How-to IFRS Series..(3/5)

How-to distinguish source of funds as a 

 Debt or Equity?

Let’s begin reading this article by knowing the definition of Financial Instruments. A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

The essence of the definition lies in contract which we generally understand as a transaction having all the three characteristics: agreement between two or more parties; for an economic consideration and legally enforceable.

The definition then highlights financial assets, financial liabilities and equity instrument. Assets, liabilities, equity instrument reminds us of the balance sheet. For example, in credit sales transaction, the entity which sold the goods has a financial asset – trade receivable – while the purchaser has to account for a financial liability – trade payable. Another example is when the entity sources finance by issuing ordinary equity shares. The entity that subscribes to the shares accounts for a financial asset – an investment in shares – while the issuer has to account for equity instrument – equity share capital.

We can now gauge that accounting for financial instruments is how we account for trade receivables, investment in shares, investment in bonds (financial assets), how we account for trade payables, borrowings (financial liabilities) , how we account for equity share capital (equity instrument). Derivatives contract are also part of financial instruments and accounting for derivatives will be discussed in another article.

There are various steps to follow as to how to account for financial instruments starting with initial measurement, classification and subsequent measurement.

This article will emphasize on the accounting for equity instruments and financial liability. Both arise when the entity receives money in return for issuing a financial instrument.

Debt v/s Equity

It is of prime importance for any entity to rightly classify the money raised as either a financial liability (debt) or an equity instrument. This distinction impacts the measurement of profit as interest cost associated with debt will be charged to the statement of profit and loss, thus reducing the reported profit of the entity, while dividends on equity shares are an appropriation of profit rather than an expense. This distinction is equally important to the users of the financial statements as it directly affects the calculation of debt-equity ratio – a key measure to assess the financial risk of the entity.

Question asked to the Issuer?

When raising finance on the transaction date the issuer has to consider replying to the question: Does he have any sort of obligation which he needs to repay on the transaction? If the issuer has an obligation to repay, the transaction will be classified as financial liability (debt) as opposed to being an equity instrument. Therefore, the issue of debenture creates a financial liability as the monies have to repaid, while the issue of ordinary equity shares creates an equity instrument. Equity instrument is formally defined in the standard as any contract evidencing a residual interest in the assets of an entity after deducting all its liabilities.

Equity Instruments

Equity is initially measured at fair value minus any issue costs. They are not remeasured. Any change in the fair value of the shares is not recognized by the entity. Equity dividends are paid at the discretion of the entity and are accounted for as reduction in the retained earnings.

·        Case Study 1: Accounting for the issue of equity

Neupane Ltd. issues 10,000 Re.1 ordinary shares for cash of Rs.2.50 each. Issue costs are Rs. 1,000.

Solution: Ordinary shares are issued increasing the ownership interest in the net assets of the company. There is no obligation on the part of the issuer to repay the money received. The issue costs are written off against the share premium. Accounting for issue of equity shares can be reflected as under:

Cash a/c …………………………………………Dr                       24,000

   To Equity Share Capital …………………………………                      10,000

   To Share Premium……………………………………….                       14,000

Financial Liabilities

Where an instrument contains an obligation to repay it is classified as financial liability. Further, financial liabilities are categorized either at amortized cost or at fair value through profit and loss (FVTPL)

Financial Liabilities at amortized cost

Most of financial liabilities are categorized and accounted for at amortized cost. All amortized cost liabilities are initially measured at fair value minus transaction costs.

The accounting for financial liability at amortized cost means that the effective interest rate (EIR) of the liability will be recorded as interest cost in the statement of profit and loss. The liability will not be revalued at any reporting date. The effect of EIR accounting is that each year the liability will increase by the amount of interest charged to the profit and loss account and decrease by the amount of actual interest paid.

·        Case Study 2: Accounting for financial liability at amortized cost

Pasupati Ltd. raises money by issuing 100 zero coupon bonds at par of Rs. 100 each. The bonds will be redeemed after three years at a premium of 1,910. The effective interest rate (EIR) calculated is 6%.

Solution: The bond is a zero coupon bond meaning that no actual interest is paid during the tenor of the bond. Even though no interest is paid there will still be interest charge to profit and loss in this borrowing. The premium paid Rs.1,910 on maturity represents the interest charge. It will not be appropriate to charge the interest each year on the straight line basis as this would ignore the compounding nature of interest, thus effective interest rate is calculated. The presentation of liability at amortized cost is summarized below:

	Opening Balance	Plus Interest @ EIR 6% - P&L a/c	Less Actual interest paid	Closing Balance – Balance Sheet
Year 1	10,000	600	0	10,600
Year 2	10,600	636	0	11,236
Year 3	11,236	674	11,910	0

Financial Liabilities at Fair Value Through Profit and Loss (FVTPL)

Financial liabilities are only categorized at Fair Value Through Profit and Loss (FVTPL) if they are held for trading or the entity designates at fair value. The entity can use the option to designate a financial liability at fair value only if by doing so it significantly reduces the ‘accounting mismatch’ which would otherwise arise from measuring the assets or liabilities or recognizing the gains and losses on them on different bases or financial assets and financial liabilities are managed together and its performance is evaluated on a fair value basis as per the investment strategy. If a financial liability contains one or more embedded derivatives that require separation then that financial liability may be designated at FVTPL.

Financial liabilities categorized as FVTPL are initially measured at fair value and transaction costs are written off to the statement of profit or loss.

The accounting of Financial Liability at FVTPL is to increase the financial liability by EIR interest cost and reduce by actual interest paid. It is then revalued at each reporting date at fair value and any unrealized gains or loss because of revaluation is recognized in the statement of profit or loss. The fair value at the reporting date will be its market price, or if not known then, the present value of the future cash flows discounted at current market interest rate.

·        Case Study 3: Accounting for financial liability at FVTPL

Prime Ltd. issued a three year 7% debentures on January 1, 2012 of the value Rs.30,000 when the EIR of the debenture was also 7%. The debentures will be redeemed at par. The liability is categorized at FVTPL. At the end of first accounting period in the market interest rate is at 8% and at the end of second accounting period the interest rate in the market has fallen down to 6%.

Solution: The initial measurement is at fair value of Rs.30,000 received and there are no transaction costs. If transaction costs then these would be expensed in the statement of profit and loss.

With the coupon rate and EIR at the end of first accounting period being the same, i.e. 7%, the carrying value of the liability will be same Rs. 30,000. This is because financial liability will be increased by an amount of EIR (30,000*7% = 2,100) and reduced by actual interest paid (30,000*7% = 2,100).

The liability is at FVTPL, this carrying value as at December 31, 2012 has to be revalued. The fair value of the liability at this date will be the present value using the market rate of 8% of the remaining 2 years cash flows:

Payment dates	Cash flow		8%discount factor		Present value of cash flow
31-12-2013	2,100	X	0.9259	=	1,945
31-12-2014	32,100	X	0.8573	=	27,520
Fair value of the liability at 31-12-2014					29,465

The reduction in the carrying value of the liability of Rs. 535 is considered as unrealized profit in the statement of profit and loss. If higher discount rate was not because of general rise in market rates but the credit risk of the entity, then the gain is recognized in Other Comprehensive Income (OCI).

Date	Opening Balance	Plus EIR on opening balance	Less Actual interest paid (7%*30,000)	Carrying Value of Liability at reporting date	Fair Value of Liability at reporting date	Unrealized Gain/Loss to P&L a/c
31-12-2012	30,000	2,100	(2,100)	30,000	29,465	535
31-12-2013	29,465	2,357	(2,100)	29,722	30,283	(283)
31-12-2014	30,283	1,817	(2100)	30,000	Repaid	Repaid

The accounting principle is based on what we have always known for debt, when interest rate increases the fair value of debt decreases and when interest rate decreases value of debt rises.