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Liabilities and Equity

SME Par.IFRS SMEU.S. GAAP
Scope of this section
22.1 This section establishes principles for classifying financial instruments as either liabilities or equity and addresses accounting for equity instruments issued to individuals or other parties acting in their capacity as investors in equity instruments (ie in their capacity as owners).  Section 26 Share-based Payment addresses accounting for a transaction in which the entity receives goods or services (including employee services) as consideration for its equity instruments (including shares or share options) from employees and other vendors acting in their capacity as vendors of goods and services.  
22.2 This section shall be applied when classifying all types of financial instruments except:
  1. those interests in subsidiaries, associates and joint ventures that are accounted for in accordance with Section 9 Consolidated and Separate Financial Statements, Section 14 Investments in Associates or Section 15 Interests in Joint Ventures.
  2. employers’ rights and obligations under employee benefit plans, to which Section 28 Employee Benefits applies.
  3. contracts for contingent consideration in a business combination (see Section 19 Business Combinations and Goodwill).  This exemption applies only to the acquirer.
  4. financial instruments, contracts and obligations under share-based payment transactions to which Section 26 applies, except that paragraphs 22.3–22.6 shall be applied to treasury shares purchased, sold, issued or cancelled in connection with employee share option plans, employee share purchase plans, and all other share-based payment arrangements.
  
Classification of an instrument as liability or equity
22.3 Equity is the residual interest in the assets of an entity after deducting all its liabilities.  A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.  Equity includes investments by the owners of the entity, plus additions to those investments earned through profitable operations and retained for use in the entity’s operations, minus reductions to owners’ investments as a result of unprofitable operations and distributions to owners.

 The definition of equity is the same as under IFRS SMEs.  The definition of a liability is more restrictive than under IFRS SMEs (see 2.15(b)).
22.4 Some financial instruments that meet the definition of a liability are classified as equity because they represent the residual interest in the net assets of the entity:
  1. A puttable instrument is a financial instrument that gives the holder the right to sell that instrument back to the issuer for cash or another financial asset or is automatically redeemed or repurchased by the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder.  A puttable instrument that has all of the following features is classified as an equity instrument:
    1. It entitles the holder to a pro rata share of the entity’s net assets in the event of the entity’s liquidation.  The entity’s net assets are those assets that remain after deducting all other claims on its assets.
    2. The instrument is in the class of instruments that is subordinate to all other classes of instruments.
    3. All financial instruments in the class of instruments that is subordinate to all other classes of instruments have identical features.
    4. Apart from the contractual obligation for the issuer to repurchase or redeem the instrument for cash or another financial asset, the instrument does not include any contractual obligation to deliver cash or another financial asset to another entity, or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity, and it is not a contract that will or may be settled in the entity’s own equity instruments.
    5. The total expected cash flows attributable to the instrument over the life of the instrument are based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognised and unrecognised net assets of the entity over the life of the instrument (excluding any effects of the instrument).
  2. Instruments, or components of instruments, that are subordinate to all other classes of instruments are classified as equity if they impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation.
 Unlike IFRS SMEs, U.S. GAAP does not include a single general principle that determines the classification of an instrument as a liability or as equity.
  1. Unlike IFRS SMEs, there is no specific requirement to classify as either a liability or equity an instrument that is mandatorily redeemable on the occurrence of an uncertain future event or, for non-SEC registrants, the death or retirement of the instrument holder.  However, current practice is not to classify an instrument issued by a non-SEC registrant as a liability solely because it is mandatorily redeemable on the death or retirement of the instrument holder.
  2. Same as IFRS SMEs for instruments that are mandatorily redeemable on fixed dates for amounts that are fixed or are determinable by reference to an interest rate index, currency index, or another external index.  For other mandatorily redeemable instruments, there is no comparable guidance for non-SEC registrants.
22.5 The following are examples of instruments that are classified as liabilities rather than equity:
  1. An instrument is classified as a liability if the distribution of net assets on liquidation is subject to a maximum amount (a ceiling).  For example, if in liquidation the holders of the instrument receive a pro rata share of the net assets, but this amount is limited to a ceiling and the excess net assets are distributed to a charity organisation or the government, the instrument is not classified as equity.
  2. A puttable instrument is classified as equity if, when the put option is exercised, the holder receives a pro rata share of the net assets of the entity measured in accordance with this IFRS.  However, if the holder is entitled to an amount measured on some other basis (such as local GAAP), the instrument is classified as a liability.
  3. An instrument is classified as a liability if it obliges the entity to make payments to the holder before liquidation, such as a mandatory dividend.
  4. A puttable instrument that is classified as equity in a subsidiary’s financial statements is classified as a liability in the consolidated group financial statements.
  5. A preference share that provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date, or gives the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount, is a financial liability.
  1. There is no comparable guidance in U.S. GAAP.
  2. Unlike IFRS SMEs, the classification of puttable shares depends on whether the put feature is freestanding or it is embedded.  If it is freestanding, unlike IFRS SMEs, the put is classified as a liability and the share is classified as equity.  If it is embedded and the shares do not meet the definition of mandatorily redeemable shares, unlike IFRS, the shares may be classified as equity.
  3. U.S. GAAP does not address mandatory dividends, but one would assume that, in practice, mandatory dividends would be treated as interest.
  4. There is no comparable guidance in U.S. GAAP.
  5. Same.
22.6 Members’ shares in co-operative entities and similar instruments are equity if:
  1. the entity has an unconditional right to refuse redemption of the members’ shares, or
  2. redemption is unconditionally prohibited by local law, regulation or the entity’s governing charter.
 Unlike IFRS SMEs, equity treatment of members’ shares in cooperative entities and similar instruments is not limited to instruments that are not mandatorily redeemable.
Original issue of shares or other equity instruments
22.7 An entity shall recognise the issue of shares or other equity instruments as equity when it issues those instruments and another party is obliged to provide cash or other resources to the entity in exchange for the instruments.
  1. If the equity instruments are issued before the entity receives the cash or other resources, the entity shall present the amount receivable as an offset to equity in its statement of financial position, not as an asset.
  2. If the entity receives the cash or other resources before the equity instruments are issued, and the entity cannot be required to repay the cash or other resources received, the entity shall recognise the corresponding increase in equity to the extent of consideration received.
  3. To the extent that the equity instruments have been subscribed for but not issued, and the entity has not yet received the cash or other resources, the entity shall not recognise an increase in equity.
  1. Generally the same.  However, unlike IFRS SMEs, an inrease in equity may be recorded in very limited circumstances in which there is substantial evidence of ability and intent to pay within a reasonable period of time, and the note is collected in cash before the financial statements are issued or are available to be issued.
  2. Same.
  3. By analogy to the U.S. GAAP guidance on stock issued in exchange for a note (see (a)), it would be expected that no increase in equity would be recognized, like IFRS SMEs.
22.8 An entity shall measure the equity instruments at the fair value of the cash or other resources received or receivable, net of direct costs of issuing the equity instruments.  If payment is deferred and the time value of money is material, the initial measurement shall be on a present value basis. Same with respect to equity instruments issued for cash or other resources.  There is no comparable guidance on the measurement of equity instruments issued in exchange for receivables.
22.9 An entity shall account for the transaction costs of an equity transaction as a deduction from equity, net of any related income tax benefit. Same.
22.10 How the increase in equity arising on the issue of shares or other equity instruments is presented in the statement of financial position is determined by applicable laws.  For example, the par value (or other nominal value) of shares and the amount paid in excess of par value may be presented separately. Unlike IFRS SMEs, how an increase in equity arising on the issuance of equity instruments is presented in the statement of financial position is determined principally by GAAP, which includes established practice.  [Accounting for decreases in equity due to the acquisition of treasury stock, however, must conform to applicable law.]
Sale of options, rights and warrants
22.11 An entity shall apply the principles in paragraphs 22.7–22.10 to equity issued by means of sales of options, rights, warrants and similar equity instruments. Like IFRS SMEs, the recognition, measurement, and presentation of equity issued by means of  sales of options, rights, warrants, and similar instruments is consistent with the recognition, measurement, and presentation of other equity instruments.
Capitalisation or bonus issues of shares and share splits
22.12 A capitalisation or bonus issue (sometimes referred to as a stock dividend) is the issue of new shares to shareholders in proportion to their existing holdings.  For example, an entity may give its shareholders one dividend or bonus share for every five shares held.  A share split (sometimes referred to as a stock split) is the dividing of an entity’s existing shares into multiple shares.  For example, in a share split, each shareholder may receive one additional share for each share held.  In some cases, the previously outstanding shares are cancelled and replaced by new shares.  Capitalisation and bonus issues and share splits do not change total equity.  An entity shall reclassify amounts within equity as required by applicable laws. Like IFRS SMEs, stock dividends and stock splits do not change total equity.  Unlike IFRS SMEs, however, the reclassification of amounts within equity for stock splits and stock dividends is governed by GAAP.  Stock dividends are accounted for by transferring an amount equal to the fair value of the stock from retained earnings to paid-in capital, and stock splits (distributions of more than, say, 20-25% of the outstanding shares immediately before the distribution) are accounted for through a memorandum entry in the capital stock account.
Convertible debt or similar compound financial instruments
22.13 On issuing convertible debt or similar compound financial instruments that contain both a liability and an equity component, an entity shall allocate the proceeds between the liability component and the equity component.  To make the allocation, the entity shall first determine the amount of the liability component as the fair value of a similar liability that does not have a conversion feature or similar associated equity component.  The entity shall allocate the residual amount as the equity component.  Transaction costs shall be allocated between the debt component and the equity component on the basis of their relative fair values. Unlike IFRS SMEs, instruments with characteristics of both debt and equity, such as convertible bonds, are not required to be split between their debt and equity components in all circumstances.  For example, traditional convertible debt is classified entirely as a liability.  Upon conversion, the carrying amount of the liability is reclassified to equity with no gain or loss recognized.

The following are examples, however, of circumstances in which split accounting is required:
  • A conversion option that is in the money at the date of issue
  • A conversion option that is not clearly and closely related to the host and the derivative would not qualify for equity classification were it a feestanding derivative instrument
Unlike IFRS SMEs, an embedded equity component of a compound instrument may be separated from the host using intrinsic value, relative fair value, or fair value depending on the reasons why it was required to be separated and whether the embedded derivative is classified as equity or a liability.
22.14 The entity shall not revise the allocation in a subsequent period.  
22.15 In periods after the instruments were issued, the entity shall systematically recognise any difference between the liability component and the principal amount payable at maturity as additional interest expense using the effective interest method (see paragraphs 11.15–11.20).  The appendix to this section illustrates the issuer’s accounting for convertible debt.
 Same.
Treasury shares
22.16 Treasury shares are the equity instruments of an entity that have been issued and subsequently reacquired by the entity.  An entity shall deduct from equity the fair value of the consideration given for the treasury shares.  The entity shall not recognise a gain or loss in profit or loss on the purchase, sale, issue or cancellation of treasury shares. Same.
Distributions to owners
22.17 An entity shall reduce equity for the amount of distributions to its owners (holders of its equity instruments), net of any related income tax benefits.  Paragraph 29.26 provides guidance on accounting for a withholding tax on dividends. Unlike IFRS SMEs, tax benefits received for the payment of dividends (other than dividends paid on unallocated shares held by an ESOP) are recognized as a reduction of tax expense and not allocated directly to equity.
22.18 Sometimes an entity distributes assets other than cash as dividends to its owners.  When an entity declares such a distribution and has an obligation to distribute non-cash assets to its owners, it shall recognise a liability.  It shall measure the liability at the fair value of the assets to be distributed.  At the end of each reporting period and at the date of settlement, the entity shall review and adjust the carrying amount of the dividend payable to reflect changes in the fair value of the assets to be distributed, with any changes recognised in equity as adjustments to the amount of the distribution. Same as to initial recognition and measurement of the liability.  U.S. GAAP does not address subsequent measurement of the liability.
Non-controlling interest and transactions in shares of a consolidated subsidiary
22.19 In consolidated financial statements, a non-controlling interest in the net assets of a subsidiary is included in equity.  An entity shall treat changes in a parent’s controlling interest in a subsidiary that do not result in a loss of control as transactions with equity holders in their capacity as equity holders.  Accordingly, the carrying amount of the non-controlling interest shall be adjusted to reflect the change in the parent’s interest in the subsidiary’s net assets.  Any difference between the amount by which the non-controlling interest is so adjusted and the fair value of the consideration paid or received, if any, shall be recognised directly in equity and attributed to equity holders of the parent.  An entity shall not recognise gain or loss on these changes.  Also, an entity shall not recognise any change in the carrying amounts of assets (including goodwill) or liabilities as a result of such transactions. Unlike IFRS SMEs, purchases of minority interests are accounted for under step acquisition accounting.  Goodwill is recognized for the difference between the cost of the additional investment and the fair values of the identifiable net assets at the date of exchange multiplied by the percentage of the newly acquired ownership interest.

Unlike IFRS SMEs, there is no specific guidance for non-SEC registrants on accounting for decreases in a parent’s interest in a subsidiary that do not result in a loss of control.
Appendix to Section 22
Example of the issuer’s accounting for convertible debt
  The Appendix accompanies, but is not part of, Section 22.  It provides guidance for applying the requirements of paragraphs 22.13–22.15.

On 1 January 20X5 an entity issues 500 convertible bonds.  The bonds are issued at par with a face value of CU100 per bond and are for a five-year term, with no transaction costs.  The total proceeds from the issue are CU50,000.  Interest is payable annually in arrears at an annual interest rate of 4 per cent.  Each bond is convertible, at the holder’s discretion, into 25 ordinary shares at any time up to maturity.  At the time the bonds are issued, the market interest rate for similar debt that does not have the conversion option is 6 per cent.

When the instrument is issued, the liability component must be valued first, and the difference between the total proceeds on issue (which is the fair value of the instrument in its entirety) and the fair value of the liability component is assigned to the equity component.  The fair value of the liability component is calculated by determining its present value using the discount rate of 6 per cent.  The calculations and journal entries are illustrated below:

  CU
Proceeds from the bond issue (A) 50,000
Present value of principal at the end of five years (see calculations below) 37,363
Present value of interest payable annually in arrears for five years 8,425
Present value of liability, which is the fair value of liability component (B) 45,788
Residual, which is the fair value of the equity component (A) – (B) 4,212

The issuer of the bonds makes the following journal entry at issue on 1 January 20X5:

Dr Cash CU50,000
Cr Financial Liability – Convertible bond CU45,788
Cr Equity CU4,212

The CU4,212 represents a discount on issue of the bonds, so the entry could also be shown ‘gross’:

Dr Cash CU50,000
Dr Bond discount CU4,212
Cr Financial Liability – Convertible bond CU50,000
Cr Equity CU4,212

After issue, the issuer will amortise the bond discount according to the following table:

  (a) (b) (c) (d) (e)
  Interest
Payment
(Cu)		 Total
Interest
Expense
(CU)=
6%x(e)		 Amorti-
sation
of hond
discount
(cu)=
(b)-(a)		 Bond
discount
(CU)=
(d)-(c)		 Net
liability
(CU)=
50,000
-(d)
1/1/
20X5 		       4,212 45,788
31/12/
20X5		 2,000 2,747 747 3,465 46,535
31/12/
20X6		 2,000 2,792 792 2,673 47,327
31/12/
20X7		 2,000 2,840 840 1,833 48,167
31/12/
20X8		 2,000 2,890 890 1,833 49,057
31/12/
20X9		 2,000 2,943 943 0 50,000
Totals 10,000 14,212 4,212    

At the end of 20X5, the issuer would make the following journal entry:

Dr Interest expense CU2,747
Cr Bond discount CU747
Cr Cash CU2,000

Calculations

Present value of principal of CU50,000 at 6 per cent

CU50,000/(1.06)^5 = CU37,363

Present value of the interest annuity of CU2,000 (= CU50,000 × 4 per cent) payable at the end of each of five years

The CU2,000 annual interest payments are an annuity—a cash flow stream with a limited number (n) of periodic payments (C), receivable at dates 1 to n.  To calculate the present value of this annuity, future payments are discounted by the periodic rate of interest (i) using the following formula:

PV = C/i × [1 - (1/(1+i)^n)]

Therefore, the present value of the CU2,000 interest payments is
(CU2,000/.06) × [1 – [(1/1.06)^5] = CU8,425

This is equivalent to the sum of the present values of the five individual CU2,000 payments, as follows:

  CU
Present value of interest payment at 31 December 20X5 = 2,000/1.06 1,887
Present value of interest payment at 31 December 20X6 = 2,000/1.06^2 1,780
Present value of interest payment at 31 December 20X7 = 2,000/1.06^3 1,679
Present value of interest payment at 31 December 20X8 = 2,000/1.06^4 1,584
Present value of interest payment at 31 December 20X9 = 2,000/1.06^5 1,495
Total 8,425

Yet another way to calculate this is to use a table of present value of an ordinary annuity in arrears, five periods, interest rate of 6 per cent per period.  (Such tables are easily found on the Internet.) The present value factor is 4.2124.  Multiplying this by the annuity payment of CU2,000 determines the present value of CU8,425.

 Assuming the convertible bonds do not include detachable warrants, unlike IFRS SMEs, the bonds would be classified entirely as a liability.  The interest rate used to calculate interest expense would be 4 percent.  Upon conversion of the convertible debt, the net carrying amount of the debt would be credited to the equity accounts to reflect the stock issued, with no gain or loss recognized.

If the convertible bonds include detachable warrants then, like IFRS SMEs, the debt and equity components must be accounted for separately.  Unlike IFRS SMEs, however, the proceeds would be allocated to the debt and equity components based on their relative fair values at the time of issuance.
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