Reporting the financial performance of a range of entities (C9)

 When Debt Seems to Be Equity

1. Debt vs. Equity Classification (Basics):

1. IAS 32 defines financial assets, liabilities, and equity, establishing principles for classification.
2. Classification significantly impacts gearing ratios, earnings, and debt covenants.
3. Equity classification can avoid some impacts but might dilute existing shareholders' interests.
4. Liability classification affects the ability to pay dividends, as payments are treated as interest.

2. Key Features of Debt and Equity:

5. Debt involves an obligation to deliver cash or another financial asset (e.g., bonds with interest and principal repayment).
6. Equity represents a residual interest in assets after liabilities are deducted.
7. Equity instruments cannot have a contractual obligation to deliver cash or other financial assets.

3. Ordinary and Preference Shares:

8. Ordinary shares are equity when payments are discretionary.
9. Preference shares mandatorily convertible to a fixed number of ordinary shares are equity.
10. Preference shares redeemable at the holder's request are debt.

4. Fixed-for-Fixed Rule:

11. Contracts requiring delivery of a fixed number of shares for a fixed amount of cash are equity.
12. Contracts with variability in the amount of cash or shares delivered are debt.
13. Example: Delivering equity shares equal to a specific cash value is treated as debt.

5. Factors Leading to Classification as Debt:

14. Redemption at the holder's option.
15. A limited life of the instrument.
16. Redemption is triggered by uncertain future events beyond control.
17. Non-discretionary dividends.

6. Factors Leading to Classification as Equity:

18. Non-redeemable shares.
19. No liquidation date.
20. Dividends are discretionary.

7. Principle of Substance over Form:

21. Classification is based on the contractual terms of the instrument, not its legal form.
22. Exceptions include puttable instruments and obligations on liquidation.

8. Classification at Initial Recognition:

23. Classification is determined when the instrument is initially recognized.
24. It doesn’t change due to subsequent circumstances.
25. Example: Redeemable preference shares are always treated as debt.

9. Mandatorily Redeemable Preference Shares:

26. Liability vs. equity classification depends on whether there’s an unconditional obligation to deliver cash.
27. Economic necessity doesn’t convert equity into liability.

10. Rights Issues in Non-Functional Currency:

28. Rights issues denominated in non-functional currency are treated as equity due to IAS 32 exceptions.

11. Compound Instruments (Debt and Equity Features):

29. Bonds convertible into shares are split into liability and equity components.
30. Split accounting allocates fair value between liability and equity.

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Example: Step-by-Step Classification

Scenario:

A company issues a convertible bond with the following terms:

• Bond value: $1,000.
• Interest: 5% annually.
• Convertible into 50 ordinary shares after 5 years.

Step-by-Step Analysis:

1. Debt Component:

   • Obligation to pay $1,000 at maturity.
   • Obligation to pay 5% annual interest.
   • These are financial liabilities.

2. Equity Component:

   • Conversion option into 50 shares if exercised by the holder.
   • No cash obligation under the conversion option.

3. Fixed-for-Fixed Test:

   • The bond is convertible into a fixed number of shares for a fixed bond value.
   • The conversion option qualifies as equity.

4. Split Accounting:

   • Calculate the present value of cash flows (interest and principal repayment) using the market rate for similar bonds without a conversion feature.
   • Allocate this present value to the liability component.
   • Residual value is allocated to the equity component.

Illustration of Allocation:

• Bond value: $1,000.
• Present value of liability: $900 (discounted cash flows).
• Equity component: $100 (residual value).

Final Classification:

• Liability: $900 (recorded as a bond liability).
• Equity: $100 (conversion option recorded as equity).

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