You are on page 1of 65

INTERMEDIATE

ACCOUNTING
TENTH CANADIAN EDITION
Kieso Weygandt Warfield Young Wiecek McConomy

CHAPTER 16
Complex
Financial
Instruments
Prepared by:

Lisa Harvey, CPA, CA


Rotman School of Management,
University of Toronto

CHAPTE
16
R
COMPLEX FINANCIAL INSTRUMENTS
After studying this chapter, you should be able to:
Understand what derivatives are and how they are used to
manage risks.
Understand how to account for derivatives.
Analyze whether a hybrid/compound instrument issued for
financing purposes represents a liability, equity, or both.
Explain the accounting for hybrid/compound instruments.
Describe the various types of stock compensation plans.
Describe the accounting for share-based compensation.
Identify the major differences in accounting between ASPE and
IFRS, and what changes are expected in the near future.
Copyright John Wiley & Sons Canada,
Ltd.

Complex Financial
Instruments
Derivatives
Managing risk
Accounting for
derivatives

Debt versus
Equity Issuer
Perspective
Economics of
complex financial
instruments
Presentation and
measurement of
hybrid/compound
instruments

Share-Based
Compensation

IFRS/ASPE
Comparison

Types of plans
Recognition,
measurement,
and disclosure of
share-based
compensation

Comparison of
IFRS and private
enterprise GAAP
Looking ahead

Copyright John Wiley & Sons Canada,


Ltd.

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
Copyright John Wiley & Sons Canada,
Ltd.

Derivatives
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

Copyright John Wiley & Sons Canada,


Ltd.

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

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
Copyright John Wiley & Sons Canada,
Ltd.

Derivatives Financial
Risks
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)
Copyright John Wiley & Sons Canada,
Ltd.

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
Copyright John Wiley & Sons Canada,
Ltd.

Accounting for 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
Copyright John Wiley & Sons Canada,
Ltd.

Non-Financial Derivatives
and Executory Contracts
Example of non-financial derivatives:
contract to buy steel at a specified date for
a specified price
Are purchase commitments (executory
contracts) derivatives?
Value changes with value of the underlying
No investment up front
Settled in future
Copyright John Wiley & Sons Canada,
Ltd.

10

10

Executory Contracts
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

Under ASPE:
Not accounted for as derivatives because difficult to
measure
Recognized when goods received
Copyright John Wiley & Sons Canada,
Ltd.

11

11

Options and Warrants


Options
1. Call Option
Holder has the right, but not the obligation, to
buy 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

Copyright John Wiley & Sons Canada,


Ltd.

12

12

Framework for Options

Written

Call right to buy

Put right to sell

Sell option for $:

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

Pay $ for option:


Obtain right to sell
shares/underlying

Copyright John Wiley & Sons Canada,


Ltd.

13

13

Options Example
Given:
Call option entered into January 2, 2014
Option expires April 30, 2014
Option to purchase 1,000 shares at $100 per share
Share market price on January 2, 2014 is $100 per share
Option is purchased for $400 (Option Premium)
Share price on March 31st is $120 per share
Options traded at $20,100 on March 31, 2014
Option settled in cash on April 1, 2014
Prepare the journal entries
Copyright John Wiley & Sons Canada,
Ltd.

14

14

Options Example
Option Price Formula
Option
Intrinsic
=
Premium
Value

Market Price less


Strike (Exercise)
Price

Option
Premium

Time
Value
Option Value
Less
Intrinsic Value

= ($100 - $100) + ($400 - $0)


Copyright John Wiley & Sons Canada,
Ltd.

15

15

Options Example
January 2 (acquisition date)

Derivatives Financial Assets


Cash
h 31 (to record change in value of option)

400
400

Derivatives Financial Assets


Gain
19,700
Assume options are trading at $20,100
*(20,100 400)

19,700*

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
Copyright John Wiley & Sons Canada,
Ltd.

16

Forwards
Under a forward contract, parties each commit upfront to
do something in the future (obligation)
The price and time period are locked in under the contract

Therefore, forward contracts are specific to the


transacting parties and
Forwards generally do not trade on exchanges
Banks are usually involved in forward contracts

Forwards are measured at the present value of any


future cash flows

Copyright John Wiley & Sons Canada,


Ltd.

17

17

Forwards Example
Given:
On January 2, 2014, 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
Upon inception, the value of the contract is zero so no
journal entry would be recorded
Copyright John Wiley & Sons Canada,
Ltd.

18

Forwards Example
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, 2014, the journal entry is:
Derivatives Financial Assets/Liabilities
Gain 50
Copyright John Wiley & Sons Canada,
Ltd.

50

19

19

Forwards Example
If the U.S. dollar depreciates, in general, this
particular contract would create a loss for
Abalone
The journal entry to record the loss must also
reverse the original gain of $50
For example, if on January 31 the fair value of
the contract now creates an overall loss of $30:
Loss 80
Derivatives Financial Assets/Liabilities
Copyright John Wiley & Sons Canada,
Ltd.

80
20

Forwards Example
Forward contracts can be settled on a net basis or
in cash
Assume that on the settlement date of February 1,
the U.S. dollar is worth $1.04
The following journal entry would be required to
settle the contract on a net basis:
Loss 80
Derivatives Financial Assets/Liabilities
Cash 110*
* $1,000 (1.15 - 1.04)

30

Copyright John Wiley & Sons Canada,


Ltd.

21

Forwards Example
The following journal entry would be
required to settle the contract on a cash
basis:
Cash 1,040*
Loss 80
Derivatives Financial Assets/Liabilities
Cash
1,150**
* $1,000 x 1.04
** $1,000 x 1.15
Copyright John Wiley & Sons Canada,
Ltd.

30

22

Futures
Futures are similar to forwards except:
They have standardized amounts and dates
They are exchange traded and have ready
market values
They are settled through clearing houses
There is a requirement to put up collateral

Copyright John Wiley & Sons Canada,


Ltd.

23

Futures Example
Given:
Forward Inc. entered into a futures
contract to sell grain for $1,000
Initial margin of $100 cash is required
This is a non-financial derivative because
the underlying is grain (a non-financial
commodity)
Record the journal entries for this contract
Copyright John Wiley & Sons Canada,
Ltd.

24

Futures Example
The contract is valued at zero at inception
however the margin must be recorded as
follows:
Deposits
Cash

100
100

Copyright John Wiley & Sons Canada,


Ltd.

25

Futures Example
The value of the grain increased after the contract
date therefore the value of the contract decreased
Assume that the contract has decreased by $50
This also required an additional margin deposit of $50
The required journal entries would be:
Loss 50
Derivatives Financial Assets/Liabilities

50

Deposits 50
Cash 50
Copyright John Wiley & Sons Canada,
Ltd.

26

Futures Example
If the contract is closed out on a net basis (no
delivery of grain) with no further changes in value,
the journal entries would be:
Cash100
Derivatives Financial Assets/Liabilities
Deposits 150

50

The loss on the contract has already been


recorded in the previous journal entries thus only
the net settlement of $50 cash is recorded
Copyright John Wiley & Sons Canada,
Ltd.

27

Derivatives Involving
Entitys Own Shares
Companies can enter into derivative
contracts with their own shares:
Options
Purchased call or put options
Written call or put options

Forwards
To buy entitys own shares
To sell the entitys own shares

This creates a presentation issue


Copyright John Wiley & Sons Canada,
Ltd.

28

Derivatives Involving
Entitys Own Shares
Under IFRS, any contracts that are for a fixed
number of shares for a fixed amount are
generally presented as equity
This is referred to as the fixed for fixed principle
There are generally two exceptions:
The derivative creates an obligation to settle in cash or other
assets
The derivative allows a choice in how the instrument is
settled

ASPE is silent on this matter but general


principles support equity presentation
Copyright John Wiley & Sons Canada,
Ltd.

29

Complex Financial
Instruments
Derivatives
Managing risk
Accounting for
derivatives

Debt versus
Equity Issuer
Perspective
Economics of
complex financial
instruments
Presentation and
measurement of
hybrid/compound
instruments

Share-Based
Compensation

IFRS/ASPE
Comparison

Types of plans
Recognition,
measurement,
and disclosure of
share-based
compensation

Comparison of
IFRS and private
enterprise GAAP
Looking ahead

Copyright John Wiley & Sons Canada,


Ltd.

30

30

Complex Financial
Instruments
Over the years, hybrid/compound have
been created in order to profit from the
best attributes of debt and equity
instruments
These instruments have characteristics of
both debt and equity
Example: convertible debt

Copyright John Wiley & Sons Canada,


Ltd.

31

31

Measurement of
Hybrid/Compound
Instruments

To determine appropriate presentation, the


following must be considered:
Contractual terms
Economic substance
Definitions of financial statement elements

Copyright John Wiley & Sons Canada,


Ltd.

32

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

Copyright John Wiley & Sons Canada,


Ltd.

33

33

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

Copyright John Wiley & Sons Canada,


Ltd.

34

34

Measurement of
Hybrid/Compound
Instruments

Financial instruments can be shown on a


net basis on the statement of financial
position if:
There is a legally enforceable right to offset
and
The company intends to settle the instruments
on a net basis or simultaneously

Copyright John Wiley & Sons Canada,


Ltd.

35

Measurement of
Hybrid/Compound
Instruments
Economic value stems from both the debt component
and the equity component
Two general approaches:
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)
ASPE 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).

Copyright John Wiley & Sons Canada,


Ltd.

36

36

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 bondholders option
Once the bond is converted, all interest
and principal no longer payable
Copyright John Wiley & Sons Canada,
Ltd.

37

37

Convertible Debt
Convertible debt is 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 a
lower interest rate because it provides the investor
with an opportunity to own equity

Copyright John Wiley & Sons Canada,


Ltd.

38

38

Convertible Debt
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

Copyright John Wiley & Sons Canada,


Ltd.

39

39

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?
Copyright John Wiley & Sons Canada,
Ltd.

40

40

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:
Cash
1,000,000
Bonds Payable
924,061
Contributed Surplus
Conversion Rights
75,939
Copyright John Wiley & Sons Canada,
Ltd.

41

41

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 using


the book value approach would be:
Bonds Payable
985,942
Contributed Surplus - Conversion Rights 75,939
Common Shares
1,061,881
Copyright John Wiley & Sons Canada,
Ltd.

42

42

Convertible Debt 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)
Copyright John Wiley & Sons Canada,
Ltd.

43

43

Convertible Debt
Example
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
Loss on Redemption of Bonds
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
Copyright John Wiley & Sons Canada,
Ltd.

44

44

Convertible Debt Normal


Retirement
Normal retirement is treated the same as
debt retirement from Chapter 14 for nonconvertible bonds
Clear the bonds payable and any outstanding
premiums, discounts, bond issue costs,
interest accrued to bondholders
Equity component remains in Contributed
Surplus

Copyright John Wiley & Sons Canada,


Ltd.

45

45

Convertible Debt Early


Retirement
Early retirement
Clear the bonds payable and any outstanding
premiums, discounts, bond issue costs,
interest accrued to bondholders
The conversion rights must be zeroed out
The loss on early retirement is allocated
between the debt and equity portion

Copyright John Wiley & Sons Canada,


Ltd.

46

Convertible Debt Early


Retirement 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

Copyright John Wiley & Sons Canada,


Ltd.

47

47

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)
Copyright John Wiley & Sons Canada,
Ltd.

48

48

Complex Financial
Instruments
Derivatives
Managing risk
Accounting for
derivatives

Debt versus
Equity Issuer
Perspective
Economics of
complex financial
instruments
Presentation and
measurement of
hybrid/compound
instruments

Share-Based
Compensation

IFRS/ASPE
Comparison

Types of plans
Recognition,
measurement,
and disclosure of
share-based
compensation

Comparison of
IFRS and private
enterprise GAAP
Looking ahead

Copyright John Wiley & Sons Canada,


Ltd.

49

49

Share-Based Compensation
Stock compensation plans are used to
remunerate or compensate employees for
services provided
This allows a more long-run focus in a
companys compensation plan

Copyright John Wiley & Sons Canada,


Ltd.

50

Types of Compensation
Plans
1. Compensatory stock option plans
(CSOPs)
2. Direct awards of stock
3. Stock appreciation rights plans (SARs)
(Appendix 16B)
4. Performance-type plans (Appendix 16B)

Copyright John Wiley & Sons Canada,


Ltd.

51

51

Uses of Stock Options


Stock Options
Issued by others e.g.
financial institutions

Issued by the company

CSOP ESOP
Not traded on
Exchange since must
Be employee to hold

Other

Options/
Warrants

Not traded on
Exchange since
Rights usually not
transferable
Copyright John Wiley & Sons Canada,
Ltd.

Often exchange
traded

52

52

Compensatory vs. NonCompensatory Plans


Stock Options
Compensatory
CSOP

Non-compensatory
ESOP

Operating transactions

Income
Statement

Capital transactions

Shareholders
Equity
Copyright John Wiley & Sons Canada,
Ltd.

53

Compensatory vs. NonCompensatory 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)
Copyright John Wiley & Sons Canada,
Ltd.

54

54

Non-Compensatory Example
Fanco Limited set up an ESOP that gives
employees the option to purchase shares for $10
per share
On January 1, 2013, 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
Copyright John Wiley & Sons Canada,
Ltd.

55

55

Compensatory Stock
Option Plans
Two accounting issues associated with stock
compensation plans
1. Determination of compensation expense
2. Periods of allocation for compensation expense
amounts

Copyright John Wiley & Sons Canada,


Ltd.

56

56

Compensatory Stock
Options Plans
- Important Dates
Work
start date

Grant
date

Vesting
date

Exercise
date

Expiration
date

Options
are
granted to
employee

Date that
employee
can first
exercise
options

Employee
exercises
options

Unexercised
options
expire

Copyright John Wiley & Sons Canada,


Ltd.

57

57

Compensatory Stock Options


Plans

Compensation Expense

is determined as of the
measurement date
and is allocated over
the service period

The service period is the period benefited by


employees service
It is usually the period between the grant date
and the vesting date

Copyright John Wiley & Sons Canada,


Ltd.

58

58

Compensatory Stock
Options Plans
- Example
On January 1, 2015, Chen Corp grants five
executives the options to purchase 2,000 shares each
The option price per share is $60
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 2015 and 2016:
Compensation Expense
110,000
Contributed Surplus Stock Options 110,000
($220,000 / 2)
Copyright John Wiley & Sons Canada,
Ltd.

59

59

Compensatory Stock
Options Plans
- Example
If 20% or 2,000 of the 10,000 options were
exercised on June 1, 2018, journal entry is:
Cash (2,000 x $60)
120,000
Contributed SurplusStock 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 SurplusStock Options 176,000
Contributed Surplus-Expired Options 176,000
(80% x $220,000)
Copyright John Wiley & Sons Canada,
Ltd.

60

60

Direct Awards of Stock


Nonmonetary reciprocal transaction
Little or no cash involved
Two-way transaction
the company gives something up (shares) and gets
the employees services in return

Recorded at fair value of the shares (the


asset given up)

Copyright John Wiley & Sons Canada,


Ltd.

61

61

Disclosure of
Compensation Plans
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
Copyright John Wiley & Sons Canada,
Ltd.

62

62

Complex Financial
Instruments
Derivatives
Managing risk
Accounting for
derivatives

Debt versus
Equity Issuer
Perspective
Economics of
complex financial
instruments
Presentation and
measurement of
hybrid/compound
instruments

Share-Based
Compensation

IFRS/ASPE
Comparison

Types of plans
Recognition,
measurement,
and disclosure of
share-based
compensation

Comparison of
IFRS and private
enterprise GAAP
Looking ahead

Copyright John Wiley & Sons Canada,


Ltd.

63

63

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

Copyright John Wiley & Sons Canada,


Ltd.

64

64

COPYRIGHT
Copyright 2013 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 John Wiley & Sons Canada,


Ltd.

65