Section 17 – Liabilities and Equity

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Section 17 – Overview

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Section 17: Liabilities and Equity

Summary

Section 17 addresses classification of financial instruments as a liability or equity and accounting for compound financial instruments. It applies to the accounting for equity instruments issued to owners of the entity and purchases of own equity.

What is new when compared to previous GAAPs – General?

FRS 105 has simpler rules for determining whether a financial instrument should be classed as debt or equity. FRS 105 states that a financial instrument must be classified as debt/financial liability where the issuer does not have an unconditional right to avoid settling an obligation in cash or delivery of another financial instrument other than by reason of liquidation of the issuer.

FRS 102 and old GAAP/FRSSE have more detailed rules and guidance in this area (liquidation was not the only reason for an item not being classified as a financial liability. It had additional circumstances where the instrument could be classified as equity. For example these frameworks had rules which stated that where a fixed amount of shares was to be exchanged for a fixed amount of debt (and this was known from inception) then this met the definition of equity (under FRS 105 rules this instrument would be classified as a financial liability). Other examples are rules for instruments where settlement was only required on the occurrence and non-occurrence of uncertain future events which the issuer could control, these were considered when determining whether an item was to be classified as debt or equity (if in control of the issuer then it could be classified as equity – This compares to FRS 105 rules where they must be classified as debt/financial liability). As a result there may be differences on transition where under old GAAP/FRSSE and FRS 102 these were classified as equity for the aforementioned reasons however on transition to FRS 105 they should now be classified as debt. The rules with regard to compound instruments remain the state.

Given the size of micro entities it is unlikely that entities applying FRS 105 will have these type of instruments so therefore this adjustment is not likely to apply too often in practice.

Very few disclosures required under FRS 105. All other GAAP’s had significant disclosures.

What is different when compared to FRSSE/old GAAP?

Section 17 gives more specific guidance on the issuance of equity instruments including the treatment of equity instruments subscribed for but not issued. This was not specifically addressed under old GAAP/FRSSE. Section 17 specifically requires that equity instruments issued are measured at the fair value of the cash or other resources receivable net of direct costs of issuing the equity instruments.

Section 17.9 makes it clear that transaction costs should be deducted from equity whereas under old GAAP/FRSSE this was not specifically dealt with so some entities may have expensed the transaction cost.

What is different when compared to FRS 102?

FRS 102 provided guidance on accounting for non-controlling interest and where this was to be presented etc. However as FRS 105 does not permit consolidated financial statements to be prepared this guidance has not been included in Section 17 of FRS 105.

What are the key points?

Equity is the residual interest in the assets of an entity after deducting all its liabilities.

A financial liability is:

A contractual obligation to deliver cash or another financial asset; or
A contract that will or may be settled in the entity’s own equity instruments and:
- under which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
- will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments (Appendix 1 of FRS 105).

A financial instrument must be classified as debt/financial liability where the issuer does not have an unconditional right to avoid settling an obligation in cash or delivery of another financial instrument other than by reason of liquidation of the issuer.

Equity should be measured at the fair value of cash received net of direct costs and related tax impact.

Compound financial instruments are instruments that contain both a liability and 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 (Section 22.13). Transaction costs should be allocated on the basis of the respective fair values.

Once it has been determined that the instrument is a liability then it should be accounted for under Section 9 – Financial Instruments (i.e. at transaction amount less repayments, plus dividend accrued etc.).

If the instrument is redeemable at the option of the holder and dividend is mandated then it should be treated as a financial liability.

Other standards affecting Section 17 where differences arise:

Section 28 – Transition to FRS 105 – A first time adopter does not have to split a compound financial instrument if the liability component is not outstanding at the date of transition.

Section 9 – Financial instruments – Accounting for financial liabilities which has been addressed in the respective sections of this guide.

Section 29 – Income tax – Current tax on any share issue costs recognised in equity need to be posted to equity whereas under old GAAP/FRSSE this was posted to the tax line in the profit and loss. This is not applicable for entities transitioning from FRS 102 as the treatment required under FRS 102 is identical to the treatment required under FRS 105.

What do accountants need to do?

Be aware of the differences between old GAAP/FRSSE/FRS 102 and Section 17 so that they can audit the transition and advise clients of its impact.

Review their client portfolio to see do any clients have preference shares or shares with unusual rights which may have both a debt and equity element i.e. compound financial instruments. If so, advise clients of the need to account for the debt and equity element on transition.

Do a fresh review of all preference shares held in client companies to ensure that they have been accounted for correctly in the past and are being accounted for correctly on transition to FRS 105.

What do Companies need to do?

Be aware of the differences between old GAAP/FRSSE/FRS 102 and Section 17 so that they can determine the adjustments they will need to post on transition to FRS 105.

Review the types of equity issued by the entity to assess whether preference shares or shares with unusual rights which may have both a debt and equity element exist and then determine the fair value of the debt element so that the accounting adjustments can be determined.

Do a fresh review of all preference shares held in client companies to ensure that they have been accounted for correctly in the past and are being accounted for correctly on transition to FRS 105.

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