, expected dividend flow) - total compensation cost included in net income and contributed surplus.

Period

Cash

4%

Amort

Principal 203,855 197,009 189,890 182,485 174,785 166,776 158,447 149,785 140,776 131,407 121,664 111,530 100,991 90,031 78,632 66,778 54,449 41,627 28,292 14,423 0

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000

8,154 7,880 7,596 7,299 6,991 6,671 6,338 5,991 5,631 5,256 4,867 4,461 4,040 3,601 3,145 2,671 2,178 1,665 1,132 577 96,145

6,846 7,120 7,404 7,701 8,009 8,329 8,662 9,009 9,369 9,744 10,133 10,539 10,960 11,399 11,855 12,329 12,822 13,335 13,868 14,423 203,855