Ch16 Complex Financial Instruments Exam Prep - Test Bank Intermediate Accounting v2 13e | Canada by Donald E. Kieso. DOCX document preview.
CHAPTER 16
COMPLEX FINANCIAL INSTRUMENTS
CHAPTER STUDY OBJECTIVES
1. Understand what derivatives are, how they are used to manage risks, and how to account for them. Derivatives are financial instruments that derive (get) their value from an underlying instrument. They are attractive because 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).
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 a contract due to cash problems. Finally, market risk is the risk of a change in value and/or cash flows related to market forces.
Derivatives are recognized on the SFP on the date the contract is initiated. They are remeasured, on each SFP 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 “expected use” contracts are accounted for as derivatives under IFRS. Under ASPE, purchase commitments are never accounted for as derivatives because 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.
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 than ASPE with respect to the accounting for these instruments.
2. Analyze and account for hybrid/compound instruments from an issuer perspective. 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, IFRS requires use of the residual value method in allocating the carrying value between the two components. There are differences in measuring compound financial instruments under IFRS versus ASPE. Related interest, dividends, gains, and losses are treated in a way that is consistent with the SFP presentation.
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 principal 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.
3. Describe and account for share-based compensation. 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, share appreciation rights (SARs), and performance-type plans. SARs and performance-type plans are discussed in Appendix 16B.
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 service provided.
CSOPs and direct awards of stock 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.
4. Identify differences in accounting between IFRS and ASPE, and what changes are expected in the near future. The differences are noted in the comparison chart in Illustration 16.11. The stock-based compensation standards are largely converged and stable; however, the IASB has been working on several projects relating to financial instruments, including macro hedging.
5. Understand how derivatives are used in hedging and explain how to apply hedge accounting standards. 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.
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 (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. Under IFRS, there are fair value hedges and cash flow hedges. 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 SFP. ASPE does not discuss fair value or cash flow hedges but rather stipulates the accounting for certain types of specific hedge transactions.
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 ASPE hedge accounting, the hedging item (which is generally a derivative) is not recognized on the balance sheet until the hedged 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.
6. Account for share appreciation rights plans and performance-type plans. 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 remeasured. 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 remeasured. Cash-settled SARs are measured using intrinsic values under ASPE and fair value (using options pricing models) under IFRS. Some SARs are settled using equity instruments. These are treated as equity and measured at fair value. ASPE allows an accounting policy choice as to how to measure equity-settled SARs.
Performance-type plans are tied to performance (of the entity, the individual, or a group of individuals). There is therefore more measurement uncertainty.
7. Understand how options pricing models are used to measure financial instruments. 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 included 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.
8. Describe and analyze required fair value disclosures for financial instruments. Additional disclosures relating to fair values of financial instruments provide useful information about the reliability of fair value estimates. As discussed in earlier chapters, including chapters 2 and 3, the IASB has established a fair value hierarchy that ranks the reliability of the fair value measures. Note disclosures under IFRS require information about which financial instruments are classified as levels 1, 2, or 3 in the fair value hierarchy. Additional information is required to be disclosed where the financial instruments are Level 3 instruments because Level 3 measurements are less reliable.
Answer No. Description
b 1. Characteristics of derivatives
d 2. Purpose of derivatives
c 3. Definition of credit risk
c 4. Types of market risks
d 5. Speculator’s objective
a 6. Arbitrageur’s objective
c 7. Valuation of derivatives
b 8. Recording gains on derivatives
b 9. Meaning of writing an option
d 10. Definition of a call option
c 11. Definition of a put option
a 12. Intrinsic value of an option
b 13. Time value of an option
c 14. Characteristics of a forward contract
d 15. Characteristics of a futures contract
b 17. Liquidity risk
a 18. Market risk
a 19. Recording a call option
a 20. Settlement of a call option
d 21. Recording a forward contract
b 22. Settlement of a forward contract
a 23. Calculating the intrinsic value of an option
b 24. Calculating the time value of an option
b 25. Recording the adjusting entry for a call option
d 26. Recording expiry of a call option
c 27. Recording the adjusting entry for a forward contract
b 28. Advantages of issuing debt
b 29. Measurement of hybrid/compound instruments
c 30. Classification of hybrid/compound instruments
b 31. Presentation of high/low preferred shares under ASPE
a 32. Classification of term preferred shares under IFRS
d 33. Characteristics of convertible bonds
a 34. Reasons for issuing convertible bonds
c 35. Recording of convertible debt
a 36. Recording conversion of bonds
d 37. Classification of options on convertible securities
a 38. Recording dividends on term preferred shares
b 39. Bond issue inducements
c 40. Convertible debt under IFRS
c 41. Allocation of proceeds from issuance of convertible bonds
b 42. Recognition of gains/losses on bond conversion
d 43. Bond issue with detachable stock warrants
a 44. Conversion of convertible bonds
b 45. Conversion of convertible bonds
a 46. Conversion of convertible bonds
b 47. Conversion of convertible bonds
b 48. Effective interest rate on convertible bonds
c 49. Calculating interest expense on bonds sold at a discount
c 50. Calculating unamortized bond discount on converted bonds
d 51. Conversion of preferred shares
a 52. Bonds issued with detachable stock warrants
d 53. Bonds issued with detachable stock warrants
c 54. Bonds issued with detachable stock warrants
d 55. Bonds issued with detachable stock warrants
a 56. Bonds issued with detachable stock warrants
d 57. Bonds issued with detachable stock warrants
c 58. Bonds issued with detachable stock warrants
d 59. Convertible preferred shares
b 60. Preferred shares with detachable stock warrants
d 61. Valuation of convertible bonds (IFRS)
d 62. Characteristics of a non-compensatory stock option plan
c 63. Accounting for a non-compensatory stock option plan
a 64. Measurement date for a compensatory stock option plan
c 65. Recognition of compensation expense for a stock option plan
b 66. Calculation of compensation expense
d 67. Stock compensation plans
d 68. Issuance of warrants
c 69. Compensation expense in a stock option plan
c 70. Determine compensation expense in a stock option plan
b 71. Determine compensation expense in a stock option plan
a 72. Determine compensation expense in a stock option plan
b *73. Definition of hedging
c *74. Fair value hedge
d *75. Hedge accounting
b *76. Hedge accounting
c *77. Swap contract
a *78. Performance-type plan
d *79. Executive compensation plans
c *80. Compensation expense in a SAR plan
a *81. Basis of performance-type plan
c *82. Compensation expense recognized in first year of a SAR plan
b *83. Compensation expense recognized in second year of a SAR plan
c *84. Compensation expense recognized in third year of a SAR plan
b *85. Compensation expense recognized in a SAR plan
a *86. SAR and timing of valuation
b 87. Options pricing models
Answer No. Description
c 88. Fair value hierarchy inputs
b 89. Fair value hierarchy inputs
d 90. Compensation plan disclosures under IFRS
*This topic is dealt with in an Appendix to the chapter.
Item Description
E16-91 Put options
E16-92 Purchased call options
E16-93 Purchased call options
E16-94 Forward contract
E16-95 Convertible debt and debt with warrants
E16-96 Convertible bonds
E16-97 Convertible bonds
E16-98 Convertible bonds
E16-99 Redeemable preferred shares and succession planning
E16-101 Stock options
E16-102 Employee share ownership plans
E16-103 Employee share ownership plans
*E16-104 Share appreciation rights
*E16-105 Options pricing models
E16-106 Fair value disclosure for financial instruments – IASB standards
*This topic is dealt with in an Appendix to the chapter.
PROBLEMS
Item Description
P16-107 Forward contract
P16-108 Employee stock options
P16-109 Employee stock options
P16-110 Convertible bonds and warrants
P16-111 Convertible debt
P16-112 Convertible debt
P16-113 Stock options
*P16-114 Hedging
*P16-115 Interest rate swap
*P16-116 Hedging (forward contract)
*P16-117 Share appreciation rights plans
P16-118 Fair value hierarchy
*This topic is dealt with in an Appendix to the chapter.
MULTIPLE CHOICE QUESTIONS
1. Derivative instruments
a) require significant investments.
b) transfer financial risks.
c) transfer primary instruments.
d) are settled at the date of issuance.
Difficulty: Easy
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
2. Derivatives exist to help companies
a) hide financial irregularities.
b) reduce interest expense.
c) manage cash flows.
d) manage risks.
Difficulty: Easy
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
3. Credit risk is the risk that
a) an instrument’s price or value will change.
b) the company itself will not be able to fulfill its obligation.
c) one of the parties to the contract will fail to fulfill its obligation and cause the other party loss.
d) cash flow will change over time.
Difficulty: Easy
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
4. The three types of market risk are
a) currency, interest rate, and liquidity risks.
b) interest rate, other price, and credit risks.
c) currency, interest rate, and other price risks.
d) liquidity, currency, and other price risks.
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
5. A speculator’s objective is to
a) reduce pre-existing risks.
b) take delivery of the underlying.
c) take advantage of information asymmetry.
d) maximize potential returns by being exposed to greater risks.
Difficulty: Easy
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
6. An arbitrageur depends on
a) information asymmetry between markets.
b) hedging opportunities between markets.
c) differing credit risks.
d) differing liquidity risks.
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
7. Derivatives should be valued at
a) historical cost.
b) fair value or historical cost.
c) fair value.
d) discounted cost.
Difficulty: Easy
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
8. Gains on derivatives should
a) be booked through other comprehensive income.
b) be booked through net income.
c) be recorded as deferred revenue.
d) not be recorded.
Difficulty: Easy
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
9. If a company writes an option, it
a) pays a fee and gains a right.
b) charges a fee and gives the holder a right.
c) charges a fee for handling option transactions.
d) endorses an option over to another party.
Difficulty: Easy
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
10. A call option is a right to
a) force another party to buy the underlying security.
b) repurchase a previously sold underlying security.
c) sell the underlying security.
d) buy the underlying security.
Difficulty: Easy
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
11. A put option is a right to
a) force another party to buy the underlying security.
b) repurchase a previously sold underlying security.
c) sell the underlying security.
d) buy the underlying security.
Difficulty: Easy
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
12. The intrinsic value of an option is the
a) difference between the price of the underlying security and the strike price.
b) value due to expectations that the price of the underlying security will rise above the strike price.
c) minimum value of the option.
d) option premium value.
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
13. The time value of an option is the
a) difference between the price of the underlying security and the strike price.
b) value due to expectations that the price of the underlying security will rise above the strike price.
c) minimum value of the option.
d) option premium value.
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
14. A forward contract
a) is generally exchange traded, and therefore has a ready market value.
b) creates a right but not an obligation.
c) commits the contracting parties upfront to do something in the future.
d) has no locked-in time period.
Difficulty: Easy
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
15. A futures contract
a) is not exchange traded, and therefore does not have a ready market value.
b) exposes the contracting party to credit risk.
c) does not require a margin account to be established.
d) is standardized as to amounts and dates.
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
16. An option (call or put) contract
a) commits the parties to the contract upfront to do something in the future.
b) creates a right, but not an obligation to do something in the future.
c) are standardized and trade on stock markets and exchanges.
d) are settled through clearing houses, thus removing credit risk.
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
17. Liquidity risk is
a) the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices.
b) the risk that an entity will have difficulty meeting obligations associated with financial liabilities.
c) the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge (respect) an obligation.
d) the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates.
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
18. Market risk is
a) the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices.
b) the risk that an entity will have difficulty meeting obligations associated with financial liabilities.
c) the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge (respect) an obligation.
d) the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates.
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
19. On April 1, 2023, Gamma Corp. purchases a call option for $500, which gives Gamma the right to buy 1,000 shares of Delta Inc. for $30 each until December 1, 2023. Delta Inc. shares are currently trading for $30. At June 30, 2023, the options are trading at $4,800 and the shares at $32 each. At December 1, 2023, the options expire with no value. The entry to record the purchase of the call option is
a) Derivatives—Financial Assets 500
Cash 500
b) Cash 500
Derivatives—Financial Assets 500
c) FV-NI Investments 500
Cash 500
d) No entry required.
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
20. On July 5, 2023, Alpha Corp. purchased a call option for $2,400, giving it the right to buy 2,000 shares of Omega Corp. for $20 per share. On August 18, 2023, when the option value is $12,000, Omega settles the option for cash. The entry on Alpha’s books to record the settlement is
a) Cash 12,000
Derivatives—Financial Assets/Liabilities 2,400
Gain or Loss on Derivatives 9,600
b) Cash 12,000
Gain or Loss on Derivatives 12,000
c) Cash or Loss on Derivatives 12,000
Derivatives—Financial Assets/Liabilities 12,000
d) Derivatives—Financial Assets/Liabilities 2,400
Cash 9,600
Gain or Loss on Derivatives 12,000
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $12,000 – $2,400 = $9,600 gain
21. On August 25, 2023, Beta Inc. entered into a forward contract to buy 25,000 Krubles (KRB) for $3,800 Canadian (CAD) on September 5, 2023. On August 31, 2023, 25,000 KRB can be purchased for $3,500 CAD. On September 5, Beta settles the contract but does NOT take delivery of the KRB.
The entry to record the change in value of the contract on August 31, 2023, is
a) no entry.
b) Other Comprehensive Loss 300
Derivatives—Financial Assets/Liabilities 300
c) Derivatives—Financial Assets/Liabilities 300
Gain or Loss on Derivatives 300
d) Gain or Loss on Derivatives 300
Derivatives—Financial Assets/Liabilities 300
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: Agreed payment $3,800 – $3,500 current cost = $300 loss
22. On August 25, 2023, Beta Inc. entered into a forward contract to buy 25,000 Krubles (KRB) for $3,800 Canadian (CAD) on September 5, 2023. On August 31, 2023, 25,000 KRB can be purchased for $3,500 CAD. On September 5, Beta settles the contract but does NOT take delivery of the KRB.
On September 5, 2023, the KRB is trading at $0.15 CAD. The entry to record the settlement of the contract is
a) Derivatives—Financial Assets/Liabilities 250
Cash 50
Gain or Loss on Derivatives 300
b) Derivatives—Financial Assets/Liabilities 300
Cash 50
Gain or Loss on Derivatives 250
c) Derivatives—Financial Assets/Liabilities 300
Cash 200
Gain or Loss on Derivatives 100
d) Cash 450
Derivatives—Financial Assets/Liabilities 250
Gain or Loss on Derivatives 200
Difficulty: Hard
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: 25,000 KRB @ $15 = $3,750
$3,750 – $3,800 settlement amount = $50 loss overall
$50 loss – $300 loss previously recorded = $250 gain (recovery of loss)
23. On April 1, 2023, Gamma Corp. purchases a call option for $500, which gives Gamma the right to buy 1,000 shares of Delta Inc. for $30 each until December 1, 2023. Delta Inc. shares are currently trading for $30. At June 30, 2023, the options are trading at $4,800 and the shares at $32 each. At December 1, 2023, the options expire with no value.
The intrinsic value of the option at April 1, 2023, is
a) $0.
b) $500.
c) $1,000.
d) $4,800.
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $30 – $30 = $0
24. On April 1, 2023, Gamma Corp. purchases a call option for $500, which gives Gamma the right to buy 1,000 shares of Delta Inc. for $30 each until December 1, 2023. Delta Inc. shares are currently trading for $30. At June 30, 2023, the options are trading at $4,800 and the shares at $32 each. At December 1, 2023, the options expire with no value.
The time value of the option at April 1, 2023 is
a) $0.
b) $500.
c) $4,800.
d) $30,000.
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $500 – $0 = $500
25. On April 1, 2023, Gamma Corp. purchases a call option for $500, which gives Gamma the right to buy 1,000 shares of Delta Inc. for $30 each until December 1, 2023. Delta Inc. shares are currently trading for $30. At June 30, 2023, the options are trading at $4,800 and the shares at $32 each. At December 1, 2023, the options expire with no value.
At June 30, 2023, Gamma’s quarter end, the adjusting entry would be
a) No entry required.
b) Derivatives—Financial Assets 4,300
Gain or Loss on Derivatives 4,300
c) Derivatives—Financial Assets 4,300
Other Comprehensive Income 4,300
d) Derivatives—Financial Assets 4,800
Gain or Loss on Derivatives 4,800
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $ 4,800 fair value less $ 500 recorded cost = $ 4,300 gain
26. On April 1, 2023, Gamma Corp. purchases a call option for $500, which gives Gamma the right to buy 1,000 shares of Delta Inc. for $30 each until December 1, 2023. Delta Inc. shares are currently trading for $30. At June 30, 2023, the options are trading at $4,800 and the shares at $32 each. At December 1, 2023, the options expire with no value.
At December 1, 2023, Gamma’s entry would be
a) No entry required.
b) Gain or Loss on Derivatives 2,000
Derivatives—Financial Assets 2,000
c) Gain or Loss on Derivatives 4,300
Derivatives—Financial Assets 4,300
d) Gain or Loss on Derivatives 4,800
Derivatives—Financial Assets 4,800
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $ 0 – $ 4,800 = $ 4,800 loss
27. On October 5, 2023, Kappa Cloth Ltd. enters into a forward contract to purchase 10,000 metres of cotton fabric at $1 per metre, good until February 1, 2024. At December 31, 2023, the forward price for February 2024 delivery of cotton fabric has increased to $1.06 per metre. The adjusting entry at December 31, 2023, would be
a) No entry required.
b) Derivatives—Financial Assets/Liabilities 600
Unrealized Gain or Loss (OCI) 600
c) Derivatives—Financial Assets/Liabilities 600
Gain or Loss on Derivatives 600
d) Gain or Loss on Derivatives 600
Derivatives—Financial Assets/Liabilities 600
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: ($1.06 – $1.00) × 10,000 = $600 gain
28. An advantage of issuing debt instead of equity is that
a) interest must be paid, regardless of earnings.
b) the interest is tax deductible.
c) it increases solvency or liquidity risks.
d) no leverage is possible.
Difficulty: Easy
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
29. With regard to the measurement of hybrid/compound instruments,
a) IFRS requires the use of the relative fair value method.
b) IFRS requires the use of the residual method.
c) ASPE does not allow the equity component to be valued at zero.
d) after the initial measurement, the debt portion is always measured at fair value.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
30. Which of the following would be classified as a hybrid/compound financial instrument resulting in two elements being reported on the SFP?
a) perpetual debt
b) mandatorily redeemable preferred shares
c) debt with detachable warrants
d) puttable shares
Difficulty: Easy
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
31. ASPE requires that high/low (redeemable) preferred shares be presented as
a) long-term debt.
b) equity.
c) either equity or long-term debt.
d) a contra-asset.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
32. Under IFRS, mandatorily redeemable preferred shares (term preferred shares) are treated as
a) a liability.
b) equity.
c) a contra-asset.
d) either a liability or a contra-asset.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
33. Convertible bonds
a) have priority over all other types of bonds.
b) are usually secured by a first or second mortgage.
c) pay interest only in the event earnings are sufficient to cover the interest.
d) may be exchanged for common shares.
Difficulty: Easy
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
34. A common reason for issuing convertible bonds is
a) to obtain debt financing at cheaper rates.
b) to avoid paying dividends on common shares.
c) to give the purchaser the option of buying preferred shares.
d) to reduce the debt to total assets ratio.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
35. Under IFRS, a convertible debt security is recorded as a debt instrument
a) with the equity feature ignored.
b) with the equity feature described in a note.
c) and an equity component.
d) with the conversion component credited to the Common Shares account.
Difficulty: Easy
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
36. When convertible debt is converted to common shares, IFRS requires that this is recorded by the
a) book value method.
b) relative fair value method.
c) market value method.
d) residual method.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
37. For convertible securities, the portion relating to the option should be classified as a(n)
a) liability.
b) asset.
c) reduction of contributed surplus.
d) addition to contributed surplus.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
38. Dividends on term preferred shares, where the shares have been recorded as a liability, should be debited to
a) interest expense.
b) retained earnings.
c) contributed surplus.
d) other comprehensive income.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
39. When a bond issuer offers some form of additional consideration (a “sweetener”) to induce conversion, this is
a) accounted for as an extraordinary item.
b) allocated between the debt and equity components of this instrument.
c) accounted for as a loss.
d) accounted for as a gain.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
40. Under IFRS, when convertible debt is retired,
a) only losses on retirement are recognized.
b) only gains on retirement are recognized.
c) either a gain or a loss on retirement is recognized.
d) neither gains nor losses are recognized.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
41. On January 2, 2023, Perseus Corp. issued 10-year convertible bonds at 105. During 2024, all the bonds were converted into common shares having a total value equal to the total face amount of the bonds. At conversion, the market price of Perseus's common shares was 50% above its average carrying value. Perseus adheres to IFRS. At issuance, the cash proceeds from the issuance of these bonds should be reported as
a) contributed surplus for the entire proceeds.
b) contributed surplus for the portion of the proceeds attributable to the conversion feature and as a liability for the balance.
c) a liability for the present value of the bonds and contributed surplus for the balance.
d) a liability for the entire proceeds.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
42. On January 2, 2023, Perseus Corp. issued 10-year convertible bonds at 105. During 2024, all the bonds were converted into common shares having a total value equal to the total face amount of the bonds. At conversion, the market price of Perseus's common shares was 50% above its average carrying value. Perseus adheres to IFRS. On conversion, Perseus would credit the Common Shares account with
a) the par value of the bonds plus the balance in the Contributed Surplus account.
b) the carrying value of the bonds plus the balance in the Contributed Surplus account.
c) the carrying value of the bonds minus the balance in the Contributed Surplus account.
d) the market value of the bonds plus the balance in the Contributed Surplus account.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
43. Antigone Corp. issued bonds with detachable common stock warrants. Only the bonds had a known market value. Using the residual method, the value attributable to the warrants is reported as
a) Stock Warrants Distributable.
b) Other Comprehensive Income.
c) Common Shares Subscribed.
d) Contributed Surplus—Stock Warrants.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
44. Wang Inc. has $3,000,000 (par value), 8% convertible bonds outstanding. Each $1,000 bond is convertible into 30 no par value common shares. The bonds pay interest on January 31 and July 31. On July 31, 2023, the holders of $900,000 worth of bonds exercised the conversion privilege. On that date the market price of the bonds was 105, the market price of the common shares was $36, the carrying value of the common shares was $18, and the Contributed Surplus—Conversion Rights account balance was $450,000. The total unamortized bond premium at the date of conversion was $210,000. Using the book value method, Wang should record, as a result of this conversion,
a) no gain or loss.
b) a loss of $9,000.
c) other comprehensive income of $9,000.
d) a gain of $18,000.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
45. Wang Inc. has $3,000,000 (par value), 8% convertible bonds outstanding. Each $1,000 bond is convertible into 30 no par value common shares. The bonds pay interest on January 31 and July 31. On July 31, 2023, the holders of $900,000 worth of bonds exercised the conversion privilege. On that date the market price of the bonds was 105, the market price of the common shares was $36, the carrying value of the common shares was $18, and the Contributed Surplus—Conversion Rights account balance was $450,000. The total unamortized bond premium at the date of conversion was $210,000. Using the book value method, what would Wang record as a result of this conversion?
a) a credit of $ 135,000 to Contributed Surplus—Conversion Rights
b) a debit of $ 135,000 to Contributed Surplus—Conversion Rights
c) a credit of $63,000 to Bonds Payable
d) a debit of $210,000 to Bonds Payable
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $450,000 x 900 ÷ 3,000 = $135,000
46. On July 1, 2023, an interest payment date, $180,000 (par value) of Lusaka Corp. bonds were converted into 3,600 of its no par common shares. At this time, the unamortized discount on the bonds was $7,200. When the bonds were originally issued, the equity portion of the bond was valued at $1,700. Using the book value method, Lusaka would record
a) a $174,500 increase in Common Shares.
b) a $172,800 increase in Common Shares.
c) a $171,100 increase in Common Shares.
d) no change to Contributed Surplus.
Difficulty: Hard
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $180,000 – $7,200 + $1,700 = $174,500
47. Johannesburg Corp. has two issues of securities outstanding: no par value common shares and 8% convertible bonds with a par value of $8,000,000. Bond interest payment dates are June 30 and December 31. The conversion clause in the bond indenture entitles the bondholders to receive 40 common shares in exchange for each $1,000 bond. The value of the equity portion of the bond issue is $60,000. On June 30, 2023, the holders of $1,200,000 par value bonds exercise the conversion privilege. The market price of the bonds on that date is $1,100 per bond and the market price of the common shares is $35. The total unamortized bond discount at the date of conversion is $500,000. In applying the book value method, what amount should Johannesburg credit to Common Shares as a result of this conversion?
a) $1,284,000
b) $1,134,000
c) $1,125,000
d) $1,116,000
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: ($1,200,000 ÷ $8,000,000) × $500,000 = $75,000 (unamortized discount)
($1,200,000 ÷ $8,000,000) × $60,000 = $9,000 (cont. surplus)
$1,200,000 – $75,000 + $9,000 = $1,134,000
48. On July 2, 2023, Martineau Ltd. issued $6,000,000 (par value), 9%, ten-year convertible bonds at 98. The bonds were dated April 1, 2023 with interest payable quarterly on July 1, October 1, January 1 and April 1. If the bonds had NOT been convertible, they would have sold for 96.1. The bond discount is amortized on a straight-line basis. On April 1, 2024, $1,200,000 of these bonds were converted into 500 no par common shares. Accrued interest was paid in cash at the time of conversion. What was the effective interest rate on the bonds when they were issued?
a) 9%
b) above 9%
c) below 9%
d) Cannot determine from the information given.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: Bonds issued at a discount, therefore effective (market) rate > stated rate
49. On July 2, 2023, Martineau Ltd. issued $6,000,000 (par value), 9%, ten-year convertible bonds at 98. The bonds were dated April 1, 2023 with interest payable quarterly on July 1, October 1, January 1, and April 1. If the bonds had NOT been convertible, they would have sold for 96.1. The bond discount is amortized on a straight-line basis. On April 1, 2024, $1,200,000 of these bonds were converted into 500 no par common shares. Accrued interest was paid in cash at the time of conversion. What is the debit to Interest Expense on Oct. 1, 2023?
a) $129,000
b) $135,000
c) $141,000
d) $143,923
Difficulty: Hard
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $6,000,000 × 96.1% = $5,766,000
$6,000,000 × 98% = $5,880,000
$ 5,880,000 – $5,766,000 = $114,000 (contributed surplus)
$6,000,000 – $5,766,000 = $234,000 (bond discount)
($6,000,000 × .09 × 3 ÷ 12) + ($234,000 × 3 ÷ 117) = $141,000
50. On July 2, 2023, Martineau Ltd. issued $6,000,000 (par value), 9%, ten-year convertible bonds at 98. The bonds were dated April 1, 2023 with interest payable quarterly on July 1, October 1, January 1 and April 1. If the bonds had NOT been convertible, they would have sold for 96.1. The bond discount is amortized on a straight-line basis. On April 1, 2024, $1,200,000 of these bonds were converted into 500 no par common shares. Accrued interest was paid in cash at the time of conversion. What is the amount of the unamortized bond discount on April 1, 2024 relating to the bonds that were converted?
a) $64,246
b) $46,800
c) $43,200
d) $44,400
Difficulty: Hard
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $234,000 × ($1,200,000 ÷ $6,000,000) × (108 ÷ 117) = $43,200
51. In 2022, Algiers Inc. issued 10,000 no par value convertible preferred shares for $103 each. One preferred share can be converted into three shares of Algiers' no par value common shares at the option of the shareholder. In August 2023, all of the preferred shares were converted into common shares. The market value of the common shares at the date of the conversion was $30 per share. What amount should be credited to Common Shares as a result of this conversion?
a) $300,000
b) $500,000
c) $900,000
d) $1,030,000
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $103 × 10,000 = $1,030,000
52. On December 1, 2023, Cairo Ltd. issued 500 of its 9%, $1,000 bonds at 103. Attached to each bond was one detachable warrant entitling the holder to purchase ten of Cairo's common shares. Currently the market value of the bonds, without the warrants is 95, and the market value of each warrant is $50. Using the residual method, the amount of the proceeds from the issuance that should be credited to Bonds Payable is
a) $475,000.
b) $489,250.
c) $500,000.
d) $515,000.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: 500 x $1,000 x .95 = $475,000, balance to contributed surplus
53. On March 1, 2023, Rabat Corp. sold $300,000 (par value), 20-year, 8% bonds at 104. Each $1,000 bond was issued with 25 detachable warrants, each of which entitled the bondholder to purchase for $50 one of Rabat’s no par value common shares. The bonds without the warrants would normally sell at 95. At this time, the market value of Rabat’s common shares was $40 per share and the market value of each warrant was $2. Using the relative fair value method, what amount should Rabat record on March 1, 2023 as Contributed Surplus—Stock Warrants?
a) $10,800
b) $12,600
c) $15,000
d) $15,600
Difficulty: Hard
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: ($300,000 ×.95) + (300 × 25 × $2) = $300,000; $300,000 × 1.04 = $312,000
× $312,000 = $15,600
54. During 2023, Khartoum Corp. issued 400 $1,000 bonds at 104. One detachable warrant, entitling the holder to purchase 15 of Khartoum’s common shares, was attached to each bond. At the date of issuance, the market value of the bonds, without the warrants, was 96. The market value of each warrant was $40. Using the relative fair value method, what amount should Khartoum credit to Bonds Payable from the proceeds?
a) $416,000
b) $400,000
c) $399,360
d) $384,000
Difficulty: Hard
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: ($400,000 × .96) + (400 × $40) = $400,000; $400,000 × 1.04 = $416,000
$384,000 x $416,000 = $399,360
$400,000
55. On April 7, 2023, Soweto Corp. sold a $1,000,000 (par value), 20-year, 8% bond issue for $1,060,000. Each $1,000 bond has two detachable warrants. Each warrant permits the purchase one of Soweto's no par value common shares for $30. At the time of the sale, Soweto's securities had the following market values:
Each $1,000 bond without warrants $1,006
Warrants 21
Common shares 27
Assuming that Soweto adheres to IFRS, what entry should the corporation make to record the sale of the bonds?
a) Cash 1,060,000
Bonds Payable 1,000,000
Contributed Surplus—Stock Warrants 60,000
b) Cash 1,060,000
Bonds Payable 1,018,000
Contributed Surplus—Stock Warrants 42,000
c) Cash 1,060,000
Bonds Payable 1,060,000
d) Cash 1,060,000
Bonds Payable 1,006,000
Contributed Surplus—Stock Warrants 54,000
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: IFRS requires residual method
$1,000,000 ÷ $1,000 = 1,000 bonds sold; 1,000 x $1,006 = $1,006,000; balance to cont. surplus
56. On May 1, 2023, Wong Ltd. issued $500,000, 10 year, 7% bonds at 103. Twenty detachable warrants were attached to each $1,000 bond, which entitled the holder to purchase one of Wong’s no par value common shares for $40. At this time, similar bonds without warrants were selling at 96. It was determined that the fair value of Wong’s common shares was $35, but the value of the warrants was NOT determinable. Wong is a private corporation that follows ASPE, but does NOT use the residual method. On May 1, 2023, Wong should credit Bonds Payable for
a) $515,000.
b) $500,000.
c) $480,000.
d) Cannot be determined from the information given.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: Under ASPE, if not using residual method, can assign zero to equity component; therefore, the entire proceeds of $500,000 x 1.03 = $515,000 credited to Bonds Payable
57. On May 1, 2023, Wong Ltd. issued $500,000, 10 year, 7% bonds at 103. Twenty detachable warrants were attached to each $1,000 bond, which entitled the holder to purchase one of Wong’s no par value common shares for $40. At this time, similar bonds without warrants were selling at 96. It was determined that the fair value of Wong’s common shares was $35, but the value of the warrants was NOT determinable. Wong is a private corporation that follows ASPE, but does NOT use the residual method. On May 1, 2023, Wong should credit Contributed Surplus—Stock Warrants for
a) $35,000.
b) $20,000.
c) $15,000.
d) $0.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
58. Lagos Inc. issued bonds with detachable warrants for $5,000,000 (par value). The bonds have a present value of $4,934,400. The fair value of the warrants is determined to be $220,000. Using the relative fair value method, how much of the issue price should be allocated to the warrants?
a) $65,600
b) $211,200
c) $213,500
d) $220,000
Difficulty: Hard
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: Bonds $4,934,400 95.73%
Warrants 220,000 4.27%
Total $5,154,400 100%
$5,000,000 issue price × 4.27% = $213,500
59. Under IFRS, when convertible preferred shares are converted into common shares,
a) the par value of the preferred is recorded in Common Shares.
b) the market value of the preferred is recorded in Common Shares.
c) a gain or loss is recognized.
d) the par value of the preferred shares and any additional paid-in capital is transferred to Common Shares and Additional Paid-in Capital.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
60. On July 1, 2023, Juba Inc. issued 10,000, $7 non-cumulative, no par value preferred shares for $1,050,000. Attached to each share was one detachable warrant, giving the holder the right to purchase one of Juba’s no par value common shares for $30. At this time, the shares without the warrants would normally sell for $1,025,000, while the market price of the warrants was $2.50 each. On October 31, 2023, when the market price of the common shares was $33.50 and the market value of the warrants was $3, 4,000 warrants were exercised. Juba adheres to IFRS. As a result of the exercise of the warrants and the issuance of the related common shares, what journal entry would Juba make?
a) Cash 120,000
Common Shares 120,000
b) Cash 120,000
Contributed Surplus—Stock Warrants 10,000
Common Shares 130,000
c) Cash 120,000
Contributed Surplus—Stock Warrants 25,000
Common Shares 145,000
d) Cash 120,000
Contributed Surplus—Stock Warrants 15,000
Common Shares 135,000
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: Dr. Cash: 4,000 × $30 = $120,000
Dr. Contributed Surplus—Stock Warrants: $25,000 × 4,000 ÷ 10,000 = $10,000
Cr. Common Shares: $120,000 + $10,000 = $130,000
61. Bissau Ltd. issued $4,000,000, 5-year, 8% convertible bonds at par. Bonds pay interest annually. Each $1,000 bond is convertible to 200 of Bissau’s no par value common shares, which are currently trading at $25 each. The current market rate for similar non-convertible bonds is 10%. Assuming Bissau adheres to IFRS, the value to be recorded for the conversion option is
a) $0.
b) $5,000.
c) $100,000.
d) $303,267.
Difficulty: Hard
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: PV $4,000,000, 5 years, 10% = $2,483,680
PV $320,000/year, 5 years, 10% = 1,213,053
Total $3,696,733
Issue price of $4,000,000 – $3,696,733 = $303,267 value of option
62. Which of the following is NOT a characteristic of a non-compensatory employee stock option plan (ESOP)?
a) The plan is generally available to all employees.
b) There is only a small discount from the market price.
c) The plan requires the employee to pay an upfront premium.
d) The plan is accounted for as compensation expense.
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
63. Under a (non-compensatory) employee stock option plan (ESOP), when an option is sold to an employee, the employer debits Cash and credits
a) Common Shares.
b) Stock Option Payable.
c) Contributed Surplus—Stock Options.
d) Stock Option Revenue.
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
64. The date on which to measure the compensation element in a compensatory stock option plan (CSOP) is normally the date on which the employee
a) is granted the option.
b) has fulfilled all the conditions required to exercise the option.
c) may first exercise the option.
d) exercises the option.
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
65. Compensation expense resulting from a compensatory stock option plan (CSOP) is generally recognized
a) in the period of exercise.
b) at the grant date.
c) in the periods in which the employee performs the service.
d) over the periods of the employee's service life to retirement.
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
66. Under a compensatory stock option plan, compensation expense is calculated (based on the fair value of the options that are expected to vest) on which of the following dates?
a) the vesting date
b) the grant date
c) the exercise date
d) the expiry date
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
67. Which of the following is NOT one of the commonly used stock compensation plans?
a) stock option plans
b) stock appreciation rights plans
c) restricted-stock plans
d) stock conversion plans
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
68. The issuance of warrants arises under all of the following situations, except to
a) make different types of securities more attractive to new investors.
b) give existing shareholders a pre-emptive right to purchase shares.
c) provide compensation to executives.
d) give bondholders the pre-emptive right to purchase additional shares.
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
69. On January 1, 2023, Orion Corp. granted an employee an option to purchase 5,000 of Orion's no par value common shares at $50 per share. The Black-Scholes option pricing model determined total compensation expense to be $220,000. The option became exercisable on December 31, 2024, after the employee completed two years of service. The market prices of Orion's shares were as follows:
January 1, 2023 $40
December 31, 2024 $52
For calendar 2024, Orion should recognize compensation expense of
a) $0.
b) $50,000.
c) $110,000.
d) $250,000.
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $220,000 ÷ 2 = $110,000
70. On January 1, 2021, Tunis Inc. granted stock options for 50,000 of its no par value common shares to key employees, at an option price of $25. On that date, the market price of the common shares was $25. The Black-Scholes option pricing model determined total compensation expense to be $375,000. The options are exercisable beginning January 1, 2024, provided the key employees are still employed by Tunis at the time the options are exercised. The options expire on January 1, 2025. On January 2, 2024, when the market price of the shares was $29 per share, all 50,000 options were exercised. The amount of compensation expense Tunis should have recorded for calendar 2023 is
a) $0.
b) $50,000.
c) $125,000.
d) $187,500.
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $375,000 ÷ 3 = $125,000/year
71. On June 30, 2021, Kinshasa Corp. granted stock options for 30,000 of its no par value common shares to key employees, at an option price of $36. On that date, the market price of the common shares was $36. The Black-Scholes option pricing model determined total compensation expense to be $720,000. The options are exercisable beginning January 1, 2024, provided the key employees are still employed by Kinshasa at the time the options are exercised. The options expire on June 30, 2025. On January 2, 2024, when the market price of the shares was $42, all 30,000 options were exercised. The amount of compensation expense Kinshasa should have recorded for calendar 2023 is
a) $120,000.
b) $288,000.
c) $360,000.
d) $720,000.
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $720,000 x 12 ÷ 30 = $288,000
72. On December 31, 2021, in order to retain certain key executives, Entebbe Corporation granted them stock options. 25,000 options were granted at an option price of $40 per share. Market prices of the shares were as follows:
December 31, 2022 $35 per share
December 31, 2023 $39 per share
The options were granted as compensation for services to be rendered over a two-year period beginning January 1, 2022. The Black-Scholes option pricing model determined total compensation expense to be $500,000. The amount of compensation expense Entebbe should have recorded for calendar 2023 is
a) $250,000.
b) $500,000.
c) $875,000.
d) $1,000,000.
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: $500,000 ÷ 2 = $250,000
*73. Hedging is the use of
a) derivatives or other instruments to increase returns.
b) derivatives or other instruments to offset risks.
c) debt to offset risks.
d) forward contracts.
Difficulty: Easy
Learning Objective: Understand how derivatives are used in hedging and explain how to apply hedge accounting standards.
Section Reference: Appendix 16A: Hedging
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
*74. A fair value hedge protects the company against
a) errors in valuation of derivative instruments.
b) a future transaction that has not yet been recognized.
c) an existing exposure related to an existing asset or liability.
d) fluctuations in exchange rates.
Difficulty: Medium
Learning Objective: Understand how derivatives are used in hedging and explain how to apply hedge accounting standards.
Section Reference: Appendix 16A: Hedging
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
*75. Hedge accounting is
a) mandatory.
b) mandatory if specified criteria are met.
c) optional until December 2024 and mandatory thereafter.
d) optional.
Difficulty: Medium
Learning Objective: Understand how derivatives are used in hedging and explain how to apply hedge accounting standards.
Section Reference: Appendix 16A: Hedging
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
*76. Using IFRS, hedge accounting allows the gain or loss on the hedge transaction to
a) be booked through net income.
b) be booked through other comprehensive income.
c) not be booked.
d) not be booked until the hedge closes.
Difficulty: Medium
Learning Objective: Understand how derivatives are used in hedging and explain how to apply hedge accounting standards.
Section Reference: Appendix 16A: Hedging
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
*77. If a company enters into a hedging contract to swap a floating interest rate for a fixed rate, by the end of the contract the interest rate incurred by the company will equal
a) the difference between the fixed and the floating rate.
b) the floating rate.
c) the fixed rate.
d) whichever rate is highest.
Difficulty: Medium
Learning Objective: Understand how derivatives are used in hedging and explain how to apply hedge accounting standards.
Section Reference: Appendix 16A: Hedging
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
*78. Compensation expense resulting from a performance-type plan is generally
a) determined at the measurement date.
b) recognized in the period of the grant.
c) allocated to the periods subsequent to the measurement date.
d) recognized in the period of exercise.
Difficulty: Medium
Learning Objective: Account for share appreciation rights plans and performance-type plans.
Section Reference: Appendix 16B: Stock Compensation Plans—Additional Complications
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
*79. An executive compensation plan in which the executive may receive compensation in cash, shares, or a combination of both, is known as
a) a nonqualified stock option plan.
b) a performance-type plan.
c) a share appreciation rights plan.
d) both a performance-type and a share appreciation rights plan.
Difficulty: Medium
Learning Objective: Account for share appreciation rights plans and performance-type plans.
Section Reference: Appendix 16B: Stock Compensation Plans—Additional Complications
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
*80. The date on which to measure the compensation in a share appreciation rights plan is the
a) date of grant.
b) date of exercise.
c) end of each interim period up to the date of exercise.
d) date that the market price exceeds the option price.
Difficulty: Medium
Learning Objective: Account for share appreciation rights plans and performance-type plans.
Section Reference: Appendix 16B: Stock Compensation Plans—Additional Complications
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
*81. The payment to executives from a performance-type plan is NEVER based on the
a) market price of the common shares.
b) return on assets (investment).
c) return on common shareholders' equity.
d) sales.
Difficulty: Hard
Learning Objective: Account for share appreciation rights plans and performance-type plans.
Section Reference: Appendix 16B: Stock Compensation Plans—Additional Complications
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
*82. On January 1, 2022, Luanda Ltd. established a share appreciation rights plan for its executives. This plan entitles them to receive cash at any time during the next four years for the difference between the market price of its common shares and a pre-established price of $20, on 50,000 SARs. Market prices of the shares are as follows:
January 1, 2022 $35 per share
December 31, 2022 $38 per share
December 31, 2023 $30 per share
December 31, 2024 $33 per share
Compensation expense relating to the plan is to be recorded over a four-year period beginning January 1, 2022. What amount of compensation expense should Luanda recognize for calendar 2022?
a) $150,000
b) $187,500
c) $225,000
d) $900,000
Difficulty: Medium
Learning Objective: Account for share appreciation rights plans and performance-type plans.
Section Reference: Appendix 16B: Stock Compensation Plans—Additional Complications
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: ($38 – $20) × 50,000 × .25 = $ 225,000
*83. On January 1, 2022, Luanda Ltd. established a share appreciation rights plan for its executives. This plan entitles them to receive cash at any time during the next four years for the difference between the market price of its common shares and a pre-established price of $20, on 50,000 SARs. Market prices of the shares are as follows:
January 1, 2022 $35 per share
December 31, 2022 $38 per share
December 31, 2023 $30 per share
December 31, 2024 $33 per share
Compensation expense relating to the plan is to be recorded over a four-year period beginning January 1, 2022. What amount of compensation expense should Luanda recognize for calendar 2023?
a) $0
b) $25,000
c) $125,000
d) $250,000
Difficulty: Medium
Learning Objective: Account for share appreciation rights plans and performance-type plans.
Section Reference: Appendix 16B: Stock Compensation Plans—Additional Complications
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: ($30 – $20) × 50,000 × .5 = $250,000; $250,000 – $225,000 = $25,000
*84. On January 1, 2022, Luanda Ltd. established a share appreciation rights plan for its executives. This plan entitles them to receive cash at any time during the next four years for the difference between the market price of its common shares and a pre-established price of $20, on 50,000 SARs. Market prices of the shares are as follows:
January 1, 2022 $35 per share
December 31, 2022 $38 per share
December 31, 2023 $30 per share
December 31, 2024 $33 per share
Compensation expense relating to the plan is to be recorded over a four-year period beginning January 1, 2022. On December 31, 2024, 8,000 SARs are exercised by executives. What amount of compensation expense should Luanda recognize for calendar 2024?
a) $65,000
b) $162,500
c) $237,500
d) $487,500
Difficulty: Medium
Learning Objective: Account for share appreciation rights plans and performance-type plans.
Section Reference: Appendix 16B: Stock Compensation Plans—Additional Complications
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: ($33 – $20) × 50,000 × .75 = $487,500; $487,500 – $250,000 = $237,500
*85. On January 2, 2023, for past services rendered, Zeus Corp. granted Joanna Wood, its president, 18,000 share appreciation rights that are exercisable immediately and expire on January 30, 2024. Upon exercise, Wood is entitled to receive cash for the excess of the market price of the shares on the exercise date over the market price on the grant date. Wood did NOT exercise any of the rights during 2023. The market price of Zeus's shares was $35 on January 2, 2023, and $45 on December 31, 2023. As a result of the share appreciation rights, Zeus should recognize compensation expense for 2023 of
a) $0.
b) $180,000.
c) $630,000.
d) $810,000.
Difficulty: Medium
Learning Objective: Account for share appreciation rights plans and performance-type plans.
Section Reference: Appendix 16B: Stock Compensation Plans—Additional Complications
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Feedback: ($45 – $35) × 18,000 = $180,000
*86. If a SAR is determined to be an equity instrument, it would be valued at
a) the grant date and not revised at subsequent interim dates.
b) each interim date.
c) the exercise date.
d) the grant date and revalued at the exercise date.
Difficulty: Medium
Learning Objective: Account for share appreciation rights plans and performance-type plans.
Section Reference: Appendix 16B: Stock Compensation Plans—Additional Complications
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
87. Pricing models incorporate numerous inputs, including a measurement of the volatility of the underlying stock. This is measured by
a) expected dividends.
b) how specific stock prices vary in relation to the market.
c) the current market price of the underlying stock.
d) the expected life of the option.
Difficulty: Medium
Learning Objective: Understand how options pricing models are used to measure financial instruments
Section Reference: Options Pricing Models
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
88. The International Accounting Standards Board established a fair value hierarchy with three broad levels. This hierarchy describes the types of inputs (organized by categories) that management uses to determine fair value of items such as derivatives. Which of the following is NOT reflective of the categories with respect to inputs related to derivatives?
a) quotes from an active market like the TSX
B) the value of similar options that the company may already own
C) observable inputs from the market that confirm management’s assumptions
D) unobservable inputs that reflect management’s assumptions
Difficulty: Medium
Learning Objective: Describe and analyze required fair value disclosures for financial instruments
Section Reference: Fair Value Disclosure for Financial Instruments
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
89. The International Accounting Standards Board established a fair value hierarchy with three broad levels. Which of the following would NOT be considered an input in the Level 1 (most reliable) category?
a) call option price as quoted on the TSX
b) call option price estimated by a subsidiary
c) put option price as quoted on the DOW
d) put option price as quoted on the TSX
Difficulty: Medium
Learning Objective: Describe and analyze required fair value disclosures for financial instruments
Section Reference: Fair Value Disclosure for Financial Instruments
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
90. Under IFRS, disclosure for compensation plans should include all of the following, except the
a) number of shares under option.
b) description of the plan.
c) assumptions and methods used to estimate the fair values of the stock options.
d) All of these options are required disclosures.
Difficulty: Medium
Learning Objective: Describe and analyze required fair value disclosures for financial instruments
Section Reference: Fair Value Disclosure for Financial Instruments
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
Exercises
Ex. 16-91 Put options
On November 15, 2023, Marvel Inc. purchased a trading investment for $150,000. Marvel also entered into a put option to sell the shares for $150,000. At December 31, 2023, the investment is valued at $155,000.
Instructions
a) Record any adjusting entries required at December 31, 2023, in connection with the above transactions.
b) CRITICAL THINKING — What type of instrument is a put option? Define and explain this type of instrument and why it is used.
Solution 16-91
a) FV-NI Investments ($155,000 – $150,000) 5,000
Gain or Loss on Derivatives 5,000
Gain or Loss on Derivatives 5,000
Derivatives—Financial Assets/Liabilities 5,000
b) CRITICAL THINKING – Put options are known as derivatives. Derivatives are 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 inherent in an underlying primary instrument without having to transfer the underlying instrument. Derivatives require little or no initial investment, the values change in response to the underlying instrument, and the instruments are settled at a future date.
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Ex. 16-92 Purchased call options
On September 15, 2023, Marvel Inc. purchased a call option for $500 from RDC Investments to purchase 1,500 MBO shares at $75 per share and the option expires on December 31, 2023. On November 30, 2023, the shares are valued at $95, and the options are trading at $30,200. Marvel chooses to settle the option on December 1, 2023.
Instructions
a) Record all of Marvel’s entries associated with this call option purchase and subsequent settlement.
b) What is the effect on Marvel’s net income resulting from the call option?
Solution 16-92
September 15, 2023
Derivatives—Financial Assets/Liabilities 500
Cash 500
November 30, 2023
Derivatives—Financial Assets/Liabilities 29,700
Gain or Loss on Derivatives 29,700
($30,200 – $500)
December 1, 2023
Cash 30,000
Gain or Loss on Derivatives 200
Derivatives—Financial Assets/Liabilities 30,200
b) Net increase in the value of the call option $29,700
Settle call option (200)
Total net income effect $29,500
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Ex. 16-93 Purchased call options
On April 1, 2024, Petty Ltd. purchased a call option from Fidelity Investments Corporation. The option gave Petty the right to buy 5,000 shares in Monahan Ltd. at a price of $50 per share. On the day Petty purchased the option, Monahan shares were trading at $50. Petty paid $1,000 for the options. On April 30, 2024, the Monahan shares were trading at $53.50 each, and the options for Monahan shares were trading at $18,000. On May 15, Petty settled the options in cash when the Monahan shares were trading at $56 and the options were trading at $30,000.
Instructions
a) Prepare the journal entries to record the above transactions.
b) Prepare the May 15 journal entries assuming Petty accepted the shares in Monahan instead.
Solution 16-93
a)
April 1, 2024
Derivatives—Financial Assets/Liabilities 1,000
Cash 1,000
April 30, 2024
Derivatives—Financial Assets/Liabilities 17,000
Gain or Loss on Derivatives ($18,000 – $1,000) 17,000
May 15, 2024
Derivatives—Financial Assets/Liabilities 12,000
Gain or Loss on Derivatives ($30,000 – $18,000) 12,000
Cash 30,000
Derivatives—Financial Assets/Liabilities 30,000
b)
Derivatives—Financial Assets/Liabilities 12,000
Gain or Loss on Derivatives 12,000
FV-NI Investments (5,000 x $56) 280,000
Cash (5,000 x $50) 250,000
Derivatives—Financial Assets/Liabilities 30,000
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Ex. 16-94 Forward contract
Fire Protection Ltd. is a fire suppression company that installs sprinkler systems in commercial buildings. It is currently working on a large project and relies completely on US suppliers for its components. The company is worried about the volatility for the CDN/US currency exchange rate. Fire Protection agrees to buy $50,000 in US currency for $65,000 Canadian from MBO bank in 30 days from now. The contract is priced so that it has a $500 fair value on the issue date. On the settlement date the exchange rate is $1.25 CDN = $1 US.
Instructions
a) Record the entries related to this forward contract assuming that the contract is settled on a gross basis.
b) Record the entries related to this forward contract assuming that the contract is settled on a net basis.
Solution 16-94
a)
Issue Date:
Derivatives—Financial Assets/Liabilities 500
Gain or Loss on Derivatives 500
Settlement Date:
Cash ($50,000 x $1.25)) 62,500
Gain or Loss on Derivatives 3,000
Cash 65,000
Derivatives—Financial Assets/Liabilities 500
b)
Issue Date:
Derivatives—Financial Assets/Liabilities 500
Gain or Loss on Derivatives 500
Settlement Date:
Gain or Loss on Derivatives 3,000
Cash (($1.30 – $ 1.25) x $50,000) 2,500
Derivatives—Financial Assets/Liabilities 500
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Ex. 16-95 Convertible debt and debt with warrants
a) Explain in detail the accounting treatment required for convertible debt under both IFRS and ASPE.
b) Explain how this compares to or differs from the accounting required for debt issued with stock warrants.
Solution 16-95
a) Convertible debt is a hybrid/compound financial instrument and is generally treated as having both a debt component and an equity component. The conversion feature makes the bond more valuable to an investor; therefore, the convertible feature has value. Under IFRS, compound instruments must be split into their components and presented separately in the financial statements. IFRS also requires the use of the residual method: the value of the debt component is determined, and the balance is assigned to the equity component (as contributed surplus). ASPE allows a zero value to be assigned to the equity component, or the use of the residual method.
b) When debt is issued with stock warrants, the warrants are also given separate recognition. After issue, the debt and the detachable warrants trade separately. The proceeds may be allocated to the two elements based on the relative fair values of the debt security without the warrants and the warrants at the time of issue, or by the residual method. The proceeds allocated to the warrants should also be accounted for as contributed surplus.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
Ex. 16-96 Convertible bonds
Lachapelle Drilling Inc., which follows IFRS, offers ten-year, 6% convertible bonds (par $ 1,000). Interest is paid annually on the bonds. Each $1,000 bond may be converted into 50 common shares, which are currently trading at $17 per share. Similar straight bonds carry an interest rate of 8%. One thousand bonds are issued at 91.
Instructions
a) Assume Lachapelle decides to use the residual method and measures the debt first. Calculate the amount to be allocated to the bond and to the option.
b) Prepare the journal entry at date of issuance of the bonds under IFRS.
c) Assume that after six years, the carrying amount of the bonds is $ 933,757. The holders of the convertible debt decide to convert their convertible bonds before the bond maturity date. Prepare the journal entry to record the conversion.
d) How many shares were issued at the conversion?
Solution 16-96
a) Value of the bonds (PV annuity 10 years, 8%, $60,000 + PV of $1,000,000 in 10 years at 8%.
Using factor tables:
Using factor tables:
$1,000,000 x .46319 = $463,190
$60,000 annuity x 6.71008 402,605
Total $865,795
Using a financial calculator or Excel PV function:
PV | $ ? | Yields $865,798 |
I | 8% | |
N | 10 | |
PMT | $(60,000) | |
FV | $(1,000,000) | |
Type | 0 |
Total proceeds $1,000,000 x .91 $910,000
Value of the bond 865,798
Incremental value of the option $ 44,202
b) Cash 910,000
Contributed Surplus—Conversion Rights 44,202
Bonds Payable 865,798
c) Bonds Payable 933,757
Contributed Surplus—Conversion Rights 44,202
Common Shares 977,959
d) 1,000 bonds x 50 shares = 50,000 shares
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Ex. 16-97 Convertible bonds
On December 1, 2023, Dango Corp. issued $ 5,000,000 (par value), 12%, 5-year convertible bonds for $5,026,000 plus accrued interest. The bonds were dated April 1, 2023, with interest payable April 1 and October 1. If the bonds had NOT been convertible, they would have sold for $5,006,000. Bond premium/discount is amortized each interest period on a straight-line basis. Dango does NOT value the equity component at zero. Dango’s fiscal year end is September 30.
On October 1, 2024, half of these bonds were converted into 35,000 no par common shares. Accrued interest was paid in cash at the time of conversion.
Instructions
a) Prepare the entry to record the interest expense at April 1, 2024. Assume that interest payable was credited when the bonds were issued (round to nearest dollar).
b) Prepare the entry to record the conversion on October 1, 2024. Use the book value method. Assume that the entry to record amortization of the bond premium/discount and interest payment has been made.
Solution 16-97
a)
April 1, 2024
Interest Payable 100,000
Interest Expense 199,540
Bonds Payable 460
Cash 300,000
Calculations:
Issue price $5,026,000
Price without conversion 5,006,000
Contributed surplus—conversion $ 20,000
Premium ($5,006,000 – $5,000,000) $6,000
Months remaining 52
Premium per month $115
Premium amortized (4 × $115) $460
b)
October 1, 2024
Bonds Payable ($2,500,000 + $2,423*) 2,502,423
Contributed Surplus—Conversion Rights ($20,000 x 50%) 10,000
Common Shares 2,512,423
Calculations:
Premium related to 1/2 of the bonds ($6,000 ÷ 2) $3,000
Less premium already amortized [($6,000 x 10 ÷ 52) ÷ 2] 577
*Premium remaining $2,423
Difficulty: Hard
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Ex. 16-98 Convertible bonds
Atlanta Ltd. sold convertible bonds at a premium. Interest is paid on May 31 and November 30. On May 31, after the required interest was paid, all the bonds were converted into 3,000 no par value common shares, which were currently trading at $50 per share.
Instructions
How should Atlanta account for the conversion of the bonds under the book value method? Discuss the rationale for this method.
Solution 16-98
To account for the conversion of bonds under the book value method, Bonds Payable should be debited for the current carrying value, the entire amount of Contributed Surplus—Conversion Rights should be removed (debited), and Common Shares should be credited for the total of these two amounts. The current market value of the shares is irrelevant. No gain or loss on conversion is recorded. The amount to be recorded for the shares is equal to the carrying value of the bonds plus the balance of the Contributed Surplus—Conversion Rights that was recorded when the convertible bonds were first issued. The rationale for the book value method is that the conversion is the completion of the transaction initiated when the bonds were issued. Since this is viewed as a transaction with shareholders, no gain or loss should be recognized. Note that both ASPE and IFRS require the use of the book value method.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
Ex. 16-99 Redeemable preferred shares and succession planning
Explain how redeemable preferred shares are used in succession planning for small business corporations.
Solution 16-99
In succession planning for a small business, it is advantageous to use high/low redeemable preferred shares. The common shares of the existing company are transferred to a new company on a tax deferred basis. The retiring family member receives new redeemable preferred shares that will freeze their interest at the current value of the business. These shares may be redeemed over time. The next generation of the family receives the new common shares, which will result in any future increase in value of the business accruing to them.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
Ex. 16-100 Stock options
Carbon Energy Inc. is a new technology start up. It has decided to adopt a stock option plan for its executive management team, since it does not believe it will have available cash on hand for year-end bonuses. The plan was implemented on July 1, 2023, and provides participants with the right to purchase up to 4,000 common shares at $30 per share. The current fair value of the shares is estimated at $26.50 per share. Options for the maximum number of shares allowed under the plan was granted to three members of the executive management team on September 15, 2023, for services performed in 2023. The options have an expiry date of January 31, 2024. The compensation expense was estimated at $270,000 based on an appropriate option pricing model. Only two of the executives exercised their options in January prior to the deadline.
Instructions
Record all of Carbon Energy’s required entries to properly account for the stock option plan.
Solution 16-100
December 31, 2023
Compensation Expense 270,000
Contributed Surplus—Stock Options 270,000
January 31, 2024
Cash (2 × 4,000 × $30) 240,000
Contributed Surplus—Stock Options ($270,000 × 2 ÷ 3) 180,000
Common Shares 420,000
Contributed Surplus—Stock Options ($250,000 – $180,000) 90,000
Contributed Surplus—Expired Stock Options 90,000
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Ex. 16-101 Stock options
Prepare the necessary entries from January 1, 2023 to February 1, 2025 for the following events. If no entry is needed, write "No entry necessary." The corporation’s year end is December 31.
1. On January 1, 2023, the shareholders of Musetta Inc. adopted a stock option plan for its top executives, where each plan participant could receive rights to purchase up to 3,000 common shares at $40 per share. At this date, the shares were trading for $40 per share.
2. On February 1, 2023, options were granted to five executives to purchase 3,000 shares each. The options were non-transferable, and the executive had to remain an employee of the company to exercise the option. The options expire on February 1, 2025. It is assumed that the options were for services performed equally during 2023 and 2024. The Black-Scholes option pricing model determined total compensation expense to be $390,000.
3. On February 1, 2025, four executives exercised their options. The fifth executive chose not to exercise their options, which therefore were forfeited.
Solution 16-101
1.
January 1, 2023
No entry necessary.
2.
February 1, 2023
No entry necessary.
December 31, 2023
Compensation Expense ($390,000 ÷ 2) 195,000
Contributed Surplus—Stock Options 195,000
December 31, 2024
Compensation Expense 195,000
Contributed Surplus—Stock Options 195,000
3.
February 1, 2025
Cash (4 × 3,000 × $40) 480,000
Contributed Surplus—Stock Options ($390,000 × 4 ÷ 5) 312,000
Common Shares 792,000
Contributed Surplus—Stock Options ($390,000 – $312,000) 78,000
Contributed Surplus—Expired Stock Options 78,000
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Ex. 16-102 Employee share ownership plans
Blanc Inc. set up an employee stock option plan under which employees may purchase shares of the company for $35 per share. The option premium is $4.50 per share and Blanc set aside 40,000 shares. On January 1, 2023, 16,000 options are purchased by employees. On December 1, 2023, 10,000 options are exercised. On February 14, 2024, 9,000 options were purchased by employees.
Instructions
Prepare the journal entries to record the above events.
Solution 16-102
January 1, 2023
Cash (16,000 × $4.50) 72,000
Contributed Surplus—Stock Options 72,000
December 1, 2023
Cash (10,000 × $35) 350,000
Contributed Surplus—Stock Options ($72,000 X 10,000/16,000) 45,000
Common Shares 395,000
February 14, 2024
Cash (9,000 × $4.50) 40,500
Contributed Surplus—Stock Options 40,500
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Ex. 16-103 Employee share ownership plans
Grieger Inc. set up an ESOP under which employees may purchase shares of the company for $20 per share. The option premium is $.50 per share and Grieger set aside 20,000 shares. On January 1, 2023, 12,000 options are purchased by employees. On December 1, 2023, all 12,000 options are exercised.
Instructions
Prepare the journal entries to record the above events.
Solution 16-103
January 1, 2023
Cash (12,000 × $.50) 6,000
Contributed Surplus—Stock Options 6,000
December 1, 2023
Cash (12,000 × $20) 240,000
Contributed Surplus—Stock Options 6,000
Common Shares 246,000
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
*Ex. 16-104 share appreciation rights
On January 1, 2023, Hay Ltd. established a share appreciation rights (SAR) plan for its executives. The executives could receive cash at any time during the next four years equal to the difference between the market price of the common shares and a pre-established price of $16 for 180,000 SARs. The market prices are:
Dec 31, 2023—$21
Dec 31, 2024—$18
Dec 31, 2025—$19
Dec 31, 2026—$20
On December 31, 2025, 40,000 SARs are exercised, and the remaining SARs are exercised on December 31, 2026.
Instructions
a) Prepare a schedule that shows the amount of compensation expense for each of the four years, starting with 2023.
b) Prepare the journal entry at December 31, 2024, to record compensation expense.
c) Prepare the journal entry at December 31, 2026, to record the exercise of the remaining SARs.
*Solution 16-104
a) Schedule of Compensation Expense
180,000 SARs
Market Set Value Percent Accrued
Date Price Price of SARs Accrued to Date Expense
Dec. 31, 2023 $21 $16 $900,000 25% $225,000 $225,000
(45,000)
Dec. 31, 2024 18 16 360,000 50% 180,000 (45,000)
225,000
Dec. 31, 2025 19 16 540,000 75% 405,000 225,000
155,000
Dec. 31, 2026 20 16 560,000 100% 560,000 155,000
($4 × 140,000)
b)
Liability Under Share Appreciation Rights Plan 45,000
Compensation Expense 45,000
c)
Liability Under Share Appreciation Rights Plan 560,000
Cash 560,000
Difficulty: Hard
Learning Objective: Account for share appreciation rights plans and performance-type plans.
Section Reference: Appendix 16B: Stock Compensation Plans—Additional Complications
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
**Ex. 16-105 Options pricing models
There are numerous options pricing models. Identify the two models discussed in the textbook and identify and describe what inputs (at a minimum) go into these models.
Solution 16-105
Black-Scholes and binomial tree options models are discussed in the textbook.
Inputs into the model include the following:
1. The exercise price
2. The expected life of the option
3. The current market price of the underlying stock
4. The volatility of the underlying stock
5. The expected dividend during the option life
6. The risk-free rate of interest for the option life
Difficulty: Medium
Learning Objective: Understand how options pricing models are used to measure financial instruments.
Section References: Appendix 16C: Advanced Models for Measuring Fair Value and Disclosure of Fair Value Information, Options Pricing Models
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
Ex. 16-106 Fair value disclosure for financial instruments – IASB standards
What are the IASB rules regarding disclosure of financial instruments in the notes to the financial statements and why?
Solution 16-106
Both the cost and fair value of all financial instruments are to be reported in the notes to the financial statements. IASB has decided that companies should disclose information that enables users to determine the extent of usage of fair value and the inputs used to implement fair value measurement. Two reasons for this are:
- Differing levels of reliability exist in the measurement of fair value information; therefore, it is important to understand the varying risks involved in the measurement.
2. Changes in the fair value of financial instruments are reported differently in the financial statements, depending on the type of financial instrument involved and whether the fair value option is used. Note disclosure provides an opportunity to explain more precisely the impact of the changes in the value of the financial instruments on financial results.
Difficulty: Medium
Learning Objective: Describe and analyze required fair value disclosures for financial instruments.
Section Reference: Fair Value Disclosure for Financial Instruments
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
PROBLEMS
Pr. 16-107 Forward contract
Trudel Builders Ltd. uses fir 2x6 lumber as its framing material. On November 15, 2023, Trudel enters into a forward contract for 1,500,000 board feet of lumber at $0.25 per board foot for March 2024 delivery. At Trudel’s year end of December 31, 2023, the market price for March delivery is $0.26. On March 5, 2024, Trudel took delivery of 1,500,000 board feet for $0.25 and settled the forward contract. The market rate on this date was $0.28 per board foot.
Instructions
Record all required entries related to this contract.
Solution 16-107
a)
November 15, 2023
No entry.
b)
December 31, 2023
Record gain to date
Derivatives—Financial Assets/Liabilities 15,000
Gain or Loss on Derivatives ($0.26 – $0.25) × 1,500,000 15,000
c)
March 5, 2024
Settlement of futures contract
Inventory ($0.28 × 1,500,000) 420,000
Derivatives—Financial Assets/Liabilities 15,000
Gain or Loss on Derivatives 30,000
Cash ($0.25 x 1,500,000) 375,000
Difficulty: Medium
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Pr. 16-108 Employee stock options
On November 1, 2021, London Corp. adopted a stock option plan allowing certain company executives to purchase a total of 30,000 common shares. The options were granted on January 2, 2022 and were exercisable four years after the grant date (Jan. 2, 2026), as long as the executives were still employees. The options expire eight years from the grant date. The exercise price was set at $46 and, using an option pricing model to value the options, the total compensation expense was estimated to be $510,000. At January 2, 2022, the market price of the shares was $50.
On January 1, 2023, 3,000 options were terminated (forfeited) when an employee left the company. The market value of the shares at that date was $32. All the remaining options were exercised during 2026: 17,000 on January 3 when the market price was $62, and 10,000 on May 1 when the market price was $77.
Instructions
a) Calculate the intrinsic value and the time value of the stock option.
b) Prepare journal entries related to the stock option plan for the years 2022 through 2026. Assume that the employees perform services equally from 2022 through 2025. Year end is December 31.
c) Discuss the advantages and disadvantages of offering stock options to employees as a means of compensation.
Solution 16-108
a) The intrinsic value of the option is the difference between the market price and the strike (exercise) price. In this case the market price is $50 and the strike price is $46.
Intrinsic value component: ($50 – $46) x 30,000 = $120,000
The time value of the option is the remaining value of the options. Since the total value of the options is $510,000, then the difference between the total value and the intrinsic value should be the time value component.
Time value component: $510,000 – $120,000 = $390,000
b)
January 2, 2022
No entry required
December 31, 2022
Compensation Expense 127,500
Contributed Surplus—Stock Options 127,500
January. 1, 2023
Contributed Surplus—Stock Options 12,750
Compensation Expense 12,750
December 31, 2023
Compensation Expense 114,750
Contributed Surplus—Stock Options 114,750
December 31, 2024
Compensation Expense 114,750
Contributed Surplus—Stock Options 114,750
December 31, 2025
Compensation Expense 114,750
Contributed Surplus—Stock Options 114,750
January 3, 2026
Cash 782,000
Contributed Surplus—Stock Options 289,000
Common Shares 1,071,000
May 1, 2026
Cash 460,000
Contributed Surplus—Stock Options 170,000
Common Shares 630,000
b) Calculation of compensation expense
2022: $510,000 ÷ 4 = $127,500
2023: Jan. 1 – remove compensation expense related to employee who left
$127,500 x 3,000 ÷ 30,000 = $12,750
For 2023, 2024, and 2025:
New annual compensation expense: ($510,000 ÷ 4) – $12,750 or $127,500 x 90% = $114,750
January 3, 2026
Dr. to Cash: 17,000 x $46 = $782,000
Dr. to Contributed Surplus: $459,000 x 17 ÷ 27 = $289,000
May 1, 2026
Dr. to Cash: 10,000 x $46 = $460,000
Dr. to Contributed Surplus: $459,000 x 10 ÷ 27 = $170,000
c) There are several advantages and disadvantages to the use of stock options as compensation.
Advantages
- This type of compensation is tied to performance, which should motivate employees to work hard.
- The mandatory service period helps to retain employees. If employees become more productive over time as they become more experienced, then the firm benefits.
- Employees become shareholders if they exercise the options. This ensures that they will act in the best interests of the company.
- Employees will benefit from any appreciation of the stock price.
Disadvantages
- Employees might be low risk tolerant and therefore not like the risk inherent in stock options.
- If employees do not understand the value of the options, they will not consider it a benefit and might ask for additional pay instead, so the firm will end up paying them more.
- Employees have limited ability to affect the stock price, so the stock options might not motivate them to work hard.
Difficulty: Hard
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Pr. 16-109 Employee stock options
Ocean Block Inc. is a new business that has been experiencing significant growth. To attract new staff, the company has established an employee stock option plan that has both an ESOP and a CSOP component to the program. The ESOP component is available to all employees, while the CSOP is only available to executive management.
At Dec 31, 2023, a total of 100,000 stock options were granted to 5 executive managers. The options have a vesting period of 2 years and expire 3 years from the end of the vesting period. If a manager leaves the firm, the options are terminated. Based on commonly used option pricing models, the intrinsic value of the 100,000 options is $200,000, and the time value of the options is $300,000. The exercise price on the shares is $45 for both the ESOP and CSOP.
Instructions
a) What is the total amount of compensation expense associated with the CSOP options?
b) All of the executives stayed with the business to the end of the vesting period and earned the options evenly throughout the period. On June 30, 2026, 40,000 options were exercised when the market price of the shares was $55. What are the journal entries from the date of grant to the date of exercise?
c) Two front-line staff who were hired in 2023 decided that they would like to participate in the ESOP established by the company. On June 30, 2024, each of them purchased 1,000 options at a premium of $4.50 each and exercised their right to buy shares at the same time as the executive managers did. What are the journal entries for these transactions?
d) CRITICAL THINKING: What is a fundamental difference between an ESOP and a CSOP that is evident in the accounting treatment?
Solution 16-109
a) Intrinsic value + Time value = Total value of the options (the compensation expense)
$200,000 + $300,000 = $500,000
b) December 31, 2023 – No entry
December 31, 2024
Compensation Expense ($500,000/2) 250,000
Contributed Surplus—Stock Options 250,000
December 31, 2025
Compensation Expense ($500,000/2) 250,000
Contributed Surplus—Stock Options 250,000
June 30, 2026
Cash ($45 x 40,000) 1,800,000
Contributed Surplus—Stock Options ($500,000 x 40%) 200,000
Common Shares 2,000,000
c)
June 30, 2024
Cash (1,000 x 2 x $4.50) 9,000
Contributed Surplus—Stock Options 9,000
June 30, 2026
Cash (2,000 x $45) 90,000
Contributed Surplus—Stock Options 9,000
Common Shares 99,000
d) CRITICAL THINKING: An ESOP is available to everyone and has nothing to do with performance or compensation for specific activities as a result of being employed with the organization. A CSOP is tied to performance and only available to defined groups of employees. The difference is also evident in the accounting treatment in that a CSOP will require “compensation expense” to be recorded whereas an ESOP does not. Another difference is that an ESOP would require the employee to purchase the option by paying the premium with cash, where the CSOP does not as the employee earns the option itself.
Difficulty: Hard
Learning Objective: Understand what derivatives are, how they are used to manage risks, and how to account for them.
Section Reference: Derivatives
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Pr. 16-110 Convertible bonds and warrants
For each of the unrelated situations described below, prepare the entries required to record the transactions.
1. On August 1, 2023, Alpha Corporation called its 10% convertible bonds for conversion. The $4,000,000 par value bonds were converted into 160,000 no par common shares. On August 1, there was $350,000 of unamortized premium applicable to the bonds. At the time of issuance, Contributed Surplus—Conversion Rights was credited for $150,000, which represented the equity portion of the convertible bonds, and the market value of the common shares was $20 per share. The company records the conversion using the book value method. Ignore all interest payments.
2. Beta Inc. issues 10% convertible bonds, par $1,000,000, at 97. The investment banker indicates that if the bonds had not been convertible, they would have sold at 94. Use the residual method.
3. Gamma Ltd. issues $2,000,000 par value, 8% bonds. To help the sale, detachable stock warrants are issued at the rate of ten warrants for each $1,000 bond sold. It is estimated that the value of the bonds without the warrants is $1,974,000 and the value of the warrants is $126,000. The bonds with the warrants sold at 101. Use the residual method.
Solution 16-110
1. Bonds Payable ($4,000,000 + $350,000) 4,350,000
Contributed Surplus—Conversion Rights 150,000
Common Shares 4,500,000
2. Cash 970,000
Bonds Payable ($1,000,000 x 94%) 940,000
Contributed Surplus—Conversion Rights 30,000
3. Cash ($2,000,000 x 101%) 2,020,000
Bonds Payable 1,974,000
Contributed Surplus—Stock Warrants 46,000
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Pr. 16-111 Convertible debt
Miron Construction Ltd. offers five-year, 8% convertible bonds (par $1,000). Interest is paid annually on the bonds. Each $1,000 bond may be converted into 100 common shares, which are currently trading at $8 per share. Similar straight bonds carry an interest rate of 10%. One thousand bonds are issued at 101.
Instructions
a) Assume Miron Construction Ltd. follows IFRS and decides to use the residual method and measures the debt first. Calculate the amount to be allocated to the bond and to the option.
b) Prepare the journal entry at the date of issuance of the bonds under IFRS.
c) Assume that after three years, when the carrying amount of the bonds was $965,290, one-half of the holders of the convertible debt decided to convert their convertible bonds before the bond maturity date. Prepare the journal entry to record the conversion.
d) How many shares were issued at the conversion?
e) Assume now that Miron follows ASPE and has chosen as an accounting policy to value the equity component at zero. Prepare the journal entry at the date of issuance of the bonds.
Solution 16-111
a) Value of the bonds (PV annuity 5 years, 10%, $80,000 + PV of $1,000,000 in 5 years at 10%.
Using factor tables:
$1,000,000 x .62092 = $620,920
$80,000 annuity x 3.79079 303,263
Total $924,183
Using a financial calculator or Excel PV function:
PV | $ ? | Yields $924,184 |
I | 10% | |
N | 5 | |
PMT | $(80,000) | |
FV | $(1,000,000) | |
Type | 0 |
Total proceeds $1,000,000 x 1.01 $1,010,000
Value of the bond 924,184
Incremental value of the option $ 85,816
b)
Cash 1,010,000
Contributed Surplus—Conversion Rights 85,816
Bonds Payable 924,184
c)
Bonds Payable ($965,290 x 50%) 482,645
Contributed Surplus—Conversion Rights1 42,908
Common Shares 525,553
1($85,816 x 50%) = $ 42,908
d) 1,000 bonds X 50% = 500 bonds; 500 x 100 shares = 50,000 shares
e)
Cash 1,010,000
Bonds Payable 1,010,000
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
Learning Objective: Identify differences in accounting between IFRS and ASPE, and what changes are expected in the near future.
Section Reference: IFRS/ASPE Comparison
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Pr. 16-112 Convertible debt
TinTech is a new technology start-up firm that is looking to grow quickly. While the company has secured investors who have already purchased equity, additional funds are needed to pay for the development of a new application that TinTech wants to bring to market. One of the existing investors approached the management team of TinTech and offered to purchase a new convertible bond from TinTech but wanted very favourable conversion terms and a 6% coupon paid semi-annually. The company needs $3,000,000 to cover all the software development costs along with additional hardware that is needed to support the project. It is estimated that the application will take 1 year to build and 5 years to generate enough excess cash flow to pay back the bond. The market rate for similar debt is 4%. TinTech is following IFRS.
Instructions
a) What should the term of the bond be, based on the information above?
b) What is the present value of this bond if it was issued without any convertible features? (Round to the nearest dollar). How would the issue price be quoted in the market?
c) The investor and the management team have agreed to the following conversion feature: Each $10,000 bond can be converted into 500 Class B common shares. The Class B common shares are a new class that come with 100 votes per share instead of 1. The estimated market price per Class B common share is $300. With this conversion feature, the bond is being issued at 115 on Jan. 1, 2023. Prepare the journal entry for the issuance of this bond.
d) Exactly halfway through the term of the bond, the investor decided to convert the bond into the Class B common shares. How many shares are issued? Prepare the necessary journal entry.
e) CRITICAL THINKING: Why do you think the investor pushed for favourable terms with regards to the conversion rights? Do you think that the terms are overly favourable? How would you react if you were one of the other investors?
Solution 16-112
a) 1 year to build, plus 5 years to have enough cash to pay back the principal means that the company should set the term at 6 years.
b) Use the following variables for a financial calculator:
FV $3,000,000
PMT $90,000 (6% coupon x $3,000,000/2)
N = 12 (6 years x 2 periods per year)
I = 2% (4%/2 periods per year)
Calculated PV = $3,317,260
$3,317,260/$3,000,000 = 110.575
c)
Cash 3,450,000
Bonds Payable 3,317,260
Contributed Surplus—Conversion Rights 132,740
d)
Number of shares issued is ($3,000,000/$10,000) x 500 = 150,000 shares
Bonds Payable 3,168,043
Contributed Surplus—Conversion Rights 132,740
Common Shares 3,300,783
e) CRITICAL THINKING: The investor likely pushed for more favourable terms because debt carries risk. In this particular case, since TinTech is a new company, the risk of non-payment (both interest and the principal) is probably fairly high. Being granted a right to acquire shares that carry more voting power than the existing shareholders is quite favourable and may come with governance issues. TinTech now has a single investor that may have more voting power (depending on the structure of the remaining shares) than the other existing investors. The other investors may be upset with this arrangement, or, in the least, would want an opportunity to participate equally in the bond issuance.
Difficulty: Medium
Learning Objective: Analyze and account for hybrid/compound instruments from an issuer perspective.
Section Reference: Debt versus Equity: Issuer Perspective
Learning Objective: Identify differences in accounting between IFRS and ASPE, and what changes are expected in the near future.
Section Reference: IFRS/ASPE Comparison
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Pr. 16-113 Stock options
Using a table format, compare and contrast employee stock option plans (ESOPs) and compensatory stock option plans (CSOPs).
Solution 16-113
ESOPs | CSOPs | |
Purpose | To give employees an opportunity to own part of the company | To remunerate management or employees |
Issuer | Issued by the company | Issued by the company |
Fair value measurement | Generally not traded on exchange; therefore, fair value cannot be measured as readily | Generally not traded on exchange; therefore, fair value cannot be measured as readily |
Type of transaction | Operating | Capital |
Disclosure | Income Statement | Shareholders’ Equity |
Difficulty: Medium
Learning Objective: Describe and account for share-based compensation.
Section Reference: Share-Based Compensation
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
*Pr. 16-114 Hedging
Identify and describe the five steps used to analyze whether hedge accounting is necessary.
*Solution 16-114
1. Identify the hedged item. Which risk is being hedged?
2. Identify the hedging item. This is usually a derivative instrument that the company has purchased or signed a contract for (such as a forward, future, option, or swap). If a risk is properly hedged, the hedging item reduces the risk noted in step 1 above.
3. Identify how the hedged item is being accounted for without hedge accounting. Note that it might not even be recognized on the SFP yet if it is an anticipated transaction, such as a future purchase. Is it accounted for at FV-NI or FV-OCI or some sort of cost basis?
4. Note that the hedging item, which is normally a derivative, will be accounted for using FV-NI unless hedge accounting is applied. Therefore, if the hedged item is accounted for in any other way, we may need to consider using hedge accounting if IFRS and/or ASPE allows it.
5. Locate where the recognized gains and losses for the hedged and hedging items are recognized (net income, OCI, or perhaps not at all). Do the gains and losses from the hedged item and hedging items offset? If they do, then we would say that there is symmetry in the accounting. The gains and losses are treated similarly in terms of measuring net income or OCI. If they do not offset, then we may need to consider hedge accounting if IFRS and/or ASPE allows it. In this case, we would argue that there is no symmetry in accounting unless we apply hedge accounting.
Difficulty: Easy
Learning Objective: Understand how derivatives are used in hedging and explain how to apply hedge accounting standards.
Section Reference: Appendix 16A: Hedging
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Analytic
*Pr. 16-115 Interest rate swap
On January 1, 2023, Miron Ltd. issues a floating rate bond for $500,000. At the same time, the corporation enters into an interest rate swap whereby it agrees to pay interest on $500,000 at 10% (the current interest rate) and to receive payments based on the floating rate. At December 31, 2023, the floating interest rate is 8%, and the value of the swap contract is $40,000 to the counterparty’s benefit.
Instructions
Prepare all journal entries required related to the swap agreement and the interest payment on the bond.
*Solution 16-115
January 1, 2023
No entry (memorandum entry only)
December 31, 2023
Payment of bond interest
Interest Expense ($500,000 × 8%) 40,000
Cash 40,000
Payment of swap interest (net)
Interest Expense ($500,000 x 10%) – $40,000 10,000
Cash 10,000
Record swap contract liability
Unrealized Gain or Loss—OCI 40,000
Derivatives—Financial Assets/Liabilities 40,000
Difficulty: Medium
Learning Objective: Understand how derivatives are used in hedging and explain how to apply hedge accounting standards.
Section Reference: Appendix 16A: Hedging
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
*Pr. 16-116 Hedging (forward contract)
On May 1, 2023, Bella Corp., a coffee wholesaler, placed an order with its supplier for six tonnes of coffee, to be delivered and paid for on September 30, 2023. At that time, the spot (current) price for one tonne of coffee was $3,000, and the future (forward) price for September 30, 2023, delivery was $2,900. Thus, Bella decided to enter into a forward contract for six tonnes of coffee at $2,900 per tonne for September 30, 2023, delivery. It designated the contract as a cash flow hedge. The contract further calls for a net cash settlement.
Bella’s year end is June 30, 2023. At that date the spot price was $2,980, the future price for three-month delivery was $2,880, and the future price for five-month delivery was $2,850.
On September 30, 2023, when the spot price was $2,940 and the future price for five-month delivery was $2,980, the company took delivery of the coffee, paid its supplier, and settled the forward contract.
On October 31, 2023, Bella sold three tonnes of coffee from this delivery to Java Unlimited for $3,400 per tonne cash.
Assume all prices are in Canadian dollars.
Instructions
a) Prepare journal entries for the following dates in 2023: May 1, June 30, September 30, and October 31. Bella is a publicly traded corporation and follows IFRS requirements.
b) CRITICAL THINKING: The CFO of Bella is questioning your decision to use hedging. Explain how you made the decision to hedge this transaction. What criteria did you take into consideration? Would your answer be different if the future price were $3,100?
*Solution 16-116
May 1: No entry. The contract value is zero. Memo entry only.
June 30 (year end)
Unrealized Gain or Loss—OCI 120
Derivatives—Financial Assets/Liabilities 120
6 x ($2,880 – $2,900) = $120
Sept. 30 (settlement of contract)
Cash 240
Derivatives—Financial Assets/Liabilities 120
Unrealized Gain or Loss—OCI 360
6 x ($2,940 – $2,880) = $360
Inventory ($2,940 x 6) 17,640
Cash 17,640
Oct. 31 (sale of coffee)
Cash ($3,400 x 3) 10,200
Sales Revenue 10,200
Cost of Goods Sold ($2,940 x 3) 8,820
Inventory 8,820
Unrealized Gain or Loss—OCI 120
Cost of Goods Sold 120
Gain/Loss ($360 – $120) x 1 ÷ 2
b) CRITICAL THINKING: The decision as to whether or not to hedge this transaction should depend on whether the company desires to eliminate the market risk associated with the fluctuations in the price of coffee. There is an optimal level of risk a firm desires to take on, and, accordingly, a decision should be made. The future price should not affect the decision as it represents the market expectations of the price at the time the company will take delivery and pay for the coffee. The future price will affect the decision only in the case the company has different expectations than the market about the future price. Because Bella is not a currency speculator, but makes its profits from selling coffee, it would make sense for this company to lower its market risk and hedge the transaction.
Difficulty: Hard
Learning Objective: Understand how derivatives are used in hedging and explain how to apply hedge accounting standards.
Section Reference: Appendix 16A: Hedging
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
*Pr. 16-117 Share appreciation rights plans
Lemire Inc. establishes a SARs program on January 1, 2024, which entitles executives to receive cash at the date of exercise (any time after the service period) for the difference between the shares’ fair value and the pre-established or stated price of $5 on 5,000 SARs. The SARs’ fair value on December 31, 2024 is $30,000, $70,000 on December 31, 2025, and $50,000 at December 31, 2026, and the service period runs for two years (2024 to 2025).
Instructions
a) Prepare a schedule of compensation expense covering the period from 2024 to 2026, assuming the executives exercise their rights after holding the SARs for three years.
b) Prepare the adjusting entry at December 31, 2024.
c) Prepare the adjusting entry at December 31, 2025.
d) Prepare the adjusting entry at December 31, 2026.
e) Prepare the entry when the executives exercise their rights.
*Solution 16-117
a)
SHARE APPRECIATION RIGHTS Schedule of Compensation Expense | |||||||
(1) | (2) | (3) | (4) | ||||
Date | Fair Value of SARsa | Percentage Accruedb | Cumulative Compensation Accrued to Date | Expense 2024 | Expense 2025 | Expense 2026 | |
12/31/24 | $30,000 | 50% | $15,000 | $15,000 | |||
55,000 | $55,000 | ||||||
12/31/25 | $70,000 | 100% | 70,000 | ||||
(20,000) | $(20,000) | ||||||
12/31/26 | $50,000 | 100% | $50,000 | ||||
aCumulative compensation for unexercised SARs to be allocated to periods of service. bThe percentage accrued is based on a two-year service period (2024 to 2025). |
b)
Compensation Expense 15,000
Liability Under Share Appreciation Rights Plan 15,000
c)
Compensation Expense 55,000
Liability Under Share Appreciation Rights Plan 55,000
d)
Liability Under Share Appreciation Rights Plan 20,000
Compensation Expense 20,000
e)
Liability Under Share Appreciation Rights Plan 50,000
Cash 50,000
Difficulty: Medium
Learning Objective: Account for share appreciation rights plans and performance-type plans.
Section Reference: Appendix 16B: Stock Compensation Plans—Additional Complications
CPA: Financial Reporting
Bloomcode: Application
AACSB: Analytic
Pr. 16-118 Fair value hierarchy
What is the fair value hierarchy and what information must a company provide under this hierarchy?
Solution 16-118
To highlight reliability in reporting, the IASB established a fair value hierarchy with three broad levels. Level 1 is the most reliable measurement because fair value is based on quoted prices in active markets for identical assets or liabilities. Level 2 is less reliable – it is not based on quoted market prices for identical assets and liabilities, but instead may be based on similar assets or liabilities. Level 3 is least reliable – is uses unobservable inputs that reflect the company’s assumption as to the value of the financial instrument.
Companies must provide:
1. Quantitative information about significant unobservable inputs used for all level three measurements.
2. A qualitative discussion about the sensitivity of recurring level three measurements to changes in the unobservable inputs disclosed.
3. A description of the company’s valuation process.
4. Any transfers between Levels 1 and 2 of the fair value hierarchy
5. Information about non-financial assets measured at fair value at amounts that differ from the assets’ highest and best use
6. The proper hierarchy classification for items that are not recognized on the statement of financial position but are disclosed in the notes.
Difficulty: Hard
Learning Objective: Describe and analyze required fair value disclosures for financial instruments.
Section Reference: Fair Value Disclosure for Financial Instruments
CPA: Financial Reporting
Bloomcode: Comprehension
AACSB: Analytic
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