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In this article we cover a simple, but an extremely important aspect of classification i.e., debt or equity in the balance sheet. This aspect has significant implication on the financial results, particularly the net worth reported by companies.
A financial instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial instruments include a broad range of financial assets and liabilities. They include both primary financial instruments (such as cash, receivables, debt and shares in another entity) and derivative financial instruments (e.g., options, forwards, futures, interest rate swaps and currency swaps). An instrument, or its component, is classified on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the respective definition of a financial liability, a financial asset and an equity instrument.
An instrument is classified as a financial liability if it contains a contractual obligation to transfer cash or other financial asset, or if it will or may be settled in a variable number of the entity’s own equity instruments.
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
Classification as equity or financial liability:
As per the currently effective Accounting Standards in India, there is no specific accounting guidance on classification of an instrument in the books of the issuer as an equity or debt i.e., financial liability. Currently the classification and presentation in the financial statements is based on the legal form of the instrument, rather than its substance. For example, redeemable preference shares are currently presented as a part of ‘share capital’ based on their legal form under the Companies Act, 1956. However, under Ind AS, the emphasis is on the substance of the contract as against the legal form for the purpose of classification of an instrument into debt or equity. It is important to analyse whether the issuer has a contractual obligation to deliver cash or another financial asset to the holder of the instrument. The existence of such an obligation would result in an instrument being classified as a financial liability. On the other hand, instruments that allow the issuer to unconditionally avoid making any payment are considered to be equity instruments.
Example 1:
A company issues a perpetual bond (a bond that contains no maturity date) that pays 5% interest per annum. The definition of financial liability states that an instrument shall be classified as a financial liability if it contains a contractual obligation to deliver cash or other financial asset. Accordingly, this perpetual bond shall be classified as a financial liability as it contains an obligation to pay interest annually.
However in this case, if there was no liability to pay interest, the instrument would have been classified as an equity.
Example 2:
A company issues a share that is redeemable for a fixed amount of cash at the option of the holder. In this case, the entity cannot avoid the settlement of this share through delivery of cash should the holder demand repayment. Accordingly, the share meets the definition of a financial liability.
Preference shares:
Under the currently effective accounting standards, preference shares have been classified as equity based on the requirements of the Companies Act, 1956. However, under Ind AS, the terms under which the preference shares have been issued shall determine the classification — financial liability or equity. Preference shares shall be classified as a financial liability
unless all the following conditions are met —
- They are not redeemable on a specific date
- They are not redeemable at the option of the holder
- Dividend payments are discretionary.
Consequently, distributions on such instruments that were previously recognised as dividend expense (including dividend distribution tax) would now be recognised as an interest expense under Ind AS.
Example 3:
A company issues redeemable preference shares, with a mandatory dividend of 8% each year. These preference shares are redeemable at the option of the holder.
As per the term of these preference shares, it contains a mandatory dividend payment of 8% and the principal amount is repayable. The holder of the instrument has the right to redeem the preference shares obliging the issuer to transfer cash or other financial asset. According to the definition of a financial liability, these preference shares shall be classified as a financial liability in the balance sheet of the issuer, although the legal form of the instrument is that of shares.
Example 4:
A company issues non-redeemable preference shares with a dividend payable at the discretion of the issuer.
As per the terms of the preference shares, dividend payments are discretionary and the issuer is not obliged to pay cash. Accordingly, the preference shares shall be classified as equity.
Compound financial instruments:
Instruments that have both — equity as well as liability features are considered compound instruments and are required to be split into their respective equity and liability components. Each component would then be presented separately in the financial statements. Ind AS provides guidance on bifurcation of the instrument into components, the liability being valued first based on the discount rate applicable to a comparable instrument with similar terms/tenure, but without the conversion feature. The residual amount is the value for the equity component. Therefore under Ind AS, instruments such as optionally convertible debentures would be considered a compound instrument for the issuer.
Debt instruments that have equity conversion features are currently presented as borrowings since there is no accounting guidance relating to instruments that have the features of both equity and a financial liability. These instruments are therefore recognised as one instrument, classified on the basis of their legal form. On conversion, the amounts relating to these instruments are then reclassified from borrowings to equity (for the par value) and reserves (for any premium on conversion).
Example 5:
Optionally Convertible Bond: Company A has issued 2,000 6% optionally convertible bonds with a 3-year term and a face value of Rs.1,000 per bond. Each bond is optionally convertible at any time until maturity into 250 equity shares. Assume that cost of debenture issue is zero. Market interest rate for similar instrument but without conversion option is 9%.
Under currently effective accounting standards, a liability will be recognised at Rs.2,000,000.
Accounting under Ind AS 32
- Financial liability component will be recognised at present value calculated using a discount rate of 9%
- Remaining amount recognised as equity § Unwinding of discount accounted as interest expense.
- Present value of financial liability component (principal and interest) recognised using a discount rate of 9%
On conversion of a convertible instrument, which is a compound instrument, the entity derecognises the liability component that is extinguished when the conversion feature is exercised, and recognises the same amount as equity. The original equity component remains as equity, although it may be transferred within equity. No gain or loss is recognised in the profit and loss account.
Example 6: Compulsorily Convertible Bond
If in the previous example, the principal amount of bonds, instead of being optionally convertible, were compulsorily convertible into 2 equity shares each i.e., fixed number of shares will be delivered in exchange for a fixed amount of the bond —
PV of interest payable contractually (Rs.120,000 as per the contractual rate of 6%) every year for 3 years, calculated at the market rate of interest of 9% p.a. will be treated as liability (this comes to Rs.303,755, similar to example 5).
The balance (Rs.2,000,000 minus Rs.303,755, i.e., Rs.1,696,245) will be treated as equity (due to the fixed for fixed criteria).
Example 7: Foreign Currency Convertible Bond
Under Ind AS, a foreign currency convertible instrument that can be settled by issuing a fixed number of equity instruments for an amount that is fixed in any currency is classified as equity. Equity is measured at cost and hence the convertible option will be carried at cost and will not result in any volatility in the profit and loss account.
A company with INR functional currency issues 200 convertible bonds denominated in US Dollars with a face value of USD 1000 per bond. The bond carries a 1% rate of interest and is convertible at the end of 10 years, at the option of the holder, into fully paid equity shares with a par value of INR 1 of the issuer at an initial conversion price of Rs. 47.00 per share with a fixed rate of exchange on conversion of INR 44.24 to USD 1.
The conversion option is an obligation for the issuer to issue a fixed number of shares [(200,000*44.24)/47] in exchange for a financial asset (principal amount of the bond — USD 200,000) that represents a right to receive an amount of cash that is fixed in US Dollar terms but variable in INR terms, depending on the exchange rate prevailing on the date of conversion.
Accordingly, under Ind AS, the convertible option shall be considered as equity as it is convertible for a fixed number of equity shares for an amount that is fixed in US Dollar. The option will be measured at cost and will not result in profit or loss. This instrument hence will be treated as a compound financial instrument, the bond being classified as liability and the conversion option being treated as equity. The accounting will be similar to that in example 6.
Under IFRS, the conversion feature in a foreign currency convertible bond is considered to be an embedded derivative and is classified as a financial liability since the conversion feature involves issuing a fixed number of equity instruments for a variable amount of cash in INR terms. Since the redemption of the bond is denominated in a foreign currency and not in the functional currency of the issuer, the financial liability derivative will be measured at fair value and the gain or loss will be taken to profit or loss account.
Accordingly, under IFRS, the convertible option is considered an embedded derivative and would have been classified as a financial liability as it is convertible for a fixed number of shares for a variable principal amount in INR terms (functional currency) (200,000 * exchange rate on the date of conversion). The convertible option will accordingly be measured at fair value with gains or losses taken to profit or loss.
As is evident, from the aforesaid examples, the impact of reclassification of debt and equity has a significant impact on the financial results. Application of these principles become challenging based on the complexity of financial instruments being issued.
