14.8 Chapter Summary

LO 1: Describe complex financial instruments and their role in accounting and business.

Companies obtain cash resources for future business operations and opportunities from internally generated free cash flow, from borrowing from a creditor (debt), and from investors through issuing shares. Historically, debt and equity sources were separate instruments. However, in recent decades hybrid (or complex) instruments that include both debt and equity attributes are now available to businesses. Examples include convertible bonds, convertible preferred shares, and various derivatives (such as options and warrants) all of which can be converted into common shares. These instruments are often simpler, cheaper, and quicker to obtain, and they offer greater flexibility and security to investors because of the embedded convertible options to common shares. These complex instruments also influence the perceptions of shareholders and the marketplace. As investors will only convert from the original instrument to common shares if it is favourable to do so, they send a positive signal to existing shareholders that the company is performing well. The issue from an accounting perspective is how to separate, classify, and value the debt and equity attributes during the instrument’s life cycle of issuance, conversion, and retirement.

LO 2: Describe the basic differences in the accounting treatments for long-term debt and equity.

For complex financial instruments, once an acceptable method to separate the debt from the equity is determined, each component will follow its respective accounting standard as discussed in previous chapters. As such, it is important to understand the basics of debt and equity instruments so that the classification and amounts reported reflect their true underlying economic substance, rather than simply their legal form. For example, equity is measured and reported at historic cost and represents unsecured permanent capital of the company. As a return on their investment, shareholders receive a share of the profits through dividends, which are optional and not subject to income taxes for the company. Long-term debt consists of principal and interest expense, which must be paid when due and is secured by company assets. The debt has a negative effect on company liquidity and solvency ratios, and the interest expense reduces company income taxes. There are differences between IFRS and ASPE regarding amortization of methods and some disclosures of long-term debt.

LO 3: Describe the two methods acceptable to IFRS and ASPE to separate, classify, measure, and disclose complex financial instruments such as convertible debt and convertible preferred shares.

IFRS uses only the residual method for the accounting treatment of convertible debt, such as convertible bonds and preferred shares. This method estimates and allocates the fair value of the most reliable component first, usually the debt component. The residual amount remaining is allocated to the equity component. For the debt component, the valuation is based on the present value of the future cash flows using the prevailing market interest rate at issuance. In contrast, ASPE uses both the residual method and the zero-equity method. The zero-equity method assigns the full value to the debt component and a zero value to the equity component.

These methods are applied at the time of issuance for convertible debt, such as bonds that are issued at par or at a premium or discount. Bonds are subsequently measured at amortized cost. Bonds that are converted to common shares use the book value method to determine the valuations. The book value method uses the carrying values of the debt and contributed surplus at the time of conversion to determine the common shares amount (IFRS and ASPE). Since carrying values are the basis for the conversion, no gains or losses are recorded.

Convertible debt can also be retired prior to maturity, usually with an incentive, also known as a sweetener. This is used to motivate the bondholders to sell the debt back to the company or to convert their bonds into common shares. Both the amounts paid to the bondholders and the sweetener must be allocated between the debt and equity components. Because of the additional proceeds added as an incentive, gains or losses will occur. The sum of the gain or loss from the redemption of the bonds, and the proportionate share of the contributed surplus, must be equal to the additional proceeds paid as a sweetener. Disclosures of convertible debt, or convertible preferred shares, are the same as disclosures of other debt and equity instruments and securities. The determination of the classification, as either a liability or equity, is based on whether the company has any control over whether an obligation will arise from these convertible instruments. In cases where there is little or no control over the obligation, the transactions are reported as a liability (IFRS) or if the obligation is only highly likely (ASPE).

LO 4: Describe various derivatives such as options, warrants, forwards, and futures.

Options, warrants, forwards, and futures are all examples of derivatives. They are valued based on of the fluctuations in some underlying instrument, object, index, or event. If these derivatives have their own value, they can be bought and sold privately, or through the marketplace. Businesses will buy or sell to minimize risk (hedging) or to make a profit (speculation). An example of hedging can be seen in how companies handle the fluctuations in foreign exchange currency. For example, companies can obtain a derivative contract that locks in the exchange rate to manage these fluctuations, thereby hedging their risk. Options are another derivative that gives the options holder the right to purchase or sell common shares in a company at a specified price. The right to purchase common shares at a specified price is called a call option, for example employee stock options; whereas, the right to sell common shares at a specified price is called a put option. In either case, this will only occur if the specified price is favourable compared to the market price. Warrants have characteristics like options. Forward and future contracts are typically used to buy and sell any type of commodity, including currencies. In the case of a forward contract, once both parties agree on the terms the contract becomes binding. A futures contract is like a forwards contract except that it is standardized regarding price and maturity dates, allowing them to be bought and sold in the stock markets. Commodities such as agricultural products and precious metals are examples of futures contracts. Generally, derivatives are subsequently measured at their fair value with a gain or loss reported in net income, except for derivatives that relate to a company’s own shares, which are at historic cost.

LO 5: Explain the accounting treatments and reporting requirements for stock options plans.

An employee stock option plan (ESOP) allows employees to purchase shares of the company at a specified price, generally offered as a reward by the company to the employee. As these employees are investing in the company, the proceeds of their shares purchases are recorded to equity. In contrast, a compensatory stock option plan (CSOP) is generally offered to key executives as part of their remuneration package. Their shares entitlement is accrued to compensation expense as earned. Stock appreciation rights (SARs) are an example of compensation based plans where compensation is paid based on the movement of the common shares price, but no actual shares are bought or sold. Performance-based plans use other performance indicators, such as growth in sales, as a basis for compensation. Required disclosures of compensation plans are extensive and include a description of the plan, the assumptions and methods used, and various other data such as the dollar values of the options issued, exercised, forfeited, and expired.

LO 6: Recall that analyses of complex financial instruments use the same techniques as those used in non-convertible debt and equity instruments.

LO 7: Explain the similarities and differences between ASPE and IFRS regarding recognition, measurement, and reporting of complex financial instruments.

While IFRS and ASPE are quite similar in this case, differences do remain. For example, regarding the issuance of complex financial instruments, ASPE provides the choice of either the residual method or the zero-equity method, whereas only the residual method is accepted for IFRS. Also, those instruments with contingent liabilities are treated as a liability for IFRS, but are only treated as such with ASPE if the contingency is highly likely. For options forfeitures in a CSOP, ASPE allows a policy choice to measure forfeitures upfront as a change in estimate or later, as they occur; whereas with IFRS, these must be measured upfront.