Section 22: Liabilities and Equity
Section 22 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?
The requirements in Section 22.19 for increases and decreases of non-controlling interest to be accounted for as equity transactions differ significantly from old GAAP. Under old GAAP, an increase in minority interest can give rise to changes in goodwill and a decrease in minority interest to gains and losses.
Section 22 requires non-controlling interest to be included in equity and as an appropriation of profit and total comprehensive income (whereas other presentations were also seen under Old GAAP).
What is different?
Old GAAP (FRS 25) is more prescriptive in its guidance on puttable instruments imposing an obligation to deliver a pro-rata share of the net assets of the entity only on liquidation. It also addresses the reclassification (and accounting on reclassification) of such instruments between equity and financial liabilities which is not specifically addressed in Section 22.
Section 22 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. Section 22 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 22.9 makes it clear that transaction costs should be deducted from equity whereas under old GAAP this was not specifically dealt with so some entities may have expensed the transaction cost.
The fair value of non-cash asset distributions must be disclosed under FRS 102. FRS 25 was silent on this issue.
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 (Section 22.3).
If the issuer does not have the unconditional right to avoid settling in cash or by delivery of another financial asset, and settlement is dependent on the occurrence or non-occurrence of uncertain future events beyond the control of the issuer and the holder, the instrument is a financial liability of the issuer unless:
- The part of the contingent settlement provision that could require settlement in cash or another financial asset (or otherwise in such a way that it would be a financial liability) is not genuine;
- The issuer can be required to settle the obligation in cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability) only in the event of liquidation of the issuer; or
- The financial instrument has all the features described of a puttable equity instrument.
Equity should be measured at the fair value of cash received net of direct costs.
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 basis of the respective fair value.
Once it has been determined that the instrument is a liability then it should be accounted for under Section 11 Basic Financial Instruments and Section 12 Other Financial Instruments Issues.
If the instrument is redeemable at the option of the holder and dividend is mandated then it should be treated as a financial liability.
Changes in Non-controlling interest which do not result in loss of control are accounted for as a transaction in equity.
Non-controlling interest to be shown as a separate component of equity.
Other standards affecting Section 22 where differences arise:
Section 35 – Transition to FRS 102 – 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 35.8).
Section 35 – Transition to FRS 102 – Section 35.9 deals with non-controlling interests and allows the below to be applied prospectively from the date of transition to FRS 102:
- To allocate profit or loss and total comprehensive income between non-controlling interest and owners of the parent;
- For accounting for changes in the parent’s ownership in a subsidiary that do not result in loss of control; and
- For accounting for a loss of control over a subsidiary.
Section 11 – Basic Financial instruments and Section 12 – Other financial instruments issues – 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 this was posted to the tax line in the profit and loss.
What do accountants need to do?
Be aware of the differences between old GAAP and Section 22 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.
What do Companies need to do?
Be aware of the differences between old GAAP and Section 22 so that they can determine the adjustments they will need to post on transition to FRS 102.
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.
Be aware of the change in which increases and decreases in minority interests are accounted for i.e. an equity transaction.