Steve’s guide to complex financial instruments
Financial instruments can be one of the most complicated areas in the world of accounting, simply because of their nature and accounting treatment. Understanding what a financial instrument is can sometimes be hard work, but essentially when a company raises finance, a third party is providing it, hence a financial instrument. As well as cash, financial instruments can also be debtors (receivables), creditors (payables), loans and shares.
Complex (or ‘compound’) financial instruments fill, not only students, with dread, but professional accountants also. Essentially a compound financial instrument is an instrument that contains a mixture of both ‘debt’ and ‘equity’ – the debt component is recognised as a liability in the balance sheet (statement of financial position), and the equity component is recognised in equity in the balance sheet (statement of financial position) . The treatment as debt or equity will on depend on the rights attached to the instrument. The most common form of compound instrument is a convertible loan note (see later), where the loan note holder has the right to receive shares in a company, as opposed to the company settling the capital element of the loan note in cash (or other forms of assets).
Preference shares
Preference shares are those shares issued by an entity that are not ordinary shares and are a way in which listed companies raise finance. The holder of the preference shares can receive a fixed rate of dividend, and these dividends are always paid before dividends on ordinary shares (hence the word ‘preference’). Such dividends are generally ‘cumulative’ dividends, which means that if the holders of the preference shares are not paid their dividend in a year (for example due to cash flow restrictions), they must be paid in full if, and when, the company is subsequently able to.
When the holder of preference shares is entitled to cash, or if the preference shares are redeemable at a later date, they are treated as debt (i.e. as a liability), rather than equity. This is because there is a contractual obligation for the company to pay cash to the holder of the preference shares. This is not absolute and they can be recognised in equity in certain situations as follows:
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Redemption of shares: |
Payments of dividends: |
Recognition in accounts as: |
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Non-redeemable |
Discretionary |
Equity |
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Non-redeemable |
Non-discretionary |
Liability |
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Redeemable at issuer’s option at some future point in time |
Discretionary |
Equity1 |
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Redeemable at issuer’s option at some future point in time |
Non-discretionary |
Liability plus an embedded call option derivative2 |
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Contractually redeemable at a fixed/determinable amount at a fixed/determinable date |
Discretionary |
Compound financial instrument3 |
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Redeemable at holder’s option at some future point in time |
Discretionary |
Compound financial instrument |
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Redeemable at holder’s option at some future point in time |
Non-discretionary |
Liability plus an embedded put option derivative |
1 In this case there is no contractual obligation to pay the holder of the shares cash. Options to redeem the shares for cash do not actually meet the definition of a financial liability. As a result, any dividends paid on these preference shares would be recognised in equity.
2 The entire proceeds would be classified as a liability because the dividends will be set at market rates and as such the proceeds will be equivalent to the fair value, at the date of issue, of the dividends payable to perpetuity. In respect of the issuer call option to redeem the shares for cash, this would be classed as an embedded derivative which may have to be separated using ‘split accounting’ unless the option’s exercise price is approximately the same on each exercise date to the amortised cost of the instrument.
3 Liability portion of the compound instrument is equal to the present value of the redemption amount. Equity amount is equal to the proceeds less liability portion. See later in the article for an example of how to calculate these. Dividends related to equity component are recognised in equity.
You can basically see from the above table that where there is an obligation to pay cash – either on redemption or by way of dividend (interest), preference shares are treated as a liability.
In respect of preference shares, dividends paid to the holders of the preference shares are not actually taken to dividends via reserves; these are instead treated as finance costs (interest) to the holders of the preference shares.
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Example Preference shares are issued to shareholders that pay 10% dividends on an annual basis. The preference shares contain an obligation to pay cash to the preference shareholders and they should be classified as a financial liability, disclosed as current/non-current dependant on the contractual terms. The 10% dividends should be recognised as a finance cost in the profit and loss account.
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Compound financial instruments
A compound financial instrument is a financial instrument which contains a mixture of both debt and equity. Here the problem child is the recognition of the debt portion and the amount to be recognised in equity, so I will illustrate with an example as follows:
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Example On 1 April 2009 an 8% convertible loan note with a nominal value of C600,000 was issued at par to Company A Ltd. It is redeemable on 31 March 2013 at par. Alternatively, it may be converted into equity shares on the basis of 100 new shares for each C200 worth of loan note. An equivalent loan note without the conversion option would carry interest at 10%. Interest of C48,000 (C600,000 x 8%) has already been paid and included as a finance cost in profit and loss. |
Present value rates are as follows:
Present Values
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End of Year |
8% |
10% |
|
1 |
0.93 |
0.91 |
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2 |
0.86 |
0.83 |
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3 |
0.79 |
0.75 |
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4 |
0.73 |
0.68 |
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In this example, there is an option to convert the shares into equity but there is also an obligation to pay cash to the loan note holders (8% interest). There is also the issue that an equivalent loan note without the conversion option would have carried interest at 10%. The loan notes attract interest at a rate of 8% but as it is only an option, in order to calculate the correct amounts to be recognised in debt and equity we have to discount the entire cash flows using a rate of 10%. Using this information the debt and equity amounts can be calculated as follows:
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8% interest (C600k x 8%) |
Factor at a rate of 10% |
Present value (rounded down) |
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Year 1 2010 |
48,000 |
0.91 |
43,600 |
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Year 2 2011 |
48,000 |
0.83 |
39,800 |
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Year 3 2012 |
48,000 |
0.75 |
36,000 |
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119,400 |
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Year 4 2013 (redemption) |
648,000 |
0.68 |
440,600 |
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Amount to be recognised as a liability |
560,000 |
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Initial proceeds |
(600,000) |
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Amount to be recognised as equity |
40,000 |
Convertible Debt
There are lots of instances in real-life where companies issue financial instruments to other companies which contain an option to enable the loans to be converted into equity shares. This is particularly common in today’s ‘climate’ where such options are being exercised.
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Example Company A received a loan from Company B amounting to C100,000 in 2006, the terms of which required redemption in 2011. Given the economic difficulties, it was apparent that Company A was unable to repay the loan at the agreed redemption date. Company B accepted C100,000 of equity shares in full and final settlement. No gain or loss will arise on this transaction as the debt is simply transferred to equity (assuming no premium on the issue of the shares) by: DR loans C100,000 CR equity C100,000 Any premium on the share issue would be transferred to a share premium account.
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Example Same facts as above, but consider if the fair value of the equity shares issued in exchange were C75,000. In this instance there would be a gain arising on the settlement of the debt and the entries would therefore be: DR loans C100,000 CR equity C75,000 CR P&L C25,000 (gain on elimination of debt)
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Conclusion
The issue of financial instruments is a very complex area, but where preference dividends are concerned it is important to scrutinise the rights attached to them. In general, where the shareholder has an obligation to receive cash (either through redemption or interest), then treat as a liability. If the decision to redeem the preference shares or pay dividends is discretionary, they become equity.
Category: Accounting and standards
