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Chapter 16

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Allan Foerster

Chapter 16- Complex Financial Instruments Debt vs. Equity - Hybrid/combined instruments have characteristics of both debt and equity - When analyzing whether it is debt or equity or both, consider the following o Contractual terms  Does the instrument explicitly obligate the entity to pay out cash or other assets  Does the instrument give the holder the choice to force the company to pay out cash  Creating an obligation  Are there settlement options  Creating an obligation o Economic substance  When an instrument gives the holder increased flexibility or choice, it is worth more  Must keep in mind if the instrument contains any equity like features that may need to be separated out o Definitions of financial statement elements  Financial liability is any liability that is a contractual obligation to do either of the following  Deliver cash or other financial assets to another party  Exchange financial instruments with another party under conditions that are potentially unfavorable  Where the instrument is settle-able using the entity’s shares instead of cash o A financial liability where the company settles the instrument using a variable number of shares instead of cash  An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities  With regards to settling instruments with an entity’s own shares o Only equity if the instrument will be settled by exchanging a fixed number of the issuers own equity instruments for a fixed amount of cash or other assets  One must look if it is a financial liability or equity instrument based on the definitions  May have to split out the equity component of certain financial instruments- Bifurcation - Measurement o What ever classification is chosen upon inception, the classification continues to be used until the instrument is removed from the balance sheet o Upon initial recognition financial instruments are measured at fair value  Generally the exchange value  Financial liabilities can be measured at fair value or amortized cost  When measured initially at amortized cost, subsequent measurements require the use of amortized cost o Hybrid or combined  Measurement is done at the time of initial recognition  Based on valuing the debt and applying the residual to the equity component  No subsequent revision - Perpetual Debt o Instrument is never repaid o Legally it is debt, but economically speaking it is similar to equity o The value of it stems from the value of the interest payments  Because interest must be paid o By definition, it is a financial liability  Due to the legal obligation to pay interest despite the fact that there is no obligation to pay the principle - Callable/Redeemable Preferred Shares o Retractable or mandatorily redeemable preferred shares are shares that will be redeemed by the issuing company for a fixed or determinable amount  They are financial liabilities and must be measured at fair value  Because an obligation exists for the company to pay cash when the shares are redeemed o High/Low preferred shares  Redeemable preferred shares used to minimize taxes when small business owners want to hand the company over to the children  Treating the shares as debt makes the company look highly debt leveraged when in fact the shares will normally not be redeemed in the short-term  Therefore, ASPE allows for these instruments to maintain their equity classification o Retractable preferred shares  Gives the issuer the option to demand redemption of the shares  The redemption requires the sacrifice of a future economic benefit/binding obligation to settle the debt with cash  Since the company has a contractual obligation to deliver cash  They are financial liabilities o Triggering Events  Certain preferred shares are redeemable if specific events occur  If the triggering event is probable or likely when the instrument is first recognized, than its recognized as a liability  Contingency  The classification remains the same until the triggering event occurs or fails to occur  Than a new assessment is made o Settlement options  Redemption in cash or equity  If equity and the number of shares varies to reflect the redemption value, treated as debt  Shares being used as currency  If equity and the number of shares is fixed, its equity - Debt with detachable stock warrants o Detachable warrants  Option to buy common shares at a fixed price (exercise price)  Warrant is only available for a limited time (exercise period)  Can be traded on public markets  Separable from the host contract o Warrants and options meet the definition of equity instruments under IFRS  They represent residual interest in the net assets of the entity o Therefore, the financial instrument is part debt and part equity - Convertible Debt o Are bonds that are convertible to other forms of securities o Combines the benefits of a bond (interest payments and principle repayment) with the privilege of exchanging the bond for shares at the bondholders option o Once the bond is converted, all interest and principle is no longer payable o Reasons for issuance  Can raise equity capital without giving up ownership control  Can achieve equity financing at a lower cost  Conversion feature provides investor with an opportunity to own equity o Which results in the investor accepting a lower coupon rate o Reporting at the time of issuance  Part of the proceeds are allocated to liability and part to equity  The amounts allocated to liability and equity are determined by using the incremental method  The FV of the debt component is determined when issued o The FV of the debt component is just the PV of the bond  PV of interest and PV of principle repayment  The remainder of the proceeds become t
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