Here’s an issue recently considered by the Canadian IFRS Discussion Group:
- “Current Canadian tax legislation permits entities in mining or oil and gas exploration, and entities in certain emerging technologies, to issue securities to investors whereby the deductions for tax purposes related to expenditures made previously, or in the future, may be claimed by the investors and not by the entity (commonly referred to as “flow-through shares”). The purchase of a flow-through share gives an investor the rights to a common share of the issuer and a future tax deduction equal to the cost of the initial investment.
- In certain circumstances, entities may issue flow-through shares with attached share purchase warrants, which in substance represents:
- the issuance of an ordinary share;
- the sale of tax deductions (i.e., flow-through liability); and
- the issuance of a warrant.
- IFRSs do not explicitly address the accounting for flow-through shares or the related tax consequences arising from such transactions. The concept of flow-through shares has been discussed previously by the Group, as well as by industry groups. The focus of this discussion is to deliberate specifically the accounting for flow-through shares with an attached share purchase warrant classified as equity.”
Those involved in this area will know the prevailing consensus on accounting for flow-through shares – that they represent in substance both an issue of ordinary shares and the sale of tax deductions, and that at the time an entity issues flow-through shares, it defers the sale of tax deductions (which might be measured using either a residual or a relative fair value method) and presents it as an other liability, subsequently recognizing the amount in profit or loss when it fulfils its obligation to pass on the tax deductions to the investors. Regarding the new discussion topic, the group identified a couple of possibilities.
First, on issuance, an entity might measure the flow-through share liability at fair value, allocating the remaining proceeds within equity (for example, between common stock and warrant reserve). There are a couple of ways of coming at this: “Paragraph 32 of IAS 32 may be helpful when determining the accounting treatment for the flow-through liability even though it is not a financial liability. When making the allocation decision, the equity component is assigned the residual amount after deducting the amount separately determined for the liability component from the fair value of the flow-through share with attached share purchase warrant as a whole. From the perspective of IAS 18, the flow-through liability can be viewed to represent the sale of future tax deductions. The obligation to fulfill this liability can be considered similar to unearned revenue. Paragraph 9 of IAS 18 requires revenue to be measured at the fair value of the consideration received or receivable.”
Alternatively, an entity might measure both the ordinary share and warrant at fair value, allocating remaining proceeds to the flow-through liability. This view regards IAS 32 as less relevant, and places weight on ensuring that the financial instrument components of the transaction (i.e., the ordinary share and the warrant) are measured at fair value based on guidance in IAS 39. Or maybe it’s simply an area where an accounting policy choice exists.
The report of the meeting points out: “Similar outcomes should arise between View A and View B if the sum of the fair values of each component equals the proceeds received. However in practice, there are situations where the total fair value of the ordinary share and/or warrant exceeds the proceeds received.” Indeed, based on my experience I’d say this happens more often than not, and that these issues often have the feeling of trying to squeeze various square pegs into a round hole. The standards on these matters generally implicitly assume (and why wouldn’t they?) that economic negotiations are essentially rational, so that if one transacts in a compound instrument, or in a bundled transaction comprising one or more instruments, then the value for the whole bears some meaningful relationship to the sum of the parts. But practice yields plenty of examples where this doesn’t seem to be borne out – for example where an entity issues flow-through shares and common shares at the same time for the same price (even though the flow-through element clearly has value). This no doubt only reflects the reality of raising capital for smaller entities, where the official market value of the shares has little meaning given the thinness of the trading, and where negotiations may be driven by compulsion and instinct as much as by economic “analysis.”
The group seems aware of this reality – there was some support for both views, but the main message was that “in the end, preparers should ensure the answer they have arrived at is reasonable in terms of the amounts derived for each component of the unit. Factors to consider include whether the shares are thinly traded and the financial situation of the seller (i.e., if distressed or issuing these instruments as an alternative form of financing). Disclosure on the judgment used in valuing these components should be included in the notes to the financial statements.” It’s hard to know what else they could have said. Ultimately, the very fact that an entity is raising finance through such means, and the terms at which it did so, carry much more information content than the accounting treatment applied to it…
The opinions expressed are solely those of the author