Complex Financial Instruments - In Depth Flashcards

1
Q

Convertible debt - Definition

A

A compound instrument that
includes:

  1. Debt: bond pays interest at
    specified rate and pays face
    amount at maturity.
  2. Equity: option to exchange
    bond for common shares;
    usually a predetermined
    number, during a specified
    time frame, without the
    need to pay additional cash.
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2
Q

Convertible debt - Initial measurement

A
  1. Debt: fair value using
    the market interest rate
    for similar debt with
    no conversion right —
    deduct pro-rata share of
    transaction costs.
  2. Equity (contributed
    surplus): residual amount
    — deduct pro-rata share
    of transaction costs.
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3
Q

Convertible debt - Subsequent measurement

A

If not converted:
1. Debt — amortized cost
2. Equity — historical cost

If converted:
1. Update for interim interest
expense up to derecognition
date.
2. Derecognize the debt and
equity components.
3. Record the issuance of the
common shares equal to the
sum of the amounts debited to
debt and contributed surplus.
4. No gain or loss is recognized.

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4
Q

Perpetual debt - Definition

A

An instrument where there is
a contractual right to receive
payments of interest at fixed
dates into the indefinite future,
either with no right to receive a
return of principal or a right to a
return of principal under terms
that make it unlikely.

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5
Q

Perpetual debt - Initial measurement

A

Fair value equal to present
value of the perpetuity of
interest payments.

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6
Q

Perpetual debt - Subsequent measurement

A

Amortized cost

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7
Q

Convertible preferred shares - Definition

A

Preferred shares that have the
option to convert into common
shares. Both components are
equity.

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8
Q

Convertible preferred shares - Initial measurement

A

Recognize as equity at fair
value of the consideration
received.

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9
Q

Convertible preferred shares - Subsequent measurement

A

If not converted: historical cost
If converted:

  1. Derecognize the preferred
    shares.
  2. Record issuance of common
    shares: debit to preferred
    shares and credit to common
    shares for the same amount.
  3. No gain or loss is recognized.
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10
Q

Mandatorily redeemable or retractable preferred shares - Definition

A

Mandatorily redeemable: issuer
must redeem the shares on or
before a specified date for a fixed
or determinable amount.

Retractable: holder has the right
to force the entity to redeem
the shares by providing cash or
another asset.

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11
Q

Mandatorily redeemable or retractable preferred shares - Initial measurement

A

Record as a liability
at fair value of the
consideration received
when shares have a
mandatory redemption
or are retractable.

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12
Q

Mandatorily redeemable or retractable preferred shares - Subsequent measurement

A
  • Subsequently measured at
    amortized cost using the
    effective interest rate method.
  • Related dividends are
    recorded as interest expense.
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13
Q

Warrants - Definition

A

Contracts that entitle the holder
to buy or sell the underlying
stock of the issuing entity at a
fixed price until the expiry date.
Can be issued attached to both
bonds and shares.

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14
Q

Warrants - Initial measurement

A
  • Bonds with warrants:
    issue proceeds
    are allocated
    proportionately based
    on fair values (bonds
    measured at fair value
    using the market interest
    rate for similar debt;
    warrants using fair value
    shortly after issuance
    or an options pricing
    model); deduct pro-rata
    share of transaction
    costs.
  • Shares with warrants:
    issue proceeds
    are allocated
    proportionately based
    on fair values (shares
    based on market prices;
    warrants using fair value
    shortly after issuance
    or an options pricing
    model); deduct pro-rata
    share of transaction
    costs.
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15
Q

Warrants - Subsequent measurement

A

Bond or shares:
1. Debt — amortized cost
2. Shares — not subsequently
remeasured

Warrants: carrying value
If exercised:
1. Record the cash received.
2. Derecognize the equity
element (contributed surplus).
3. Record the issuance of the
common shares equal to the
sum of the amounts debited
to cash and contributed
surplus.
No gain or loss is recognized.

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16
Q

Options - Definition

A

Contracts that give the holder
the right, but not the obligation,
to buy (call options) or sell (put
options) a specified amount of
something for a specified price
and for a specific period of time.

17
Q

Options - Initial measurement

A

Issuer: presented as equity
(contributed surplus) at the
amount of consideration
received.

Purchaser: recognized as
an investment asset at fair
value.

18
Q

Options - Subsequent measurement

A

Issuer: at carrying value, no
adjustments for changes in fair
value.

Purchaser: at fair value, which
increases and decreases with the
value of the underlying asset.
Gains and losses reported through
profit and loss.

19
Q

Interest rate swaps - Definition

A

Contracts in which two entities
agree to exchange interest rates
on debt. This generally involves
one entity with a fixed rate
exchanging a rate with an entity
that holds a variable rate.

20
Q

Interest rate swaps - Initial measurement

A

There is generally nothing to
recognize at initiation of the
interest rate swap.

21
Q

Interest rate swaps - Subsequent measurement

A

At fair value, which is the
difference between the interest
rates obtained in the swap and the
current interest rate. Gains and
losses are reported through profit
or loss.

22
Q

ASPE differences (ASPE 3856)

A

ASPE allows two options to initially measure convertible bonds:
1. Measure the equity portion at zero and record the entire amount as debt.
2. Measure the more easily determinable component at fair value, and then allocate the residual amount to the other
component.
The effective interest rate method or the straight-line method may be used for amortized cost.

23
Q
A