Chapter 14: Complex Debt and Equity Instruments
1. Historically, financial instruments were classified as debt or equity based on their
legal form. The financial instrument rules require classification based on the
substance of the financial instrument—liabilities carry firm commitments to pay
out cash or other financial instruments and equities are residual interests in net
2. A financial instrument is any contract that gives rise to both a financial asset of
one party and a financial liability or equity instrument of another party. Examples
include bonds, common shares and preferred shares.
3. A hybrid financial instrument is a security that has characteristics of both debt and
equity. An example is convertible debt, where the interest must be paid (debt) and
the principal will be converted to common shares (equity).
4. If the instrument is classified as debt, the annual payments are classified as
interest expense, which reduces income, and the redemption premium is recorded
as a loss on retirement, also reducing income. (If the $6,000 excess of retirement
price over par were verifiable in advance, it would be accrued over the life of the
liability). If the financial instrument were equity, both items would reduce
retained earnings directly, by-passing the income statement.
5. Retractable preferred shares are preferred shares that must be redeemed, or may
be redeemed at the option of the shareholder. Because the agreement to pay out
the redemption price is legally enforceable, such shares are classified as debt.
6. Convertible debt is a (bond) liability with the provision that it may be converted
by the investor, at the investor‟s option, into shares at a specific price or ratio of
exchange. The instrument is a hybrid financial instrument in that it has some
characteristics of debt and some characteristics of equity; the challenge is to
recognize and value these at the date of issuance when the option has no easily
verifiable market value.
7. The financial instruments rules require that the debt and equity portions split on
initial recognition. If the bond is convertible at the investor‟s option, an option
(equity) account is recognized in addition to the liability accounts. If the bond is
convertible at the company‟s option, both (interest) liability and (principal) equity
accounts are recognized.
8. The conversion option may be valued incrementally or proportionately. Under
the incremental approach, the bond is valued as though it were not convertible,
and the difference between this value and the actual proceeds is assigned to the
conversion option. Under the proportionate method, the bond is valued and an
options pricing model is used to assign value to the conversion privilege. These
two relative values are used to apportion the actual proceeds.
9. When a convertible bond is converted, the common stock conversion option
account is transferred into the common stock account. If the bond is not
converted, this account is still left in equity, but transferred to a contributed
10. The principal of convertible debt is classified entirely as equity if it is convertible
at the issuer‟s option. The portion related to annual interest is an unavoidable
obligation of the company and must be classified as a liability. Thus, the security
is hybrid. If the convertible debt is convertible at the investor‟s option, the initial
proceeds are divided between the debt (both principal and interest) and the
11. Interest expense, $76,400 x .08 = $6,112
Interest paid, $400,000 x .08 = $32,000
Charge to retained earnings, ($400,000 - $76,400) x .08 = $25,888
Note that $6,112 + $25,888 = $32,000, since the bonds were issued at par.
12. Stock rights provide the holder with an option to acquire a specified number of
shares in a corporation under prescribed conditions and within a stated future time
period. Options that are issued as an attachment to other securities are called
stock warrants. Rights often have a limited life while warrants usually have no
13. If stock rights are recognized on issuance, the stock rights account is transferred
into the common stock account on exercise and into a contributed capital account
if options are allowed to lapse. This is identical to the treatment given to the
common stock conversion option account for convertible bonds.
14. Stock options are not recognized, but rather disclosed (memorandum entries)
when they are issued to existing shareholders for no consideration to preserve
their preemptive right, when rights are issued as a poison pill, when issued for
fractional shares in a stock dividend that is itself not recognized, and for most
employee stock option plans (both non-compensatory plans and compensatory
plans, as long as the intrinsic value method is used and the exercise price exceeds
or equals current market value at the date of grant for compensatory plans.)
„Disclosure only‟ is deemed appropriate because there is no value inherent in the
rights, or the value is too difficult to ascertain.
15. A derivative is an exchange contract meant to transfer risk. It is a secondary
financial instrument whose value is linked to a primary financial instrument or a
commodity. Derivatives are options or forward contracts, or a combination of
both. Derivatives embody an exchange of financial instruments at fixed terms.
16. The company could hedge against the risk of exchange fluctuations by entering
into a forward exchange contract with a bank to deliver US dollars. The price to
be paid would be set by the terms of the contract, and would not fluctuate. The
contract would be recorded at cost, and revalued to fair market value annually.
Changes in market value would be reported as gains/losses in the income
17. A financial restructuring happens when a company that is in legal violation of
debt agreements is financially reorganized and allowed to continue operating,
rather than be placed in receivership or bankruptcy. Restructuring can involve a
financial reorganization (substantial realignment of debt and equity) or a troubled
debt restructure (lenders „settle‟ for less).
18. Financial restructuring may be bound by the following principles or rules,
although there are no explicit standards in Canada:
a) Accounting entries must reflect the terms of the agreements made by debt
and equity holders.
b) Conversions of debt to equity are made at book value.
c) Debt forgiveness is recognized as a gain on the income statement.
19. The debt and the assets would be removed from the books. A $150,000 gain on
asset disposal and a $200,000 gain on debt restructure would be recognized to
balance the entry.
20. In a comprehensive revaluation, all assets and liabilities are revalued to fair value,
whether fair value is higher or lower than book value. Retained earnings (if any)
is reclassified; any debit balance of retained earnings is eliminated by reducing
other equity accounts. Gains and losses go directly to retained earnings and by-
pass the income statement.
Sunbeam Mining Corporation
To: Mr. Morantz
From: Ms. Chow
Re: Financial statement presentation
Dear Mr. Morantz,
I have carefully reviewed the information you have provided me regarding Sunbeam
Mining Corporation (SMC) with the intention of identifying important issues relating to
financial statement presentation. While conducting this review, I have kept in mind the
users of your financial statements. At present, the most important user of your financial
statements is the Canadian Bank (CB) because of the significant loan they have provided
SMC. I assume that they are the most important because if for some reason your
relationship with them deteriorated (i.e., from not providing them with their information
needs on SMC) they may pull the loan and consequently insufficient funds would be
available to develop your single mine. Other users would be the Ontario Teachers‘
Pension Fund (Teachers‘) and potential new shareholders, if and when SMC goes public.
Furthermore, because SMC is considering going public, one additional concern is
whether the statements should be prepared in accordance with GAAP. At present GAAP
is not a constraint, but it would be if /when SMC goes public. As such, in preparation of
the initial public offering, I suggest that GAAP be followed. There is an ethical standard
to provide complete and appropriate information to all users.
The financial statement users (CB, Teachers‟, and potential shareholders) likely have a
cash flow prediction objective so as to decipher SMC's ability to meet required loan
payments (or gold production in the case of CB) and dividend payments (for Teachers‟).
Important accounting issues are:
the capitalization of costs
the appropriate classification of the preferred shares
disclosure for the commodity linked loan and foreign currency fluctuations
disclosure/classification of the subordinated debenture.
With respect to the current practice of capitalizing costs, the users‘ needs for cash flow
prediction conflict with general practice in the mining industry, which allows such
deferral. If cash flow prediction were the only goal, all such expenditures should be
expensed as paid. However, if these substantial costs are expensed, few assets would
appear on the balance sheet. While the intelligent reader would not be fooled, it would be
disconcerting to see large deficits, and the company's financial statements would not
conform to industry norms.
Cash flow is perfectly well disclosed on the cash flow statement.
Cost deferral should continue.
The convertible preferred shares held by Teachers‘ are both legally and substantively
equity. They are convertible to common shares. Shareholders cannot force SMC to buy
out the shares. Thus, the liability definition of future cash outflow is not met. The only
requirement under GAAP is that the terms and conditions (eg. interest rate and the
convertible option) be disclosed in the notes to the financial statements.
The loan from the CB is not a financial instrument, according to the classifications of the
CICA Handbook, because its payment terms are linked to a non-monetary item, gold.
Therefore, its classification is not established by the terms of that section. The issues with
respect to the loan are as follows:
1. Is it a loan or a sale contract? In substance, some argue that commodity loans simply
establish a future customer for the company‘s product, and should be recorded as
deferred revenue. Others believe that the transaction is, in substance, a loan. Industry
practice should be consulted in this area. It seems likely, though, that this contract is true
to its legal form and should be recorded as a loan, because of its payment terms and
security. Thus, the amount should be recorded as a long-term loan. Terms and condition
should be very clearly disclosed due to the unique nature of the loan. The dividend
restriction, in particular, must be reported.
2. How should the loan be valued at year-end - at the amount of money that was raised, or
the current price of gold? Again, industry practice should be investigated in this regard.
Historical cost appears to meet user needs of showing cash flows, which would be
tangled up in unrealized gains and losses if the loan were revalued yearly. Furthermore,
SMC should be fully hedged with respect to gold, through their gold reserves, and thus is
not vulnerable to gains or losses if gold prices changed.
3. How should the foreign currency aspects be recognized? The reference price for the
gold to be repaid is in US dollars. If the loan is valued at historic rates, the historic
exchange rate appears the most logical. Again, user needs seem well served by avoiding
accounting recognition of unrealized exchange gains and losses.
If all gold is priced in US dollars, one consideration might be to report all operating
activities on your financial statements in US currency.
A final issue concerns the classification of the subordinated debentures. Is the debenture
debt or equity? Assuming that SMC is a going concern, it seems that the loan will
eventually be repaid. It should be classified as debt. Its contingent nature must clearly be
disclosed. This seems an ethical choice for the benefit of the financial statement users.
Wilson Gold Mines Inc.
Wilson Gold Mines Inc. is a small public gold mining operation. It has had three years of
poor results, and has an overall shareholders‘ deficit at the moment—that is, it is technically
insolvent. Economic viability has been a constant question, and going-concern is an
issue. However, gold mining operations are very volatile, as is the price of gold.
Major users of the financial statements would be shareholders and lenders, and both
would be primarily concerned with the assessment of economic viability. There is a high
ethical standard applied to policy choice and presentation, given Wilson‘s risky profile.
1. Going concern
2. Revenue recognition
3. Exploration expenditures
4. Restoration costs
5. Classification and valuation of government loan
6. Loan extinguishment.
1. Going concern
Since the firm has a shareholders‟ deficit, which has worsened this year (presumably
based on operating results), is it a going concern? If not, the basis for accounting is
questionable, and significant disclosures must be made.
On the other hand, gold prices have improved, operations have re-commenced at
their (only) active site, and all output is sold under an eighteen-month contract. This
will presumably result in positive cash flows.
The company has signed option agreements that, if exercised, will result in a change
of control of the company, and result in significant cash infusions: The SEREM
agreement would result in over 15 million shares (more than the 11.1 million shares
now outstanding) issued at $0.71 per share; $10.65 million would be invested in the
company. The contract is an option, and appears to be based on anticipated revenues
SEREM will generate on an Australian project. The probability of this option being
exercised should be explored—it is pivotal to the going concern assessment of the
The other option, with Wilson SA, involves a loan being forgiven, and an option for
3,715,000 shares granted at an exercise price of $0.20 per share, later $0.70 per
share. This, again, represents a significant cash flow to Wilson and the probability
of its exercise should be assessed. Since it involves forgiveness of debt, it seems
logical to suggest that Wilson SA plans to exercise the options, so they get
something of value in exchange for the forgiven debt. Exercise will be contingent on
Wilson SA‟s having the cash necessary to exercise the option at the „cheap‟ price.
Also, Wilson must have economic value to support further investment.
Going concern questions are thorny ethical problems. In calling “going concern”
into question, status as a going concern might be further undermined. Thus, the issue
needs to be investigated with considerable sensitivity. However, it is important to
thoroughly investigate regardless of the consequences, since those who rely on the
financial statements may be seriously misled.
To assess going concern, evidence should be gathered on:
1. Mineral resources of Wilson (geological data).
2. Cash flow and pro forma financial statements for the next five years, under a
range of assumptions for gold prices.
3. The Australian project of SEREM, and SEREM‟s financial position.
4. The financial position of Wilson S.A.
The balance of this analysis is written assuming evidence is gathered to support
Wilson as a going concern.
2. Revenue Recognition
Wilson recognizes revenue as goods are shipped. This is appropriate, and
conservative. The CICA Handbook establishes delivery as the appropriate revenue
recognition point. The risks and rewards of ownership have transferred at this point.
However, in the precious metals industry, some companies recognize revenue as ore
is processed; shipping is considered a trivial function. Wilson could adopt this
policy, especially as all its output is committed under contract for the next eighteen
months. This earlier revenue recognition would increase inventory values, net assets
and income. However, this is not recommended:
Not all companies in the industry follow this policy, which is historically rooted
in stable commodity prices but does not reflect current realities of volatile gold
Only short delays between production and shipment are likely, since production is
all pre-sold; the differences will not be significant.
Inventory levels are now low; again, differences are not likely to be significant.
Wilson is a high-risk company; conservative counting policies are appropriate.
In an efficient market investors will not be fooled by changes in policy that do not
reflect improved cash flows.
A change in policy is not recommended.
3. Exploration expenditures
On the 31 July 20x6 financial statements, $2,197,000 is reported as a deferred
exploration expenditure on the Toodoggone property in Northern Labrador. Active
exploration ceased in February of 20x5 after yielding no commercially viable
mineral deposits, despite promising geological reports. Company policy is to defer
costs until a project is brought into commercial production, sold or abandoned. This
project has been “put on hold” but mining rights are held for another 20 years.
Should the costs be deferred or written off? The asset only has value if it has future
cash flow, unless there is some concrete hope of commercial production or sale of
the mineral rights. This amount should be written off.
Wilson is particularly risky right now, and questionable assets must be viewed with
skepticism. Unless sufficient evidence is presented to the contrary, the following
entry should be made:
Loss on write-down of mineral properties 2,197,000
Mineral properties 2,197,000
The loss is in the ordinary course of business (a typical risk in the mining industry)
and thus is not extraordinary. It may be presented as an unusual item in the income
statement because it is, in all likelihood, an infrequent event.
4. Restoration costs
Wilson has legal obligations to restore its active mining site, Lawyer‟s Mine, to pre-
mining condition. No accrual has been made, as Wilson claims it is not comfortable
with the estimate that would be necessary. Thus, liability recognition fails the
recognition criteria of „estimability‟. The nature of the unrecorded liability is
disclosed. This is acceptable accounting policy, and is common practice among
many mining companies. Its result is to overstate income and understate liabilities,
which is hardly desirable.
Wilson‟s alternative is to obtain an estimate and begin accrual, disclosing the
presence of measurement uncertainty. This is a better portrayal of the entity‟s
financial position and results of operations, although it does introduce an element of
unreliability into the financial statements. Many other mining companies take this
approach, and prefer to record their legal obligations to help communicate their
Wilson should be encouraged to obtain a restoration cost estimate, although their
current policy is acceptable and they may well be loath to increase liabilities at this
time. Again, there is an ethical responsibility to fully and fairly report the financial
position of the company, a financial position that includes a legal and ethical
responsibility for environmental matters.
5. Government of Canada Loan
The Government of Canada loan is at prime, a low interest rate for a company as
risky as Wilson. It is secured by a second charge on the Lawyer‟s Mine property;
first charge is held by a chartered bank as security for a $3.7 million loan. The
Lawyer‟s mine property, which is capable of economic production at some level of
gold price, may be worth more than $3.7 million and thus the second charge would
be of economic value.
However, interest only accrues, and principal only must be repaid, in months where
metal prices—gold and silver—exceed a certain level; this has never happened. Is
this amount really debt if it involves no cash flow? A number of alternatives can be
1. The price of precious metals will never exceed the minimum and the loan will
never attract interest or principal. In this case, there is no future cash outflow
and the ‗loan‘ is really a government grant.
2. The price of precious metals will never exceed the minimum and the loan will
never attract interest but the principal will have to be repaid when the mine is
sold or permanently shut down. In this case, Wilson has a no-interest loan,
which should be valued at its present value using an appropriate market interest
3. The price of precious metals will sometimes exceed the minimum and the loan
will sometimes (frequently or infrequently) require interest and principal
payments. This is a likely scenario, and in a world of ideal information, one
would value the debt at the present value of its cash flows, discounted at an
appropriate market interest rate. However, measurement problems are manifest,
as precious metal prices are notoriously volatile, and thus no present value
calculation would be possible.
4. The price of precious metals will soon exceed the minimum and the loan will
regularly start to incur interest and principal payments. The loan, under these
circumstances, is a conventional loan, and, in all likelihood, is properly
classified. One could argue that, at prime, it is a low-interest loan and should be
discounted to a higher rate, but overall this scenario seems unlikely and thus is
not pursued in any depth.
Up to now, the price of precious metals has been so low that interest and principal
has not yet been required. What will the future hold?
It will be necessary to assess current metal prices with respect to the minimum level.
However, even if they are significantly below this level, it would not be possible to
move to category 1 or 2 (2 seems most likely) and discount or reclassify based on
expectations of future low ore prices. The fact is that the price of precious metals is
extremely volatile. One would like to be in category 3, but quality information is
simply not available.
What‟s left? It can‟t be reclassified as a government grant, and it can‟t be discounted
as no or low interest debt due to problems with quality information.
Therefore, it looks as though it should continue to be recorded as is, with clear
disclosure. Given its unique nature, a separate classification on the balance sheet
seems most appropriate. That is, it should be excluded from long-term debt. It
would also be appropriate to disclose the actual precious metal price, and the
contractual minimum, along with some historical trend data in this regard, to assist
financial statement users in assessing the debt.
6. Loan extinguishment
The Wilson S.A. loan, recorded at $5,307,000 in the 31 July, 20x6 financial
statements, has been extinguished under the terms of the subscription agreement
dated 31 May, 20x6. The extinguishment must be recorded at book value.
The extinguishment creates a „stock option outstanding‟ account resulting from
granting of an option; if the option is exercised, the stock rights account, along with
the cash received, are folded into common shares. If the option is allowed to lapse,
then contributed capital is created.
The impact of this entry is to increase shareholders equity and decrease long-term
debt; this is part of the financial arrangements Wilson has made to ensure their
financial viability. It almost eliminates the net shareholder deficit.
1. Accounts receivable A, FA
2. Inventory A
3. Prepaid expenses A
4. Revenue received in advance L
5. Preferred shares E or L, FL depending on terms
6. Bank loans payable L, FL
7. Deferred charges A
8. Retained earnings E
9. Warranty repair obligation L
10. ST investment in shares A, FA
11. Contributed capital E
12. Common shares E
13. Goodwill A
14. Accumulated amortization, buildings A (contra)
15. Accounts payable L, FL
16. Property, plant and equipment A
17. Obligation under capital lease L, FL
18. Bonds payable L, FL or partially E depending on terms
19. Term-preferred shares L, FL
20. Loans receivable A, FA
Series A preferred shares, annual $6 cumulative dividend, convertible into two common
shares for every $100 preferred share at the investor’s option, redeemable at $110 per
share at the company’s option in 20x10.
These shares are equity because they are convertible into common equity at the option of
the investor. While the company has the option to redeem for cash, this cannot be forced
by the investor.
Subordinated 8% debentures payable, interest payable semi-annually, due in the year
20x4. At maturity, the face value of the debentures may be converted, at the company’s
option, into common shares at a price of $12.50 per share.
This is a hybrid instrument, part debt and part equity. The interest payments have to be
made semi-annually, so the present value of the interest obligation is debt. Equity can, at
the company‟s option, be converted into common shares, and thus it is equity. The
present value of the principal is therefore an equity instrument.
Series B preferred shares, annual $6 cumulative dividend, redeemable at the investor’s
option for $110 per share, plus dividends in arrears. The company may, at its option,
redeem the total obligation for preferred shares in common shares issued at market
This is a liability. The investor can demand redemption of principal and dividends in
arrears, which makes the instrument appear to be debt. As well, at its option, the
company can fulfil its obligation by issuing common shares at market value for the full
Subordinated debentures payable, bearing an interest rate of 9%, interest re-set every
three years with reference to market rates; principal due to be repaid only on the
dissolution of the company, if ever, although may be repaid at the company's option on
interest repricing dates.
This is perpetual debt, and it is recorded as a liability. Strictly speaking, this is a hybrid
instrument. The principal portion is equity since it never has to be repaid (but can be
repaid voluntarily by the company.) The obligation to pay annual interest is a financial
liability. However, the value assigned to the indefinite equity payment is zero, so the
equity component is zero. All that is left is the interest liability, which represents all of
the proceeds on issuance.
1. These are “straight” convertible debentures. The value of the conversion option
must be determined (by an option pricing model) and must be reported as a
component of shareholders‟ equity. The proceeds of the debentures, net of the
value assigned to the conversion option, will be shown as a long-term liability.
The liability represents the discounted cash flow of the interest and principal,
discounted at the effective rate of interest.
2. The interest must be paid regularly, in cash. The present value of the interest
obligation will be shown as a financial liability, discounted at the market rate
of interest. The difference between the present value of the interest and the
proceeds from the debentures will be shown as a component of shareholders‘
equity because the obligation will be settled either by voluntary conversion by
the holders or by forced conversion by the company.
3. These shares require the company to pay cash ―dividends‖ and to redeem the
shares in cash at the holder‘s option. This share issue is a liability (both
interest and principal) for the company.
Assignment 14-8 (WEB)
Discount on bonds payable (2) ........................................ 760,000
Bonds payable .......................................................... 5,000,000
Contributed capital: common stock
conversion rights (1) ................................................ 1,085,000
(1) $5,325,000 – $4,240,000
(2) $5,000,000 – $4,240,000
The conversion rights are valued at the difference between the actual proceeds and the
amount that would have been received had the bond not been convertible.
Discount on bonds payable ($5,000 – $4,100) ................ 900,000
Bonds payable .......................................................... 5,000,000
Contributed capital: common stock
conversion rights ...................................................... 1,225,000
Bond $4,240 77% × $5,325 $4,100
Option 1,250 23% × 5,325 1,225
Principal $5,000 (P/F,10%,15 yrs,) (.23939) $1,197
Interest 400 (P/A,10%,15 yrs) (7.60608) 3,042
Price $4,239 (rounded to $4,240)
An option pricing model (such as the Black-Scholes model) would have been used to
value the conversion option.
Interest expense, based on requirement 1
Cash cost ($5,000,000 × .08) ...................................................................... $400,000
Discount amortization ($760,000/15) ......................................................... 50,667
Total expense .............................................................................................. $450,667
Interest expense, based on issuance price
Cash cost ..................................................................................................... $400,000
Premium amortization ($325,000/15) ......................................................... ( 21,667)
Total expense .............................................................................................. $378,333
This is not a hybrid security. Although it has a conversion option, the conversion price is
not fixed. The conversion price is determined by the market value of the shares on the
date of conversion.
The debenture was issued at the market rate of interest, as follows (not required):
Principal: $1,000,000 × (P/F, 4%, 20) = $1,000,000 × 0.45639 = $ 456,390
Interest: ($1,000,000 × 5%) × (P/A, 4%, 20) = $50,000 × 13.59033 = 679,517
Debenture payable 1,000,000
Premium on debenture payable 135,907
The amount shown on the balance sheet will be the principal amount plus the
unamortized premium. Premium amortization for years 1 and 2 is as follows:
$50,000 – ($1,135,907 × 4%) = $50,000 – $45,436 = $ 4,564
$50,000 – ($1,135,907 – $4.564) × 4%) = $50,000 – $45,254 = 4,746
$50,000 – [($1,131,343 – $4,746) × 4%] = $50,000 – $45,065 = 4,935
$50,000 – [($1,126,617 – $4,935) × 4%] = $50,000 – $44,867 = 5,133
Balance: $1,135,907 – $19,378 = $1,116,529
Alternatively, the balance can be determined as the present value of the remaining cash
flows for 16 periods:
Principal: $1,000,000 × (P/F, 4%, 16) = $1,000,000 × 0.53391 = $ 533,910
Interest: ($1,000,000 × 5%) × (P/A, 4%, 16) = $50,000 × 11.6523 = 582,615
($4 difference is due to cumulative rounding.)
Debenture payable 1,135,907
Premium on debenture payable 116,529
Common shares 1,252,436
If the conversion rate were fixed, then this would be a hybrid security. The value of the
conversion option would be calculated by means of an option pricing model, and that
portion of the proceeds would be credited to a contributed capital account when the
debenture was issued, thereby reducing the amount of premium on the debenture. The
reduced premium (or discount, if the value of the conversion option is higher than the
excess proceeds) will then be amortized as usual. Upon conversion, the contributed
capital account would be transferred to the common share account.