Tag: debt

Presentation of Debt vs Equity in International Financial Reporting Standards

The nature of an instrument is used to determine both its presentation in the statement of financial position and the presentation of related payments or distributions.

In many financing transactions, it is clear that the instrument is either debt or equity, such as common shares or a plain vanilla term loan. However, when the terms differ from the plain vanilla variety the preparer of the financial statements needs to take a closer look to determine the appropriate presentation.

The concept of distinguishing between debt and equity, which is the primary purpose behind International Accounting Standard (IAS) 32, Financial Instruments: Presentation, is often overlooked.

In some cases, what appears to be equity should actually be classified as debt and in other cases the same instrument may contain both debt and equity components (known as hybrid instruments) and each component should be measured and accounted for separately.

The consequences of getting this wrong are clearly significant.

The simplest definition of a financial liability is a contractual obligation to deliver cash or another financial asset to someone else. It also includes a contract that will or may be settled by either: issuing a variable number of the entity’s own equity instruments in exchange for a fixed (meaning non-derivative) obligation; or issuing a fixed number of the entity’s own equity instruments in exchange for a variable (derivative) obligation.

An equity instrument is an instrument that represents an interest in the entity’s residual net assets, which is therefore after deducting all of its liabilities.

Application of this definition can be a thorny exercise. By way of illustration, this article considers some common examples:

Equity that should properly be classified as debt

Some company’s issue instruments that give the holder of the instrument the right to put it back to the issuer for cash or for another financial asset. Such contracts are referred to as puttable instruments. The put is either exercisable at the option of the holder, or is automatically exercised as a result of some future event, such as the death or retirement of the holder.

Consider shares that are held by a member of management, where the shareholder agreement automatically requires the company to repurchase them in the event of the death of the individual. Such a clause is commonly included in shareholder agreements to retain the close ownership of the company by avoiding shares passing to a spouse or other beneficiary of the estate.

The shareholder agreement therefore creates an obligation for the company to deliver cash. The company has no unconditional ability to avoid delivering cash in this case, meaning these shares now meet the definition of a liability. The effect of this treatment is that any dividends paid on those shares are treated as an expense through profit and loss instead of as a distribution out of retained earnings.

Significantly, the instruments are classified as debt even though the triggering event (the death of the holder) has not yet occurred. This could be considered as something of an exception to IAS 10, Events after the Reporting Period, because the actual obligation of the entity to make the payment did not exist at the reporting period.

Instruments that consist of debt and equity components – Hybrid instruments

Many companies issue debt with an added conversion feature which allows the holder to receive a fixed number of shares of the company in settlement of the debt. Such instruments are often used by early stage companies to entice the lender to enter into the financing by also enabling the lender to share in the future growth in the company.

IAS 32 explicitly states that the component parts of a financial instrument must be considered for classification. In this case, the proceeds received are allocated between the liability and the equity components.

Economically, the addition of the conversion feature means the issuer can pay a lower interest rate for the financing because the conversion feature itself has some value to the lender. Therefore, a market interest rate must be identified for a liability instrument that has the same terms (such as maturity, security, and so on) but with no conversion feature. The present value of the cash flows under the convertible instrument discounted with this market interest rate represents the carrying amount of the liability on initial recognition. The difference between this amount and the proceeds received is the equity component. Any costs of issuing the convertible instrument are also allocated between the two components.

Entities without equity instruments and the classification exception

The effect of IAS 32 is, in some cases, to classify all financial instruments as liabilities such that there is no equity presented on the statement of financial position. This can be the case for certain vehicles where the holder of the instrument has the right to put the instrument back to the entity in exchange for cash.

An exception to the definition of a liability exists for puttable instruments and instruments that entitle the holder to a pro rata share of the net assets on a winding up if certain conditions are met.

Controversy Surrounding the Credit Risk of Liabilities and the Counterintuitive Effect on Performance Measures

This article was originally published by Wiley.

1) Do you think that non-performance risk should be considered in the measurement of financial liabilities at fair value through profit or loss?

Note that the standard refers to the credit risk (or non-performance risk) specific to the liability and not to the credit risk of the entity itself, usually referred to as “own credit risk”. Changes in the credit risk of the entity will not necessarily be mirrored by changes in the credit risk of its liabilities, for example, liabilities that are secured by collateral may be unaffected.

IFRS 13 defines the fair value of a liability as the price that would be paid to transfer the liability in an orderly transaction between market participants at a specific date. The standard clarifies that the valuation measurement takes place in the principal market for the liability or in the absence of a principal market, in the most advantageous market.

Applying the definition of fair value from IFRS 13 means the fair value measurement takes into account the effect of non-performance risk related to the liability. There are problems with such an outcome, however, such as: in what sense is there a market or market participant here given that such liabilities are rarely, if ever, traded? These practical problems of measurement are ignored in this response to Global Insights.

Despite the theoretical feel of taking into account the credit risk of the liability in measuring liabilities at fair value, in my opinion, this is the correct accounting in order to reflect an accurate financial position of the entity at a point in time. The alternative would be to exclude this credit risk effect from the carrying amount of the liability, which would effectively be a change in the definition of “fair value” used for financial reporting purposes versus fair value in other valuation applications. Furthermore, as pointed out in the Basis for Conclusions to IFRS 9, paragraph BCZ 5.31(d), such a change would be inconsistent with the measurement of liabilities at initial recognition because the fair value at that point in time reflects the liability’s credit risk.

2) If so do you think that the outcome generated by the accounting for financial liabilities at fair value through profit or loss provides useful information to investors?

Under IFRS® Standards, an entity’s overall performance is measured by comprehensive income, within which entities can use other additional GAAP performance measures. Profit and loss is also a required GAAP performance measure. The International Accounting Standards Board (the Board) has not defined a principle for which items are presented in profit and loss and which are included in other comprehensive income (OCI).

The previous accounting for financial liabilities at fair value through profit and loss under IAS 39, presented the total change in fair value in profit and loss. If the credit risk related to the liability deteriorates then the entity recognizes a reduction in liabilities and an increase to profit/reduction in loss, hence the counterintuitive financial reporting. This is clearly a distortion of profit and loss, a key performance measure under IFRS Standards, which thereby diminishes the usefulness of this measure to investors.

In an earlier round of amendments to IAS 39, the Board attempted to fix this issue, by requiring disclosure of the amount of the fair value change that relates to changes in the credit risk of the liability. It seems ironic that an entity is not permitted to use additional disclosures to rectify a departure from an accounting standard, while the Board took exactly this approach in an attempt to rectify a presentation issue!

Clearly the effect of credit risk on the fair values of liabilities is not relevant to how the entity has performed, as measured by profit and loss, and, if this amount is to be recognized, it should not be included in that measure.

3) Do you think that the solution proposed by the Board of accounting for changes in an entity’s own credit worthiness in other comprehensive income resolves the counterintuitive outcomes generated by the current accounting treatment?

Under IFRS 9, paragraphs 5.7.1(c) and 5.7.7, the change in fair value of a financial instrument liability designated as at fair value through profit and loss attributable to changes in the credit risk of that liability is recognized in OCI. The remaining change in fair value of the liability is recognized in profit and loss, unless that presentation would create or enlarge an accounting mismatch in profit or loss, in which case the entire change in fair value is recognized in profit and loss.

Given the opinion that the statement of financial position should reflect the credit risk specific to liabilities at fair value through profit and loss, there are two alternatives to present the other side of the entry. One is to record the change directly in equity, and the second alternative is to present the change in OCI. The former was considered in the exposure draft on own credit risk in 2010, however, almost all respondents to the draft did not support it and the Board agreed. Therefore inclusion in OCI appears to be the best option remaining.

The IFRS 9 solution is an improvement in financial reporting because the profit and loss performance measure is not distorted. A definitive conclusion with respect to inclusion in OCI is difficult to reach in the absence of clear principles of what, exactly, OCI represents and what the objective of the measure is.

4) Do you think that recycling between OCI and profit or loss for changes in own credit risk is appropriate?  If so, under what circumstances?

The premise behind the “no recycling” rule set out by the Board is that any adjustments will net off to zero once the debt is settled for the contractual consideration at the instrument’s maturity date. The fair value of the debt between initial recognition and maturity is likely to deviate from the contractual liability of the instrument. Therefore such a liability settled at maturity would not give rise to any amount to be recycled from OCI to profit and loss. An amount to be recycled only exists if the liability is settled during the term.

In the event that a liability is settled early, it seems reasonable that the difference that is crystalized should be recycled because it then represents a realized gain or loss. This view arises from the opinion that OCI represents recognized but unrealised gains and losses that should be moved to profit and loss when realized. The Board took issue with this approach on the grounds of a comparison with investments in equity instruments measured at fair value with changes presented in OCI for which recycling is prohibited.

Related to the lack of a principal behind OCI, there is no clearly defined principal as to what items should be recycled and which should not. Some clarity around this topic would help to achieve a consistent treatment that is justified on theoretical grounds. The IASB has included a requirement to disclose the amount of accumulated OCI that has been realized during the period. In addition, IFRS 9 gives an entity the option to transfer the accumulated gain or loss within equity in the event of an early settlement.

5) Do you think own credit risk is specific to financial liabilities measured at fair value through profit or loss or should IFRS® Standards provide clearer guidance on the role of own credit risk in other standards such as the ones dealing with insurance contracts or provisions?

Insurance contract accounting is the subject of an ongoing project. Therefore, in answering this question, only provisions have been considered.

Paragraph 47 of IAS 37, states that the discount rate to be used should reflect the current market assessment of the risks specific to the liability, in addition to the time value of money. This is consistent with the requirement in paragraph 37 of that standard of measuring the liability as the best estimate of the expenditure required to settle the present obligation at the end of the reporting period or to transfer it to a third party at that time.

The practice in the Canadian market is to exclude the effect of changes in own credit risk related to the entity itself when measuring provisions. This is consistent with the measurement of financial liabilities at fair value through profit and loss under IFRS 9. The accounting treatment of the change related to the change in credit risk of the liability is not consistent because there is no requirement under IAS 37 to recognize that amount through OCI. The nature of these two types of liability does not appear to justify different treatment on the comprehensive income side of the entry. This inconsistency warrants attention by the Board as part of a project on OCI.