ED 98 Presentation and Disclosure of Financial Instruments

15 December 1998

The Executive Director
Australian Accounting Research Foundation
211 Hawthorn Road
Caulfield Vic 3162

Dear Sir,

ED 98 Presentation and Disclosure of Financial Instruments

The Group of 100 is pleased to comment on the above exposure draft. Overall, the Group of 100 does not agree with the changes proposed in the exposure draft. Our specific comments are set out below.

Lack of consistency with the definition of a liability

The issue of an equity instrument does not meet the definition of a liability as defined in Accounting Standards because it is never unfavourable to the issuer. This is the case irrespective of whether the number of shares is determined at the time the securities are issued (fixed) or varies depending on the fair value of the equity instruments at ‘settlement’ (variable). In our view, the way in which the number of shares is determined is not relevant to the classification of the instrument from the point of view of the issuer.

For an instrument to be classified as a liability it must require a future sacrifice of economic benefits by the issuer. The Group of 100 does not believe that the issue of an entity’s own shares involves a sacrifice of future economic benefits. This view is consistent with the requirements of AASB 1033 which states that an entity’s obligation to issue its own equity instruments in exchange for financial assets of another party is not potentially unfavourable since it results in an increase in equity and it cannot result in a loss to the entity" (Appendix A, paragraph 7). In addition paragraph 8.1.10 of AASB 1033 provides that an obligation of an entity to issue or deliver its own equity instruments is itself an equity instrument since the entity is not obliged to deliver cash or another financial asset.

The Group of 100 believes that the classification of a converting financial instrument should be determined in accordance with the definitions of a liability and should be viewed from the issuer’s and not the holder’s perspective. We do not believe that the holder’s perspective is relevant in determining the classification of a financial instrument by the issuing entity.

Classification of contractual obligations as equity distributions

ED 98 proposes that classification in the financial reports of the issuer of a converting financial instrument is based on the risks and rewards enjoyed by the holder of the financial instrument and not the contractual substance of the financial instrument from the point of view of the issuer.

A consequence of amending the criteria for classification is that there are instances where the issuer has a contractual obligation to make payments (for example, fixed rate cumulative interest payments) to the holder that will be classified as equity distributions, that is, after profit has been determined.

In these circumstances the reported profit will not reflect the contractual obligations that would have been recognised as expenses under existing generally accepted accounting principles because they relate to a converting financial instrument.

In all other instances under existing generally accepted accounting principles, contractual obligations to make payments/distributions for the servicing of debt would be treated as expenses. The Group of 100 believes that adoption of the principles of ED 98 will result in inconsistent treatment of these contractual obligations within the profit and loss account.

Payment of dividends from negative retained earnings

ED 98 requires the classification of interest, dividends, losses and gains as expenses or revenues or as changes in equity to be consistent with the classification of the financial instrument. Accordingly, a newly formed entity that has issued converting financial instruments will be required to classify its funding costs as dividends. Such classification may constitute a breach of the Corporations Law if the dividends are paid whilst the company has negative retained earnings.

The meaning of "mandatorily" converts to ordinary equity

ED 98 does not provide a clear explanation of the term "mandatorily" with respect to the conversion of an instrument into ordinary equity. Clarification is required under each of the following circumstances:

the issuer of the instrument has the option to redeem the instrument during its life. If the option is not exercised the instrument becomes mandatorily convertible to ordinary equity at a specified date;
the conversion date is not specified at the inception of the instrument;
the financial instrument mandatorily converts to a contracted fixed amount of equity upon the occurrence of a certain defined event and the same event results in the equity of the total value of the company being less than the contracted fixed amount (for example, the winding up of an entity).

Conversion to Preference Shares

ED 98 does not include any discussion regarding the accounting treatment for financial instruments that convert to equity preference shares. ED 98 is only applicable to financial instruments that mandatorily convert to ordinary equity instruments.

Impact on Ratios

Entities operating within strict ratio constraints and with instruments structured in such a way to avoid breaching target ratios are potentially adversely affected if the proposals in ED 98 result in the reclassification of equity instruments to financial liabilities.

International Harmonisation Program

Neither the International Accounting Standards Committee nor the Financial Accounting Standards Board has finalised deliberations with respect to classification of converting instruments. Therefore, we believe that it is premature to adopt this proposal in an Australian Standard.

Please contact Darcy Thompson (9641-0476) if you have any queries in relation to any of the issues raised above.

Yours sincerely,

Bryce JH Denison
National President