CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Financial Accounting - Module 2
(8) Financial Instruments
71
Financial Liabilities vs. Equity Instruments
•
financial liabilities are a contractual obligation to deliver cash or
another financial asset to another party in the future
•
equity instruments shows evidence of a residual interest in the
assets of the corporation once all liabilities have been settled
72
1
© CMA Ontario, 2011
1 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Financial Accounting - Module 2
Convertible Bonds
•
convertible bonds are compound financial instruments because they
have both the attributes of debt (obligation to deliver cash) and
equity (right to acquire shares)
•
accounting for convertible bonds is done using the residual
approach: value the bond component and allocate difference to the
equity component
73
Convertible bonds - Journal Entries
•
at issue:
dr. Cash
cr. Bonds Payable
cr. Contributed Surplus - Conversion Rights
•
on conversion (book value method):
Dr. Bonds Payable
Dr. Contributed Surplus - Conversion Rights
Cr. Common Shares
74
2
© CMA Ontario, 2011
2 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Financial Accounting - Module 2
Convertible Bonds Example
On December 31, 20x2, you issue $25,000,000 of 7.5%, 20 year
convertible bonds for total proceeds of $23,678,950. Interest
payment dates are June 30 and Dec 31. Prepare journal entries…
1.
To record the issuance of bonds assuming bonds of similar risk
are yielding 8.2%.
2.
On July 2, 20x11, 60% of the bond issue is converted into
common shares.
3.
On December 31, 20x22 the remaining bonds are retired.
75
Debt with Detachable Stock Warrants
•
bonds issued with detachable stock warrants as a means to induce
the sale of the bonds
•
warrants have the same features as a stock option: they allow the
holder to purchase stock at a pre-specified price (the exercise price)
•
split using the residual approach (residual gets allocated to the
warrants) - under both IFRS and ASPE
•
any value attached to the warrants get credited to ‘Contributed
Surplus - Warrants’
•
on exercise, we debit cash, debit Contributed Surplus and credit
Common Stock (note that the market value of the common shares
at the time of exercise is not relevant)
76
3
© CMA Ontario, 2011
3 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Financial Accounting - Module 2
Detachable Warrant Example
The Harrison Corporation issued $20,000,000 of 15 year, 8% bonds
on December 31, 20x2 for total proceeds of $20,000,000. Each
$1,000 bond came with 5 detachable warrants allowing the holder
to purchase one share of the corporation within the next 5 years at
a price of $20. The yield to maturity on debt with similar maturity
and risk is 8.4%.
Prepare the journal entry to record the issue of the bonds.
77
Perpetual Debt
•
no residual ownership interest, plus
•
the value of a long-term bond is mostly derived from the PV of the
coupon payments
•
classified as a financial liability
78
4
© CMA Ontario, 2011
4 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Financial Accounting - Module 2
Redeemable/Convertible Preferred Shares
•
if preferred shares are redeemable at the option of either the
company or the holder, they are classified as a financial liability
because of the contractual obligation to deliver cash in the future
– if classified as debt, then dividends are treated as interest
expense
•
convertible preferred shares: the proceeds are split between
Preferred Shares and Contributed Surplus using the incremental
approach
79
Hedge Accounting
•
hedge accounting is optional
•
to qualify for hedge accounting, designation as such must be noted at the
inception of the hedging relationship, must be carefully documented and
on an ongoing basis, the effectiveness of the hedge must be monitored and
measured
•
if hedge accounting is not opted for, any FX gains/losses between the time
the forward contract is taken out and the transaction date flow to the
income statement
80
5
© CMA Ontario, 2011
5 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Financial Accounting - Module 2
Fair Value Hedges
•
using a derivative instrument to hedge the exposure to a financial
asset or liability
•
both the changes in the fair value of the financial asset and liability
and derivative instrument flow to the income statement
– even if the financial asset is classified as an FVTOCI
81
Fair Value Hedge Example
On October 31, 20x4 you purchase 1,000 shares of the Putnam
Corporation for $25 per share (classified as FVTOCI). On the same
day you purchase a put option contract to sell 1,000 shares of the
Putnam Corporation at an exercise price of $25. The cost of the
contract is $500 (the premium).
On December 31, 20x4, the stock is trading for $20. The value of the
put contract has increased by 1,000 shares x (25 - 20) = $5,000.
82
6
© CMA Ontario, 2011
6 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Financial Accounting - Module 2
Cash Flow Hedges
•
hedging a future cash flow stream with a derivative instrument
•
example: variable interest payments hedged by entering into an
interest rate swap agreement
•
the cash settlement on the hedge offsets the hedged
expense/revenue
•
any change in value of the derivative gets recorded on the balance
sheet; offset goes to OCI
83
Cash Flow Hedges - Example
On December 31, 20x2, you issue 20 year bonds with a face value of
$30,000,000 the LIBOR rate + 1% The LIBOR at December 31,
20x2 is 6.5%. In order to hedge any future interest rate fluctuations,
you enter into a 20 year interest rate swap agreement with a third
party whereby you agree to pay a fixed amount of interest of 7.5%
on a notional value of $30,000,000. In exchange, you will receive a
variable rate of interest equal to LIBOR + 1%. Assume interest is
paid annually.
At December 31, 20x3, the LIBOR rate dropped to 5%.
84
7
© CMA Ontario, 2011
7 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Financial Accounting - Module 2
ASPE Differences
•
compound financial instruments that include both a debt and equity
component - the entity may opt to measure the equity component
at zero value
•
hedge accounting is limited to:
– hedges of an anticipated purchase or sale of a commodity or an
anticipated transaction in a foreign currency,
– interest rate or cross-currency rate swaps, or
– hedges of net investments in a self-sustaining foreign operation
85
8
© CMA Ontario, 2011
8 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Problem 11 – Investments
On January 1, 20x2, Pantry Ltd. purchased 70% of the common shares of Santry Ltd. for
$506,100. Financial data for Santry Ltd. are as follows:
Santry Ltd.
Statement of Financial Position
January 1, 20x2
Cash
Accounts receivable
Inventory
Capital assets
Accumulated depreciation
Current liabilities
Bonds payable at 12% interest
Common shares
Retained earnings
Book value Fair market value
$ 56,000
$56,000
102,000
108,000
197,000
180,000
1,250,000
700,000
(500,000)
$1,105,000
$ 140,000
240,000
375,000
350,000
$1,105,000
140,000
270,000
Additional Information:
1.
2
3.
4.
The capital assets are being written off over 10 years on a straight-line basis.
Goodwill is tested annually for impairment. Impairment losses are as follows:
20x4
$30,000
20x5
20,000
The bonds have ten years remaining.
During 20x5, Pantry declared and paid $50,000 of dividends. Santry declared and
paid $40,000 of dividends.
© CMA Ontario, 2011
9 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Financial statements of Pantry Ltd. and Santry Ltd. as at December 31, 20x5 are:
Statement of Financial Positions December 31, 20x5
Cash
Accounts receivable
Inventory
Capital assets – net
Investment in subsidiary (cost)
Current liabilities
Bonds payable at 12% interest
Common shares
Retained earnings
Pantry Ltd
$ 145,500
300,000
609,500
1,000,000
506,100
$2,561,100
$ 100,000
400,000
2,061,100
$2,561,100
Santry Ltd
$ 85,000
200,000
400,000
800,000
$1,485,000
$ 131,000
264,000
375,000
715,000
$1,485,000
Income Statements Year Ended December 31, 20x5
Sales and other revenues
Cost of goods sold
Depreciation
Interest expense
Other expenses
Income tax expense
Net income
Pantry Ltd
$ 1,200,000
(800,000)
(80,000)
(107,000)
(85,200)
$ 127,800
Santry Ltd
$ 925,000
(500,000)
(70,000)
(42,000)
(80,000)
(69,900)
$ 163,100
Required:
1.
2.
3.
4.
Prepare a consolidated statement of income and retained earnings for the year
ended December 31, 20x5.
Provide a proof of the ending Consolidated Retained balance.
Prepare the consolidated Statement of Financial Position as at December 31,
20x5.
Provide a reconciliation of the NonControlling Interest Liability account from the
opening balance to the ending balance.
© CMA Ontario, 2011
10 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Problem 14 – Foreign Currency Transactions
The Charlie Company purchased inventory from a U.S. company on April 30, 20x8, for
$US80,000. The amount is payable on July 31, 20x8, in US dollars. Charlie Company has
a June 30th year-end. The relevant exchange rates are as follows:
April 30, 20x8
June 30, 20x8
July 31, 20x8
$US 1.00 = $C1.47
$US 1.00 = $C1.45
$US 1.00 = $C1.51
Required:
Prepare the journal entries to account for the above transactions.
© CMA Ontario, 2011
11 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Problem 16 – Foreign Currency Transactions
On August 1, 20x4, Zip Ltd. Purchased some merchandise from a company in
Switzerland for SF450,000. The liability was not due until March 1, 20x5. Zip was quite
confident that the exchange rate fluctuations were not a problem and took no action to
hedge the liability. On November 1, 20x4, Zip looked at the exchange rates and decided
that they had better offset the liability with a 120-day forward contract. Assume a
December 31 year end and that all months have 30 days.
EXCHANGE RATES
August 1, 20x4
November 1, 20x4
November l, 20x4
December 31, 20x4
December 31, 20x4
Aug 1 – Dec 31, 20x4
March 1, 20x5
December 31, 20x5
March 1, 20x6
spot rate
spot rate
120-day forward rate
spot rate
60-day forward rate
average rate
spot rate
spot rate
spot rate
C$1 = SF2.5
C$1 = SF2.1
C$1 = SF1.9
C$1 = SF1.7
C$1 = SF1.6
C$1 = SF2.0
C$1 = SF2.7
C$1 = SF2.9
C$1 = SF2.4
Required:
1. Prepare all the journal entries for the years 20x4 and 20x5 for Zip for this transaction.
2. Assume that the liability was a note due on March 1, 20x6 (instead of 20x5, as given
above), and that Zip does not offset with a forward contract. Prepare all the journal
entries for the year 20x4. Assume that the interest in the note is 10%.
© CMA Ontario, 2011
12 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Problem 19 – Foreign Currency Translation
Cancorp Ltd. purchased 90% of the shares of Forsub Inc. on January 1, 20x1. Forsub is
located in the country of Amandaland. The financial statements of Forsub as at December
31, 20x2 are as follows:
Forsub
Statement of Financial Position
as at December 31, 20x2
CORBINS
Cash
Accounts receivable
Inventory
Fixed Assets
Accumulated depreciation
150,000
175,000
650,000
1,480,000
(520,000)
1,935,000
Current liabilities
Long-term liabilities, 8%
Common shares
Retained earnings, January 1, 20x2
Net income - 20x2
Dividends (declared and paid on December 31, 20x2)
125,000
300,000
100,000
1,350,000
100,000
(40,000)
1,935,000
Forsub
Income Statement
for the year ended December 31, 20x2
Sales
Cost of goods sold
Depreciation
Interest expense
Other
Gain on sale of fixed assets
Net income
700,000
(450,000)
(70,000)
(28,000)
(72,000)
20,000
100,000
Additional Information 1. The inventory is on a FIFO basis. The opening inventory was 175,000 CORB at
1 CORB = $0.700 and 200,000 CORB at 1 CORB = $0.729. The purchases during
20x2 were 350,000 CORB at 1 CORB = $0.686, 240,000 CORB at 1 CORB = $0.660
and 135,000 CORB at 1 CORB = $0.673.
© CMA Ontario, 2011
13 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
2. The fixed asset account is composed of land, 345,000 CORB which was purchased
when the exchange rate was 1 CORB = $0.449 and buildings and equipment,
1,135,000 CORB purchased when the exchange rate was 1 CORB = $0.479. There
have been no fixed asset acquisitions since January 1, 20x1.
3. The long-term liabilities were issued on January 1, 20x1. On July 1, 20x2 the longterm debt was reduced by 100,000 CORB.
On April 1, 20x2, fixed assets were sold for proceeds of 40,000 CORB.
Exchange rates are as follows:
January 1, 20x1
July 1, 20x1 =Average for 20x1
December 31, 20x1
April 1, 20x2
July 1, 20x2 = Average for 20x2
Average for Jan-Jun 20x2
Average for Jul- Dec 20x2
December 31, 20x2
1 CORB = $0.625
1 CORB = $0.673
1 CORB = $0.745
1 CORB = $0.725
1 CORB = $0.686
1 CORB = $0.700
1 CORB = $0.670
1 CORB = $0.660
Part (A)
Prepare a translated income statement assuming that Forsub’s functional currency is te
Canadian dollar.
Part (B)
Use the same data as in Part (A), but assume that Forsub’s functional currency is the
CORB.
Forsub earned 250,000 CORB in 20x1 and declared and paid dividends of 100,000
CORB on December 31, 20x1.
Calculate the balance in the Cumulative translation gain/loss account .
© CMA Ontario, 2011
14 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Problem 20 – Foreign Currency Transactions
On September 1, 20x5 you order a machine from a Swiss supplier. The cost of the
machine is SF1,000,000. The machine is received on November 30, 30x5. You pay the
invoice on March 31, 20x6. Your year-end is December 31.
The following rates are available:
Spot
Sep 1, 20x5
Nov 30, 20x5
Dec 31, 20x5
Mar 31, 20x6
1SF = $0.75
1SF = $0.86
1SF = $0.92
1SF = $1.02
Forward
Sep 1 (7 months)
Oct 31 (5 months)
Nov 30 (4 months)
Dec 31 (3 months)
1SF = $0.82
1SF = $0.90
1SF = $0.97
1SF = $0.99
Required –
Prepare all journal entries for the above transactions assuming that …
a.
no forward contract is taken out to offset the payable.
b.
a forward contract is taken out to offset the payable on November 30, the day the
goods are received.
© CMA Ontario, 2011
15 of 16
CMA Accelerated Program - 2011/2012
Lecture Student Weekly File - Week 11
Accelerated Program
Week 11 Work Plan
Suggested study plan for this week:
Primary List
1.
Review what we did in class on Saturday.
2.
Financial Instruments
• Problem 1, 2, 3, 4
© CMA Ontario, 2011
Secondary List
16 of 16