Accounting. Convertible notes. In this issue

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Accounting BDO Kendalls news A national audit & assurance publication It s reporting season again and many of you will be in the midst of preparing your financial statements for the second time under

First time AIFRS preparation last year meant a great focus on correct application of AIFRS measurement requirements, coming to terms with the enormous amount of additional disclosures required, and

1 Accounting BDO Kendalls news A national audit & assurance publication It s reporting season again and many of you will be in the midst of preparing your financial statements for the second time under Australian Equivalents to International Financial Reporting Standards (AIFRS). First time AIFRS preparation last year meant a great focus on correct application of AIFRS measurement requirements, coming to terms with the enormous amount of additional disclosures required, and understanding the new IFRS jargon. Second year preparation has seen increased focus on the accounting treatment of some of the more complex areas of AIFRS. This newsletter summarises some of the frequently asked questions we have been dealing with recently. Convertible notes There seem to be so many different types of convertible notes in the market. How do we account for these under AASB 132? Basic Principle Convertible notes are compound financial instruments under AASB 132 Financial Instruments: Presentation and Disclosure, comprising a liability and an equity component. The issuer is firstly required to determine the present value of the liability. The value of the equity component is the residual difference between the fair value of the convertible note and the present value of the liability. The value of the equity component represents the option to convert into issuer s equity. The discount rate used to compute the present value of the liability is the rate that could be earned on a similar debt instrument without the conversion feature. Issue costs incurred are allocated to the equity and the liability components on a pro rata basis. In this issue Convertible notes Modification of terms of employee share options Financial guarantee contracts Fair valuing fixed rate loans Interpretation 11 AASB 2 Group and Treasury Share Transactions Latest developments Conversion at the option of the holder Generally, where convertible notes are convertible into equity at the option of the holder, the value of the equity component represents a call option issued to the holder to convert the notes into equity in a number of year s time. When the terms of the convertible notes are such that the notes are convertible into a variable number of shares based on a variable conversion factor, the value of the conversion feature will depend on the specific terms of the variable conversion factor. Example: The terms of the conversion are such that the note can be converted into a variable number of shares depending on the weighted average share price in the last 6 months to conversion date. The option is valuable because the option holder is likely to exercise the option if the weighted average share price is lower than the share price at conversion. 1

2 However, if the conversion feature only allows the holder to convert into a variable number of shares based on the share price at conversion date, it is likely that the conversion feature has very little or no value, i.e. the holder can receive the same number of shares regardless of whether the option is exercised or by electing to receive payment for the principal and then purchasing the shares in the market. The following table summarises the accounting treatment, depending on whether the notes are convertible into a fixed or variable number of shares. Conversion Options Note convertible into a fixed number of shares Note can be converted into a variable number of shares (i.e. liability is fixed) Yes Compound Financial Instrument? Yes, but if shares are to be converted at the fair value at the date of conversion, then the equity component will have no value. Accounting Treatment Liability component: Interest stream + principal Fair value the financial liability residual is equity. Liability component: Interest stream + principal Fair value the financial liability residual is equity. Mandatory Conversion It is generally expected that the value of the equity component of a convertible note where the holder has the option to convert is higher than the value of the equity component of a mandatorily convertible note. Where convertible notes are mandatorily convertible, the value of the equity component theoretically represents two options, a call option being issued to the holder and a put option being issued to the issuer. The rationale being as follows: If at the date of conversion, the share price is higher than the conversion price, the holder receives the benefit, which is equivalent to the holder having an in-the-money call option. If at the date of the conversion, the share price is lower than the conversion price, the issuer receives the benefit, which is equivalent to the issuer having an in-the-money put option. Although there are theoretically two derivatives wtihin a mandatorily convertible note, AASB 132 only requires separation of a convertible note into its liability and equity components. Therefore, the issuer is not required to recognise the two options separately as both options are options to convert into the issuer s equity. The following table summarises the accounting treatment, depending on whether the notes are convertible into a fixed or a variable number of shares for mandatory conversion. Conversion Options Note will convert into a fixed number of shares (no interest). Note will convert into a fixed number of shares, with interest payable in cash throughout the period Note will be converted into a variable number of shares (i.e. liability is fixed) No Yes Compound Financial Instrument? Yes but if shares are to be converted at the fair value at the date of conversion, then the equity component will have no value. Accounting Treatment Note is recognised in equity at amount received. There is no liability component because there is, no obligation to pay out cash to the holder Liability component: Interest stream Fair value the liability residual will be equity. Liability component: Interest stream + principal Fair value the liability residual will be equity Equity component conisists of a call and a put option Coupon Rates Generally, convertible notes offer lower coupon rates than similar bonds without a conversion feature. This is because the lower coupon rate is usually compensated for by the value of the free option to convert at a later date into a fixed number of shares. If convertible notes are issued with a coupon rate that is higher or equal to the entity s current discount rate how do we account for these? If convertible notes have been issued to a director or a related party with a coupon rate higher or equal to the entity s current discount rate, Continued next page... 2

3 Continued from previous page...then it is very likely that the convertible notes have not been issued at arms length, with the present value of the liability being higher or equal to the proceeds of the issue, leaving no residual value for the equity component. The entity would effectively be giving away the conversion feature (the option to convert). This is in substance a share-based payment and should be accounted for in accordance with AASB2. If the convertible notes are being issued to a third party with a coupon rate that is higher or equal to the entity s current discount rate and the transaction is at arm s length, then it is very likely that the discount rate used to measure the present value of the liability is incorrect or represents payment for another service. Modification of terms of employee share options Because employee share options are out-of-the-money, we have cancelled them and issued new ones in their place. Can we ignore the remaining unamortised share-based payment expense because the options will never vest? No. AASB 2 Share-Based Payments requires that cancelling options has the effect of accelerated vesting. This means that any unamortised share-based payment expense outstanding because the options had not yet vested must be recognised immediately as an expense in the income statement. We have decided to amend the terms of existing share options to employees. AASB 2 requires that we only measure the fair value of these options at grant date and expense them between grant date and vesting date. Does this mean that we ignore the modified terms? No. When an entity decides to subsequently modify its employee share options that it had previously granted, the modification must be accounted for under AASB 2 Share-Based Payments, which requires that entities recognise, as a minimum, the fair value of the employee share options at grant date. If there is a subsequent modification that increases the total fair value of the options, then the entity recognises as an expense, the difference between the fair value of the original options and the fair value of the modified options at modification date. The fair value of the original options is re-estimated at the modification date. When the fair value of the original options is re-estimated at modification date, the assumptions used should be reassessed, i.e. the share price, volatility, risk free rate and dividend yield should be based on market information at the modification date. The same assumptions are used for estimating the fair value of the modified options. Any difference in fair value between the original option and the modified option should only be due to the differences in the terms of the options, such as exercise price or the life of the option. 3

4 Financial guarantee contracts We seem to have a number of guarantees noted in our Contingent Liability note last year. Will these all need to be measured and recognised in our financial statements for 30 June 2007? AASB 139 defines a financial guarantee contract as a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument. This means that for a guarantee to meet the definition of a financial guarantee contract under AASB 139, there must be a contract in place with a specified holder, there must be the possibility of a debtor failing to make payment and there must be a debt instrument. The following are examples of guarantees that are not financial guarantee contracts under AASB 139: A parent entity giving a letter of support to its subsidiary is not a financial guarantee because there is no contract and the letter is not specifically issued to a specified holder. An entity guaranteeing that a second entity will meet a supply agreement (i.e. guaranteeing a performance on a contract) is not a financial guarantee because the contract is guaranteeing a supply of goods and not guaranteeing repayment of a specified debt. A parent entity guarantees a director of a subsidiary against legal action that may arise in his capacity as director. The company is insured against such legal action and if legal action arises the entity would be reimbursed. This is not a financial guarantee as there is no specified debt or debtor. If legal action does arise, it would fall under the scope of AASB 137 Provisions, Contingent Liabilities and Contingent Assets. The company obtains a rental guarantee from the bank in the form of paying a monthly charge to the bank so that the bank guarantees the lease. This is not a financial guarantee because under the rental guarantee, the bank is guaranteeing a series of lease payments and not a specific debt. Furthermore, the bank is the issuer of the guarantee and not the company. One method used to determine the fair value of the financial guarantee is to calculate the differential between the interest rate: actually granted to the borrower by the third party, and that would have been received had the guarantee not been in place If the borrower would never have been granted a loan had the guarantee not been in place, how can we determine the interest rate for the borrower? Under AASB 139, guidance is provided that we should observe the borrowing rate of other entities with the same risk profile. However, this is difficult in Australia, because unlike the United States, we do not have a deep and active corporate bond market. We propose that an alternative is to refer to the cost of equity, the argument being that equity would be the alternative source of financing had the borrower not obtained the loan from the bank. The differential between the interest rate that is actually granted to the borrower by the third party and the cost of equity is effectively the cost that the parent incurred to provide the guarantee rather than capital injection. Fair valuing fixed rate loans Can we assume that all receivables and payables have a fair value that approximates carrying value at reporting date? No. AASB 132 Financial Instruments: Presentation and Disclosure requires disclosure of the fair value of financial instruments where it differs from their carrying value. For fixed rate loans that are repayable within 12 months, it is acceptable to state that the carrying value of the loan approximates its fair value. The effect of discounting the liability to a fair value for a short period of time would be unlikely to have a material impact (remember to only adjust for discounting where it has a material impact). However for fixed rate loans that are repayable in more than 12 months, it is likely that calculating fair value based on a discounted amount will have a material impact and would therefore be disclosable. The discount rate to be used when calculating the fair value at reporting date would be the revised fixed rate that the entity would obtain had they entered into a similar loan with similar terms and conditions at reporting date. 4

5 Interpretation 11 AASB 2- Group and Treasury Share Transactions Interpretation 11 was briefly discussed in the June 2007 version of Accounting News. Interpretation 11 addresses how to apply AASB 2 Share-Based Payments (either as equity-settled or cash-settled) when the transaction involves equity instruments of the parent or another group entity. In this issue, the accounting treatment for two scenarios addressed in Interpretation 11 is demonstrated below. Scenario 1: Parent grants rights to its equity instruments to employees of its subsidiary When a parent grants rights to its equity instruments to employees of its subsidiary, the subsidiary must measure the services rendered by calculating the fair value of instruments given using AASB 2 and recognise a corresponding increase in equity as a contribution from the parent. The journal entries are: Subsidiary Parent DR CR DR CR Share-based payment expense Equity Investment in Sub Option Reserve Scenario 2: Subsidiary grants rights to equity instruments of its parent When a subsidiary grants rights to equity instruments of its parent, to its employees, for employee services rendered to the subsidiary, the subsidiary accounts for the transaction as a cashsettled share based payment. Subsidiary DR CR Share-based payment expense Liability (Cash SARS) This liability then must be fair valued at each reporting date until the rights vest. A second set of journal entries depends on how the subsidiary intends to acquire the equity instruments to fulfil its obligation to its employees; either by way of payment or by a contribution from its parent. If the subsidiary receives a contribution from its parent, then the entries for the parent are the same as Scenario 1. Interpretation 11 is effective for annual reporting periods beginning on or after 1 March Latest developments Interpretation 13 Customer Loyalty Programmes Interpretation 13 was recently released by the Australian Accounting Standards Board. It is effective for annual financial periods commencing on or after 1 July 2008, i.e. for 30 June 2009 financial years. It requires that the fair value of revenue be allocated between sales and rewards credits i.e. a portion of revenue will be deferred until the rewards have been redeemed. The deferred revenue is based on the fair value of the reward to the customer NOT the fair value of the cost of providing the reward. As there are no specific transitional provisions included in Interpretation 13, any change in accounting treatment comprises a change in accounting policy and you will be required to retrospectively restate your 30 June 2008 comparatives included in your 30 June 2009 financial statements. Interpretation 13 also potentially has implications for entities whose sales contracts have different components. It implicitly introduces revenue splitting principles into AIFRS because AASB 108, paragraph 11(a) requires that when determining accounting policies where accounting standards have no specific requirements, the requirements and guidance in Australian Accounting Standards dealing with similar and related issues should be considered. 5

6 Comments sought Comments are sought by the AASB on a number of issues: IFRIC Draft Interpretation D21 Real Estate Sales IFRIC Draft Interpretation D22 Hedges of a Net Investment in a Foreign Operation ITC12 Request for Comment on a Proposed Differential Reporting Regime for Australia and IASB Exposure Draft of a Proposed IFRS for Small and Mediumsized Entities Proposals To standardise accounting treatment by property developers for off the plan sales of units, apartments and houses Clarifies issues about accounting for hedging foreign currency risks arising from a net investment in a foreign operation AIFRS to apply to general-purpose financial reports of: publicly accountable entities; other non-publicly accountable forprofit entities of a certain size; not-for-profit entities of a certain size; and public sector entities of a certain size. For more information, refer to July 2007 version of Accounting News. Comments due to AASB by: 17 September September September 2007 Conclusion The application and refinement of AIFRS will continue to present preparers and auditors with a large number of challenges going forward, with major IASB projects including the SME Standard and Business Combination Phase II coming close to completion. For more information Phone or visit NSW/ACT* Sean Osborn Telephone sean.osborn@bdo.com.au Northern Territory Casmel Taziwa Telephone casmel.taziwa@bdo.com.au North Queensland Katrina Faulkner Telephone katrina.faulkner@bdo.com.au South Australia Greg Wiese Telephone gregory.wiese@bdo.com.au Tasmania Craig Stephens Telephone craig.stephens@bdo.com.au Western Australia Glyn O Brien Telephone glyn.obrien@bdo.com.au Queensland Tim Kendall Telephone timothy.kendall@bdo.com.au Victoria Nick Burne Telephone nick.burne@bdo.com.au BDO Kendalls is a national association of separate partnerships and entities. Disclaimer: This publication is issued exclusively for the general information of clients and staff of BDO Kendalls. The contents are not a substitute for specific advice and should not be relied upon as such Accordingly, whilst every care has been taken in the presentation of the publication, no responsibility is accepted for persons acting on this information. *Liability limited by a scheme approved under Professional Standards Legislation. 6

NEWS ACCOUNTING. At a February 2011 joint meeting of the IASB and FASB (the boards), it was tentatively LEASING UPDATE IN THIS EDITION

NEWS ACCOUNTING. At a February 2011 joint meeting of the IASB and FASB (the boards), it was tentatively LEASING UPDATE IN THIS EDITION MARCH 2011 www.bdo.com.au ACCOUNTING NEWS LEASING UPDATE IN THIS EDITION P1 Leasing update P3 Business combination reminders P4 Not-for-profit (NFP) scoping study for a national not-for-profit regulator