Here’s another issue considered in the past by CPA Canada’s IFRS Discussion Group:
- “An entity may settle a loan due to a shareholder by the issuance of the entity’s equity instruments (for example, common shares). This transaction may give rise to a difference between the carrying amount of the shareholder loan and the fair value of the common shares issued.
- Paragraph 41 of IAS 39 Financial Instruments: Recognition and Measurement and paragraph 3.3.3 in IFRS 9 Financial Instruments both state that: “The difference between the carrying amount of a financial liability (or part of a financial liability) extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, shall be recognized in profit or loss.”
- Paragraphs 6 and 9 of IFRIC 19 Extinguishing Financial Liabilities with Equity Instruments require that: “When equity instruments issued to a creditor to extinguish all or part of a financial liability are recognized initially, an entity shall measure them at the fair value of the equity instruments issued, unless that fair value cannot be reliably measured.” “The difference between the carrying amount of the financial liability (or part of a financial liability) extinguished, and the consideration paid, shall be recognized in profit or loss, in accordance with paragraph 41 of IAS 39…”
- However, paragraph 3(a) of IFRIC 19 states that the Interpretation shall not be applied in situations when “the creditor is also a direct or indirect shareholder and is acting in its capacity as a direct or indirect existing shareholder.””
Against this backdrop, the group considered an entity that has a non-convertible loan due to a significant shareholder. The shareholder agrees to convert the amount into common shares of the entity, at a conversion price higher than the current market price of the entity’s common shares, meaning that the fair value of the common shares issued is less than the carrying amount of the loan. How should the entity account for the difference between the fair value of the consideration paid and the carrying value of the loan extinguished?
You might take the view that any difference should be recognized as a gain or loss in the income statement, based mainly on a strict application of the IAS 39 requirement cited above. Alternatively, you might think it should be recognized in equity, on the basis that: “the difference between the fair value of the consideration paid and the carrying value of the shareholder loan is in effect a contribution from the shareholder that does not meet the definition of income and should be recorded as a credit in another equity account.” Then again, you might conclude that there’s no requirement here to measure the shares at fair value in the first place, because such a requirement flows from IFRIC 19, which as noted above doesn’t apply here; in this case the shares might just be issued at the carrying value of what’s being extinguished. Or perhaps it’s simply an area where an accounting choice exists between all these alternatives.
Assuming it’s clear that the shareholder is acting “in its capacity as a shareholder,” the group rejected the treatment of recognizing the gain or loss in income, on the basis that a contribution from a shareholder clearly belongs in equity. It didn’t express a preference between recognizing the difference in equity, and side-stepping the issue by measuring the shares at the same carrying value as the extinguished debt. It’s always seemed to me the former approach provides a better illustration of the economics of the transaction, but on the other hand, the difference only reflects different ways of moving things around within equity, not really a very big deal, and not an area on which IFRS typically expresses too much concern.
All of that said, if it isn’t clear that the shareholder is acting “in its capacity as a shareholder,” then treatment in the income statement might still be appropriate. Here’s what the group said on that:
- “Group members agreed that the question of whether or not the shareholder is acting in its capacity as a shareholder should determine the appropriate accounting treatment, but that the answer to that question is not always clear. As a result, several Group members suggested that beginning with the presumption that a shareholder is acting in his or her capacity as a shareholder might be appropriate, unless there is clear and convincing evidence to the contrary.
- Group members agreed that evidence of the same or similar transactions executed with other nonshareholder creditors is a factor to consider in determining whether the transaction is with a shareholder acting in his or her capacity as a shareholder. However, they noted that other factors are not relevant in this determination (for example, whether the amount due to the shareholder originated from fees for services rather than advances of cash, or whether the shareholder agreed to extinguish the loan through a cash payment that is less than the carrying amount of the loan rather than the issuance of shares).”
That is, if ten debtholders all provide exactly the same economic concession to the company, it might not be meaningful to exclude from income the gain or loss on just one of those concessions, just because that debtholder also happens to be a shareholder. In that situation, you might conclude it can be objectively demonstrated that the debtholder would have made the same deal absent whatever ownership-driven motive it might have for helping out the company. If there’s no such non-shareholder benchmark to measure against though, it can sometimes be very difficult to make the distinction (and of course it’s far from ideal that an accounting treatment for a transaction might vary materially based on different notions of what was in the counterparty’s mind). In such cases, clear disclosure and labeling are vital in ensuring that key performance indicators aren’t materially distorted by such machinations…
The opinions expressed are solely those of the author