Complex Debt and Equity Instruments

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					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
   capital account.

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
    conversion option.

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
    expiry date.

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.
Case 14-1
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.
Case 14-3

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
     „green‟ side.

     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.
Assignment 14-1

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
Assignment 14-3

Part A
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.

Part B
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.

Part C
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

Part D
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.
Assignment 14-5

   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)

Requirement 1
Cash.................................................................................. 5,325,000
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.

Requirement 2
Cash.................................................................................. 5,325,000
Discount on bonds payable ($5,000 – $4,100) ................ 900,000
     Bonds payable ..........................................................                        5,000,000
     Contributed capital: common stock
     conversion rights ......................................................                        1,225,000
Relative value:
Bond           $4,240             77%           ×        $5,325            $4,100
Option           1,250            23%           ×          5,325             1,225
               $5,490                                                      $5,325

Requirement 3
Present value:
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.

Requirement 4
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
Assignment 14-12

Requirement 1

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.

Requirement 2

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

    Cash                                                           1,135,907
              Debenture payable                                                  1,000,000
              Premium on debenture payable                                         135,907
Requirement 3

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:

Year 1:
   Payment 1:
        $50,000 – ($1,135,907 × 4%) = $50,000 – $45,436 =                   $ 4,564
   Payment 2:
        $50,000 – ($1,135,907 – $4.564) × 4%) = $50,000 – $45,254 =            4,746
Year 2:
   Payment 3:
        $50,000 – [($1,131,343 – $4,746) × 4%] = $50,000 – $45,065 =           4,935
   Payment 4:
        $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.)

Requirement 4

    Debenture payable                                              1,135,907
    Premium on debenture payable                                     116,529
            Common shares                                                        1,252,436

Requirement 5

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.

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