Chapter 16 Complex Financial Instruments Notes
c c Exclude p. 1031 ± 1038, accounting portion of hedging, Appendix B
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financial instruments are contracts that create a financial asset for one party and a financial liability or equity instrument for the other primary financial instruments include most basic financial assets and financial liabilities as well as equity instruments derivative instruments are called as such because they derive their value from an underlying primary instrument, index, or nonfinancial item, such as a commodity derivatives are defined by the accounting standards as financial instruments that create rights and obligations that have the effect of transferring, between parties to the instrument, one or more of the financial risks that are inherent in an underlying primary instrument without either party having to hold any investment in the underlying they have three characteristics: (1) their value changes in response to the underlying instrument; (2) they require little or no initial investment; and (3) they are settled at a future date options, forwards, and futures are common types of derivatives
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there are many layers of costs relating to the use of derivatives three categories of costs are as follows: (1) direct costs; (2) indirect costs; and (3) hidden or opportunity costs companies use derivatives to manage risks, and especially financial risks there are various kinds of financial risks, and they are defined in IFRS as follows: 1)p Credit risk²The risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge (respect) an obligation. 2)p Liquidity risk²The risk that an entity will have difficulty meeting obligations that are associated with financial liabilities. 3)p Market risk²The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. There are three types of market risk: currency risk, interest rate risk, and other price risk. a)p Currency risk²The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates. b)p Interest rate risk²The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates. c)p Other price risk²The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (other than price changes arising from interest rate risk or currency risk), whether those changes are caused by factors that are specific to the individual financial instrument or its issuer, or factors that affect all similar financial instruments being traded in the market.
the basic principles regarding accounting for derivatives are as follows: 1)p Financial instruments (including financial derivatives) and certain non-financial derivatives represent rights or obligations that meet the definitions of assets or liabilities and should be recognized in financial statements when the entity becomes party to the contract. 2)p Fair value is the most relevant measure. 3)p Gains and losses should be booked through net income. 2 ap purchase commitments are generally labelled as executory contracts: contracts to do something in the future (where no cash or product changes hands up front)
!"" # " Legal form Purchase contract/commitment. Generally Forward/futures/ option contract does not include net settlement clause. ap
Trade on a market (thus establishing liquidity and fair value)?
No
Yes and generally net settleable
Meet the definition of an executory contract (i.e., promise to do something in the future where neither party has yet performed)?
Yes. A contract is signed upfront but no money or goods change hands until later.
Yes. A contract is signed upfront but no money or goods change hands until later.
Meet the definition of a derivative (i.e., value depends on underlying, little or no upfront investments, and settled in future)?
Yes. The value of the contract depends upon the value of the underlying (e.g., inventory), there is no upfront investment, and it will be settled in the future.
Yes. The value of the contract depends upon the value of the underlying (e.g., inventory), there is no upfront investment, and it will be settled in the future.
Perspective for accounting purposes
Generally accounted for as an unexecuted contract and not recognized until the underlying non-financial item is delivered. (Derivative accounting does not apply to these contracts either because they are not exchange
Generally accounted for as a derivative (unrecognized and measured at FV-NI). Accounted for as an executory contract under IFRS, where there is no net settlement feature or where one exists but company expects to
traded [PE GAAP] or because they are not settleable on a net basis [IFRS]).
take delivery or deliver the underlying asset.
- ap an option or warrant gives the holder the contractual right to acquire or sell an underlying instrument at a fixed price (the exercise or strike price²the agreed-upon price at which the option may be settled) within a defined term (the exercise period) ap the underlying is the shares; i.e., this option derives its value from the share price of the underlying shares ap the holder has the right to exercise the option but is not obliged to buy the shares at the exercise price ap options may be purchased (purchased options) or written by a company (written options) ap if a company purchases an option, it will pay a fee or premium and gain a right to do something ap if a company writes an option, it charges a fee or premium and give the holder/purchaser the right to do something ap the ³right´ in question may be either of the following: 1)p a right to buy the underlying (a call option) 2)p a right to see the underlying (a put option) c $right to buy $right to sell & ' & ' % Transfer rights to buy shares/underlying Transfer rights to sell shares/underlying ' ' ! Obtain right to buy shares/underlying Obtain rights to sell shares/underlying ap under a forward contract, the parties to the contract each commit upfront to do something in the future ap the forward contract meets the definition of a financial liability as it is a contractual obligation to exchange financial instruments with another party under conditions that are potentially unfavourable ap future contracts are the same as forwards except for the following: 1)p They are standardized as to amounts and dates. 2)p Futures contracts are exchange traded and therefore have ready market values. 3)p They are settled through clearing houses, which generally removes the credit risk. 4)p There is a requirement to put up collateral in the form of a ³margin´ account. The margin account represents a percentage of the contract¶s value. Daily changes in the value of the contract are settled daily against the margin account by the clearing house (known as marking to market) and resulting deficiencies in the margin account must be made up daily. ap initial margin is treated as a deposit account similar to a bank account, and is increased or decreased as the margin amount changes ap the gain or loss on the contract, reflected in the daily change in the account, is recognized in income
sometimes companies enter into derivative contracts that deal with their own shares examples of ³own equity´ derivative instruments include: 1)p options a)p purchased call or put options to buy/sell the entity¶s own shares b)p written call or put options to buy/sell the entity¶s own shares 2)p forwards a)p to buy the entity¶s own shares b)p to sell the entity¶s own shares - ap not all contracts involving own equity instruments are treated as equity; some end up being treated as financial liabilities or assets ap as a general rule, any analysis should go back to basic principles and definitions ap the following exceptions exist 1)p ÷ When a derivative contract is entered into that creates an obligation to pay cash or other assets even if it is for a fixed number of the entity¶s shares, it overrides the ³fixed for fixed´ principle and the contract should generally be treated as a financial liability. Therefore, any time there is an obligation to pay cash, a financial liability is recognized. 2)p When the derivative contract allows choice in how the instruments will be settled, the instrument is a financial asset/liability by default under IFRS unless all possible settlement options result in it being an equity instrument. Under PE GAAP, the instrument would likely be treated as equity if the entity can avoid settling with cash or other assets (i.e., where the entity has the option to choose the way the contract is settled and can avoid paying cash or other assets).
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it is generally agreed that effective compensation programs: 1)p motivate employees to high levels of performance 2)p help retain executives and recruit new talent 3)p base compensation on employee and company performance 4)p maximize the employee¶s after tax benefit and minimize the employer¶s after-tax cost 5)p use performance criteria that the employee can control although straightforward cash compensation plans (salary and, perhaps, a bonus) are an important part of any compensation program, they are oriented to the short term many companies recognize that a more long-run compensation plan is often needed in addition to a cash component stock-based compensation plans can help preserve cash and ensure that company¶s performance is satisfactory
ÿ ! Ñ - ap companies can also use stock options for the following reasons: 1)p To give employees an opportunity to own part of the company, with the issue being made to a wide group of people (e.g., all employees). Another benefit of these plans if they are widely subscribed to is that the company raises cash. These are generally called employee stock option or purchase plans (ESOPs). 2)p To remunerate management or employees. These are called compensatory stock option plans (CSOPs). 3)p As compensation in a particular purchase or acquisition transaction, with the stock options being provided instead of paying cash or another asset, or incurring a liability.
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full disclosure should be made of the following: mp the accounting policy that is being used mp a description of the plans and modifications mp details of the numbers and values of the options issued, exercised, forfeited, and expired mp a description of the assumptions and methods being used to determine fair values mp the total compensation cost included in net income and contributed surplus mp other
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) *#+ 1.p !! !! Derivatives are financial instruments that derive (get) their value from an underlying instrument. They are attractive since they transfer risks and rewards without having to necessarily invest directly in the underlying instrument. They are used for both speculative purposes (to expose a company to increased risks in the hope of increased returns) and for hedging purposes (to reduce existing risk). 2.p @ ,! Financial risks include credit, currency, interest rate, liquidity, market, and other price risks. Credit risk is the risk that the other party to a financial instrument contract will fail to deliver. Currency and interest rate risk are the risk of a change in value and cash flows due to currency or interest rate changes. Liquidity risk is the risk that the company itself will not be able to honour the contract due to cash problems. Finally, market risk is the risk of a change in value and/or cash flows related to market forces. 3.p !! ! Derivatives are recognized on the balance sheet on the date that the contract is initiated. They are re-measured, on each balance sheet date, to their fair value. The related gains and losses are recorded through net income. Written options create liabilities. Futures contracts require the company to deposit a portion of the contracts¶ value with the broker/exchange. The contracts are marked to market by the broker/exchange daily and the company may have to deposit additional funds to cover deficiencies in the margin account. Purchase commitments that are net settleable and are not ³expected use´ contracts are accounted for as derivatives under IFRS. Under PE GAAP, purchase commitments are never accounted for as derivatives as they are not exchange-traded futures contracts. Exchange traded derivatives relating to commodities are generally accounted for as derivatives under ASPE. Special hedge accounting may affect how derivatives are accounted for. 4.p @ - ! ! # . - Under IFRS, derivatives that are settleable in the entity¶s own equity instruments are accounted for as equity (or contra-equity) if they will be settled by exchanging a fixed number of equity instruments for a fixed amount of cash or other assets and they do not create an obligation to deliver cash or other assets. Otherwise, they are financial assets/liabilities. In general, if the instruments are net settleable or have settlement options, they most often do not meet the criteria for equity presentation and are therefore financial assets/liabilities. IFRS provides significantly more guidance with respect to the accounting for these instruments. 5.p ë / #!" ! ! # - # ! Complex instruments include compound and hybrid instruments where the legal form may differ from the economic substance. The economic substance dictates the accounting. The main issue is that of presentation: should the instrument be presented as debt or equity? The definitions of debt and equity are useful in analyzing this. It is also important to understand what gives the instruments their value from a finance or economic perspective. If an instrument has both debt and equity components, use of the proportional and incremental methods will help in allocating the carrying value between the two components. There are differences in measuring compound financial instruments under IFRS versus PE GAAP. Related interest, dividends, gains, and losses are treated in a way that is consistent with the balance sheet presentation. 6.p @ ! # The method for recording convertible bonds at the date of issuance is different from the method that is used to record straight debt issues. As the instrument is a compound instrument and contains both debt and equity components, these must be measured separately and presented as debt and equity, respectively. Any discount or premium that results from the issuance of convertible bonds is amortized, assuming the bonds will be held to maturity. If bonds are converted into other securities, the principle accounting problem is to determine the amount at which to record the securities that have been exchanged for the bond. The book value method is often used in practice. ASPE allows an entity to value the equity portion of compound instruments at $0. 7.p # , Stock compensation includes direct awards of stock (when a company gives the shares to an employee as compensation), compensatory stock option plans whereby an employee is given stock options in lieu of salary, stock appreciation rights, and performance-type plans.
8.p @ !# ! ! Employee stock option plans are meant to motivate employees and raise capital for the company. They are therefore capital transactions. Compensatory stock option plans are operating transactions since they are meant to compensate the employee for services provided. Costs relating to the latter are booked as expense. 9.p # , CSOPs are measured at fair value (using an options pricing model) at the grant date. The cost is then allocated to expense over the period that the employee provides service. 10.p ! + ! # !! ! 0& ! ! The differences are noted in the comparison chart. The stock-based compensation standards are largely converged and stable; however, the IASB is currently working on several projects relating to financial instruments including defining equity versus liabilities and hedging. 11.p !! !! ! . Any company or individual that wants to protect itself against different types of business risk often uses derivative contracts to achieve this objective. In general, where the intent is to manage and reduce risk, these transactions involve some type of hedge. Derivatives are useful tools for this since they have the effect of transferring risks and rewards between the parties to the contract. Derivatives can be used to hedge a company¶s exposure to fluctuations in interest rates, foreign currency exchange rates, equity, or commodity prices. 12.p @ ! !! - ! . Hedge accounting is optional accounting that ensures that properly hedged positions will reduce volatility in net income created by hedging with derivatives. It seeks to match gains and losses from hedged positions with those of the hedging items so that they may be offset. Since this is special accounting, companies must ensure that there is in fact a real hedge (i.e., that the contract insulates the company from economic loss or undesirable consequences) and that the hedge remains effective. Proper documentation of the risks and risk management strategy is important. 13.p @ !# ! ! ! . A fair value hedge reduces risks relating to fair value changes of recorded assets and liabilities as well as purchase commitments. Cash flow hedges protect against future losses due to future cash flow changes relating to exposures that are not captured on the balance sheet. PE GAAP does not discuss fair value or cash flow hedges but rather stipulates the accounting for certain types of specific hedge transactions. 14.p c ! # ! . Properly hedged positions reduce income fluctuations because gains and losses are offset. Under IFRS, for cash flow hedges, the gains and losses on the hedging items are booked through Other Comprehensive Income and are brought into net income in the same (future) period that the hedged items are booked to net income. For fair value hedges, hedge accounting adjusts the hedged asset to ensure that it is recognized and measured at fair value and that related gains/losses are booked through net income. Both types of hedges ensure that the gains/losses of the hedged and hedging positions offset. Under PE GAAP hedge accounting, the hedging item (which is generally a derivative) is not recognized on the balance sheet until the hedging item is settled. Thus both the hedged item (usually a future transaction) and the hedging item (the derivative) are off-balance sheet and there is no mismatch. Only certain prespecified transactions are eligible for hedge accounting under PE GAAP. 15.p ë , . SARs are popular because the employee can share in increases in value of the company¶s shares without having to purchase them. The increases in value over a certain amount are paid to the employee as cash or shares. Obligations to pay cash represent a liability that must be re-measured. The cost is therefore continually adjusted, with the measurement date being the exercise date. The related expense is spread over the service period. If the SARs are not exercised at the end of the service period, the liability must continue to be re-measured. Cash-settled SARs are measured using intrinsic values under PE GAAP and fair value under IFRS. 16.p @ - These plans are tied to performance (of the entity, the individual or a group of individuals). There is therefore more measurement uncertainty. 17.p !! ! ! . Fair value is most readily determined where there is an active market with published prices. Where this is not the case, a valuation technique is used. More basic techniques include discounted cash flows. More complex techniques include options pricing models such as the Black-Scholes and binomial tree models. Where possible, valuation techniques should use available external inputs to ensure that they are more objective. Having said this, significant judgement goes into determining fair values using options pricing models.
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financial instruments are contracts that create a financial asset for one party and a financial liability or equity instrument for the other primary financial instruments include most basic financial assets and financial liabilities as well as equity instruments derivative instruments are called as such because they derive their value from an underlying primary instrument, index, or nonfinancial item, such as a commodity derivatives are defined by the accounting standards as financial instruments that create rights and obligations that have the effect of transferring, between parties to the instrument, one or more of the financial risks that are inherent in an underlying primary instrument without either party having to hold any investment in the underlying they have three characteristics: (1) their value changes in response to the underlying instrument; (2) they require little or no initial investment; and (3) they are settled at a future date options, forwards, and futures are common types of derivatives
ap ap ap ap
there are many layers of costs relating to the use of derivatives three categories of costs are as follows: (1) direct costs; (2) indirect costs; and (3) hidden or opportunity costs companies use derivatives to manage risks, and especially financial risks there are various kinds of financial risks, and they are defined in IFRS as follows: 1)p Credit risk²The risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge (respect) an obligation. 2)p Liquidity risk²The risk that an entity will have difficulty meeting obligations that are associated with financial liabilities. 3)p Market risk²The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. There are three types of market risk: currency risk, interest rate risk, and other price risk. a)p Currency risk²The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates. b)p Interest rate risk²The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates. c)p Other price risk²The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (other than price changes arising from interest rate risk or currency risk), whether those changes are caused by factors that are specific to the individual financial instrument or its issuer, or factors that affect all similar financial instruments being traded in the market.
the basic principles regarding accounting for derivatives are as follows: 1)p Financial instruments (including financial derivatives) and certain non-financial derivatives represent rights or obligations that meet the definitions of assets or liabilities and should be recognized in financial statements when the entity becomes party to the contract. 2)p Fair value is the most relevant measure. 3)p Gains and losses should be booked through net income. 2 ap purchase commitments are generally labelled as executory contracts: contracts to do something in the future (where no cash or product changes hands up front)
!"" # " Legal form Purchase contract/commitment. Generally Forward/futures/ option contract does not include net settlement clause. ap
Trade on a market (thus establishing liquidity and fair value)?
No
Yes and generally net settleable
Meet the definition of an executory contract (i.e., promise to do something in the future where neither party has yet performed)?
Yes. A contract is signed upfront but no money or goods change hands until later.
Yes. A contract is signed upfront but no money or goods change hands until later.
Meet the definition of a derivative (i.e., value depends on underlying, little or no upfront investments, and settled in future)?
Yes. The value of the contract depends upon the value of the underlying (e.g., inventory), there is no upfront investment, and it will be settled in the future.
Yes. The value of the contract depends upon the value of the underlying (e.g., inventory), there is no upfront investment, and it will be settled in the future.
Perspective for accounting purposes
Generally accounted for as an unexecuted contract and not recognized until the underlying non-financial item is delivered. (Derivative accounting does not apply to these contracts either because they are not exchange
Generally accounted for as a derivative (unrecognized and measured at FV-NI). Accounted for as an executory contract under IFRS, where there is no net settlement feature or where one exists but company expects to
traded [PE GAAP] or because they are not settleable on a net basis [IFRS]).
take delivery or deliver the underlying asset.
- ap an option or warrant gives the holder the contractual right to acquire or sell an underlying instrument at a fixed price (the exercise or strike price²the agreed-upon price at which the option may be settled) within a defined term (the exercise period) ap the underlying is the shares; i.e., this option derives its value from the share price of the underlying shares ap the holder has the right to exercise the option but is not obliged to buy the shares at the exercise price ap options may be purchased (purchased options) or written by a company (written options) ap if a company purchases an option, it will pay a fee or premium and gain a right to do something ap if a company writes an option, it charges a fee or premium and give the holder/purchaser the right to do something ap the ³right´ in question may be either of the following: 1)p a right to buy the underlying (a call option) 2)p a right to see the underlying (a put option) c $right to buy $right to sell & ' & ' % Transfer rights to buy shares/underlying Transfer rights to sell shares/underlying ' ' ! Obtain right to buy shares/underlying Obtain rights to sell shares/underlying ap under a forward contract, the parties to the contract each commit upfront to do something in the future ap the forward contract meets the definition of a financial liability as it is a contractual obligation to exchange financial instruments with another party under conditions that are potentially unfavourable ap future contracts are the same as forwards except for the following: 1)p They are standardized as to amounts and dates. 2)p Futures contracts are exchange traded and therefore have ready market values. 3)p They are settled through clearing houses, which generally removes the credit risk. 4)p There is a requirement to put up collateral in the form of a ³margin´ account. The margin account represents a percentage of the contract¶s value. Daily changes in the value of the contract are settled daily against the margin account by the clearing house (known as marking to market) and resulting deficiencies in the margin account must be made up daily. ap initial margin is treated as a deposit account similar to a bank account, and is increased or decreased as the margin amount changes ap the gain or loss on the contract, reflected in the daily change in the account, is recognized in income
sometimes companies enter into derivative contracts that deal with their own shares examples of ³own equity´ derivative instruments include: 1)p options a)p purchased call or put options to buy/sell the entity¶s own shares b)p written call or put options to buy/sell the entity¶s own shares 2)p forwards a)p to buy the entity¶s own shares b)p to sell the entity¶s own shares - ap not all contracts involving own equity instruments are treated as equity; some end up being treated as financial liabilities or assets ap as a general rule, any analysis should go back to basic principles and definitions ap the following exceptions exist 1)p ÷ When a derivative contract is entered into that creates an obligation to pay cash or other assets even if it is for a fixed number of the entity¶s shares, it overrides the ³fixed for fixed´ principle and the contract should generally be treated as a financial liability. Therefore, any time there is an obligation to pay cash, a financial liability is recognized. 2)p When the derivative contract allows choice in how the instruments will be settled, the instrument is a financial asset/liability by default under IFRS unless all possible settlement options result in it being an equity instrument. Under PE GAAP, the instrument would likely be treated as equity if the entity can avoid settling with cash or other assets (i.e., where the entity has the option to choose the way the contract is settled and can avoid paying cash or other assets).
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it is generally agreed that effective compensation programs: 1)p motivate employees to high levels of performance 2)p help retain executives and recruit new talent 3)p base compensation on employee and company performance 4)p maximize the employee¶s after tax benefit and minimize the employer¶s after-tax cost 5)p use performance criteria that the employee can control although straightforward cash compensation plans (salary and, perhaps, a bonus) are an important part of any compensation program, they are oriented to the short term many companies recognize that a more long-run compensation plan is often needed in addition to a cash component stock-based compensation plans can help preserve cash and ensure that company¶s performance is satisfactory
ÿ ! Ñ - ap companies can also use stock options for the following reasons: 1)p To give employees an opportunity to own part of the company, with the issue being made to a wide group of people (e.g., all employees). Another benefit of these plans if they are widely subscribed to is that the company raises cash. These are generally called employee stock option or purchase plans (ESOPs). 2)p To remunerate management or employees. These are called compensatory stock option plans (CSOPs). 3)p As compensation in a particular purchase or acquisition transaction, with the stock options being provided instead of paying cash or another asset, or incurring a liability.
" ! ap
full disclosure should be made of the following: mp the accounting policy that is being used mp a description of the plans and modifications mp details of the numbers and values of the options issued, exercised, forfeited, and expired mp a description of the assumptions and methods being used to determine fair values mp the total compensation cost included in net income and contributed surplus mp other
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) *#+ 1.p !! !! Derivatives are financial instruments that derive (get) their value from an underlying instrument. They are attractive since they transfer risks and rewards without having to necessarily invest directly in the underlying instrument. They are used for both speculative purposes (to expose a company to increased risks in the hope of increased returns) and for hedging purposes (to reduce existing risk). 2.p @ ,! Financial risks include credit, currency, interest rate, liquidity, market, and other price risks. Credit risk is the risk that the other party to a financial instrument contract will fail to deliver. Currency and interest rate risk are the risk of a change in value and cash flows due to currency or interest rate changes. Liquidity risk is the risk that the company itself will not be able to honour the contract due to cash problems. Finally, market risk is the risk of a change in value and/or cash flows related to market forces. 3.p !! ! Derivatives are recognized on the balance sheet on the date that the contract is initiated. They are re-measured, on each balance sheet date, to their fair value. The related gains and losses are recorded through net income. Written options create liabilities. Futures contracts require the company to deposit a portion of the contracts¶ value with the broker/exchange. The contracts are marked to market by the broker/exchange daily and the company may have to deposit additional funds to cover deficiencies in the margin account. Purchase commitments that are net settleable and are not ³expected use´ contracts are accounted for as derivatives under IFRS. Under PE GAAP, purchase commitments are never accounted for as derivatives as they are not exchange-traded futures contracts. Exchange traded derivatives relating to commodities are generally accounted for as derivatives under ASPE. Special hedge accounting may affect how derivatives are accounted for. 4.p @ - ! ! # . - Under IFRS, derivatives that are settleable in the entity¶s own equity instruments are accounted for as equity (or contra-equity) if they will be settled by exchanging a fixed number of equity instruments for a fixed amount of cash or other assets and they do not create an obligation to deliver cash or other assets. Otherwise, they are financial assets/liabilities. In general, if the instruments are net settleable or have settlement options, they most often do not meet the criteria for equity presentation and are therefore financial assets/liabilities. IFRS provides significantly more guidance with respect to the accounting for these instruments. 5.p ë / #!" ! ! # - # ! Complex instruments include compound and hybrid instruments where the legal form may differ from the economic substance. The economic substance dictates the accounting. The main issue is that of presentation: should the instrument be presented as debt or equity? The definitions of debt and equity are useful in analyzing this. It is also important to understand what gives the instruments their value from a finance or economic perspective. If an instrument has both debt and equity components, use of the proportional and incremental methods will help in allocating the carrying value between the two components. There are differences in measuring compound financial instruments under IFRS versus PE GAAP. Related interest, dividends, gains, and losses are treated in a way that is consistent with the balance sheet presentation. 6.p @ ! # The method for recording convertible bonds at the date of issuance is different from the method that is used to record straight debt issues. As the instrument is a compound instrument and contains both debt and equity components, these must be measured separately and presented as debt and equity, respectively. Any discount or premium that results from the issuance of convertible bonds is amortized, assuming the bonds will be held to maturity. If bonds are converted into other securities, the principle accounting problem is to determine the amount at which to record the securities that have been exchanged for the bond. The book value method is often used in practice. ASPE allows an entity to value the equity portion of compound instruments at $0. 7.p # , Stock compensation includes direct awards of stock (when a company gives the shares to an employee as compensation), compensatory stock option plans whereby an employee is given stock options in lieu of salary, stock appreciation rights, and performance-type plans.
8.p @ !# ! ! Employee stock option plans are meant to motivate employees and raise capital for the company. They are therefore capital transactions. Compensatory stock option plans are operating transactions since they are meant to compensate the employee for services provided. Costs relating to the latter are booked as expense. 9.p # , CSOPs are measured at fair value (using an options pricing model) at the grant date. The cost is then allocated to expense over the period that the employee provides service. 10.p ! + ! # !! ! 0& ! ! The differences are noted in the comparison chart. The stock-based compensation standards are largely converged and stable; however, the IASB is currently working on several projects relating to financial instruments including defining equity versus liabilities and hedging. 11.p !! !! ! . Any company or individual that wants to protect itself against different types of business risk often uses derivative contracts to achieve this objective. In general, where the intent is to manage and reduce risk, these transactions involve some type of hedge. Derivatives are useful tools for this since they have the effect of transferring risks and rewards between the parties to the contract. Derivatives can be used to hedge a company¶s exposure to fluctuations in interest rates, foreign currency exchange rates, equity, or commodity prices. 12.p @ ! !! - ! . Hedge accounting is optional accounting that ensures that properly hedged positions will reduce volatility in net income created by hedging with derivatives. It seeks to match gains and losses from hedged positions with those of the hedging items so that they may be offset. Since this is special accounting, companies must ensure that there is in fact a real hedge (i.e., that the contract insulates the company from economic loss or undesirable consequences) and that the hedge remains effective. Proper documentation of the risks and risk management strategy is important. 13.p @ !# ! ! ! . A fair value hedge reduces risks relating to fair value changes of recorded assets and liabilities as well as purchase commitments. Cash flow hedges protect against future losses due to future cash flow changes relating to exposures that are not captured on the balance sheet. PE GAAP does not discuss fair value or cash flow hedges but rather stipulates the accounting for certain types of specific hedge transactions. 14.p c ! # ! . Properly hedged positions reduce income fluctuations because gains and losses are offset. Under IFRS, for cash flow hedges, the gains and losses on the hedging items are booked through Other Comprehensive Income and are brought into net income in the same (future) period that the hedged items are booked to net income. For fair value hedges, hedge accounting adjusts the hedged asset to ensure that it is recognized and measured at fair value and that related gains/losses are booked through net income. Both types of hedges ensure that the gains/losses of the hedged and hedging positions offset. Under PE GAAP hedge accounting, the hedging item (which is generally a derivative) is not recognized on the balance sheet until the hedging item is settled. Thus both the hedged item (usually a future transaction) and the hedging item (the derivative) are off-balance sheet and there is no mismatch. Only certain prespecified transactions are eligible for hedge accounting under PE GAAP. 15.p ë , . SARs are popular because the employee can share in increases in value of the company¶s shares without having to purchase them. The increases in value over a certain amount are paid to the employee as cash or shares. Obligations to pay cash represent a liability that must be re-measured. The cost is therefore continually adjusted, with the measurement date being the exercise date. The related expense is spread over the service period. If the SARs are not exercised at the end of the service period, the liability must continue to be re-measured. Cash-settled SARs are measured using intrinsic values under PE GAAP and fair value under IFRS. 16.p @ - These plans are tied to performance (of the entity, the individual or a group of individuals). There is therefore more measurement uncertainty. 17.p !! ! ! . Fair value is most readily determined where there is an active market with published prices. Where this is not the case, a valuation technique is used. More basic techniques include discounted cash flows. More complex techniques include options pricing models such as the Black-Scholes and binomial tree models. Where possible, valuation techniques should use available external inputs to ensure that they are more objective. Having said this, significant judgement goes into determining fair values using options pricing models.
