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
CHAPTER 16
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.
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Complex Financial Instruments
Derivatives
•Managing risk
•Accounting for
derivatives
Debt versus
Equity – Issuer
Perspective
Share-Based
Compensation
IFRS/ASPE
Comparison
•Types of plans
•Economics of complex
financial instruments
•Recognition,
measurement, and
disclosure of sharebased compensation
•Comparison of IFRS
and private enterprise
GAAP
•Presentation and
measurement of
hybrid/compound
instruments
Copyright © John Wiley & Sons Canada, Ltd.
•Looking ahead
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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
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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
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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
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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)
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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
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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
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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
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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
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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
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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
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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
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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)
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Options – Example
January 2 (acquisition date)
Derivatives – Financial Assets
400
Cash
March 31 (to record change in value of option)
Derivatives – Financial Assets
Gain
Assume options are trading at $20,100
*(20,100 – 400)
400
19,700*
April 1 (cash settlement of option)
Cash
20,000
Loss
100
Derivatives - Trading
Time Value lost through cash settlement before expiry
= $20,100 less intrinsic value of $20,000
Copyright © John Wiley & Sons Canada, Ltd.
19,700
20,100
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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
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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
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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
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50
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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
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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
Derivatives – Financial Assets/Liabilities
Cash
* $1,000 (1.15 - 1.04)
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30
110*
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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
30
Cash
1,150**
* $1,000 x 1.04
** $1,000 x 1.15
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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
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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
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Futures – Example
• The contract is valued at zero at inception
however the margin must be recorded as
follows:
Deposits
Cash
100
100
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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
Cash
50
50
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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:
Cash
Derivatives – Financial Assets/Liabilities
Deposits
100
50
150
• The loss on the contract has already been
recorded in the previous journal entries thus
only the net settlement of $50 cash is
recorded
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Derivatives Involving Entity’s 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 entity’s own shares
• To sell the entity’s own shares
• This creates a presentation issue
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Derivatives Involving Entity’s 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
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Complex Financial Instruments
Derivatives
•Managing risk
•Accounting for
derivatives
Debt versus
Equity – Issuer
Perspective
Share-Based
Compensation
IFRS/ASPE
Comparison
•Types of plans
•Economics of complex
financial instruments
•Recognition,
measurement, and
disclosure of sharebased compensation
•Comparison of IFRS
and private enterprise
GAAP
•Presentation and
measurement of
hybrid/compound
instruments
Copyright © John Wiley & Sons Canada, Ltd.
•Looking ahead
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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
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Presentation and Measurement of
Hybrid/Compound Instruments
• To determine appropriate presentation, the
following must be considered:
– Contractual terms
– Economic substance
– Definitions of financial statement elements
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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
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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
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Presentation and 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
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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).
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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 bondholder’s option
• Once the bond is converted, all interest
and principal no longer payable
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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
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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
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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?
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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
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75,939
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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
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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)
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Convertible Debt — Example
• Assume Bond Corp. offers an additional cash premium
of $15,000, when carrying amount of the debt is
$972,476 and bond’s 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 – Conversion Rights 75,939*
Retained Earnings (15,000 – 8,986)
6,014
Common Shares
Cash
* Calculated previously using Incremental Method
Copyright © John Wiley & Sons Canada, Ltd.
1,048,415
15,000
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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
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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
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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
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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)
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Complex Financial Instruments
Derivatives
•Managing risk
•Accounting for
derivatives
Debt versus
Equity – Issuer
Perspective
Share-Based
Compensation
IFRS/ASPE
Comparison
•Types of plans
•Economics of complex
financial instruments
•Recognition,
measurement, and
disclosure of sharebased compensation
•Comparison of IFRS
and private enterprise
GAAP
•Presentation and
measurement of
hybrid/compound
instruments
Copyright © John Wiley & Sons Canada, Ltd.
•Looking ahead
49
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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
company’s compensation plan
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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)
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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
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Compensatory vs. NonCompensatory Plans
Stock Options
Compensatory
CSOP
Non-compensatory
ESOP
Operating transactions
Income
Statement
Capital transactions
Shareholders’
Equity
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Compensatory vs. Non-Compensatory
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)
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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
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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
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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
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Compensatory Stock Options Plans
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
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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, and the market price
is $70 per share 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 2015 and 2016:
Compensation Expense
110,000
Contributed Surplus – Stock Options
110,000
($220,000 / 2)
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Compensatory Stock Options Plans
- 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)
120,000
Contributed Surplus–Stock 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 Surplus–Stock Options 176,000
Contributed Surplus-Expired Options 176,000
(80% x $220,000)
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Direct Awards of Stock
• Nonmonetary reciprocal transaction
– Little or no cash involved
– Two-way transaction
• the company gives something up (shares) and gets
the employee’s services in return
• Recorded at fair value of the shares (the
asset given up)
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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
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Complex Financial Instruments
Derivatives
•Managing risk
•Accounting for
derivatives
Debt versus
Equity – Issuer
Perspective
Share-Based
Compensation
IFRS/ASPE
Comparison
•Types of plans
•Economics of complex
financial instruments
•Recognition,
measurement, and
disclosure of sharebased compensation
•Comparison of IFRS
and private enterprise
GAAP
•Presentation and
measurement of
hybrid/compound
instruments
Copyright © John Wiley & Sons Canada, Ltd.
•Looking ahead
63
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Looking Ahead
• There are a number of IASB projects that
are expected to simplify and promote
consistent application of accounting
standards for financial instruments
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