Chapter 16 - Complex Financial Instruments PDF

Title Chapter 16 - Complex Financial Instruments
Course Intermediate Financial Accounting II
Institution York University
Pages 10
File Size 274.3 KB
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Chapter 16: Complex Financial Instruments Financial Instruments - Financial instruments: Contracts that create both a financial asset for one party and a financial liability or equity 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. Derivatives - Derivatives are financial instruments that create rights and obligations that transfer financial risk(s) that are inherent in an underlying primary instrument, from one party to the other party. - They transfer risks that are inherent in the underlying primary instrument without either party having to hold any investment in the underlying. - They are called “derivatives” because they derive (get) their value from an underlying primary instrument, index, or non-financial item, such as a commodity (called the “underlying”) Derivatives have the following three 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. - The “underlying” can be a financial asset (like an option) or not (weather). - Common types of derivative instruments include options, forwards, and futures. - For example: Stock Options  The stock is the “underlying”  If the share price goes up, the option is worth more and vice versa. Managing Risks - Derivates exist to help companies manage financial risks (like the ones below). 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) Example: McCain Foods Limited is a large producer of potatoes and has market risk related to its inventory. Because the company is concerned that the price of potatoes will drop, it signs a forward contract in which it agrees to sell its potatoes today at the current market price, but for delivery in two months. McDonalds is on the other side of the contract because they think the current price is excellent and that prices may increase in two months. Both parties are managing market risk related to the potatoes with this type of contract.

Accounting for Derivates - The basic principles regarding accounting for derivatives: 1) Financial instruments (including financial derivates) and certain non-financial derivates represent rights or obligations that meet the definitions of assets or liabilities and should be recognized in financial statements when the entity become party to the contract. 2) Fair value is the most relevant measure. 3) Gains and losses should be booked through net income. Non-Financial Derivatives and Executory Contracts - A financial derivative’s underlying instrument can be a financial asset – an asset that has value based on a contractual claim, rather than a physical net worth, such as stocks, bonds, and bank deposits. - An example of a financial derivative is a forward contract to buy US dollars. - A non-financial derivative’s underlying instruments can be a non-financial asset – an asset with physical value, such as real estate, equipment, and inventory. - An example of a non-financial derivative is a contract to buy steel at a specified date for a specified price. - Purchase commitments are generally labelled as executory contracts: contracts to do something in the future (where no cash or product changes hands up front). - Technically, purchase commitments meet the accounting definition of derivates; however they are accounted for differently under ASPE and IFRS. - Under ASPE, purchase commitments and similar commodities contracts are generally not accounted for as derivates because they may be difficult to measure. They are not recognized in the financial statements until the goods are received. - Under IFRS, purchase commitments are 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”. - If the company does not intend to take delivery of the goods, then it can treat it as a derivative. (1) Options and Warrants - An option or warrant gives the holder the contractual right to acquire or sell an underlying instrument at a specific price (exercise/strike price) within a specific term (exercise period). - A good example is an option to purchase shares of a company. The underlying is the shares; that is, the option derives its value from the share price. Call Option: Holder has the right, but not the obligation to buy the “underlying” at a pre-set price. Put Option: Holder has the right, but not the obligation to sell the “underlying” at a pre-set price.

- If a company purchases an option, it will pay a fee/premium to gain a right to do something. - If a company writes an option, it gives the purchaser the right to do something. Example: • January 2, 2017: Abalone Inc. purchases a call option from Baird Investment Corp. • Option expires April 30, 2017 • Option gives right to Abalone to purchase 1,000 Laredo Corp. shares at $100 per share • Share market price on January 2, 2017 is $100 per share • Option is purchased for $400 (Option Premium) • Share price on March 31st is $120 per share • Option is traded at $20,100 on March 31, 2017 • Option settled in cash on April 1, 2017 ^ This is a financial derivative because the underlying is a financial asset (Laredo shares). - If the price of Laredo shares increases above $100, Abalone can exercise the option and still purchase the shares for $100 per share. Abalone may also sell the option to someone else. - Baird has market risk associated with the shares. - Abalone has market risk associated with the option itself. - If Baird didn’t invest in Laredo itself, it will suffer a loss if the price of Laredo shares increases. - If Laredo’s share price never increases above $100 per share, the call option is worthless and Abalone recognizes a loss equal to the initial price of the call option ($400). Prepare the necessary journal entries.

Option Premium = ($100 - $100) + ($400 - $0) = $0 + $400 = $400  On Jan. 2, 2017 the intrinsic value of the option related to the Laredo shares is zero because the market price is equal to the strike price of $100.  Time value refers to the option’s value over and above its intrinsic value.

January 2, 2017 (acquisition date): Derivatives – Financial Assets Cash

$400 $400

- “Derivates – Financial Assets” is an asset account however if it gets to a credit balance, it has an obligation (liability) in the future. March 31, 2017 (to record change in value of option): - Because share prices increases to $120 per share, intrinsic value of the call option contract is now $20,000. Abalone could exercise the call option and purchase 1000 shares from Baird for $100 per share and then sell the shares in the market for $120 per share. This also increases the value of the option. Assume now that the options are trading at 20,100. Derivatives – Financial Assets (20,100 – 400) Gain April 1, 2017 (cash net settlement of option): Cash ($120,000 - $100,000) Loss ($20,100 – 20,000) Derivatives – Financial Assets

$19,700 $19,700

$20,000 $100 $20,100

Net effect on income: 19,700 – 100 = $19,600. - On April 1, 2017, Abalone could have taken delivery of the shares under the option contract. Assuming that the company decides to present the investment in the shares as FV-NI, the entry to record this is as follows: FV-NI Investment $120,000 Loss $100 Cash $100,000 Derivates – Financial Assets $20,100 (2) 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 - Forwards are measured at the present value of any future cash flows, discounted at a rate that reflects risk.

Example: • On January 2, 2017, Abalone Inc. agrees to buy $1,000 in U.S. currency for $1,150 in Canadian currency in 30 days from Bowen Bank. (therefore, $1 U.S = $1.15 CDN) • January 2, 2017: U.S. $1 = Canadian $1.10 • 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 • On January 5, 2017, the fair value of the contract is $50.

^ This is a financial derivative because the underlying is a financial asset: foreign currency. - The US dollar is the underlying. - Like the option, the value of the forward considers both the intrinsic value and the time value component. It is generally valued at the present value of future net cash flows. - The forward is re-measured at fair value. January 5, 2017: Derivatives – Financial Assets Gain

$50 $50

- Suppose that on January 31, 2017, the contract moves into a loss position; that is, if the contract were settled today, the company would suffer an overall loss of $30. This might occur for instance if the value of the U.S. currency declines. Loss $80 Derivatives – Financial Assets $80 - Since the derivative is at a credit balance, it can be presented as a liability on the SFP. To make things easier, use the account “Derivatives – Financial Assets/Liabilities”. - Assume that on February 1, 2017, the settlement date, the U.S. dollar is worth $1.05 Canadian. The following entry would be booked to settle the contract if it was settled on a net basis: Loss $70 Derivatives – Financial Assets/Liabilities $30 (to eliminate carrying value) Cash (1000 * 1.15) – (1000 * 1.05) $100 If instead Abalone actually took delivery of the U.S. dollars, the following journal entry would be booked: Cash (1000 * 1.05) $1,050 Derivatives – Financial Assets/Liabilities $30 (to eliminate carrying value) Loss $70 Cash $1,150

(3) Futures - Futures are similar to forwards except: 1) They are standardized as to amounts and dates. 2) They are exchange traded and therefore have ready market values. 4) They are settled through clearing houses, which generally remove the credit risk. 4) There is a requirement to put up collateral in the form of a “margin” account.  The margin account represents a percentage of the contract’s value.  Daily changes in the value of the contract are settled daily against the margin account by the clearing house.  The initial margin is treated as a deposit account similar to a bank account, and is increased or decreased as the margin amount changes. Example: • Fairway Inc. entered into a futures contract to sell grain for $1,000 in 30 days • Initial margin of $100 cash is required by the broker (normally a % of market value of contract) - This is a non-financial derivative because the underlying is grain (a non-financial commodity). - Like the forward, the futures contract would have a zero value up front. - The contract is valued at inception, however the margin deposited with the broker must be recorded. Deposits $100 Cash $100 - Assume that the value of grain increases and causes the market value of the contract to decrease by $50. The clearing house then requires Fairway to deposit an additional $50. Loss $50 Derivatives – Financial Assets/Liabilities $50 Deposits $50 Cash $50 If the contract is closed out on a net basis (no delivery of grain) with no further changes in value, the journal entry would be: Cash $100 Derivatives – Financial Assets/Liabilities $50 Deposits $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. Instead of delivering the grain, Fairway paid the difference in cash.

Derivatives Involving the Entity’s Own Shares

- For instance, a company might enter into forward contracts to buy or sell its own shares at a future date. - Assume Abalone Inc. paid $400 to Baker Corp. for the right to buy 1,000 of Abalone’s own common shares for $30 each. Assume further that the contract may only be settled by exercising the option and buying the shares.  Under IFRS, this transaction would be presented as a reduction in shareholder’s equity and not as an investment like the other examples.  ASPE is silent on this matter but general principles support presenting the financial instrument as a contra-equity. * Refer to page 985

Debt verses Equity: Issuer Perspective - Over the years, capital markets have created many hybrid-type instruments that are neither fully debt nor fully common shares (equity). - Hybrid/compound instruments have characteristics of both debt and equity. - For example: convertible debt, debt with detachable warrants, preferred shares (kind of). Presentation of Hybrid/Compound Instruments - When analyzing whether the contract is debt, equity, or both (hybrid/compound), consider the following: 1) Contractual terms 2) Economic substance 3) Definition of financial statement elements  Financial liability: A contractual obligation to either of the following: - Deliver cash or another financial asset to another party, or - Exchange financial instruments with another party under conditions that are potentially unfavourable.  Equity instrument: Any contract that represents residual interest in the assets of an entity after deducting all of its liabilities. - Another presentation issue is whether the instruments should be offset against other financial instruments when presented on the SFP. Generally, they should not; however, a company can show these amounts on a net basis when:  The company has a legally enforceable right to do so.  The company intends to settle the instruments on a net basis or simultaneously (that is, collect the receivable and immediately pay out the payable) Measurement of Hybrid/Compound Instruments - Upon initial recognition, financial instruments are measured at fair value, which is generally the exchange value. - If they have components of both debt and equity, they may require bifurcation (splitting into debt and equity). - Two general approaches: 1) Residual value method (incremental method) 2) Relative fair value method (proportional method)

- IFRS requires the use of the residual value method, with any debt components being valued first and the residual being allocated to the equity components. - ASPE allows the use of the residual method with the more easily measureable component being value first, OR allows the equity component to be valued at zero. Convertible Debt: - A convertible bond is a bond that may be converted into common shares of the company at the holder’s option. It is purchased by investors who want the security of a bond holding – guaranteed interest – plus the added option of conversion if the value of the common shares increases significantly. - Corporations issue convertible debt for two main reasons: 1) The desire to raise equity capital without giving up more ownership control than necessary. 2) A more common reason is to obtain debt financing at cheaper rates (issuing bonds is debt financing). The convertible privilege entices the investor to accept a lower interest rate than what would normally be the case of a straight debt issue. This means that the issuing company has to pay less interest. For this lower interest rate, the investor can receive the right to buy the company’s common shares at a fixed price until the debt’s maturity. - There are reporting issues in accounting for convertible debt at all of the following times: 1) Issuance 2) Conversion 3) Retirement (1) Convertible Debt at Time of Issuance: - The obligation to deliver cash under the bond represents a financial liability and the right to acquire the company’s common shares represents an equity instrument. Example: Assume that Bond Corp. Offers three-year, 6% convertible bonds (par $1,000). Each $1,000 bond may be converted into 250 common shares, which are currently trading at $3 per share. Similar straight bonds carry an interest rate of 9%. One thousand bonds are issued at par.  What portion of the proceeds is allocated to Bond Liability and what portion to equity? - Assume that the company decides to use the residual method and measure the debt first. * Refer to Example 1, part a

(2) Convertible Debt and Time of Conversion: - Assume that the holders of the convertible debt of Bond Corp. decide to convert their convertible bonds before the bonds mature. Assume at this point that the unamortized portion is $14,058. * Refer to Example 1, part b

- Sometimes the issuer wants to induce (cause) a prompt conversion of its convertible debt to equity securities in order to reduce interest costs or to improve its debt to equity ratio. This is referred to as induced conversion and as a result the issuer may offer some form of consideration such as cash. - The additional premium paid should be allocated between the debt and equity components at the time of the transaction. Assume that Bond Corp. wants to reduce interest costs at some point during the life of the debt. It therefore offers an addition cash premium of $15,000 to the bondholders to convert, at a time when the carrying amount of the debt was $972,476. The bonds fair value at the conversion time is $981,462. (3) Retirement of Convertible Debt: - The normal retirement of the liability component of convertible debt at maturity (its repayment) is treated the same was as non-convertible bonds, as in Chapter 14. The equity component remains in Contributed Surplus. - What happens when there is early retirement? Example: Assume that Bond Corp. decides to retire the convertible debt early and offers the bondholders $1,070,000 cash, which is the fair value of the instrument at the time of early retirement. *Note that the $1,070,000 fair value includes the fair value of the bond AND the embedded option. * Refer to Example 1, part c

Share-Based Compensation - Stock compensation plans are used to remunerate or compensate employees; this allows a more long-run focus in the company. Types of Compensation Plans - Four common compensation plans are: *1) Compensatory stock option plans (CSOP) *2) Direct awards of stock 3) Stock appreciation rights plans (SARs) 4) Performance-type plans *Refer to pg 994-5

Compensatory Stock Option Plans - Two accounting issues associated with the stock compensation plans: 1) Determination of compensation expense 2) Periods of allocation for compensation expense amounts

- The total compensation expense is calculated on the date when the options are granted to the employee (grant date) and is based on the fair value of the options that are expected to vest. - No adjustments are made after the grant date for any changes in the share price. - Compensation expense is recognized in the periods in which the employee performs the service. Thus, total compensation cost is determined at the grant date and allocated to the periods that benefit from the employee services. Example: Assume that on November 1, 2017, the shareholders of Chen Corp. approve a plan that grants options to the company’s five executives to purchase 2,000 of the company’s common shares each. The options are granted on January 1, 2018, and may be exercised at any time after December 31, 2019. The exercise price is $60. Let’s assume that the fair value results in total compensation expense of $220,000. At June 1, 2021, 20% or 2,000 of the 10,000 options were exercised. * Refer to Example 2

Direct Awards of Stock - Instead of paying cash salary, the company may offer company shares as remuneration. This would be recorded as salary expense at the shares’ fair value. - This is known as a non-monetary reciprocal transaction....


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