1. Ch.16

Chapter Overview

Topic: Complex Financial Instruments

Authors: Kieso, Weygandt, Warfield, Wiecek, McConomy

Learning Objectives

After studying this chapter, you should be able to:

• Understand the key concepts of derivatives and their applications in risk management accounting.

• Analyze and account for hybrid and compound financial instruments from the perspective of the issuer.

• Describe the various types of share-based compensation and their accounting treatment.

• Identify and explain accounting differences between IFRS (International Financial Reporting Standards) and ASPE (Accounting Standards for Private Enterprises), along with expected changes that could impact reporting standards.

Financial Instruments

Definition:Financial instruments are contracts that create a financial asset for one party and a financial liability or equity for another, facilitating the flow of capital and investment.Primary Instruments:Basic financial assets include receivables (money owed to a business), payables (money a business owes), and shares (equity instruments representing ownership).Derivatives:These are specialized financial instruments that derive their value from the performance of underlying assets, market indices, or other financial metrics. Common types of underlying instruments include currencies, interest rates, indices, and commodities.

Derivatives

Nature of Derivatives:

Derivatives derive value from the performance of an underlying asset and are primarily used for risk management. They enable organizations to hedge against fluctuations in asset prices without requiring direct investment into those assets, thus allowing better liquidity management. Some derivatives are commonly traded on exchanges, which simplifies their valuation due to the availability of market prices, though some, like certain stock options, trade over-the-counter (OTC), leading to less transparency.

Characteristics of Derivatives

Usage:

1. Speculative Purposes: Derivatives can be used to take calculated risks with the potential for substantial returns when market movements favor the trader.

2. Hedging Purposes: Derivatives are widely utilized by businesses to offset or mitigate risks associated with fluctuations in market prices.

Key Characteristics:

• Value Changes: The value of derivatives fluctuates in relation to the performance of the underlying instrument.

• Investment Requirement: They typically require little or no initial investment, making them accessible for various investors.

• Settlement Date: Derivatives have defined expiration dates, with settlements occurring at specified future points in time.

• Common Examples: Options, forwards, and futures are prevalent types of derivatives, which are typically measured at fair value with their gains and losses reflected in net income over the reporting periods.

Derivatives for Managing Risks

Importance in Risk Management:

Organizations leverage technology and financial analytics to enhance the management of financial risks, enabling timely decision-making and risk assessments.

Types of Financial Risk (as defined by IFRS):

1. Credit Risk: The risk associated with the potential default by a counterparty in a financial transaction.

2. Liquidity Risk: The risk of being unable to meet commitments when they come due without incurring unacceptable losses.

3. Market Risk: Refers to the risk of losses due to adverse changes in market prices, including stock prices, interest rates, and currency exchanges.

Costs of Managing Risks

• Direct Costs: Include explicit expenses such as bank charges, brokerage fees, and premiums associated with hedging strategies.

• Indirect Costs: Include the time and resources spent on analyses, research, and decision processes related to risk management.

• Other Costs: Such as lack of transparency and potential penalties, along with opportunity costs of capital tied up in hedging activities.

Users of Derivatives

Risk Management Users:

• Producers: Businesses involved in manufacturing or agricultural production, looking to manage commodity price risks.

• Consumers: Entities purchasing raw materials that are susceptible to price volatility.

• Borrowers and Companies with Debt: Organizations aiming to manage interest rate fluctuations.

• Currencies: Businesses operating internationally and exposed to foreign exchange risks.

Profit-Maximizing Users:

• Speculators: Individuals or firms that take on financial risks with the intent to profit from market movements.

• Arbitrageurs: Traders who exploit price discrepancies in different markets to lock in guaranteed profits (e.g., by simultaneously buying and selling futures contracts).

Accounting for Derivatives

Accounting Principles:

• It is essential to recognize financial derivatives, as well as some non-financial derivatives, on financial statements as soon as contracts are initiated.

• Derivatives must be remeasured to fair value on a periodic basis, with the associated gains and losses reported through net income, compliant with the Fair Value through Net Income (FV-NI) approach, which aims for transparency in financial reporting.

Options and Warrants

Options:

Provide the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a defined period.

• Exercise Price: The pre-determined price at which an option can be exercised.

• Exercise Period: The specific term during which an option can be exercised.

Types of Options:

• Call Option: Confers the right to buy the underlying asset.

• Put Option: Confers the right to sell the underlying asset.

Accounting for Options:

When options are executed, they are removed from the balance sheet, and any financial adjustments are made to reflect the transaction accurately.

Accounting for Options Example

Call Option Example:Suppose a trader pays a premium of $200 for a call option with a strike price of $50. If the market price rises to $60, the trader can exercise the option, thus profiting by selling at the market price while buying at the strike price, yielding a profit of $10 per share.

Convertible Debt and Hybrid Instruments

Hybrid/Compound Instruments:

These instruments are created to combine advantageous features of both debt and equity funding. Examples include convertible debt and preferred shares.

• Accounting for Convertible Debt:Initially measured at fair value, these must be tracked separately on the balance sheet. When converted into shares, the accounting treatment involves recognizing any amortization depending on the chosen method of accounting, either residual or proportional.

Share-Based Compensation

Types of Plans:

• Direct Stock Awards: Grants of stock directly to employees or stakeholders.

• Compensatory Stock Options: Options that are extended as part of an employee’s remuneration.

• Share Appreciation Rights (SARs): Entitles employees to receive a payout equal to the increase in the company's stock price over a predetermined period.

Accounting Treatment:

Share-based compensation must be recognized as an expense over the service period, based on the fair value established at the grant date. Importantly, there are no subsequent adjustments made after the initial grant date, and expenses are recorded as incurred throughout the vesting period.

IFRS/ASPE Comparisons

Standards Convergence:

Both IFRS and ASPE are evolving towards greater consistency in the rules governing stock-based compensation, illustrating ongoing efforts for alignment in global financial reporting standards.

Future Considerations:

There is expected continuous evolution regarding hedge accounting guidance issued by the International Accounting Standards Board (IASB), potentially impacting reporting practices worldwide.