STUDY STEPS

Understanding the Underlying Business Arrangements Related to Complex Financial Instruments and Share-Based Compensation Plans

Derivatives

Primary financial instruments include most basic financial assets and financial liabilities such as accounts receivable, accounts payable, and long-term debt. The value of these instruments is based on their contractual right to receive or obligation to pay cash in the future. In contrast, derivative financial instruments “derive” their value from an underlying primary financial instrument, index, or non-financial item. Derivatives are defined as financial instruments that create rights and obligations that have the effect of transferring, between parties to the instrument, one or more of the financial risks that are inherent in an underlying primary financial instrument. They transfer risks that are inherent in the underlying primary instrument without either party having to hold any investment in the underlying (per CICA Handbook, Part II S. 3856.05 and IAS 39.9). Derivatives have three characteristics:

1. Their value changes in response to the underlying instrument.
2. They require little or no initial investment.
3. They are settled at a future date.

Derivatives include options and warrants, forwards, and futures.

Businesses face many financial risks, including credit risk, liquidity risk, and market risk, which are defined in IFRS as follows:

1. “Credit risk is the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge (respect) an obligation.”
2. “Liquidity risk is the risk that an entity will have difficulty meeting obligations that are associated with financial liabilities …”
3. “Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices.” There are three types of market risk: currency risk, interest rate risk, and other price risk.

Derivatives help companies in many different industries manage risk. For example, a company that has market risk related to its inventory faces the risk that the value of its inventory may change while the company is holding the inventory. To help manage this market risk, the company may enter into a forward contract to sell and deliver a quantity of inventory units on an agreed-upon date at an agreed-upon price, as specified in the forward contract.

Options may be purchased options (purchased by the company which becomes the option holder) or written options (sold by the company to an option holder). An option gives the option holder the right to buy (call) or sell (put) an underlying instrument (called “the underlying”) at a certain price (exercise price) over a certain period (exercise period), regardless of changes in market value of the underlying over the exercise period. An option or right to do something in future is valuable; as a result, an option holder usually pays an upfront fee or premium to purchase an option. For example, an investor may pay a $1 fee for a call option to buy a share of a company (the underlying) for $10 (exercise price) at some time in the exercise period. If the share's market price increases to above $10 (exercise price) at some time in the exercise period, the option is considered “in-the-money” at that time. For example, if the market price of the share goes up to $20, the investor need only pay $10 (exercise price) to acquire the share, and the total cost to the investor would be $11 ($10 exercise price plus $1 option fee) for a share with a market value of $20. If the share's market price decreases to below $10 (exercise price), the option is considered worthless and “out-of-the-money.” However, the investor is not obligated to exercise his or her option to purchase the share for $10 (exercise price) and would only lose $1 (the option fee). Therefore, options allow the option holder to benefit from changes in market value of the underlying instruments, while limiting exposure to loss.

Warrants are similar to options, but are often attached to debt, and may be detachable (sold separately). A company may attach warrants to debt to increase the investor's potential yield on the instrument and “sweeten” the deal, thus allowing the company to pay lower interest on the debt portion of the instrument and manage its liquidity risk.

Forwards are contracts under which both parties commit to perform or do something in the future. Parties in a forward contract may not opt out of their commitment. For example, if one party agrees to buy U.S. $100 in 30 days for $120 cash, and the other party agrees to sell U.S. $100 under those terms, the price and time period are locked in under the forward contract and both parties must honour their commitment regardless of changes in the exchange rate. In this example, both parties are managing currency risk. Forward contracts are usually unique to the parties involved, and are therefore not actively traded.

Futures are standardized forward contracts that are actively traded. Futures contracts also require a deposit of collateral (usually a percentage of the contract's value) to a margin account (similar to a bank account) with the exchange or broker.

Recall that the value of a derivative is derived from the value of its underlying primary instrument, index, or non-financial item. Referring to the examples above, the call option derives its value from the underlying company shares, and the forward contract derives its value from the market price of a U.S. dollar (versus the contract price). Because the value of a derivative is derived from the value of its underlying, a derivative can be used to offset, or hedge, risks associated with an underlying. For example, if a company purchases an investment and would like to offset the risk that the fair value of the investment (the underlying) will decrease, the company may enter into a fair value hedge by, for example, purchasing a put option to sell the investment at a certain price. If the fair value of the investment does in fact decrease, the fair value of the put option would increase. A derivative can also be used to offset risks associated with an underlying series of payments. For example, if a company agrees to make a series of payments to a debt holder at a variable interest rate, and would like to offset the risk that the interest rate will increase, the company may enter into a cash flow hedge by, for example, swapping payments in an interest rate swap. In an interest rate swap, the company would pay a fixed interest rate to a counterparty and receive the variable interest rate from the counterparty, which would be used to pay the variable interest rate payments to its debt holder.

Hybrid/compound instruments

Hybrid/compound instruments have both debt and equity characteristics, and may have a debt component as well as an equity component. The contractual terms and economic substance of hybrid/compound instruments and the conceptual framework definitions of liability and equity must be analyzed to determine proper classification of these instruments as debt, equity, or part debt/part equity. Examples of hybrid/compound instruments include perpetual debt, convertible debt, and debt with detachable warrants.

Perpetual debt is debt with no maturity date but with a steady stream of interest payments. Because perpetual debt represents an obligation to pay interest (a debt-like feature) but has no maturity date (an equity-like feature), it is considered to have both debt and equity characteristics. However, perpetual debt is classified as debt (a liability) because it represents a contractual obligation to pay cash (interest), and is measured at the present value of interest to be paid (in perpetuity).

Convertible debt is debt that carries with it an option for the holder to convert the debt to common shares of the company. Convertible debt allows the holder to limit his or her risk and still participate in the rewards of common share ownership, by receiving stable interest payments that rank in payout priority (over dividends on preferred shares) and having the option to convert to common shares if the value of common shares increases significantly. Convertible debt holders have added security if the convertible debt they hold is secured by company assets. Because convertible debt offers holders greater choice, it is generally more valuable, and allows the issuing company to obtain the related convertible debt financing at a lower interest rate. Because convertible debt has a debt component as well as an equity component (conversion option), it is classified as part debt/part equity.

Share-based compensation

The intent of employee share-based compensation plans is generally to motivate senior employees to improve the company's performance in the long term. Share-based compensation plans also help companies conserve cash because they do not require any cash payment. In fact, if options in a share-based compensation plan are exercised, employees will pay cash into the company upon exercise.

It is important to note that not all employee stock option plans are compensatory (in payment for employee services provided). For example, employee stock option or purchase plans (ESOPs) are usually made available to a wide variety of employees to give them an opportunity to invest in the company. Employees in ESOPs usually pay for their options, either fully or partially, and the company records these options as increases in assets (cash) and shareholders' equity (contributed surplus). In contrast, compensatory stock option plans (CSOPs) are usually made available to senior executives or restricted groups of employees, and are considered part of their remuneration package. Therefore, the fair value of options in CSOPs are recorded as compensation expense, allocated to the periods when the company expects to benefit from the related (employees') services. Determining whether an employee stock option plan is compensatory or not may require professional judgement, and analysis of various factors including option terms (compensatory options tend to have more flexible terms), amount of discount from market price (compensatory options tend to have a larger discount from market price), and eligibility (compensatory options are usually offered only to certain restricted groups of employees).

Share appreciation rights (SARs) plans, sometimes called “phantom” stock plans, reward employees for increases in share price by giving them the right to receive compensation equal to the share appreciation (excess of market price per share at exercise date over a pre-established price) multiplied by a notional number of shares or SARs held. Therefore, SARs plans are always compensatory. Share appreciation may be paid in cash, shares, or a combination of both. SARs plans allow employees to benefit from share appreciation without having to pay cash on the exercise date, and without requiring the company to issue the related shares to the employee. It is expected that if the executive (employee) is more productive and effective, the company will perform better and its share price will increase, causing the value of the executive's SARs to increase. SARs plans are often in effect for a limited time, and employees under SARs plans may exercise their SARs at any time during the pre-established SARs period. The notional number of shares or SARs held may reflect the executive's status in the company. For example, a more senior executive would generally have more notional shares or SARs.

Understanding the Presentation and Measurement Issues Related to Complex Financial Instruments and Share-Based Compensation Plans

Derivatives

In general, derivatives are recognized in financial statements at cost when the company becomes party to the contract, and are subsequently remeasured to fair value with gains and losses through net income. (At subsequent remeasurements, the fair value of the derivative is affected by fair value changes in the underlying.) However, there are some significant exceptions to this general rule, including purchase commitments, derivatives involving the entity's own shares, and hedges accounted for under special optional hedge accounting. See Illustration 16-1 for further discussion.

Hybrid/compound instruments

Consistent with the conceptual framework definition of a liability, a hybrid/compound instrument is classified as debt or part debt/part equity if the instrument represents or includes a contractual obligation to pay cash that the company is required to satisfy. Under IFRS, if the instrument includes a contingent settlement provision where the contingency is outside the control of the issuer, the instrument is classified as a liability. Under ASPE, the instrument would be classified as a liability only if the contingency is highly likely to result in a liability.

Under IFRS, the value of a hybrid/compound instrument that is part debt/part equity is allocated to each component based on the residual value method, with the debt component being valued first (at fair value or present value of future cash flows discounted at the market rate for similar straight debt), and the residual being allocated to the equity component. Under ASPE, the equity component of a hybrid/compound instrument that is part debt/part equity may be measured at $0; or the component that is more easily measurable may be measured first, with the residual being allocated to the other component.

Share-based compensation plans

Because share-based compensation plans are compensatory (in payment for employee services provided), they result in the recording of compensation expense or salaries and wages expense, which must be recognized and measured in the periods in which the employee performs the related services.

Compensatory stock option plans (CSOPs) are recorded at the fair value of the options that are expected to vest (that employees are expected to earn the right to). Fair value is measured at the date the options are granted to employees (grant date), using market prices or an options pricing model. The grant date is therefore the measurement date. No adjustments are made after the grant date in response to increases or decreases in share price. The options pricing model incorporates several input measures as follows:

• The exercise price
• The expected life of the option
• The current market price of the underlying shares
• The volatility of the underlying shares
• The expected dividend during the option life
• The risk-free rate of interest during the option life

The fair value of the options that are expected to vest is allocated over the periods in which the employee performs the related services (service period), which is usually also the vesting period. The vesting period is the time between grant date and vesting date.

Share appreciation rights (SARs) plans give rise to different measurement issues. Under a stock option plan, the employee receives a fixed number of shares upon option exercise. However, under a SARs plan, the employee receives an amount of cash, shares, or a combination of both cash and shares, based on the excess of the market share price at the exercise date over a pre-established price. As a result, total compensation cost is not known until the exercise date. However, for faithfully representative financial reporting, total compensation expense must still be estimated and allocated over the service period. Under IFRS, total compensation expense is estimated using an options pricing model. Under ASPE, total compensation expense is usually estimated as the rights' intrinsic value—the difference between the share's current fair value and the pre-established exercise price, multiplied by the number of SARs outstanding. Estimated total compensation expense is recalculated, based on current information, at the end of each reporting period that the SARs are outstanding. Compensation expense for each interim period is recorded based on the percentage of the total service period that has elapsed, multiplied by updated estimated total compensation expense, minus compensation expense that has already been recognized in previous periods.

TIPS ON CHAPTER TOPICS

ILLUSTRATION 16-1

Accounting for Derivatives

In general, derivatives (including options and warrants, forwards, and futures) are recognized in financial statements at cost when the company becomes party to the contract, and are subsequently remeasured to fair value with gains and losses through net income. (After acquisition, the fair value of the derivative is affected by fair value changes in the underlying.) However, there are some significant exceptions to this general rule:

1. Purchase commitments. Purchase commitments are executory contracts (contracts to do something in the future, with no cash or goods exchanged upfront). Most purchase commitments are not accounted for as derivatives, and therefore most purchase commitments do not affect the statement of financial position until the related goods are received. However, under IFRS, if the purchase commitment can be settled on a net cash basis or by transferring other assets (instead of taking delivery of the underlying goods) and if the goods are not expected use (the company does not expect to take delivery of the underlying goods), then the purchase commitment is accounted for as a derivative.
2. Derivatives involving the entity's own shares. If the derivative's underlying is the company's own shares, the derivative may not be recorded as either a financial asset or a financial liability, as a normal derivative would be. Under IFRS, if the derivative will be settled by issuing a fixed amount of cash for a fixed number of shares (fixed for fixed), then the derivative should be recorded as either contra-equity or equity. However, IFRS identifies some exceptions to this general “fixed for fixed” rule: (1) if the derivative represents an obligation to pay cash or other assets, it should be recorded as a financial liability, and (2) if the derivative can be settled on a net cash basis or by exchanging shares, unless all possible settlement options result in the instrument being equity, the derivative should be recorded as either a financial asset or a financial liability. ASPE does not give explicit guidelines regarding derivatives involving the entity's own shares; however, if the derivative meets the definition of an asset or liability, it should be recorded as such.
3. Hedges accounted for under special optional hedge accounting. Under IFRS, if the derivative is a fair value hedge or a cash flow hedge, it may be accounted for under special optional hedge accounting. Under hedge accounting for fair value hedges, the underlying or hedged item is recognized and measured at fair value with gains and losses through net income, in order to match or offset its fair value hedge (the derivative), which is also recorded at fair value with gains and losses through net income. Under hedge accounting for cash flow hedges, the cash flow hedge (the derivative) is recorded at fair value with gains and losses through other comprehensive income, because changes in value (and resulting gains and losses) related to the cash flow hedge's underlying future variable cash flows are not captured in financial statements. The gains and losses on the derivative that are booked through other comprehensive income may be recycled to net income when the hedged item is booked to net income. Under ASPE, special optional hedge accounting may only be applied to certain specific types of hedging transactions that also qualify as effective and properly documented hedges. In all, the objective of hedge accounting is to achieve symmetry in, or match, the recording of gains and losses due to changes in fair value of the derivative, with the recording of gains and losses due to changes in fair value of the derivative's underlying instrument or future transactions.

EXERCISE 16-1

PURPOSE: This exercise will illustrate how to account for purchased call options.

On July 1, 2014, Dalia Corporation paid $100 for a call option to buy 1,000 shares of Base Corporation at an exercise price of $30 per share any time during the next six months. The market price of Base's shares was $25 per share on July 1, 2014. On November 30, 2014, the market price of Base's shares was $38 per share, and the fair value of the option was $8,900.

Instructions

Solution to Exercise 16-1

EXPLANATION: A call option gives the holder the contractual right to purchase an underlying instrument at a fixed price (the exercise price) within a defined term (the exercise period). In this exercise, Dalia purchased a call option and has the contractual right to purchase 1,000 shares of Base at $30 per share within the exercise period, which ends on December 31, 2014. In general, derivatives (including options and warrants, forwards, and futures) are recognized in financial statements at cost when the company becomes party to the contract, and are subsequently remeasured to fair value with gains and losses through net income.

EXERCISE 16-2

PURPOSE: This exercise will illustrate how to record the issuance of convertible debt and subsequent conversion to common shares.

Wagagoostui Corporation has 300,000 common shares outstanding on January 1, 2014, when it issues convertible bonds. The debt issue is composed of 1,000 bonds at $1,000 face value with a 20-year term and a 10% coupon rate. Each bond is sold at 101 and is convertible into 20 common shares. An underwriter advises Wagagoostui that the bonds would likely have sold for 99 without the conversion feature. The straight-line method is used to amortize any premium or discount, as well as bond issue costs. Wagagoostui prepares financial statements in accordance with ASPE.

Instructions

Solution to Exercise 16-2

EXPLANATION: The net book value of bonds payable is removed from the accounts and recorded in appropriate shareholders' equity accounts. A proportionate share of contributed surplus is reclassified to common shares. No gain or loss is recorded.

EXERCISE 16-3

PURPOSE: This exercise will illustrate how to account for convertible preferred shares.

Royal Corporation has 1,000 shares of $50 no par value, 6% convertible preferred shares outstanding at December 31, 2014. Each share was issued in a prior year at $54. The preferred shares are convertible into common shares.

Instructions

Solution to Exercise 16-3

If the preferred shares had been $50 par value and a contributed surplus account was used to record the difference between the par value and the $54 issue price, a proportionate amount of the contributed surplus account would also be closed to common shares.

Note that the journal entry would be the same in both situations. However, financial statements would be updated and would show different numbers of convertible preferred shares and common shares issued under each situation.

EXERCISE 16-4

PURPOSE: This exercise will review the accounting procedures for issuance of debt with detachable warrants.

A new issue of 1,000 bonds was sold at 102.5 on January 1, 2014. Each bond had a face amount of $1,000 and one detachable warrant attached. One warrant allows the holder to purchase 10 common shares at $43 per share. Market price per common share was $46 on January 1, 2014. Shortly after issuance of the bonds and warrants, quotes were 98.5 for a bond ex-warrant and $48 for a common share warrant. A few months later, 800 warrants were exercised. Two years later, the remaining 200 warrants expired. The company prepares its financial statements in accordance with IFRS.

Instructions

Solution to Exercise 16-4

ILLUSTRATION 16-2

Accounting for Stock Option Plans Issued to Employees

Before accounting for stock options issued to employees, it is necessary to determine whether the stock options are compensatory (used to compensate employees for their services provided) or non-compensatory (used to give employees an opportunity to invest in the company or to raise capital). Employee stock option plans (ESOPs) are usually fully or partially paid for by employees and considered non-compensatory. Therefore, stock options under ESOPs increase assets (cash) and increase shareholders' equity (contributed surplus and, if options are exercised, common shares). In contrast, compensatory stock option plans (CSOPs) are considered compensatory and in payment for the employee's services provided. Therefore, the fair value of options granted under CSOPs is recognized as an expense (compensation expense) which is allocated to the periods when the company benefits from the employee's services.

Some factors to consider in determining whether or not a stock option plan is compensatory are as follows:

• Option terms—Non-standard terms giving employees a longer time to enrol and the ability to cancel the option would imply that the options are compensatory.
• Discount from market price—A larger discount would imply that the options are compensatory. Note that non-compensatory plans might also offer options at less than fair value, but the discount would be small and represent savings on issue costs.
• Eligibility—Availability only to certain restricted groups of employees (such as executives) would imply that the options are compensatory.

In accounting for stock option plans that are compensatory, the issues usually revolve around recognition and measurement of compensation expense.

The steps in determining compensation expense are as follows:

1. Total compensation expense is measured by the fair value method. Using the fair value method, total compensation expense is measured at the fair value of the options that are expected to vest (that employees are expected to earn the right to), at the date the options are granted to employees (or grant date), using market prices or an options pricing model.
2. Allocate total compensation expense to one or more periods in which the employees are required to provide services to the company in exchange for the options (often called the service period). The grant or award may specify the service periods, or the service periods may be inferred from the grant terms or from patterns of past grants or awards. Unless otherwise specified, the service period is the vesting period (the time between grant date and vesting date). The vesting date is the date when the employees' right to receive or retain shares or cash under the grant is no longer contingent upon remaining employed by the company.

EXERCISE 16-5

PURPOSE: This exercise will illustrate the application of the fair value method in accounting for a compensatory stock option plan.

Worldwise Corporation granted options for 10,000 common shares to certain executives on January 1, 2014, when the market price was $52 per share. The option price is $44 per share and the options must be exercised between January 1, 2016, and December 31, 2018, after which time they expire. The options state that the related service period is January 1, 2014, to December 31, 2015. An options pricing model determined that, at the date of grant, the estimated fair value of these options was $500,000.

Instructions

Solution to Exercise 16-5

ANALYSIS OF MULTIPLE-CHOICE QUESTIONS

Question

EXPLANATION: Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate due to a change in foreign exchange rates (currency risk), market interest rates (interest rate risk), and/or other market factors (other price risk). Credit risk is the risk that one of the parties to the contract will fail to fulfill its obligation. Liquidity risk is the risk that the company itself will not be able to fulfill its obligation under the contract. (Solution = c.)

Question

EXPLANATION: Bonds payable, accounts receivable, and redeemable/retractable preference shares are examples of primary financial instruments because their value is not derived from an underlying instrument, index, or non-financial item. A forward contract is a derivative financial instrument because its value is derived from an underlying primary instrument, index, or non-financial item—in this case, the market price of the U.S. dollar (versus the contract price). (Solution = b.)

Question

EXPLANATION: In general, derivatives are recognized in financial statements when the entity becomes party to the contract, and are measured at fair value with gains and losses booked through net income. In this case, as at the statement of financial position date, the forward contract may potentially be settled with favourable terms. Therefore, the forward contract is a financial asset as at the statement of financial position date, and should be measured at fair value, resulting in recognition of a gain on the income statement. (Solution = d.)

Question

EXPLANATION: Under IFRS, a purchase commitment contract that has net settlement features (and can be settled on a net basis by paying cash or other assets instead of taking delivery of the underlying product) is not accounted for as a derivative as long as the purchase commitment is expected use (and the company intends to take delivery of the underlying product). In this example, Puree intends to take delivery of and use the apples in its production process; therefore, the purchase commitment should be accounted for as an executory contract and Puree's statement of financial position should not be affected until the apples are delivered (even though the contract has net settlement features). Note that because this purchase commitment contract has net settlement features, if the purchase commitment was not “expected use,” it would generally be accounted for as a derivative and measured at fair value with gains and losses booked through net income. (Solution = c.)

Question

EXPLANATION: Under IFRS, a written call option that is settleable using the entity's own shares is presented as an increase in shareholders' equity if the holder has the right to buy a fixed number of the company's shares for a fixed amount of consideration (called the fixed for fixed principle), and there is no contractual obligation to pay cash or other assets. The terms of Barrie's written call options are consistent with the conditions for application of the fixed for fixed principle; therefore, the written call options should be presented in Barrie's financial statements as an increase in shareholders' equity. (Solution = a.)

Question

EXPLANATION: A dilutive security is a security that would reduce the book value per common share or earnings per share if it was converted to common shares or exercised to purchase common shares. As such, warrants, options, and convertible preferred shares are dilutive since, if they are issued or converted, there would be more common shares outstanding, and therefore a smaller amount of earnings for each of the remaining groups of common shareholders. (Solution = a.)

Question

EXPLANATION: Under IFRS, instruments that have both debt and equity components are required to be bifurcated (split into their debt and equity parts and presented separately in the financial statements) using the residual method with the debt component being measured first (at fair value or present value of future cash flows discounted at the market rate for similar straight debt). Under ASPE, the residual method may be used (with the more easily measurable component being measured first); or the equity component may be measured at $0. (Solution = b.)

Question

EXPLANATION: Recall that under IFRS, instruments that have both debt and equity components are required to be bifurcated (split into their debt and equity parts and presented separately in the financial statements) using the residual method with the debt component being measured first, at fair value or present value of future cash flows discounted at the market rate for similar straight debt. Since the above bonds would have been issued at a discount (99) without the conversion feature, 99 is an estimate of the fair value of the bonds without the conversion feature, and the conversion feature is the reason the bonds were issued at a premium. The journal entry to record issuance would be as follows:

Question

EXPLANATION: When an issuer offers some form of additional consideration (called a “sweetener”) to induce conversion of convertible debt, the consideration is allocated between debt and equity components using the method originally used at the time of issuance (to bifurcate the convertible debt). In most cases, this will be the residual (book value) method, which would require a portion of the consideration to be expensed as a debt retirement cost, with the remainder treated as a capital transaction similar to a redemption cost. (Solution = d.)

Question

EXPLANATION: Reconstruct the journal entry to record conversion. The book value of the bonds is removed from the accounts and recorded in the appropriate shareholders' equity accounts. There is never a gain or loss recognized when the book value method is used to record the conversion of bonds to shares. The journal entry is as follows:

Question

EXPLANATION: Referring to the factors listed in Illustration 16-2, it is evident that the size of the discount from market price of the shares is a factor (the higher the discount, the more likely it is that the plan is compensatory); eligibility is a factor (if the plan is restricted to a group of employees, such as executives, it is likely compensatory); and finally, the option terms are a factor (non-standard terms indicate that the plan is likely compensatory). (Solution = b.)

Question

EXPLANATION: The cost of a CSOP is measured at the grant date at fair value (which is estimated using market prices or a valuation technique such as an options pricing model), and expensed over the service period. The cost should be expensed over the service period since it is the period when the employee is motivated to work harder as a result of the plan. The service period is normally the period between the grant date and vesting date. Any fluctuations in value of the options during the service period are not accounted for by the company; the employee is considered to be the bearer of this risk. (Solution = b.)

Question

EXPLANATION: (1) Calculate total compensation expense. Total compensation expense is $120,000, or fair value of the options determined at the grant date. (2) Determine the service period, or the span of time over which employees are required to provide services to the company in exchange for the options. In this example, the service period is clearly identified as four years starting from grant date: 2014, 2015, 2016, and 2017. (3) Divide total compensation expense ($120,000) by number of years in the service period (four years) to arrive at $30,000 per year. (Solution = b.)

Question

EXPLANATION: Reconstruct the journal entry to record compensation expense for 2014:

Total compensation expense is the fair value of the options determined at the grant date, $6,000 in this case. Total compensation expense is allocated to the periods included in the two-year service period ($6,000 ÷ 2 = $3,000 per year). (Solution = c.)

Question

EXPLANATION: The main feature of a share appreciation rights (SARs) plan (or phantom stock option plan) is that the employee is entitled to participate in the increases in value of the company's shares without actually having to buy the shares. (Solution = a.)

Question

EXPLANATION: While it is usually best to pay off debt, it is presumed that the company is unable to do this. This presumption would also exclude the possibility of lending money at a floating interest rate. The most common method of managing interest rate risk is to enter into an interest rate swap contract. Recall that any company that has long-term debt will be exposed to interest rate risk. Those with fixed rate debt face the risk that market interest rates will go down, and those with floating rate debt face the risk that market interest rates will go up. (Solution = d.)

Question

EXPLANATION: In an interest rate swap contract, no principal amount is exchanged between the parties. Rather, each party pays the other party's interest rate based on the agreed notional principal. Therefore, Thériault-Morin Corporation pays the market interest rate (instead of its own fixed rate) on $100,000 of its long-term debt, and pays its own fixed rate (7%) on the remainder of its long-term debt. Interest expense totals $36,000: $400,000 × 7% plus $100,000 × 8%. (Solution = d.)

Question

EXPLANATION: The interest rate swap contract is a derivative and would be recorded on the statement of financial position (in this case, as a liability) at fair value. (Solution = c.)