Share Treatment Under IFRS


1 September 2005


David Chopping of Moore Stevens, explains how UK regulations concerning shares are changing. They are being brought into line with other European countries and with general UK accounting principles.


Up until now, accountants in the UK have adopted a fairly simplistic approach to dealing with shares and instruments connected to shares. That is about to change.

Accounting for shares, and other capital instruments, has previously been governed by FRS 4. While this standard has required companies to disclose the nature of shares, and give details of the rights associated with them, anything called a share has nonetheless been treated as part of shareholders' funds.

"The biggest impact of the change will be on redeemable shares."

Payments made in respect of anything described as a share have been treated as dividends, an appropriation of profits, not a charge. While there has long been a requirement to split shares between equity and non-equity, this has been a disclosure requirement rather than something affecting the accounting treatment.

When accounting for items that might become shares a similar simple treatment has been adopted. Under FRS 4 convertible debt, for example, is simply debt.

Disclosure of the conversion rights is required, but shareholders' funds change only when conversion actually takes place. No attempt has previously been made to deal with accounting for the conversion rights separately.

'SUBSTANCE OVER FORM'

Such a treatment of shares and related items has long looked anomalous. In all other areas, 'substance over form' has long been one of the basic principles of accounting in the UK.

It means that where there is a conflict between the economic substance of a transaction and its legal form it is the economic substance that determines the accounting treatment.

In effect, it does not matter how a transaction is structured, the accounting has to reflect the impact the transaction actually has. Why accounting for shares should be an exception has never been exactly clear.

But now that exception is disappearing.

A NEW APPROACH

Whether a company is moving to IFRS or staying with UK GAAP, a different approach to accounting for shares and related items needs to be adopted (the old rules will continue for some small UK companies, but it is likely that this position will change in 2006.)

"The accounting has to reflect the impact that the transaction actually has."

Under both the international standard, IAS 32 and the UK standard, FRS 25 (which is simply the UK version of IAS 32) a substance over form approach is to be taken to the problem of equity and debt.

Debt is where the company has an obligation to pay out resources (usually but not necessarily cash) at a future point. It does not have to be immediate, nor does the date on which payment is to be made even need to be known.

Nonetheless, at some point in the future either the company will have to pay, or some other party may require it to pay.

Equity is a residual interest, even if it is in respect of a fixed amount. Calling something a share does not change its economic substance, and therefore does not change the appropriate accounting treatment. So shares may appear within either debt or equity, depending on the rights connected with those shares.

REDEEMABLE SHARES

The biggest impact of the change will be on redeemable shares. A redeemable share needs to be treated as debt if:

  • The redemption date is fixed
  • The holder has the option of redemption at any point
  • Redemption is to take place on the occurrence (or non-occurrence) of a future event that is outside of the control of the company

What all of these situations have in common is that the company either will or may be required to pay money. Redeemable shares will be treated as equity only where the redemption is solely at the option of the company. In this case there is no obligation, since if the company can choose to redeem, it can also choose not to.

The profit and loss account (or income statement) treatment follows the balance sheet. So 'dividends' in respect of shares treated as debt will be shown within or alongside all other forms of interest. Alongside is better, since some of the legal restrictions associated with share will continue to apply.

The treatment of convertible debt, and similar, is also changing. It has always been the case that the conversion rights attached to convertible debt reduce the amount of interest payable (if they did not, why would a company issue convertible debt?)

"The UK's fairly simplistic approach to dealing with shares and connected instruments is about to change."

But, as noted above, accountants have previously chosen to ignore this fact, treating conversion rights simply as a disclosure matter. Now, the value of the conversion rights needs to be determined when the debt is issued, and accounted for separately.

CALCULATION OF DEBT VALUE

On issue, the present value of the cash flows associated with the convertible debt needs to be treated as debt with the balance treated as equity. In effect, as an advance in respect of the conversion.

The present value is not calculated by using the interest rate actually payable, but the rate that would have been obtained in the absence of the conversion rights.

For example, a company wishes to borrow £10m. It can borrow on normal repayment terms at a rate of, say, 7%. The company feels it can get cheaper finance, and is able to issue convertible debt at, say, 5%.

The actual cash flows will be determined using an interest rate of 5%. But for the purposes of determining the split between debt and conversion rights these cash flows, including any capital repayment that will occur in the absence of conversion, need to be discounted using a rate of 7%.

Whenever a simple set of cash flows at one rate are discounted at a higher rate then the amount will fall. So if this is done the resulting amount will be less than £10m. If the amount were, for example, £9.6m, then this amount would be treated as debt.

The balance of £400k would be treated as part of equity immediately, since this is the amount of interest the providers of the convertible debt have been willing to forego in order to obtain the conversion rights.

While it will not always be obvious to someone reading the accounts, the interest charges on the debt shown in the balance sheet will (using this example) be at an effective rate of 7%. They have to be. That is how the debt amount was calculated in the first place.

RATES, CALCULATIONS AND THE FUTURE

This treatment does not change according to whether the convertible debt is at a fixed or variable rate.

In both cases, the discount is calculated at the date of issue and not affected by any future changes. This covers both any future changes in interest rates, but also any future changes in the likelihood of conversion.

"The treatment of convertible debt, and similar, is also changing."

In fact, the treatment does not change even if conversion never takes place; the amount initially taken to equity is never taken to debt.

Taking all of this together, the change in the treatment of some shares will both reduce the apparent net assets of affected companies, as shares fall to be treated as debt, and their reported profits, as payments move from dividends to interest.

The change in the treatment of convertible debt will not affect profits, since the interest charges will be unaffected by the difference in the treatment of the amounts initially received. But it will change the ratio of interest payments to debt.