CH17

Kieso, Weygandt, Warfield, Young, Wiecek
Intermediate Accounting, Seventh Canadian Edition
CHAPTER 17
COMPLEX FINANCIAL INSTRUMENTS
ASSIGNMENT CLASSIFICATION TABLE

Topics 1. Convertible debt and preferred shares. 2. Warrants and debt. 3. Stock options. 4. Derivative instruments for speculation 5. Classification: debt vs. equity *6. Derivative instruments for hedging. *7. Stock appreciation rights. Brief Exercises Exercises Problems 1, 2 3, 4 5 10, 11, 12, 13 6, 7, 8, 9 14 16, 17, 18 13, 14 10, 11, 12 1, 2, 3, 4, 5, 6, 7, 8 7, 8, 9 10, 11, 12 15 2, 4 1, 3 1, 5 6, 7, 8, 9, 1 2 Writing Assignments
15
*This material is dealt with in an Appendix to the chapter.
Solutions Manual 17-1 Chapter 17 Copyright 2005 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.
ASSIGNMENT CHARACTERISTICS TABLE

Item E17-1 E17-2 E17-3 E17-4 E17-5 E17-6 E17-7 E17-8 E17-9 E17-10 E17-11 E17-12 *E17-13 *E17-14 E17-15 *E17-16 *E17-17 *E17-18 P17-1 P17-2 P17-3 P17-4 P17-5 P17-6 P17-7 P17-8 P17-9 *P17-10 *P17-11 *P17-12 W18-1 W18-2 Description Issuance and conversion of bonds. Conversion of bonds. Conversion of bonds. Conversion of bonds. Conversion of bonds. Conversion of bonds. Issuance of bonds with warrants. Issuance of bonds with detachable warrants. Issuance of bonds with warrants. Issuance and exercise of stock options. Issuance, exercise, and termination of stock options. Issuance, exercise, and termination of stock options. Stock appreciation rights. Stock appreciation rights. Derivative transaction. Cash Flow Hedge. Cash Flow Hedge. Fair Value Hedge. Entries for various financial instruments. Entries for conversion, amortization, and interest of bonds. Issuance of notes with warrants. Conversion of bonds: book value vs. market value methods. Stock option plan. Call option contract purchased. Call option contract written. Put option contract derivative instrument. Put option contract derivative instrument. Fair value hedge interest rate swap. Cash flow hedge futures contract. Fair value hedge put option. Stock warrantsvarious types. Stock compensation plans. Level of Time Difficulty (minutes) Simple Moderate Simple Moderate Simple Moderate Simple Simple Simple Moderate Moderate Moderate Moderate Moderate Simple Moderate Moderate Complex Moderate Moderate Simple Moderate Moderate Moderate Moderate Moderate Moderate Complex Complex Complex Moderate Moderate 15-20 20-25 5-10 15-20 10-20 25-35 10-15 10-15 10-15 15-25 15-25 15-25 15-25 15-25 10-15 15-20 15-20 20-25 35-40 45-50 10-15 10-15 30-35 30-40 30-40 30-40 35-45 35-45 40-50 40-50 15-20 25-30
SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 17-1 Bonds Payable............................................... Discount on Bonds Payable ................. Common Shares .................................... BRIEF EXERCISE 17-2 Preferred Shares ........................................... Common Shares .................................... BRIEF EXERCISE 17-3 Cash (900 X $1,000 X 1.01)............................ Discount on Bonds Payable ......................... Bonds Payable ....................................... Contributed SurplusStock Warrants FMV of bonds (900 X $1,000 X .99) FMV of warrants (900 X $35) Aggregate FMV Allocated to bonds (891/922.5 X $909,000) Allocated to warrants (31.5/922.5 X $909,000) 909,000 22,039 900,000 31,039 $ 891,000 31,500 $ 922,500 $ 877,961 31,039 $ 909,000 65,000 65,000 500,000 30,000 470,000
BRIEF EXERCISE 17-4 Cash (1,000 X $1,000 X 1.03)......................... 1,030,000 Discount on Bonds Payable ......................... 30,000 Bonds Payable ....................................... 1,000,000 Contributed SurplusStock Warrants 60,000
BRIEF EXERCISE 17-5 1/1/05 12/31/05 No entry Compensation Expense............. Contributed SurplusStock Options ............................ Compensation Expense............. Contributed SurplusStock Options ............................ 70,000 70,000 70,000 70,000
12/31/06
[$70,000 = $140,000 X 1/2]
BRIEF EXERCISE 17-6 The bond is 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 bond would be reported on Jamiesons balance sheet at the present value of the annuity of interest payments over the term of the bond, calculated at the market rate of interest, ignoring the future value of the principal payment. Because the perpetual bonds value is driven solely by the contractual obligation to pay interest it would be classified as a long-term debt on the balance sheet.
BRIEF EXERCISE 17-7 Under the terms of the agreement with the preferred shareholders, it is highly likely that Silky Limited will be redeeming the preferred shares before the dividend rate doubles after five years. Failing 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 and this obligation to deliver cash creates a
liability. Consequently, the preferred shares should be classified as long-term debt on the balance sheet. BRIEF EXERCISE 17-8 Because the preferred shares are classified as long-term debt on the balance sheet, the dividends declared and paid to preferred shareholders would be classified as interest expense on the income statement. Depending on the degree of significance distinguishing between interest and dividends on the income statement, it might be desirable to separate the amount of dividends paid on the preferred shares with the interest paid on other debt.
BRIEF EXERCISE 17-9 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 shares should be classified as long-term debt on the balance sheet.
BRIEF EXERCISE 17-10 Pseudo should account for the call option at the cost to acquire it $500 and record it as Investments Trading. Pseudo is not obligated to exercise the option and buy the shares. The investment would be measured at market value at year-end with a gain or loss recorded for the difference between the cost and the market value.
BRIEF EXERCISE 17-11 Unlike BE17-10 Pseudo has written a call option and is obligated to deliver to Alter shares in Ego under the terms of the option. Because the call option creates an obligation for Pseudo, it is accounted as a liability on the balance sheet of Pseudo. BRIEF EXERCISE 17-12 Investment Held for Trading Forward Contract ............................... Gain on Forward Contract.............. ($1,300 - $1,230) 70 70
BRIEF EXERCISE 17-13 January 15, 2005 Investment Held for Trading Forward Contract................................ Cash ................................................. Investment Held for in Trading Forward Contract............................... Gain on Forward Contract.............. *BRIEF EXERCISE 17-14 A fair value hedge would protect Tinsdale against an existing exposure that results from an existing asset, in this case the Notes Receivable. A cash flow hedge would protect Tinsdale against a future transaction that has not yet been realized on the balance sheet. The latter would be appropriate if Tinsdale was concerned with the risk of a change in variable interest. There is no mention of interest for the notes receivable. Tinsdale is concerned about the exchange risk of an existing asset, and so should use a fair value hedge.
10 10
70 70
*BRIEF EXERCISE 17-15 2005: 2006: [5,000 X ($22 $20)] X 50% = $5,000 [5,000 X ($29 $20)] $5,000 = $40,000
SOLUTIONS TO EXERCISES
EXERCISE 17-1 (15-20 minutes) (a) Cash ($10,000,000 X .98) ....................... 9,800,000 Discount on Bonds Payable ................. 500,000 Bonds Payable ................................ 10,000,000 Contributed Surplus Conversion Rights ..................... 300,000 Bond Issue Costs .................................. Cash ................................................. 70,000 70,000
(b) Cash ........................................................ 19,600,000 Discount on Bonds Payable ................. 1,200,000 Bonds Payable ................................ 20,000,000 Contributed SurplusStock Warrants 800,000 Value of bonds plus warrants ($20,000,000 X .98) Value of warrants (200,000 X $4) Value of bonds $19,600,000 800,000 $18,800,000
(c) Bond Conversion Expense ................... 65,000 Bonds Payable ....................................... 10,000,000 Contributed Surplus Conversion Rights .................... 200,000 Discount on Bonds Payable .......... 75,000 Common Shares ............................. 10,125,000 Cash ................................................. 65,000
EXERCISE 17-2 (20-25 minutes) The journal entry for the initial issuance follows: Cash ........................................................ Discount on Bonds Payable ................. Bond Payable ................................. Interest Payable.............................. Contributed Surplus Conversion Rights .................... *[($5,000,000 X .98) + $75,000] (a) Interest Payable ($225,000 X 2/6) ......... Interest Expense .................................... Discount on Bonds Payable .......... Cash ($5,000,000 X 9% 2) ............ Calculations: Par value Issuance price @ .97 Total discount Months remaining Discount per month ($150,000 118) Discount amortized (4 X $1,271) $5,000,000 4,850,000 $ 150,000 118 $1,271 $5,084 4,975,000* 150,000 5,000,000 75,000 50,000 75,000 155,084 5,084 225,000
EXERCISE 17-2 (Continued) (b) Bonds Payable ....................................... 1,500,000 Contributed Surplus Conversion Rights ..................... 15,000 Discount on Bonds Payable ........... 41,186 Common Shares .............................. 1,473,814 Calculations: Discount related to 30% of the bonds ($150,000 X .3) Less discount amortized [($45,000 118) X 10] Unamortized bond discount Actual proceeds when bonds sold Value of bonds only Value of conversion rights Proportion converted Value of rights converted $45,000 3,814 $41,186 $4,900,000 4,850,000 50,000 _ _30% $15,000
EXERCISE 17-3 (5-10 minutes) Bonds Payable ...................................... 1,500,000 Premium on Bonds Payable ................ 20,500 Contributed Surplus Conversion Rights ................... 14,000 Preferred Shares ............................ 1,534,500
EXERCISE 17-4 (15-20 minutes) (a) Cash ........................................................ 10,800,000 Discount on Bond Payable ................... 1,500,000 Bonds Payable ............................... 10,000,000 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 ....................................... 3,000,000 Contributed Surplus Conversion Rights ................... 690,000 Discount on Bonds Payable (Schedule 1)............................... 405,000 Common Shares (Schedule 2) ..... 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 Unamortized Discount on Bonds Converted Discount on bonds payable on January 1, 2004 $1,500,000 Amortization for 2004 ($1,500,000 20) $75,000 Amortization for 2005 ($1,500,000 20) 75,000 150,000 Discount on bonds payable on January 1, 2006 1,350,000 Bonds converted 30% Unamortized discount on bonds converted $405,000
EXERCISE 17-4 (Continued) Schedule 2 Computation of Common Shares Resulting from Conversion Number of shares convertible on January 1, 2004: Number of bonds ($10,000,000 $1,000) Number of shares for each bond Stock split on January 1, 2005 Number of shares convertible after the stock split % of bonds converted Number of shares issued
10,000 X 5 50,000 X 2 100,000 X 30% 30,000
EXERCISE 17-5 (10-20 minutes) Interest Expense............................................ Discount on Bonds Payable ................. [$10,240 40 = $256; $256 X 4] Cash (10% X $500,000 X 1/2)................. 26,024 1,024 25,000
(Assumed above that the interest accrual was reversed as of January 1, 2006 with only the amount of the payable reversed to the interest expense account and not the amortization of the discount; if the interest accrual was not reversed, interest expense would be $17,691 and interest payable would be debited for $8,333) Interest Expense............................................ Discount on Bonds Payable ................. [$10,240 40 = $256; $256 X 6] Cash (10% X $500,000 X 1/2)................. 26,536 1,536 25,000
(Alternately assumed that the entire interest accrual entry was reversed as of January 1, 2006)
Bonds Payable............................................... Contributed Surplus Conversion Rights .......................... Discount on Bonds Payable ................. Common Shares .................................... * ($10,240 $1,024)
500,000 19,000 9,216* 509,784
EXERCISE 17-6 (25-35 minutes) (a) December 31, 2005 Bond Interest Expense.......................... Premium on Bonds Payable ................. ($120,000 X 1/20) Cash ($6,000,000 X 7% X 6/12) ......
204,000 6,000 210,000
(b)
January 1, 2006 Bonds Payable ....................................... 400,000 Contributed Surplus Conversion Rights ................... 8,000* Premium on Bonds Payable ................. 6,400 Common Shares............................. *[1.04 less 1.02 = 2% X $6 million X 6.667%] Total premium ($6,000,000 X .02) Premium amortized ($120,000 X 2/10) Balance Bonds converted ($400,000 $6,000,000) Related premium ($96,000 X 6.667%)
414,400
$120,000 24,000 $96,000
6.667% 6,400
(c)
March 31, 2006 Bond Interest Expense.......................... Premium on Bonds Payable ................. ($120,000 / 10 X 3/12 X 6.667%) Bond Interest Payable ................... ($400,000 X 7% X 3/12)
6,800 200 7,000
EXERCISE 17-6 (Continued) March 31, 2006 Bonds Payable ....................................... Contributed Surplus Conversion Rights ................... Premium on Bonds Payable ................. Common Shares.............................
400,000 8,000 6,200 414,200
Premium as of January 1, 2006 for $400,000 of bonds $6,400 8 years remaining X 3/12 Premium as of March 31, 2006 for $400,000 of bonds (d) June 30, 2006 Bond Interest Expense.......................... Premium on Bonds Payable ................. Bond Interest Payable ........................... ($400,000 X 7% X 3/12) Cash ................................................
$6,400 (200) $6,200
176,800 5,200 7,000 189,000*
[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 2004 amortization 2005 amortization Jan. 1, 2006 write-off Mar. 31, 2006 amortization Mar. 31, 2006 write-off $120,000 (12,000) (12,000) (6,400) (200) (6,200) $83,200
EXERCISE 17-7 (10-15 minutes) (a) Basic formulas:

Value of bonds without w arrants X Issue price = Value assigned to bonds Value of bonds without w arrants + Value of warrants Value of warrants X Issue price = Value assigned to warrants Value of bonds without w arrants + Value of warrants
$136,000 X $152,000 = $129,200 $136,000 + $24,000
Value assigned to bonds
$24,000 X $152,000 = 22,800 Value assigned to warrants $136,000 + $24,000 $152,000 Total
Cash ........................................................ 152,000 Discount on Bonds Payable ................. 40,800 ($170,000 $129,200) Bonds Payable ............................... Contributed SurplusStock Warrants
170,000 22,800
(b) When the warrants are non-detachable, separate recognition is given to the warrants. The accounting treatment parallels that given convertible debt because the debt and equity element must be separated.
EXERCISE 17-8 (10-15 minutes) SANDS CORP. Journal Entry September 1, 2005 Cash.................................................................. 5,192,500 Bond Issue Costs ............................................ 20,000 Bonds Payable (5,000 X $1,000) ............. 5,000,000 Premium on Bonds PayableSchedule 1 70,000 Contributed SurplusStock Warrants Schedule 1............................................ 30,000 Bond Interest ExpenseSchedule 2 ..... 112,500 (To record the issuance of the bonds) Schedule 1 Premium on Bonds Payable and Value of Stock Warrants Sales price (5,000 X $1,000 X 1.02) Face value of bonds Deduct value assigned to stock warrants (5,000 X 2 = 10,000 X $3) Premium on bonds payable Schedule 2 Accrued Bond Interest to Date of Sale Face value of bonds Interest rate Annual interest Accrued interest for 3 months ($450,000 X 3/12) $ $5,000,000 9% $ 450,000 112,500 $5,100,000 5,000,000 100,000 30,000 $ 70,000
EXERCISE 17-9 (10-15 minutes) (a) Cash ($5,000,000 X 1.01) ....................... 5,050,000 Discount on Bonds Payable ................. 100,000 [(1 .98) X $5,000,000] Bonds Payable ............................... 5,000,000 Contributed SurplusStock Warrants 150,000* *$5,050,000 ($5,000,000 X .98) (b) Market value of bonds without warrants ($5,000,000 X .98) Market value of warrants (5,000 X $40) Total market value $4,900,000 X $5,050,000 = $4,851,961 $5,100,000 $200,000 X $5,050,000 = $198,039 $5,100,000 $4,900,000 200,000 $5,100,000
Value assigned to bonds
Value assigned to warrants
Cash ........................................................ 5,050,000 Discount on Bonds Payable ................. 148,039 Bonds Payable ............................... 5,000,000 Contributed SurplusStock Warrants 198,039
EXERCISE 17-10 (15-25 minutes) 1/2/06 No entry (total compensation cost is $450,000)
12/31/06 Compensation Expense....................... 225,000 Contributed SurplusStock Options 225,000 [To record compensation expense for 2006 (1/2 X $450,000)] 4/1/07 Contributed SurplusStock Options 28,125 Compensation Expense.......... 28,125 ($450,000 X 2,000/32,000) (To record termination of stock options held by resigned employees)
12/31/07 Compensation Expense....................... 225,000 Contributed SurplusStock Options 225,000 [To record compensation expense for 2007 (1/2 X $450,000)] 1/3/08 Cash (20,000 X $40).............................. 800,000 Contributed SurplusStock Options. 281,250 ($450,000 X 20,000/32,000) Common Shares ........................ 1,081,250 (To record issuance of 20,000 shares upon exercise of options at option price of $40) (Note to instructor: The market price of the shares has no relevance in this entry and the following one.) 5/1/08 Cash (10,000 X $40) ................................ 400,000 Contributed SurplusStock Options ... 140,625 ($450,000 X 10,000/32,000) Common Shares ..............................
540,625
(To record issuance of 10,000 shares upon exercise of remaining options at option price of $40)
EXERCISE 17-11 (15-25 minutes) 1/1/06 No entry
12/31/06 Compensation Expense................ 275,000 Contributed SurplusStock Options 275,000 ($550,000 X 1/2) (To recognize compensation expense for 2006) 12/31/07 Compensation Expense................ 275,000 Contributed SurplusStock Options 275,000 ($550,000 X 1/2) (To recognize compensation expense for 2007) 3/31/08 Cash (12,000 X $20)...................... Contributed Surplus Stock Options .................... ($550,000 X 12,000/40,000) Common Shares.................... 240,000 165,000 405,000
(To record exercise of stock options) 12/31/08 Contributed Surplus Stock Options .................... ($550,000 X 28,000/40,000) Contributed Surplus Expired Stock Options .....
385,000
385,000
(To record expiration of stock options)
EXERCISE 17-12 (15-25 minutes) 1/1/04 No entry
12/31/04 Compensation Expense .................. 200,000 Contributed Surplus Stock Options ....................... ($400,000 X 1/2) 12/31/05 Compensation Expense .................. 200,000 Contributed Surplus Stock Options ........................ 5/1/06 Cash (8,000 X $25)............................ 200,000 Contributed Surplus Stock Options................................. 160,000* Common Shares ........................ *($400,000 X 8,000/20,000) Contributed Surplus Stock Options................................. 240,000 Contributed Surplus Expired Stock Options ........... ($400,000 $160,000)
200,000
200,000
360,000
1/1/08
240,000
*EXERCISE 17-13 (15-25 minutes) (a)Schedule of Compensation Expense - Stock Appreciation Rights (250,000)
Market Price $15 9 21 19 Preestablished Price $12 12 12 12 Cumulative Compensation Recognizable $ 750,000 0 2,250,000 1,750,000 Percentage Accrued 25% 50% 75% 100% Compensation Accrued to Date $ 187,500 ( (187,500) 0 1,687,500 62,500 $1,750,000 Expense 2001 $187,500 $(187,500) Expense 2002 Expense 2003 Expense 2004
Date 12/31/01 12/31/02 12/31/03 12/31/04
$1,687,500 $62,500
(b) Compensation Expense .......................................................... Liability Under Stock Appreciation Plan........................ (c) Liability Under Stock Appreciation Plan................................ Cash [250,000 X ($19 $12)] ...........................................
62,500
1,750,000
*EXERCISE 17-14 (15-25 minutes) (a)Schedule of Compensation Expense - Stock Appreciation Rights (50,000)
Cumulative Compensation Recognizable $200,000 350,000 650,000 200,000 800,000 Compensation Accrued to Date $50,000 125,000 175,000 312,500 487,500 (287,500) 200,000 600,000 $800,000
Date 12/31/03 12/31/04 12/31/05 12/31/06 12/31/07
Market Price $36 39 45 36 48
Preestablished Price $32 32 32 32 32
Percentage Accrued 25% 50% 75% 100%
Expense 2003 $50,000
Expense 2004 $125,000
Expense 2005
Exp 20
$312,500
$(28
(b) 2003 Compensation Expense..................................................................... Liability Under Stock Appreciation Plan................................... 2006 Liability Under Stock Appreciation Plan .......................................... Compensation Expense ............................................................. 2007 Compensation Expense..................................................................... Liability Under Stock Appreciation Plan................................... 50,000
287,500
600,000
EXERCISE 17-15 (10-15 minutes) (a) January 2, 2004 Investment Trading - Call Option .............. Cash .................................................... (b) March 31, 2004 Investment Trading - Call Option .............. Gain [1,000 X ($53-$40)] (c) (d)
200 200
13,000 13,000
The gain increases net income for the period by $13,000. Jones has used the option for speculative purposes. Jones is not hedging to minimize the risk of a current or future transaction.
*EXERCISE 17-16 (15-20 minutes) (a) June 30, 2005 Interest paid Cash received on swap Interest expense * (5.7% + 1%) X 6/12 December 31, 2005 Interest paid Cash received on swap Interest expense ** (6.7% + 1%) X 6/12 (b) December 31, 2005 Interest Expense............................................ Cash......................................................... 7,200 7,200 Note $ 100,000 $ 100,000 Rate 3.85%** 3% Amount $ 3,850 (850) $3,000
Note $ 100,000 $ 100,000
Rate 3.35%* 3%
Amount $ 3,350 (350) $ 3,000
[(100,000 X 6.7% X 6/12) + ($100,000 X 7.7% x 6/12)] = $7,200 Cash ($850 + $350) ........................................ Interest Expense..................................... (c) 1,200 1,200
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 17-17 (15-20 minutes) (a) December 31, 2004 Interest paid Cash paid on swap $ 10,000,000 Interest expense December 31, 2005 Interest paid Cash received on swap $ 10,000,000 Interest expense (b) December 31, 2004 Interest Expense............................................ Cash ...................................................... Interest Expense............................................ Cash ...................................................... December 31, 2005 Interest Expense............................................ Cash ...................................................... Cash................................................................ Interest Expense..................................... (d) 6% $ 600,000 Note $ 10,000,000 6% Rate 6.6% (60,000) Amount $ 660,000
Note $ 10,000,000
Rate 5.8%
Amount $ 580,000 20,000 $ 600,000
580,000 580,000 20,000 20,000 660,000 660,000 60,000 60,000
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 17-18 (20-25 minutes) (a) December 31, 2005 Cash................................................................ Interest Revenue..................................... (1,000,000 X 7.5%) (b) December 31, 2005 Cash................................................................ Interest Revenue..................................... (c) December 31, 2005 Held for Trading Swap Contract................ Unrealized Holding Gain or Loss Income .............................................. (d) December 31, 2005 Unrealized Holding Gain or Loss on Available for Sale Investments. Fair Value Allowance on Available for Sale Investments - Bonds ...............
75,000 75,000
13,000 13,000
48,000 48,000
48,000 48,000
Note: Had the investment in bonds not been hedged, the unrealized loss would have been recorded to Other Comprehensive Income. (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.
*EXERCISE 17-18 (Continued) (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 into the hedge is considered a fair value hedge.
TIME AND PURPOSE OF PROBLEMS

Problem 17-1 (Time 35-40 minutes)
Purposeto provide the student with an opportunity to prepare entries to properly account for a series of transactions involving the issuance and exercise of common stock rights and detachable stock warrants, plus the granting and exercise of stock options. The student is required to prepare the necessary journal entries to record these transactions and the shareholders equity section of the balance sheet as of the end of the year.
Problem 17-2
(Time 45-50 minutes)
Purposeto provide the student with an understanding of the entries to properly account for convertible debt. The student is required to prepare the journal entries to record the conversion, amortization, and interest in connection with these bonds on specified dates.
Problem 17-3
Purposeto provide a simple entry of the issuance of a note payable sold together with a warrant. The incremental method applies in this case.
Problem 17-4
Purposeto provide the student with an opportunity to contrast the rationale of recording of the conversion of bonds payable into common shares using the book value or market value methods.
Problem 17-5
Purposeto provide the student with an understanding of the entries to properly account for a stock option plan over a period of years. The student is required to prepare the journal entries when the stock option plan was adopted, when the options were granted, when the options were exercised, and when the options expired.
Problem 17-6
Purposethe student calculates and records the purchase and the transactions concerning a call option contract for shares over two accounting periods and also record the ultimate settlement of the call option.
TIME AND PURPOSE OF PROBLEMS (CONTINUED)

Problem 17-7 (Time 30-40 minutes)
Purposethe student calculates and records the writing of a call option contract for shares over two accounting periods and also records the ultimate settlement of the call option.
Problem 17-8
Purposethe student calculates and records the purchase and the adjustments concerning a put option contract for shares over two accounting periods and also records the ultimate write-off of the put option as the market value never falls below the strike price.
Problem 17-9
Purposethe student calculates and records the purchase and the transactions concerning a put option contract for shares over two accounting periods and also records the ultimate settlement of the put option as the market value falls below the strike price.
*Problem 17-10 (Time 35-45 minutes)

Purposethe student calculates and records the transactions concerning a fair value hedge interest rate swap, over two accounting periods and also provides partial balance sheet and income statement disclosure at three points in time over the term of the swap.

Purposethe student calculates and records the transactions concerning a cash flow hedge concerning the purchase of gold, over two accounting periods and also provides partial balance sheet and income statement disclosure at two points in time over the term of the futures contract.

Purposethe student calculates and records the transactions concerning a fair value hedge put option, over three accounting periods and also provides partial balance sheet and income statement disclosure at two points in time over the term of the option.
SOLUTIONS TO PROBLEMS
PROBLEM 17-1
(a) 1. Memorandum entry made to indicate the number of rights issued. 2. Cash .................................................. Discount on Bonds Payable* ........... Bonds Payable ........................ Contributed Surplus Stock Warrants** ............. **Allocated to Bonds: 200,000 15,385 200,000 15,385
$96 X $200,000 = $184,615; $96 + $8 Discount = $200,000 $184,615 = $15,385 **Allocated to Warrants: $8 X $200,000 = $15,385 $96 + $8 3. Cash *................................................. Common Shares...................... *[(100,000 10,000) rights exercised] *[(10 rights/share) X $32 = $288,000 288,000 288,000
PROBLEM 17-1 (Continued) 4. Contributed SurplusStock Warrants 12,308 (15,385 X 80%) Cash*....................................................... 48,000 Common Shares........................... *.80 X $200,000/$100 per bond = 1,600 *warrants exercised; 1,600 X $30 = $48,000 5. Compensation Expense*...................... Contributed Surplus Stock Options......................... *$10 X 5,000 options = $50,000 6. For options exercised: Cash (4,000 X $30) ................................. 120,000 Contributed SurplusStock Options .. 40,000 (80% X $50,000) Common Shares........................... For options lapsed: Contributed SurplusStock Options .. 10,000 Compensation Expense* ............. 50,000 50,000
60,308
160,000
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. Conversely, if a stock option lapses because the share price is lower than the exercise price, then a credit to Contributed SurplusExpired Stock Options occurs.)
PROBLEM 17-1 (Continued) (b) Shareholders Equity: Share Capital: Common Shares, authorized 1,000,000 shares, 314,600 shares issued and outstanding $4,108,308 Contributed SurplusStock Warrants 3,077 $4,111,385 Retained Earnings 750,000 Total Shareholders Equity $4,861,385 Calculations: Common Shares Number Amount 300,000 $3,600,000 9,000 288,000 1,600 60,308 4,000 160,000 314,600 $4,108,308
At beginning of year From stock rights (entry #3 above) From stock warrants (entry #4 above) From stock options (entry #6 above) Total
PROBLEM 17-2
(a) Entries at August 1, 2006 Bonds Payable.................................................. 150,000 Discount on Bonds Payable (Schedule 1) Common Shares ....................................... (To record the issuance of 750 common shares in exchange for $150,000 of bonds and the write-off of the discount on bonds payable) *($64,000 X 1/10) X (107/120) Interest Payable .................................................... 1,500 Cash ($150,000 X 12% X 1/12)...................... (To record payment in cash of interest accrued on bonds converted as of August 1, 2006 accrual and amortization was recorded July 31, 2006) (b) Entries at August 31, 2006 Bond Interest Expense......................................... Discount on Bonds Payable (Schedule 1) .. (To record amortization of one months discount on $1,350,000 of bonds) *($64,000 X 90%) X (1/120) Bond Interest Expense......................................... 13,500 Interest Payable ($1,350,000 X 12% X 1/12) (To record accrual of interest for August on $1,350,000 of bonds at 12%) (c)
5,707* 144,293
1,500
480* 480
13,500
Entries at December 31, 2006 (Same as August 31, 2006, and the following closing entry) Income Summary........................................... 178,631 Bond Interest Expense (Schedule 2) ... 178,631 (To close expense account)
PROBLEM 17-2 (Continued) Schedule 1 Monthly Amortization Schedule Unamortized discount on bonds payable: Amount to be amortized over 120 months Amount of monthly amortization ($64,000 120) Amort. for 13 months to July 31, 2006 ($533 X 13) Balance unamortized 7/31/06 ($64,000 $6,929) 10% applicable to debentures converted Balance August 1, 2006 Remaining monthly amort. over remaining 107 months Schedule 2 Interest Expense Schedule Amortization of bond discount charged to bond interest expense in 2006 would be as follows: 7 months X $533 $3,731 5 months X $480 2,400 Total $6,131 Interest on Bonds: 12% on $1,500,000 Amount per month ($180,000 12) 12% on $1,350,000 Amount per month ($162,000 12) Interest for 2006 would be as follows: 7 months X $15,000 5 months X $13,500 Total Total interest Amortization of discount Cash interest paid Bond interest expense $64,000 $533 $6,929 $57,071 (5,707) $51,364 $480
$180,000 $15,000 $162,000 $13,500 $105,000 67,500 $172,500
6,131 172,500 $178,631
PROBLEM 17-3 Cash................................................................ 20,040,000 Discount on Notes Payable .......................... 3,960,000* Notes Payable ......................................... 18,000,000 Contributed SurplusStock Warrants.. 6,000,000 *($18,000,000 X 22%)
PROBLEM 17-4 When accounting for the conversion of bonds into common shares, whether using the book value or the market value methods, certain accounts will need to be relieved of their proportionate carrying value in order to properly record the conversion. Since the conversion took place immediately after an interest date, there is no accrued interest nor amortization of bond discount to record prior to the recording of the conversion. Under the book value method, the pro-rata carrying value of the Bonds Payable, Discount on Bonds Payable and Contributed Surplus Stock Options would be removed and a corresponding net entry to Common Shares would result. No gain or loss on redemption would result. Under the market value method, the common shares would be recorded at market value (their market value or the market value of the bonds), the Contributed Surplus, Bonds Payable, and Discount on Bonds Payable amounts would be proportionately reduced, and a gain/credit or loss/debit would result. Since the CICA requires shares to be recorded at their cash equivalent value, legal requirements would tend to support this approach. The interesting question is whether the resulting gain/credit or loss/debit would be treated as an operating or capital transaction. If it was seen as arising from debt extinguishment, it would be an operating item (gain or loss) and recognized through the income statement. If it was seen as part of the process of issuing shares, it should be booked through equity.
PROBLEM 17-5 2006. 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, 2006, 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. 2007 No entry January 2
December 31 Compensation Expense................................ 209,524 Contributed SurplusStock Options. (To record compensation expense attributable to 200722,000 options) Pro-rata calculation: 2007 2008 President 15,000 13,000 Vice- President 7,000 7,000 Total options 22,000 20,000 Compensation Expense $ 209,524* $ 190,476** * 22,000 / 42,000 X $400,000 = $209,524 ** 20,000 / 42,000 X $400,000 = $190,476 2008 December 31 Compensation Expense................................ 190,476 Contributed SurplusStock Options. (To record compensation expense attributable to 200820,000 options) Contributed SurplusStock Options.......... 209,524 Contributed SurplusExpired Stock Options ................................... (To record lapse of presidents and vice presidents options to buy 22,000 shares)
209,524
Total 28,000 14,000 42,000 $400,000
190,476
209,524
PROBLEM 17-5 (Continued) 2009 December 31 Cash (20,000 X $8) ......................................... 160,000 Contributed SurplusStock Options.......... 190,476 Common Shares............................... 350,476 (To record issuance of 20,000 common shares upon exercise of options at option price of $8)
PROBLEM 17-6 (a) July 7, 2004 Investment Trading - Call Option .............. Cash......................................................... (b) September 30, 2004 Investment Trading - Call Option .............. Gain ......................................................... [200 X ($77-$70)] Loss ................................................................ Investment Trading Call Option ...... ($240-$180) (c) December 31, 2004 Loss ................................................................ Investment Trading Call Option ...... [200 X ($75-$77)] Loss ................................................................ Investment - Trading Call Option ....... ($180-$65) (d) January 4, 2005 Cash [200 x ($76 -$70)].................................. Gain on Settlement of Call Option ........ Investment - Trading - Call Option ........ July 7, 2004 Sept. 30, 2004 Sept. 30, 2004 Dec. 31, 2004 Dec. 31, 2004 Balance $ 240 1,400 (60) (400) (115) $ 1,065
240 240
1,400 1,400
60 60
400 400
115 115
1,200 135 1,065
PROBLEM 17-7 (a) July 7, 2004 Cash................................................................ Obligation Call Option......................... (b) September 30, 2004 Loss - Call Option.......................................... Obligation Call Option......................... [200 X ($77-$70)] Obligation Call Option................................ Gain Call Option .................................. ($240-$180) (c) December 31, 2004 Obligation Call Option................................ Gain Call Option .................................. [200 X ($75-$77)] Obligation Call Option................................ Gain Call Option .................................. ($180-$65) (d) January 4, 2005 Obligation Call Option................................ Loss on Settlement of Call Option............... Cash [200 x ($76 -$70)]........................... July 7, 2004 Sept. 30, 2004 Sept. 30, 2004 Dec. 31, 2004 Dec. 31, 2004 Balance $ (240) (1,400) 60 400 115 $ (1,065)
240 240
1,400 1,400
60 60
400 400
115 115
1,065 135 1,200
PROBLEM 17-8 (a) July 7, 2004 Investment Trading Put Option .............. Cash.........................................................
240 240
(b) September 30, 2004 No accrual of Unrealized Holding Gain since the market price of Ewing shares increased beyond the $70 strike price. Loss - Put Option........................................... Investment Trading - Put Option ........ ($240-$125) 115 115
(c) December 31, 2004 No accrual of Unrealized Holding Gain since the market price of Ewing shares still exceeds $70, the strike price. Loss Put Option.......................................... Investment Trading Put Option ...... ($125-$50) 75 75
(d) January 31, 2005 Put option is not used as the market price of Ewing shares exceeds $70, the strike price. Loss Put Option.......................................... Investment Trading - Put Option ........ July 7, 2004 Sept. 30, 2004 Dec. 31, 2004 Balance $ 240 (115) (75) $ 50 50 50
PROBLEM 17-9 (a) January 7, 2004 Investment Trading - Put Option............... Cash......................................................... (b) March 31, 2004 Investment Trading - Put Option................ Gain Put Option .................................. [400 X ($85-$80)] Loss Put Option.......................................... Investment Trading - Put Option ........ ($360-$200) (c) June 30, 2004 Loss Put Option.......................................... Investment Trading - Put Option ........ [400 X ($82-$80)] Loss Put Option.......................................... Investment Trading - Put Option ......... ($200-$90) (d) July 6, 2004 Cash [400 x ($85 -$77)].................................. Gain on Settlement of Put Option ......... Investment Trading - Put Option ........ Jan 7, 2004 March 31,2004 March 31,2004 June 30, 2004 June 30, 2004 Balance $ 360 2,000 (160) (800) (110) $ 1,290
360 360
2,000 2,000
160 160
800 800
110 110
3,200 1,910 1,290
*PROBLEM 17-10 (a) (1) No entry required December 31, 2004
(2) June 30, 2005 Interest Expense............................................ Cash......................................................... ($10,000,000 X 7% X 6/12) (3) June 30, 2005 Interest Expense............................................ Cash......................................................... ($10 million X 8% less 7% X 6/12) (4) June 30, 2005 Note Payable .................................................. Unrealized Holding Gain or Loss Income ................................................ (5) June 30, 2005 Unrealized Holding Gain or Loss - Income Other Liabilities Swap Contract ......... (b) Mercantile Corp. Balance sheet (partial) December 31, 2004 Long-term liabilities Note payable
350,000 350,000
50,000 50,000
200,000 200,000
200,000 200,000
$10,000,000
Income Statement (partial) For the Year Ending December 31, 2004 No items to report
*PROBLEM 17-10 (Continued) (c) Mercantile Corp. Balance sheet (partial) June 30, 2005 Current liabilities Swap contract Long-term liabilities Note payable
$200,000
$9,800,000
Income Statement (partial) For the Six Months Period Ending June 30, 2005 Interest expense Other revenues and gains: Unrealized holding gain Note payable Unrealized holding loss- Swap contract (d) Mercantile Corp. Balance sheet (partial) December 31, 2005 Current assets Swap contract Current liabilities Note payable $60,000 $400,000
$200,000 (200,000)
$10,060,000
Income Statement (partial) For the Year Ending December 31, 2005 Interest expense* Other revenues and gains: Unrealized holding loss Note payable Unrealized holding gain Swap contract *($10 Million X 8 %)
$800,000
$(60,000) 60,000
*PROBLEM 17-11 (a) No entry required April 1, 2005
(b) June 30, 2005 Futures Contract............................................ Unrealized Holding Gain or Loss Income (OCI) ...................................... ($310-$300) X 500 ounces (c) September 30, 2005 Futures Contract............................................ Unrealized Holding Gain or Loss Income (OCI) ...................................... ($315-$310) X 500 ounces (d) October 31, 2005 Raw Materials Inventory - Gold .................... Cash (500 ounces X $315) ..................... Cash................................................................ Other Assets Futures Contract .......... ($157,500 - $150,000) (e) December 20, 2005 Accounts Receivable/Cash........................... Sales ........................................................ Cost of Goods Sold ....................................... Finished Goods Inventory ..................... Unrealized Holding Gain or Loss Income (OCI) ............................................ Cost of Goods Sold ................................
5,000 5,000
2,500 2,500
157,500 157,500 7,500 7,500
350,000 350,000 200,000 200,000
7,500 7,500
*PROBLEM 17-11 (Continued) (f) LEW Jewellery Corp. Balance sheet (partial) June 30, 2005 Current assets Futures Contract Equity Accumulated Other Comprehensive Income $5,000
$5,000
Income Statement (partial) For the Six Months Period Ending June 30, 2005 Other Comprehensive Income: Unrealized holding gain Futures contract
$5,000
(g) LEW Jewellery Corp. Income Statement (partial) For the Year Ending December 31, 2005 Sales Cost of goods sold ($200,000 - $7,500) Gross profit $350,000 192,500 $ 157,500
*PROBLEM 17-12 (a) (1) November 3, 2005 Investments Available-for-Sale Johnstone.................................................. Cash......................................................... Investments Available-for-Sale Put Option ......................................................... Cash......................................................... (2) December 31, 2005 Loss ............................................................... Investments Available-for-Sale Investments Put Option................... ($600-$375) (3) March 31, 2006 Unrealized Holding Gain/Loss on Available-for-Sale Investments (OCI)...... Fair Value Allowance on Availablefor-Sale Investments........................... [4,000 X ($50-$45)] Loss ................................................................ Investments Available for Sale Investments Put Option................... ($375-$175) (4) June 30, 2006 Unrealized Holding Gain/Loss on Available-for-Sale Investments (OCI)...... Fair Value Allowance on Availablefor-Sale Investments........................... [4,000 X ($45-$43)]
200,000 200,000
600 600
225 225
20,000 20,000
200 200
8,000 8,000
*PROBLEM 17-12 (Continued) June 30, 2006 Loss ................................................................ Investments Available for Sale Investments Put Option .................. ($175-$40) (5) July 1, 2006 Cash (4,000 X $43) ......................................... Loss on Sale of Available-for-Sale Securities Investments Available-for- SaleJohnstone.......................................... Cash [4,000 X ($50-$43)] ............................... Gain/Loss on Settlement of Put Option ................................................ Fair Value Allowance on Available-forSale Investments ...................................... Unrealized Holding Gain/Loss on Available-for-Sale Investments (OCI) . Loss ................................................................ Investments Available for Sale Investments Put Option ................. Nov. 3, 2005 Dec. 31, 2005 March 31, 2006 June 30, 2006 Balance $ 600 (225) (200) (135) $ 40 135 135
172,000 28,000 200,000 28,000 28,000
28,000 28,000 40 40
*PROBLEM 17-12 (Continued) (b) Spinkle Corp. Balance sheet (partial) December 31, 2005 Current Assets: Investments Available for Sale Put option Non-Current Assets: Investments Available for Sale - Johnstone $375
$200,000
Income Statement (partial) For the Year Ending December 31, 2005 Other expenses and losses: Loss on available-for-sale investments put option
$225
(c) Sprinkle Corp. Balance sheet (partial) June 30, 2006 Current Assets: Investments Available for Sale Put option Investments Available for Sale - Johnstone Less: Fair Value Allowance on Available-for-Sale Investments Equity: Accumulated Other Comprehensive Income $40 $200,000 (28,000) $172,040 $(28,000)
*PROBLEM 17-12 (Continued) Income Statement (partial) For the Six Months Period Ending June 30, 2006 Other expenses and losses: Loss on available-for-sale investments put option Other Comprehensive Income: Unrealized Holding Gain/Loss on Available-for-Sale Investments *March 31,2006 loss June 30, 2006 loss (200) (135) $ (335)
$335
$(28,000)
TIME AND PURPOSE OF WRITING ASSIGNMENTS

Assignment 17-1 (Time 15-20 minutes)
Purposeto 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 companys 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 companys shares, and the necessary information that should be disclosed in the financial statements when stock warrants are outstanding for each of the groups.
Assignment 17-2 (Time 25-30 minutes)

Purposeto provide the student with an opportunity to respond to a contrary view of the FASBs standard on Accounting for Stock-Based Compensation, and to defend the concept of neutrality in financial accounting and reporting.
SOLUTIONS TO WRITING ASSIGNMENTS

ASSIGNMENT 17-1
(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 companys shareholders and also because it is likely to be less expensive than a public offering. 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 companys 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. Warrants to purchase common shares may be issued to purchasers of a companys bonds in order to stimulate the sale of the bonds by increasing their speculative appeal and 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. 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 companys 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.
3.
(b)
1.
ASSIGNMENT 17-1 (Continued)

2. Warrants may be offered to key employees below, at, or above the market price of the shares on the day the rights are granted except for incentive stock option plans. If a stock option plan is to provide a strong incentive, warrants that can be exercised shortly after they are granted and expire, say, within two or three years, usually must be exercisable at or near the market price at the date of the grant. Warrants that cannot be exercised for a number of years after they are granted or those that do not lapse for a number of years after they become 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. Income tax laws impose no restrictions on the exercise price of warrants issued to purchasers of a companys bonds. The exercise price may be above, equal to, or below the current market price of the companys 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. Financial statement information concerning outstanding stock warrants issued to a companys 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. Financial statement information concerning stock warrants issued to key employees should include the following: status of these plans at 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. Financial statement disclosure of outstanding stock warrants that have been issued to purchasers of a companys 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.
3.
(c)
1.
2.
3.
ASSIGNMENT 17-2
The following is an excerpt from a presentation given by Dennis Beresford on the concept of neutrality. The Board often hears that we should take a broader view, that we must consider the economic consequences of a new accounting standard. The FASB should not act, critics maintain, if a new accounting standard would have undesirable economic consequences. We have been told that the effects of accounting standards could cause lasting damage to American companies and their employees. Some have suggested, for example, that recording the liability for retiree health care or the costs for stock-based compensation will place U.S. companies at a competitive disadvantage. These critics suggest that because of accounting standards, companies may reduce benefits or move operations overseas to areas where workers do not demand the same benefits. These assertions are usually combined with statements about desirable goals, like providing retiree health care or creating employee incentives. There is a common element in those assertions. The goals are desirable but the means require that the Board abandon neutrality and establish reporting standards that conceal the financial impact of certain transactions from those who use financial statements. Costs of transactions exist whether or not the FASB mandates their recognition in financial statements. For example, not requiring the recognition of the cost of stock options or ignoring the liabilities for retiree health care benefits does not alter the economics of the transactions. It only withholds information from investors, creditors, policy makers, and others who need to make informed decisions and, eventually, impairs the credibility of financial reports. One need only look to the collapse of the thrift industry to demonstrate the consequences of abandoning neutrality. During the 1970s and 1980s, regulatory accounting principles (RAP) were altered to obscure problems in troubled institutions. Preserving the industry was considered a greater good. Many observers believe that the effect was to delay action and hide the true dimensions of the problem. The public interest is best served by neutral accounting standards that inform policy rather than promote it. Stated simply, truth in accounting is always good policy. Neutrality does not mean that accounting should not influence human behaviour. We expect that changes in financial reporting will have economic consequences, just as economic consequences are inherent in existing financial reporting practices. Changes in behaviour naturally follow from more complete and representationally faithful financial statements. The fundamental question, however, is whether those who measure and report on economic events should somehow screen the information before reporting it to achieve some objective. In FASB Concepts Statement No. 2, Qualitative
ASSIGNMENT 17-2 (Continued)

Characteristics of Accounting Information (paragraph 102), the Board observed: Indeed, most people are repelled by the notion that some big brother, whether government or private, would tamper with scales or speedometers surreptitiously to induce people to lose weight or obey speed limits or would slant the scoring of athletic events or examinations to enhance or decrease someones chances of winning or graduating. There is no more reason to abandon neutrality in accounting measurement. The Board continues to hold that view. The Board does not set out to achieve particular economic results through accounting pronouncements. We could not if we tried. Beyond that, it is seldom clear which result we should seek because our constituents often have opposing viewpoints. Governments, and the policy goals they adopt, frequently change.
Chapter 17 Suggested Case Solutions

See the Case Primer on the Digital Tool also the Suggested outline for case solutions. Note that the first few chapters lay the foundation for financial reporting decision making.
CA 17-1 Sanford Corp.

Overview: the company is in the business of selling fire extinguishers it is using shares as incentive to sell its products closely held company and therefore GAAP may not be a constraint unless users e.g. shareholders request as more relevant and reliable assume so note that as an analyst, would start with these statements (GAAP or not) and adjust the numbers to get the most meaningful information about the company as financial analyst looking at quality of income and whether net income represents sustainable income and reflects the underlying business model of the company. Would therefore want transparency (f/s should reflect underlying substance)
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 (see - represents the true value to the 3870.14) dealers - this is the point at which the - the shares were technically not value is transferred from the issued prior to this they sat in company the trust for the interim period (not outstanding) - additional increases in value - this is the date at which the accrue to the dealers the dealers performance is company has no access to the complete (3870.14) trust or the shares once transferred Treatment of related cost Marketing cost
reflects the economic substance the dealers would see this as a motivation to buy more from the company and resell them similar to commission not a capital transaction since reciprocal purpose is to compensate nonshareholders for service
Recommendation: Treat as marketing costs since this is more transparent. If the company did not issue shares 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, 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 17-2 Home Depot/Royal Group Technologies

Overview:
big box retailers = major purchaser of Royal goods want lower prices which affects Royal profit margins Royal looking for ways to say money and cut costs Royal is a public company since share trade on the TSE GAAP constraint
Analysis and recommendations:

Issue: Accounting for compensatory stock options Recognition at FV operating cost represents economic substance options are meant to take the place of remuneration to management to achieve corporate objectives if options were not granted would be paying remuneration in another form e.g. bonus or salary or other would affect net income No recognition capital transaction when options exercised - no cash impact when granted as a matter of fact, will never result in a cash outlay as all other expenses do; therefore, requires different treatment - no real cost upon issuance since FV of shares normally less than exercise price therefore intrinsic
motivation to improve net income not a justification for non recognition
value is nil when exercised results in cash inflow to the company
Recommendations: More transparent to use full recognition at fair value reflects the reality of the situation. Remuneration of management no matter what legally for is a cost of doing business.
CA 17-3 Air Canada

Overview: industry suffering main expense is fuel which accounts for 15% of total costs of company need to manage cost since as a commodity, its costs fluctuate uses hedging strategy high risk accounting since complex transaction
Analysis and recommendations: Issue: Accounting for hedge of fuel the hedging instruments are not listed in detail and so discuss in general terms these are likely cash flow hedges since they protect the company against changes in the costs of fuel in the future (versus fair value hedges which protect the company against fluctuations in assets or liabilities that are already recognized on the balance sheet) the hedging instruments are likely financial instruments and must therefore be measured at fair value under proposed GAAP (EDs on Hedge accounting, Financial Instruments and Comprehensive Income). Resulting gains/losses would be recorded in Comprehensive Income until the related fuel expenses hit the income statement (i.e. when the company uses the fuel). At that point, related gains/losses would be transferred from Comprehensive Income to Fuel expense. The hedging thus determines the value of the fuel. alternatively, ignoring the ED, the hedging items are executory contracts that do not necessarily get recognized. They do, however, by definition establish the price of the fuel. Therefore, when the fuel is booked as an expense, the amount is determined by the hedging strategy. either way the fuel expense is determined by the hedging since fuel costs are so material and uncertain, management would be wise to identify this risk and explain how it is being dealt with or managed. A good place to disclose this would be in the notes to the financial statements premiums/discounts associated with the hedging activity are similar to insurance costs and could therefore be expensed over the period being protected
CA 17-4 Coach Corporation

Overview: - 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 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, should not change just because of the compensation plan
IC 17-1 Legacy Hotels

Legacy Overview Legal structure important since it has cash flow implications must pay out substantially all of cash flows = distributable income (NI before amortization, income taxes and special charges less capital replacement reserve). Bias to show stable and growing distributions - must be careful that income not overstated due to cash flow implications Units listed on TSE and therefore GAAP constraint 35% owned by Fairmount = major shareholder and therefore related party - this and other users will be looking for distributable income as a measure of unit value plus management part of Fairmount Incentive fees to hotel managers based on net operating income plus amortization less capital replacement reserve additional pressure on net income numbers Debt carries covenants restriction on additional debt incentive to classify debt as equity Challenging year due to decreased business travel might put pressure to make earnings look better Role as auditor more conservative focus especially since new client must be considered in conclusions
Analysis and recommendation Issue: renovation programs Expense - since business is first class and luxury hotels part of general maintenance to keep rooms up to date and decorated Capitalize - guestroom and lobby upgrades enhance value of property if able to increase room rates - the costs related to the spa might be treated as pre-operating costs since this
involves an existing company setting up a new business (costs which are incremental and directly related to the spa would be deferred as long as recoverable Conclude : Likely expense since more conservative. Would decrease distributable income and therefore company may be opposed to expensing. Would also potentially decrease incentive fees (unless part of capital replacement reserve) Issue 7.75% convertible debentures Equity - since company may elect to settle the interest and principal portion through issue of equity no obligation exists - interest does not reduce distributable income
Part debt and part equity - convertible into units of the company (which are equity-like as they share in the profits and losses of the company). This is like an embedded option and is therefore equity-like. - legal form is debt obligation to pay interest (7.75%) creates a financial liability - not redeemable until 2004 and until that time have obligation to pay interest - interest affects distributable income makes sense since cash outflow and reduces amount available to unit holders - may affect debt covenant since will increase debt
Conclusion: Treating as equity does not appear unreasonable. Would want to clearly note disclose so that debt holders can see transparency. Issue: FHR long term incentive fees/depreciation Defer and amortize Recognize as income - more conservative - earned since company does not - reflects decreased incentive fees in have to do anything else to earn substance - payment for contract - not easy to separate from incentive fee payments like bundled sale Conclusion: More conservative to defer and amortize since difficult to separate. Depreciation does not affect distributable income nor incentive fees although issue of whether method reflects best matching. Issue: Related Party Transactions with FHR (note that this is not covered until a later chapter but students may raise and discuss the issue in general terms i.e. because the parties are related, is the transaction measured properly?) FHR is a related party since owns 35% of legacy = significant influence. It also manages its hotels.
Legacy pays management, incentive and a LT incentive fee to FHR Issue is one of measurement. Is the payment of fees in the normal course of business? Yes, since Legacy owns the hotels and subcontracts out the management. However, it appears as though FHR is the only company that manages the hotels and so may not be able to use this as a benchmark. Is there substantive change in ownership/bargaining? Yes, since other shareholders own 65% of Legacy, the company must consider these shareholders in terms of setting a fair arms length price. These payments affect distributable earnings. Since the transactions are monetary (paid for in cash) may measure at exchange value
CHAPTER 17 RESEARCH AND FINANCIAL ANALYSIS

RA17-1 INTRAWEST CORPORATION
(a) Stock Option Plan a) Who is eligible b) Required to buy shares to access benefits? c) What is the benefit or compensation based on? Employee Share Purchase Plan (ESPP) a) Who is eligible b) Required to buy shares to access benefits? c) What is the benefit or compensation based on? Certain full-time employees Officers and employees Yes Stock price
Yes Benefit is the $1 contributed by the company for every $3 contributed by employee
Deferred Share Unit Plan (DSUP) b) Who is eligible b) Required to buy shares to access benefits? c) What is the benefit or compensation based on? Executive officers
No All or a percentage of his or her annual incentive award
Funded Senior Employee Share Purchase Plan (FSESPP) a) Who is eligible b) Required to buy shares to access benefits? c) What is the benefit or compensation based on? Designated eligible employees Yes Benefit to participant is the interest avoided on the loan
Key Executive Employee Benefit Plan (KEEBP) a) Who is eligible Executive Officers
b) Required to buy shares to access No, company buys shares and awards benefits? them to officers c) What is the benefit or Shares vest to employees in part compensation based on? over time and the balance on the attainment of future earnings levels
(b)
As explained in Note 1 to the financial statements: the Company continues to account for employee stock option grants using the intrinsic value-based method under which no expense is recorded on grant and provides, on a proforma basis, information as if a fair value methodology has been applied. The company does record the cost of the DSU plan as compensation expense and amortizes a portion of the value of the shares bought under the KEEBP to income each year.
(c) One of the plans, the DSUP, is a performance type plan in that the amount awarded is based on the employees annual incentive award. This award might have criteria of performance that allow a range of performance with some interpretation within the criteria laid down in the plan and thus be subject to professional judgement. Also, the determination of the amount to amortize to income under the KEEBP might require the exercising of professional judgement since this amount would result from a choice of amortization method and other factors. (d) Although the impact which using the fair value method would have on earnings is disclosed on a pro-forma basis, the fact that there is no compensation expense actually recorded in the financial statements when stock options are granted to employees impairs the quality of earnings
reported. The quality of earnings would be higher if the fair value method was used.
RA17-2
CANADIAN TIRE CORPORATION
(a) Read MD&A. (b) The company is exposed to a number of different risks. Retail competitive risk refers to competing for customers with, and the risk of losing customers to, other retailers at the regional, national and international level. Environmental risk refers to the risks associated with handling gas, oil, propane and recycling paint, oil and lawn chemicals. Commodity price risk refers to the risk associated with the fluctuation of petroleum prices. Seasonality risk refers to the risk associated with the sales of items which have a seasonal market and the demand for which can be affected by weather. Dealer contracts create risks associated with the success of the company being closely tied to the success of the associate dealers. Capital management risk is the risk associated with potential investments in the capital markets. Financial products risk is the risk associated with fluctuations in interest rates, foreign currency exchange rates and commodity prices. Foreign exchange risk is the risk associated with fluctuations in foreign currency exchange rates. Credit charge receivables risk is the risk of non-collection associated with offering customers sales on credit terms. Securitization risk is the risk associated with unexpected changes to the portfolio of credit charge receivables. Interest rate risk is the risk associated with changes in interest rates which impact the companys investments. (c) The company is dealing with financial products risk by dealing only with counterparties that are highly rated financial institutions since this limits the risk of such parties not meeting their financial commitments and by using derivatives. The company is dealing with credit card receivables risk by effectively using technology in both its credit granting processes and its collection processes. It uses sophisticated and automated scoring models to determine creditworthiness and is constantly improving the models used.
(d) The derivative instruments being used by the company to hedge its risks are interest rate swap contracts, foreign exchange contracts and equity contracts. (e) In order for hedge accounting to be used the company would have to specifically identify and document the hedged item, the hedging item being used to offset the risk against it and show that the hedge is effective.
RA17-3
CANADIAN UTILITIES LIMITED
(a) Read note on deferred electricity cost obligation. (b) This obligation arose as the result of the sale of deferred costs since the sale had to be treated as a financing arrangement rather than a sale. This resulted in the cash received being credited to an offsetting obligation rather than directly against the deferred cost balance. Treatment as a financing arrangement ensures that the deferred costs, which are similar to accounts receivable, are still reported in the selling companys financial statements. (c) The financial reporting issue involved is whether this transaction should be treated as an outright sale or as a financing arrangement. It is very similar to a sale of accounts receivable which are treated as financing arrangements when significant risks and responsibilities associated with the receivables (or the deferred costs, in this case) remain with the party making the sale. Since ATCO electric continues to serve as the agent for the purchaser in billing, collecting and remitting amounts due from customers, it does continue to have significant responsibilities with respect to this asset. As a result, the transaction was treated as a financing arrangement rather than as a sale.
RA17-4
THE THOMPSON CORPORATION
(a) Read the note on Stock Appreciation Rights Plan. (Note 22 in the 2003 financial statements) (b) The plan grants stock appreciation rights to officers and key employees which are granted at the closing price of the stock on the day prior to the
grant date. The SAR gives the holder the opportunity to earn a cash bonus equal to the difference between the fair market value of the companys stock at the end of the reporting period less the price at which the SAR was issued. The SARs vest over a four to eight year period and expire within five to eleven years of the grant date. (c) The plan is being recorded on the balance sheet and income statement by tracking the liability on a cumulative basis at each reporting date and by recognizing the increase in the reported liability for the reporting period as compensation expense. Because this particular plan does not give the company the option of paying out in something other than cash, it is clear that a liability exists and must be recorded as opposed to recording equity. If the stock price rises during the reporting period, there will be compensation expense recognized. If the stock price declines significantly enough so that the cumulative liability amount decreases from one reporting date to the next, there will be a recovery amount rather than an expense amount recognized in income for that period. This was the case in 2002 when a recovery was recorded because the liability decreased whereas in 2003 an expense was recorded because the liability increased. The total cumulative amount of expense can never be a credit because the balance sheet amount can never be an asset. (d) Over time, the exercise price has been declining. The weighted average exercise price for SARs exercised in 2001 was $27.46, in 2002 was $26.09 and in 2003 was $23.44.
RA17-5
(a)
STOCK COMPENSATION COSTS
The two accounting pronouncements that govern accounting for stock compensation plans in the US are APB Opinion #25 Accounting for Stock Issued to Employees, issued in 1972, and FASB Statement #123 Accounting for Stock-based Compensation, issued in 1995. The two accounting options allowed are the intrinsic value method which was the method prescribed under Opinion #25 issued in 1972 and the fair value method which is the method encouraged, but not mandated, under FASB Statement # 123.
(b)
(c)
The Canadian GAAP standard provides more meaningful information than the US standards because it requires the fair value method rather than allowing a choice between the fair value method and the intrinsic value method. The fair value method more faithfully represents the economic substance of the transaction and the lack of choice of method improves the comparability of reported financial information. Use of the fair value method also results in greater international comparability. The US position still allows choice because of practical considerations rather than conceptual ones. When Statement #123 was issued, it clearly established the fair value method as the conceptually preferable method and encouraged entities to adopt it. It continued to allow the intrinsic value method in spite of this. In March 2003 FASB added a new project to address issues related to equity-based compensation. The resulting exposure draft issued March 31, 2004, Share-based Payment - an amendment of Statements 123 and 95 requires the fair value method for all public companies.
(d)

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Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

COMPLEX FINANCIAL INSTRUMENTS

ASSIGNMENT CLASSIFICATION TABLE

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

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

ASSIGNMENT CHARACTERISTICS TABLE

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

SOLUTIONS TO BRIEF EXERCISES

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

[$70,000 = $140,000 X 1/2]

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

10,000 X 5 50,000 X 2 100,000 X 30% 30,000

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

500,000 19,000 9,216* 509,784

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

204,000 6,000 210,000

$120,000 24,000 $96,000

6,800 200 7,000

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

400,000 8,000 6,200 414,200

$6,400 (200) $6,200

176,800 5,200 7,000 189,000*

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

EXERCISE 17-7 (10-15 minutes) (a) Basic formulas:

$136,000 X $152,000 = $129,200 $136,000 + $24,000

Value assigned to bonds

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

Value assigned to bonds

Value assigned to warrants

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Seventh Canadian Edition

EXERCISE 17-11 (15-25 minutes) 1/1/06 No entry

(To record expiration of stock options)