Tax

Resolving the debt vs equity quandary

Oct 01, 2016
Practitioners are often challenged with the classification of a financial instrument as a financial liability or as an equity instrument. Goind Ram Khatri discusses FRS 102 requirements using a practical example.

The correct classification of a financial instrument as a financial liability or as equity is crucial in determining initial and subsequent measurement. It therefore has a direct impact on the amounts presented in financial statements. The good news is that there is no change in classification criteria under FRS 102 as compared with old Irish GAAP. However, the initial and subsequent measurement of financial liabilities is substantially different under FRS 102. FRS 102 defines a financial liability as any liability that is:


  • A contractual obligation to (i) deliver cash or another financial asset to another entity; or (ii) exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or
  • A contract that will be, or may be, settled in the entity’s own equity instruments and (i) under which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or (ii) will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. 
For this purpose, the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity’s own equity instruments. And ‘equity’ is defined as “the residual interest in the assets of the entity after deducting all its liabilities”.

Step-by-step process

A step-by-step process to determine whether an instrument is a financial liability or an equity is set out below:
 

Step 1: determine whether the borrower has a contractual obligation to deliver cash or another financial asset. If yes, it is a financial liability. If not, move on to the next step.

Step 2: is the instrument convertible into a variable number of ordinary shares? If yes, it is a financial liability. If the instrument is convertible into a fixed number of ordinary shares, it is an equity instrument.

Step 3: does the instrument have a contractual obligation to deliver cash or another instrument as well as an option for the borrower to convert the instrument into a fixed number of ordinary shares? If this is the case, the instrument has characteristics of both a financial liability and equity instrument, referred to as a compound financial instrument.  On issuing convertible debt or similar compound financial instruments that contain both a liability and an equity component, an entity shall allocate the proceeds between the liability component and the equity component. To make the allocation, the entity shall first determine the amount of the liability component, which is the fair value of a similar liability that does not have a conversion feature or similar associated equity component. The entity shall then allocate the residual proceeds as the equity component. Transaction costs shall be allocated between the debt component and the equity component on the basis of their relative fair values.

Step 4: determine the amount at which the instrument should be measured on initial recognition. An equity instrument is recognised at the nominal amount net of direct costs of issuing the instrument, while a financial liability in a financing transaction is initially measured at the present value of future cash flows discounted at a market rate of interest for a similar debt instrument. The initial measurement amount of compound instruments is outlined in Step 3 above. Where the market rate of interest used in Step 4 is different from the interest rate in the loan agreement, a day-one fair value gain/loss arises which is the difference between the present value calculated using the market rate and the transaction price. If the lender is a third party, such day-one gain/loss is recognised in the profit and loss account both by the lender and the borrowing entity. Where the lender is an existing shareholder of the company, the day-one fair value gain/loss is recognised by the lender as an investment in the subsidiary while the borrowing subsidiary will recognise an equivalent amount in equity as a capital contribution.

Step 5: determine whether the financial liability is a ‘basic’ or ‘other’ financial instrument. The distinction between ‘basic’ or ‘other’ financial instruments is based on the rules in Section 11 of FRS 102. The distinction is important as it impacts the subsequent measurement of the financial liability (at each reporting date). A basic debt instrument is subsequently measured at amortised cost. In contrast, an ‘other’ debt instrument is subsequently measured at fair value with any fair value gain/loss on remeasurement recognised in the profit and loss account.

Step 6: calculate the amortised cost and interest expense using the effective interest rate method in the case of a ‘basic’ financial liability and the fair value and interest expense in the case of an ‘other’ financial liability. 

An illustrative example

Let us now look at a practical example to illustrate the above step-by-step process.
ABC Company Limited (ABC) issued 4,000 Class A preference shares for cash at a price of €0.01 together with a premium of €24.99 per Class A preference share, raising in total €100,000 (4,000 x {0.01+24.99}). The Class A preference share incurs a 3% cumulative interest and nothing is payable until the fifth anniversary of allotment, when the accumulated interest and capital is due in one lump sum. The market interest rate for similar preference shares at the date of issuance is 5%. How should the Class A preference shares be recognised and measured in the books of ABC? Applying the step-by-step process, it will be recognised and measured as follows:
 

Step 1: ABC has a contractual obligation to deliver cash (principal + accumulated interest) at the fifth anniversary. This means that the Class A preference shares are financial liabilities.

Steps 2 and 3: Class A preference shares are not convertible into ordinary shares. Therefore, steps two and three are not relevant in this scenario.

Step 4: determine the initial recognition amount. As the 3% coupon rate is lower than the 5% market rate of interest, the present value is lower than the proceeds received on the allotment date. The lump sum due on the fifth anniversary of allotment is €115,927 (i.e. €100,000 x 1.035). The present value of this lump sum using the market interest rate of 5% is €90,832 (i.e.  €115,927/1.055).

Accordingly, under FRS 102, the preference shares are initially recognised as a non-current financial liability of €90,832. The difference of €9,168 arising between the transaction amount of €100,000 and present value of €90,832 (i.e. the day-one gain) will be recognised by the   borrower as a fair value gain on initial recognition.


The accounting entries required on initial recognition of the Class A preference shares in the books of ABC are set out below:

  Dr. (€)  Cr. (€) 
Dr. Cash/Bank  100,000
Cr. Loan Payable    90,832
Cr. Fair value gain     9,168
 
If the lender (i.e. the holder of preference shares) is an existing shareholder, the difference of €9,168 is recognised in ABC’s equity as a capital contribution.

Step 5: determine whether the financial liability is ‘basic’ or ‘other’. In this case, the debt instrument meets the criteria for recognition as a basic instrument per Paragraph 11.9 of FRS 102.

Step 6: subsequent measurement. Calculate the interest expense for each year and the amortised cost at each year end using the effective interest rate. In this scenario, as there are no transaction costs, the effective interest rate is the same as the market rate of interest. Table 1 (above) illustrates the calculation of the amortised cost and interest expense for each year. The interest charge in Column B is recognised as an interest expense in the respective years, with the corresponding credit to preference shares payable.

Conclusion

Careful consideration is required in interpreting the terms and conditions of each debt agreement to ensure that the agreement is correctly classified, recognised and measured in an entity’s financial statements.

Goind Ram Khatri is Senior Audit Manager at Deloitte Ireland.