1. Powerpoint slides by: Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Michael L. Hockenstein  Commerce Department Vanier College Intermediate Accounting Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management Dalhousie University

2. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-2 Complex Debt and Equity Instruments Chapter 15

3. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-3 The Debt:Equity Continuum  The old method of classifying debt and equity on the balance sheet doesn’t work when the formerly clear cut boundary between debt and equity is bridged by hybrid securities  Redeemable preferred shares : preferred shares issued with the condition that the company may, at its option, repurchase its shares for a specified price at a specified time  Convertible debt : debt instrument issued by a company that allows or forces the investor to exchange the debt for shares in the company at some stipulated conversion rate

4. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-4 The Debt:Equity Continuum (cont.)  Hybrid securities : securities with both debt and equity characteristics  Stock option : a derivative instrument allowing the holder to purchase a specified number of shares of a company at a specified price at or during a specific period  Derivative instruments : derivative instruments are designed to transfer risk by setting the conditions of an exchange of financial instruments at a particular time at fixed terms derivative instruments derive their values from the underlying equity or debt instruments

5. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-5 Exhibit 15-1

6. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-6 Exhibit 15-1 (cont.)

7. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-7 Exhibit 15-1 (cont.)

8. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-8 Financial Instruments---General Principles  In 1995, the AcSB introduced a new section on financial instruments into the CICA Handbook, working in conjunction with the International Accounting Standards Committee  Generic rules covering the classification, measurement, and disclosure of a wide range of financial statement items  Their deliberations also covered derivative instruments, such as foreign exchange forward contracts and risk-management arrangements such as interest rate swaps and currency swaps

9. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-9 Financial Instruments---Definitions  Financial instrument : any contract that gives rise to both a financial asset of one party and a financial liability or equity instrument of another party  Assets : economic resources controlled by an entity as a result of past transactions or events and from which future economic benefits may be obtained

10. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-10 Financial Instruments---Definitions (cont.)  The definition of financial asset augments this definition, and creates a sub-classification: not all assets are financial assets  Financial asset: any asset that is cash a contractual right to receive cash or another financial asset from another party a contractual right to exchange financial instruments with another party under conditions that are potentially favourable an equity instrument of another entity

11. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-11 Financial Instruments---Definitions (cont.)  Liabilities : obligations of an entity 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  Financial liability : any liability that is a contractual obligation, including: to deliver cash or another financial asset to another party to exchange financial instruments with another party under conditions that are potentially unfavourable

12. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-12 Financial Instruments---Definitions (cont.)  Equity : the ownership interest in the assets of a profit oriented enterprise after deducting the liabilities  Equity instrument : any contract that evidences residual interest in the assets of an entity after deduction all of its liabilities

13. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-13 CICA Handbook Presentation Recommendations  The primary presentation requirement of the financial instruments section of the CICA Handbook is that: The issuer of a financial instrument should classify the instrument, or its component parts, as a liability or as equity in accordance with the substance of the contractual arrangement on initial recognition and the definitions of a financial liability and an equity instrument [CICA 3860.18]

14. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-14 CICA Handbook Presentation Recommendations (cont.)  Payments to investors for the use of capital that are associated with financial liabilities should be presented on the income statement, and such payments associated with equity instruments should be presented on the retained earnings statement  Gains and losses associated with debt retirement are classified on the income statement, those associated with equity are capital transactions and affect equity

15. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-15 Convertible Debt  Bonds often are issued by a corporation with the provision that they may be converted into shares (usually, common shares) at a specified price or ratio of exchange  Bonds that are convertible into common shares at the investor’s option embody two financial instruments: a liability, and an option contract on common shares  The two components are recognized separately on issuance, and classified accordingly

16. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-16 Convertible Debt (cont.)  Bonds that are convertible into common shares at the company’s option are likely to be classified as equity as to their principal and as a liability as to their annual cash interest component

17. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-17 Exhibit 15-3

18. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-18 Retractable Preferred Shares  Most preferred shares have a call provision---the corporation can call in the shares and redeem them at a call price specified in the corporate by- law governing that class of share  Some preferred shares include the provision that shares must be redeemed on or before a specified date (term-preferred shares) or at the option of the shareholder (retractable shares)  When redemption is required at the option of the shareholder then the mandatory final cash payout effectively makes the preferred shares a liability

19. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-19 Perpetual Debt  Perpetual debt : a type of debt whose principle does not have to be repaid or is highly unlikely to be repaid  Generally yields a stream of interest income to investors

20. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-20 Perpetual Debt (cont.)  Although perpetual debt seems to be substantively equivalent to preferred shares, the Financial Instruments section of the CICA Handbook states (in the Appendix) that perpetual debt should be classified as a liability at the present value of the stream of future interest payments [CICA 3860.A19]  This treatment is recommended because “the issuer assumes a contractual obligation to make a stream of future interest payments”

21. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-21 Commodity-Linked Debt  Commodity loans : debt issued that will be repaid upon maturity with a commodity product instead of cash

22. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-22 Stock Options  Stock options : instruments that give the holder the right to buy shares at a fixed price  If the exercise price of the option is above the value of the share, the option has no value  Only when the share price rises above the exercise price does the option itself have a value

23. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-23 Derivatives  Derivative : a secondary financial instrument whose contract is linked to a primary financial instrument or commodity  All derivatives are either options or forward contracts or some combination thereof  Option : the right to buy or sell something in the future  Forward contract : an obligation to buy or sell something in the future

24. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-24 Derivatives (cont.)  Derivatives are exchange contracts meant to transfer risk  Since these contracts embody an exchange of financial instruments at fixed terms, any change in the market price of the underlying variables can create gains and losses  These contracts are financial assets if they involve contractual exchanges under conditions that are potentially favourable (gains)  These contracts are financial liabilities if conditions are potentially unfavourable (losses)

25. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-25 Stock Rights and Warrants  Stock rights : provide the holder with an option to acquire a specified number of shares in the corporation under prescribed conditions and within a stated future time period  Stock warrants : stock rights that are issued as an attachment to other securities (usually to bonds)

26. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-26 Stock Rights and Warrants (cont.)  A common distinction between stock rights and stock warrants is that stock rights often have a short life while warrants are valid for longer periods of time and often have no expiry date  Stock rights and warrants may be exercised by purchasing additional shares from the corporation, sold at the market value of the rights, or allowed to lapse on the expiration date (if any)

27. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-27 Accounting for Stock Rights  Stock options may be recognized on issuance, and disclosed as an element of shareholders’ equity accounted for through disclosure, a memo entry approach

28. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-28 Recognition-check  Options are commonly recognized in the financial statements when options are granted as: compensation to outside parties fractional rights in a stock dividend that is recognized itself warrants on the issuance of bonds part of a convertible bond when stock option plans involve compensation

29. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-29 Disclosure of Stock Options  All options are financial instruments, and both terms and conditions and fair market value must be disclosed  CICA Handbook specific disclosures for options: the accounting policy for option plans a description of the plan(s), including the terms and prices of options

30. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   15-30 Disclosure of Stock Options (cont.) specific information about options outstanding, the number and weighted-average exercise price of options outstanding at the beginning and end of the year, and details about options exercised, granted, and lapsed during the year the amount of compensation expense recognized, if any, and amounts charged to retained earnings, credited to share capital and any amounts receivable