Reprinted from NZ Farmers Weekly, March 24, 2004 p7
http://www.farmersweekly.co.nz
Draft disclosure standard will be confusing
Alan Robb
Exposure drafts of accounting standards rarely generate much interest.
An exception is International Accounting
Standard 32 – Financial Instruments: Disclosure and Presentation. This is generating strong opposition from
co-operatives in
A key measure of the financial stability or risk of a company is its ratio of debt to equity (D/E). The higher the D/E ratio, the more risky the business.
Debt finance is traditionally considered to be anything other than share capital, retained earnings and reserves.
Debt and liabilities have been synonymous since accounting began.
Share capital can comprise ordinary shares or preference shares. In the past preference shares were, like ordinary shares, issued with no predetermined life.
They might be preferential as regards entitlement to dividends or repayment on a winding up (or both) but it was clearly understood that they were not debt.
Debt involves a liability to an external party. It is an obligation to repay, sometimes with interest, and usually at a predetermined date. There have been exceptions to all of these characteristics of debt.
Loans can be interest free. Fixed terms loans can become repayable on demand if certain covenants are broken.
Some debt can be issued with apparently unlimited duration. The Perpetual Capital Bonds issued by Motor Trade Finances Ltd are an example of a liability with no predetermined date.
Convertible notes, which change from being an interest-bearing debt instrument to a dividend-earning equity instrument, have been a common and valuable tool for many years.
Convertibles illustrate a classification problem when calculating a D/E ratio. A decision must be made whether to recognise their present legal form and treat them as a liability, or decide that “in substance” they are equity.
Until recently it has been common practice to give priority to legal form and to acknowledge that in substance calculations are of secondary importance.
For example, when calculating Earnings per Share, the primary computation is based on the shares actually existing at balance date. Diluted Earnings per Share is calculated taking into account such things as the shares that will arise when convertible notes become shares.
Increasingly accounting standard setters have decided that a ‘substance over form’ approach is preferable to ‘telling it as it is’.
This has important implications for the balance sheet.
The balance sheet is a legal document which is meant to portray financial position at a particular date.
It is not a statement of what things might become in the future.
It is meant to show the interests of members, shareholders, separately from liabilities which are the interests of non-members.
Because business depends on the enforceability of contracts it is difficult to see how a balance sheet can be meaningful if it disregards the legal form of contracts and transactions and reports things as if they are something else at that date.
To treat members’ interests as if they were those of non-members, or vice versa, is bound to create confusing and misleading reports.
IAS 32, if adopted, will create such confusion because it will affect the way liabilities and equity are classified in many companies’ balance sheets.
The proposed standard defines financial instruments as liabilities if they create an obligation to deliver cash (or another financial asset) to another entity. There are some other definitional aspects but we can disregard them here.
To be classified as equity an instrument will, in future, have to entitle the holder to a residual interest in the assets of an entity after deducting all of its liabilities.
This means that only some preference share will be treated as equity; others will have to be treated as liabilities.
Some convertible notes will continue to be treated as liabilities; others will “in substance” be equity and will be included as such from the day they are issued.
Not all ordinary shares will continue to be treated as equity even though they may represent ownership of the company and entitle the holders to attend meetings of their company and elect the directors.
If a share enables the holder to require the issuer to deliver cash or another financial asset in the future it will have to be classified as a liability and not equity.
This is going to result in some nonsensical balance sheets.
Co-operative companies are particularly concerned at this proposed standard because in many, if not most, co-operatives’ members have the right to surrender their shares for cash when they leave the co-operative. Such shares will have to be reported as liabilities.
The standard would result in many co-operatives apparently having no members’ equity and total funding from liabilities. This is clearly at variance with commonsense and commercial reality.
Shares in a co-operative are not an investment instrument and are not bought and sold in the market. They are an instrument to facilitate membership.
Shares, whether nominal value or fair value shares, are a part of members’ equity. They are not a liability owed to non-members.
It is ironic that only recently the
Co-operatives worldwide have been making
representation to their local accounting bodies and to the International
Accounting Standards Board (IASB) in
They are seeking to have co-operatives and mutuals excluded from the standard. Fonterra recently took the unusual step of making direct representations to the IASB to have the co-operatives situation recognised.
The NZ Co-operatives Association is planning a meeting within the next few weeks to discuss the implications of the standard and to plan possible action.
It is likely
that the
Alan Robb is a senior lecturer in
accountancy at the