INTERMEDIATE
ACCOUNTING
Seventh Canadian Edition
KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK
Prepared by:
Gabriela H. Schneider, CMA
Northern Alberta Institute of Technology
CHAPTER
17
Complex Financial Instruments
Learning Objectives
1. Describe the presentation and measurement
issues related to various complex financial
instruments.
2. Explain the accounting for issuance, conversion
and retirement of convertible securities.
3. Understand the nature of derivatives in general
and why they exist.
4. Explain the various types of financial risks
including how they arise.
Learning Objectives
5. Understand the nature of options, forwards and
futures.
6. Describe the recognition, measurement and
presentation issues relating to options, forwards
and futures.
7. Describe the various types of stock
compensation plans.
8. Explain the differences between employee and
compensatory option plans and other options.
Learning Objectives
9. Describe the accounting for compensatory stock
option plans under generally accepted
accounting principles.
10.Understand how derivatives are used in hedging
(Appendix 17A).
11.Explain what hedge accounting is and identify
the qualifying hedge criteria (Appendix 17A).
12.Explain the difference between a fair value and
cash flow hedge.
Learning Objectives
13.Calculate the impact on net income using hedge
accounting for both types of hedges (Appendix
17A).
14.Account for stock appreciation rights plans
(Appendix 17B).
15.Explain the nature of performance related plans
(Appendix 17B).
Complex Financial Instruments
Presentation and
Measurement
Issues
Perpetual debt
Callable/redeemable
preferred shares
Debt with
detachable stock
warrants
Dealing with
uncertainty
Interest/Dividends/G
ains/Losses
Perspectives
Basic Derivatives
Understanding derivatives
Financial risks defined
Using derivatives –
hedging versus
speculation
Recognition,
measurement and
presentation issues
Options/warrants
Forwards
Futures
Perspectives
Stock
Compensation
Plans
Types of Plans
Direct awards of
stocks
Stock options
revisited
Compensatory
stock option plans
Perspectives
Complex Financial Instruments
Appendix 17A –
Hedging
Derivatives used for
hedging
Qualifying hedge criteria
Fair value hedges
Cash flow hedges
Disclosures
Perspectives
Appendix 17B – Stock
Compensation Plans
Stock appreciation rights
plans
Performance type plans
Presentation Issues
• Compound financial instruments
– aka: hybrid instruments
• Have characteristics of both debt and equity
– e.g. convertible and perpetual debt
• Presentation issue requires that the economic
substance of the instrument be examined to
determine reporting classification
Measurement Issues
•
•
Economic value stems from both the debt
component and the equity component
Two measurement tools will be presented:
1. Incremental (residual) method
2. Proportional method
Perpetual Debt
• By definition the instrument is debt, however
it is never repaid
• By definition equity is never repaid
• Should perpetual debt be classified
as debt?
or
as equity?
• Question is answered by examining the
source of the value of the instrument
Perpetual Debt
• Value for a perpetual debt stems from the
value of the interest payments
– Interest, not the principal must be paid
• Therefore, by definition, perpetual debt is a
liability
– Due to the legal obligation to pay interest,
unlike shares where there is no legal
obligation to pay dividends
Callable/Redeemable Preferred
Shares
• Term, or mandatorily redeemable preferred
shares
– Shares that will be redeemed by the issuing
company
• This type of instrument is a liability
– Obligation exists for the company to pay cash
when the shares are redeemed
Debt with Detachable Stock
Warrants
• Detachable warrant
– Option to buy common shares at a fixed price
(exercise price)
– Warrant available only for a limited time
(exercise period)
– Warrants traded on public markets
• CICA Handbook, Section 3860.A7 defines
warrants and options as equity instruments
Debt with Detachable Stock
Warrants
•
•
•
•
Sale of debt, with warrants, allocated
between both debt and equity
Debt portion relating to the note, bond or
the like
Equity portion relating to the warrant or
equity portion
Two measurement options
1. Proportional method
2. Incremental or residual method
Proportional Method
• Market value for the pure debt component is
established
– PV of cash flows for similar debt may be used
• Warrant/option portion value determined
using options pricing model
• Values are then assigned to the respective
debt and equity components on a pro-rata
basis
Incremental or Residual Method
• Only one component (debt or equity) is
valued
– Whichever is easier to value
• Remaining component is assigned the
remaining value
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
Convertible Debt
•
Issued for two main reasons
1. Corporation can raise equity capital without giving
up ownership control
2. It can also achieve equity financing at a lower cost
•
•
Conversion feature allows the corporation to offer
the bond issue at a lower coupon or stated rate
Conversion feature provides investor with an
opportunity to own equity. This feature generally
results in the investor accepting a lower coupon
rate than they would with non-convertible debt.
Convertible Debt – Accounting
Issues
•
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
Reporting at the
Time of Issuance
• On issue date, part of the proceeds are
allocated to liability and part to equity
• This reflects the nature of the security—since
a convertible debt is part liability and part
equity
• The amounts allocated to liability and equity
are determined by using either:
– The Incremental Method
– The Proportional Method
The Incremental Method
•
•
The value of the most easily measured
component is determined and allocated to that
component
– Debt generally the easier component to
value
Remainder of the proceeds become the value
of the other component
The Incremental Method—
Example
Given:
• $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?
The Incremental Method—
Example
Total proceeds for the bond issue
($1,000,000 * at par value)
=
$ 1,000,000
Fair value of the liability without the
conversion option PV at 9%) =
Residual allocated to option
$
$
924,061
75,939
The Proportional Method
• When values for both the liability and
equity components are known or
determinable
• The Bond Discount (or Premium) becomes
a calculated amount under the
Proportional Method
The Proportional Method
Given:
• $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)
The Proportional Method
Present value (fair value) of the bonds
Fair value of conversion rights
Using an option pricing model
Aggregate fair market value
Cash
1,000,000
Discount on Bonds Payable
73,000
Bonds Payable
Contributed Surplus
$924,061
$ 72,341
$996,402
1,000,000
73,000
Note that in this case fair values for both the liability
and the conversion feature are clearly given
Reporting at Time of Conversion
• Main issue is determining the amount at which to
record the securities which are being exchanged
• Two approaches available
– Book value approach
• Gain or loss on conversion does not occur
• Most common approach
– Market value approach
• Gain or loss on conversion can occur
– Either method acceptable under GAAP
Book Value Approach
• When market price of bonds or shares not
known
– Book Value of the bonds and conversion rights
used to record the conversion
• The basis for this method is that a “swap” or
exchange of security has taken place
• The values were established when the bonds
were originally issued and therefore should
not be changed, as there was a contract in
place
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 based on fair
value at time of conversion
Reporting at the
Time of Retirement
• Treated the same as debt retirement from
Chapter 15
– 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
Convertible Preferred Shares
• Convertible preferred shares considered equity
– Convertible debt considered liability and equity
• At the time of issuance no allocation between
debt and equity components
• Exception is redeemable preferred shares
• When conversion occurs the book value
method is used
– Deemed the exchange of one equity for another
equity instrument
Derivatives
• Derivatives are financial instruments that create
rights and obligations, that transfer financial risk
from one party to the another party
• Used to reduce financial risks
– Price risk
– Credit risk
– Liquidity risk
– Cash flow risk
• Derivative instruments include
– Forwards
– Futures
– Options
Financial Risks Defined
• Price Risk
– Risk of a price or value change
• Currency risk
• Interest rate risk
• Market risk
• Credit Risk
– Risk of failing to meet an obligation (other party)
• Liquidity Risk
– Risk of being unable to meet own financial obligation
• Cash Flow Risk
– Risk that contract related cash flows will change over
time
Derivatives
• Three characteristics of derivatives:
1. Values changes with underlying instrument
2. Require little or no initial investment
3. Settled at a future date
• Traditional accounting historically has not
reported these instruments
• Movement is towards recognition and reporting
of these instruments, to
–
–
Provide information on exposed risks
Provide information on risk management
Derivatives
• Used by
– Producers and Consumers
• Lock in future revenues or costs
– Speculators and Arbitrageurs
• Maintain market liquidity
• Additional motivations to use derivatives
– Manage interest rate volatility
– Manage foreign exchange rate volatility
Derivative Reporting
•
New CICA Handbook Sections 3855, 1530
and 3865
– Three current Exposure Drafts to
become these new Handbook sections
– Dealing with recognition, measurement,
and presentation of derivatives
Derivative Reporting
• Basic principles for these new sections:
a) All derivatives to be recognized on the
Balance Sheet
b) All derivatives to be classified and presented
as being for trading
c) All derivatives measured/valued at fair value
d) All derivative gains/losses recognized in net
income
e) Increased disclosure
Derivative Instruments
• Financial forwards or financial futures
• Options
– Call Option
• Holder has the right, but not the obligation, to
purchase at a preset (strike or exercise) price
– Put Option
• Holder has the right to sell at a preset price
• Swaps
– Interest rate
A Framework for Options
Call – right to buy
Put – right to sell
Written
Sell for $
Transfer rights to buy
shares/underlying
Sell for $
Transfer right to sell
shares/underlying
Purchased
Pay $
Obtain right to buy
shares/underlying
Pay $
Obtain right to sell
shares/underlying
Derivative Accounting - Example
Given:
• Call option entered into January 2, 2004
• Option expires April 30, 2004
• Option to purchase 1,000 shares at $100 per
share
• Share market price on January 2, 2004 is $100
per share
• Option is purchased for $400 (Option Premium)
• Share price March 31st $120 per share
Accounting for Derivatives
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)
Journal Entries
Accounting for Derivatives
January 2
Investment – trading
Cash
400
400
March 31
Investment – trading
20,000
Gain
Intrinsic Value = 1,000 shares ($100 - $120)
20,000
March 31
Gain/Loss
Investment – trading
Time Value = ($400 - $100)
300
300
Accounting for Derivatives
April 1
Cash
Loss
20,000
100
20,100
Investment - trading
Investment-trading
400
20,000
20,100
300
Gain/Loss
300
Reported on
March 31st
Balance Sheet, with
Call Option balance
20,000
Investment-trading
April 1, 2004
20,100
Value Increase 19,700
Settle option
100
Net Income
19,600
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
1. Determination of compensation expense
2. Periods of allocation for compensation expense
amounts
Types of Compensation Plans
1.
2.
3.
4.
Direct stock awards
Compensatory stock option plans (CSOP)
Stock appreciation rights plans (SAR)
Performance-type plans
Direct Stock Awards
• Non-monetary reciprocal transaction
– Little or no cash involved
– Two-way transaction
• Recorded at fair value of the shares
Stock Options - 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
Uses of Stock Options
Stock Options
Issued by other e.g.
Financial institutions
Issued by the company
CSOP ESOP
Not traded on
Exchange since must
Be employee to hold
Other
Warrants
Not traded on
Exchange since
Rights usually not
transferable
Often exchange
traded
Compensatory vs. NonCompensatory Plans
Stock Options
Compensatory
CSOP
Operating transactions
Income
Statement
Non-compensatory
ESOP
Capital transactions
Shareholders’
Equity
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)
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
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 include in net
income/contributed surplus, and
– Other (CICA Handbook, Section 3870.67)
COPYRIGHT
Copyright © 2005 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.
