Part 1: Complex Debt and Equity Instruments. Introduction. Financial Accounting 3 Lesson summary 1 1. Financial Accounting: Liabilities & Equities

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1 Financial Accounting: Liabilities & Equities Module 4 Audio lecture presented by: Barbara M. Wyntjes, B.Sc., CGA FA3 Module 4 1 Part 1: Complex Debt and Equity Instruments FA3 Module 4 2 Introduction Financial Instruments Convertible bonds Stock options Derivative instrument Disclosure FA3 Module 4 3 Financial Accounting 3 Lesson summary 1 1

2 Financial Instruments A financial asset of one party and a financial liability or equity instrument of another party. FA3 Module 4 4 Financial Assets Economic resources controlled by an entity as a result of past transactions or events and from which future economic benefits may be obtained Monetary fixed or determinable amount of cash FA3 Module 4 5 Financial Liability Obligations of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services, or other yielding of economic benefits in the future FA3 Module 4 6 Financial Accounting 3 Lesson summary 1 2

3 Equity The ownership interest in the assets of a profit oriented enterprise after deducting the liabilities Residual interest in the assets of an entity after deduction all of its liabilities FA3 Module 4 7 Financial Instruments Distinction was clear based on legal form 1995: Section 3860 Record historical value and disclose fair value FA3 Module 4 8 Financial Instruments Section 3855 fair value measurement for trading instruments and all derivatives (October, 2006) FA3 Module 4 9 Financial Accounting 3 Lesson summary 1 3

4 Classification Substance over legal form Classify as a liability or as equity in accordance with the substance of the contractual arrangement on initial recognition and the definitions of a financial liability and an equity instrument FA3 Module 4 10 Classification If a financial instrument is a liability in substance, it is classified as debt, even if it is legally equity Redeemable preferred shares (contractually required or option of holder) FA3 Module 4 11 Classification If a financial instrument is equity in substance, it is classified as equity, even if it is legally a liability Financial ratios Unfavourable change in debt-to-equity ratio FA3 Module 4 12 Financial Accounting 3 Lesson summary 1 4

5 Classification - Payments Payments should be consistent with classification Payments associated with financial liabilities should be presented on the income statement Redeemable Preferred share dividends expensed in Income statement (not for tax purposes) Gains or losses FA3 Module 4 13 Classification - Payments Payments associated with equity instruments should be presented on the retained earnings statement Gains and losses associated with equity are capital transactions and affect equity Consistent FA3 Module 4 14 Convertible Debt Hybrid convertible bonds Bonds that are convertible into common shares at the investor s option embody two financial instruments: a liability, and an option contract on common shares FA3 Module 4 15 Financial Accounting 3 Lesson summary 1 5

6 Convertible Debt The two components (debt and equity) are recognized separately on issuance, and classified accordingly Split and present compound securities based on its separate components FA3 Module 4 16 Convertible Debt Section 3860, 2 approaches are used: 1. Incremental approach - only if MV of option is not available 2. Proportional approach (preferred) FA3 Module 4 17 Proportional Method On issuance: Cash = amount received (PV) Bond Payable = face value Conversion rights = Option pricing model FA3 Module 4 18 Financial Accounting 3 Lesson summary 1 6

7 Proportional Method On issuance: Premium/discount = Face value market value of bond Relative market value FA3 Module 4 19 Incremental Method On issuance: Conversion rights = PV with PV without conversion rights Premium/discount = Face value - PV without conversion rights FA3 Module 4 20 Both Methods On conversion: Common shares = NBV + conversion rights FA3 Module 4 21 Financial Accounting 3 Lesson summary 1 7

8 Both Methods On conversion: If lapse: close conversion rights to contributed capital FA3 Module 4 22 Book or Market Method Book value method used in practice Record bonds at NBV + conversion rights Market value usually report a loss as recording shares at market value and investors would convert if market value is greater than face value of bond (not common) FA3 Module 4 23 Split Accounting Advantages: Signals FA3 Module 4 24 Financial Accounting 3 Lesson summary 1 8

9 Split Accounting Advantages: Interest on pure debt FA3 Module 4 25 Text Example See text, pages 867 and 868 FA3 Module 4 26 Part 2: Assignment A14-8 Req d 1 See Chapter 14, page 913 And handout 1, page 1 FA3 Module 4 27 Financial Accounting 3 Lesson summary 1 9

10 Assignment A14-8 Req d 2 See Chapter 14, page 913 And handout 1, page 1 FA3 Module 4 28 Assignment A14-8 Req d 3 See Chapter 14, page 913 And handout 1, page 1 FA3 Module 4 29 Assignment A14-8 Req d 4 See Chapter 14, page 913 And handout 1, page 1 FA3 Module 4 30 Financial Accounting 3 Lesson summary 1 10

11 Part 3: FA3 Module 4 31 Convertible Debt Issuer option More complex If the bond is convertible to an unknown number of shares: Liability - if number of shares determined based on market value at conversion date No equity portion FA3 Module 4 32 Convertible Debt Hybrid - if convertible to a fixed number of shares: Equity = PV of principal Debt = PV of interest stream Equity = if principal and all interest payments can be paid in shares FA3 Module 4 33 Financial Accounting 3 Lesson summary 1 11

12 Retractable Preferred Shares Call provision - corporation can call in the shares and redeem them at a call price specified Retractable shares - at the option of the shareholder FA3 Module 4 34 Retractable Preferred Shares Liability = when redemption is either contractually required, at the option of the shareholder or essentially forced Term-preferred shares - redeemed on or before a specified date FA3 Module 4 35 Perpetual Debt A type of debt whose principle does not have to be repaid or is highly unlikely to be repaid Yields a stream of interest income Classified as a liability - the issuer assumes a contractual obligation to make a stream of future interest payments Value = present value of the stream of future interest payments FA3 Module 4 36 Financial Accounting 3 Lesson summary 1 12

13 Derivative A secondary financial instrument whose contract is linked to a primary financial instrument or commodity All derivatives are either options or forward contracts or some combination thereof Option: the right to buy or sell something in the future Forward contract: an obligation to buy or sell something in the future FA3 Module 4 37 Derivative Example Forward contract on foreign exchange transaction $100US in 3 months agree to pay $110 Cdn FA3 Module 4 38 Derivative Exchange contracts meant to transfer risk These contracts are financial assets - potentially favourable (gains) These contracts are financial liabilities - potentially unfavourable (losses) FA3 Module 4 39 Financial Accounting 3 Lesson summary 1 13

14 Derivative Executory contracts Not normally reported on balance sheet Section 3860 disclosure Section at fair value Derive value from primary instrument FA3 Module 4 40 Stock Options An instruments that give the holder the right to buy shares at a fixed price If the exercise price > market value of the share, the option has no value FA3 Module 4 41 Stock Options in the money - Only when the share price rises above the exercise price does the option itself have a value (derivative) Example: Exercise price = $10, Market price = $15. Intrinsic value = $5 FA3 Module 4 42 Financial Accounting 3 Lesson summary 1 14

15 Stock Rights Provide the holder with an option to acquire a specified number of shares in the corporation under prescribed conditions and within a stated future time period Often have a short life FA3 Module 4 43 Stock Warrants Stock rights that are issued as an attachment to other securities (usually to bonds) Valid for longer periods of time than rights and often have no expiry date Choice to buy or not FA3 Module 4 44 Rights and Warrants Stock rights and warrants may be exercised by purchasing additional shares from the corporation Sold at the market value of the rights Or allowed to lapse on the expiration date (if any) FA3 Module 4 45 Financial Accounting 3 Lesson summary 1 15

16 Accounting for Stock Rights For shareholder - received them from the company because of shares already owned The value of the shares and the rights or warrants is allocated based upon the market value of each. FA3 Module 4 46 Accounting for Stock Rights For investor - purchased on the open market The price paid will be allocated as an asset until rights are exercised (cost of shares acquired) or they lapse (cost expensed). FA3 Module 4 47 Accounting for Stock Rights For issuer: Stock options may be: Recognized on issuance, and disclosed as an element of shareholders equity Accounted for through disclosure, a memo entry approach See exhibit 14-5 in text, page 877 FA3 Module 4 48 Financial Accounting 3 Lesson summary 1 16

17 Accounting for Stock Rights Issuance of stock rights to existing shareholders (pre-emptive rights): Memorandum announcement and issuance date Issuer records cash received and credit shares on exercise date If rights lapse memorandum FA3 Module 4 49 Accounting for Stock Rights Rights issued as a Poison Pill Rights issued in a non-compensatory stock option plan for employees FA3 Module 4 50 Accounting for Stock Rights Rights issued in a compensatory stock option plan for specific employees Significant discount Part of compensation FA3 Module 4 51 Financial Accounting 3 Lesson summary 1 17

18 Fair Value Method Fair value established with option pricing model Announcement date memorandum Issuance date or grant date fair value of option established memorandum FA3 Module 4 52 Fair Value Method Annual entry (year end) recognized compensation expense and Contributed capital: common share options outstanding (equity section) cost = total fair value of option/time period FA3 Module 4 53 Fair Value Method Exercise date record cash (at exercise price), Dr balance in contributed capital and total close to shares FA3 Module 4 54 Financial Accounting 3 Lesson summary 1 18

19 Fair Value Method Expiration date if lapsed, transfer with in contributed capital No change to total Shareholders equity No impact on income Forfeited CR compensation expense FA3 Module 4 55 Disclosure: Financial Instruments Extensive Stock-based Compensation: Accounting policy Description of plan Specific information of stock outstanding Compensation expense FA3 Module 4 56 Disclosure: Cash Flow Statement Only include transactions involving cash Financing section - includes issuance, cash paid on maturity (Hybrid separate debt an equity) Interest and dividends based on substance (debt interest under operating) (equity dividends under financing) Non-cash transactions do not appear on the CFS. Example - conversion. FA3 Module 4 57 Financial Accounting 3 Lesson summary 1 19

20 Part 4: Assignment A14-27 Req d 1 See Chapter 14, page 920 And handout 1, page 2 FA3 Module 4 58 Assignment A14-27 Req d 2 See Chapter 14, page 920 And handout 1, page 2 FA3 Module 4 59 Assignment A14-26 See Chapter 14, page 920 And handout 1, page 3 FA3 Module 4 60 Financial Accounting 3 Lesson summary 1 20

21 Part 5: Assignment A14-21 Req d 1 See Chapter 14, page 918 And handout 1, page 4 FA3 Module 4 61 Assignment A14-21 Req d 2 See Chapter 14, page 918 And handout 1, page 4 FA3 Module 4 62 Assignment A14-21 Req d 3 See Chapter 14, page 918 And handout 1, page 4 FA3 Module 4 63 Financial Accounting 3 Lesson summary 1 21

22 Assignment A14-21 Req d 4 See Chapter 14, page 918 And handout 1, page 4 FA3 Module 4 64 Assignment A14-21 Req d 5 See Chapter 14, page 918 And handout 1, page 4 FA3 Module 4 65 Part 6: Past Exam Questions: See Module 4 Handout 2 FA3 Module 4 66 Financial Accounting 3 Lesson summary 1 22

23 Question 6 See Module 4 Handout 2 FA3 Module 4 67 Multiple Choice h See Module 4 Handout 2 FA3 Module 4 68 Multiple Choice i See Module 4 Handout 2 FA3 Module 4 69 Financial Accounting 3 Lesson summary 1 23

24 Multiple Choice j See Module 4 Handout 2 FA3 Module 4 70 Multiple Choice k See Module 4 Handout 2 FA3 Module 4 71 Multiple Choice f See Module 4 Handout 2 FA3 Module 4 72 Financial Accounting 3 Lesson summary 1 24

25 Question 3 See Module 4 Handout 2 FA3 Module 4 73 Memo or journal entry Proper terms Key areas hybrid instruments FA3 Module 4 74 End of presentation FA3 Module 4 75 Financial Accounting 3 Lesson summary 1 25

Financial Instruments: Presentation INTRODUCTION

IAS 32 Financial Instruments: Presentation INTRODUCTION Objective Scope Application The stated objective of IAS 32 is to establish principles for presenting financial instruments as liabilities or equity