Buoyed by the expectation of a steady progressive government, the market sentiment in India is definitely up again. Investors are looking out for opportunities and corporates have more optimism than in the recent past. Accordingly, one can expect a steady uptick in the number of companies who are looking to draw more finance, be in the form of debt or equity.

By:  Ashish Gupta, Partner & Leader – Financial Reporting Advisory Services (FRAS), Walker Chandiok & Co LLP

Buoyed by the expectation of a steady progressive government, the market sentiment in India is definitely up again. Investors are looking out for opportunities and corporates have more optimism than in the recent past. Accordingly, one can expect a steady uptick in the number of companies who are looking to draw more finance, be in the form of debt or equity.

Accomplished senior executives of a company feel upbeat about striking a sweet funding deal for their company. Amidst the celebrations, they need to take a step back and check whether accounting considerations figure in the deal negotiators’ list of “must haves” when the deal is inked. This read analyses some of accounting considerations that companies need to keep in perspective, including changes accounting and corporate affairs regulators are making to the standards, which can potentially cause undesirable and unforeseen effects on financial statements, owing to certain clauses of the funding deals.

Steps towards new accounting rules

The Institute of Chartered Accountants of India (ICAI) and Ministry of Corporate Affairs (MCA) seem all set to roll out the new accounting language soon, the Indian Accounting Standards or Ind-AS. The trigger for these developments is a road map issued by the ICAI, supplemented by budget speech of the Hon’ble Finance Minister, in which he stated the urgent need for convergence with the International Financial Reporting Standards (IFRS), and proposed the voluntary adoption of Ind-AS by the Indian companies for their consolidated financial statements from the financial year 2015-16, and on a mandatory basis from the financial year 2016-17.

ICAI has already finalised a roadmap for the adoption of Ind-AS, which mandates transition to Ind-AS by all listed companies and by unlisted companies with net worth in excess of Rs. 500 crores, except Banking, NBFCs and Insurance companies. As readers must be aware, preparation of consolidated financial statements is mandatory under the Companies Act, 2013. As the new rules will not affect the standalone financial statements, taxation related issues are automatically taken care of. In another step forward, the newly constituted National Committee on Accounting Standards (NACAS) is organising meetings expectedly to reiterate the Government’s commitment made in the Budget as regards adoption of IFRS-converged standards by Indian companies. Reserve Bank of India (RBI) is also planning to announce its road map for transition to Ind-AS by Banks and NBFCs very soon.

Accounting for typical clauses of funding deals under Ind-AS

Capital raising contracts are complex, uniquely customised and full of mandatory and contingent clauses. To add to that, the accounting guidance under Ind-AS is principles based and will make consideration of each term critical. The impact on leverage ratios and earnings per share can be extremely significant, and may even warrant appropriate restructuring of the capital raising contracts.

Under the current Indian GAAP, accounting for financial instruments is based on their legal form. So, a convertible debenture or a bond would likely be classified as liability, whereas convertible and/or redeemable preference shares would likely be classified as shareholders’ funds or equity. In contrast, guidance under Ind-AS does not consider legal form, rather it is based on substance and thus requires consideration of the financial effect of the provisions of the contract.

What one needs to watch out for in a contract to determine whether it is a liability or equity and whether it will affect income statement or not, has been briefly evaluated hereunder. To discuss the guidance under Ind-AS and how it is applied, we use illustrations of a few clauses which generally form part of legal agreements for capital raising in India.

Redemption rights and dividend rights

Let us take the example of typical clauses in preference share instruments.

Under Ind AS 32, a contractual obligation to deliver cash (or another financial asset) satisfies the definition of ‘financial liability’. Redeemable preference shares, with fixed mandatory redemption date or redemption at investor’s discretion, are therefore, typically classified as liabilities. If the option to redeem the preference shares had instead been at the discretion of the issuer, such preference shares are classified as equity. Thus classification as a liability or equity goes with financial obligation of the issuer.

Similarly, preference shares with only mandatory dividends and no obligation for repayment of principal contain a liability element. If such preference shares are convertible, the terms of conversion could either result in residual equity element or identification of embedded derivatives in the contract. The former leads to a category called ‘compound financial instruments’, while the latter is called ‘hybrid financial instruments’ which could add significant volatility to the entity’s profit or loss, owing to fair valuations (of the embedded derivative or the entire instrument) necessitated at each reporting period-end.

Equity classification is not precluded in cases where payment of dividend on preference shares is discretionary. In certain cases, payment of dividends may be made contingent upon occurrence of certain event, in which case the analysis is especially judgmental to conclude whether the issuer has true discretion or not.

A relatively common case of contingent dividend is where dividend payment is mandatory based on a percentage of profits. In such a case, discretion would likely be evaluated to not exist, and so the instrument gets classified as a liability.

Exit clauses – conversion rights

Private equity (PE) and venture capital (VC) investors commonly invest in early stage companies through optionally or compulsorily convertible instruments (say preference shares or debentures) and plan their exit in a liquidity event, such as an IPO. Such early stage companies often underwrite a minimum return to PE/VC investors in liquidity events by agreeing to a variable conversion ratio of investor’s preference shares or debentures, such that the investor has as much of entity’s equity instruments to offload in the capital market as are necessary for earning the committed return.

Under the new accounting rules (Ind-AS 32), a preference share or debenture convertible into equity instruments of an entity is classified as equity if, and only if, there are no circumstances under which the entity can be contractually obligated to convert the preference share or debenture into a variable number of equity shares. This rule is commonly known as “fixed for fixed” rule i.e. fixed number of equity shares for a fixed consideration from convertible preference shares or debentures or other instruments. The conversion rights with PE/VC investors mentioned above violate the “fixed-for-fixed” criterion for equity classification.

Convertible preference shares or debentures that do not satisfy the “fixed for fixed” criterion are generally financial liabilities. As mentioned earlier, such convertible instruments not meeting the “fixed for fixed” criterion often contain embedded derivatives, or put in simple words, the value of a component of such preference shares or debentures changes in response to the change in certain variables, such as the entity’s share price or interest rates. Entities need to evaluate whether the embedded derivative element can to be separated and accounted for at fair value through profit or loss. Alternatively, entities have an option to treat the entire instrument at fair value through profit or loss. Nevertheless, any of these alternate accounting treatments add volatility to the income statement of the entity.

Exit clauses – Put options

Entities commonly issue preference shares to investors which give them the right to redeem such shares (i.e. non-mandatory redemption) for cash or put them to the entity in certain situations (for example, non-achievement of an IPO event).

A contract that contains such an obligation for the entity to purchase its own equity instruments for cash (or another financial asset) gives rise to a financial liability for the present value of the redemption amount. If the investor holding such an option does not exercise the option by the end of the stated option period, then the liability will be derecognised with a corresponding credit to equity.

There are certain exceptions to this accounting principle, albeit those are extremely rare circumstances.

Changes to conversion ratio

Preference or equity share or debenture/bond purchase agreements often contain clauses which seek to preserve the ownership rights of investors in circumstances such as bonus issue or rights issue relative to the entity’s other equity shareholders. An adjustment to the conversion ratio will preserve the rights of the holders of the instrument relative to other equity shareholders if its effect is to ensure that all classes of equity interest are treated equally. Such types of adjustment are often referred to as ‘anti-dilutive’ and do not underwrite the value of the conversion option. Rather they preserve the value of the option relative to the other ordinary shares in specified circumstances. Such clauses do not violate the “fixed for fixed” criteria and hence result in classification of the instrument as equity.

However, many clauses in such agreements, though termed as “anti-dilutive”, fail the “fixed for fixed” criteria. For example, clauses that link the number or value of the shares to be received on exercise to the entity’s share price or some other price or index, will breach the “fixed for fixed” test and hence result in classification of the instrument as a liability. These conversion options are not equity components although they do represent embedded derivatives which, as mentioned above, must be accounted for as a derivative at fair value through profit or loss although problems of separating the embedded derivative can be avoided by designating the entire instrument at fair value through profit or loss.

Accordingly, application of this guidance can be extremely critical and judgmental in cases where the conversion ratio has a potential to change.

Foreign currency convertible bonds (FCCB)

Accounting for foreign currency convertible bond (FCCB) has been under debate for quite some time now. Generally a foreign currency convertible bond is issued at a lower coupon rate, as compared to a similar non-convertible bond. The discount for the issuer is in consideration of the equity conversion option which the issuer provides to the holder.

Under Indian GAAP, generally several companies continue to recognise the interest on FCCB at the stated coupon rate, and the premium on redemption is often adjusted against the Securities Premium Account. This results in lower charge in the income statement on account of the coupon, over the life of FCCB. Under Ind-AS on the other hand, interest is recognised using effective interest rate and premium on redemption is recognised as an expense over the period of the bond as adjustment to the effective interest rate.

Another important question is the classification of such conversion component. If the conversion option entails issuance of a fixed number of equity shares upon conversion, the conversion option of the FCCB is classified as equity.

Conclusion – ‘A stitch in time saves nine’

The above are only few of several examples to illustrate that the accounting for clauses in funding deals is going to be complex under Ind-AS, and the implications are very significant. While Ind-AS aligns the standards of financial reporting in India with global standards and is widely expected to attract more capital, CFOs have a task cut out for them. Subjective fair valuation exercises will also be needed while making the evaluation and designing contracts to achieve the intended objectives. They may need to go back to the drawing boards again, evaluate the impact of these clauses and make suitable amendments wherever necessary, and more importantly, wherever possible.

With contributions from: Siddharth Talwar, Director – Walker Chandiok & Associates

The article appeared in the The Firm on CNBC TV18. The article can be found here.