Mohan R. Lavi
If appearances can be deceiving, financial statements of companies can be hiding more than they reveal. Developments over the last few years have not assisted matters with the twin blows of recession and a series of scams. The International Accounting Standards Board (IASB) has been developing International Financial Reporting Standards — shifting the focus to reporting from accounting — which lays emphasis on mark-to-market values and detailed disclosure requirements. The theme seems to be that accounting can be done by all but what is the need of the hour is disclosing in detail what has been accounted.
In this regard, the IASB has brought out a proposal to amend IAS 32 Financial Instruments: Disclosure. The IASB has followed the DMR — disclose, measure, recognise principle for an important standard such as financial instruments while India has followed the RMD — recognise, measure and disclose method. Both the methods do not budge on the magnitude of the disclosures. The Notes on Accounts of a banking company, for instance, has detailed disclosures about risk management, hedging and derivative transactions.
Multi-currency rights issues
The purpose of the amendment to IAS 32 Financial Instruments: Disclosure is to clarify the classification of instruments that give the holders the right to acquire an entity’s own equity instruments at a fixed price (rights issue) when that price is stated in a currency other than the entity’s functional currency.
The proposed amendment specifies that a rights issue offered pro rata to all of an entity’s existing shareholders on the exercise of which the entity will receive a fixed amount of cash for a fixed number of the entity’s own equity instruments, is classified as an equity instrument regardless of the currency in which the exercise price is denominated. In 2005, the International Financial Reporting Standards Interpretation Committee (IFRIC) was asked whether the equity conversion option embedded in a convertible bond denominated in a foreign currency met IAS 32’s requirements to be classified as an equity instrument.
IAS 32 states that a derivative instrument relating to the purchase or issue of an entity’s own equity instruments is classified as equity only if it results in the exchange of a fixed number of equity instruments for a fixed amount of cash or other assets. At that time, the IFRIC concluded that if the conversion option was denominated in a currency other than the entity’s functional currency, the amount of cash to be received in the functional currency would be variable.
Equity instrument and liability
Consequently, the instrument was a derivative liability that should be measured at its fair value with changes in fair value included in profit or loss. However, the IFRIC also concluded that this outcome was not consistent with the board’s approach when it introduced the ‘fixed for fixed’ notion in IAS 32. Therefore, the IFRIC decided to recommend that the board amend IAS 32 to permit a conversion or stand-alone option to be classified as equity if the exercise price was fixed in any currency. The board agreed with the IFRIC’s previous conclusion that a contract with an exercise price denominated in a foreign currency would not result in the entity receiving a fixed amount of cash in its functional currency. However, the board also agreed with the IFRIC that classifying rights as derivative liabilities was not consistent with the substance of the transaction. Rights are issued only to existing shareholders on the basis of the number of shares they already own. In this respect, they resemble dividends paid in shares.
The recession has forced companies to issue rights shares in differing currencies in differing countries — the amendment makes a case for classifying all this as equity. Other requirements of IFRS too lay emphasis on making a clear distinction between an equity instrument and a liability — an instrument with an element of both has to be split up into its individual components.
Little show One of the criticisms against Indian Accounting Standards is their minimal emphasis on disclosures. Although Accounting Standards (AS) 30, 31 and 32 seek to change this pattern, other accounting standards need to play catch-up. If IFRS adoption occurs by 2011 with a corresponding reflection of the previous year’s IFRS figures, annual reports could get thicker with the new disclosure norms - a good sign for investors in the know.