How-to distinguish source of funds as a
Debt or Equity?
Let’s begin reading this article by knowing the definition
of Financial Instruments. A financial instrument is a contract that gives rise
to a financial asset of one entity and a financial liability or equity
instrument of another entity.
The essence of the definition lies in contract which we
generally understand as a transaction having all the three characteristics:
agreement between two or more parties; for an economic consideration and
legally enforceable.
The definition then highlights financial assets, financial
liabilities and equity instrument. Assets, liabilities, equity instrument
reminds us of the balance sheet. For example, in credit sales transaction, the
entity which sold the goods has a financial asset – trade receivable – while
the purchaser has to account for a financial liability – trade payable. Another
example is when the entity sources finance by issuing ordinary equity shares.
The entity that subscribes to the shares accounts for a financial asset – an
investment in shares – while the issuer has to account for equity instrument –
equity share capital.
We can now gauge that accounting for financial instruments
is how we account for trade receivables, investment in shares, investment in
bonds (financial assets), how we account for trade payables, borrowings
(financial liabilities) , how we account for equity share capital (equity
instrument). Derivatives contract are also part of financial instruments and
accounting for derivatives will be discussed in another article.
There are various steps to follow as to how to account for
financial instruments starting with initial measurement, classification and
subsequent measurement.
This article will emphasize on the accounting for equity
instruments and financial liability. Both arise when the entity receives money
in return for issuing a financial instrument.
Debt
v/s Equity
It is of prime importance for any
entity to rightly classify the money raised as either a financial liability
(debt) or an equity instrument. This distinction impacts the measurement of
profit as interest cost associated with debt will be charged to the statement
of profit and loss, thus reducing the reported profit of the entity, while
dividends on equity shares are an appropriation of profit rather than an
expense. This distinction is equally important to the users of the financial
statements as it directly affects the calculation of debt-equity ratio – a key
measure to assess the financial risk of the entity.
Question
asked to the Issuer?
When raising finance on the transaction
date the issuer has to consider replying to the question: Does he have any sort
of obligation which he needs to repay on the transaction? If the issuer has an
obligation to repay, the transaction will be classified as financial liability
(debt) as opposed to being an equity instrument. Therefore, the issue of
debenture creates a financial liability as the monies have to repaid, while the
issue of ordinary equity shares creates an equity instrument. Equity instrument
is formally defined in the standard as any contract evidencing a residual
interest in the assets of an entity after deducting all its liabilities.
Equity
Instruments
Equity is initially measured at fair
value minus any issue costs. They are not remeasured. Any change in the fair
value of the shares is not recognized by the entity. Equity dividends are paid
at the discretion of the entity and are accounted for as reduction in the
retained earnings.
·
Case Study 1: Accounting for the issue of equity
Neupane Ltd. issues 10,000 Re.1 ordinary shares for cash of
Rs.2.50 each. Issue costs are Rs. 1,000.
Solution: Ordinary shares are issued increasing the
ownership interest in the net assets of the company. There is no obligation on
the part of the issuer to repay the money received. The issue costs are written
off against the share premium. Accounting for issue of equity shares can be
reflected as under:
Cash a/c …………………………………………Dr 24,000
To Equity Share
Capital ………………………………… 10,000
To Share Premium………………………………………. 14,000
Financial
Liabilities
Where an instrument contains an
obligation to repay it is classified as financial liability. Further, financial
liabilities are categorized either at amortized cost or at fair value through
profit and loss (FVTPL)
Financial
Liabilities at amortized cost
Most of financial liabilities are
categorized and accounted for at amortized cost. All amortized cost liabilities
are initially measured at fair value minus transaction costs.
The accounting for financial liability at amortized cost
means that the effective interest rate (EIR) of the liability will be recorded
as interest cost in the statement of profit and loss. The liability will not be
revalued at any reporting date. The effect of EIR accounting is that each year
the liability will increase by the amount of interest charged to the profit and
loss account and decrease by the amount of actual interest paid.
·
Case Study 2: Accounting for financial liability at
amortized cost
Pasupati Ltd. raises money by issuing 100 zero coupon bonds
at par of Rs. 100 each. The bonds will be redeemed after three years at a
premium of 1,910. The effective interest rate (EIR) calculated is 6%.
Solution: The bond is a zero coupon bond meaning that no
actual interest is paid during the tenor of the bond. Even though no interest
is paid there will still be interest charge to profit and loss in this
borrowing. The premium paid Rs.1,910 on maturity represents the interest
charge. It will not be appropriate to charge the interest each year on the
straight line basis as this would ignore the compounding nature of interest,
thus effective interest rate is calculated. The presentation of liability at
amortized cost is summarized below:
Opening Balance
|
Plus Interest @ EIR 6%
- P&L a/c
|
Less Actual interest
paid
|
Closing Balance –
Balance Sheet
|
|
Year 1
|
10,000
|
600
|
0
|
10,600
|
Year 2
|
10,600
|
636
|
0
|
11,236
|
Year 3
|
11,236
|
674
|
11,910
|
0
|
Financial
Liabilities at Fair Value Through Profit and Loss (FVTPL)
Financial liabilities are only
categorized at Fair Value Through Profit and Loss (FVTPL) if they are held for
trading or the entity designates at fair value. The entity can use the option
to designate a financial liability at fair value only if by doing so it
significantly reduces the ‘accounting mismatch’ which would otherwise arise
from measuring the assets or liabilities or recognizing the gains and losses on
them on different bases or financial assets and financial liabilities are
managed together and its performance is evaluated on a fair value basis as per
the investment strategy. If a financial liability contains one or more embedded
derivatives that require separation then that financial liability may be
designated at FVTPL.
Financial
liabilities categorized as FVTPL are initially measured at fair value and transaction
costs are written off to the statement of profit or loss.
The accounting of Financial Liability at FVTPL is to
increase the financial liability by EIR interest cost and reduce by actual
interest paid. It is then revalued at each reporting date at fair value and any
unrealized gains or loss because of revaluation is recognized in the statement
of profit or loss. The fair value at the reporting date will be its market
price, or if not known then, the present value of the future cash flows
discounted at current market interest rate.
·
Case Study 3: Accounting for financial liability at FVTPL
Prime Ltd. issued a three year 7% debentures on January 1,
2012 of the value Rs.30,000 when the EIR of the debenture was also 7%. The
debentures will be redeemed at par. The liability is categorized at FVTPL. At
the end of first accounting period in the market interest rate is at 8% and at
the end of second accounting period the interest rate in the market has fallen
down to 6%.
Solution: The initial
measurement is at fair value of Rs.30,000 received and there are no transaction
costs. If transaction costs then these would be expensed in the statement of
profit and loss.
With the coupon rate and
EIR at the end of first accounting period being the same, i.e. 7%, the carrying
value of the liability will be same Rs. 30,000. This is because financial
liability will be increased by an amount of EIR (30,000*7% = 2,100) and reduced
by actual interest paid (30,000*7% = 2,100).
The liability is at
FVTPL, this carrying value as at December 31, 2012 has to be revalued. The fair
value of the liability at this date will be the present value using the market
rate of 8% of the remaining 2 years cash flows:
Payment dates
|
Cash flow
|
8%discount factor
|
Present value of cash
flow
|
||
31-12-2013
|
2,100
|
X
|
0.9259
|
=
|
1,945
|
31-12-2014
|
32,100
|
X
|
0.8573
|
=
|
27,520
|
Fair value of the
liability at 31-12-2014
|
29,465
|
||||
The reduction in the carrying value of the liability of Rs.
535 is considered as unrealized profit in the statement of profit and loss. If
higher discount rate was not because of general rise in market rates but the
credit risk of the entity, then the gain is recognized in Other Comprehensive
Income (OCI).
Date
|
Opening Balance
|
Plus EIR on opening
balance
|
Less Actual interest
paid (7%*30,000)
|
Carrying Value of
Liability at reporting date
|
Fair Value of Liability
at reporting date
|
Unrealized Gain/Loss to P&L
a/c
|
31-12-2012
|
30,000
|
2,100
|
(2,100)
|
30,000
|
29,465
|
535
|
31-12-2013
|
29,465
|
2,357
|
(2,100)
|
29,722
|
30,283
|
(283)
|
31-12-2014
|
30,283
|
1,817
|
(2100)
|
30,000
|
Repaid
|
Repaid
|
The accounting principle is based on what we have always
known for debt, when interest rate increases the fair value of debt decreases
and when interest rate decreases value of debt rises.
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