Complex Financial Instruments

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COMPLEX FINANCIAL INSTRUMENTS

1. Complex securitiesIs 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 examinedto 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 afinancial 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 withanother party under potentially favorable conditions(e.g., forward contract)(iii) an equity instrument of another entity (e.g., tradingsecurities)

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

(e.g., forward contract).

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

ISSUES:Identify a Complex InstrumentRecording the issuance of complex debtValuation of warrants

Valuation of conversion privilegesRecording securities issued on conversionsIssuing 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 thenallocate the residual proceeds on the sale to the remaining component.

Proportional method

- Value each component separately and allocate total proceeds based onrelative 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 conversionValuation of warrants - done when issued

Valuation of conversion privileges of debt

Book Value ApproachConversion recorded at book value of bonds and conversion rights

Market Value ApproachNew securities recorded at market value.


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Do questions 1,2

6. RetirementMaturity 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 aspecified 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. expenseCr. Share Cap.

8. DatesWork startGrant date Option granted to employeeVesting date Date employee can first exercise the optionsExercise date Employee exercises optionsExpiration date Unexercised options expire

9. How should stock options be accounted for?

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

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

- No further income statement impact when stock options areexercised and shares are issued

Do question 3


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10. What are derivatives?

A contract between two (or more) parties that transfers some type of financialrisk from one party to another. The contract has little or no upfront cost and itwill 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/liabilitys value will change

Example: A foreign exchange contract (derivative) between: a Canadiancompany that sells goods to US customers, and a bank or other financialinstitution (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 thestrength of the $USD will fall between now and the date of collection (i.e., thereceivable will be worth less in $CDN funds). Therefore, the company entersinto 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, thenthe company loses (i.e., in retrospect it should not have entered into thecontract). The point is that the company may not wish to take a chance onfluctuating 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 jetfuel. In order to fix the price that it pays for fuel, AC enters into a contractwith a bank (counter party). Under this arrangement, a fixed price per gallonand a settlement date are determined and agreed upon. Normally thesettlement date will coincide with ACs expected purchase date). If the priceof jet fuel increases between now and settlement, then AC will receive thedifference between the market (spot) price and the contract price (i.e., AC ishappy). If the price of jet fuel decreases between now and settlement, thenAC 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 aderivative other than to increase the expected return of an investmentportfolio).

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 - ConversionOn January 1, 20x1, Left issued $10 million of 8% convertible bonds (paysinterest annually on Dec. 31). The bonds had a life of 10 years and each $1,000bond was convertible into 25 shares of Left's common shares. Right purchasedthe 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 soldfor $9,358,234 (a yield of 9%). On June 30, 20x3, Right converted 30% of thebonds to common shares. Assume that accrued interest since December 31,20x2, had not been paid by Left. At the time of conversion, Lefts shares wereselling 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 theincremental method to value the bonds conversion feature.

January 1, 20x1:Cash 10,200,000Bonds Payable 10,000,000Discount 641,766Contributed 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) = 5,018,663800,000 x PV

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

Interest expense 127,528Discount 7,528Interest payable 120,000


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June 30, 20x3 cont.

Market Value Method Book Value Method

Bonds Payable 3,000,000 3,000,000Interest payable 120,000 120,000Discount 158,517* 158,517*Conversion feature 252,530** 252,530**Common shares 3,375,000*** 3,214,013Loss 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 - AllocationOn February 1, 20x1, Corleone Ltd. issued a $10 million, 5 year, 8% bond withsemi-annual interest paid each June 30 and December 31. Due to unexpecteddelays, the bond was issued one month late. Each $1,000 bond can beconverted into 50, no par value common shares. In addition, each $1,000 bond

came with 10 detachable common share warrants that allow the holder topurchase common shares at an exercise price of $20. Immediately afterissuance, these warrants were being traded at $5 each. If the bonds did not havedetachable warrants or a conversion feature, they would have sold for$10,903,289 (including accrued interest for the month of January) which equatesto an annual yield of 6%. Instead, gross proceeds of $12,000,000 were receivedon the sale on February 1.

On July 1, 20x1, 2,000 of the warrants were exercised. On this day, the commonshares were trading at $40.

Required:Prepare the journal entry on the date of the bonds issuance and on June 30.Assume that the company uses the incremental method to allocate bondsproceeds to each of the features.

Bonds payable 10,000,000Premium 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 1/122 10,903,289 10,000,000 66,6673 ($10,000,000/$1,000) x 10 x $54 Plug

February 1DR Cash 12,000,000

CR Bonds Payable 10,000,000CR Premium 836,622CR Interest payable 66,667CR Contributed surplus warrants 500,000CR Contributed surplus conversion feature 596,711


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June 30DR Interest exp. 270,916 **DR Interest payable 66,667DR 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 1DR 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 areexercised. This is because cash is part of the consideration received. On theother hand, when there is a conversion of bonds or preferred shares to commonshares (i.e., no cash trading hands), then the company can record the commonshares either at market value or book value.


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Question #3 Stock Option AccountingOn January 1, 20x1, Brigante Inc. granted stock options to officers and otheremployees for the purchase of 200,000 of the companys no-par value commonshares at $25 each.

The options were exercisable within a five-year period beginning January 1, 20x3by grantees still in the employ of the company, and they expire December 31,20x8. The market price of Brigantes common shares was $20 per share at thedate 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 ofcommon shares was $40 per share.

Using the Black-Scholes option pricing model, the estimated fair value of eachoption on January 1, 20x1 was $3.00.

Required:Account for the options using the fair market value method. Assume that thecompany has a December 31 year end.

December 31, 20x1Compensation Expense

Contributed SurplusStock Options300,000

300,000

December 31, 20x2

Compensation ExpenseContributed Surplus - Stock Options 300,000300,000

March 31, 20x3CashContributed SurplusStock Options

Common Shares

3,000,000

360,0003,360,000


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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 thepurchase of 200,000 of the companys no-par value common shares at $25 each.

The options are vested and became exercisable, beginning January 1, 20x3, bygrantees still in the employ of the company. All of the options are due to expireon December 31, 20x8. Using Black-Scholes option pricing model, the imputedvalue of each option on January 1, 20x1 was $3. No compensation expenseassociated with stock option grants was charged to net income during 20x3.

# of Options Ave. Exercise PriceOptions outstanding at the start of the year 200,000 $25New options grander 0Options exercised 120,000 $25Options forfeited/expired 0

Options outstanding end of year 80,000 $25

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Complex Financial Instruments