Lots of companies raise finance – for example, to either start up in business or fund expansion plans or to raise working capital requirements.
When a company raises finance it enters into a ‘financial instrument’ which is accounted for under FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland using Section 11 Basic Financial Instruments or Section 12 Other Financial Instruments Issues.
Section 22 Liabilities and Equity is closely related to Sections 11 and 12 of FRS 102. Section 22 outlines the requirements in classifying financial instruments as either a financial liability (i.e. debt) or as equity. It also deals with the issue of ‘compound financial instruments’ (an instrument which contains a mix of debt and equity) and are defined in the Glossary to FRS 102 as:
‘A financial instrument that, from the issuer’s perspective, contains both a liability and an equity element.’
In many cases, debt will be treated as a liability in the balance sheet of a company, but this is not always the case. The overriding principle in Section 22 is that where the issuer (the borrower) does not have an unconditional right to avoid settling a debt in cash, or by giving up another form of financial asset, and the contract does not, in substance, evidence a residual interest in the net assets of the issuer (the lender) after deducting all of its liabilities, the financial instrument is classified as a financial liability.
So what does this mean in layman’s terms? Effectively, where a borrower has an obligation to part with cash or other assets in either complying with the terms of the financial instrument, such as paying the lender interest; or by way of redemption at some point in the future, the contract is a financial liability. So whenever there is a contractual obligation on the part of the borrower to pay cash or settle an obligation by parting with another asset, a liability is recognised. The classic instrument usually cited in such an example is a preference share. Usually preference shares entitle the owner to receive dividends, whereas ordinary shareholders receive dividends at the discretion of the company.
A financial instrument is classified as equity when it fails to meet the definition of a financial liability (i.e. there is no obligation on the part of the company to deliver cash or other financial assets to the third party). The key requirement is to consider whether there is an unconditional ability to avoid delivering cash or other assets.
Equity instruments issued prior to payment being received
Paragraph 22.47(a) of IFRS for SMEs says:
‘If the equity instruments are issued before the entity receives the cash or other resources, the entity shall present the amount receivable as an offset to equity in its statement of financial position, not as an asset.’
FRS 102 does not reflect the same provisions as paragraph 22.47(a) of IFRS for SMEs on the grounds that offsetting the debtor (receivable) against equity would be inconsistent with UK company law.
Equity instruments subscribed for but not issued
Paragraph 22.7(c) says that when equity instruments have been subscribed for but not issued (or called up), and the entity has not received the cash or other resources to pay for the shares, no increase in equity is recognised. Care needs to be taken to ensure that any increases in equity are accounted for at the appropriate time – the shares would need to be issued (or called up) prior to increasing equity in the balance sheet.
Convertible debt or similar ‘compound financial instruments’ are dealt with in FRS 102 (September 2015) at paragraphs 22.13 to 22.15. There is also an appendix to Sectrh45ion 22 providing an example of the issuer’s accounting for convertible debt.
Convertible debt contains both a liability feature and an equity feature. Convertible bonds, for example, may require the issuer to pay fixed coupons (interest) and there is an option for the holder to convert some of the instrument (usually the capital element) into shares when the instrument matures. The legal form of such instruments is that of debt, but for financial reporting purposes, its substance is of two instruments:
(a) a financial liability to deliver cash by making interest payments or interest and capital payments as long as the bond is not converted; and
(b) a call option which grants the holder the option to convert the bond into a fixed number of ordinary shares of the entity, thus meeting the definition of equity.
There is a two-stage process to initially recognising convertible debt:
- Stage 1. Determine the amount of the liability component as the fair value of a similar liability which does not contain the conversion option.
- Stage 2. Allocate the difference between the liability calculated in Stage 1 and the fair value of the proceeds received as equity.
Paragraph 22.14 says that the entity shall not revise the allocation in a subsequent period.
The liability portion of the debt will be subsequently accounted for at amortised cost using the effective interest method in Section 11 Basic Financial Instruments or at fair value through profit or loss under Section 12 Other Financial Instruments Issues. It is anticipated that the Section 11 accounting treatment will be more common in practice.
On conversion, the liability portion is extinguished (as is the case in the example above) and equity is issued. The value of the equity recognised since initial inception will remain in equity, although it may be reallocated to another line item within equity.
Early redemption of a compound instrument
Section 22 is silent on the issue where a compound instrument is redeemed early (i.e. before the date it contractually matures). It would therefore be acceptable that when a compound instrument is redeemed early, the redemption amount plus any directly attributable transaction costs, will need to be allocated between the liability and equity components on the date early redemption takes place. An acceptable method would be to allocate part of the redemption amount to the liability component based on the liability’s fair value at the date of redemption, with any residual amount being allocated to the redemption of the equity component.
Where the redemption amount allocated to the liability exceeds the carrying amount of the liability component at the redemption date, a loss is recognised in profit and loss. Where the redemption amount is lower than the carrying amount of the liability, a gain is recognised in profit and loss.
It is important that AAT Licensed Members and members working for companies that are involved in raising various forms of finance carefully scrutinise the terms of the arrangement to identify if the terms provide for payments of interest/dividends to the lender because if they do, in substance the entity has incurred a liability. Where payments of dividends are at the discretion of the reporting entity and there is no obligation to redeem the instrument (for example ordinary shares), then in substance the entity has received equity. While many instruments will be straightforward, complex calculations may be needed where an instrument contains a mix of both debt and equity.
Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd.