The Hindu Business Line : Equity and liability classification

The Institute of Chartered Accountants of India (ICAI) is in the process of converging Indian GAAP with International Financial Reporting Standards (IFRS) and has already made an announcement indicating the compliance date as April 1, 2011. Consequently, the ICAI recently approved Accounting Standard (AS) 31, Financial Instruments: Presentation, where equity and liability classification will be based on substance rather than the legal form of the financial instrument.

The AS will come into effect in respect of accounting periods commencing on or after April 1, 2009, and will be recommendatory in nature for a period of two years. The AS will have a significant impact on the financial statement of entities, particularly in regard to what is being disclosed as equity and debt and their consequences in regard to debt covenants, debt equity ratios, gearing, net profit, EPS, etc.

A key aspect

Classification of a financial instrument into equity and liability is very important to present true and fair view of the financial statements. Any misclassification will affect decision-making of various stakeholders such as investors, bankers, lenders, taxation authorities, etc. Currently, the classification and accounting for liability and equity under Indian GAAP is dictated by the legal form of the instrument rather than the substance.

The financial instrument classified as equity creates an ownership interest in a company, remunerated by dividends, which is accounted for as a distribution of retained profit, not a charge made in arriving at the result for a particular period. Liabilities, such as loan finance, on the other hand, are remunerated by interest, which is charged in the profit and loss account as an expense.

In economic terms, however, the distinction between share and loan capital can be far less clear-cut than the legal categorisation would suggest. For example, a redeemable preference share could be considered to be in substance, a liability rather than equity.

Contractual obligation

Under the AS the key feature determining a financial instrument as a liability is the existence of a contractual obligation of one party (the issuer) to deliver cash or another financial assets to another party (the holder), or to exchange financial assets or liabilities under conditions that are potentially unfavourable. In contrast, in the case of an equity instrument the right to receive cash in the form of dividends or other distributions is at the issuer’s discretion and as such no obligation to deliver cash or another financial asset to the holder of the instrument exists.

Financial instrument classified as liability will normally have features such as presence of maturity date, mandatory redemption; put option of the holder for redemption of the instrument, etc. Equity instrument will normally have features such as absence of maturity date, discretionary cash flows, economic compulsion (where there is no contractual obligation) to make dividend payments, etc.

FCCB, preference shares

Now let us take a look at how the standard will impact two key financial instruments in India, namely, foreign currency convertible bond (FCCB) and preference shares.

FCCBs are very popular in India. Currently the entire amount raised is shown as a liability. Under the AS, split accounting would apply to FCCB. A part of the FCCB will be treated as liability and the conversion option embedded in the FCCB will be separately accounted for as a derivative.

Another common example in the Indian context is that of preference shares. Many of the preference shares are actually liability, though they are presented as equity as per requirement of the Companies Act. The AS requires preference capital with liability features to be treated as a liability and the corresponding dividend would be treated as interest expense.

From a balance-sheet perspective, this would completely change the gearing and debt-equity ratios. From a profit and loss perspective, it would reduce the net profit number since dividend is an appropriation of the profit and loss, whereas interest is a charge to the profit and loss. Consequently, EPS would decrease.

Significant impact

It is evident that the AS will have significant impact on financial statements, some of which are as follows:

Change in debt equity situation will have a significant impact on the income statement and will affect debt-equity ratio, interest-coverage ratio, debt-service ratio, EPS, etc.

This, in turn, will impact decision making of stakeholders such as financial institutions, banks, equity holders and tax authorities. It could also result in violation of debt covenants, and could affect other amounts such as the number or stock options to be granted or managerial remuneration to be paid.

Violation of debt covenants could mean loss of control, and could result in other accounting consequences. For example, the promoter company would no longer be allowed to consolidate the underlying company on account of the dilution in interest.

Tax consequences arising out of treating dividend as interest and vice-versa.

A point to be noted is that classification as per AS in many cases will not be in accordance with the statute — for example, the Companies Act requires disclosure of preference shares and debentures including convertibles as debt under Schedule VI, irrespective of their substance.

Similarly, interest and dividend classification is based on the form of the financial instrument rather than the substance of the instrument. Preface to ED states, that till the time statute is amended, companies need to follow classification as per the statute and need not follow the requirements of ED. Hence, regulators need to take steps/initiatives to change the statute to align with the accounting standard.

The AS is a significant initiative taken by ICAI in its exercise to converge Indian GAAP with IFRS. Considering the radical impact of the AS, entities should take a serious look at it immediately.

The approved standard will be issued shortly.

(The author is a senior professional in a member firm of Ernst & Young Global. The views are personal.)

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