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.

Other Comprehensive Income (OCI)

 

Prior to the introduction of IFRS 9, OCI had 5 components and the easier way to remember was the acronym CAART – which is:

• C – The effective portion of gains/losses on hedging instruments in a Cash flow hedge
• A - Actuarial gains and losses on defined benefit pension plans 
• A - Gains and losses on Available-for-sale financial assets
• R - Revaluation surplus related to property, plant and equipment
• T - Gains and losses arising from Translating the financial statements of a foreign operation

Now with IFRS 9 earlier adoption, the acronym has changed from CAART to CRAAFT

• C – The effective portion of gains and losses on hedging instruments in a Cash flow hedge
• R - Revaluation surplus related to property, plant and equipment
• A - Actuarial gains and losses on defined benefit pension plans 
• A - Gains and losses on Available-for-sale financial assets
• F - Financial liabilities designated as at fair value through profit or loss: fair value changes attributable to changes in the liability’s credit risk (IFRS 9)
• T - Gains and losses arising from Translating the financial statements of a foreign operation

There are many doubts as accountants are not sure whether a particular item is OCI or P&L and why other comprehensive income is also called as equity account, if it has anything to do with statement of changes in equity. What is the difference between other comprehensive income and profit or loss? What is the difference between other comprehensive income and changes in equity?

The answers to the above questions is in "Net Assets" of an organization. Net assets are contracts’ evidencing total assets less total liabilities of a company. It is the same as Equity which is the residual interest in the assets of an entity after deducting all of its liabilities. So equity will therefore consists of share capital, share premium, reserves, retained earnings or losses, etc.

Net assets or equity changes because of the following: 

• shareholders contribute cash to the company (share application money)
• profit or loss of the company for the year 
• buy back of own shares back from the market
• dividend payment to shareholders
• revaluation of certain assets directly through equity (e.g. available for sale financial assets) and not through profit or loss

The key to understand the difference between profit or loss, other comprehensive income and changes in equity is to understand where these changes are coming from. 

We can classify changes in net assets or equity into 2 main categories:

1. Capital changes – these are all changes related to owners of the company:

• Issuance of new shares
• Dividends payment to shareholders
• Buy-back of own shares from the market

All capital changes must be reported in the statement of changes in equity.

2. Revenue changes – these are all changes coming from the activities of the company and not from the owners. Revenue changes are further sub divided into 2 categories: 

• Changes resulting from main operating activities of the company that are reported in profit or loss. For example:
• Revenue from sales of goods or services 
• Expenses incurred to make sales of goods or services 
• All other income and expenses, such as finance, administrative, marketing, personnel, etc. 
• Gains related to primary performance (sale of property, plant and equipment, etc.) 

All these changes are reported in profit or loss.

• Changes resulting from other, non-primary or non-revenue producing activities of the company that are not reported in profit or loss as required or permitted by other IFRS standard. For example:
• The effective portion of gains and losses on hedging instruments in a Cash flow hedge
• Revaluation surplus related to property, plant and equipment
• Actuarial gains and losses on defined benefit pension plans 
• Gains and losses on Available-for-sale financial assets
• Financial liabilities designated as at fair value through profit or loss: fair value changes attributable to changes in the liability’s credit risk
• Gains and losses arising from Translating the financial statements of a foreign operation

This list is exhaustive and the standard setters do not think of other items that should potentially belong here. All these changes are reported in other comprehensive income.

The reason for introducing other comprehensive income and merging it with profit or loss into the statement of comprehensive income was to distinguish between capital and revenue changes.

The company needs to show clearly why its net assets go up or down – is it due to capital change or revenue change? 

If you answer these questions, you will exactly understand why OCI has only 6 components. Remember CRAAFT..

TREASURY SHARES

When a company buys back or reacquires its own shares, such portion of shares are called as Treasury Shares. These are the shares that the company keeps in its own treasury and therefore they will be deducted from equity. These shares don't pay dividends, have no voting rights, and should not be included in shares outstanding calculations for EPS. No gain or loss is recognized in the statement of profit and loss on the purchase, sale, issue or cancellation of an entity’s own equity instruments.

Case Study 1: Accounting of buy back of equity shares

IStaR Co buys back 100,000 of its own equity shares in the market for INR 10 per share. The accounting entry for recording the purchase of treasury shares as a deduction from equity is as follows:

Equity – Treasury Shares a/c………Dr                                        1000,000

To Cash/ Bank a/c                                                                                           1000,000

(Being treasury shares recognized as a deduction from equity)

Disclosures:

The amount of treasury shares held is disclosed separately either on the face of the balance sheet or in the notes to accounts. Further, a company provides disclosures in accordance with the requirements of Related Party Disclosures (RPD) in cases where the company reacquires its own equity instruments from related parties.

Indian companies have to comply with the requirements of the Share Buy Back rules as prescribed by SEBI (Securities and Exchange Board of India). In India, shares cannot be bought back for treasury operations.

Case Study 2: Treasury shares – Economic Hedge

IStaR is a big financial institution whose shares are listed and included in NIFTY 50 index of NSE (National Stock Exchange). IStaR issues a debenture whose principal amount varies with the movement in the NIFTY 50 share index (an ‘index tracker debt’). In order to hedge economically the equity derivative that is embedded in the debenture, IStaR purchases a portfolio of the shares contained in the NIFTY 50 index and classifies them as held-for-trading (HFT).

IStaR cannot classify its own purchased shares as held-for-trading (HFT) in order to hedge economically the index tracker debt. IAS 32 – Financial Instruments – Presentation requires that treasury shares should be shown in the balance sheet as a deduction from equity and not as assets, and that no gain or loss should be recognized in the profit or loss on such shares.

When an entity holds its own shares on behalf of others – when a financial institution holds its own shares on behalf of a client as a custodian – this represents an agency relationship and as a result the shares are not included in the balance sheet of the financial institution.

EARNINGS PER SHARE (EPS) - BASIC

EPS is simply profit amount divided by number of shares. Valuing a company as a whole is crucial during merger negotiations, buyouts or in similar arrangements – relatively rare events in the ongoing life of a company. For day-to-day valuations, many analysts prefer to focus on the value of single equity share. Here the earnings per share (EPS) computation helps to know how much of the company’s total earnings accrue to each share.

A simple capital structure exists when a company has no convertibles, no options or no warrants outstanding. The simple formula used to compute earnings per share (EPS) is:

To illustrate, IStaR Ltd. discloses the following information in the year 2012:

	January 1	December 31
Equity shares ( ` 1 face value)
160,000 shares issued and outstanding	160,000
200,000 shares issued and outstanding		200,000
Reserves	12,000,000	16,000,000
Retained earnings	1,100,000	1,800,000
7% Preference shares ( ` 100 face value)
10,000 shares issued and outstanding	1,000,000	1,000,000

The 40,000 additional equity shares were issued on September 1 and thus were outstanding for the last quarter of the year. The following factors explain the movement in retained earnings during the year 2012:

Retained earnings, January 1	1,100,000
Net income for the year	1,257,331
Preference dividend paid	(70,000)
Equity dividends	(487,331)
Retained earnings, December 31	1,800,000

The denominator of the basic EPS computation uses the weighted average number of equity shares outstanding. Since the additional shares were issued during the year, the weighted average number of outstanding shares is computed as follows:

  

Time	Shares outstanding (a)	Portion of the year (b)	Weighted average shares (c) = (a) * (b)
January 1 – August 31	160,000	2/3	106,667
September 1 – December 31	200,000	1/3	66,667
Weighted average outstanding shares			173,334

So now Basic EPS will be:

      = ` 6.85 per share