Financial Instruments

Financial Repor ting Financial Instruments

Financial Instruments Robert Kirk demystifies the presentational issues of IAS 32

Scope IAS 32 applies in presenting information about all types of financial instruments with the following exceptions: • Interests in subsidiaries, associates, and joint ventures that are accounted for under IAS 27 Consolidated and Separate Financial Statements, IAS 28 Investments in Associates, or IAS 31 Interests in Joint Ventures. However, IAS 32 applies to all derivatives on interests in subsidiaries, associates, or joint ventures. • Employers' rights and obligations under employee benefit plans (see IAS 19). • Rights and obligations arising under insurance contracts (see IFRS 4). ccounting for financial instruments has been one of the more complex of accounting issues to resolve for standard setters. However, now both local FRS (FRS 25) and international IFRS (IAS 32) agree on how these instruments should be presented in the financial statements. In addition, the expected IFRS for Private Entities will include a similar section on the topic in the forthcoming standard.

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• Contracts for contingent consideration in a business combination (see IFRS 3). • Contracts that require a payment based on climatic, geological or other physical variables (weather derivatives) (see IAS 39).

Key Definitions Financial instrument:

Objective of IAS 32 The objective of IAS 32 is to enhance users' understanding of the significance of financial instruments to an entity's financial position, performance, and cash flows. IAS 32 addresses this in a number of ways: • Clarifying the classification of a financial instrument issued by an enterprise as either a liability or as equity or even a mixture of the two. • Prescribing the accounting treatment for treasury shares (a company's own repurchased shares). • Prescribing strict conditions under which assets and liabilities may be offset in the balance sheet. Its sister standard IAS 39 ‘Financial Instruments: Recognition and Measurement’ deals with, among other things, the initial recognition of financial assets and liabilities, the measurement subsequent to initial recognition, impairment, derecognition, and hedge accounting. These are not covered in this article nor are the contents of the disclosure standard, IFRS 7 ‘Financial instruments: disclosure’.

• A contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

Financial asset: • Any asset that is: - cash; - an equity instrument of another entity; - a contractual right: ▼ to receive cash or another financial asset from another entity; or ▼ to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or ▼ a contract that will or may be settled in the entity's own equity instruments and is: - a non-derivative for which the entity is or may be obliged to receive a variable number of the entity's own equity instruments; or - a derivative that will or may be settled other than by the exchange of a fixed amount of cash or

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Financial Repor ting Financial Instruments

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.

Financial liability: Any liability that is: - a contractual obligation: ▼ to deliver cash or another financial asset to another entity; or ▼ to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or ▼ a contract that will or may be settled in the entity's own equity instruments

Equity instrument: Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

To illustrate, a convertible bond contains two components. One is a financial liability, namely the issuer's contractual obligation to pay cash, and the other is an equity instrument, namely the holder's option to convert into common shares. Another example of a compound instrument would be debt issued with detachable share purchase warrants. When the initial carrying amount of a compound financial instrument is required to be allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component.

Example

Example – convertible loan

A start up company is experiencing severe cash flow problems. A supplier agrees to supply goods to the value of €1,000 in return for the company issuing to it, in 60 days time, shares that have a market value of €1,000. The number of shares that the company must deliver under the contract is variable – it will depend on the market value of its shares at the settlement date.

Facts: A company issues a 3 year convertible bond at its par value of €1m which carries interest at 5% per annum annually in arrears. Must assume a market rate for a similar straight loan without conversion rights, say 7%.

This contract would be classified as a financial liability – it is no different from a contract to pay €1,000 cash or to deliver other assets worth €1,000 in exchange for the goods.

X 0.8163 = 816,299 Interest €50,000 for 3 years discounted at 7% X 2.6243 = 131,214 947,513 Total net proceeds 1,000,000 Equity component 52,487

Fair value: The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.

Classification as Liability or Equity The fundamental principle of IAS 32 is that a financial instrument should be classified as either a financial liability or an equity instrument according to the substance of the contract, not its legal form. The enterprise must make the decision at the time the instrument is initially recognised. The classification may not be subsequently changed based on changed circumstances. Effectively, this means that preference shares which are redeemable must now be classified as liabilities, not as equity. On the other hand, if the preference shares are non redeemable their nature is more like equity. The dividends attached to these instruments must be consistent with their balance sheet treatment and thus dividends on redeemable preference shares must be treated as finance costs and not appropriations of income.

Compound Financial Instruments Some financial instruments - sometimes called compound instruments or hybrids - have both a liability and an equity

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component from the issuer's perspective. In that case, IAS 32 requires that the component parts be accounted for and presented separately according to their substance based on the definitions of liability and equity. The split is made at issuance and not revised for subsequent changes in market interest rates, share prices or other event that changes the likelihood that the conversion option will be exercised.

Solution: Liability: Principal €1m discounted at 7% end of year 3

One company applying the split accounting required for compound instruments is BAE Systems Plc:

BAE Systems Plc: Preference Shares The 7.75p (net) cumulative redeemable preference shares of 25p each are convertible into ordinary shares of 2.5p each at the option of the holder on 31 May in any of the years up to 2007, on the basis of 0.47904 ordinary shares for every preference share. During the year 187, 489 shares were converted for 89,814 ordinary shares. The Group may redeem all of the remaining preference shares at any time after 1 July 2007 and, in any case, will redeem any remaining shares on 1 January 2010, in each case at 100p per share together with any arrears and accruals of dividend. The maximum redemption value of the preference shares, ignoring any arrears or accruals of dividend, is therefore £266m. As stated in note 1, the Group has adopted IAS 39 from 1 January 2005. In accordance with IAS 32 the convertible preference shares are considered to be a compound financial instrument consisting of both a debt element and an equity component which require separate accounting treatment. Under IAS 32, the equity option element of preference shares of £78m is included as a separate component of equity. The debt component is recognised within loans and overdrafts (note 20).

Financial Repor ting Financial Instruments

In the year that Irish listed companies adopted IAS 32 Glanbia Plc explained how they have changed their presentation from equity to liabilities. In addition, the cost of shares held by an Employee Share Trust has been deducted from equity.

Glanbia Plc (q) Share capital (i) Preferred securities and preference shares For 2004: Preferred securities and preference shares, with fixed dividend entitlements and fixed redemption dates,are accounted for as non-equity minority instruments within shareholders’ funds. From 2005: Such preferred securities and preference shares are classified as liabilities. (ii) Own Shares The cost of own shares, held by and Employee Share Trust in connection with the Company’s Sharesave Scheme, is deducted from equity.

Treasury Shares The cost of an entity's own equity instruments that it has reacquired ('treasury shares') is deducted from equity. A gain or loss is not recognised on the purchase, sale, issue, or cancellation of treasury shares. Treasury shares may be acquired and held by the entity or by other members of the consolidated group. Any consideration paid or received is recognised directly in equity.

Offsetting IAS 32 also prescribes rules for the offsetting of financial assets and financial liabilities. It specifies that a financial asset and a financial liability should be offset and the net amount reported when, and only when, an enterprise: • has a legally enforceable right to set off the amounts; and • it intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.

Example Facts: A manages its exposure to changes in copper prices and locks in the cost of funding by entering into options. These included both call and put options at various strike prices and various maturity dates. These will be settled in cash and are thus derivatives. The bank permits a legal right of set off on termination or on default but not in the ordinary course of business. Solution: As only allowed to offset in the event of a contingent event e.g. default or termination IAS 32 is not satisfied. Also, by having different maturity dates, the company does not demonstrate an intention to settle net simultaneously.

IFRS for Private Entities (due December 2008)

The scope is identical to the full IAS 32 standard.

Initial recognition of financial assets and liabilities An entity may only recognise these when it becomes a party to the contractual provisions of the instrument but the rules will be exactly the same as the full IAS 32. For example, compound financial instruments will still require to be separated between their debt and equity components.

Amendment to FRS 12 (February 2008) Puttable instruments and obligations arising on liquidation In February 2008, the IASB amended IAS 32 and IAS 1 Presentation of Financial Statements with respect to the balance sheet classification of puttable financial instruments and obligations arising only on liquidation. As a result of the amendments, some financial instruments that currently meet the definition of a financial liability will be classified as equity because they represent the residual interest in the net assets of the entity. The amendments have detailed criteria for identifying such instruments, but they generally would include: • Puttable instruments that are subordinate to all other classes of instruments and that entitle the holder to a pro rata share of the entity's net assets in the event of the entity's liquidation. A puttable instrument is a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder. • Instruments, or components of instruments, that are subordinate to all other classes of instruments and that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation. The amendments result from proposals that were in an Exposure Draft published by the Board in June 2006. These amendments are effective for annual periods beginning on or after 1 January 2009 but earlier application is permitted.

Summary Since both FRS 25 and IAS 32 have lost their disclosure requirements the essence of the revised standards has been to ensure that the various financial instruments reflect the substance of their arrangements and not necessarily their legal form. Even after introducing this principle the IASB has had to issue an amendment to interpret whether puttable instruments should be classified as equity or as liabilities. Inevitably there could be further interpretations to come as financial instruments become increasingly complex.

Robert Kirk is Professor of Financial Reporting at the University of Ulster.

Section 11 of the exposure draft for the new IFRS is entitled Financial Assets and Financial Liabilities and, at present, permits companies to opt for full coverage of IAS32/39 or apply the IFRS for Private Entities

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