Complex Financial Instruments

COMPLEX FINANCIAL INSTRUMENTS ISSUES: Identify a Complex Instrument Recording the issuance of complex debt Valuation of warrants Valuation of conversion privileges Recording securities issued on conversions Issuing stock options

1. Complex securities Is it debt or equity???? Or is it a hybrid?? Hybrids have both characteristics eq: We must ensure the that the economic substance of the instrument is examined to ensure proper classification. 2. What is a financial instrument (CICA 3855)? FI


A contract that gives rise to a financial asset of one party and a financial liability or equity instrument of another. FA
(i) the right to receive cash or another financial asset (e.g., A/R) (ii) the right to exchange financial instruments with another party under potentially favorable conditions (e.g., forward contract) (iii) an equity instrument of another entity (e.g., trading securities) FL


(i) obligation to deliver cash or another financial asset (e.g., A/P) (ii) obligation to exchange financial instruments with another party under potentially unfavorable conditions (e.g., forward contract).

Equity
any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities (e.g., most stock options)

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3. What prompted the need for CICA 3855? -

New and complex financial instruments (derivatives, swaps, etc.) Increased use of preferred shares with debt-like features Compound financial instruments (e.g., convertible debt)

4. Procedure for debt with a convertible feature to be valued? 1st we must split out the equity and debt components Incremental method - Value the easiest of the features first (usually the bond) and then allocate the residual proceeds on the sale to the remaining component. Proportional method -

Value each component separately and allocate total proceeds based on relative values. Must first establish values of each: o Establish market value of pure debt component. o Use pricing model to determine the warrant/option component.

5. Value of new securities at conversion Valuation of warrants - done when issued

Valuation of conversion privileges of debt Book Value Approach Conversion recorded at book value of bonds and conversion rights

Market Value Approach New securities recorded at market value.

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Do questions 1,2 6. Retirement Maturity comes and conversion right is still not exercised?

Early retirement?

7. Why do companies offer stock options? Employee can purchase a specified number of shares at a specified price for a specified time. a) Recruit and retain b) Goal Congruence! c) Taxation/Tax planning d) No Cash compensation e) Realize the cost over time – if we just issued shares: Dr. expense Cr. Share Cap. 8. Dates Work start Grant date – Option granted to employee Vesting date – Date employee can first exercise the options Exercise date – Employee exercises options Expiration date – Unexercised options expire 9. How should stock options be accounted for? -

Value the options (at the date of grant) at FMV using an option pricing model (e.g., Black-Scholes)

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Expense the FMV figure over the period that the options vest

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No further income statement impact when stock options are exercised and shares are issued Do question 3 3

10. What are derivatives? A contract between two (or more) parties that transfers some type of financial risk from one party to another. The contract has little or no upfront cost and it will be settled at some specified date in the future.

11. What risks are derivatives meant to minimize? Price risk
The risk that an existing asset/liability’s value will change Example: A foreign exchange contract (derivative) between: a Canadian company that sells goods to US customers, and a bank or other financial institution (counter party). The company currently has a $1,000,000 USD receivable that will be collected in 30 days. The risk to the company is that the strength of the $USD will fall between now and the date of collection (i.e., the receivable will be worth less in $CDN funds). Therefore, the company enters into a forward contract to sell $1,000,000 USD to the bank in 30 days for $CDN at a pre-determined rate. If the $USD loses value compared to $CDN, then the company “wins”. If the $USD gains value compared to $CDN, then the company “loses” (i.e., in retrospect it should not have entered into the contract). The point is that the company may not wish to take a chance on fluctuating currency values.

Cash flow risk
The risk that future cash flows re: a contract will change Example: Air Canada is concerned about constantly fluctuating prices for jet fuel. In order to “fix” the price that it pays for fuel, AC enters into a contract with a bank (counter party). Under this arrangement, a fixed price per gallon and a settlement date are determined and agreed upon. Normally the settlement date will coincide with AC’s expected purchase date). If the price of jet fuel increases between now and settlement, then AC will receive the difference between the market (spot) price and the contract price (i.e., AC is happy). If the price of jet fuel decreases between now and settlement, then AC must pay the difference between the market price and the contract price (i.e., AC is unhappy).

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12. What are the two main strategies involving derivatives? Speculating • Entity exposes itself to greater risk with the intent/hope of maximizing returns. • No pre-existing operational risk (i.e., little justification for obtaining a derivative other than to increase the expected return of an investment portfolio). Hedging • Entity trying to minimize/eliminate risk. • Pre-existing risk (price risk, cash flow risk, etc.). • Removing uncertainty. • E.g., Terasen 13. How Does GAAP affect the reporting of derivatives in the F/S? Speculative • Derivatives are reported on the balance sheet at FMV at all times (Mark-to Market). • Gains and losses on the derivative are recorded in income in the current period (No LCM). • Increases volatility of earnings. Hedging Fair Value Hedge (Price risk) • Hedge of an existing asset/liability. • Derivative is reported on the balance sheet at FMV at all times. • Gains and losses on the derivative are recorded in income in the current period. • Allowed to record gains and losses on the underlying asset/liability in income in the same period as above. • No net impact on earnings for the period. Cash Flow Hedge (Cash flow risk) • Hedge of a future anticipated cash flow. • Derivative is reported on the balance sheet at FMV at all times. • Gains and losses on the derivative are recorded on the balance sheet under “Accumulated Comprehensive Income”. • No net impact on earnings for the period.

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Question #1 Compound Instruments - Conversion On January 1, 20x1, Left issued $10 million of 8% convertible bonds (pays interest annually on Dec. 31). The bonds had a life of 10 years and each $1,000 bond was convertible into 25 shares of Left's common shares. Right purchased the entire bond issue for $10.2 million on January 1, 20x1. Right's investment broker estimated that without the conversion feature, the bonds would have sold for $9,358,234 (a yield of 9%). On June 30, 20x3, Right converted 30% of the bonds to common shares. Assume that accrued interest since December 31, 20x2, had not been paid by Left. At the time of conversion, Left’s shares were selling at $45 each. Required: Prepare the entries to record: (1) the January 1, 20x1 issuance of the bonds, and (2) the June 30, 20x3 bond conversion. Assume that the company uses the incremental method to value the bonds’ conversion feature. January 1, 20x1: Cash 10,200,000 Bonds Payable 10,000,000 Discount 641,766 Contributed surplus – conversion feature 841,766 June 30, 20x3: First we need to determine the NBV of the entire bond issue at January 1, 20x3: 10,000,000 x PV$1(9% ; 8) 800,000 x PVA(9% ; 8)

= =

5,018,663 4,427,855 9,446,518 Therefore, discount= 553,482

Now, take 6 months of interest accrual and discount amortization on the 30%: Interest expense = Interest payable = Discount amortization Interest expense Discount Interest payable

9,446,518 x 9% x 6/12 x 30% 10,000,000 x 8% x 6/12 x 30% = 127,528 – 120,000

= = =

127,528 120,000 7,528

127,528 7,528 120,000

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June 30, 20x3 – cont. Market Value Method Bonds Payable Interest payable Discount Conversion feature Common shares Loss

3,000,000 120,000

Book Value Method 3,000,000 120,000

158,517* 252,530** 3,375,000***

158,517* 252,530** 3,214,013

160,987

* (553,482 x 30%) – 7,528

** 841,766 x 30%

*** ($3,000,000/$1,000) x 25 x $45

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Question #2 Compound Instruments - Allocation On February 1, 20x1, Corleone Ltd. issued a $10 million, 5 year, 8% bond with semi-annual interest paid each June 30 and December 31. Due to unexpected delays, the bond was issued one month late. Each $1,000 bond can be converted into 50, no par value common shares. In addition, each $1,000 bond came with 10 detachable common share warrants that allow the holder to purchase common shares at an exercise price of $20. Immediately after issuance, these warrants were being traded at $5 each. If the bonds did not have detachable warrants or a conversion feature, they would have sold for $10,903,289 (including accrued interest for the month of January) which equates to an annual yield of 6%. Instead, gross proceeds of $12,000,000 were received on the sale on February 1. On July 1, 20x1, 2,000 of the warrants were exercised. On this day, the common shares were trading at $40. Required: Prepare the journal entry on the date of the bond’s issuance and on June 30. Assume that the company uses the incremental method to allocate bonds proceeds to each of the features. Bonds payable Premium Interest payable Warrants Conversion feature Total Proceeds

10,000,000 836,6222 66,6671 500,0003 596,7114 12,000,000

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$10,000,000 x 8% x 1/12 10,903,289 – 10,000,000 – 66,667 3 ($10,000,000/$1,000) x 10 x $5 4 Plug 2

February 1 DR Cash CR CR CR CR CR

12,000,000 Bonds Payable Premium Interest payable Contributed surplus – warrants Contributed surplus – conversion feature

10,000,000 836,622 66,667 500,000 596,711

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June 30 DR Interest exp. DR Interest payable DR Premium CR Cash

270,916 ** 66,667 62,417 400,000 *

* $10,000,000 x 8% x 6/12 ** (10,000,000 + 836,622) x 6% x 5/12

July 1 DR Cash Contributed surplus – warrants DR Common shares CR

40,000* 10,000** 50,000

* $20 x 2,000 ** (2,000/100,000) x 500,000

Note: We ignore the market value of the common shares when the warrants are exercised. This is because cash is part of the consideration received. On the other hand, when there is a conversion of bonds or preferred shares to common shares (i.e., no cash trading hands), then the company can record the common shares either at market value or book value.

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Question #3 Stock Option Accounting On January 1, 20x1, Brigante Inc. granted stock options to officers and other employees for the purchase of 200,000 of the company’s no-par value common shares at $25 each. The options were exercisable within a five-year period beginning January 1, 20x3 by grantees still in the employ of the company, and they expire December 31, 20x8. The market price of Brigante’s common shares was $20 per share at the date of grant. The service (vesting) period for this award is two years. On March 31, 20x3, 120,000 options were exercised when the market value of common shares was $40 per share. Using the Black-Scholes option pricing model, the estimated fair value of each option on January 1, 20x1 was $3.00. Required: Account for the options using the fair market value method. Assume that the company has a December 31 year end. December 31, 20x1 Compensation Expense Contributed Surplus–Stock Options

December 31, 20x2 Compensation Expense Contributed Surplus - Stock Options

March 31, 20x3 Cash Contributed Surplus–Stock Options Common Shares

300,000 300,000

300,000 300,000

3,000,000 360,000

3,360,000

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Disclosure in notes to financial statements (December 31, 20x3) On January 1, 20x1, Brigante Inc. granted stock options to key employees for the purchase of 200,000 of the company’s no-par value common shares at $25 each. The options are vested and became exercisable, beginning January 1, 20x3, by grantees still in the employ of the company. All of the options are due to expire on December 31, 20x8. Using Black-Scholes option pricing model, the imputed value of each option on January 1, 20x1 was $3. No compensation expense associated with stock option grants was charged to net income during 20x3.

Options outstanding at the start of the year New options grander Options exercised Options forfeited/expired Options outstanding end of year

# of Options 200,000 0 120,000 0 80,000

Ave. Exercise Price $25 $25 $25

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