Complex Financial Instruments - In Depth

Question 1

Convertible debt - Definition

Answer 1

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.

Question 2

Convertible debt - Initial measurement

Answer 2

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.

Question 3

Convertible debt - Subsequent measurement

Answer 3

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.

Question 4

Perpetual debt - Definition

Answer 4

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.

Question 5

Perpetual debt - Initial measurement

Answer 5

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

Question 6

Perpetual debt - Subsequent measurement

Answer 6

Amortized cost

Question 7

Convertible preferred shares - Definition

Answer 7

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

Question 8

Convertible preferred shares - Initial measurement

Answer 8

Recognize as equity at fair
value of the consideration
received.

Question 9

Convertible preferred shares - Subsequent measurement

Answer 9

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.

Question 10

Mandatorily redeemable or retractable preferred shares - Definition

Answer 10

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.

Question 11

Mandatorily redeemable or retractable preferred shares - Initial measurement

Answer 11

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

Question 12

Mandatorily redeemable or retractable preferred shares - Subsequent measurement

Answer 12

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

Question 13

Warrants - Definition

Answer 13

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.

Question 14

Warrants - Initial measurement

Answer 14

• 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.

Question 15

Warrants - Subsequent measurement

Answer 15

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.

Question 16

Options - Definition

Answer 16

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.

Question 17

Options - Initial measurement

Answer 17

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

Purchaser: recognized as
an investment asset at fair
value.

Question 18

Options - Subsequent measurement

Answer 18

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.

Question 19

Interest rate swaps - Definition

Answer 19

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.

Question 20

Interest rate swaps - Initial measurement

Answer 20

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

Question 21

Interest rate swaps - Subsequent measurement

Answer 21

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.

Question 22

ASPE differences (ASPE 3856)

Answer 22

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.