FA3 – Lesson 4 Complex debt and equity instruments 1.Classification: Debt vs. equity 2.Debt convertible at investor’s option 3.Debt convertible at issuer’s option 4.Accounting for stock options 5.Cash flow statement 6.Other

1. Classification: Debt vs. equity Liabilities (Inevitable) obligations arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services, or other yielding of economic benefits in the future Equity Ownership interests in the assets of a profit oriented enterprise after deducting its liabilities

1. Classification: Debt vs. equity (cont’d) Liabilities Payment is inevitable Interest payments, gains and losses on redemption flow through income statement Equity Payment can be avoided Dividend payments, “gains” and “losses” on retirement flow through shareholders’ equity

1. Classification: Debt vs. equity (cont’d) Guiding principle: Accounting should be consistent with the substance of the instrument, not its legal form. If a bond is in substance an equity item, the bond is presented in shareholders’ equity and the interest is reported as dividend. If a type of share is in substance a liability, the shares are presented in the liability section and the dividends are reported as an expense.

1. Classification: Debt vs. equity (cont’d) 1.Is the periodic return on capital (interest, dividends) obligatory? 2.Is the debtor legally obligated to repay the principal, either at some fixed date or at the option of the creditor? YES/YES: liability NO/NO: equity 1 YES/1 NO: hybrid instrument, part debt and part equity Exercise: A15-3

2. Debt convertible at investor’s option The investor acquires two things: (1) a promise to pay debt and interest; and (2) an option to use the principal to buy common shares Correct accounting must record the liability portion (1) and the equity portion (2) separately Valuation at issue: based on liability alone, or both liability and value of option Example: A15-10

3. Debt convertible at issuer’s option The issuer now has the option to repay the principal by issuing equity; this makes the principal an equity item. The stream of interest payments represents a liability Issuer records interest expense related to the interest liability, and a capital charge related to the equity portion of the instrument Example: A15-14

4. Accounting for stock options Initial valuation Intrinsic value: Option value = current stock price – exercise price at grant date, if this value is positive; otherwise, option value = 0 Fair value: Option value = fair value of consideration received, or fair value of option, whichever is more reliably measurable Example: A15-21

5. Cash flow statement Cash flows related to complex instruments are reported in a manner consistent with the economic substance of the instrument. -Interest/dividend payments related to substantially debt instruments are operating cash flows -Interest/dividend payments related to substantially equity instruments are financing cash flows

5. Cash flow statement (cont’d) Other issues Transactions involving bonds, shares and options are reported in the financing section of the cash flow statement Non-cash transactions Conversion from debt to equity Lapse of options Capital charge related to bond convertible at issuer’s option Example: A15-28, parts B and D

6. Bonds issued between interest dates Must record accrued interest (interest that has accumulated between last interest date and bond issue date); this is not interest expense since the bonds have not been outstanding Any bond discount or premium is amortized only over the period during which the bond is outstanding Example: A13-17