Appendix Financial Ratios

CHAPTER 16

COMPLEX FINANCIAL INSTRUMENTS

ASSIGNMENT CLASSIFICATION TABLE

| | |Brief | | | | | |Writing Assignments |
|Topics | |Exercises | |Exercises | |Problems | | |
| | | | | | | | | |
|1. Stock options. | |16 | |15, 16, 17 | |10 | |2, 5 |
|2. Derivative instruments for speculation | |1, 3, 4 | |1, 2 | |1, 2, 3, | |6, 7, 8, 9
|
| | | | | | | | | |
|3. Executory contracts | |2 | |3 | | | | |
| | | | | | | | | |
|4. Derivatives with an entity’s own shares | |4 | |4 | |4 | | |
|5. Classification: debt vs. equity | |6, 7, 8, 9 | |5, 6,10, 14, | |6, 7, 9 | |2 |
|6. Convertible debt and preferred shares. | |10, 11 | |7, 8, 9, 11, 12 | |8 | |2 |
| | | | | | | | | |
|7. Warrants and debt. | |12, 13 | |13 | | | |1, 2 |
|*8. Derivative instruments for hedging. | | | |18, 19, 20 | |11, 12, 13 | |3, 4, 6 |
| | | | | | | | | |
|*9. Stock appreciation rights. | |17 | |21, 22, 23 | | | |5 |
| | | | | | | | | |

*This material is dealt with in an Appendix to the chapter.

NOTE: If your students are solving the end-of-chapter material using a financial calculator or an Excel spreadsheet as opposed to the PV tables, please note that there will be a difference in amounts. Excel and financial calculators yield a more precise result as opposed to PV tables. The amounts used for the preparation of journal entries in solutions have been prepared from the results of calculations arrived at using the PV tables.

ASSIGNMENT CHARACTERISTICS TABLE

| | | | |Level of | |Time |
|Item | |Description | |Difficulty | |(minutes) |
| E16-1 | |Derivative transaction. | |Simple | |10-15 |
| E16-2 | |Derivative transaction. | |Simple | |10-15 |
| E16-3 | |Purchase Commitment | |Simple | |10-15 |
| E16-4 | |Derivatives Involving Entity’s Own Shares | |Simple | |10-15 |
| E16-5 | |Issuance and conversion of bonds. | |Moderate | |20-25 |
| E16-6 | |Issuance and conversion of bonds. | |Moderate | |20-25 |
| E16-7 | |Conversion of bonds. | |Moderate | |20-25 |
| E16-8 | |Conversion of bonds. | |Simple | |10-20 |
| E16-9 | |Conversion of bonds and expired rights | |Simple | |10-20 |
| E16-10 | |Conversion of bonds | |Moderate | |20-25 |
| | | | | | | |
|E16-11 | |Conversion of bonds. | |Simple | |10-20 |
| E16-12 | |Conversion of bonds. | |Complex | |30-40 |
| | | | | | | |
| E16-13 | |Issuance of bonds with detachable warrants. | |Simple | |10-15 |
| E16-14 | |Issuance, exercise, and termination of stock options. | |Moderate | |25-35 |
|E16-15 | |Issuance, exercise, and termination of stock options. | |Moderate | |10-15 |
| E16-16 | |Issuance of bonds with detachable warrants. | |Simple | |10-15 |
| E16-17 | |Issuance and exercise of stock options. | |Moderate | |15-25 |
|*E16-18 | |Cash Flow Hedge. | |Moderate | |15-20 |
|*E16-19 | |Cash Flow Hedge. | |Moderate | |15-20 |
|*E16-20 | |Fair Value Hedge. | |Complex | |20-25 |
|*E16-21 | |Stock appreciation rights. | |Moderate | |15-25 |
|*E16-22 | |Stock appreciation rights. | |Moderate | |15-25 |
|*E16-23 | |Stock appreciation rights. | |Moderate | |25-30 |
|P16-1 | |Call option contract – purchased. | |Moderate | |30-40 |
|P16-2 | |Call option contract – written. | |Moderate | |30-40 |
|P16-3 | |Put option contract – derivative instrument. | |Moderate | |30-40 |
|P16-4 | |Derivatives Involving Entity’s Own Shares | |Moderate | |30-40 |
| P16-5 | |Entries for various financial instruments. | |Moderate | |35-40 |
| P16-6 | |Correction of issuance of bond, calculate yield. | |Moderate | |35-40 |
| P16-7 | |Issuance of notes with warrants. | |Simple | |15-20 |
|P16-8 | |Bonds, warrants, conversion rights. | |Moderate | |30-35 |
|P16-9 | |Loan, CSOP, and forward contract | |Moderate | |30-35 |
| P16-10 | |Stock option plan. | |Moderate | |30-35 |
|*P16-11 | |Fair value hedge interest rate swap. | |Complex | |35-45 |
|*P16-12 | |Cash flow hedge – futures contract. | |Complex | |40-50 |
|*P16-13 | |Fair value hedge – put option. | |Complex | |40-50 |

SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 16-1

Saver Rio Ltd. should account for the call option at the cost to acquire it ($500) and record it as Derivatives – Trading. Saver Rio Ltd. is not obligated to exercise the option and buy the shares. The investment would be measured at fair value at the reporting date with a gain or loss, if any, recognized in net income for the difference between the cost and the market value.

This call option results in Market Risk for Saver Rio Ltd.

BRIEF EXERCISE 16-2

Under IFRS, this purchase commitment is an executory contract that can be settled on a net basis by paying cash as opposed to taking delivery of the apples. However, because Fresh Produce Ltd. intends on taking delivery of the apples, the contract is designated as ‘expected use’ and not accounted for as a derivative; rather, the contract is not recognized until delivery of the apples takes place.

This call option results in Market Risk for Fresh Produce.

BRIEF EXERCISE 16-3

January 1, 2011
No journal entry necessary since the fair value of the forward would be $0.

January 15, 2011
Derivatives – Trading 35 Gain 35

This call option results in Market Risk.
BRIEF EXERCISE 16-4

January 1, 2011 Deposit 25 Cash 25

January 15, 2011 Deposit 10 Cash 10

BRIEF EXERCISE 16-5

Pacer Ltd. is faced with a presentation issue: should the $1,000 cost of the option be treated as an investment, similar to the cost of an option to purchase the shares of another company? In this transaction, Pacer Ltd. has agreed to buy back a fixed number of the company’s own shares for a fixed amount of consideration.

IAS 32 states that this type of “fixed for fixed” transaction would be presented as a reduction from shareholders’ equity and not as an investment. This is, effectively, the prospective retirement of shares (or acquisition of treasury shares, if that is permitted).

BRIEF EXERCISE 16-6

These bonds are considered to be a perpetual debt obligation. Jamieson is obligated to provide to the holder payments on account of interest at fixed dates extending into the indefinite future, and a principal payment for the face value of the bond very far into the future. The bonds would be reported on Jamieson’s statement of financial position at the present value of the annuity of interest payments over the term of the bond, calculated at the market rate of interest (at the date of issue), ignoring the future value of the principal payment. Because the perpetual bond’s value is driven solely by the contractual obligation to pay interest it would be classified as a long-term debt on the statement of financial position. It would not be remeasured annually unless designated under the fair value option, in which case it would be revalued at fair value and gains/losses booked to net income.
BRIEF EXERCISE 16-7

Under the terms of the agreement with the preferred shareholders, it is highly likely that Silky Limited will redeem the preferred shares before the dividend rate doubles after five years.
Accordingly, failure to do so would result in Silky paying an extremely high dividend to the preferred shareholders. Silky has little or no discretion to avoid paying out the cash to redeem the shares before the end of the fifth year and this likely obligation to deliver cash creates a liability. Consequently, the preferred shares should be classified as long-term debt on the statement of financial position.

Because the preferred shares are classified as long-term debt on the statement of financial position, the dividends declared and paid to preferred shareholders would be classified as interest expense on the statement of income. It might be desirable to separate the amount of dividends (reported as interest expense) paid on the preferred shares with the interest paid on other debt.

BRIEF EXERCISE 16-8

Under IFRS, the preferred shares would be recorded as a liability because the contingent settlement provision is based on an event outside the company’s control.

However, under ASPE, the preferred shares would be accounted for as a liability only when it is highly likely that the firm’s net income will drop below $500,000 in a future fiscal period. If the triggering event is unlikely, then the preferred shares would be accounted for as
equity.

BRIEF EXERCISE 16-9

The solution is the same for IFRS and ASPE.

When a preferred share provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date or gives the holder the right to require the issuer to redeem the share at or after a particular date for a fixed or determinable amount, the instrument meets the definition of a financial liability. Consequently, the preferred share should be classified as long-term debt on the statement of financial position.

BRIEF EXERCISE 16-10

Bonds Payable 236,000 Common Shares 236,000

BRIEF EXERCISE 16-11

Preferred Shares 80,000
Contributed Surplus—Conversion Rights 8,000 Common Shares 88,000

BRIEF EXERCISE 16-12

Cash (500 X $1,000 X 1.03) 515,000 Bonds Payable 485,000 Contributed Surplus—Conversion Rights 30,000

The residual method is applied under IFRS whereby cash is allocated to the value of the debt instrument first, and the residual is allocated to equity. The debt value is calculated as follows: 500 x $1,000 x 0.97.

BRIEF EXERCISE 16-13

There are two options available under ASPE. The first is to apply the residual method to the more easily measurable – which is the debt. In this case, the journal entry would be the same as under IFRS (see BE16-12).

The second option is to value the equity component at zero, with all the value being allocated to the debt. In this case, the journal entry would be:

Cash (500 X $1,000 X 1.03) 515,000 Bonds Payable 515,000

BRIEF EXERCISE 16-14

Four common stock compensation plans are:

1. Compensatory stock option plans (CSOPs)

2. Direct awards of stock

3. Stock appreciation rights plans (SARs)

4. Performance-type plans

BRIEF EXERCISE 16-15

The main difference between an employee stock option plan (ESOP) and a compensatory stock option plan (CSOP) is that with ESOPs, the employee usually pays for the options (either fully or partially). Thus these transactions are seen as capital transactions (credited to equity accounts). The employee is investing in the company.

However, CSOPs, on the other hand, are primarily seen as an alternative way to compensate the employees for their services, like a barter transaction. The services are rendered by the employee in support of the act of producing revenues. This information must be recognized on the income statement as an operating transaction (expense).

BRIEF EXERCISE 16-16

1/1/11 No entry

12/31/11 Compensation Expense 53,000 Contributed Surplus—Stock Options 53,000

12/31/12 Compensation Expense 53,000 Contributed Surplus—Stock Options 53,000
[$53,000 = $106,000 X 1/2]

*BRIEF EXERCISE 16-17

2011: [5,400 X ($22 – $20)] X 50% = $5,400

2012: [5,400 X ($34 – $20)] – $5,400 = $70,200
BRIEF EXERCISE 16-18

Performance-type plans award specified executives common shares (or cash) if specified performance criteria are attained during the performance period (generally three to five years).

Compensation is measured by the market value of shares issued on the exercise date. Compensation expense is allocated by the percentage approach over the service period, and then marked to market, whereas under other compensatory plans options are valued at the date of grant under an options pricing model such as Black-Scholes and allocated evenly to the period of required service.

BRIEF EXERCISE 16-19

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. For options, option pricing models are useful for calculating fair value.

The inputs to the model include:

1. The exercise price. This is the price at which the option may be settled. It is agreed upon by both parties to the contract.

2. The expected life of the option. This is the term of the option. It is agreed upon by both parties to the contract. Some options may only be settled at the end of the term (known as European options) while others may be settled at points during the term (known as American options).

3. The current market price of the underlying stock. This is readily available from the stock market.

4. The volatility of the underlying stock. This is the magnitude of future changes in the market price. Volatility looks at how the specific stock price moves relative to the market.

5. The expected dividend during the option life.

6. The risk-free rate of interest for the option life. In general, government bonds carry a return that is considered to be the risk-free return.
SOLUTIONS TO EXERCISES

EXERCISE 16-1 (10-15 minutes)

(a) January 2, 2011
|Derivatives – Trading |350 | |
| Cash | |350 |
| | | |

(b) March 31, 2011
|Derivatives – Trading |15,150 | |
| Gain | | 15,150 |
|($15,500 – $350) | | |

c) The gain increases net income for the period by $15,150.

(d) As no information is provided as to other investments or exposures that Reflow may have, it appears that the company has used the option for speculative purposes. Reflow appears not to be hedging to minimize the risk of a current or future transaction.

(e) This derivative will expose the company to Market Risk, as the price of the underlying is a variable that may change the value of the option.

EXERCISE 16-2 (10-15 minutes)

(a) April 1, 2011
|Derivatives – Trading |150 | |
| Cash | |150 |
| | | |

(b) June 30, 2011
|Derivatives – Trading |6,550 | |
| Gain | | 6,550 |
|($6,700 – $150) | | |

(c) June 30, 2011
|Investment (500 X $35) |17,500 | |
|Loss |1,700 | |
| Cash (500 X $25) | |12,500 |
| Derivative - Trading | |6,700 |

d) Recall that the value of a call option is based on the intrinsic value and the time value. The option is a 6 month option and it was exercised at the 4 month point. The market would not be able to predict the exercise date and so the value would have to make some assumptions that may be different from actual. Therefore, the loss is a result of the lost time value for the two months that were remaining. Note that it is netted against the gain recognized on the same day, so the net gain is equal to the increase in intrinsic value from the date of purchase to the date exercised.

EXERCISE 16-3 (10-15 minutes)

(a) Under IFRS, this purchase commitment is an executory contract that can be settled on a net basis by paying cash as opposed to taking delivery of the oranges. However, because Fresh Juices Ltd. fully intends to take delivery of the oranges, the contract is designated as ‘expected use’ and not accounted for as a derivative; rather, the contract is not recognized until delivery of the oranges takes place.

Therefore, there are no journal entries required at either January 1 or January 31. A journal entry will be recorded when Fresh Juice actually takes delivery of oranges.

(b) If Fresh Juices Ltd. does not intend to take delivery of the oranges, then the executory contract will be viewed as a derivative because it can be settled on a net basis. Therefore, the contract would be recorded at fair value.

Because there was no cost to enter into the contract, there would be no initial entry on January 1.

However, the contract will be marked to market and will change as the price of oranges change. Therefore the following journal entry will take place on January 31:

|Loss (10,000 X (0.50 – 0.49) |100 | |
| Derivative – Oranges | | 100 |

(c) Under ASPE, this purchase commitment contract would not be accounted for as a derivative on the basis that this agreement is not exchange traded. Therefore, the contract would not be recognized until delivery of oranges takes place.

EXERCISE 16-4 (10-15 minutes)

(a) The derivative is considered a fixed-for-fixed derivative in an entity’s own shares as the option stipulates that the entity will purchase (buy back) a fixed numbers of shares for a fixed amount of consideration. IFRS states that this transaction would be presented as a reduction from shareholders’ equity and not as an investment. This is, effectively, the prospective retirement of shares (or acquisition of treasury shares, if that is permitted).

|Equity – Fixed-for-fixed Derivative |250 | |
| Cash | |250 |
| | | |

(b) Because the option allows a choice in how the option will be settled, the instrument is a financial asset or liability (derivative) by default under IFRS unless all possible settlement options result in it being an equity instrument. In this case, one settlement option is the delivery of cash. Therefore, it will be classified as a financial asset (derivative). EXERCISE 16-5 (20-25 minutes)

1. Market value of bonds without warrants is $285,000 ($300,000 X .95) Cash ($300,000 X 1.04) 312,000 Bonds Payable 285,000 Contributed Surplus—Stock Warrants 27,000

2. ASPE allows for the use of the residual value, with the most easily measurable component being valued first, or allows for the equity component to be valued at zero. The entries under these two approaches are, respectively, as follows:

Cash ($10,000,000 X .97) 9,700,000 Bonds Payable 9,300,000 Contributed Surplus— Conversion Rights 400,000

Cash ($10,000,000 X .97) 9,700,000 Bonds Payable 9,700,000

3. There are two options available under ASPE: 1) the company can use the residual method; or 2) the company can measure the warrants at $0 and allocated all of the proceeds to the debt.

Under the residual method, ASPE allows for an allocation to the equity component first if it is more easily measurable than the equity. Therefore, the warrants are valued first, and the remainder is allocated to the debt.

Cash 19,600,000 Bonds Payable 18,400,000 Contributed Surplus—Stock Warrants 1,200,000

Value of bonds plus warrants ($20,000,000 X .98) $19,600,000
Value of warrants (200,000 X $6) 1,200,000
Value of bonds $18,400,000
EXERCISE 16-5 (Continued)

Alternatively, the entire proceeds are allocated to the bond, leading to this entry:

Cash 19,600,000 Bonds Payable 19,600,000

4. Expense—Debt Retirement Cost 63,279 Retained Earnings 1,721 Bonds Payable 9,925,000 Contributed Surplus— Conversion Rights 270,000 Common Shares 10,195,000 Cash 65,000

|$9,925,000 |X $65,000 = $63,279 |Assigned to debt |
|$10,195,000* | | |

|$270,000 |X $65,000 = $1,721 |Assigned to equity |
|$10,195,000* | | |

* [($10,000,000 – $75,000) + $270,000]

5. Market value of bonds without warrants $475,000 ($500,000 X .95)

Cash ($500,000 X 1.03) 515,000 Bonds Payable 475,000 Contributed Surplus—Stock Warrants 40,000

EXERCISE 16-6 (15 – 25 minutes)

| |Type of financial instrument |Timing of recognition |Measurement |Gains or Losses |
|1. |Financial Derivative – forward |When fair value fluctuates. |PV of future cash flows |Net income. |
| |contract |Value at acquisition is $nil. | | |
|2. |Non-financial derivative – exchange |When fuel prices fluctuate. |PV of future cash flows |Net income. |
| |traded futures |Value at acquisition is $nil | | |
|3. |This is not a financial instrument |N/A |N/A |N/A |
|4. |This is a purchase commitment (and |As these are not exchange |Not recognized unless onerous |N/A |
| |therefore not exchange traded) |traded and the company intends | | |
| | |to take delivery of the steel, | | |
| | |these are not recognized in the| | |
| | |financial statements under | | |
| | |either ASPE or IFRS | | |
|5. |Contra equity - this is a purchased |When options are purchased and |Cash paid |N/A |
| |call option that is settleable only |cash is paid | | |
| |in the entity’s own equity | | | |
| |instruments | | | |
|6. |Non-financial derivative – exchange |Initial margin is similar to a |Cash deposited on margin |Net Income |
| |traded futures |bank account. | | |
|7. |Liability. Increase in redemption |When shares are issued |PV of future cash flows |Net Income |
| |amount makes it highly likely company| | | |
| |will redeem, and imposes a liability | | | |
| |to deliver cash or other assets at | | | |
| |the time of redemption. | | | |

EXERCISE 16-6 (Continued)

| |Type of financial instrument |Timing of recognition |Measurement |Gains or Losses |
|8. |Hybrid instrument. |When debt is issued |IFRS – debt at PV of future cash |Net Income for debt |
| |Warrants are written call options, | |flows and rest to equity |component including |
| |and debt is a liability. | |ASPE – may allocate $0 to the |interest and gains/losses |
| | | |warrant or may bifurcate the |upon extinguishment |
| | | |initial amount between debt and | |
| | | |equity allocating the more easily | |
| | | |measurable first with the residual | |
| | | |to the other component | |
|9. |Hybrid instrument – conversion |When debt is issued |IFRS – debt at PV of future cash |Net Income for debt |
| |option is a written call option and | |flows and rest to equity |component including |
| |is equity since a fixed number of | |ASPE– may allocate $0 to the |interest and gains/losses |
| |shares will be issued. | |conversion feature or may bifurcate|upon extinguishment |
| | | |the initial amount between debt and| |
| | | |equity allocating the more easily | |
| | | |measurable first with the residual | |
| | | |to the other component | |
|10. |Liability – these are puttable |When instruments are |Amount received |Net Income for debt |
| |shares and since the option to put |issued | |component including |
| |the shares back to the company is | | |interest and gains/losses |
| |beyond the control of the entity, | | |upon extinguishment |
| |they are liabilities unless certain | | | |
| |specific conditions are met. | | | |

EXERCISE 16-7 (20-25 minutes)

(a) Cash 5,970,000** Bond Payable ($6,000,000 X .97) 5,820,000 Interest Payable 90,000* Contributed Surplus— Conversion Rights 60,000

* ($6,000,000 X 9% X 2/12) ** [($6,000,000 X .98) + $90,000]

(b) Interest Payable 90,000 Interest Expense 186,102 Bonds Payable 6,102 Cash ($6,000,000 X 9% ÷ 2) 270,000

Calculations:

Par value $6,000,000 Issuance price @ .97 5,820,000 Total discount $ 180,000

Months remaining 118 Discount per month $1,525 ($180,000 ÷ 118) Discount amortized $6,102 (4 X $1,525)

EXERCISE 16-7 (Continued)

(c) Bonds Payable ($1,500,000 – $41,186) 1,458,814 Contributed Surplus— Conversion Rights 15,000 Common Shares 1,473,814

Calculations:

Discount related to 25% of the bonds ($180,000 X .25) $45,000 Less discount amortized [($45,000 ÷ 118) X 10] 3,814 Unamortized bond discount $41,186

Actual proceeds when bonds sold $5,880,000 Value of bonds only 5,820,000 Value of conversion rights 60,000 Proportion converted _ _25% Value of rights converted $15,000

d) The bondholders would only be motivated to convert bonds into common shares if they perceived an increase in the value of their investment. They expect they get common shares with a market value higher than the fair value of the bonds that were given up in the conversion. The book value of what they gave up at the time of conversion is shown in the entry above as $1,473,814 for 30,000 common shares. This works out to slightly over $49 per share. Likely the common shares are trading at an amount higher than $49 by a good margin. There should be an excess over the book value of $49 as the bondholders are giving up a steady cash inflow from the interest income obtained from the bonds in exchange for shares, which might not yield any dividends. This is especially true as continuing to hold the bonds provides a return in the form of interest, yet the option feature locks in the stock appreciation in favour of the holder – so the immediate opportunity for a gain must be considerable.
EXERCISE 16-8 (10-20 minutes)

(a) Bonds Payable ($2,400,000 + $44,500) 2,444,500 Contributed Surplus— Conversion Rights 22,200 Preferred Shares 2,466,700

b) The advantages of bonds from the perspective of the bondholder are principally security and steady cash flows from the interest and the return of capital at the maturity date of the bonds. The advantages of preferred shares would be similar to bonds as to the cash flows from dividends received, particularly if the preferred shares are cumulative and the company has a strong history of dividend paying ability. Whereas the bonds have a fixed maturity date, typically the preferred shares do not. The lack of a maturity date or a date at which the preferred shareholder can get his capital investment returned at a fixed amount might be perceived as a disadvantage. This might also be the perception because the issuing company has no plans to redeem the preferred shares, although this perceived disadvantage is alleviated significantly if the preferred shares are actively traded. The conversion from bonds might be precipitated by a rise in interest rates, causing the market value of the bonds to drop, leading to a lower return on investment if sold. Other considerations might be that the dividend rate on the preferred shares outpaces the return of the bonds. Finally the tax treatment of the revenue type (interest versus dividends) might be another motive for the conversion by bondholders; the effect of the dividend tax credit can increase the after tax yield significantly for an individual, and intercorporate dividends attract no net tax in a corporation.

EXERCISE 16-9 (10-20 minutes)

(a) Bonds Payable 963,000 Contributed Surplus— Conversion Rights 135,000 Common Shares 1,098,000

Premium as of July 31, 2011 for $3,000,000 of bonds $210,000
Face value of bond converted 3,000,000
Carrying value of bond converted $3,210,000

|$900,000 |X $3,210,000 = $963,000 |
|$3,000,000 | |

|$900,000 |X $450,000 = $135,000 |
|$3,000,000 | |

(b) Contributed Surplus— Conversion Rights 315,000 Contributed Surplus— Conversion Rights Expired 315,000

($450,000 – $ 135,000)

EXERCISE 16-10 (20-25 minutes)

(a) Cash 10,800,000 Bonds Payable 8,500,000 Contributed Surplus— Conversion Rights 2,300,000

(To record issuance of $10,000,000 of 8% convertible debentures for $10,800,000. The bonds mature in 20 years, and each $1,000 bond is convertible into 5 common shares)

(b) Bonds Payable (Schedule 1) 2,595,000 Contributed Surplus— Conversion Rights 690,000 (2,300,000 X 30%) Common Shares 3,285,000

(To record conversion of 30% of the outstanding 8% convertible debentures after giving effect to the 2-for-1 stock split)

Schedule 1
Computation of Carrying Value of Bonds Converted

Discount on bonds payable on January 1, 2011 $1,500,000
Amortization for 2011 ($1,500,000 ÷ 20) $75,000
Amortization for 2012 ($1,500,000 ÷ 20) 75,000 150,000
Discount on bonds payable on January 1, 2013 1,350,000
Bonds converted 30%
Unamortized discount on bonds converted 405,000
Face value of bonds converted 3,000,000
Carrying value of bonds converted $2,595,000
EXERCISE 16-10 (Continued)

(c) Computation of Common Shares Resulting from Conversion

Number of shares convertible on January 1, 2011: Number of bonds ($10,000,000 ÷ $1,000) 10,000 Number of shares for each bond X 5 50,000
Stock split on January 1, 2012 X 2
Number of shares convertible after the stock split 100,000
% of bonds converted X 30%
Number of shares issued 30,000

(d) From the perspective of Plato Corporation, the conversion from bonds to common shares has the following advantages:

1. No obligation (or more flexibility) to pay dividends, as opposed to fixed cash outflows for interest payments, reducing financial risk.

2. No obligation to repay principal at maturity date of bonds.

3. Increased income from reduced interest costs (to be computed on an after tax basis).

4. Depending on Plato’s financial structure, the effect of the conversion might be a positive or negative effect on earnings per share.

5. Positive effect on debt to equity ratio.

The disadvantages of the conversion to Plato Corporation include:

1. Dilution of earnings for existing shareholders might make shareholders unhappy; offset at least in part by higher income because less interest is paid.

2. Existing shareholders will conceivably pressure the company not to dilute their ownership and power to vote (this may actually be unlikely, as the fact of the

EXERCISE 16-10 (Continued)

conversion feature would have been fully disclosed since the initial issuance of the bonds, and the possibility of conversion would be fully reflected in the price of the shares).

3. Pressure from new shareholders for dividend payout. EXERCISE 16-11 (10-20 minutes)

Bonds Payable 1,125,000 Contributed Surplus— Conversion Rights 9,000 Common Shares 1,134,000

Discount as of June 30, 2011 for $8,000,000 of bonds $500,000
Face value of all bonds 8,000,000
Carrying value of all bonds $7,500,000

Carrying value of bonds converted:

| $1,200,000 |X $7,500,000 = $1,125,000 |
|$8,000,000 | |

Carrying value of rights exercised on conversion:

|$1,200,000 |X $60,000 = $9,000 |
|$8,000,000 | |

EXERCISE 16-12 (30-40 minutes)

(a) (1) December 31, 2012 Bond Interest Expense 204,000 Bonds Payable ($120,000 X 1/20) 6,000 Cash ($6,000,000 X 7% X 6/12) 210,000

(2) January 1, 2013 Bonds Payable 406,400 Contributed Surplus— Conversion Rights 8,000* Common Shares 414,400 *[1.04 less 1.02 = 2% X $6 million X 6.667%]

Total premium ($6,000,000 X .02) $120,000 Premium amortized ($120,000 X 2/10) 24,000 Balance $96,000

Bonds converted ($400,000 ÷ $6,000,000) 6.667% Related premium ($96,000 X 6.667%) $6,400 Face value of bond redeemed 400,000 Carrying value of bond redeemed $406,400

(3) March 31, 2013 Bond Interest Expense 6,800 Bonds Payable 200 ($120,000 / 10 X 3/12 X 6.667%) Bond Interest Payable 7,000 ($400,000 X 7% X 3/12)
EXERCISE 16-12 (Continued)

March 31, 2013 Bonds Payable 406,200 Contributed Surplus— Conversion Rights 8,000 Common Shares 414,200

Premium as of January 1, 2009 for $400,000 of bonds $6,400 $6,400 ÷ 8 years remaining X 3/12 (200 )
Premium as of March 31, 2013 for $400,000 of bonds 6,200
Face value of bond converted 400,000
Carrying value of bond converted $406,200

(4) June 30, 2013 Bond Interest Expense 176,800 Bonds Payable 5,200 Bond Interest Payable 7,000 ($400,000 X 7% X 1/4) Cash 189,000 *

[Premium to be amortized: ($120,000 X 86.667%) X 1/20 = $5,200, or $83,200** ÷ 16 (remaining interest and amortization periods) = $5,200]

**Total to be paid: ($5,200,000 X 7% ÷ 2) + $7,000 = $189,000

***Original premium $120,000 2011 amortization (12,000 ) 2012 amortization (12,000 ) Jan. 1, 2013 write-off (6,400 ) Mar. 31, 2013 amortization (200 ) Mar. 31, 2013 write-off (6,200 ) $83,200

EXERCISE 16-12 (Continued)

(b) Bondholders would be motivated to hold off converting their investment in bonds into common shares to continue to take advantage of the security and steady cash flows from the interest and the return of capital at the maturity date of the bonds. Should the value of the common shares continue to climb higher, the opportunity to convert is still available until the conversion right expires. On the other hand, if the market value of the common shares declines, the bondholder can continue to hold the bonds to their maturity and receive the face value of the bond, and collect interest payments to maturity.

The risk in postponing the conversion lies in the volatility of the market value of the common shares. If the bondholder does not convert when the common share price is high, the bondholder cannot realize a gain on the resale of the shares. Subsequently, if the market value of the common shares declines the bondholder will not be able to sell the bond at a substantial gain since the incentive to convert to common shares is now non-existent and the conversion right is worthless.

EXERCISE 16-13 (10-15 minutes)

ASPE allows for two options: 1) to allocate the entire issuance to the debt component; or 2) to use the residual method.

Residual method:

The residual method under ASPE allows for the first allocation to be to the component that is more easily measurable, in this case, the equity component:

SANDS CORP.
Journal Entry
September 1, 2011

Cash ($5,304,000 + $117,000) 5,421,000 Bonds Payable—Schedule 1 5,252,000 Contributed Surplus—Stock Warrants— Schedule 1 52,000 Bond Interest Expense—Schedule 2 117,000 (To record the issuance of the bonds)

Schedule 1 Premium on Bonds Payable and Value of Stock Warrants

Sales price (5,200 X $1,000 X 1.02) $5,304,000
Deduct value assigned to stock warrants (5,200 X 2 = 10,400 X $5) 52,000
Bonds payable $5,252,000

Schedule 2 Accrued Bond Interest to Date of Sale

Face value of bonds $5,200,000
Interest rate 9%
Annual interest $ 468,000

Accrued interest for 3 months – ($468,000 X 3/12) $ 117,000

EXERCISE 16-13 (Continued)

Allocation of zero to equity

A second option is available under ASPE whereby the entire issuance is allocated to the debt.

SANDS CORP.
Journal Entry
September 1, 2011

Cash ($5,304,000 + $117,000) 5,421,000 Bonds Payable— 5,304,000 Bond Interest Expense—Schedule 1 117,000

Schedule 1 Accrued Bond Interest to Date of Sale

Face value of bonds $5,200,000
Interest rate 9%
Annual interest $ 468,000

Accrued interest for 3 months – ($468,000 X 3/12) $ 117,000

EXERCISE 16-14 (15-25 minutes)

a) Under IFRS, financial liabilities that are indexed to an entity’s performance are measured at the higher of the amortized cost and the amount owing at the balance sheet date given the feature. Therefore, the journal entry upon issuance is recorded at the issue amount.

Cash ($1,000 x 100 x 1.03) 103,000 Bonds Payable 103,000

(b) The bond amortized carrying amount should be compared to the potential cash outflow under the indexing feature to determine its year-end carrying amount.

| |Amortized |Indexed feature |Higher of two options |
| |cost | | |
|Dec. 31, 2011 |$102,400 |$75,000 |$102,400 |
| |($103,000 – $600*) |($250 x 3 x 100) | |
|Dec. 31, 2012 |$101,800 |$105,000 |$105,000 |
| |($102,400 – $600) |($350 x 3 x 100) | |
|Dec. 31, 2013 |$101,200 |$135,000 |$120,000** |
| |($101,800 – $600) |($450 x 3 x 100) | |

* The amortization of the premium is calculated as follows:
Bond Premium: $3,000
Years to Maturity: 5
Amortization per year: $600

** Although the indexed feature calculates a redemption feature at $135,000, the bond agreement states that the bonds cannot be redeemed for more than $1,200 per bond.
EXERCISE 16-15 (15-25 minutes)
(a)
1/2/12 No entry (total compensation cost is $5 50,000)

12/31/12 Compensation Expense 275,000 Contributed Surplus—Stock Options 275,000 [To record compensation expense for 2012 (1/2 X $550,000)]

4/1/12 Contributed Surplus—Stock Options 21,389 Compensation Expense 21,389 ($275,000 X 3,500/45,000) (To record termination of stock options held by resigned employees)

12/31/12 Compensation Expense 253,611 Contributed Surplus—Stock Options 253,611 [To record compensation expense for 2012 (1/2 X $550,000) – 21,389]

1/3/13 Cash (31,500 X $42) 1,323,000 Contributed Surplus—Stock Options 385,000 ($550,000 X 31,500/45,000) Common Shares 1,708,000

(To record issuance of 31,500 shares upon exercise of options at option price of $42)

(Note to instructor: The market price of the shares has no relevance in this entry and the following one.)

5/1/13 Cash (10,000 X $42) 420,000 Contributed Surplus—Stock Options 122,222 ($550,000 X 10,000/45,000) Common Shares 542,222

(To record issuance of 10,000 shares upon exercise of remaining options at option price of $42)
EXERCISE 16-15 (Continued)

b) The pricing model cannot take into account forfeitures as they cannot be reasonably estimated. The objective of offering stock options is to attract, motivate and remunerate selected individuals in the organization. Including a reduction of the expected expenditure by an arbitrary amount of forfeitures is contrary to the goal and does not reflect management’s intention. Had estimated forfeitures been included in the pricing model at the time of the grant of the options the total expense would be proportionately reduced.

c) Four common compensation plans are:

1. Compensatory stock option plans (CSOPs)

2. Direct awards of stock

3. Stock appreciation rights plans (SARs)

4. Performance-type plans

These different plans are used to compensate employees and especially management. It is generally agreed that effective compensation programs:

1. Motivate employees to high levels of performance.

2. Help retain executives and recruit new talent.

3. Base compensation on employee and company performance.

4. Maximize the employee’s after-tax benefit and minimize the employer’s after-tax cost.

5. Use performance criteria that the employee can influence.

EXERCISE 16-15 (Continued)

d) The main difference between an employee stock option plan (ESOP) and a compensatory stock option plan (CSOP) is that with ESOPs, the employee usually pays for the options (either fully or partially) and there may be a very large number of participants across the company. Thus these transactions are seen as capital transactions (charged to equity accounts). The employee is investing in the company.

CSOPs, on the other hand, are primarily seen as an alternative way to compensate particular, often senior, employees for their services, like a barter transaction. The services are rendered by the employee in the act of producing revenues. This information must be recognized on the income statement as an operating transaction (expense).

EXERCISE 16-16 (25-35 minutes)

(a)
1/1/11 No entry

12/31/11 Compensation Expense 375,000 Contributed Surplus— Stock Options 375,000 ($750,000 X 1/2)

12/31/12 Compensation Expense 375,000 Contributed Surplus— Stock Options 375,000

5/1/13 Cash (8,000 X $25) 200,000 Contributed Surplus— Stock Options 300,000 * Common Shares 500,000 *($750,000 X 8,000/20,000)

1/1/14 Contributed Surplus— Stock Options 450,000 Contributed Surplus – Expired Stock Options 450,000 ($750,000 – $300,000)

b) The market price of the Nichols shares at the date of grant would likely be lower than the exercise price. The objective of issuing the stock options is principally to motivate employees to work at enhancing the market value of the company’s shares. The options have a service period, typically of more than one year. Consequently, the company wishes to allow for an upward movement in the share price to justify the remuneration of key employees whose work would have lead to the increase in the share market value. If the market value of the shares at the date of grant was at or greater that the exercise price, the incentive would be substantially removed, and so the plan would be less effective.
EXERCISE 16-16 (Continued)

c) The market price of the Nichols shares at May 1, 2013 of $31 is not used in recording the exercise of the stock options. From an accounting perspective, the market price is not relevant. It is nonetheless relevant to the executives in making their decision to exercise their stock options. The market price is mentioned to indicate that the timing of the exercise is justified, or at least makes sense. The market price of the shares exceeds the carrying value of the stock options plus the cash paid. Executives exercising a stock option would have paid $25 and could resell the shares immediately for $31, a $6 per share gain.

d) During 2014 the market price of the stock likely fell below $25 per share. This would explain why no additional stock options were exercised, and were left to lapse, as there was no benefit to be gained by the executives in exercising them. They could not recover the cash required to exercise the stock option through the resale of the shares if the stock price was below the exercise price of $25 per share.

e) The executives holding the stock options might delay the exercise of the options to postpone the requirement of obtaining the necessary cash to exercise the option. Often executives must sell the shares obtained on the exercise of stock options to pay off bank loans secured to obtain the necessary cash required. Proceeds from the sale of the shares are also used for the payment of the personal income taxes that are assessed on the income for tax purposes realized on the sale of the shares obtained through the exercise of stock options.
EXERCISE 16-17 (10-15 minutes)

(a) January 1, 2010 No entry

(b) December 31, 2010 Compensation Expense 12,500 Contributed Surplus— Stock Options 12,500 (5,000 X $10 X 1/4)

(c) January 1, 2015 Cash (4,000 X $62) 248,000 Contributed Surplus— Stock Options 40,000 * Common Shares 288,000 *(5,000 X $10 X 4,000 / 5,000)

(d) December 31, 2017 Contributed Surplus— Stock Options 10,000 * Contributed Surplus – Expired Stock Options 10,000 *(5,000 X $10 X 1,000 / 5,000)

*EXERCISE 16-18 (15-20 minutes)

|(a) | | | |
|June 30, 2011 |Note |Rate |Amount |
|Interest paid | $ 100,000 |3.35%* | $ 3,350 |
|Cash received on swap | | | (350) |
|Interest expense | $ 100,000 |3% | $ 3,000 |
|* [(5.7 % + 1%) X 6/12] | | | |
| | | | |
|December 31, 2011 |Note |Rate |Amount |
|Interest paid | $ 100,000 |3.85%** | $ 3,850 |
|Cash received on swap | | | (850) |
|Interest expense | $ 100,000 |3% |$3,000 |

** [(6.7 % + 1%) X 6/12]

(b) December 31, 2011
|Interest Expense |7,200 | |
| Cash | |7,200 |
| |
|[(100,000 X 6.7% X 6/12) + ($100,000 X 7.7% x 6/12)] = $7,200 |

|Cash ($850 + $350) |1,200 | |
| Interest Expense | | 1,200 |

c) The interest rate swap is a cash flow hedge because the purpose in using the hedge is to protect MacCloud against variations in future cash flows caused by the changes in the prime rate of interest. At the time of entering into the contract, MacCloud had not yet incurred the interest charges for the note. The cash flows are therefore related to future interest payments. Consequently the hedge cannot be a fair value hedge.

*EXERCISE 16-19 (15-20 minutes)

|(a) | | | |
|December 31, 2011 |Note |Rate |Amount |
|Interest paid | $ 10,000,000 |5.8% | $ 580,000 |
|Cash paid on swap | | | 20,000 |
|Interest expense | $ 10,000,000 |6% | $ 600,000 |
| | | | |
|December 31, 2012 |Note |Rate |Amount |
|Interest paid | $ 10,000,000 |6.6% | $ 660,000 |
|Cash received on swap | | | (60,000) |
|Interest expense | $ 10,000,000 |6% |$ 600,000 |

(b) December 31, 2011
|Interest Expense |580,000 | |
| Cash | |580,000 |

|Interest Expense |20,000 | |
| Cash | | 20,000 |

December 31, 2012
|Interest Expense |660,000 | |
| Cash | |660,000 |

|Cash |60,000 | |
| Interest Expense | | 60,000 |

e) The interest rate swap is a cash flow hedge because the purpose in using the hedge is to protect Parton against variations in future cash flows caused by the changes in the LIBOR rate of interest. At the time of entering into the contract, Parton had not yet incurred the interest charges for the note. The cash flows are therefore related to future interest payments. Consequently the hedge cannot be a fair value hedge.

*EXERCISE 16-20 (20-25 minutes)

(a) December 31, 2012
|Cash |75,000 | |
| Interest Revenue | |75,000 |
|($1,000,000 X 7.5%) | | |
| | | |

(b) December 31, 2012
|Cash |13,000 | |
| Interest Revenue | | 13,000 |
| | | |

(c) December 31, 2012
|Derivatives – Trading |48,000 | |
|Holding Gain | |48,000 |
| | | |

(d) December 31, 2012
|Holding Loss (FV-NI) | 48,000 | |
|Investments in Bonds (FV-NI) | | 48,000 |

(e) The interest rate swap is a fair value hedge in this situation because the interest rate exposure is from an existing asset, the bonds.

f) The interest rate swap can act as a cash flow hedge because the hedge allows Sarazan to participate in the potential for a higher return on its investment caused by an increase in variable interest rates in the future. At the time of entering into the contract, Sarazan had not yet earned the interest income from its investment in bonds. The cash flows are therefore related to future interest receipts. Consequently the hedge can be a cash flow hedge. Sarazan decided to change from a fixed to variable rate of interest on its investment, using the hedge. Since the investment was already in place at the time of entering the hedge, it is a fair value hedge.
*EXERCISE 16-21 (15-25 minutes)

(a)

| |

(a) July 7, 2011
|Derivatives – Trading |240 | |
| Cash | |240 |
| | | |

(b) September 30, 2011
|Derivatives – Trading |1,100 | |
| Gain ($1,340 – $240) | | 1,100 |

(c) December 31, 2011
|Loss ($1,340 – $825) |515 | |
|Derivatives – Trading | | 515 |

(d) January 4, 2012
|Cash [ 200 X ($76 – $70) ] |1,200 | |
|Gain | |375 |
|Derivatives – Trading | | 825 |

|July 7, 2011 | $ 240 |
|Sept. 30, 2011 | 1,100 |
|Dec. 31, 2011 | (515) |
|Balance |$825 |

The option is “in the money” at the exercise date since Hing Wa (the option holder) can purchase the shares for $70 when they are worth $76.

|PROBLEM 16-2 |

(a) July 7, 2011
|Cash |240 | |
| Derivatives – Trading | |240 |
| | | |

(b) September 30, 2011
|Loss ($1,340 – $240) |1,100 | |
| Derivatives – Trading | | 1,100 |
| | | |

(c) December 31, 2011
|Derivatives – Trading |515 | |
|Gain ($1,340 – $825) | | 515 |
| | | |

(d) January 4, 2012
|Derivatives – Trading |825 | |
|Loss |375 | |
|Cash [200 x ($76 – $70)] | | 1,200 |

|July 7, 2011 | $ 240 |
|Sept. 30, 2011 | 1,100 |
|Dec. 31, 2011 | (515) |
|Balance | $ 825 |

The option is “in the money” (for the holder) at the exercise date since the holder of the option can purchase the shares for $70 when they are worth $76. Hing Wa loses because they must sell the shares at a price below the current market value.

|PROBLEM 16-3 |

(a) July 7, 2011
|Derivatives – Trading |480 | |
| Cash | |480 |
| | | |

(b) September 30, 2011
| | | |
|Loss ($480 – $250) |230 | |
|Derivatives – Trading | |230 |
| | | |

(c) December 31, 2011
| | | |
|Loss ($250 – $100) |150 | |
|Derivatives – Trading | |150 |
| | | |

(d) January 31, 2012
|Put option is not exercised as the market price of Mykia shares exceeds $50, the strike price. |
| | | |
|Loss |100 | |
|Derivatives – Trading | | 100 |

|July 7, 2011 | $ 480 |
|Sept. 30, 2011 | (230) |
|Dec. 31, 2011 | (150) |
|Balance | $ 100 |

|PROBLEM 16-4 |

(a) The derivative is considered a fixed-for-fixed derivative in an entity’s own shares as the option stipulates that the entity will issue a fixed numbers of shares for a fixed amount of consideration. IFRS states that this transaction would be presented as a reduction from shareholders’ equity and not as an investment, as this is, effectively, the prospective retirement of shares

|Equity – Fixed-for-fixed Derivative |750 | |
| Cash | |750 |
| | | |

(b) Because the option allows a choice in how the option will be settled, the instrument is a financial asset/liability (derivative) by default under IFRS unless all possible settlement options result in it being an equity instrument. In this case, one settlement option is the delivery of cash. Therefore, it will be classified as a derivative.

(c) ASPE is silent about the accounting for derivatives involving the entity’s own shares; however, the treatment of similar items would support presenting the option as a contra equity item because it clearly does not meet the definition of an asset. Therefore, the conclusion will not change.

|PROBLEM 16-5 |

(a) 1. Memorandum entry made to indicate the number of rights issued including full details as to characteristics.

2. Cash 200,000 Bonds Payable ($200,000 x 0.96) 192,000 Contributed Surplus— Stock Warrants 8,000 *

3. Cash * 288,000 Common Shares 288,000

*[(100,000 – 10,000) rights exercised] ÷ *[(10 rights/share) X $32 = $288,000

4. Contributed Surplus—Stock Warrants 6,400 ($8,000 X 80%) Cash* 48,000 Common Shares 54,000

*.80 X $200,000/$100 per bond = 1,600 *warrants exercised; 1,600 X $30 = $48,000

5. Compensation Expense* 50,000 Contributed Surplus – Stock Options 50,000

*$10 X 5,000 options = $50,000
PROBLEM 16-5 (Continued)

6. For options exercised: Cash (4,000 X $30) 120,000 Contributed Surplus—Stock Options 40,000 (80% X $50,000) Common Shares 160,000

For options lapsed: Contributed Surplus—Stock Options 10,000 Compensation Expense* 10,000

*(Note to instructor: This entry provides an opportunity to indicate that a credit to Compensation Expense occurs when the employee fails to fulfill an obligation, such as remaining in the employ of the company, performing certain job functions, etc. However, if a stock option lapses because the share price is lower than the exercise price, then a credit to Contributed Surplus—Expired Stock Options occurs.)

(b)

Shareholders’ Equity: Share Capital: Common Shares, authorized 1,000,000 shares, 314,600 shares issued and outstanding $4,102,000 Contributed Surplus—Stock Warrants* 1,600 $4,103,600 Retained Earnings 750,000 Total Shareholders’ Equity $4,853,600
* $8,000 – $6,400
Calculations:
| |Common Shares |
| |Number | |Amount |
| | | | |
|At beginning of year |300,000 | |$3,600,000 |
|From stock rights (entry #3 above) | 9,000 | | 288,000 |
|From stock warrants (entry #4 above) | 1,600 | | 54,000 |
|From stock options (entry #6 above) | 4,000 | | 160,000 |
|Total |314,600 | |$4,102,000 |

|PROBLEM 16-6 |

(a) Entry at January 1, 2011 should have been:

Cash ($1,000,000 X 1.08) 1,080,000 Bonds Payable ($1,000,000 X .98) 980,000 Contributed Surplus— Conversion Rights 100,000

At the issuance of the convertible bond, the bookkeeper should have recognized the debt (bond) and conversion right (equity) components separately in the accounts.

As the company is compliant with IFRS, the residual method, as illustrated in the corrected entry above, should have been used. First allocate from the cash proceeds obtained on issuance, the market value of the bond alone to the bond and the remainder of the cash proceeds is left to be allocated in the entry to the conversion rights.

(b) ASPE does have an option to allow for the equity portion to be allocated zero, with all the proceeds being allocated to the debt component. If this option was available, the bookkeeper would be correct. However, this is an optional treatment and the correction noted in part (a) above is still in order dues to the concern as to the debt-to-equity ratio.
PROBLEM 16-6 (Continued)

(c) Using either a financial calculator or Excel the effective interest rate on the bonds is calculated as follows:

Excel formula =RATE(nper,pmt,pv,fv,type)

|Using a financial calculator: |
|PV | $ 980,000 |
|I |? % |Yields 10.53482 % |
|N | 5 |
|PMT | $ (100,000) |
|FV | $ (1,000,000) |
|Type | 0 |

(d)
|Schedule of Bond Discount Amortization |
|Effective Interest Method |
|10% Bonds Sold to Yield 10.53482% |
| |

a) The entry for the issuance of the notes on January 1, 2011:

The present value of the note is: $1,200,000 X .56743 (factor for a single payment in 5 years at 12%) = $680,912 (Rounded by $4).

|Using a financial calculator: |
|PV | $ ? |Yields $680,912 |
|I |12% |
|N | 5 |
|PMT | $ 0 |
|FV | $ (1,200,000) |
|Type | 0 |

|Excel formula =PV(rate,nper,pmt,fv,type) |

January 1, 2011
Cash 1,000,000
Notes Payable 680,912 Contributed Surplus—Stock Warrants.. 319,088

PROBLEM 16-7 (Continued)

(b)
The amortization schedule for the zero interest bearing note is:

|SCHEDULE FOR INTEREST AND DISCOUNT AMORTIZATION— |
|EFFECTIVE INTEREST METHOD |
|$1,200,000 NOTE ISSUED TO YIELD 12% |
| | |Cash Interest | |Effective Interest | |Discount Amortized | |Carrying Amount |
|Date | | | | | | | | |
|1/1/11 | | | | | | | |$ 680,912 |
|12/31/11 | |$0 | |$ 81,709* | |$ 81,709 | | 762,621** |
|12/31/12 | | 0 | | 91,515 | | 91,515 | | 854,136 |
|12/31/13 | | 0 | | 102,496 | |102,496 | | 956,632 |
|12/31/14 | | 0 | |114,796 | | 114,796 | | 1,071,428 |
|12/31/15 | | 0 | | 128,572 | |128,572 | | 1,200,000 |
|Total | |$0 | |$519,088 | |$519,088 | | |

*$680,912 X 12% = $81,709 **$680,912 + $81,709 = $762,621

(c)
December 31, 2011
Interest Expense 81,709 Notes Payable 81,709

(d)
January 1, 2014
Cash (500,000 x $20)………… 10,000,000
Contributed Surplus – Stock Warrants 159,544 Common Stock 10,159,544 ($ 319,088 X ½ = $159,544)

|PROBLEM 16-8 |

(a)
September 30, 2011:
Cash 4,600,000 Bonds Payable ($4,300,000 – $100,000) 4,200,000 Contributed Surplus— Stock Warrants 240,000* Contributed Surplus— Conversion Rights 160,000

*($4,000,000 / 1,000 X 20 warrants X $3)

(b)
| |
|Using either a financial calculator or Excel, the effective interest rate on the bonds is calculated as follows: |
| |
|Excel formula =RATE(nper,pmt,pv,fv,type) |

|Using a financial calculator: |
|PV | $ 4,200,000 |
|I |? % |Yields 3.6436 % |
|N | 20 |
|PMT | $ (160,000) |
|FV | $ (4,000,000) |
|Type | 0 |

PROBLEM 16-8 (Continued)

(c)
|Schedule of Bond Premium Amortization |
|Effective Interest Method |
|8% Semi-annual Bonds Sold to Yield 7.2872% |
| |

(a) Financial Instrument #1

This is a hybrid financial instrument. Under ASPE, the company can allocate the proceeds between the liability and the equity portion, or allocate 100% to the liability, as is required in this case. Under IFRS, the company must allocate the proceeds between the liability and the conversion feature.

| |ASPE |IFRS |
| |Debit |Credit |Debit |Credit |
|Cash |5,000,000 | |5,000,000 | |
| Bond Payable | |5,000,000 | |4,567,072 |
| Contributed Surplus - Conversion | | | |432,928 |
|Option | | | | |
|To record issue of convertible debt. |
|$5,000,000 X .78353 (table A2) + $150,000 x 4.32948 (Table A4) = $4,567,072. |
|Interest Expense |150,000 | |228,354 | |
|Bond Payable | | | |78,354 |
| Interest Payable | |150,000 | |150,000 |
|To record interest expense for year $4,567,072 x 5% = $228,354 |

PROBLEM 16-9 (Continued)

Financial Instrument #2:

This is a compensatory stock option plan. The entries are the same under ASPE and IFRS.

| |ASPE |IFRS |
| |Debit |Credit |Debit |Credit |
|Compensation Expense* |275,000 | |275,000 | |
| Contributed Surplus – Stock Options | |275,000 | |275,000 |
|To record annual compensation expense related to CSOP |
|Cash |250,000 | |250,000 | |
|Contributed Surplus – Stock Options** |55,000 | |55,000 | |
| Common Shares | |305,000 | |305,000 |
|To record one employee exercising options and purchasing shares. |

* $550,000 X ½
** $550,000 X 1/10

Financial Instrument #3:

This is a forward contract. The entries are the same under ASPE and IFRS.

| |ASPE |IFRS |
| |Debit |Credit |Debit |Credit |
|Derivatives – Financial Assets |70,000 | |70,000 | |
| Gain | |70,000 | |70,000 |
|To record gain on forward contract. |

PROBLEM 16-9 (Continued)

(b)

Balances at December 31, 2011:
|Account |Balance under ASPE |Balance under IFRS |
|Derivatives – Financial Asset |$70,000 Dr |$70,000 Dr |
|Interest Payable |150,000 Cr |150,000 Cr |
|Bond Payable |5,000,000 Cr |4,645,426 Cr |
|Contributed Surplus – Stock Options |220,000 Cr |220,000 Cr |
|Contributed Surplus – Conversion Option | |432,928 Cr |

Note to instructor:
It may be useful to illustrate the following “proof”:

|Bond Payable under IFRS | |4,645,426 Cr |
|Contributed Surplus – Conversion Option | |432,928 Cr |
|Subtotal | |5,078,354 Cr |
|Less: Amortization to date of bond discount | |(78,354) Dr |
|Balance under PE GAAP | |5,000,000 Cr |

|PROBLEM 16-10 |

2011. No journal entry would be recorded at the time the stock option plan was adopted. However, a memorandum entry in the journal might be made on November 30, 2011, indicating that a stock option plan had authorized the future granting to officers of options to buy 70,000 common shares at $8 a share.

2012 January 2
No entry

December 31
Compensation Expense 209,524 Contributed Surplus—Stock Options 209,524 (To record compensation expense attributable to 2012—22,000 options)

|Pro-rata calculation: |2012 |2013 |Total |
| President | 15,000 | 13,000 |28,000 |
| Vice- President | 7,000 | 7,000 |14,000 |
| Total options | 22,000 | 20,000 | 42,000 |
| Compensation Expense | $ 209,524* | $ 190,476** | $400,000 |

* 22,000 / 42,000 X $400,000 = $209,424
** 20,000 / 42,000 X $400,000 = $190,476

2013 December 31
Compensation Expense 190,476 Contributed Surplus—Stock Options 190,476 (To record compensation expense attributable to 2013—20,000 options)

Contributed Surplus—Stock Options 209,524 Contributed Surplus—Expired Stock Options 209,524 (To record lapse of president’s and vice president’s options to buy 22,000 shares)
PROBLEM 16-10 (Continued)

2014 December 31
Cash (20,000 X $8) 160,000
Contributed Surplus—Stock Options 190,476 Common Shares 350,476 (To record issuance of 20,000 common shares upon exercise of options at $8)

|*PROBLEM 16-11 |

(a) (1) December 31, 2011
|No entry required at the date of the swap because the fair value of the swap at inception is zero. |
| | | |

(2) June 30, 2012
|Interest Expense |400,000 | |
|Cash Cash | |400,000 |
|($10,000,000 X 8% X 6/12) | | |

(3) June 30, 2012
|Cash |50,000 | |
| Interest Expense | | 50,000 |
|($10 million X 8% less 7% X 6/12) | | |
| |Interest Received | |
| |(Paid) | |
|Swap receivable (8% X $10,000,000 X 1/2) |$ 400,000 | |
|Payable at LIBOR (7% X 10,000,000 X 1/2) | (350,000) | |
|Cash settlement | 50,000 | |

(4) June 30, 2012
|Note Payable |200,000 | |
|Unrealized Holding Gain or Loss - Income | | |
| | |200,000 |
| | | |

(5) June 30, 2012
|Holding Loss | 200,000 |
|Other Liabilities – Swap Contract | | 200,000 |
*PROBLEM 16-11 (Continued)

b)
Mercantile Corp.
Statement of Financial Position (partial)
December 31, 2011

Long-term liabilities Note payable $10,000,000

Statement of Income (partial) For the Year Ending December 31, 2011

No items to report

(c)
Mercantile Corp. Statement of Financial Position (partial)
June 30, 2012
Current liabilities Derivatives – Trading $200,000

Long-term liabilities Note payable $9,800,000

Statement of Income (partial) For the Six Months Period Ending June 30, 2012

Interest expense $350,000 ($400,000 – $50,000)

Other revenues and gains: Holding gain – Note payable $200,000 Holding loss- Swap contract (200,000) 0
*PROBLEM 16-11 (Continued)

(d) Mercantile Corp. Statement of Financial Position (partial)
December 31, 2012
Other assets Derivatives – Trading $60,000

Current liabilities Note payable $10,060,000

Statement of Income (partial) For the Year Ending December 31, 2012

Income Statement Interest expense First six months $ 350,000 [as shown in (c)] Next six months 375,000* (see below) Total $ 725,000

Unrealized Holding Gain— Swap $ 60,000 Unrealized Holding Loss— Note Payable (60,000) Total $ 0

*Swap receivable (8% X $10,000,000 X 1/2) $ 400,000 Payable at LIBOR (7.5% X $10,000,000 X 1/2) 375,000 Cash settlement $ 25,000

Interest expense unadjusted June 30–December 31, 2011 $ 400,000 Cash settlement (25,000) $ 375,000

|*PROBLEM 16-12 |

(a) April 1, 2011
|No entry required | | |
| | | |

(b) June 30, 2011
|Derivatives -- Trading |5,000 | |
|Holding Gain (OCI) | | 5,000 |
| | | |

(c) September 30, 2011
|Derivatives -- Trading |2,500 | |
|Holding Gain (OCI) | | 2,500 |
| | | |

(d) October 31, 2011
|Raw Materials Inventory - Gold |150,000 | |
|Cash (500 ounces X $300) Cash | |150,000 |
| | | |

(e) December 20, 2011
|Accounts Receivable/Cash / Cash |350,000 | |
|Sales | | 350,000 |
| | | |
|Cost of Goods Sold Cash |200,000 | |
|Finished Goods Inventory | |200,000 |
| | | |
|Holding Gain (OCI) | 7,500 | |
|Cost of Goods Sold | |7,500 |

*PROBLEM 16-12 (Continued)

(f)
LEW Jewellery Corp. Statement of Financial Position (partial)
June 30, 2011
Current assets Derivatives -- Trading $5,000

Equity Accumulated Other Comprehensive Income $5,000

Statement of Income (partial) For the Six Months Period Ending June 30, 2011

Other Comprehensive Income: Holding gain – Futures contract $5,000

(g)
LEW Jewellery Corp.
Statement of Income (partial) For the Year Ending December 31, 2011

Sales $350,000
Cost of goods sold ($200,000 – $7,500) 192,500
Gross profit $157,500

TIME AND PURPOSE OF WRITING ASSIGNMENTS

WA 16-1 (Time 15–20 minutes)

Purpose—to provide the student with an understanding of the proper accounting and conceptual merits for the issuance of stock warrants to three different groups: existing shareholders, key employees, and purchasers of the company’s bonds. This problem requires the student to explain and discuss the reasons for using warrants, the significance of the price at which the warrants are issued (or granted) in relation to the current market price of the company’s shares, and the necessary information that should be disclosed in the financial statements when stock warrants are outstanding for each of the groups.

WA 16-2 (Time 25–30 minutes)

Purpose—to provide the student with an opportunity to under the use of the Black Scholes option pricing model and to understand how it used in determining fair values, the inputs required and the impact on compensation costs if the inputs are varied for CSOPs. .

WA 16-3 (Time 25–30 minutes)

Purpose—to have the students identify various financial risks using “real-life” examples and explain why it is important for a company to manage risk. Students are asked to describe derivatives and how they are used to hedge various risks and to explain the difference between hedging from an economic perspective and hedge accounting.

WA 16-4 (Time 25–30 minutes)

Purpose—to develop an understanding of executory contracts and derivative contracts. Students are required to explain how purchase commitments and futures contracts are measured and reported under IFRS and ASPE.

WA 16-5 (Time 25–30 minutes)

Purpose—to develop an understanding of share appreciation rights. Student must explain how SARs are treated under IFRS and ASPE, in addition to explaining why there are these differences. In addition, students are required to explain how the accounting for SARs and compensatory stock options differ under both IFRS and ASPE.

TIME AND PURPOSE OF WRITING ASSIGNMENTS (Continued)

WA 16-6 (Time 25–30 minutes)

Purpose—to have the student distinguish between various treatments of derivatives used as economic hedges for three different transactions. The student must identify when hedge accounting would be appropriate and how this is accomplished under IFRS and ASPE.

WA 16-7 (Time 25–30 minutes)
Purpose – to have students explain why instruments settleable in the entity’s own shares cause accounting issues.

WA 16-8 (Time 25–30 minutes)
Purpose—to provide the student with an opportunity to understand the differences between PE GAAP and IFRS and the conceptual reasons for any differences.

SOLUTIONS TO WRITING ASSIGNMENTS

WA 16-1

(a) 1. The objective of issuing warrants to existing shareholders on a pro-rata basis is to raise new equity capital. This method of raising equity capital may be used because of pre-emptive rights on the part of a company’s shareholders and also because it is likely to be less expensive than a public offering.

2. The purpose of issuing stock warrants to certain key employees, usually in the form of a nonqualified stock option plan, is to increase their interest in the long-term growth and income of the company and to attract new management talent. Also, this issuance of stock warrants to key employees under a stock option plan frequently constitutes an important element in a company’s executive compensation program. Though such plans result in some dilution of the shareholders’ equity when shares are issued, the plans provide an additional incentive to the key employees to operate the company efficiently.

3. Warrants to purchase common shares may be issued to purchasers of a company’s bonds in order to stimulate the sale of the bonds by increasing their speculative appeal and by aiding in overcoming the objection that rising price levels cause money invested for long periods in bonds to lose purchasing power. The use of warrants in this connection may also permit the sale of the bonds at a lower interest cost.

(b) 1. Because the purpose of issuing warrants to existing shareholders is to raise new equity capital, the price specified in the warrants must be sufficiently below the current market price to reasonably assure that they will be exercised. Because the success of the offering depends entirely on the current market price of the company’s shares in relation to the exercise price of the warrants, and because the objective is to raise capital, the length of time over which the warrants can be exercised is very short, frequently 60 days.

2. Warrants, except for incentive stock option plans, may be offered to key employees below, at, or above the market price of the shares on the day the rights are granted. If a stock option plan is to provide a strong incentive, warrants that can be exercised shortly after they are granted and expire quickly, say, within one or two years, usually must be exercisable at or near the market price at the date of the grant. Warrants that cannot be exercised until a number of years after they are granted or those that do not lapse for a number of years after they become

WA 16-1 (Continued)

exercisable may, however, be priced somewhat above the market price of the shares at the date of the grant without eliminating the incentive feature. This does not upset the principal objective of stock option plans: heightening the interest of key employees in the long-term success of the company. Income tax laws penalize the issuance of warrants and stock options at prices below market price on the day the rights are granted by taxing them as part of employment income.

3. Income tax laws impose no restrictions on the exercise price of warrants issued to purchasers of a company’s bonds. The exercise price may be above, equal to, or below the current market price of the company’s shares. The longer the period of time during which the warrant can be exercised, however, the higher the exercise price can be and still stimulate the sale of the bonds because of the increased speculation appeal. Thus, the significance of the length of time over which the warrants can be exercised depends largely on the exercise price (or prices). A low exercise price in combination with a short exercise period can be just as successful as a high exercise price in combination with a long exercise period.

(c) 1. Financial statement information concerning outstanding stock warrants issued to a company’s shareholders should include a description of the shares being offered for sale, the option price, the time period during which the rights may be exercised, and the number of rights needed to purchase a new share.

2. Financial statement information concerning stock warrants issued to key employees should include the following: status of these plans at the end of periods presented, including the number of shares under option; the prices at which the warrants may be exercised; the time periods and conditions under which they may be exercised; and the number of warrants exercised and forfeited during the year.

3. Financial statement disclosure of outstanding stock warrants that have been issued to purchasers of a company’s bonds should include the prices at which they can be exercised, the length of time they can be exercised, and the total number of shares that can be purchased by the bondholders.

WA 16-2

(a) The Black Scholes model is used to determine the fair value of options. Consequently, any financial instrument that is an option or has an option embedded in it, will require that some form of option pricing model be used.

i. Derivatives that are options used by companies to manage risk (hedging or speculation) will require the Black Scholes model to determine the fair value; ii. Convertible bonds issued by the entity have an option to convert embedded in the bond that must be separately measured; iii. Compensatory stock option plans (CSOP) are plans where employees are given stock options in the company in lieu of employment services to be provided. The fair value of these plans must be determined using the Black Scholes option pricing model.

Under IFRS, the following standards apply:

i. Derivatives have to be measured at fair value initially and at each subsequent reporting period. ii. Convertible bonds contain both a liability and an equity component which are classified separately on the initial issuance of the bonds. Under IFRS, the residual method is used whereby the fair value of the debt component is measured first, and then any residual amount is allocated to the equity component. The amount classified to equity is not changed during the life of the bond, so does not need to be subsequently remeasured. iii. CSOPs are measured at fair value at the time of the grant of the options to the employees. The fair value of the options must be determined using some option pricing model ( generally the Black Scholes option pricing model). This value is used to measure the compensation expense at the time of the grant, and does not change throughout the life of the options.

Under ASPE, the following standards apply to each of the above:

i. Derivatives generally have to be measured at fair value initially and at each subsequent reporting period. However, if the derivative is required to be settled in the company’s shares and the fair value of these shares cannot be readily determined, then the derivative is measured at cost. ii. Convertible bonds contain both a liability and an equity component which should be classified separately. However, under ASPE, at the time of issuance, the company has a choice to either recognize the equity portion at zero (allocating all the proceeds on issue to the liability component) or determine the value of the component that is the most readily measurable first and any residual is allocated to the other component. The equity component does not change value throughout the life of the bond. iii. CSOPs are measured at fair value at the time of the grant. The fair value of the options must be determined using some option pricing model (generally the Black Scholes option pricing model). This value is used to measure the
WA 16-2 (Continued)

compensation expense at the time of the grant, and does not change throughout the life of the options.

(b) The inputs into the Black Scholes model include: i. the exercise price ii. the expected life of the option iii. the current market price of the underlying share iv. the volatility of the price of the underlying shares v. expected dividend during the life of the option vi. the risk free rate of interest over the life of the option.

The difficulty for private enterprises is in determining the volatility of the shares, since the entity’s shares are not publicly traded. However, the private company must still make an attempt to estimate what this volatility would be by looking at similar company shares in the market. The other input that is more difficult to determine is the current market price of the shares, since again, the shares are not publicly traded. For a public company, this information would be readily available.

(c) Assuming all other inputs remain unchanged: i. an increase in the risk free rate will increase the fair value of the options granted since the time value of money has increased; ii. a decrease in the volatility will decrease the fair value of the options granted since the likelihood of being able to exercise at higher prices is reduced; iii. an increase in the expected life of the options will increase the fair value of the options since there is a longer time period before they need to be exercised which increased the time value component of the price.

(d) The major differences between exchange traded options and stock options granted under employee benefit plans are the following: i. employee stock options have a vesting period during which they cannot be exercised and during which the options are forfeited if the employee leaves; ii. employee stock options tend to have much longer periods to maturity (often up to 10 years from the date of grant) which normal exchange traded options do not; iii. new shares are issued by the company when the employee stock options are exercised; this is not the case with exchange traded options where the shares are already issued and outstanding by the company.

As a result of these significant differences, some believe that the Black Scholes formula is not the correct model to use. However, even given these weaknesses, it is still believed to be the best alternative available to estimate the fair value of options under employee stock option plans.

WA 16-3

(a) The business model of Barrick Gold Corporation and its financial risk profile can be a good example. The company engages in the production and sale of gold, as well as in related activities such as exploration and mine development. It produces some copper and holds interests in oil and gas properties in Canada. Its mining operations are concentrated in its four regional business units: North America, South America, Africa, and Australia Pacific. It sells its gold and copper production into the world market.

This business model exposes the company to various risks such as commodity price risk (the risk associated with the fluctuation of prices of various commodities), foreign exchange risk (risk associated with fluctuations in foreign currency exchange rates), and interest rate risk (the risk associated with changes in interest rates).

In addition, the company is exposed to credit risk (the risk that a third party might fail to fulfill its performance obligations under the terms of a financial instrument). As the company uses derivatives, it is exposed to another risk called market liquidity risk, which is the risk that a derivative cannot be eliminated quickly by either liquidating it or by establishing an offsetting position.

If a company focuses solely on minimizing risk it could end up minimizing value, since risk creates opportunities and opportunities translate into value. In creating shareholder value it is important for a company to manage risk for various reasons. A company with better risk management strategies in place is consistently able to manage its price-value ratios better than its competitors, get better value for investments, and score higher ratings with the customer base.

(b) Derivatives as defined by the accounting standards 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 that are inherent in an underlying primary instrument. They transfer risks that are inherent in the underlying primary instrument without either party having to hold any investment in the underlying.” (CICA Handbook, Part II, Section 3856.05 and IAS 39.9). They derive their value due to the underlying instrument, require little or no upfront investment and are settled in the future. Examples of derivatives are options, futures, forward contracts and swaps.

WA 16-3 (Continued)

(c) Companies that are exposed to financial risks might choose to reduce their exposure to these risks. Hedging is when derivatives are used to mitigate or offset these risks. In a perfectly hedged transaction, there should be no economic loss to the company. In other words, the loss of the hedged item is offset with any gain on the hedging item (the derivative). From an economic perspective, the hedge should reduce or limit the potential for loss. Hedging adds value for a company since it reduces the risk and volatility of the cash flows for a company. Hedge accounting is an option that is available under accounting standards to report and measure hedges. The key point to note is that hedge accounting is optional. A company can still be using hedging from an economic perspective and decide not to use hedge accounting to report and measure the hedged and hedging items. However, hedge accounting can only be used when the company is engaged in actual hedging practices. The company can also apply hedge accounting to some of its hedging practices and not to others. There is no need for hedge accounting if there is symmetry in the reporting gains and losses on the asset or liability that has a market risk and the derivative that is used to mitigate that risk. That is, in both cases, the gains and losses may both be reported to the earnings, and therefore are automatically offset. Where hedge accounting is useful is where there might be a mismatch in the reporting of these gains and losses, or the derivative is for a future transaction that has not yet been recognized. An example of a mismatch in reporting of the gains and losses would be where the change in the fair value of an investment is recorded to other comprehensive income, and the change in the derivative used to hedge that investment is reported into current earnings. Hedge accounting would allow both the changes in fair value of the asset and of the derivative to be reported in current earnings, so the economic offset is properly reflected in the accounting records. Similarly, if a company has hedged a future transaction, then the changes in the fair value of the derivative can be recorded into other comprehensive income until the transaction impacts the earnings. At this time, the cumulative gains and losses on the derivative used to hedge the transaction would also be reported in current earnings. In this way the net economic gain or loss (which should be minimal) would be properly reported in the accounting earnings for the company. As hedge accounting is an exception to the usual rules for financial instruments, there are strict criteria that must be met before it can be used. Management must identify, document, and test the effectiveness of those transactions for which it wishes to use hedge accounting. The criteria to achieve hedge accounting are onerous and will have systems implications for all entities. Therefore, management should always consider the costs and benefits when deciding whether to use it. Especially for small or medium sized companies, the costs can be significantly higher than the benefits. Also, management should think about the needs of its financial information users when it makes the decision about using hedging accounting. If a derivative becomes ineffective, then it no longer qualifies for hedge accounting and any gains or losses would be immediately reported into current earnings.

WA 16-4

(a) The first contract for the Papula Mine is a sales contract to deliver copper at a fixed price and a fixed volume (fixed by the annual production of the mine). This sale commitment is not traded on an exchange and is an executory contract. No money has changed hands at the beginning of the contract and cash will be received as delivery is made. This contract cannot be net settled in cash since delivery of the copper must be made. In this case, the contract is treated as an unexecuted contract, meaning that it does need to be measured at fair value at each reporting period. Instead, the sale is recorded at the fixed committed price when delivery of the copper is made. This is true under IFRS and ASPE. The exchange traded options for the Minera Mine are non-financial derivatives. The premium paid for the options is the fair value paid at the time the options are purchased. Under ASPE, because the options are exchange traded, then the options are measured and reported at fair value at each reporting period. Under IFRS, these options are a non-financial derivative which can be settled on a net basis. If the intent of the company is to make physical delivery of the copper, then the option can be designated as “expected use” and may be treated as an executory contract and only be recorded when delivery and a sale is made. Alternatively, if the company’s intent is to settle on a net cash basis at some time during the term of the options, then the option is treated as a derivative. As such, the options would be measured and reported at fair value at each reporting period.

(b) If the sale commitment contract was able to be settled in net cash, rather than making delivery of the copper, it would still be recorded when executed under ASPE. However, under IFRS, the company would have to assess the likelihood of making delivery of the copper or settling on a net basis. If the company intends to deliver the copper, then the contract is designated as “expected use” and can be recorded when the delivery is made as a sale. If the company intended to settle on a net basis, then the contract would be treated as a derivative and would measured and reported at fair value at every reporting period.

WA 16-5

(a) Compensatory stock options require the employee to pay the exercise price of the shares. The employee then takes these shares and sells them on the open market and receives a capital gain on the disposition equal to the difference between the exercise price and the current market price. Transaction costs will also have to be paid at this time. A much easier process for the employee to receive this gain on the share price is using share appreciation rights (SARs). Under a SARs plan, the employee receives directly cash (or shares) for the value of this difference in the share price, and there are no actual shares issued. This makes a less complex process.

b) SARs are measured at the value that will be distributed to the employee, and as a result this changes over time. Initially, an estimate of the fair value of the SAR is determined and recorded as compensation expense with an offsetting entry to a liability, since the amount will be paid in cash. Over the time of the service period, until the employee is paid or the right expires, the compensation expense will be adjusted, as will the liability. As a consequence, the liability will always represent the current value of the share appreciation rights. Under ASPE, this is the intrinsic value which is equal to the share price less the option price multiplied by the number of rights outstanding multiplied by the percentage of service time (vesting period) that has lapsed. Under IFRS, the fair value of the SAR must be used rather than the intrinsic value. The fair value would include some time value in addition to the intrinsic value and can be determined using an option pricing model such as Black Scholes.

As a consequence, the annual compensation expense will be impacted by changes in the share price, changes in the lapsed portion of the service period and any forfeitures. Initially, the compensation expense will be recorded over two years. After this point in time, the compensation expense will be adjusted as the share price changes until expiry or exercise.

This differs from compensatory stock option reporting since the value of the fair value of the stock option is determined at the grant date and then does not change. The compensation expense will change only due to the vesting period and any forfeitures.

The reason that IFRS uses the fair value of the SAR is to be consistent with the accounting treatment for all the other stock based compensation plans. ASPE is using the intrinsic value only likely for two reasons: first, it is simpler and given that the company is a private enterprise, it would be difficult to determine the fair value; and secondly, this has historically been Canadian practice.

WA 16-5 (Continued)

(c) In the case of Zenon, under IFRS, the fair value of the SARs is $65,000. For the first year, $32,500 (50% of this amount) will be recognized as an expense and an offsetting liability. Under ASPE, the amount to be expensed in the first year will be $25,000 since only the intrinsic value of the SARs is used. Under both standards, this amount will change in the second year, as the fair value of the SAR changes due to share price changes. In the next three years, until expiry or exercise, the compensation expense will be adjusted to reflect the fair value of the liability. The compensation expense may even be negative in some years, if the liability is overstated at some point.

This again differs with compensatory stock options. If the stock options were granted instead, the treatment under IFRS and ASPE is the same. The fair value of the options of $65,000 would be allocated equally over the vesting period of two years, with $32,500 reported in the first and second year. Since shares would be issued, the offsetting entry would be to contributed to surplus. There would be no change in the compensation expense, regardless of how the value of the options changed over time, and whether or not they were eventually exercised.

WA 16-6

(a) The investment in the publicly traded shares is recorded at fair value under both IFRS and ASPE. Under ASPE, the gain or loss on the change in fair value is directly reported to current earnings. The option is a derivative, and since it is exchange traded, it is also measured at fair value at each reporting period with the changes reported in the current earnings. This results in symmetric reporting and a netting of the gains and losses on the hedged item and the hedging item in the profit or loss for the period. There is no need to use hedge accounting under ASPE in this case.

Under IFRS, the company has a choice to classify the investment in fair value through profit or loss, or fair value through OCI. The derivative must be recorded at fair value through profit or loss. If the company chooses to report the investment at fair value through profit or loss, then this would match the treatment of the option derivative. Similar to ASPE above, there would be no need for hedge accounting since the gains and losses on the hedged item and hedging item would be offset in the current earnings. However, if the company chooses to report the investment at fair value through OCI, then there is a mismatch because changes in the derivative will be reported in the profit or loss for the period, whereas changes in the investment are reported in OCI. Consequently, the company would adopt fair value hedge accounting and designate the investment as the hedged item and the option as the hedging item. The gains and losses on the investment would be recorded in the profit or loss for the period and now offset against the gains and losses on the option derivative.

(b) Under IFRS and ASPE, the US dollar receivable must be translated into the equivalent Canadian dollars at each reporting period. Any foreign exchange gain or loss is recognized in the profit or loss for the period. The forward contract, which is a derivative, also must be reported at fair value with the gains and losses reported to net earnings. This accounting treatment results in symmetric reporting of the gains and losses, showing a net impact in the current earnings. Therefore, no hedge accounting is required.

(c) The forward contracts to buy Australian dollars are to hedge anticipated future transactions. In this case, the hedged item has not yet occurred, but the purchase of the derivative has. The derivative would have to be reported at fair value at each reporting period, with gains and losses reflected in the current earnings. However, this results in a mismatch, since the anticipated future transaction has not yet taken place. The company would then like to qualify for hedge accounting. Under ASPE (CICA 3856.A63 Part II), a foreign currency forward contract must meet all of the following criteria in order to qualify for hedge accounting:

WA 16-6 (Continued)

• the forward contract is for the same amount and same currency as the anticipated future transaction; • the forward contract matures within two weeks of the anticipated hedged transaction; • it is probable that the future transaction will occur; • the fair value of the forward contract is zero at the time it is entered into.

If we assume that all of the above criteria are met, then the forward contract can be designated as a hedge. This means that the derivative does not need to be recognized until it actually matures – in six months. When the anticipated transaction actually occurs, the gain or loss on the forward contract will be adjusted to the carrying amount of the anticipated future transaction.

Under IFRS, the same mismatch as described above would result if the forward contracts were reported at fair value at each reporting period. Under IFRS, the forward contract may qualify as a cash flow hedge assuming all the criteria are met. The forward contracts are still reported at fair value at each reporting period except that the gains and losses are now reported in OCI until the future transaction impacts the earnings. When this happens, the accumulated gains and losses in OCI related to the forward contract are transferred to profit or loss and reported in the same account as the anticipated transaction. In designating the derivative as a cash flow hedge, the company must document the hedging relationship, the hedged item and the hedging item and test for effectiveness at each reporting period. If the hedge becomes ineffective, then gains and losses on the forward contract must be immediately transferred out of OCI into profit and loss.

WA 16-7

The main issue that arises for instruments that are settleable in the entity’s own shares is whether the instrument should be presented as equity, a financial liability or a financial asset. Generally, going back to basic principles is required to determine the appropriate presentation. However, there is some guidance that IFRS has noted in the standard:

• “fixed for fixed principle” – where the number of shares and the consideration required to settle the instrument are both fixed, this will be presented as equity. An example of this is a written call option giving the holder the right to buy a fixed number of shares for a fixed amount of consideration and no choice for cash settlement. Purchased put or call options that give the entity to right to sell or buy a fixed amount of shares for a fixed amount of consideration is equity, since there is no obligation to pay cash. • An obligation to pay cash (or other assets) is required – any time there is an obligation to pay cash (even if there is a fixed number of shares with a fixed amount of consideration), the instrument is presented as a liability. A written put option that obligates the entity to buy back a fixed number of shares for a fixed amount of consideration is a liability since it requires the entity to outlay cash consideration in settlement. Similarly, a forward contract requiring the company to buy a fixed number of shares for a fixed amount of consideration will require a cash outlay and is recorded as a financial liability. • A choice in settlement – Anytime there is a choice for cash settlement (or other assets) by either party, the instrument is a financial liability. (Only in cases where all the possible choices resulted in shares being issued would the instrument be recorded as equity.) Under ASPE, if the company can make a choice and avoid settling in cash or other assets, then this instrument would be recorded as equity. Contracts that will be net settled in cash or shares are financial assets or liabilities since either cash will be or a variable number of shares will be used for settlement.

WA 16-8

There are many differences between IFRS and ASPE with respect to measurement and reporting for complex financial instruments. Primarily, ASPE has been written to keep recognition and measurement issues simple and therefore requiring less cost and time to calculate and report. Finally, ASPE has been designed with the primary user in mind of being the creditor, rather than outside shareholders and creditors. Given that generally creditors have access to management; the disclosure has also been simplified.
These differences are highlighted below:

a) Generally purchase commitments are treated as executory contracts under ASPE, which simplifies the identification and measurement of these contracts. Under IFRS, if these contracts can be net settled in cash, and the entity is not likely to take delivery, then the purchase commitment must be reported at fair value, similar to other derivatives. b) ASPE would generally not require compound instruments that have components of both debt and equity to be separated. Under ASPE, it can be assumed that equity components are equal to zero (or if readily determinable, then these values can be used). Under IFRS, the liability and equity component must be separately classified. Again, ASPE has made the accounting treatment simpler without having to determine the values of the separate components unless the entity chooses to do so. c) Certain tax efficient preferred shares that are used extensively by private enterprises for estate planning can be shown as equity even if they are puttable for a certain amount of cash consideration. ASPE deems these to be “in-substance” equity, and since they are used regularly by private enterprises, this keeps the reporting less complicated. Under IFRS, these puttable shares would be reported as liabilities unless certain criteria are met for equity presentation. d) Instruments that have a choice to be settled in cash are always reported as liabilities under IFRS. Under ASPE, if the contingent settlement in cash is highly likely to occur, these instruments must be reported as liabilities. e) For instruments that can be settled using the entity’s own shares, ASPE has less guidance on how to treat these instruments. In these cases, a review of the basic principles is necessary to determine whether the instrument should be reported as a financial liability or equity. Private companies are less likely to use complicated instruments related to their own shares, since the shares are not easily transferrable. IFRS provides more guidance stating that only when there is a fixed number of shares to issue for a fixed consideration and there is no choice for cash settlement, can the instrument be presented as equity. In all other cases, the instrument would likely be classified as a financial liability.

WA 16-8 (Continued)

f) Where the private enterprise has historically bought back the shares after the employee has exercised, the CSOP can be reported as a liability rather than equity. Because there is no ready market for these shares, the buying back of the shares by private enterprises happens more often so that employees can realize the value of these options. Under IFRS, CSOPs are reported as equity. In determining the fair value of the CSOP, a private enterprise will have to estimate a measurement of volatility, whereas this can be readily measured for publicly traded entities. g) SAR’s are reported at fair value under IFRS and at intrinsic value under ASPE. The main reason for this is the difficulty in determining the fair value of a SAR on shares that are not publicly traded. h) Hedging under IFRS is a lot more complex, with a choice between designating a cash flow hedge or a fair value hedge. Derivatives are still fair valued, but hedge designation will result in different reporting requirements for the gains and losses on the derivative and the hedged item. For cash flow hedges, the gains and losses on the hedging item can be reported in OCI. Under ASPE, if the company qualifies for hedge accounting for anticipated transactions, the derivative does not need to be recorded until settled. This is done for two reasons – first of all ASPE has no OCI, so there is no mismatch for fair value type hedges. And since there is no OCI, there is no other alternatives for reporting the income on the derivatives, and so the company does not have to report them at all until settled, eliminating any mismatch. i) Finally, the disclosure under ASPE is greatly reduced in comparison to IFRS. The reason for this is due to the nature of the limited users for private company reports.

CASES

Note: See the Case Primer on the Student website, as well as the Summary of the Case Primer in the front of the text. Note that the first few chapters in volume 1 lay the foundation for financial reporting decision making.

CA 16-1 Sanford Corp.

Overview

- The company is in the business of selling fire extinguishers and it is using shares as incentive to sell its products. - It is a closely held company but shares trade on the stock exchange therefore IFRS is a constraint. - Note that as an analyst, you would start with these statements (GAAP or not), and adjust the numbers to get the most meaningful information about the company. - As a financial analyst—you are looking at quality of income and whether net income represents sustainable income and reflects the underlying business model of the company. You would therefore want transparency (f/s should reflect underlying substance).

CA 16-1 (Continued)

Analysis and recommendations

Issue: Valuation of the shares transferred

|BV or FV at time of transfer to trust |FV at time shares granted to dealers |
|Equals measurement date — the shares appear to be vested and are |Represents the true value to the dealers. |
|non-forfeitable at this date, i.e., the shares will be earned by |The shares were technically not issued prior to this— they sat in|
|the sales force over the three year period, |the trust for the interim period (not outstanding). |
|This is the point at which the value is transferred from the |The shares still belong to the company, they are just restricted.|
|company, |This is the date at which the dealer’s performance is complete. |
|Additional increases in value accrue to the dealers— the company |Other. |
|has no access to the trust or the shares once transferred. | |
|Other. | |

Recommendation:

Record and measure at fair value on the date that the shares are transferred to the trust. This is the date that the deal with the dealers is struck and the commitment made.

Issue: Treatment of related cost

|Defer |Expense |
|Reflects the economic substance. It is like a prepaid commission.|This should be expensed since it is unclear as to whether this |
|The dealers would see this as a motivation to buy more from the |will generate future benefit. |
|company and resell them— therefore it represents an asset. |The outcome of the incentive plan is uncertain and may not |
|Similar to commission. |generate future sales above the minimum predetermined amounts— it|
|It is not a capital transaction since it is reciprocal— the |may be worthwhile to look to the company’s history. |
|purpose is to compensate non-shareholders for service. |This is like any other marketing/incentive program— too much |
|Other. |uncertainty and does not meet the definition of an asset (no |
| |probable future benefit). |
| |Other. |

Recommendation:

Treat as marketing costs since this is more transparent. If the company did not issue shares—it would have likely incurred commissions. Therefore, this helps determine the sustainable, ongoing income of the company. In terms of measurement, if this is a marketing cost, it would measure at date incurred. This would be at the grant date. At this point, the company would determine the value that it was prepared to give up— most easily measured at the date of issue of the shares (as FV). Since the company releases the shares to the trust and has no further interest in the trust, changes in the value of the shares after issue of the shares is irrelevant. The shares must be paid out to the dealers and will not revert back to the company. In a sense, they are like stock options.

CA 16-2 Air Canada

Overview

- The industry is a challenging one with many bankruptcies and significant competition. - The company’s main expense is fuel which accounts for significant amount of total costs of the company—the need is to manage cost since as a commodity. - Air Canada uses a hedging strategy to fix its fuel costs. Hedges are complex and there are operational risks (risks in implementing and managing the hedges).

Analysis and recommendations

Issue: Accounting for hedge of fuel

|Apply hedge accounting |Do not |
|The hedged item is the anticipated fuel acquisitions and the |Hedge accounting is optional. |
|hedging items are the derivatives used to lock in the prices on |There is a cost associated with applying hedge accounting |
|these. |(accountants must prepare documentation and assess effectiveness |
|From an economic perspective, these financial instruments will |and all this must be audited). |
|fix or cap the price for a significant percentage of fuel |Hedge accounting has risks associated with it as the transactions|
|acquisitions and so this is an economic hedge. |and accounting are very complex. |
|Under IFRS, the anticipated fuel acquisitions will not be |Could note disclose the existence of the hedge instead. |
|recognized in the financial statements but the hedging items |Other. |
|(derivatives) will be since they meet the accounting definition | |
|of derivatives. They will be measured at fair value at each | |
|reporting date; the gains/losses will otherwise be reflected in | |
|net income. Thus—even though there is an economic hedge in place | |
|with no further risk of loss, gains/losses will be booked through| |
|net income and introduce volatility. This is not reflective of | |
|the fact that the company has taken steps to protect itself and | |
|get rid of the volatility from an economic perspective. | |
|One option is to use hedge accounting. This will result in the | |
|gains/losses from the revaluation of the derivatives to be booked| |
|through other comprehensive income thus shielding the net income | |
|number. The gains/losses will be reclassified to net income when | |
|the fuel is actually used. This has the effect of remeasuring the| |
|fuel costs to reflect the locked in prices. This would generally | |
|be treated as a cash flow hedge as it is a hedge of a future | |
|transaction and related cash flows. | |
|The company will have to identify the hedging relationship and | |
|assess the effectiveness of the hedge. | |
|Other. | |

Recommendation:

Hedge accounting makes sense in this case as it provides greater transparency and allows users to see the impact of the actions management has taken to protect the company.

CA 16-3 Coach Corporation

Overview

- The company uses performance based compensation plans that are based on net income. - Subjective estimates of bad debt expense affect the calculation. - Net income is therefore a key number. - IFRS is a constraint since this is a public company.

Analysis and recommendations

- Subjectivity of income is affecting compensation of executives. - Controller faces ethical issue. - As long as bad debt expense is calculated using best estimates; it should not change just because of the compensation plan. - Accounting should be neutral and unbiased.

IC 16-1 JANSON inc (ji)

Overview

- Public co – therefore IFRS is a constraint. - Debt to equity ratio (3:1) is a key ratio for banker who is a key user. May be a bias to ensure that the ratio is not exceeded. - Other users – CSC – will likely be reviewing financial statements for compliance with IFRS. - Potential downturn in industry. Anticipating real estate transaction that may result in overall loss to the company. May be company bias to attempt to counteract in financial statements. - Role – outside adviser – for controller but must remain professional and ensure that statements are transparent.

Analysis and recommendations

Issue: Land

|Inventory |PP&E |
|- Held for the purposes of selling for profit. |- May be held for development purposes – intent unclear. |
|- In business of buying and selling property. |- Long term – will be used to generate revenues (already have |
|- Have buyer lined up. |plans drawn up for development). |
|- If treated as inventory, will value at lower of cost and net |- Held for sale criteria met? Available for sale and buyer |
|realizable value. |already lined up. |
|- Other. |- If treated as PP&E – several accounting policy choices are |
| |available as noted below. |
| |- Other. |

Recommendation:

Would want to ensure transparency but given the ambiguity of the intent re the land – either option is a possibility. If treated as PP&E, the following measurement alternatives are available.

IC 16-1 (Continued)

|Cost |FV |FV – revaluation method |
|- Include capitalize interest. IAS 23 – |- Investment property under IFRS – argue |- May not qualify for investment property |
|requires capitalization of borrowing costs |that the investment is passive i.e. not |yet since in development stage. |
|that are directly attributable to the |going to use the land to produce revenues |- Gains to equity and losses to income. |
|building activity. |– other than to sell. |- Other. |
|- Include architectural drawings if can |- Gains/losses to income. | |
|argue that these costs are required to get |- Other. | |
|the asset ready for its intended use. (Note | | |
|that the company is not sure whether they | | |
|will use the property for this purpose so | | |
|this is a judgement call). | | |
|- Overhead costs generally not capitalized. | | |
|- Must break down into components for | | |
|depreciation. | | |
|- Recognize loss if held for sale or if | | |
|considered impaired – since offer exists at | | |
|less than cost – evidence of potential | | |
|impairment. | | |
|- Other. | | |

Recommendation:

Using the FV model or revaluation method would provide greater transparency as to the true value of the land (which is needed by the bank). This will improve the debt to equity ratio as it will increase equity as long as the property is growing in value.

Issue: Apartment – radon problem

|Impairment |Not |
|- Letter from tenants provides evidence of problem – may impair |- Engineer study inconclusive. |
|ability to collect rents/rent out. Tenants already want free rent|- May be from building across street. |
|until they can vacate. |- Too preliminary. |
|- Other. |- May be recoverable from lawsuit launched if there is a problem.|
| |- Other. |

IC 16-1 (Continued)

Recommend note disclosure only of both the potential problem and the lawsuit. It is too early to write down the property as it is not known whether the problem is coming from across the street.

Other related issues:

- Likely too early to accrue for any costs to insulate since have not yet decided. - Similarly too early to account for lost revenues except through potential impairment of asset (note that case asks for issue related to current year). - May consider capitalization of engineer costs if they add value to the property or extend life - If any losses booked – loss/EI versus expense (likely expense since in the business of property). NB under IFRS – extraordinary items not allowed - Potential disclosure of gas problem since relevant information/transparency

Issue – financial instrument:

|Debt |Debt/equity |
|Maturity and interest - legal form is debt. |Debt plus option to buy shares – hybrid instrument and must be |
|If convertible to variable number of shares – debt-like. |bifurcated. |
|Other. |If convertible into fixed number of shares = equity component |
| |Interest is a function of profits – residual interest. |
| |Other. |

Recommend treating as part debt and part equity. This will have a positive impact on the debt to equity ratio.

IC 16-2 SALTWORKS iNC (si)

Overview

- Public company looking to buy out therefore IFRS a constraint as public company has asked for IFRS to evaluate and in case they buy it (at which point would be more useful for consolidation). Will use the statements to make a decision to buy or not - Role – as accountant – will want to be transparent but make the company look good so as to maximize value.

Analysis and recommendations

Issue: Mines 1 and 2 – costs incurred to build mine

|Capitalize costs |Expense |
|Allowed to capitalize exploration and evaluation costs under IFRS|Unsure of future benefit (uncertainty as to value of potential |
|6. Captilalizable costs include studies, exploratory drilling, |salt find). |
|sampling and those related to establishing technical feasibility |This is especially the case for mine 3 as not sure of quality of |
|and commercial viability. |salt – may not be a market. |
|Development costs must be analyzed under IAS 38 (intangible |Other. |
|assets). For mine 2 costs – more likely developmental costs and | |
|may capitalize if technically feasible, intent to complete, | |
|ability to mine, existing market for output, availability of | |
|resources and ability to measure costs. In this case, not much | |
|information however, the company has certainly displayed intent | |
|to complete and assuming the salt is the same quality as mine 1 –| |
|a market exists for the mine 2 salt. The company appears to have | |
|the resources to carry on with the development. | |
|If capitalize – then must test for impairment. | |
|Other. | |

Recommendation:

Probably best to expense the costs for mine 3 as there is too much uncertainty. Costs for mine 2 may be capitalized assuming criteria for capitalization is met. More data may need to be gathered.

Issue: Revenue recognition – logging rights

|Recognize revenues |Defer |
|Paid up front for access to trees. |Access over three years therefore recognize over three years. |
|Revenue not dependent upon how many trees cut down. |The other company is paying for the right to cut down a certain |
|Access immediately granted – may log the whole thing immediately |number of the trees over a three year period. Just because they |
|or over time. |paid upfront does not mean that the entity can recognize the |
|May want to expense replanting costs against any revenue |revenues upfront. |
|recognized so that profits are not overstated. |Other. |
|Other. | |

Recommendation:

Better to defer revenues as more reflective of economic reality. As trees are cut down, recognizing obligation to replant as a constructive obligation exists.

Issue: Roads

|Capitalize costs |Expense |
|Future value since may use after logging complete. |Impaired since washed out and must be rebuilt. |
|Weather derivative will cover losses. |If hedge accounting not used (no information given as to whether |
|Other. |used or not) then the derivative would have been booked with |
| |gains being recognized in income (as long as derivative was |
| |measurable). Thus, the gains and losses will offset. |
| |Other. |

Recommendation:

It is likely more transparent to recognize impairment.

Issue: Weather derivative/hedging

- Must decide whether contract meets the definition of a derivative and therefore whether derivative accounting would be used as discussed above.

- Likely the case as long as measurable.

- No mention of whether hedge accounting used or not. Would consider using hedge accounting as long as costs outweigh the benefits.

RESEARCH AND FINANCIAL ANALYSIS

RA16-1 POTASH CORP.

(a)
Stock Option Plans

|a) Who is eligible? |Designated senior executives and designated directors |
|b) Required to buy shares to access benefits? | |
| |Yes for stock based settled plans – company issues new shares |
| |to settle the options |
|c) What is the benefit or compensation based on? | |
| |Share price |
|d) Vesting period |Performance Option Plans vest, if at all, three-year average |
| |excess of the company’s consolidated cash flow return on |
| |investment over the weighted average cost of capital |
| |Directors, Officers and Employee Plans - one half vested one |
| |year from date of grant, and the other half vesting in the |
| |following year |
|e) Expiry period |Term is 10 years |
|f) How is compensation expense determined |Uses Black Scholes formula to determine the fair value of the |
| |options |
|g) Offsetting amount |To contributed surplus |
|h) when is compensation expense recorded |Over the vesting period |

RA16-1 (Continued)

Deferred Share Unit Plans

|a) Who is eligible? |Non-employee directors |
|b) Required to buy shares to access benefits? | |
| |No - settled in cash - based on the common share price at the |
| |time |
|c) What is the benefit or compensation based on? | |
| |Directors fees – directors may choose to receive all or a |
| |percentage of director’s fees in shares. Uses market value of |
| |shares to determine the cash equivalent of the DSU’s |
|d) Vesting period |Fully vest upon award, but not distributed until directors |
| |leave |
|e) Expiry period |Cash payable when directors leave the Board |
|f) How is compensation expense determined |Uses market value of the share units (i.e. share price X |
| |number of DSUs) |
|g) Offsetting amount |To liabilities |
|h) when is compensation expense recorded |Immediately when issued and adjusted until cash is settled. |

RA16-1 (Continued)

Performance Unit Incentive plan

|a) Who is eligible? |Senior executives and other key employees |
|b) Required to buy shares to access benefits? | |
| |No - settled in cash based on the common share price at the |
| |time |
|c) What is the benefit or compensation based on? |Share price of the units, and some incentive award based on |
| |meeting targets |
|d) Vesting period |One half of the vesting of awards is based on increases in the |
| |total return to shareholders over the three-year performance |
| |period ending December 31, 2011 |
| |The other half vests to the extent that total shareholder |
| |return matches or exceeds that of a per group |
| |Shareholders’ return is the capital appreciation of the share |
| |price plus dividends paid. |
|e) Expiry period |Payable in cash when performance period ends |
|f) How is compensation expense determined |Uses market value of the shares units |
|g) Offsetting amount |To liabilities |
|h) when is compensation expense recorded |Over the three year performance period and is adjusted as |
| |required based on meeting performance targets. |

b) As explained in Note 25 of the financial statements, the stock based compensation plans are reported at fair values. The compensation expense is charged to earnings, and the offsetting entry is either to contributed to surplus for equity settled plans or liabilities for cash settled plans. Any consideration received on the exercise of options recorded to share capital, along with the contributed surplus related to the options. As per note 25,

RA16-1 (Continued)

during the year $45.4 million was charged to compensation expense for the year for all the plans. As per note 18, contributed surplus was increased by $23.3 million due to stock based plans. The remaining amount of $22.1 million would be included in liabilities.

c) The fair value of stock option plans is determined using the Black Scholes option pricing model. Inputs to this option pricing model are subject to estimates and include: the expected dividend, expected volatility, risk-free rate, and the expected life of the options. The table below outlines how these inputs have changed over time:

| |2009 |2008 |2007 |2006 |2005 |
|Expected dividend |$.40 |$.40 |$.40 |$.20 |$.20 |
|Expected volatility |48% |34% |29% |30% |28% |
|Risk-free rate |2.53% |3.30% |4.48% |4.90% |3.86% |
|Expected life of the |5.9 |5.8 |6.4 |6.5 |6.5 |
|options | | | | | |

In Note 25, the company comments that the expected dividend is based on the annualized dividend at the grant date; the expected volatility is based on historical data over the expected life of the options; the risk free rate is based on the implied yield on zero-coupon government bonds issued with a remaining term equal to the expected life of the options; and based on past experience, the expected life of the options is estimated.

Holding all other inputs constant, the following would be the impact on the compensation expense for changes in each input:

(a) increases in the dividend rate will reduce the value of the option since as dividends are paid, the share price declines;

RA16-1 (Continued)

(b) increases in the expected volatility will increase the value of the option since there is now a greater chance that a higher price can be realized;

(c) decreases in the risk free rate will decrease the value of the option; and

(d) decreases in the expected life of the options will decrease the value of the options since there is less time for the share price increases to be realized.

RA16-2 CANADIAN TIRE CORPORATION

a) Read MD&A.

b) The company is exposed to a number of different business risks. Seasonality risk refers to the risk associated with the sales of items which have a seasonal market, and the demand of which can be affected by weather. Supply chain disruption risk refers to the potential disruptions due to foreign supplier failures, geopolitical risk, labour disruption or insufficient capacity at ports, and risks of delays or loss of inventory in transit. Environmental risk refers to the risks associated with handling gas, oil, propane, and recycling things such as tires, paint, oil, and lawn chemicals.

The company is also exposed to financial risks. Credit risk comprises two items—risk exposure from receivables from dealers and exposure with respect to hedges and similar financial instruments. The first one represents the loss that would be incurred if the company’s counterparties were to default and includes consumer credit risk (the risk of non-collection associated with offering customers sales on credit terms). Foreign exchange risk is the risk associated with fluctuations in US dollar currency exchange rates due to global sourcing for merchandise. Commodity price risk refers to the risk associated with the fluctuation of petroleum prices which can also impact the company’s earnings. Interest rate risk is the risk associated with changes in interest rates which impact the company’s investments.

c) To manage foreign exchange risk, the company sets ranges of future US dollar purchases that must be hedged. During 2009, the company was able to achieve some stability since some US dollar purchases were hedged at exchange rates more favourable than spot rates at the time of the transactions. To manage interest rate risk, the uses interest rate swaps. The company has a policy to maintain a minimum of 75% of its long term debt in fixed rate debt versus variable.
RA16-2 (Continued)

d) As per note 1, the derivative instruments used by the company to hedge its risks are interest rate swap contracts, foreign exchange contracts, and equity contracts. As further explained in Note 1, the company has both fair value hedges and cash flows hedges. Fair value hedges are used for certain interest rate swaps. Cash flow hedges are used for foreign currency contracts for future purchases of inventory related items. When the inventory is recognized, the value of the merchandise inventory is adjusted by the accumulated gains and losses on these foreign currency contracts. Equity derivative contracts are also cash flow hedges used to hedge various future stock based compensation. As the stock based plans vest, the amount of accumulated gains and losses on these equity derivatives is transferred to income.

(e) As explained in Note 19, the company measures the fair value of the derivatives using Level 2 inputs. Total derivatives represented as assets were $5.8 Million and as liabilities were $ 88.1 million. These values are designated as cash flow hedges and fair value hedges as follows:

|$ millions |Cash flow hedges |Fair value hedges |Not designated |Total |
|Assets |0.3 |4.5 |1.0 |5.8 |
|Liabilities |78.8 |1.3 |8.0 |88.1 |
| | | | | |
| | | | | |

RA16-3 LOBLAW COMPANIES LIMITED

(a) Note 19 describes the Second Preferred shares as follows: • 9 million shares issued • Face value of $225 million, and originally issued at $218 million • Non-voting; • 5.95% dividend – fixed cumulative dividend of $1.4875 per share per annum (if declared) payable quarterly; • After July 31, 2013, the company may, at its option, redeem the shares for cash at the price of $25.75 per share on or after July 31, 2013; $25.50 on or after July 31, 2014; and $25.00 on or after July 31, 2015. • After July 31, 2013, the company may also convert at its option the preferred shares into the number of common shares determined by taking the required redemption price divided by the greater of $2.00 and 95% of the then current market price of the common share price. • The second preferred shares rank after the first preferred shares and rank in priority to the common shares with respect to dividends and dissolution of the company. The company has recorded these shares are a liability since they may be redeemed for cash. The company has used the effective interest rate method to measure these securities.

(b) The shares were originally issued for $218 million as per note 21. At January 2, 2010, the shares were measured at $220 million and are classified as Capital Securities on the statement of financial position. Effectively, the discount is being amortized until the face value is reached in 2013.

(c) As per note 4, the dividends paid on these capital securities were included in “Interest and other financing charges”. The total amount paid during the year for the dividends as per note 21 was $13.3875 million ($1.4875 X 9 million shares). $14 million was recorded in interest expense, which would represent the actual amount paid plus the amortization of the discount to reflect the effective interest on the preferred shares.

(d) As per note 21, the company includes these preferred shares as equity in its determination of capital. As a result, in calculating its Debt to Equity, Interest Coverage and Net Debt to EBITDA ratios, the Capital Securities are excluded from debt, and included in equity.

RA16-4 LUFTHANSA AG

(a) Lufthansa AG is an international airline, headquartered in Germany. It flies passengers and freight around the world. During 2009, the company flew 76.5 million passengers and 1.7 million tonnes of freight on 893 thousand flights.

(b) The company is exposed to fuel price risk, interest rate risk and foreign currency risk. The company monitors and manages these risks in a conservative and systematic manner. Lufthansa uses derivatives to manage these risks with the primary aim to reduce earnings volatility due to fuel price and foreign exchange rate fluctuations. Interest rate hedging is used to reduce and minimize fluctuations in the company’s interest expense. Fuel costs represent 14.7% of total costs. Therefore the company hedges fuel costs for up to the next 24 months, with 85% of the next 6 months hedged and 26% of the 2011’s forecasted usage being hedged. The company uses primarily option combinations for these fuel price hedges.
Foreign currency risk arises from international tickets sales and purchases of fuel, aircraft and spare parts. The company deals in 60 different currencies of which 20 are managed, primarily being the US dollar, the Japanese yen and British sterling.
Interest rate risk is managed using swaps to ensure that 85% of the debt rates are floating.

(c) From Note 46, the percentages of the risks are hedged: • Currency exposure for operating expenses: US dollar – 43%; yen 41% and sterling 28%; • Currency exposure for new capital expenditures varies from 74% to as high as 89% during the forecasted years for 2011 to 2016; • Interest rate risks are hedged to 15%; • Fuel price risk is hedged 67.3% for 2010 and 25.8% for 2011.

RA16-4 (Continued)

(d) The following table identifies the type of derivative and its designation as either a cash flow hedge or a fair value hedge.

|In millions of Euros |Fair Value hedge |Cash flow hedge |
|Interest rate swaps |87 | |
|Spread options for fuel hedging | |162 |
|Hedging combinations for fuel hedging | |169 |
|Futures contracts for foreign currency hedging | |-228 |
|Spread options for fuel hedging | |59 |

The fuel hedges and foreign currency hedges are all designated as cash flow hedges since they relate to anticipated future transactions related to purchases of fuel, operating costs, operating income and aircraft costs. The interest rate swaps are fair value hedges since the swap is on existing debt that is outstanding at the report date.

(e) As explained in Note 46, the following explanations are provided as to how the market values of the derivatives have been determined: • All derivatives are valued at the price an independent party would pay (or receive) to take on the rights and /or obligations of the derivatives. • Interest rate swaps are measured using a discounted cash flow. • Currency derivatives are discounted based on their future rates and the corresponding interest rate yield curves. • Fuel price options are valued using option pricing models.

(f) As per note 46, during the year: • EUR 160 million was moved from equity to fuel costs, • For the foreign currency derivatives EUR 154 million was moved from equity to other operating income, EUR 301 million to other operating expenses and EUR 111 to capital expenditures for aircraft.

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