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Equity

LO: Define and identify the components of equity

Equity is defined as (the Framework):


- The residual interest in the assets of the entity after
deducting its liabilities
- Implications of the definition of equity:
- Equity cannot be identified, recognised and measured
until this is done for assets and liabilities.
Rights to an entitys equity belong to some other
entity or entities.
If an entity is wound up, equity ranks after all
liabilities.

Components of equity for companies are:


- Share capital
- Retained earnings
- Reserve

LO: Distinguish between ordinary shares and preference shares

Preference shares are:


- Issued with conditions that give them priority (or
preference) over ordinary shares under specified
conditions
- Usually subject to special conditions, e.g. dividends set
at a fixed minimum level, accumulate if they are not
paid or participate in profits above the fixed minimum
level
Ordinary shareholders will not receive a dividend until:
- the preference shareholders entitlements have been
met

LO: Understand the requirements of AASB 132 as they relate to the


classification of preference shares

AASB 132: 15
Preference shares classified as a liability:
- AASB 132: 18 (a)
- AASB 132:19
- Preference shares classified as equity:
- AASB 132: AG25

Preference shares that are redeemable on a specific date or at


the holders option:
- The issuer has an obligation to transfer financial assets
to the shareholder

The issuer should disclose the shares as liabilities rather


than equity
Preference shares that are redeemable at the issuers option:
- The issuer has no obligation to transfer financial assets
to shareholders.
- The shares should be classified as equity
-

LO: Explain the nature of compound financial instruments and how


to account for them

Some securities may be legally classified as debt but contain


elements of equity
Convertible securities are:
- Debt instruments that include an option to convert them
to equity under specified conditions
Ways of treating convertible notes include:
- Recognising them as a liability consistent with their legal
form.
- The definitions and recognition criteria of liability and
equity in the Framework could be applied.
- The notes could be separated into equity and debt
components.
AASB 132 requirements on preference shares & compound
financial instruments (convertible notes)
- AASB 132: 18 (a)
- AASB 132: 19
- AASB 132: AG25
- AASB132: 29-30
- A departure from the AASB Framework?
- Probability of redemption by holders
- Probability of conversion of notes

LO: Understand the requirements of AASB 132 as they relate to


accounting for convertible notes

Controversies over classification


AASB 132:15 Substance over form
Scope for professional judgement
Critical feature in distinguishing a financial liability from an
equity instrument is the existence of a contractual obligation
to deliver cash or another financial asset or another financial
instrument
To test if the instrument is an equity instrument: see AASB
132:16

A financial instrument is an equity instrument only if (a) the


instrument includes no contractual obligation to deliver cash or
another financial asset to another entity and (b) if the instrument

will or may be settled in the issuer's own equity instruments, it is


either:
- a non-derivative that includes no contractual obligation
for the issuer to deliver a variable number of its own
equity instruments; or
- a derivative that will be settled only by the issuer
exchanging a fixed amount of cash or another financial
asset for a fixed number of its own equity instruments.
(AASB 132.16)
- AASB132:15, AG30-35 and IE34 IE36, IE39-IE46
- Financial instruments that contain a liability and equity
component
- Typically converting financial instruments
- convertible notes or convertible bonds or convertible
preference shares
- fixed maturity date and a right to convert into an equity
instrument (ordinary shares)
- AASB 132: 15, 28 requires classification into the component
parts according to the substance of the contractual
arrangement and the definition of the instrument
- interest, dividends, losses and gains should be classified in
P&L consistent with balance sheet treatment (as either debt or
equity)
- Consist of note payable (liability) and a conversion option
(equity component)
- Measure the present value of the liability component as:
PV of principal + PV of interest payments
- The equity component is calculated as the residual (AASB132:
31) when the initial carrying amount of a compound
financial instrument is allocated to its equity and liability
components, the equity component is assigned the residual
amount after deducting from the fair value of the instrument
as a whole the amount separately determined for the liability
component.
An entity issues 2 million convertible notes on 1 July 2010. The
notes have a 4-year term, and are issued at $4 per note. Interest is
payable annually at a rate of 8% pa. Each note is convertible into
one ordinary share at or before maturity. At the time of issue, the
prevailing market interest rate for a similar debt instrument without
a conversion option is 10% pa.
Step 1. Calculate the PV of the liability component
Using the residual valuation of the equity component required
by AASB 132.28 and AASB 139.11, the liability is measured first.
Calculate the PV using the prevailing market interest rate for a
similar debt instrument without a conversion option
Liability component = PV of principal + PV of interest

Calculate PV of principal:
FV= 8,000,000; n=4; i=10%
8,000,000 x 0.683 = 5,464,000
Calculate PV of interest:
A=640,000; n=4; i=10%
640,000 x 3.170 = 2,028,800
Calculate the liability component:
5,464,000 + 2,028,800 = 7,492,800
Step 2. Calculate the equity component
The difference between the proceeds of the note issue and the
liability is then assigned to the equity component.
- When market rate is greater than note rate, the
option has a positive value
- When market rate is less than note rate, the
option has no value today

Scenario 1. Assume notes are converted after second


interest payment 30 June 2012:
Convertible notes (liability)
7,722,288
Convertible notes option (equity)
507,200
Share capital
8,229,488
(AG33. When an entity extinguishes a convertible instrument before
maturity through an early redemption or repurchase in which the
original conversion privileges are unchanged, the entity allocates
the consideration paid and any transaction costs for the repurchase
or redemption to the liability and equity components of the
instrument at the date of the transaction)
Scenario 2. Assume notes are converted at maturity 30 June
2014:
Conversion on 30 June 2014:
Convertible notes (liability)

8,000,000

Convertible notes option (equity)


507,200

Share capital
8,507,200
(AG32. On conversion of a convertible instrument at maturity, the
entity derecognises the liability component and recognises it as
equity. The original equity component remains as equity (although it
may be transferred from one line item within equity to another).
There is no gain or loss on conversion at maturity.)
Scenario 3. Assume notes are redeemed at maturity 30 June
2014:
Convertible notes (liability)
8,000,000
Cash
8,000,000
Convertible notes option (equity) 507,200
Retained earnings
507,200
This means the option is worthless out of the money so the option
lapses, the noteholder loses and the company in effect gains to
the value of the option reflecting the interest differential
An entity issues 2 million dollars convertible notes on 1 July 2011.
The notes have a 3-year term. Interest is payable annually at a rate
of 7% pa. Each note is convertible into one ordinary share at or
before maturity. At the time of issue, the prevailing market interest
rate for a similar debt instrument without a conversion option is 9%
pa.
Prepare all journal entries, assuming the notes were converted after
second interest payment on 30 June 2013.
Step 1. Calculate the PV of the liability component
PV of principal: 2,000,000 x 0.772 =
1,544,000
PV of interest: 140,000 x 2.531 =
354,340
1,898,340
Step 2. Calculate the equity component
2,000,000 1,898,340 = 101,660
Step 3 Record the issue of note
Issue 1 July 2011:
Cash
2,000,000
Convertible notes (liability)
Convertible notes option (equity)

1,898,340
101,660

Step 4. Subsequent treatment


First interest payment 30 June 2012:
Dr Interest expense
$ 170,851
Cr Cash
140,000
Cr Convertible Note (Liability)
30,851
Second interest payment 30 June 2013:
Dr Interest expense
$ 173,627
Cr Cash
140,000
Cr Convertible Note (Liability)
33,627
The notes are converted after second interest payment 30
June 2013:
Convertible notes (liability)
1,962,818
Convertible notes option (equity)
101,660
Share capital
2,064,478