IAS 32 Financial Instruments Presentation | IFRS Lectures | ACCA Exam | International Accounting

Summary

Professor Farhad introduces IFRS 32, focusing on financial instruments and their presentation. He defines financial assets, liabilities, and equity, explaining their characteristics and differences. The session covers the basics of financial instruments, including contracts that give rights to receive cash or exchange financial assets and liabilities. The professor also discusses the classification of financial instruments as liabilities or equity, highlighting the importance of understanding contractual obligations. Examples of financial liabilities and equity instruments are provided, with an emphasis on the distinction between the two for proper accounting treatment.

Takeaways

• 📚 The session focuses on IFRS 32, which deals with the presentation of financial instruments.
• 🔗 Professor Farhad reminds viewers to connect with him on various platforms like YouTube, Instagram, and Facebook for more accounting, auditing, and tax lectures.
• 🎓 The topic of financial instruments is briefly covered in the CPA and ACCA exams.
• 💻 The instructor's website offers donations to support the channel and promotional offers for study materials like Becker's courses with $1,000 off.
• 📈 Becker's course provides extensive study materials including over 10,000 multiple-choice questions and exercises for CPA exam preparation.
• 📝 The definition of a financial instrument according to IFRS 32 is a contract that gives rise to both a financial asset for one entity and a financial liability or equity for another.
• 💼 Financial assets include cash, contracts that give the right to receive cash or another financial asset, and equity instruments like stocks in another entity.
• 📉 Financial liabilities are contractual obligations to deliver cash or another financial asset, and can include bonds, loans, and other debt instruments.
• 🏢 Equity instruments represent a residual interest in the assets of an entity after deducting liabilities, but do not include instruments accounted for under the equity method or consolidated method.
• 🔑 The distinction between financial liabilities and equity instruments can depend on the contractual terms and whether the instrument can be settled in the entity's own equity.
• 🔄 Compound financial instruments, such as convertible bonds, have features of both equity and liability and require split accounting to separately report the two components.

Q & A

What is the main focus of the session presented by Professor Farhad?

The main focus of the session is IFRS 32, which deals with financial instruments and their presentation.

What does IFRS 32 define as a financial instrument?

IFRS 32 defines a financial instrument as any contract that gives rise to both a financial asset of one entity and a financial liability or equity of another entity.

What are the different types of financial assets mentioned in the script?

The different types of financial assets mentioned include cash, a contract that gives the right to receive cash or another financial asset (like debt instruments), a contractual right to exchange financial assets or liabilities under favorable conditions (like call and put options), and equity instruments.

What is the definition of a financial liability according to the script?

A financial liability is a contractual obligation to deliver cash or another financial asset to another entity, or to exchange financial assets or liabilities under potentially unfavorable conditions.

What is the difference between equity method and the consolidated method in accounting for equity instruments?

The equity method is used when there is significant influence (usually when ownership is between 20% and 50%), while the consolidated method is used when there is control (usually when ownership is more than 50%).

How does the script define an equity instrument?

An equity instrument is defined as any contract that evidences a residual interest in the assets of an entity after deducting its liabilities.

What is the significance of the Federal Reserve Bank interest rate in the example of preferred stock?

The Federal Reserve Bank interest rate is significant because if it rises above 5%, it triggers a contingency that allows the preferred stockholders to redeem their shares at par value, making it a financial liability for the company.

What is a compound financial instrument and how is it accounted for?

A compound financial instrument is one that has features of both an equity and a liability. It should be split into its liability and equity components and accounted for separately using methods such as the with-and-without method or the incremental method.

What is the purpose of issuing convertible bonds from the issuer's perspective?

The purpose of issuing convertible bonds is to allow the company to pay a lower interest rate than they would have to pay without the conversion feature, potentially attracting more investors and giving them the option to convert the bond into common stock.

How is the fair value of a convertible bond determined in the script's example?

The fair value of a convertible bond is determined by comparing the bond's issue price to the present value of its principal and interest payments, using the market interest rate for similar bonds without the conversion feature.

What is the journal entry for issuing a convertible bond according to the script?

The journal entry for issuing a convertible bond would debit cash for the total issue price, credit bonds payable for the fair value of the liability component, and credit the remainder to additional paid-in capital for the equity component.

Outlines

00:00

📚 Introduction to IFRS 32 and Financial Instruments

Professor Farhad introduces the session focused on IFRS 32, which pertains to financial instruments and their presentation. He emphasizes the importance of this topic in international accounting courses and CPA and ACCA exams. The professor also encourages viewers to connect with him on various platforms, subscribe to his YouTube channel, and take advantage of premium offers on his website, such as Becker's $1,000 discount on their courses. He outlines the basic definition of financial instruments, distinguishing between financial assets, liabilities, and equity instruments, using examples like bonds and stocks to illustrate the concepts.

05:09

🏦 Equity Instruments and Their Accounting Treatment

The paragraph delves into the specifics of equity instruments, explaining how they represent a residual interest in an entity's assets after liabilities are deducted. It discusses the accounting for investments in equity instruments, particularly when the ownership percentage influences the accounting method used, such as the equity method for significant influence (20-50% ownership) and consolidation for controlling interests (over 50%). The professor clarifies that equity instruments discussed in this session are those with less than significant influence, typically considered as passive investments or marketable securities.

10:10

📘 Understanding Financial Liabilities and Their Examples

This section provides a comprehensive explanation of financial liabilities, which are contractual obligations to deliver cash or other financial assets. Examples include payables, loans, bonds, and other debt instruments. The professor illustrates how the issuance of bonds results in a financial liability for the issuer and a financial asset for the bondholder. The paragraph also touches on the distinction between financial liabilities and equity, emphasizing the importance of contractual obligations in classification.

15:11

🔄 Classifying Equity vs. Liability in Financial Instruments

The professor explores the complexities of classifying financial instruments as either equity or liability, highlighting that some instruments may have features of both. He uses the example of preferred stocks that are redeemable or contingently redeemable, which under certain conditions should be classified as liabilities. The paragraph explains the importance of understanding the contractual terms and the substance of the arrangement to determine the correct classification.

20:11

🔄 Compound Financial Instruments: Split Accounting

The session continues with a discussion on compound financial instruments, which contain elements of both equity and liability. A convertible bond is used as a prime example, where the bond has a liability component (the obligation to pay interest and principal) and an equity component (the option to convert into common stock). The professor explains the split accounting method, which involves determining the fair value of each component and allocating the initial carrying amount accordingly.

25:11

📊 Valuation and Accounting for Convertible Bonds

This paragraph focuses on the practical application of accounting for convertible bonds, including the process of valuation using the with-and-without method to separate the liability and equity components. An example is provided where the Sharma Corporation issues convertible bonds, and the professor demonstrates how to calculate the fair value of the bond without the conversion feature and the resulting journal entries under different GAAP standards.

📝 Conclusion and Further Study Recommendations

In the concluding paragraph, the professor offers guidance for those who find the topic of bonds and their accounting complex, recommending further study in intermediate accounting, particularly chapters on bond computation and the time value of money. He invites questions and encourages donations to support the educational channel, wishing students well in their ACCA or CPA exam preparations.

Keywords

💡IFRS 32

IFRS 32, or International Financial Reporting Standard 32, pertains to the presentation of financial instruments in financial statements. In the video, it is the central topic being discussed, with the professor aiming to clarify what constitutes a financial asset, liability, and equity instrument under this standard. The script mentions that it is covered briefly in the CPA exam, indicating its importance in the field of accounting.

💡Financial Instrument

A financial instrument, as defined by the script, is any contract that gives rise to both a financial asset for one entity and a financial liability or equity for another. This concept is fundamental to understanding the video's theme, as it sets the stage for the discussion on how these instruments are accounted for under IFRS 32.

💡Financial Asset

A financial asset is defined in the script as any asset that gives an entity the right to receive cash or another financial asset. It is a key concept in the video, as the professor explains different types of financial assets, such as cash, debt investments, and equity instruments, using examples like buying a bond or an equity investment in Amazon.

💡Equity Instrument

An equity instrument is a type of financial asset that represents a residual interest in the assets of an entity after deducting its liabilities. In the video, the professor clarifies that equity instruments do not include investments accounted for using the equity method or consolidated method, and provides examples like purchasing stocks in another entity.

💡Financial Liability

A financial liability is a contractual obligation to deliver cash or another financial asset. The script explains that it is the opposite of a financial asset, where one entity's liability is another entity's asset. Examples given include issuing bonds, which creates a liability for the issuer and an asset for the bondholder.

💡Equity Method

The equity method is an accounting technique used when an investor has significant influence over an investee, typically owning between 20% and 50% of the investee's shares. The script mentions that investments accounted for using the equity method fall outside the scope of IFRS 32, which is an important distinction in financial reporting.

💡Consolidation

Consolidation in the context of the script refers to the accounting practice where an entity that owns more than 50% of another company's shares includes the subsidiary's financial statements within its own. This is mentioned as a method that does not fall under the scope of IFRS 32, contrasting with the financial instruments discussed in the video.

💡Convertible Bond

A convertible bond is a type of compound financial instrument that has both debt and equity features. The script uses this as an example to explain split accounting, where the bond's liability component and equity component are accounted for separately. This is a crucial concept in understanding the complexities of financial instruments under IFRS 32.

💡Compound Financial Instrument

A compound financial instrument is one that contains both equity and liability elements. The script discusses how these need to be split and accounted for separately, using the example of a convertible bond, which has a bond component (liability) and a conversion option component (equity).

💡Split Accounting

Split accounting is the process of separating the components of a compound financial instrument into their respective equity and liability parts. The script explains this concept through the example of issuing a convertible bond, where the initial carrying amount of each component is determined using the with-and-without method.

💡Time Value of Money

The time value of money is a fundamental concept in finance, which the script mentions as essential for understanding computations related to financial instruments, such as bonds. The professor suggests revisiting this concept if the computations in the video are confusing, highlighting its importance in accounting and finance.

Highlights

Introduction to IFRS 32, focusing on financial instruments and their presentation.

Brief overview of how IFRS 32 is covered in CPA and ACCA exams.

Encouragement for viewers to subscribe and engage with the channel on social media.

Details on premium accounting, auditing, and tax lectures available on Gumroad.

Information on Becker's current offer of $1,000 off and its unlimited course access.

Explanation of financial instruments as contracts that give rise to financial assets and liabilities.

Definition and examples of financial assets, including cash, debt instruments, and equity instruments.

Clarification on the difference between passive investments and significant influence in equity method accounting.

Discussion on the classification of financial liabilities, including contractual obligations to deliver cash or other assets.

Examples of financial liabilities such as loans, bonds, and written put options.

Equity instruments defined as contracts evidencing a residual interest in an entity's assets after liabilities are deducted.

Exclusion of insurance contracts and employee benefit plans from the scope of IFRS 32.

Differentiation between equity and liabilities based on contractual obligations.

Accounting treatment of compound financial instruments, such as convertible bonds, which contain both equity and liability elements.

The split accounting method for compound financial instruments, including the with-and-without method.

Incremental method under US GAAP for compound financial instruments, contrasting with IFRS.

Example of Sharma Corporation's issuance of convertible bonds and the accounting for both liability and equity components.

Importance of understanding the time value of money for accounting students, especially in the context of bonds.

Transcripts

hello and welcome to the session this is

Professor Farhad in this session we're

going to be looking at IFRS 32 which is

financial instrument and specifically

presentation

thus topic is covered in international

accounting course a CPA exam very brief

very briefly in the ACCA exam as always

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for the whole thing you can buy it and

pieces whatever you need to have so

today we're gonna focus on IAS 32 which

is financial instrument presentation so

what is that well I have IFAs 32 define

basically some very specific it defines

a financial instrument as any contract

that give the that gives rise to both a

financial asset of one entity and a

financial

liability or equity of another entity

that's all what it does oh we're gonna

be learning today is in a sense basic

definition of those fine what are they

what are financial assets what are they

financial what are financial liabilities

were not gonna look at recognition would

not gonna look at how we measured them

we're not gonna look at how do its

disclose them are we gonna do that

obviously yes but in a separate

recording and a separate and a separate

IFRS section but today we're only gonna

have to learn what is a financial asset

so if I say it this is a financial asset

in the in the following session you know

what a financial asset is okay what if I

said a financial liability order and

order an equity instrument so what is a

financial asset financial asset is

defined it as in any any asset that's

obviously cash cash as a financial asset

which we off we are all familiar with

cash that's easy a contract right a

contractual right not a contract right a

contractual right what is a contractual

right well you have the right to receive

financial another financial asset when

do you have the right to receive another

financial asset well guess what if you

buy a debt instrument if you buy a debt

investment what is it that investment

when you buy a bond when you buy a bond

you credit cash $100,000 and you debit

some sort of a debt investment so that

investment is basically you bought a

bond you bought a bond debt investment

let's assume $100,000 okay what happened

is you bought a bond by buying a bond

that's gonna give you the right to

receive cash what type of cash interests

and also it's gonna give you the right

to receive the principal amount same

thing if you lend money notes receivable

the feud if you lend money $100,000 you

will debit notes receivable basically

the same concept also a contractual

right that it to give you the right to

exchange a financial asset or a

financial liability under favorable

condition here we are talking about call

option input option what our call option

and put option co-option gives you the

right to buy an asset to buy a stock an

equity at a certain price and put option

gives you the right

don't worry about coal simple were gonna

call send pull option we're gonna cover

them in a separate recording and

separate chapter we're gonna talk a lot

about them but this is what the

definition of a financial asset is also

an equity instrument basically what is

an equity instrument an equity

instrument basically a stock basically

an investment of another entity so

basically you bought a stock and another

entity so let me just show you let's

assume you have $100,000 you bought an

equity investment in Amazon AM Z and

Amazon that's their stock symbol so you

debit 100,000 and you credit cash

100,000 so that's also a financial asset

and equity instrument it's a financial

asset that you purchase you purchase

okay a contract that will may or may not

be settled in the entity's own equity

instrument and it's not classified as an

equity instrument of the entity so it's

not your equity instrument you are not

Amazon you purchase you happen to have

some extra cash and you decided you know

what I'm not gonna keep that extra cash

in the bank

I'm gonna go ahead and buy an equity

instrument what is that equity

instrument stocks and Amazon stocks and

Amazon now now we have to be very

careful when we talk about equity

instrument because depending on how much

you buy of that equity instrument

determine how you account for it

for example investment and equity

instrument that are accounted took for

under the equity method or the

consolidated method would not fall under

the scope of is 32 or IFL IFRS 9 which

is we did not talk about IFRS 9 but it

doesn't fall under the scope of IRS IFRS

9

what is the equity method and what's the

consolidated method well it all depends

how many how many how much is your

investment in that particular company

let me show you on a timeline what we

are looking at this is zero and this is

100% of the company as long as you buy

less than 20

percent you are considered to have

what's called a passive interests

passive interest means really have no

say in the company you're a passive

investor therefore you would use what I

just showed you here this is an equity

instrument once you have more than

twenty up to fifty percent once you fall

it within this range once you fall

within this range so you have more than

twenty percent equity but you're still

less than fifty then you are considered

to be using the equity well they are

considered to have significant influence

let's use the term significant influence

it means you have some influence over

the company significant influence under

those circumstances you have to use a

method called B equity method you have

to use the equity method once you have

more than 50 percent once you own more

than 50 percent of a particular company

more than 50 percent then you have to

use the consolidation consolidate

consolidate the subsidiary okay so what

does that mean it means when we're

defining the financial instrument here

we are assuming you own less than 20

percent so only those investment and

equity that result in less than

significant influence over the other

entity sometimes they're labeled as

marketable securities are accounted for

in in accordance with IAS 32 and IFRS 9

which is again don't worry about IFRS 9

okay

so we're dealing with stocks you own the

stocks but it's less than 20 percent

what are we talking about this now

you're gonna see in the next session

when we try to recognize them and

measure them we have to know what type

of assets are we dealing with okay

that's very important so those what

those are that's what a financial asset

is let's talk about a financial

liability well a financial liability is

a contractual obligation to deliver cash

or other financial asset think about

when you sell a bond when you sell a

bond when you raise money using bonds

guess what you're gonna have to pay

interest you're gonna have to transfer

or deliver cash to an to another party

for example the financial asset holder

is the financial asset holder

would receive the cash you would have a

financial liability why because now you

need to pay the cash so to notice of

notice maybe maybe this is this this is

interesting

notice financial liability it's gonna

ask you to deliver cash to or another

financial asset the let me just erase

this and highlight highlight financial

asset just show you it's kind of the

opposite of it if you look at financial

asset the definition of financial asset

it's the right to receive cash from from

another entity notice so one company

could have a financial liability the

other side will be defining the

financial asset okay or to exchange

financial asset or financial liabilities

under potentially unfavorable condition

again here here we're talking about

Kohl's an option but you might get it in

those calls and options okay also a

contract that will that will or maybe

settle in the entity own equity

instruments or sometimes you have to pay

off your liability using your own equity

instrument in other words you have a

debt you have a bond but what's gonna

end up happening is you're gonna pay off

that bond may be issuing some equity

instruments your own equity incident

that means it means your own company

stocks so you would exchange the bond

with with stocks that's what we are

talking about here example of financial

liabilities include payables payables

loans from other entities when you

borrow money you have a notes payable

when you borrow money you have a notes

payable notice the lender will have a

financial asset you will have a

financial liability the lender will have

a financial asset you will have a

financial liability issue bonds again

you issue the bond you have a financial

liability the person that buys the bond

will have a financial asset because they

have an investment in you other debt

instrument an obligation to deliver an

entity own share for a fixed amount of

cash again any debt that you're gonna

have to deliver stocks for which kind of

convertible that that's a financial

liability written put option when you

write a put option when you are

responsible for buying that put option

those who are financial liability equity

instruments were

equity instrument equity instruments are

defined as any contract that evidence a

residual interest in the asset and the

asset of an entity after deducting its

liability that's what an equity

instrument is but equity instruments one

that you know what does not include it

does not include which we talked about

this in addition to subsidiaries and

equity method investi so we talked about

subsidiaries and equity method invested

is's will you own 50% Plus this is where

you own between 50 2250 2250 used used

those method the following rx occluded

from the scope of is 32 insurance

contract that's not considered an equity

instrument and employers write an

obligation under employee pension plan

which is benefit plan which is a pension

that's not included we looked at this in

a separate recording shared base paid

share based payment program again we

looked at share base basement program

that's not equity instrument transaction

and the entity's own equity instruments

such as Treasury stock those are not

considered equity instrument okay now

let's take a look at some time what do

you have a liability or an equity so

some time you have an instrument and it

has the feature of a liability in

features of equity well let's talk about

a little bit about what is a liability

and what is in equity when we take when

we say liability it means you have that

what does that implies that implies you

have to pay back the money okay

so if you if I lend you money if I gave

you money

that's just I gave you money so there we

go you have two individuals okay this is

one and this is still I gave you money

and you gave me in return and instrument

now I don't know what what that

instrument is but we have a deal between

us and the deal says you're gonna pay me

I gave you money I gave you $100,000 and

here's what's gonna happen

you're gonna be paying me back making

payment making payments now you did not

define the payment I can't call those

payment interests I can't call those

payment dividend okay because I gave you

the money but we really did not define

the term whether its interest or

dividend but here's what's gonna happen

we

you told me in addition to the interest

and the payment you're gonna pay me back

this money $100,000 ten years from now

well guess what if you pay back the

money if you're gonna be paying me back

the money we have a loan we have a

liability okay but let's assume we're

not gonna pay me back the money I gave

you the money and you're gonna be

receiving interest and dividend and and

what's gonna happen is I'm gonna give

you some equity interest I'm gonna I'm

gonna let you vote I'm gonna let you

have a decision in my company then what

I have is an equity okay so the point is

you have to know what is the contractual

obligation here so you have to read the

agreement something if it's not clear to

determine whether we are dealing with an

equity instrument or a liability

insurance so I asked 30 to require

financial instrument to be classified as

financial liabilities am i buying at

that am i investing in that or am i

investing in equity or both in

accordance with or both or is it both

it's an equity and liability which we'll

see some some some instrument will be

both we have to look at the substance of

the contractual a great arrangement and

the definition of the financial

liability and equity if an equity

instrument contain a contractual

obligation that meets the definition of

a financial liability it means you'd

call in it it you'd call in it an equity

but it's not really in equity because

you have to give me back the money then

it should be classified as a liability

you might call something stocks like to

preferred stocks well guess what that

sounds like stock that sounds like

equity but if you said this is a

preferred stock and gonna give you back

your money

then it's not a preferred stock you

basically I gave you alone therefore

that's a liability even though it's

legal for is that of an equity

instrument so if it sounds if it sounds

like a liability but you call it equity

it's a liability okay for example if an

entity issue prefer chairs that are

redeemable redeemable means the

shareholder can come back at any time

and get their money back and the entity

cannot avoid the payment of the cash to

shareholder and the company cannot say

well am I gonna pay you back okay if

they redeem them you have no option you

have to give them back their money then

what you're looking at is a liability

not equity although you call them prefer

that well stock is equity but if I can

go back and ask you back for my money

it's not it's not equity anymore prefer

chairs are contingently redeemable based

on future event outside the control of

either the issue or the shareholder also

would be classified as a financial

liability sometime it's it's it's a

preferred stock but what happened is

it's redeemable if something happened so

if something happened I have I have the

right to go back and get my money back

well guess what

that's not stocks this is not how stocks

work this is not how equity work equity

basically once you make that investment

that's your investment you can't go back

to the mat you go back to the company

said I want my money back because you

did not lend them the money if a

preferred stock is contingently

redeemable contingently means if

something happened what could be an

example let's assume your stock price

your common stock price reaches a

certain number okay or falls below a

number or your retained earning false

above a number or below a number it's a

contingent upon something happening then

I can go back and get my money guess

what we're not looking at an equity

anymore this sounds like a liability so

if it sounds you can get your money back

it's a liability it's alone let's take a

look at an example to see how the Swart

on October 29th year one this company

issued 1 million five percent preferred

stock preferred shares at par value okay

the preferred shares have a right to

force the company to redeem the sheer at

par value so guess what you you well it

there's even a contingency if the

Federal Reserve Bank interest rate rise

above five percent to be more specific

so this is the contingency so the

company they have to buy it back from

you if the Federal Reserve Bank and tris

rise above five percent this is what a

contingent liability is well guess what

if it's contingent guess what is this a

stock or is this the death knell well

guess what now it said that why because

there is a contingency to remove - to

pay it back on December 10th the year 3

the Federal Reserve interest reaches

that level because a future event that

triggered redemption of the preferred

stock is outside the control of both the

company and the shareholder the 5%

preferred shares must be classified as a

liability therefore they will debit cash

a million and they will credit

redeemable preferred chair

a million okay under US GAAP it's

treated differently the preferred Cheers

initially would be classified as equity

then on December 10th year 3 what is

December 10th yeah what's December 10th

here 3 December 10th year 3 is when the

Federal Reserve raised the interest rate

to 5%

once that happened then we would

reclassify the liability so first under

US GAAP it will be a preferred stock so

you will debit cash under US GAAP you

have it cash and you will credit

preferred stock for the million then on

December 10th you will debit preferred

stock for a million and create a

liability why do you create a liability

because now it's a liability it's no

longer equity you have to take it out of

the preferred stock and put it into a

liability a bond or whatever you want to

call it whatever liability what I call

it I just call it a liability okay so

this is whenever you have either a

inequity or a liability this is how US

GAAP treated some time what we're gonna

have is a compound financial instrument

what's a compound financial instrument

it's a financial instrument that had the

future both of an equity and a liability

so we're looking at something that has

the feature of both well it has the

feature of an equity and it has a

feature of a liability what are we

looking at what are we looking at well

we're looking at for example convertible

bond okay compound financial instrument

can contain both alive out of the

element and an equity element should be

split between the two component that are

reported separately so now here what's

gonna happen is we have two instruments

although it's one contract although it's

one financial instrument but we really

have two things to account for this this

is what we call split accounting

convertible bond is a classic example

from it from a for a for a compound

financial instrument from the from the

issuers perspective the bond is

comprised of two components so when a

company sells a convertible bond guess

what they're selling you a contractual

obligation to make cash payment of

interest and principle as long as the

bond is not converted well guess what

they've given you a bond and they have

to pay you cash for the entry

and they have to pay you back your money

this sounds like a financial liability

that's a good that's that's part of the

bond the second part of it it has a cool

option that grant the bondholders right

to convert the bond into a fixed number

of common stock well this is an equity

instrument this is an equity instrument

hold on

so what is it is it that or asset

liability it's both it has the feature

it has the feature of both it has a bond

it's a bond you have to pick make

interest payment but also it has a call

option comes with it

okay under the split accounting the

initial carrying amount of the liability

and the equity are determined using what

we called with and without method so we

have to do as we act when we sell the

bond we're gonna get one price okay when

we sell the bond when we sell the

convertible bond when the company would

receive one price so they have to

determine how much of that money is for

the bond and how much that money is for

the call option for the equity component

the business it's an instrument that

it's a compound financial instrument

that has both it has a bond and the

liability not either or it has both okay

so the fair value of the financial

instrument with conversion feature is

determined so basically we'll try to

determine what is the fair value of the

whole of the whole deal so let's assume

for the whole deal here we said this is

I'm just gonna make up this number five

million dollars okay so so we sold the

bond at five million dollars and that

include the bond feature and the equity

feature then we'll try to determine the

fair value of the financial instrument

without the conversion feature then we

say okay if the whole thing is five

million dollar we're gonna will find the

we're gonna find the fair value of the

equity and we say the value of the

equity is two hundred thousand so we're

gonna subtract two hundred thousand from

the equity for the equity component so

we say the equity component is worth two

hundred thousand well guess what then

the bond is 4.8 million then the bomb

value is four point eight million so we

we take out the difference the

difference between the fair value of the

instrument as a whole and the amount

separately determined for the liability

component allocated to the equity

component well the two hundred thousand

as allocated to the equity we take it

out what's left for the bond

for the liability or the bond whatever

you want to call it liability or bond is

4.8 million this is what we do now an

under US GAAP we have the incremental

method we can use something called the

incremental method or the proportional

method similar but not the same okay

note that a compound financial

instrument is a financial asset for the

holder of the instrument so a few Bordas

okay if you bought this instrument if

you bought a convertible bond you have a

financial asset the company that issued

it will have a financial liability as I

told you what's financial asset for one

party is a financial liability for the

other let's take a look at an example to

see how this all worked Sharma

corporation issued two million 4%

convertible bond notice its convertible

the bond has a five year life with

interest payable annually so so far so

good

each bond has a face value of $1,000 and

s convert is converted at any time up to

maturity for 250 shares of common stock

so the bond holder bought the bond okay

but guess what this one is great why

because if the company is doing really

well you can convert the bond you can

convert each bond for shares that's a

convertible bond so it has a bond it has

a liability feature I'm gonna get my

interest then the company said look if

you like to switch themes and go from

being a lender to an owner we can get we

you do have that right we have you have

that convertible right now you might be

saying why would the company do so why

would the company sell a bond that gives

you the right to convert well guess what

when you sell a bond and the company

have tried to convert the bond it's

gonna the company will pay lower

interests in other words they're givin

you an additional feature so the company

don't have to pay a high interest so

here what they pay in is 4% maybe

without the feature they might have to

pay 8% or 7% so what they say they say

we'll pay you four percent anyway you

might you might tell them this is too

low I'm not gonna buy your bond well I'm

gonna pay you four percent and I'm gonna

tell you this bond is convertible

anytime you would like to convert it you

can't convert it well that's that's a

good feature then now I might accept the

4% okay at the date of the issue the

interest rates were similar that without

conversion is 6% there you go

so if that

the FDA if the convertible feature did

not exist if the convertible feature

does not exist for the spawn the company

would have to pay 6% rather than 4% okay

now we have to find because we have both

a debt and equity we have to find how

much of the bond is that and how much of

it is equity now what do we do well we

know the bond should have a 6% interest

rate so what we're saying is the bond

should earn interest rate at 6% then we

have to find the fair value of the bond

that we sold at 2 million well if we

sold the bond at 2 million okay we're

gonna have to find the price of the bond

to find the price of the bond you have

to discount the 2 million you have to

discount the principal and you have to

discount the payment let me show you the

computation okay we're gonna take the

principal amount and this is how we find

the price of the bond multiplied by the

present value factor point seven four

seven three five periods interest rate

equal to 6% we use the interest rate

that the market that the interest rate

for similar bond will paying so the bond

is worth the face value of the bond is

worth 1 million four hundred ninety four

thousand five sixteen then we have to

find the payment on that bond the

payment is eighty thousand why eighty

thousand because the bond is two million

dollar and paying eight percent times

with interest payable annually

I'm sorry paying four percent eight

percent times four percent so every year

the bond pays eighty thousand and this

is gonna be five payments we're gonna

make five payments on this bond why cuz

it's five years therefore when we go to

the present value annuity table we use

an equal to five and we always use the

market rate 6% therefore we discount the

eighty thousand had that factor

therefore the bond by itself so remember

we have the bond and the call option the

bond by itself the fair value of the

liability is 1 million eight hundred

thirty one thousand five fifteen this is

the bond the bond on its own

on its own let me go back to that

example here let me go back to that

example here and show you the picture so

what happened here let me erase

everything then show you on the picture

what does it look like

so we're saying what we saying is we

receive 2 million for the whole thing

then we determine the value of the bound

the value of the bond was 1 million

eight hundred thirty one thousand 505

based on the present value of the

principal based on the present value of

the payment now if you don't know how to

do this computation well you're gonna

have to you know go to my intermediate

accounting bond bond the bond

computation which is chapter fourteen

and in my intermediate accounting if you

don't know how to do this so what's left

for the for the other section is one

sixty eight four ninety five so this is

1 million eight hundred thirty one

thousand 505 and the equity portion is

worth one hundred sixty eight thousand

four ninety five so we know the total

and we know the bond sometimes we know

the total and we can know the equity

okay good now we know the bond now let's

take a look at the journal entry the

journal entry the company will debit

cash two million they will credit bonds

payable for 1 million eight hundred

thirty one thousand five or five and

remainder will go to additional paid-in

capital now under US GAAP the entry

would look little bit different okay

because we might have a discount you

might have a premium but this is

basically it's just an idea to help you

move on to understand the compound

financial instrument okay now if you

have any issues with bond okay any

issues with bond like yeah I really

don't understand bond especially if he

if this is if this was confusing to you

this this computation here was confusing

to you what I did here well over for

what I did here is confusing go to

chapter fourteen intermediate accounting

okay now if you feel that this those

factors was this coming from point seven

seven four seven three those are

intimidating to me I don't I don't

understand how it works then go to my

intermediate accounting chapter

six chapter six stop talks about

discusses the time value of money which

is I have three four hours of lectures

and examples and if you don't know how

the time value of money work then you

should not be in accounting okay or you

should not be studying accounting or you

should go back learning time value of

money because we're gonna see this

concept in pent and leases and pension

and bonds and anything and everything

okay why because the time value of money

is an important concept if you have any

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