Query
Top Co, whose functional
currency is INR, has issued preference shares to a foreign investor. As per the
terms, at the end of 3-years from the issuance date, the holder has the option
to either redeem each preference share for cash payment of USD 10 or to get 10
equity shares of Top Co for each preference share. Whether the equity
conversion option represents an equity instrument or a (derivative) financial
liability of Top Co?
Response
ITFG
responded to a similar issue in Bulletin No. 17 and its view is reproduced
below.
ITFG view
Ind AS 32,
Financial Instruments: Presentation lays down the principles for the
classification of financial instruments as financial assets, financial
liabilities or equity instruments from the issuer’s perspective. As per
paragraph 11 of Ind AS 32, “A financial liability 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 equity
instruments; or
(ii) a derivative that will or may be settled
other than by the exchange of a fixed amount of cash or another financial asset
for a fixed number of the entity’s own equity instruments. For this purpose,
rights, options or warrants to acquire a fixed number of the entity’s own
equity instruments for a fixed amount of any currency are equity instruments if
the entity offers the rights, options or warrants pro rata to all of its
existing owners of the same class of its own non-derivative equity instruments.
Apart from the aforesaid, the equity conversion option embedded in a convertible
bond denominated in foreign currency to acquire a fixed number of the entity’s
own equity instruments is an equity instrument if the exercise price is fixed
in any currency. …….
As per the
above definition, as a general principle, a derivative is a financial liability
if it will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity’s own equity
instruments. The term ‘fixed amount of cash’ refers to an amount of cash fixed
in functional currency of the reporting entity. Since, an amount fixed in a
foreign currency has the potential to vary in terms of functional currency of
the reporting entity due to exchange rate fluctuations, it does not represent
“a fixed amount of cash”. However, as an exception to the above general
principle, Ind AS 32 regards the equity conversion option embedded in a
convertible bond denominated in a foreign currency to acquire a fixed number of
entity’s own equity instruments to be an equity instrument if the exercise
price is fixed in any currency, i.e., whether fixed in functional currency of
the reporting entity or in a foreign currency. [It may be noted that the
corresponding standard under IFRSs (viz., IAS 32) does not contain this
exception].
Ind AS 32
makes the above exception only in the case of an equity conversion option
embedded in a convertible bond denominated in a foreign currency, even though
it explicitly recognises at several places that other instruments can also
contain equity conversion options. Given this position, it does not seem that
the above exception can be extended by analogy to equity conversion options
embedded in other types of financial instruments denominated in a foreign
currency such as preference shares.
In view of
the above, the equity conversion option forming part of terms of issue of
preference shares under discussion would be a (derivative) financial liability.
Authors’ point of view
- It appears that the above opinion provides unwarranted emphasis
on the nomenclature of the instrument rather than the terms and conditions of
the instrument. It may be noted that an instrument is classified based on its
terms and conditions under Ind AS, rather than its nomenclature. In other
words, from an Ind AS perspective, there is no difference in how the preference
share or the bond is accounted, if they contain similar terms and conditions.
From that perspective, it appears unreasonable that the exemption of treating
the conversion option fixed in foreign currency as equity is allowed only for
conversion options in bonds and not for conversion options in preference
shares, though both instruments are similarly accounted under Ind AS.
- Whilst a preference share and a bond under the Indian Companies
Act have different liquidation rights, from the point of view of RBI
regulations and Ind AS accounting there is no difference. Consequently, all
that an entity has to do is to nomenclate a preference share as a bond or
structure it like a bond. Sometimes debt covenants with existing bond holders
may prohibit an entity from issuing new bonds. In those cases, there will be a
restriction on the entity from raising funds using a bond. On the other hand,
raising foreign funds using a preference share with a conversion option may be
debilitating from an accounting and balance sheet perspective.
- The ITFG opinion has not
provided a strong case or basis for making a difference between accounting for
conversion option contained in a bond and that contained in a preference share.
Neither has it defined the term bond and preference share, which may result in
different interpretation. However, common practice will be to use the same
definition contained in the Companies Act. The exemption for a bond and not for
a preference share appears arbitrary and rule based, rather than based on sound
and solid accounting principles.
Final Remarks
The ITFGs main argument is
that the carve-out from IAS 32 was meant to operate more like an exemption
rather than based on a sound principle. In the long run carve-outs is not the
preferred option, particularly if those are not supported by a strong basis of
conclusion or a well-defined principle. In addition to the possibility of
multiple interpretation of the carve-out, it will camouflage gearing in
financial statements and create confusion in the minds of investors. The
International Accounting Standard Board has issued a discussion paper titled Financial
Instruments with Characteristics of Equity (FICE). The objective of the
discussion paper is to clearly set out the principles of debt vs. equity.
Indian standard setters will have an opportunity of participating in this
discussion and eliminating any differences between the IFRS and Ind AS standard
with respect to debt vs equity classification.
At last, I am reminded of a
quote from Shakespeare’s Romeo and Juliet – “What’s in a name? that which we
call a rose by any other name would smell as sweet.” The ITFG has proved
him wrong!!
