It’s incremental!

Issues relating to the costs of raising equity

Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 15th edition:

  • “The issuer is a pharmaceutical company which was listed for the first time on the stock exchange in 2010. On that occasion it issued new shares for which it incurred issuance and listing costs. Certain listing costs were included in the income statement and others in the statement of changes in equity, whereas all costs of the capital increase were recognized in equity.
  • The issuer allocated expenses to the capital increase and to the listing based on their nature. The costs that related to both the capital increase and the listing were allocated on a rational basis, that is, the proportion of newly issued shares in relation to the total share capital.
  • The lawyer’s fees were allocated between the listing and the capital increase, according to their nature. The success fee paid to investment banks was directly attributable to the capital increase and recognized directly in equity. The cost of the preparation of the prospectus in accordance with foreign rules for the subscription of new shares by foreign market investors was attributed to sales promotion and expensed accordingly. If the company did not want to attract investors from those foreign markets, this cost would not have been incurred.
  • Approximately two-thirds of the costs relating to the capital increase concerned success fees and fees paid to lawyers for the preparation of the prospectus as the issuer wanted a prospectus prepared in accordance with foreign market regulations in order to have access to foreign investors on other markets than Europe.”

On this occasion, the enforcer (as ESMA likes to term it) concluded that the issuer’s allocation of costs to the capital increase and the stock exchange listing didn’t conflict with the requirements of IAS 32. The report observes the premise of IAS 32.25, that transaction costs of an equity transaction are accounted for as a deduction from equity, net of any related income tax benefit. IAS 32.27 says these “might include registration and other regulatory fees, amounts paid to legal, accounting and other professional advisers, printing costs and stamp duties” and specifies: “The transaction costs of an equity transaction are accounted for as a deduction from equity to the extent they are incremental costs directly attributable to the equity transaction that otherwise would have been avoided.” IAS 32.38 adds that transaction costs relating jointly to more than one transaction “are allocated to those transactions using a basis of allocation that is rational and consistent with similar transactions.” Against all this backdrop, the issuer’s methodology as laid out above seems to have caused no basis for concern.

Many practitioners will have encountered situations though where these allocations are a bit challenging. To make up an example, suppose an offering of shares requires amending a problematic covenant attaching to outstanding debt. This may be an “incremental cost directly attributable to the equity transaction that otherwise would have been avoided” in the literal sense that if the equity transaction wasn’t taking place, the covenant could have stayed as it was. On the other hand, it has aspects of a housekeeping exercise in that it presumably only eliminates barriers to raising equity, rather than doing anything specific to draw in new capital. What if the entity had noticed the problem with the covenant earlier and proactively fixed it at a time when no capital-raising activity was going on? – presumably no one would claim then that the costs could be put to equity. If equity treatment becomes acceptable as a result of the entity’s dallying until something’s under way, isn’t that a form of accounting arbitrage based on inefficiency? I mean, many other imperfect aspects of an entity’s day to day operations probably constitute barriers to raising equity too, but that doesn’t mean the cost of fixing them belongs outside operations.

Of course, that’s only to say that you can always make up scenarios where such aspects of the standards will be challenged, and it’s hopeless to think the IASB can anticipate or address them all. In 2008, actually, IFRIC was asked for guidance on the area, but decided not to go there, noting only that: “judgment will be required to determine which costs are related solely to other activities undertaken at the same time as issuing equity, such as becoming a public company or acquiring an exchange listing, and which are costs that relate jointly to both activities that must be allocated in accordance with paragraph 38.” IFRIC did make one potentially interesting observation – that the terms ‘incremental’ and ‘directly attributable’ are used with similar but not identical meanings in many Standards and Interpretations, and they recommended that common definitions should be developed for both terms and added to the Glossary as part of the Annual Improvements process. It doesn’t look like anything ever came of that though, meaning that such matters will often be determined, as much as anything, by who can weave the most skillful story…

The opinions expressed are solely those of the author

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