Page 1 of 31 Module 4: Complex debt and equity instruments Overview This module addresses the classification rules for financial instruments. A financial instrument must be classified as a liability if there are payments required or as equity if it represents a residual, or risky, interest in net assets. This primarily affects classification of preferred shares that have to be repaid. Legally these shares are equity, but in substance they are a liability. If a financial instrument has component parts, debt and equity, the components have to be separated on initial recognition. This rule primarily affects classification of convertible bonds. This module provides an in-depth review of accounting for bonds convertible at the investor's option. It also includes a computer activity on the subject of convertible debt. Stock option accounting is another major topic in this module. The cash flow statement, and disclosure notes associated with complex financial instruments are also covered. Complex financial instruments such as convertible bonds and stock options demonstrate that the accounting model can grow and stretch to accommodate such transactions; an understanding of them is an important part of understanding current issues in accounting. Test your knowledge Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required. Learning objectives 4.1 Explain the nature of debt and equity and classify financial instruments according to their terms. (Level 1) 4.2 Account for convertible bonds, convertible at the investor's option, and explain the valuation problems that arise when recognizing a conversion option on the issuance of convertible debt. (Level 1) 4.3 Explain accounting for convertible bonds, convertible at the issuer's option. (Levels 1 and 2) 4.4 Account for stock options using both the recognition pattern and the disclosure pattern and explain when each pattern is appropriate. (Level 1) 4.5 Describe the three areas of required disclosure for financial instruments. (Level 1) 4.6 Prepare appropriate cash flow statement disclosures reflecting typical transactions for financial instruments. (Level 1) 4.1 Classification issues Learning objective Explain the nature of debt and equity and classify financial instruments according to their terms. (Level 1)
Page 2 of 31 Required reading Chapter 14, pages 855-863 (to "Convertible Debt") (Carefully study the section, "Debt versus Equity The General Problem," pages 859-861.) (Level 1) LEVEL 1 Financial instruments This topic addresses financial instruments. "Financial instrument" is a generic term used to describe receivables, investments, debt, equity, and derivatives. A financial instrument is a contract that creates a financial asset for one party and a financial liability or equity instrument for another party. This generic term "financial instrument" is used to ensure that the classification rules apply to all securities that a company could issue. There is a lot of creativity with respect to financial instruments. There are always two sides to a financial instrument: a receivable and a payable, or investment and equity. The two sides of a financial instrument are recorded on different companies' books. Practise classifying financial instruments in Activity 4.1-1, below. Activity 4.1-1: Classifying financial instruments Some of the following financial statement elements are financial instruments. Identify the financial instruments. Then, classify each financial instrument as a financial asset, liability, or equity item. 1. Inventory 2. Accounts receivable 3. Investment in notes payable 4. Notes payable 5. Bonds payable 6. Warranty liability 7. Taxes payable 8. Common shares 9. Preferred shares Solution Your required reading covers the application of the important accounting principle that a transaction should be accounted for according to its economic substance rather than its legal form. Here's the problem: An entity can issue a security that is legally classified as debt (form), but in substance functions as equity (substance). Or, conversely, an entity can issue a security that is legally classified as equity, but that functions as debt. Thus, the legal form of a security might be different than its true substance. If a liability (in substance) which is legally classified as equity is recorded on the financial statements as equity, then the financial statements will be misleading. Be sure you clearly understand the nature of the two classifications debt and equity. It is not just a balance sheet problem, since the classification of annual payments and the potential gain or loss on retirement is
Page 3 of 31 important as well. Classification rules You should note that these reporting requirements apply to the issuer, not the investor. Accounting for investments is covered in other courses, notably FA4. Appropriate classification of several complex financial instruments is discussed in your textbook. Preferred shares Use these basics to think about the various classifications that could be applied to preferred shares: 1. If the principal has to be repaid, then the preferred shares are a liability. 2. If the principal can be extinguished by issuing common shares (an equity instrument), then the preferred shares are still equity. 3. If the company can redeem preferred shares in cash if it wishes, this does not make the shares a liability as the cash does not have to be paid. 4. The future dividend stream is almost always not a liability, since the board of directors cannot be forced to declare dividends. Cumulative dividends in arrears are also not a liability, since the only feature of a cumulative dividend in arrears is that it must be paid before common dividends are paid. There is no obligation to pay common dividends. Nevertheless, if cumulative dividends are in arrears, and have to be paid at a certain date (along with principal at a fixed redemption date, for instance), then they would be a liability and must be accrued and reported as such. Note the comments on page 861 regarding the effect on classification if a dividend/principal escalation clause exists. Private companies Classification of financial instruments is an area in which non-public (private) companies can choose differential accounting. Many will choose to do so, in order to report substance over form specific to their environment. For example, some private companies issue preferred shares with the characteristics of debt as part of tax planning (for example, a father takes back redeemable preferred shares; his son gets common shares). If these shares are classified as debt, the debt-to-equity ratio is significantly altered. In most cases, there is no intent to redeem the preferred shares, and inflated debt levels are misleading. With unanimous shareholder consent, private companies may adopt differential accounting and continue to classify these shares in equity. Full disclosure of the classification policy, and the terms of the shares and other financial instruments, is required. Practise classification involving preferred shares in Activity 4.1-2 below. Activity 4.1-2: Classifying financial instruments preferred shares Classify the following financial instruments: 1. Series A cumulative first preferred shares, bearing a dividend rate of $4.00 per share or twice the
Page 4 of 31 dividend paid on common shares, whichever is greater: The shares are redeemable in cash at the company's option on January 1, 20X6, at 110% of par value, plus any dividends in arrears. 2. Series B preferred shares, bearing a cumulative dividend of $5.00 per share: The preferred shares must be redeemed by the company for par value on December 15, 2015. Dividends in arrears on that date, if any, must also be paid. 3. Series C preferred shares, $8, cumulative, convertible into common shares of the company on June 30, 2011, at the investor's option, at a value of $50 per share: Dividends in arrears on that date, if any, must also be paid, but may be paid at the investor's option through the issuance of common shares at a value of $50 per share. Solution 4.1 Classification issues - Content Links Activity 4.1-1 solution All items except 1, 6, and 7 are financial instruments. Items 2 and 3 are financial assets, 4 and 5 are financial liabilities, and 8 and 9 are equity instruments. Inventory is an asset, but not a financial asset. The warranty liability is a liability, but not a financial liability (Does anyone record the opposite side, a warranty receivable? No.) Taxes payable are a liability, but are a statutory requirement rather than a contractual obligation. Activity 4.1-2 solution The Series A preferred shares are equity. While the company can redeem the shares if it wishes, there is no "unavoidable obligation" to do so. The dividends, also, must be paid if the shares are redeemed, but since redemption is voluntary, there is no liability for the dividends either. Remember that a company can generally buy back equity if it wants to, by buying the shares on a stock exchange. Thus, an option to repurchase on the part of the company has no teeth and does not change the classification of preferred shares. The Series B shares, on the other hand, are a liability and must be classified as such on the balance sheet. Dividends paid would be disclosed on the income statement, likely at the bottom, in a separate classification called "financing charges dividends on preferred shares that have the characteristics of debt" or something to that effect. Dividends would be accrued annually, whether declared or not, because there is a legal obligation to repay them at the redemption date. The Series C shares are equity. They, and their dividends, may be converted into common shares, another equity instrument, but equity is still equity, and no recognition is accorded to a conversion privilege for a preferred share issue.
Page 5 of 31 4.2 Debt convertible at the investor's option Learning objective Account for convertible bonds, convertible at the investor's option, and explain the valuation problems that arise when recognizing a conversion option on the issuance of convertible debt. (Level 1) Required reading Chapter 14, pages 863-868, 890-892, 913, (Read Assignment 14-8 before you do the computer activity.) and 915 (Assignment 14-15) (Level 1) LEVEL 1 What happens when a financial instrument contains both a financial liability and an equity component? It is called a hybrid, and its two components are recorded separately in the financial statements. (See Example 4.2-1, below.) This topic applies to bonds that are convertible at the option of the investor. Topic 4.3 considers bonds that are convertible at the issuer's option. Example 4.2-1 : Hybrid financial instruments Woods Corp. issued a $5,000,000 bond payable on July 1, 20X2. The bond matures on December 31, 20X13. On its maturity date, investors may elect to convert the bond into 60,000 common shares. The interest rate is 7.5% compounded semi-annually, with interest paid on June 30 and December 31. When the bond was issued, the market interest rate was 8%. The bond was issued for $5,175,000. Using an option pricing model, market analysts predicted that the option, selling alone, would be worth $400,000. The bond alone would sell for $4,814,308: Present value of principal ($5,000,000 P/F, 4%, 23*) ($5,000,000 0.40573) $ 2,028,650 Present value of interest ($5,000,000 0.0375) (P/A, 4%, 23) ($187,500 14.85684) 2,785,658 $ 4,814,308 * 1 period in 20X2, 2 each in the 11 years 20X3 to 20X13 inclusive By calculator, PV = $4,814,289. To record this hybrid financial instrument on issuance, the company could use either just the bond valuation, or both the bond valuation and the option valuation: Alternative 1; based on bond valuation alone (the incremental method):
Page 6 of 31 Cash 5,175,000 Discount on bonds payable ($5,000,000 $4,814,308) 185,692 Bonds payable 5,000,000 Common stock conversion rights ($5,175,000 $4,814,308) 360,692 Alternative 2; based on the bond value and the option value (the proportional method): Cash 5,175,000 Discount on bonds payable *($5,000,000 $4,776,525) 223,475 Bonds payable 5,000,000 Common stock conversion rights* 398,475 * Allocation of total proceeds, relative values: Value of bond $4,814,308 92.3% $5,175,000 $4,776,525 Value of rights 400,000 7.7% $5,175,000 398,475 Total $5,214,308 100.0% $5,175,000 Using the second alternative, interest expense would be recorded semi-annually, using the effective interest method to amortize the discount. The assigned value of the bond, $4,776,525, must be used in an IRR calculation to ascertain the effective interest rate. Using IRR in Excel or a calculator, this is determined to be 4.05% every six months. This is logical, because it is just slightly higher than the 4% used to arrive at the original present value of $4,814,308. The entry to record interest is below: Interest expense ($4,776,525 4.05%) 193,450 Discount on bonds payable ($187,500 $193,450) 5,950 Cash ($5,000,000 0.0375) 187,500 The entry at maturity, assuming conversion when common shares were worth $95 per share, or $5,700,000: Bonds payable 5,000,000 Common stock conversion rights 398,475 Common shares 5,398,475 Market value is not recorded. The discount has already been reduced to zero through annual amortization. The entry at maturity, assuming cash is paid: Bonds payable 5,000,000 Cash 5,000,000 Common stock conversion rights 398,475 Contributed capital, lapse of rights 398,475 At maturity, the option account is either folded into the common share account (on conversion) or a contributed capital account (on lapse).
Page 7 of 31 Example 4.2-1 illustrates a number of key points: Estimates First, the valuations used for the elements of the hybrid instruments are clearly estimates. The key assumption in bond valuation is the market interest rate, which depends on the credit rating of the company, security for the issue, its length, and so on. Option pricing models are relatively well respected when used to value short-term, traded options. Two examples of option pricing models are the Black Scholes option pricing model and the binomial option pricing model. Both consider risk-free interest rates, dividend yields, time to maturity and stock price volatility. These are estimated values. The preceding data suggests that, if the valuations were accurate, the "bundle" should have sold for $5,214,308, which is the sum of the market values. The fact that it really sold for $5,175,000 indicates the presence of measurement errors, although they do not appear material. Presumably, the Canadian corporate world will have opinions on the validity of the various valuation techniques as it experiments with these valuations. Valuation alternatives On initial recognition of the bond, the company may base its valuation on either the incremental method, where the value of the bond alone is used, or the proportional method, where the relative values of the bond and option are used. Using the bond and option value is preferable because it uses more complete information. The bond-only alternative may only be used if the value of the option is not available. This should be rare because valuation techniques exist to value the option. Market value of options and shares There is no attempt to track the value of the common share option after it is granted, or the value of the common shares on the day the bond is converted. Presumably, investors would only opt for common shares if they were worth more than the $5,000,000 par value of the bond. The accounting model does not record the opportunity cost of these shares. They were worth $5,700,000 ($95 60,000) on the day of conversion. Shareholders are not given information in the financial statements to evaluate the retroactive wisdom of the terms of the convertible bond. Conversion could be reported at market value, as the text notes, but since this always results in a reported loss for the company (investors only take shares if they're worth more than the bonds), it is rarely found in practice. Prior accounting practice Level 1 Review problems 1. Refer to the data in Assignment 14-15 on page 915. Answer the requirement and refer to the solution below. Use the effective interest method in part 4.
Page 8 of 31 Solution 2. Review problem A on pages 890-892 of the text. Computer activity 4.2-1: Convertible debt The purpose of this computer activity is to provide another example of accounting for convertible debt and increase your familiarity with Excel. Material provided The file FA3M4P1 contains two worksheets: a partially completed worksheet M4P1, based on the data in Assignment 14-8 (page 913), and M4P1S, which contains the solution to the problem. You will complete calculations for debt convertible at the investor's option. Round figures to closest thousand. Description Complete the following requirements using Excel. Required 1. Complete requirement 1 in the text. 2. Complete requirement 2 in the text. Use Excel to allocate issuance proceeds to the bond and the conversion option. 3. Complete requirement 3 in the text. Use Excel to establish the present value of the bond. 4. Using Excel, determine the effective interest rate implicit in the bond value recorded in requirement 2. 5. Using Excel, prepare an interest table covering the bond's life, using the effective interest method. Procedure 1. Complete requirement 1. 2. To complete requirement 2, open the file FA3M4P1. Click the worksheet tab M4P1. 3. Observe the layout of the worksheet. Sections are provided to help answer requirements 2, 3, 4 and 5, above. 4. To complete requirement 2, enter appropriate numbers and formulas in cells B9 to F11, and then construct an appropriate entry. Use the ROUND function to round C9 and C10 to 2 decimal places. 5. To complete requirement 3, enter appropriate numbers and formulas in cells B17 to D19. 6. To complete requirement 4, enter appropriate numbers and formulas in cells D23 to D38 and B23. 7. To complete requirement 5, enter appropriate numbers and formulas in cells B45 to H60. Check your answers against the solution below; you may also refer to the M4P1S tab in the file FA3M4P1. Solution
Page 9 of 31 4.2 Debt convertible at the investor's option - Content Links Prior accounting practice In relation to the pre-financial instrument rules, the prior accounting treatment has the following results: 1. On issuance, it used to be that all of the proceeds were classified as debt (the par value plus a premium). Under our current financial instruments rules, the bond is typically valued at a discount and some of the proceeds increase equity. This increase to equity is permanent, as the option account is simply reclassified in equity on use or lapse. 2. Annually, it used to be that premium amortization would decrease interest expense from cash paid. The premium was recorded on initial recognition. Now, with a discount recognized, discount amortization will increase interest expense. The company will report a more accurate cost of debt financing. Assignment 14-15 solution Requirement 1 If the bond were not convertible, it would sell for the present value of its cash flows, both principal and interest, discounted at the current market interest rate: Principal: $5,000,000 (P/F, 5%, 20) (0.37689) = $1,884,450 Interest payments: ($5,000,000 4%) (P/A, 5%, 20) (12.46221) = 2,492,442 Bond price $4,376,892 Notice that the 10-year bond has twenty six-month periods, and that the market interest rate is for 6 months, or 10% 2. Requirement 2 The option could be valued, on the incremental basis, as the difference between proceeds of issuance, $4,900,000, and the PV of the bond alone, $4,376,892. This gives an amount of $523,108. Alternatively, the option could be valued using an option pricing model and the proportionate values of the option and the bond used to allocate the proceeds of $4,900,000. No information is given to do the latter calculations. Requirement 3 To record issuance on 1 January 20X1: Cash 4,900,000
Page 10 of 31 Discount on bonds payable (1) 623,108 Bonds payable 5,000,000 Contributed capital: common stock conversion rights (2) 523,108 (1) $5,000,000 $4,376,892 (2) $4,900,000 $4,376,892 Requirement 4 Interest expense ($4,376,892 5%) 218,845 Discount on bonds payable 18,845 Cash ($5,000,000 4%) 200,000 Requirement 5 When the bond matures and is converted to common shares, both the bond account and the contributed capital account are folded into the common share account. Bonds payable 5,000,000 Contributed capital: common stock conversion rights 523,108 Common shares, no-par 5,523,108 Note that the discount account need not be considered because it has been amortized to zero by the maturity date. Requirement 6 If the bond is repaid rather than converted, the repayment decreases both the bond liability and cash. Bonds payable 5,000,000 Cash 5,000,000 The final entry reclassified the original contributed capital account, but it is still equity. Contributed capital: common stock conversion rights 523,108 Contributed capital: lapse of conversion rights 523,108 Source: Adapted from Solutions Manual, Assignment 14-15, page 776. Computer activity 4.2-1 solution Requirement 1 Cash 5,325,000 Discount on bonds payable (2) 760,000
Page 11 of 31 Bonds payable 5,000,000 Contributed capital: common stock conversion rights (1) 1,085,000 (1) $5,325,000 $4,240,000 (2) $5,000,000 $4,240,000 The conversion rights are valued at the difference between the actual proceeds and the amount that would have been received had the bond not been convertible. Requirement 2 Cash 5,325,000 Discount on bonds payable ($5,000,000 $4,100,000) 900,000 Bonds payable 5,000,000 Contributed capital: common stock conversion rights 1,225,000 Requirement 3 Commentary: The bond value is the present value using a market interest rate for a bond of comparable risk. An option pricing model (such as the Black-Scholes model) would have been used to value the conversion option.
Page 12 of 31 Requirement 4 Requirement 5 Source: Adapted from Solutions Manual, Assignment 14-8, page 766. 4.3 Debt convertible at the issuer's option Learning objective Explain accounting for convertible bonds, convertible at the issuer's option. (Levels 1 and 2) Required reading Chapter 14, pages 869-871 (up to the first entry on page 871) (Level 2) and pages 873-874 (Level 1)
Page 13 of 31 LEVEL 2 What changes when convertible bonds are issued and it is the issuer's choice, not the investor's, to pay out cash or equity at maturity? Quite a bit changes. Accounting rules are dependent on whether the number of shares to be issued (the ratio) is set at the beginning, or based on the market value of common shares (the conversion price) at the conversion date. See Example 4.3-1. Example 4.3-1: Bonds convertible at the issuer's option Assume that RevCor issued a $10,000,000, 20-year bond, convertible at RevCor's option at maturity into common shares. The common shares to be issued are to be worth a total of $10,000,000, using the market value of the shares on the conversion date. If the market value is $50 at that time, 200,000 ($10,000,000 $50) shares will be issued. If the market value is $10, 1,000,000 ($10,000,000 $10) shares will be issued. This arrangement does not give the debt holder "risk of ownership" until after the conversion takes place. The company (RevCor) could just as easily issue shares for cash and use the cash to repay the bond. These bonds are straight liabilities. Most convertible bonds, convertible at the issuer's option have this "variable number of shares" structure, and thus are classified as liabilities. Alternatively, the bond could state that the conversion option was for a fixed number of shares, regardless of their market value at the conversion date. Say, for example, the $10,000,000 bond was convertible into 250,000 shares. In this case, the bond holder has risk if the shares decrease in value. The company, on the other hand, has a set equity stake established. These bonds have an equity component. Since the company has no legal obligation to pay the principal of the bond in cash, but does have to pay interest, the bond is a hybrid instrument. The proceeds of issuance are split between principal (equity) and interest (debt) based on the relative present values of the two components. Here is a summary of the rules for a bond that is convertible at the issuer's (company's) option: If the bond is convertible to an unknown number of shares, with the number of shares to be determined based on their market value at the conversion date, then this is a financial liability and has no equity portion. If the bond is convertible to a fixed number of shares, then the bond is a hybrid instrument, where the present value of the principal is equity, and the present value of the interest stream is debt. The textbook reading explains the rules that used to apply to all bonds convertible at the company's (issuer's) option. You are responsible for classification issues regarding bonds that are convertible at the issuer's option. You must be able to initially record such a bond if it is convertible into a variable number of shares (normal bond issuance) and if it is convertible into a fixed number of shares (hybrid). You are not responsible for entries subsequent to issuance, as these financial instruments are very rare. Review and summary The rules for convertible bonds are summarized in the text on pages 873-874. Take a moment to study these now. It makes a tremendous difference whether the bond is convertible at the investor s or the issuer s option. If it is convertible at the issuer s option, it makes a difference whether the number of shares is fixed
Page 14 of 31 or variable. Classification must be done carefully. 4.4 Accounting for stock options Learning objective Account for stock options using both the recognition pattern and the disclosure pattern and explain when each pattern is appropriate. (Level 1) Required reading Chapter 14, pages 874-883 (Work through the examples carefully, especially the seven examples illustrated on pages 877-882.) (Level 1) Note: There is an error in the textbook. On page 876, Valuation Method, the second paragraph should read ten years (not eight years). LEVEL 1 Exhibit 14-5 in your textbook (page 877) summarizes the kinds of options that are recorded using the recognition pattern versus the disclosure pattern. In both cases, any increase or decrease in the value of the stock option while it is outstanding is not recognized or disclosed. Employee stock options The requirement to record compensation expense for stock options is relatively new in Canada, having been enacted in 2004. Before that, recorded compensation expense with respect to stock options was easily avoided and seldom seen. However, the substance of a stock option is that employees do receive something of value, and some expense is appropriate. Fair value method Canadian practice follows the fair value method of accounting for all stock-based employee payments. Using the fair value method, options are valued at the fair value of the option issued. The fair value of options can be established by use of an option pricing model, such as Black-Scholes. or the binomial model. The critical factors that these models must consider are the exercise price, life of the option, current market value of the stock, the volatility of the stock, expected dividends, and the risk-free interest rate. You have already reviewed some of the potential problems associated with using option pricing models for financial instrument valuation; these concerns are valid in this context as well.
Page 15 of 31 Compensation expense is recorded when the options vest, or are exerciseable. If options are exerciseable immediately, their value is immediately recorded as an expense and equity. More commonly, options become exerciseable (vest) over some period of service and the value of the options is recognized straightline over this time. Derivatives 4.4 Accounting for stock options - Content Links Derivatives Derivatives are now required to be recorded in the financial statements at fair value. These requirements involve recognizing complex derivative contracts as net assets or net liabilities. A gain or loss is recorded when fair value changes. Again, the accuracy of estimated fair values will be of obvious concern. For more information on this issue, see Chapter 14, pages 884 and 885. This topic is covered in FA4, the next financial accounting course in the CGA-Canada stream. 4.5 Disclosure Learning objective Describe the three areas of required disclosure for financial instruments. (Level 1) LEVEL 1 Extensive disclosure is required for financial instruments. To be precise, disclosure must be made of the following: 1. Terms and conditions (a requirement satisfied by full description of the financial instrument) 2. Interest rates, both stated and effective 3. Fair value, for liabilities (Fair value of equity items is not required.) Credit risk is also mentioned as a disclosure requirement for financial instruments in general, but it is hard to see how a company can discuss investor's credit risk for its own liabilities. Therefore, it is not on the list. The requirement to disclose fair values is interesting. It provides companies with a chance to become familiar with the present value techniques commonly used to value liabilities, and may help foster a climate where
Page 16 of 31 fair value recognition is encouraged and then required. Companies are also required to disclose information about the significance of financial instruments for the company s financial position and performance, the nature of risks arising from financial instruments, and how those risks are managed. In particular, there is an emphasis on disclosure of a company s exposure to economic factors and unhedged risks. 4.6 Cash flow statement Learning objective Prepare appropriate cash flow statement disclosures reflecting typical transactions for financial instruments. (Level 1) Required reading Chapter 14, pages 888-889 (Level 1) LEVEL 1 Cash flow Transactions involving bonds, shares, and options are reported in the financing section of the cash flow statement. Dividend payments are also classified as financing transactions, but interest is an outflow in operations. All the cash flow rules you have learned in relation to debt and equity apply to complex financial instruments. For example, discount amortization is an adjustment in operations, cash spent to retire debt or equity is an outflow in financing, and so on. It helps to reconstruct journal entries that explain the change in balance sheet accounts. Finally, remember that a conversion from debt to equity (at maturity, usually) does not involve cash flows. There is also no cash associated with the lapse of options or the capital charge that is recorded as the annual increase to the equity account recorded when a convertible bond is convertible at the issuer's option. None of these transactions are shown on the cash flow statement. Activity 4.6-1 shows how to reflect various option transactions on the cash flow statement. Activity 4.6-1: Accounting for stock options Breonne Corporation reports the following balances as of December 31, 20X5. 20X5 20X4 Common shares $6,471,000 $5,941,000 Contributed capital: common share options outstanding 644,000 842,000
Page 17 of 31 Contributed capital: lapse of share options 407,000 302,000 Other information: a. At the beginning of the year, 200,000 options were granted to senior executives, allowing purchase of 200,000 common shares in five year's time. Using a binomial valuation model, the options were valued at $275,000. b. Options of prior years were recognized during 20X5 in the amount of $62,000. c. Options with a recorded value of $105,000 lapsed. d. Options with a recorded value of $210,000 were exercised, allowing issuance of 40,000 common shares at $8 per share. Required: List the items that would appear on the cash flow statement for the year ended December 31, 20X5, assuming that the indirect method is used in the operating activities section. Solution 4.6 Cash flow statement - Content Links Activity 4.6-1 solution Here is the journal entry for the above: Breonne Corporation Partial cash flow statement year ended December 31, 20X5 Operating activities Add back non-cash expenses Compensation expense ($275,000 5) + $62,000 $117,000 Financing activities Issued common shares (40,000 $8) 320,000 a) Compensation expense (275,000 5) 55,000 CC: common share options outstanding 55,000 b) Compensation expense 62,000
Page 18 of 31 CC: common share options outstanding 62,000 c) CC: common share options outstanding 105,000 CC: lapse of common share options 105,000 d) Cash (40,000 $8) 320,000 CC: common share options outstanding 210,000 Common shares 530,000 The cash flow statement reflects the cash received or paid by the company. In the above transactions, there is only one cash flow, cash of $320,000 received on the exercise of options. This appears in the financing section of the CFS as an inflow. The CFS, in operations, also includes an add-back of the non-cash compensation expense, in the amount of $117,000 ($55,000 + $62,000). This expense was included in the net income but because it is not a cash expense, it must be added back, like amortization expense. Audio lectures Audio lectures are available for this module. System requirements and instructions on how to access the online lectures are included. Module 4 self-test Question 1 Computer question Canadian Scientific Ltd. issued $4,000,000 of convertible bonds on July 1, 20X2. The bonds mature on June 30, 20X10 and bear an interest rate of 5%, paid annually each June 30. The bonds are convertible at the investor's option, at the rate of 100 common shares for every $1,000 bond. The financial instrument was issued for total proceeds of $4,235,000. The bond alone was valued at $3,751,600. No value can be separately calculated for the option.
Page 19 of 31 Required 1. Calculate the portion of the bond proceeds allocated to debt versus equity. 2. What interest rate is implicit in the bond valuation? 3. Prepare a table showing interest expense and net bond liability over the life of the bond. 4. What would appear on the balance sheet (indicate category), and the income statement for the year ended June 30, 20X6? Do not separate the current portion of long-term debt. 5. Prepare a journal entry to reflect the following independent events: Procedure 1. Conversion of the bond to common shares on June 30, 20X10. 2. Repayment of the bond with cash on June 30, 20X10 and the lapse of rights. 1. Open the file FA3M4Q1. Examine the layout of the worksheet. It is similar to the one used in the computer activity in Topic 4.2. 2. From the information given in the problem, determine the values for requirement 1 and enter them into cells B21 and B22. Sum the values in cell B23. 3. To complete requirement 2, enter the required cash flows for the issuer of the bonds in cells B30 to B38. Determine the IRR by entering the correct function in cell C30. Enter this interest rate in B14 and B15. 4. To complete requirement 3, enter the appropriate formulas in cells B45 to E52. Note: Adjust cell C52 for rounding error as needed. 5. Save your file. 6. Answer requirements 4 and 5. Solution Question 2 Assignment 14-4, pages 911-912 Solution Question 3 Assignment 14-9, page 913 Solution
Page 20 of 31 Question 4 Assignment 14-13, pages 914-915, requirements 1 and 2 only Solution Question 5 Assignment 14-25, pages 919-920 Note: The options vest over the two years that they must be held prior to exercise. Solution Question 6 Assignment 14-28, pages 920-921 Note: In part h, there is no compensation expense because the options are granted at the end of the current year. Solution Question 7 The following cases are independent: Case A Information from the 31 December 20X5 balance sheet of Norton Ltd.: 20X5 20X4 Bonds payable 16,000,000 Discount on bonds payable 495,000 Common stock conversion rights 1,400,000 Convertible bonds were issued during the year. Discount amortization recorded after issuance amounted to $75,000. Case B Information from the 20X4 balance sheet of Tarisai Ltd.: 20X4 20X3 Employee stock options outstanding 475,000 409,000 Contributed capital, lapse of rights 104,000 Common shares 16,800,000 16,429,000
Page 21 of 31 The company uses the fair value method to record options. The option account was increased by $301,000 for option compensation expense. Some options expired unexercised during the year. Other options were exercised, and common shares were issued under option terms. No other common shares were issued. Case C Information from the 20X4 balance sheet of Chowdury Corp: 20X4 20X3 Bonds payable 7,000,000 Discount on bonds payable 110,000 Common stock conversion rights 750,000 Common stock 25,250,000 12,400,000 The bond matured during the year and was converted into common stock. Other common stocks were issued for cash. The conversion of the bonds took place immediately after the bonds matured. Required For each case, indicate the appropriate disclosure on the cash flow statement. Indicate whether each item would be classified as investing, financing, or operating. The indirect method is used to present the operating section. Solution Self-test - Content Links
Page 22 of 31 Self-test 4 Financial Accounting: Liabilities Equities [FA3] Question 1: Computer solution Requirements 1, 2, and 3 Requirement 4 On June 30, 20X6, end of fourth year: Balance sheet Long-term liabilities Bonds payable (net) $3,861,385 Equity Common stock conversion rights 483,400
Page 23 of 31 Income statement Interest expense 229,890 Requirement 5 a. June 30, 20X10: Bonds payable 4,000,000 Common stock conversion rights 483,400 Common stock 4,483,400 b. June 30, 20X10: Bonds payable 4,000,000 Cash 4,000,000 Common stock conversion rights 483,400 Contributed capital, lapse of rights 483,400 Self-test 4 Question 2 solution Requirements 1 and 2 Case 1 Financial Instrument: Financial liability. Perpetual debt is a financial liability because of the legal obligation to pay annual interest. Legal classification: Debt. Case 2 Financial Instrument: Financial liability. Term-preferred shares involve a requirement for the company to pay out cash for principal at maturity. Legal classification: Equity. Firms may offer term-preferred shares to take advantage of preferential tax treatment of dividends in the investors' hands, and thus lower the cost to the company. Case 3 Financial Instrument: Debt. The terms of the shares are such that any prudent board of directors would arrange to retire the shares prior to the dividend and retirement price escalation. This represents a probable future cash outflow: a financial liability.
Page 24 of 31 Legal classification: Equity. Firms may offer such shares to take advantage of tax rules for dividends. Case 4 Financial Instrument: Equity. The claim is a residual interest in net assets and the company cannot be forced to pay out cash. Legal classification: Equity. Case 5 Financial Instrument: Equity. The claim is a residual interest in net assets and the company cannot be forced to pay out cash (may substitute shares). Legal classification: Equity. Case 6 Financial Instrument: Hybrid: both debt (pure bond portion) and an equity option (conversion privilege). This is a classic hybrid instrument consisting of both a guaranteed cash flow and an opportunity to participate in residual gains. Legal classification: Debt. Firms would issue convertible debt to "sweeten the deal" for investors, in lieu of common shares in a depressed stock market, or to suit the preferences of a major shareholder. Case 7 Financial Instrument: Hybrid: both debt (interest) and equity (principal). The company has a legal obligation to pay annual interest, so it (present value of interest payments) is a liability. The principal portion may be converted to equity if the company wishes, and thus they are not forced to pay out cash: a residual equity interest. Note that the shares to be issued are at a predetermined price, which makes them equity. Legal classification: Debt. Firms would likely issue this instrument in lieu of common shares in a depressed stock market or to suit the preferences of a major shareholder. Source: Adapted from Solutions Manual, Assignment 14-4, page 763. Self-test 4 Question 3 solution Requirement 1 Convertible bonds are hybrid instruments in that they have some characteristics of debt (guaranteed interest payments, minimum cash payout at maturity) and some characteristics of equity (ability to participate in residual interest in net assets).
Page 25 of 31 Requirement 2 The conversion option can be valued using an option pricing model (Black-Scholes is often cited). The bond is valued (PV) based on interest rates on similar issues, and the two relative values are used to allocate the actual proceeds to the two component parts. More commonly, only the bond is valued and the residual proceeds allocated to the option: $400,000 ($4,300,000 $3,900,000) in this case. Requirement 3 Cash 4,300,000 Discount on bonds payable 100,000 Bonds payable 4,000,000 Contributed capital: common stock conversion rights 400,000 Requirement 4 Bonds payable 4,000,000 Contributed capital: common stock conversion rights 400,000 Contributed capital: lapse of rights 200,000 Common stock ($2,000,000 + $200,000) 2,200,000 Cash 2,000,000 Requirement 5 A split is unusual because it is usually either a better deal to take the stock, in which case all convert, or the money, in which case all cash out. Source: Solutions Manual, Assignment 14-9, page 767. Self-test 4 Question 4 solution Requirement 1 Principal: $5,000,000 (P/F, 6%, 5) (0.74726) = $3,736,300 Interest payments: ($5,000,000 6%) (P/A, 6%, 5) (4.21236) = 1,263,700 * Bond price (rounded) $5,000,000 * rounded Requirement 2 Cash 5,000,000 Interest liability on bond 1,263,700 Share equity bond 3,736,300
Page 26 of 31 Source: Solutions Manual, Assignment 14-13, page 773. Self-test 4 Question 5 solution In 20X3 and 20X4: Compensation expense ($30,000 2) 15,000 Contributed capital: stock rights outstanding 15,000 Exercise date: Cash (1,000 $60) 60,000 Contributed capital: stock rights outstanding ($30,000 1,000 1,200) 25,000 Common shares 85,000 Lapse date: Contributed capital: stock rights outstanding 5,000 Contributed capital: share options expired 5,000 Source: Adapted from Solutions Manual, Assignment 14-25, page 787. Self-test 4 Question 6 solution Requirement 1 a. Memorandum entry: options issued allowing purchase of 2 shares for each existing share held, at a price of $1. b. c. Cash (12,300 3 $26) 959,400 Contributed capital: common share warrants outstanding 110,000 Common shares 1,069,400 Contributed capital: stock options outstanding* 35,000 Cash (10,000 $19) 190,000 Common shares 225,000
Page 27 of 31 *$161,000 (10,000 46,000) d. Stock dividends (retained earnings) 19,279,260 Common shares (458,000 $42) 19,236,000 Contributed capital: common share fractional share rights (10,300 $4.20) 43,260 e. Contributed capital: common share fractional share rights 43,260 Common shares (8,300 $4.20) 34,860 Contributed capital: lapse (2,000 $4.20) 8,400 f. Cash 45,000 Contributed capital: common stock options outstanding 45,000 g. Cash (10,000 $35) 350,000 Contributed capital: common stock options outstanding ($45,000 1/4) 11,250 Common shares 361,250 h. No entry because options are granted at the end of the current year. Next year, there will compensation expense of $72,000 6 = $12,000. Requirement 2 Shareholders' equity Common shares, no-par, unlimited shares authorized, issued and outstanding, 5,059,130 shares (1) $37,802,910 Common share options outstanding, allowing purchase of 30,000 shares at $35 (2) 33,750 Contributed capital, stock options outstanding 126,000 Contributed capital, lapse of fractional rights 8,400 Retained earnings (3) 15,281,640 Total equity $53,252,700 (1) Shares Value Opening 4,543,400 $16,876,400
Page 28 of 31 Warrants in (b) 36,900 1,069,400 Options in (c) 10,000 225,000 Stock dividend in (d) 458,000 19,236,000 Shares in (e) 830 34,860 Shares in (g) 10,000 361,250 5,059,130 $37,802,910 (2) $45,000 3/4 (3) $34,560,900 $19,279,260 Other options outstanding, not recorded: $1 poison pill options Requirement 3 Investing activities Issuance of shares for cash (1) $1,499,400 Issued options for cash 45,000 (1) See requirement 1; $959,400 + $190,000 + $350,000. The stock dividend is a noncash transaction. Source: Adapted from Solutions Manual, Assignment 14-28, page 790-791. Self-test 4 Question 7 solution Case A Operating activities Add back Discount amortization $75,000 Financing activities Issuance of bonds (1) $16,830,000 (1) $16,000,000 $495,000 $75,000 + $1,400,000 Case B Operating activities Add back Non-cash compensation expense $301,000 Financing activities Sale of shares under options (1) $240,000
Page 29 of 31 (1) $409,000 + $301,000 = $710,000 in options vs. $475,000 recorded $235,000 decrease; composed of $104,000 in contributed capital plus $131,000 in stock $16,429,000 + $131,000 = $16,560,000 vs. $16,800,000 = $240,000 cash Case C Operating activities Add back Discount amortization $110,000 Financing activities Sale of Shares (1) $5,100,000 The bond conversion is a non-cash transaction (1) $12,400,000 + $7,000,000 + $750,000 = $20,150,000 vs. $25,250,000 = $5,100,000 cash Module 4 summary Complex debt and equity instruments This module describes the classification rules for financial instruments. A financial instrument must be classified as a liability if there are required payments or as equity if it represents a residual, or risky, interest in net assets. This module reviews hybrid financial instruments, such as convertible bonds, which have characteristics of both debt and equity. Accounting for stock options is also covered. You will find a summary of key points of Chapter 14 on pages 889-890. Explain the nature of debt and equity and classify financial instruments according to their terms. A financial instrument (FI) is a contract that gives rise to a financial asset of one party and a financial liability or equity instrument of another party (for example, receivables/payables, investment/common shares). If an FI is a liability in substance, it is classified as debt, even if it is legally equity (for example, preferred shares that have to be redeemed at a certain date at a certain price). If an FI is equity in substance, it is classified as equity, even if it is legally a liability. Account for convertible bonds, convertible at the investor's option, and explain the valuation problems that arise when recognizing a conversion option on the issuance of convertible debt. If an FI is part debt and part equity, then proceeds on issuance are split between debt and equity. For bonds that are convertible at the investor s option, the equity amount is the value of the option.
Page 30 of 31 The option can be valued through proportional or incremental methods. At maturity, the option amount is rolled into common shares (exercise) or contributed capital (lapse). Explain accounting for convertible bonds, convertible at the issuer's option. If the conversion price or ratio depends on market value at the conversion date, the bond is pure liability. There is no equity or option value. If the conversion price or ratio is set, the bond is hybrid and divided between debt and equity. The present value of interest at issuance is a liability; the present value of principal is equity. Account for stock options using both the recognition pattern and the disclosure pattern and explain when each pattern is appropriate. There are two accounting patterns for stock options recognition and disclosure only. That is, some options are accounted for through recognition, others by disclosure only. Companies must use the fair value method when accounting for employee stock options options are valued at the fair value of the option issued on the grant date. Compensation expense is recognized straight-line over the exercise (vesting) period. This will decrease earnings and increase share equity and contributed capital. When options lapse, the value is transferred to another contributed capital account. When options are exercised, the value plus cash received is transferred to common shares. Describe the three areas of required disclosure for financial instruments. The disclosure requirements for all financial instruments are terms and conditions interest rates, both stated and effective market values (for the liability portion only, not equity) Prepare appropriate cash flow statement disclosures reflecting typical transactions for financial instruments. Transactions involving cash appear in the financing section. This includes issuance and cash paid on maturity. Non-cash transactions do not appear on the CFS. This includes conversion.
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