IFA 2 - Chapter 14 - Financial Instruments

substance over form

a phrase used to express that in accounting for financial instruments, it is more important to consider the substance (what that instrument is comprised of) over the legal form of the instrument on the contract

for example: a convertible loan’s legal form is debt but if it has a convertible aspect, then we must consider this substance and book part of it into equity as well

financial innovation

ongoing development of financial products designed to achieve particular client objectives

usually done by banks

3 major types of financial instruments

(1) basic financial asset, liability, and equity instruments

(2) derivatives

(3) compound financial instruments (CFIs)

financial liabilities can be accounted for using

(1) amortized cost - for most financial liabilities and for non-financial companies

(2) fair value through profit or loss (FVPL) - for liabilities designated at FVPL

derivative

a financial instrument that is derived from some other underlying quality

underlying quality

value of an asset, index value, or an event that helps determine the value of the derivative

it does not have to be financial in nature

for example: the underlying quality could be a prediction of how much rain Montreal will receive

derivates are used to:

hedge or to speculate

i.e. try to transfer risk from one party to another

hedging

uses derivatives to mitigate a perceived risk

speculation

tries to profit from an identified risk

credit risk

risk to one party that the other party will fail to meet an obligation (ex. risk to the bank that you will fail to repay your outstanding loan balance)

liquidity risk

risk of being unable to meet your own financial obligations

market risk

risk 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 risks)

currency risk

risk due to changes in foreign exchange rates

interest rate risk

risk due to changes in interest rates

other price risks include

commodity price fluctuation, oil price fluctuations, etc.

5 common types of derivates

(1) options

(2) warrants

(3) forwards

(4) futures

(5) swaps

option

a derivative contract that gives the holder the right, but not the obligation, to buy or sell an underlying financial instrument at a specified price

includes call and put options

call option

gives the right to buy the underlying financial instrument - most common type of option

• includes employee stock options

put option

gives the right to sell the underlying financial instrument

out-of-the-money

when an option is out of the money it means the value of the underlying instrument in an option contract is unfavorable compared to just letting the option expire

in-the-money

when an option is in the money it means that the value of the underlying instrument in an option contract is favorable to the holder exercising the option, compared to letting the option expire

• note: this does not mean the option is profitable b/c you might make less than you paid for the option but you will make money as opposed to losing it just from exercising

the value of an option has two parts:

(1) intrinsic value

(2) the time value

intrinsic value

in a all option, it is the greater of zero (value if you do not exercising the option) and the difference between the market and strike price (value if you do exercise the option) → variable

time value of an option

portion of an option’s value that reflects the probability that the future market price of the underlying will exceed the strike price → constant

strike price

the price at which the option allows you to purchase (or sell) the underlying financial instrument

employee stock option

an option a company issues to its employees, giving them the right to buy shares in the enterprise at a pre-specified strike price (usually higher than current strike price) and usually not exerciseable for a period of time (vesting period)

warrants

the right but not obligation to buy a share of the issuing company at a specified price over a specified period of time

• can be considered a call option but my own shares as a company are the underlying financial instrument

• typically have a longer time to maturity when compared to options

these are sweeteners - they are often issued in combination with other financial instruments

• a company may not want to give you more money for X shares but they may be willing to give you more money for X shares and a warrant

• opens up the opportunity for staged financing

forward

a contract in which one party commits upfront to buy or sell something at a defined price at a defined future date

• no choice in the purchase or sale (unlike an option)

very specific and customizable terms, very flexible compared to futures

forwards are only possible when..

parties have different expectations or risk tolerances about future price changes.

• meaning, you either think the price will change in your favor OR you want to secure a certain future price so bad that you’re willing to lose out on potential savings if the value goes down

futures

similar to a forward but the contract is written in more standardized terms

• less custom than forwards - might not match exactly what I need when I need it

Involves commonly traded items like commodities and currencies

where do futures trade

in organized markets

swaps

a swap is a derivative contract in which two parties agree to exchange cash flows

• dependent on one party wanting the cash flow of another party

compound financial instruments

when the instrument has more than one underlying financial instrument components that come together into one compound financial instruments

• includes convertible bonds or bundled shares with warrants, and more

two benefits of a convertible bond being converted

• you save on repayment of the bond

• free up borrowing room

conversion features and warrants are used as..

sweeteners and opportunities for staged financing down the line

why are CFIs suitable and commonly used when operational uncertainty is high (for start-ups and mining)

because of moral hazard - they allow investors to be able to observe for a period before deciding whether they wish to exercise their rights to additional shares/investment

moral hazard

a facet of information asymmetry which says that individuals may behave differently than they said they would when they are unsupervised and have control

why do convertible bonds signal better than equity

convertible bonds signal better to investors than equity because they show that you expect your equity to grow a lot and thus are not willing to give it up right now because the cost of doing so would be much higher than the cost of borrowing

T/F: A compound financial instrument can be comprised of components that are both equity and liabilities

True!

redeemable/retractable preferred shares

CFI

give the holder an option to redeem (sell back) shares at some point in time at the fixed date of redemption

this is basically debt so it is treated as such

• for example, the dividends on retractable preferred shares (which we deem as debt) would be recorded as an interest expense and go through the income statement instead of retained earnings

Accounting for - FVPL investments

always measured at fair value and value changes are recorded through the income statement

accounting for - dividends that relate to the entity’s own equity

recorded at historical cost

Call options JEs (purchase, year end, and option expiry or exercise )

purchase:

• Dr. Cash

  • Cr. Liability for call options issued

Year end:

if FMV went up

• Dr. Liability for call options issued

  • Cr. Gain on call options issued

If FMV went down

• Dr. Loss on call options issued

  • Cr. Liability for call options issued

At option expiry:

• Dr. Liability for call options issued

  • Cr. Gain on call options issued (would not expire if they were in-the-money for holder)

At exercise (net cash settled):

• Dr. Loss on call options issued

• Dr. Liability for call options issued

  • Cr. Cash

CFIs - at issuance

separate and account for each component separately (unless they are both equity)

We can either use the proportional method, incremental method (recommended by IFRS and ASPE), or the zero-common equity method (also permitable under ASPE)

proportional method

estimate fair value of each component and allocated proportionately

incremental method

(also known as the residual value method) - estimate the fair value of each component and allocate in descending order of reliability of fair value estimate. The least reliably estimated component will be allocated the remaining value

• note: market value over an estimate will always be more reliable

zero common equity method

assign zero value to the common equity component

how are transaction costs related to issuance of CFIs treated

transaction costs directly related to issuance are allocated to debt and equity on a prorata basis

• this impacts the EIR of the components by changing the issuance costs of the individual components as they will have lower individual issuance costs than if all allocated to one coponent

CFIs - Measurement at balance sheet date

Not complex → just apply the regular accounting treatment related to each individual component.

For example: for a convertible bond

• the financial liability for the bond is at amortized cost

• the contributed surplus for the conversion option (type C) in equity at historical cost

CFIs - accounting for the exercise of options/warrants on convertible instruments

extinguish the financial instrument in exchange for the issuance of common shared

amount added to common shares = cash received or debt forgiven + amount removed from contributed surplus

for convertible elements two methods are available:

• book value: no gain/loss on conversion (REQUIRED by both ASPE and IFRS)

• market value: difference recognized in net income

CFIs - convertible bond JEs

At issuance:

• Dr. Cash (actual cash received)

  • Cr. Bond payable (amount bond would have sold for without conversion rights)

  • contributed surplus - conversion rights (residual amount)

before we can record the conversion, we will need to calculate the bond payable balance (using our financial calculator an adjusting N)

At conversion:

• Dr. Bonds Payable (remaining BP discussed above)

  • Cr. Contributed surplus - conversion rights

  • Cr. common shares

if only a % of the shares are converted, only include that portion and prorate everything

How do stock compensation plans align employee and company interest?

(1) typically offered to people making strategic decisions so that they have some “skin in the game:

(2) good way to attract very experience/talented employees without needing to pay them a huge cash salary

(3) good way to retain employees

(4) Raises cash when exercised

(5) increases demand for shares

two common types of stock compensation plans

• employee stock options

• Stock appreciation rights (SARs)

employee stock options - how to value

to value an employee stock options, use fair value of stock options at grant date (the day options are granted)

• like other options the fair value is comprised of the intrinsic value and the time value

employee stock options - expense recognition

value of the stock option is determine on the grant date and allocated forr the employer as an expense over the vesting period

if the option can be exercised immediately (no vesting period) than it should be fully expense in the period granted

vesting period

minimum time option must be held before it can exercised

employee stock options - JEs

at issuance

• Dr. Compensation expense (value @ grant date / vesting period)

  • Cr. Contributed surplus - employee stock options

each financial reporting period until end of vesting period

• Dr. Compensation expense (value @ grant date / vesting period)

  • Cr. Contributed surplus - employee stock options

If options are exercised

• Dr. Cash

• Dr. Contributed Surplus

  • Cr. Common Shares

If options expire

• Dr. Contributed surplus - employee stock options

  • Cr. contributed surplus - expired employee stock options

employee stock appreciation rights

employee receives the difference between the market price at the settlement date and the benchmark price (kind of like strike price)

if the share price increases, SARs may be settled in

(1) cash

(2) cash or shares at the option of the employer

(3) cash or shares at the option of the employee

Would be specified in compensation agreement

because a SARs is a liability, it is accounted for at

FVPL - this means that expense is adjusted for price changes during the exercise period

(as opposed to an option that is an equity instrument)

ASPE vs IFRS - SARs expense amount

IFRS: expense SARs based on the fair value of SARs

ASPE: expense is based on the market price of SARs

IFRS - to determine a periods compensation expense

(1) calculate percentage to accrue

• = time since grant date/vesting period

(2) calculate liability at the period’s end

• = fair value of SARs x number of SARs x percentage to accrue

(3) compare liability at period’s end to period’s beginning and record adjustment

employee stock appreciation rights - JEs

if liability increased:

• Dr. Compensation expense

  • Cr. Liability for SARs

if liability decreased:

• Dr. Liability for SARs

  • Cr. Compensation expense

When value remains unchanged:

• no entry needed

When SARs are exercised CS:

• Dr. Liability for SARs

• Dr. Cash

  • Cr. Common Shares

When SARs are exercised Cash:

• Dr. Liability for SARs

  • Cr. Cash

ASPE vs. IFRS - initial recognition of compound financial instruments

IFRS: use the residual value method

ASPE: use the residual value method or the zero-value method

ASPE vs. IFRS - measurement of the value of cash-settled SARs

IFRS: measures obligation at fair value of SARs (time value + intrinsic value = fair value)

ASPE: measures the obligation of the intrinsic value of the stock appreciate rights (i.e. market value)