For emerging growth companies in the technology and life sciences sector, rapid growth often requires access to funding which can take many forms. Private companies in these sectors are attracting attention from outside investors, who might be more familiar with International Financial Reporting Standards (IFRS) than Accounting Standards for Private Enterprises (ASPE). This means companies may be required to convert or reconcile their accounts to IRFS, or another standard, to facilitate the lending process. When organizations secure additional funding, the financial instruments they issue grow increasingly complex. As these instruments become more complex, so does the accounting. Careful attention must be paid to the terms of these agreements so that they present a true financial picture for their investors. Before signing on the dotted line, it is critical to understand and evaluate the accounting treatment and its impact on investors.
Under IFRS, there are two specific areas relating to financial instruments that emerging growth companies should consider:
- The classification of financial instruments as equity or liability under IAS 32 Financial Instruments: presentation.
- The measurements of compound financial instruments
If the classification of financial instruments or the measurement of compound financial instruments is incorrect, then the company will inadvertently misstate its financial statements.
1. Classifying the instrument
A financial instrument is a contract that creates a financial asset for one entity and a financial liability or equity instrument for another entity.
- A financial asset comprises any asset that is cash; a contractual right to receive cash or another financial asset from another party; a contractual right to exchange financial instruments with another party under conditions that are potentially favourable; or an equity instrument of another entity.
- A financial liability is any liability that is a contractual obligation to deliver cash or another financial asset to another party or to exchange financial instruments with another party under conditions that are potentially unfavourable to the entity.
- An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
- A compound financial instrument has both liability and equity characteristics. These characteristics are split based on the initial recognition of the instrument and are not subsequently revised.
The complex accounting challenge is not whether an instrument is a financial instrument. That is reasonably self-evident. The real challenge is determining whether the instrument is an equity, liability or compound instrument based on its substance rather than its legal form (IAS 32.18).
When the company first recognizes the financial instrument, it must classify it either as a financial liability or equity, or a compound instrument. This determination has an immediate and significant effect on the entity's reported results and financial position. Liability classification affects an entity's gearing ratios and typically results in any payments being treated as interest and charged to earnings. Equity classification avoids these impacts but may be perceived negatively by investors if it is seen as diluting their existing equity interests.
To determine the classification of an instrument, consider the following questions:
When considering each instrument and answering the questions above to determine their accounting position, emerging growth companies will also want to read all of the relevant agreements, including related agreements such as shareholder agreements, in search of such clauses and factors as:
- Mandatory dividends
- Future events
- Put/call options
- Cash settlement options
- Change in control provisions
- Functional currency
- Strike price adjustments
These terms will alert the company whether the classification of the instrument is debt or equity. This in turn will impact the presentation of the financial statements and will be of interest to users of the statements.
2. Measuring compound instruments
If an emerging growth company has determined that it has a compound financial instrument (both liability and equity components) or it is a liability with an embedded derivative, it will need to identify which parts are equity and which are liabilities. once the company has determined the classification of each of the components, it needs to determine the fair value of the compound financial instrument as a whole. In addition to measuring the fair value, the company will need to determine if there is a deferred tax liability and whether any of the liability components contain embedded derivatives. This series of steps to determine the proper accounting, as well as an understanding of subsequent measurement requirements for liabilities, are provided in the chart below.
Examples of embedded derivatives (IAS 39.AG30-33)
- Call or put options that enable the holder to require the issuer to reacquire the instrument based on a fluctuating variable
- An option or automatic provision to extend the remaining term to maturity of a debt instrument
- Equity or commodity-indexed interest or principal payments in a host debt instrument or insurance contract — by which the amount of interest or principal is indexed to the value of equity instruments or to the price of a commodity
- Equity conversion feature in a convertible debt instrument
- Call, put, or prepayment option embedded in a host debt contract or host insurance contract
- Credit derivatives which allow the transfer of credit risk
- Principal or interest payments that are denominated in a foreign currency and embedded in a host debt instrument
- Lease payments tied to inflation-related indices, contingent rentals based on related sales or variable interest rates
- Unit linking features which require payments denominated in units of an internal or external investment fund
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The information in this publication is current as of April 28, 2015.
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