Capital raising - Accounting rules that may haunt you

Let us take the example of typical clauses in preference share instruments.

Under the accounting rules (SFRS 32), a contractual obligation to deliver a financial asset satisfies the definition of ‘financial liability’. Redeemable preference shares, with fixed mandatory redemption date or redemption at investor’s discretion, are, therefore, typically classified as liabilities. If the option to redeem the preference shares is at the discretion of the issuer, such preference shares are classified as an equity. Thus, classification as a liability or an equity depends on the financial obligation of the issuer.

Similarly, preference shares with only mandatory dividends and no obligation for repayment of principal contain a liability element. If such preference shares are convertible, the terms of conversion could either result in a residual equity element or identification of embedded derivatives in the contract. The former leads to a category called ‘compound financial instruments’, while the latter is called ‘hybrid financial instruments’ which could add significant volatility to the entity’s profit or loss, owing to fair valuations necessitated at each reporting period-end.

Equity classification is not precluded in cases where payment of dividend on preference shares is discretionary. In certain cases, payment of dividends may be made contingently, in which case the analysis is based on whether the issuer has true discretion or not.

A relatively common case of contingent dividend is where the dividend payment is mandatory based on a percentage of profits. In such a case, discretion would not exist, and so the instrument may be classified as a liability.

Private equity (PE) and venture capital (VC) investors commonly invest in early stage companies through optionally or compulsorily convertible instruments (for example, preference shares or debentures) and plan their exit in a liquidity event, such as an IPO. Early stage companies often underwrite a minimum return to PE/VC investors in liquidity events by agreeing to a variable conversion ratio of investor’s preference shares or debentures, so that the investor has as much entity’s equity instruments to offload in the capital market as are necessary for earning the committed return.

Under SFRS 32, a preference share or debenture convertible into equity instruments of an entity is classified as an equity only if there are no circumstances under which the entity can be contractually obligated to convert the preference share or debenture into a variable number of equity shares. This rule is commonly known as the “fixed for fixed” rule i.e. fixed number of equity shares for a fixed consideration from convertible preference shares, debentures or other instruments. The conversion rights for PE/VC investors mentioned above violate the “fixed-for-fixed” criterion for equity classification.

Convertible preference shares or debentures that do not satisfy the “fixed for fixed” criterion are generally financial liabilities. Such convertible instruments not meeting the “fixed for fixed” criterion often contain embedded derivatives, which is the value of a component of preference shares or debenture changes in response to certain variable changes, such as the entity’s share price or interest rates. Entities need to evaluate whether the embedded derivative element can be separated and accounted for at fair value through profit or loss. Alternatively, entities may choose to treat the entire instrument at fair value through profit or loss. Nevertheless, both of these alternate accounting treatments add volatility to the income statement of the entity.

Entities commonly issue preference shares to investors which give them the right to redeem such shares (i.e. non-mandatory redemption) for cash or put them to entity in certain situations (for example, non-achievement of an IPO).

A contract that contains such an obligation for the entity to purchase its own equity instruments for a financial asset gives rise to a financial liability for the present value of the redemption amount. If the investor holding such an option does not exercise the option by the end of the stated option period, then the liability will be derecognised with a corresponding credit to equity.

There are certain exceptions to this accounting principle, however, these are extremely rare circumstances.

Preference or equity share or debenture/bond purchase agreements often contain clauses which seek to preserve the ownership rights of investors in circumstances such as bonus issue or rights issue relative to the entity's other equity shareholders. An adjustment to the conversion ratio will preserve the rights of the holders of the instrument relative to other equity shareholders if its effect is to ensure that all classes of equity interest are treated equally. Such types of adjustment are often referred to as 'anti-dilutive' and do not underwrite the value of the conversion option. Rather, they preserve the value of the option relative to the other ordinary shares. Such clauses do not violate the “fixed for fixed” criterion and hence result in classification of the instrument as an equity.

However, many clauses in such agreements, although termed as “anti-dilutive”, fail the “fixed for fixed” criterion. For example, clauses that link the number or value of the shares to be received to the entity's share price or some other price or index, will breach the “fixed for fixed” test and hence result in classification of the instrument as a liability. These conversion options are not equity components although they do represent embedded derivatives which, as mentioned above, must be accounted for as a derivative at fair value through profit or loss. Problems of separating the embedded derivative can be avoided by designating the entire instrument at fair value through profit or loss.

Application of this guidance can be extremely significant in cases where the conversion ratio has a potential to change.