What CHAPTER
16
ComplexFinancialInstruments
QuestionsWeNeedtoAnswer
QuestionsWeNeedtoAnswer
1. are the major types of hybrid financial
What
instruments?
instruments?
2. What are the presentation and measurement
What
issues in accounting for hybrid financial
instruments?
instruments?
3. How to account for the issuance, conversion,
How
and retirement of convertible debts.
and
4. What are the basic derivatives?
What
5. How to record and disclose derivatives?
5.
Debtvs.Equity
Debtvs.Equity
What are the differences between debt instruments and
What
equity instruments?
equity
Debt Instrument
The borrower pays interests and has to pay back the debt in
The
the future.
the
Equity Instrument
The holders of equity instrument are the owners of the firm
No refund of the investment, and return is not guaranteed
PresentationIssues
PresentationIssues
Hybrid instruments (compound financial instruments)
Hybrid
have characteristics of both debt and equity
characteristics
The economic substance of the instrument needs to
The economic
be examined to determine reporting classification
be
Examples:
Examples:
perpetual debt
callable / redeemable preferred shares, and
retractable preferred shares
convertible debt
Perpetualdebtexample
Perpetualdebtexample
Source:AirCanada2004AnnualReport
Thematurityofthissubordinatedperpetual
debtwasonlyupontheliquidation,ifever,of
thePredecessorCompany.Principaland
interestpaymentsonthedebtwere
unsecuredandweresubordinatedtotheprior
paymentinfullofallindebtednessfor
borrowedmoney.
Question: Debt or Equity?
Answer: Debt-Air Canada has the obligation to pay interests, not the principal.
Answer: Debt-Air
Callable/Redeemablepreferred
Callable/Redeemablepreferred
shares
Shares that will be redeemed by the
Shares
issuing company.
issuing
Question: Debt or Equity?
Answer: It depends.
Answer:
Debt, if little or no discretion to avoid
Debt,
redeeming the shares.
redeeming
Equity, if the issuing company has the option
not to redeem the shares.
Retractablepreferredshares
Retractablepreferredshares
The holders have the option to force the
company to redeem the instrument.
Question: Debt or Equity?
Answer: Debt-Obligation exists for the
Answer: Debt-Obligation
company to pay cash when the shares are
redeemed.
Convertibledebtexample
Convertibledebtexample
Source:AirCanada2005AnnualReport
Question: Debt or Equity?
Answer:Debt&EquityTheinterestsandprincipalare
debts,andtheconversionoptionisanequity
Convertibledebtexample
Convertibledebtexample
Source:AirCanada2005AnnualReport
Question: Debt or Equity?
Answer:Debt&EquityOnlytheinterestsaredebts,but
theprincipalandconversionoptionareequities
ConvertibleDebtAccounting
Issues
The reporting of convertible debt and the
The
conversion feature result in three issues:
conversion
1.
2.
3.
Reporting at the time of issuance
Reporting
time
Reporting at the time of conversion
Reporting
time
Reporting at the time of retirement
Reporting
time
Reportingatthe
TimeofIssuance
On issue date, part of the proceeds are allocated
On
to liability and part to equity
to
This reflects the nature of the securitysince a
This
convertible debt is part liability and part equity
convertible
The amounts allocated to liability and equity are
The
determined by using either:
determined
The Incremental Method / Residual Value Method
The Proportional Method / Relative Fair Value
The
Method
Method
IncrementalMethod
IncrementalMethod
Only one component (debt or equity) is
Only
valued
valued
Whichever is easier to value
The other component is assigned the
The
remaining value
remaining
IncrementalMethod
IncrementalMethod
Given:
$1,000,000 par value, 3-yr, 6% convertible
$1,000,000
bonds.
bonds.
Similar bonds (without conversion feature) have
Similar
a 9% interest rate.
9%
The bond is sold at par value.
Each $1,000 bond convertible to 250 common
Each
shares (current market price of $3)
shares
IncrementalMethod
IncrementalMethod
Total proceeds from the bond issuance
($1,000,000 at par value)
($1,000,000
=
$ 1,000,000
PV of the liability without the
PV
without
conversion option, discounted at 9% ) = $
9%
924,061
924,061
Residual allocated to the option
Residual
75,939
75,939
Cash
$
1,000,000
Bonds Payable
Contributed Surplus-stock option
924,061
75,939
ProportionalMethod
ProportionalMethod
PV for the pure debt component is established
PV of cash flows for similar debt may be used
Fair value of conversion option is determined using
Fair
options pricing model
options
The total proceeds are then assigned to the
The
respective debt and equity components on a pro-rata
basis:
basis:
Value allocated to A = Total Proceeds * {A/(A+B)}
Value allocated to B =Total Proceeds * {B/(A+B)}
ProportionalMethod
ProportionalMethod
Given:
Same as previous example, except:
-- Using an option pricing model, the fair value
-of the conversion option can be determined as
$72,341
$72,341
ProportionalMethod
Present value (fair value) of the bonds $924,061 92.7%
Present
$924,061 92.7%
Fair value of conversion option
Using an option pricing model*
$ 72,341 7.3%
72,341 7.3%
Aggregate fair market value
$996,402 100%
$996,402 100%
Value allocated to the bond=1,000,000* 92.7% =927,000
Value
92.7%
Value allocated to the option = 1,000,000* 7.3% =73,000
Value
7.3%
Cash
1,000,000
Bonds Payable
Contributed Surplus-stock option
927,000
73,000
73,000
ReportingatTimeofConversion(by
theholder)
Main issue is determining the amount at which
Main
the securities are being exchanged
the
Two approaches available
Book value approach
Gain or loss on conversion does not occur
Gain
does
Most common approach
Market value approach
Gain or loss on conversion can occur
Gain
can
Either method acceptable under GAAP
Bookvalueapproach
Assume bond holders want to convert bonds into common
shares before the bonds mature, and the unamortized
discount is $14,058. The journal entry will be:
Bonds Payable
985,942*
Bonds
Contributed SurplusStock Option
73,000
Contributed
73,000
Common Shares
1,058,942
1,058,942
* 985,942=1,000,000-14,058
ExampleofInducedEarlyConversion
(bytheissuer)
Assume the company wishes to reduce interest costs
Assume
and offers bond holders $15,000 cash premium to
$15,000
convert the bonds into common shares before they
mature.
Par value of the bond =
$1,000,000
Par
$1,000,000
unamortized discount =
$27,524 .
unamortized
$27,524
the carrying value of the bond = $972,476,
the
$972,476
the fair value of the bond is $981,462 (not including the
the
of
$981,462
conversion feature).
conversion
Conversion option was originally valued at $75,939,
Conversion
$75,939
using incremental method.
using
The firm use book-value approach to record bond
The
book-value
conversion
conversion
ExampleofInducedEarlyConversion
Step 1: Determine how much of the $15,000
Step
premium should be allocated as bonds
retirement costs.
retirement
FV-BV=981,462-972,476=8,986
FV-BV=
Step 2: The residual is allocated as share
Step
redemption costs
redemption
15,000-8,986=6,041
InducedEarlyConversion
Journal entry to record induced conversion:
Bond Payable
Expensedebt retirement cost
Contributed Surplus-Stock options
Contributed
Retained Earnings
Common Shares
Cash
972,476*
972,476*
8,986
75,939
75,939
6,014
1,048,415**
15,000
15,000
* 972,476=1,000,000-27,524
** 1,048,415=(1,000,000-27,524)+75,939
Reportingatthe
TimeofRetirement
If it is a normal retirement at maturity:
the treated same as debt retirement from Chapter
treated
15
Equity components remains in Contributed Surplus
Equity
because the bond holder decided not to exercise
conversion option.
conversion
If it is a early retirement before maturity:
Clear any outstanding premiums, discounts, bond
Clear
issue costs, interest accrued to bondholders
issue
Clear contributed surplus-stock options
Loss will be allocated to debt retirement costs and
Loss
share redemption costs
share
Derivatives
Derivatives
Derivative instruments include
Option
Forward
Future
Three characteristics of derivatives:
1.
2.
3.
Values changes with underlying instrument
Values
underlying
Require little or no initial investment
Require little
Settled at a future date
Settled
future
DerivativeReporting
DerivativeReporting
Basic principles:
a) All derivatives to be recognized on the
All
recognized
Balance Sheet
Balance
b) All derivatives to be classified and presented
All
classified
as held for trading
as
c) All derivatives measured/valued at fair value
All
measured/valued
d) All derivative gains/losses recognized in net
All
income
income
e) Increased disclosure
Increased disclosure
Option
Option
Options
Call Option
Holder has the right, but not the obligation, to
Holder
right,
to
purchase at a preset (strike or exercise) price
purchase
Put Option
Holder has the right to sell at a preset price
Holder
right sell
Written Option
An option is a written one for the firm issues the
An
written
issues
option and receives a premium
option
Purchased Option
An option is a purchased one for the firm buys
An
purchased
buys
the option and pay a premium
the
AccountingforOption
AccountingforOption
Example: A purchase call option:
Firm A spend $400 to buy a call option from Firm B on
Firm
January 2, 2004
January
The option gives Firm A the right to buy from Firm B
The
Firm
Firm
1,000 shares of Firm Cs common shares at $100 per
Firm
share
share
Option will expire on April 30, 2004
Market price of Firm Cs shares on January 2, 2004 is
Market
Firm
$100 per share
$100
Share price increased to $120 on March 31 and on
Share
April 1
The options are trading at $20,100 on March 31.
On April 1, Firm A settle the options with Firm B.
On
Firm
Firm
AccountingforOption
AccountingforOption
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)
OptionPrice
OptionPrice
Date
Jan. 2
Mar. 31
April. 1
Intrinsic Value Gain/Loss Time Value
Gain/Loss Option Value
$0 $400 $400
$20,000
$20,000
$100
-$300
$20,100
$20,000
$0
$0
-$100
$20,100
Total Gain=
$19,600
=$20,000-$300-$100
FirmAsAccountingforOption
FirmA
January 2
Derivative trading
Cash
400
400
March 31
Derivative trading
20,000
Gain
20,000
Intrinsic Value = 1,000 shares *($100 - $120)=20,000
sume
ssume the options are trading at $20,100
Gain/Loss
Derivative trading
*300= $400 ($20,100-20,000)
Time Value=20,100-20,000=100
300*
300
FirmAsAccountingforOption
FirmA
pril 1, the firm settle the option
pril
settle
Cash
Loss
Loss
20,000
100
100
20,100
Derivative - trading
Date
Intrinsic
Intrinsic
Value
Value
Time
Time
Value
Value
Option
Option
Value
Value
Jan. 2
Mar. 31
Apr. 1
$0
$20,000
$20,000
$400
$100
$0
$400
$20,100
$20,000
CompensatoryStockOptionPlans
CompensatoryStockOptionPlans
(CSOP)
Provide the employees with an opportunity to
Provide the
purchase shares at a given price, within a
specified period of time
specified
Two accounting issues associated with stock
Two
compensation plans
compensation
1. Determination of compensation expense
2. Periods of allocation for compensation expense
Periods
amounts
CSOPImportantDates
CSOPImportantDates
MeasurementDate
Vesting/serviceperiod
Work
start date
Grant
Grant
date
date
Vesting
Vesting
date
date
Exercise
date
Expiration
date
Options
Options
are
granted to
granted
employee
Date that
Date
employee
employee
can first
exercise
options
Employee
exercises
options
Unexercised
options
expire
AllocatingCompensationExpense
AllocatingCompensationExpense
Compensation Expense
iis determined at the
s
measurement date
using option pricing model
using
and is allocated over
the service period
the service
The service period is the period benefited by
employees service
employees
It is usually the period between the grant date
and the vesting date
and
AccountingforCSOPExample
AccountingforCSOPExample
Jan., 1, 2005. Chen Corp. grants five executives
Jan.,
options to purchase 10,000 shares,
options
Vesting/service period=2 yrs.
The options will expire in 10 years
Exercise price=$60 per share
The current market price for the share is $70 per
The
share.
share.
Assume the total fair value of the option is $220,000
Assume
at the grant date,
AccountingforCSOPExample
AccountingforCSOPExample
At grant date, Jan. 1. , 2005 : no entry required.
On Dec. 31, 2005 & Dec 31, 2006:
Compensation Expense
110,000***
Compensation
Contributed SurplusStock Options
110,000
*** 110,000=220,000/2
If 2,000 options (20% ) were exercised on June 1, 2008.
Cash
120,000*
Cash
Contributed SurplusStock Options
44,000**
Common Shares
164,000
* 120,000=2,000* $60
$60
** 44,000= 20% *220,000
20% *220,000
AccountingforCSOPExample
AccountingforCSOPExample
Assume the remaining options were expired on Jan. 1,
Assume
2015. The journal entries are:
2015.
Contributed SurplusStock Options 176,000*
Contributed Surplus Expired Stock Options 176,000*
Contributed
Expired
176,000*
*176,000= 80% *220,000
*176,000= 80%
AccountingforforfeitedCSOP
AccountingforforfeitedCSOP
If stock options were forfeited because the an employee
If
forfeited
fails to satisfy a service requirement, an adjusting
journal entry will be make to reduced the compensation
expenses:
Dr. Contributed SurplusStock options
Dr.
Cr. Compensation Expense
Compensatoryvs.Non
Compensatoryvs.Non
CompensatoryPlans
Factors to determine if a plan is compensatory
1. Option terms
Non-standard terms imply compensatory
1. Discount from market price
Implies compensatory
1. Eligibility
If available to only a certain group of
If
employees (i.e. management)
employees
Compensatoryvs.Non
Compensatoryvs.Non
CompensatoryPlans
Stock Options
Compensatory
CSOP
Operating transactions
Income
Income
Statement
Statement
Non-compensatory
ESOP
Capital transactions
Shareholders
Equity
AccountingforESOPExample
AccountingforESOPExample
Fanco Ltd. set up an ESOP under which
Fanco
employees may purchase company share for
$10 per share, The option premium is $1 per
share, and Fanco has set aside 10,000
shares. On Jan 1, 2004, employees purchase
6000 options for $6000.
Cash
Cash
Contributed SurplusStock Options
6000
6000
AccountingforESOPExample
AccountingforESOPExample
Subsequently, all 6000 options are exercised,
Subsequently,
resulting in 6000 shares being issued.
Cash
Cash
Contributed SurplusStock Options
Common Shares
60,000
6,000
66,000
CA152
CA152
If you were the auditor of Centre Corporation, what is your
If
analysis of the situation described, how would you respond to
Youngs proposal about dividends and loans to executives?
Youngs
Casefornextweek
Casefornextweek
CA16-1, Question of the case change to:
If you were a financial analyst of Sanford Corp. , how
If
would you analyze the impacts of the transferred
shares on Sanfords financial statements?
shares