IAS 32 and 39, IFRS 7 and 9 - Liability and equity hybrids

Executive summary Both IFRS and US GAAP have definitions for financial instruments that are classified as a liability or as equity. Under IFRS, classification of certain instruments with characteristics of both debt and equity focuses on the contractual obligation to deliver cash, assets or an entity’s own shares. US GAAP specifically identifies certain instruments with characteristics of both debt and equity that must be classified as liabilities. Under IFRS, hybrid financial instruments (e.g., convertible bonds) are required to be split into a debt and equity component and, if applicable, a derivative component. The derivative component may be subject to fair value accounting. Under US GAAP, hybrid financial instruments are not split into debt and equity components unless certain specific conditions are met, but they may be bifurcated into debt and derivative components, with the derivative components subject to fair value accounting.

Progress on convergence The Boards agreed to review the accounting for financial instruments with characteristics of equity. The FASB issued its Preliminary Views document in November 2007, and the IASB issued a Discussion Paper in February, 2008. Both documents were titled Financial Instruments with Characteristics of Equity. The objective of the joint project and related discussion documents was to improve and simplify the financial reporting requirements in this area. The Boards received comments on their respective documents, deliberated various issues of the project and made a number of decisions on financial instruments with characteristics of equity. However, with all of the other convergence projects, the Boards decided in October 2010, that they did not have the capacity to devote to the project and decided to not issue an ED until sometime after June 2011.

Definitions US GAAP IFRS Standards define the following: Financial instruments Financial liabilities Equity instruments Similar

Definitions US GAAP IFRS The definitions are central to the analysis of how to account for financial instruments: A financial instrument is “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another ….”

Definitions US GAAP IFRS A financial instrument, per ASC 825-10-20-Glossary, is defined as “cash, evidence of an ownership interest in an entity, or a contract that both: a. Imposes on one entity a contractual obligation either: 1. To deliver cash or another financial instrument to a second entity. 2. To exchange other financial instruments on potentially unfavorable terms with the second entity. b. Conveys to one entity a right to do either of the following: 1. Receive cash or another financial instrument from the first entity. 2. Exchange other financial instruments on potentially favorable terms with the first entity.” IFRS A financial instrument, per IAS 32, paragraph 11, is “ … any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another …”

Definitions US GAAP IFRS A financial liability, per ASC 825-10-20-Glossary is defined as “a contract that imposes on one entity an obligation to do either of the following: a. Deliver cash or another financial instrument to a second entity, or b. Exchange other financial instruments on potentially unfavorable terms with the second entity.” IFRS A financial liability, per IAS 32, paragraph 11, is “… any liability that is: (a) A contractual obligation (i) To deliver cash or another financial asset to another entity, or (ii) To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or (b) A contract that will or may be settled in the entity’s own equity instruments and is (i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own instruments ….”

Definitions

Definitions US GAAP An equity instrument is not as yet well defined under US GAAP. By reference to ASC 320-10-20, Investments-Debt and Equity Securities-Glossary, an equity security is any security representing an ownership interest in an entity (e.g., common, preferred or other capital stock) or the right to acquire (e.g., warrants, rights and call options) or dispose of (e.g., put options) an ownership interest in an entity at fixed or determinable prices. Under ASC 505-10-05-3, Equity-Overall-Overview and Background, equity is defined as the residual interest in the assets of an entity that remain after deducting its liabilities. IFRS An equity instrument, according to IAS 32, paragraph 11, is “any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.” This includes common shares and certain preferred shares.

Definitions

Classification, recognition and measurement US GAAP IFRS Financial instruments must be classified as debt or equity in the balance sheet. Similar Liability and equity hybrid financial instruments can be very complex and require a great deal of judgment to evaluate all characteristics of the underlying instrument. Similar

Classification, recognition and measurement US GAAP IFRS Instruments that require settlement with a variable number of shares establish a debtor/creditor relationship and are thus treated as liabilities. This is true even if the legal form is preferred stock. Those that require settlement with a fixed number of shares generally establish more of a shareholder relationship and are thus treated as equity. Similar, although preferred stock is referred to as preference shares.

Classification, recognition and measurement Classification of debt versus equity US GAAP Classification is addressed on an instrument-by-instrument basis: The legal form often dictates the classification — that is, a bond or loan is debt and preferred or common stock is equity. ASC 480 requires that specific instruments be classified as liabilities, even if they are stock and even if they have characteristics of both debt and equity. Some examples of instruments that must be accounted for as debt include: Mandatorily redeemable shares. Instruments that must be redeemed or repaid using a variable number of the entity’s shares. Instruments requiring an entity to repurchase its own stock for cash or other assets. IFRS Classification starts with the definitions. The focus is on whether there is a contractual obligation to deliver cash, other assets or a variable number of the entity’s own shares. If such an obligation exists, a liability exists. This is applied to all instruments whether they are loans/bonds or preferred or common stock. Unless the entity has an unconditional right to avoid delivering cash or other financial assets, it is a liability. IAS 32, paragraphs 17 through19 address this issue.

Bifurcation of hybrid financial instruments US GAAP Hybrid financial instruments are not split into debt and equity components unless certain conditions are met, as may be the case with instruments that include embedded derivatives, conversion features, redemption features, etc. Careful analysis is required on an individual instrument-by-instrument basis to determine if bifurcation is appropriate. Related debt issuance costs are recorded as deferred assets and amortized over the life of the liability. IFRS The liability and equity components are determined as follows: The liability component is calculated as the net present value of all potential contractual future cash flows at market interest rates at the time of issuance. The difference between the proceeds from the offering and the net present value calculated above is the equity component. This component is included in equity generally under a heading of “other capital reserves.” Issuance costs are also bifurcated by determining the fair value of the components and applying the percentage to the issuance costs. Liability component issuance costs are offset directly to the balance of the liability component. Equity component issuance costs are charged to equity generally under a heading of “other capital reserves.”

Debt versus equity – hybrid instruments example Hang Glide Inc. (Hang) issues $2.0 million worth of convertible bonds at par with an annual interest rate of 6% when the market rate is 9%. The bonds, due in three years, are convertible into 250 common shares. Prepare the initial journal entry to record these bonds under US GAAP and IFRS.

Debt versus equity – hybrid instruments example Example 1 solution: US GAAP: Cash $2,000,000 Bonds payable $2,000,000 Split accounting would not apply.

Debt versus equity – hybrid instruments example Example 1 solution (continued): IFRS: The instrument would be split into a debt component (measured at the present value of the cash flows of the debt at the market rate of interest) with the equity components being the residual. The present value at three years, 9% annual interest of $120,000 and principal repayment of $2,000,000: Interest $120,000 (PV annuity) $ 303,721 Principal $2,000,000 (par value $1) 1,544,401 Value of liability $1,848,122 Value of equity = $2,000,000 – $1,848,122 = $151,878 Cash $2,000,000 Bonds payable $1,848,122 Equity – conversion option 151,878

Convertible debt example The Really Cheap Company (RCC) issued $20 million of five-year convertible bonds at par with 6% annual interest, which would be due December 31, 2015. The 6% bonds are convertible at any time after issuance, which was January 1, 2011, at the rate of 10 shares of common stock for each $1,000 of the face value of the convertible bonds. Issuance costs total $100,000. The current market rate for non-convertible bonds is 8% interest. Show the journal entries to record the issuance of the convertible bonds using US GAAP and IFRS (round to the nearest thousand). Calculate the expenses related to the convertible debt that RCC should record each year using US GAAP and IFRS (round to the nearest thousand). Provide the journal entries.

Convertible debt example Example 2 solution: Issuance of convertible bonds: US GAAP: RCC would record a liability for the amount of the bonds and a deferred charge for the issuance costs. Cash $19,900,000 Unamortized bond issuance costs 100,000 Convertible bonds payable $20,000,000

Convertible debt example Example 2 solution (continued): IFRS: RCC needs to bifurcate the convertible debt and issuance costs between liability and equity components. RCC should calculate the liability component as the net present value (NPV) of future cash flows using the current 8% market rates at the time of issuance. Cash flow for year 1 through year 4 is the interest payment calculated as $20,000,000 x 6% = $1,200,000. Cash flow for year 5 includes the proceeds of $20 million and interest of $1.2 million. Based on the NPV of these cash flows, the liability component is calculated as $18,403,000 as shown in the table. Cash flow NPV at 8% Year 1 $ 1,200,000 $ 1,111,000 Year 2 $ 1,200,000 1,029,000 Year 3 953,000 Year 4 882,000 Year 5 $21,200,000   14,428,000 Fair value of liability component $18,403,000

Convertible debt example Example 2 solution (continued): RCC then calculates the equity component of $1.597 million as the proceeds of $20 million less the liability component of $18.403 million. The issuance costs would be allocated to equity based on the equity component percentage as follows: $1,597,000/$20,000,000 = 8% The equity component issuance costs are $8,000 (8% x $100,000). The journal entry would be as follows: Cash $19,900,000 Convertible bonds payable $18,311,000 Other capital reserves 1,589,000 Cash received would be $20 million less $100,000 of issuance costs. The convertible bonds would be recorded as $18.403 million with an offset for debt issuance costs of $92,000. Other capital reserves in equity would be credited with $1.597 million and charged with issuance costs of $8,000.

Convertible debt example Example 2 solution (continued): US GAAP: RCC should record amortization of bond issuance expense annually of $20,000, calculated as the total of the issuance costs of $100,000 amortized on a straight-line basis over the five-year life of the bonds. RCC should record interest expense of $1.2 million each year, calculated as $20 million multiplied by the stated rate of 6%. The journal entries for each year would be as follows: Amortization expense $20,000 Unamortized bond issuance costs $20,000 Interest expense $1,200,000 Cash $1,200,000

Convertible debt example Journal entries: Year 1: Interest expense $1,488,000 Cash $1,200,000 Liability 288,000 Year 2: Interest expense $1,511,000 Liability 311,000 Year 3: Interest expense $1,536,000 Liability 336,000 Year 4: Interest expense $1,563,000 Liability 363,000 Year 5: Interest expense $1,591,000 Liability 391,000 Example 2 solution (continued): IFRS: In substance, the amount of interest expense should reflect the effective interest assuming the bonds did not have the convertible feature. Therefore, the effective interest rate on this debt is determined by solving for the effective yield on the difference between the face value of the bonds of $20.0 million and the amount allocated to the liability component of $18,311,000. The effective interest rate is 8.125%. Therefore, interest expense by year would be as follows: Beginning liability Interest expense at 8.125% Interest paid Ending liability Year 1 $18,311,000 $ 1,488,000 $(1,200,000) $18,599,000 Year 2 1,511,000 (1,200,000) $18,910,000 Year 3 1,536,000 $19,246,000 Year 4 1,563,000 $19,609,000 Year 5 1,591,000 $ 20,000,000 $ 7,689,000

Classification, recognition and measurement Stock or shares with settlement options that are contingent upon another event US GAAP These financial instruments are not classified as liabilities until the instruments are mandatorily redeemable. For example, a share may become redeemable if a certain future event happens (such as a consumer price index rising above a certain point). This future event is uncertain. When the contingency resolves itself in the future (i.e., occurs or not), the instrument is reassessed to see if a liability exists. If it does, an amount equaling the fair value of the liability is reclassified from equity to liability. IFRS These instruments are recognized as liabilities if the issuer does not have an unconditional right to avoid delivering cash or another financial asset. Per IAS 32.25, there are certain limited situations when such instruments would not be classified as liabilities.

Debt versus equity – contingency example On December 31, 2011, the Motor Cross Company (MCC) issued redeemable preferred shares for $100 that are redeemable if the S&P index rises beyond a certain benchmark. On December 31, 2013, the S&P reaches the benchmark. How should MCC account for these shares under US GAAP and IFRS at December 31, 2011 and December 31, 2013?

Debt versus equity – contingency example Example 3 solution: US GAAP: Upon issuance, the shares are only contingently redeemable (as opposed to mandatorily redeemable). US GAAP does not use split accounting for these, and the legal form is equity. Therefore, the shares are initially treated as equity. However, on December 31, 2012, a liability is created and now the shares are indeed mandatorily redeemable. An amount equal to the fair value of the liability would be reclassified from equity and to a liability classification on the balance sheet. 2010 Cash $100 Redeemable preferred shares – equity $100 2012 Redeemable preferred shares – equity $100 Redeemable preferred shares – liability $100

Debt versus equity – contingency example Example 3 solution (continued): IFRS: At December 31, 2010, a liability exists. MCC has an obligation to repay the principal if a future event occurs that is beyond its control. Since MCC does not have an unconditional right to avoid delivering the cash, the instrument is a liability. 2010 Cash $100 Redeemable preferred shares – liability $100 2012 There are no journal entries necessary.

Classification, recognition and measurement Preferred stock US GAAP Preferred shares that pay dividends do not require bifurcation. IFRS Preference shares that pay dividends may require bifurcation. The present value of the dividend payments will be classified as a liability, even if the preferred shares are otherwise classified as equity.

Preferred stock example The Rock Star Records Company (RSR) decides to issue $20 million of redeemable preferred stock (preference shares using IFRS terminology) on January 1, 2011. The redeemable preferred stock has a 5% fixed annual cash dividend (no vote of shareholders or others is required), has no maturity date and RSR can repay it at any time. Current market interest rates are 5%. Explain how RSR should account for the preferred stock using US GAAP and IFRS. (No journal entries required.)

Preferred stock example Example 4 solution: For US GAAP, which does not require split accounting, these shares would be evaluated for their redemption features. If there were any redemption features required upon the occurrence of certain contingent events (e.g., an IPO, change in control, liquidation event, achievement of a performance condition) or upon the option of the holder, then this instrument would be classified as a liability. However, if redemption of the instrument is not certain to occur, which is assumed in this example, the instrument is classified as equity for US GAAP purposes. For IFRS purposes, split accounting would be considered and the components of the instrument would be evaluated for liability and equity characteristics: The repayment of the principal would be considered an equity instrument as payment is at the issuer’s option and there is no present obligation to transfer financial assets to the holder. The dividend is fixed and payment is not at the discretion of the issuer, thus this represents a mandatory or potential obligation to transfer assets or cash to the holder. Accordingly, the dividend component of the financial instrument would be a liability.

Preferred stock example Example 4 solution (continued): The fair value of the stream of perpetual dividends would be substantially equivalent to the face value of the preferred stock. Therefore, little to no value will actually be ascribed to the residual equity component, and the preferred stock issuance would be classified as a liability. Also, if the principal amount is paid at some point after issuance, then this would be an indication that the issuance was debt and was classified appropriately as a liability.