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)

1
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.

2
 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)

- Expense the FMV figure over the period that the options vest

- 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).

4
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.

5
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) = 5,018,663

800,000 x PVA(9% ; 8) = 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 = 9,446,518 x 9% x 6/12 x 30% = 127,528

Interest payable = 10,000,000 x 8% x 6/12 x 30% = 120,000
Discount amortization = 127,528 – 120,000 = 7,528

Interest expense 127,528

Discount 7,528
Interest payable 120,000

6
June 30, 20x3 – cont.

Market Value Method Book Value Method

Bonds Payable 3,000,000 3,000,000

Interest payable 120,000 120,000
Discount 158,517* 158,517*
Conversion feature 252,530** 252,530**
Common shares 3,375,000*** 3,214,013
Loss 160,987

* (553,482 x 30%) – 7,528

** 841,766 x 30%

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

7
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 10,000,000

Premium 836,6222
Interest payable 66,6671
Warrants 500,0003
Conversion feature 596,7114
Total Proceeds 12,000,000
1
$10,000,000 x 8% x 1/12
2
10,903,289 – 10,000,000 – 66,667
3
($10,000,000/$1,000) x 10 x $5
4
Plug

February 1
DR Cash 12,000,000
CR Bonds Payable 10,000,000
CR Premium 836,622
CR Interest payable 66,667
CR Contributed surplus – warrants 500,000
CR Contributed surplus – conversion feature 596,711

8
June 30
DR Interest exp. 270,916 **
DR Interest payable 66,667
DR Premium 62,417
CR Cash 400,000 *

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

July 1
DR Cash 40,000*
DR Contributed surplus – warrants 10,000**
CR Common shares 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.

9
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
300,000
Contributed Surplus–Stock Options
300,000

December 31, 20x2

Compensation Expense
300,000
Contributed Surplus - Stock Options
300,000

March 31, 20x3

Cash
3,000,000
Contributed Surplus–Stock Options
Common Shares 360,000
3,360,000

10
 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.

# of Options Ave. Exercise Price

Options outstanding at the start of the year 200,000 $25
New options grander 0
Options exercised 120,000 $25
Options forfeited/expired 0
Options outstanding end of year 80,000 $25

11