Kế toán, kiểm toán - Chapter 16: Complex financial instruments

CHAPTER 16:COMPLEX FINANCIAL INSTRUMENTS2CHAPTER 16: Complex Financial InstrumentsAfter 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 IFRS and APSE, and what changes are expected in the near future.3Financial InstrumentsFinancial instruments: contracts that create both a financial asset for one party and a financial liability or equity instrument for the other partyFinancial instruments can be primary or derivativePrimary financial instruments: include most basic financial assets and financial liabilities such as receivables and payables, and equity instruments such as shares4DerivativesDerivatives are financial instruments that create rights and obligations that transfer financial risk from one party to the another partyDerivatives have the following characteristics:Their value changes in response to the underlying instrument (the “underlying”)2. They require little or no initial investmentThey are settled at a future date5DerivativesDerivative instruments include:OptionsForwardsFuturesExample: 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 worthless6Derivatives – Financial RisksDerivatives are used to manage financial risks:Credit RiskRisk to one party that the other party will fail to meet an obligationLiquidity RiskRisk of not being able to meet own financial obligationMarket RiskRisk 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) 7DerivativesUsed byProducers and ConsumersLock in future revenues or costsSpeculators and ArbitrageursGenerate cash profit from tradingMaintain market liquidityAdditional motivations to use derivativesManage interest rate volatilityManage foreign exchange rate volatility8Accounting for DerivativesBasic principles of accounting for derivatives: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 contractDerivatives should be reported at fair value (most relevant)Gains and losses should be recorded through net incomeSpecial accounting is used for items that have been designated as being part of a hedging relationship. This is covered in Appendix 16A9Non-Financial Derivatives and Executory ContractsExample of non-financial derivatives: contract to buy steel at a specified date for a specified priceAre purchase commitments (executory contracts) “derivatives”?Value changes with value of the underlying No investment up frontSettled in future10Executory ContractsUnder IFRSNot 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 measureRecognized when goods received11Options and WarrantsOptions-gives the holder a right to acquire/sell underlying instrument at a fixed priceCall OptionHolder has the right, but not the obligation, to buy the “underlying” at a preset (strike or exercise) pricePut OptionHolder has the right, but not the obligation, to sell the “underlying” at a preset price12Framework for OptionsCall – right to buyPut – right to sellWrittenSell option for $:Transfer rights to buy shares/underlyingSell option for $:Transfer right to sell shares/underlyingPurchasedPay $ for option:Obtain right to buy shares/underlyingPay $ for option:Obtain right to sell shares/underlying13Options – ExampleGiven:Call option entered into January 2, 2017Option expires April 30, 2017Option to purchase 1,000 shares at $100 per shareShare market price on January 2, 2017 is $100 per shareOption is purchased for $400 (Option Premium)Share price on March 31st is $120 per shareOptions traded at $20,100 on March 31, 2017Option settled in cash on April 1, 2017Prepare the journal entries14Options – ExampleOption Price FormulaOptionPremium=IntrinsicValue+TimeValueMarket Price lessStrike (Exercise)PriceOption ValueLessIntrinsic ValueOptionPremium=($100 - $100)+($400 - $0)15Options – ExampleJanuary 2 (acquisition date)Derivatives–Financial Assets 400 Cash 400March 31 (to record change in value of option)Derivatives–Financial Assets 19,700* Gain 19,700Assume options are trading at $20,100*(20,100 – 400)April 1 (cash settlement of option)Cash 20,000Loss 100 Derivatives–Trading 20,100Time Value lost through cash settlement before expiry = $20,100 less intrinsic value of $20,00016ForwardsUnder a forward contract, parties each commit upfront to do something in the future (obligation)The price and time period are locked in under the contractTherefore, forward contracts are specific to the transacting parties andForwards generally do not trade on exchangesBanks are usually involved in forward contractsForwards are measured at the present value of any future cash flows, discounted at a rate that reflects risk17Forwards – ExampleGiven: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 Bond BankAbalone 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 dateThis forward contract transfers the currency risk inherent in the Canada-U.S. exchange rateUpon inception, the value of the contract is zero so no journal entry would be recorded18Forwards – 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 AbaloneThe forward is remeasured at fair valueFor example, if the fair value of the contract is $50, on January 5, 2017, the journal entry is: Derivatives–Financial Assets/Liabilities 50 Gain 5019Forwards – Example If the U.S. dollar declines, in general, this particular contract would create a loss for AbaloneThe journal entry to record the loss must also reverse the original gain of $50For example, if on January 31 the fair value of the contract now creates an overall loss of $30: Loss 80 Derivatives–Financial Assets/Liabilities 8020Forwards – Example Forward contracts can be settled on a net basis or in cashAssume that on the settlement date of February 1, the U.S. dollar is worth $1.05The following journal entry would be required to settle the contract on a net basis: Loss 70 Derivatives–Financial Assets/Liabilities 30 Cash 100* * $1,000 (1.15 - 1.05)21Forwards – Example The following journal entry would be required to settle the contract on a cash basis: Cash 1,050* Loss 70 Derivatives–Financial Assets/Liabilities 30 Cash 1,150** * $1,000 x 1.05 ** $1,000 x 1.1522FuturesFutures are similar to forwards except:They have standardized amounts and datesThey are exchange traded and have ready market valuesThey are settled through clearing housesThere is a requirement to put up collateral23Futures – Example Given:Forward Inc. entered into a futures contract to sell grain for $1,000Initial margin of $100 cash is requiredThis is a non-financial derivative because the underlying is grain (a non-financial commodity)Record the journal entries for this contract24Futures – Example The contract is valued at zero at inception however the margin deposited with the broker must be recorded as follows: Deposits 100 Cash 10025Futures – 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 $50This also required an additional margin deposit of $50The required journal entries would be: Loss 50 Derivatives–Financial Assets/Liabilities 50 Deposits 50 Cash 5026Futures – 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 100 Derivatives–Financial Assets/Liabilities 50 Deposits 150The loss on the contract has already been recorded in the previous journal entries thus only the net settlement of $50 cash is recorded27Derivatives Involving Entity’s Own SharesCompanies can enter into derivative contracts with their own shares:OptionsPurchased call or put optionsWritten call or put optionsForwardsTo buy entity’s own sharesTo sell the entity’s own sharesThis creates a presentation issue28Derivatives Involving Entity’s Own SharesUnder IFRS, any contracts that are for a fixed number of shares for a fixed amount are generally presented as equityThis is referred to as the “fixed for fixed” principleThere are generally two exceptions:The derivative creates an obligation to settle in cash or other assetsThe derivative allows a choice in how the instrument is settledASPE is silent on this matter but general principles support equity presentation29Complex Financial InstrumentsOver the years, hybrid/compound have been created in order to profit from the best attributes of debt and equity instrumentsThese instruments have characteristics of both debt and equityExample: convertible debt, or debt with detachable warrants30Presentation and Measurement of Hybrid/Compound InstrumentsTo determine appropriate presentation, the following must be considered: Contractual termsEconomic substanceDefinitions of financial statement elements31Definitions RevisitedFinancial 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, or2. Exchange financial instruments with another party under conditions that are potentially unfavourableIFRS explicitly includes instruments settled using variable number of shares as financial liabilitiesThis is supported by ASPE but is not part of the definition 32Definitions RevisitedAn equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilitiesIFRS provides additional guidance when instruments are settled through own sharesSee Illustration 16-7 for specific examples33Presentation and Measurement of Hybrid/Compound InstrumentsFinancial instruments can be shown on a net basis on the statement of financial position if:There is a legally enforceable right to offset andThe company intends to settle the instruments on a net basis or simultaneously34Measurement of Hybrid/Compound InstrumentsEconomic value stems from both the debt component and the equity componentTwo general approaches:Residual value method (or incremental method)Relative fair value method (or proportional method)IFRS requires the use of residual method (with debt valued first)ASPE allows equity component to be valued at zero, or the use of residual method (with component that is easier to measure being valued first)35Convertible DebtBonds that are convertible to other forms of securities (e.g., common shares) during a specified period of timeCombines the benefits of a bond (interest payments, principal repayment) with the privilege of exchanging the bond for shares at the bondholder’s optionOnce the bond is converted, all interest and principal no longer payable36Convertible Debt Convertible debt is issued for two main reasons:Corporation can raise equity capital without giving up unnecessary ownership controlIt can also achieve equity financing at a lower costConversion feature allows the corporation to offer a lower interest rate because it provides the investor with an opportunity to own equity37Convertible DebtThe reporting of convertible debt and the conversion feature result in three issues:Reporting at the time of issuanceReporting at the time of conversionReporting at the time of retirement38Convertible Debt — ExampleGiven:3 year, $1,000,000 par value, 6% convertible bondsSimilar bonds (without conversion feature) have a 9% interest rateEach $1,000 bond convertible to 250 common shares (current market price of $3)What portion of the proceeds are allocated to BondLiability, and what portion to equity?39Convertible Debt — ExampleTotal proceeds at par = $ 1,000,000Fair value of the liability without theconversion option (PV at 9%) = $ 924,061Incremental value of option $ 75,939Journal entry at issuance: Cash 1,000,000 Bonds Payable 924,061 Contributed Surplus – Conversion Rights 75,93940Convertible Debt — ExampleConversion before maturity - assume that the unamortized portion is $14,058 therefore, book value of Bonds Payable is 1,000,000 – 14,058 = 985,942The entry to record the conversion using the book value approach would be:Bonds Payable 985,942Contributed Surplus - Conversion Rights 75,939 Common Shares 1,061,88141Convertible Debt – Induced ConversionWhen the corporation wants to entice or induce the bondholders to convert their bonds into sharesAdditional 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)42Convertible Debt — ExampleAssume 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 972,476Loss on Redemption of Bonds 8,986Contributed Surplus – Conversion Rights 75,939*Retained Earnings (15,000 – 8,986) 6,014 Common Shares 1,048,415 Cash 15,000* Calculated previously using Incremental Method43 Convertible Debt – Normal RetirementNormal retirement is treated the same as debt retirement from Chapter 14 for non-convertible bondsClear the bonds payable and any outstanding premiums, discounts, bond issue costs, interest accrued to bondholdersEquity component remains in Contributed Surplus44Convertible Debt – Early RetirementEarly retirement Clear the bonds payable and any outstanding premiums, discounts, bond issue costs, interest accrued to bondholdersThe conversion rights must be zeroed outThe loss on early retirement is allocated between the debt and equity portion45Convertible Debt – Early Retirement ExampleAssume that Bond Corp. decides to retire the convertible debt early and offers the bondholders $1,070,000 cashBonds Payable 972,476Expense – Debt Retirement 8,986Contributed Surplus – Conversion Rights 75,939Retained Earnings 12,599 Cash 1,070,00046Interest, Dividends, Gains/LossesThe related interest, dividends, gains, and losses must be consistently treated as the financial instrument they relate toExample: term preferred share presented as a liabilityrelated dividends would be recorded as interest expense (or dividend expense) and charged to the income statement (instead of Retained Earnings)47Share-Based CompensationStock compensation plans are used to remunerate or compensate employees for services providedThis allows a more long-run focus in a company’s compensation plan48Types of Compensation PlansCompensatory stock option plans (CSOPs)Direct awards of stockStock appreciation rights plans (SARs) (Appendix 16B) Performance-type plans (Appendix 16B)49Uses of Stock OptionsStock OptionsIssued by the companyIssued by others e.g.,financial institutionsOptions/WarrantsOtherESOPCSOPNot traded onExchange since mustBe employee to holdNot traded onExchange sinceRights usually nottransferableOften exchangetraded50Compensatory vs. Non-Compensatory PlansStock OptionsNon-compensatoryESOPCompensatoryCSOPIncome StatementShareholders’EquityOperating transactionsCapital transactions51Compensatory vs. Non-Compensatory PlansFactors to determine if a plan is compensatory:Option termsNon-standard terms implies compensatoryDiscount from market priceImplies compensatoryEligibilityIf available to only a certain group of employees (i.e., management)52Non-Compensatory - ExampleFanco Limited set up an ESOP that gives employees the option to purchase shares for $10 per shareOn January 1, 2016, employees purchase 6,000 options for $6,000: Cash 6,000 Contributed Surplus-Options 6,000If employees exercise all 6,000 options: Cash (6,000 x $10) 60,000 Contributed Surplus-Options 6,000 Common Shares 66,00053Compensatory Stock Option PlansTwo accounting issues associated with stock compensation plansDetermination of compensation expensePeriods of allocation for compensation expense amounts 54Compensatory Stock Options Plans- Important DatesGrant dateOptions are granted toemployeeWorkstart dateVesting dateDate that employeecan firstexerciseoptionsExercisedateEmployeeexercisesoptionsExpirationdateUnexercisedoptionsexpire55Compensatory Stock Options PlansCompensation Expenseis determined as of the measurement date and is allocated overthe 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 56Compensatory Stock Options Plans- ExampleOn November 1, 2017, Chen Corp. approves a plan to grant five executives options to purchase 2,000 shares each. The options are granted on January 1, 2018The option price per share is $60The fair value, determined by an option pricing model, results in compensation expense of $220,000Assuming expected period of service is two years, journal entries at year end for 2018 and 2019: Compensation Expense 110,000 Contributed Surplus–Stock Options 110,000 ($220,000 / 2)57Compensatory Stock Options Plans- ExampleIf 20% or 2,000 of the 10,000 options were exercised on June 1, 2021, the journal entry is: Cash (2,000 x $60) 120,000 Contributed Surplus–Stock Options 44,000 (20% x $220,000) Common Shares 164,000If the remaining stock options are not exercised before their expiration date, the journal entry is: Contributed Surplus–Stock Options 176,000 Contributed Surplus–Expired Options 176,000 (80% x $220,000)58Direct Awards of StockNonmonetary reciprocal transactionLittle or no cash involvedTwo-way transactionthe company gives something up (shares) and gets the employee’s services in returnRecorded at fair value of the shares (the asset given up)59Disclosure of Compensation PlansFollowing is fully disclosed:Accounting policy usedDescription of the plans and modificationsDetails of number and values of options issued, exercised, forfeited, and expiredDescription of assumptions and methods used to determine fair valuesTotal compensation cost included in net income/contributed surplus, andOther60Looking AheadThere are a number of projects that are expected to simplify and promote consistent application of accounting standards for financial instrumentsThe IASB issued a Discussion Paper on macro hedging in 2014 entitled Accounting for Dynamic Risk Management: A Portfolio Revaluation Approach to Macro HedgingThe AcSB issued an Exposure Draft in 2014 entitled Redeemable Preferred Shares Issued in a Tax Planning Arrangement61