Here’s a recent fact pattern discussed by CPA Canada’s IFRS Discussion Group
- Company A holds a combination of common shares and preferred shares in Company B. Company A has 20 per cent voting rights of Company B through its investment in common shares.
- The preferred shares are non-voting but are convertible into common shares on a one-to-one basis at the option of the holder. If all its preferred shares are converted, Company A will increase its voting rights of Company B to 30 per cent.
- The preferred shareholders are not obligated to fund Company B’s losses. They have no liquidation preferences or preference in the event of distribution. Distributions are at Company B’s discretion. If a preference dividend is declared, it is calculated based on a percentage of Company B’s available profits.
- Assume all other facts and circumstances support Company A having significant influence over Company B and Company A does not control Company B.
This provides an opportunity to return, as we periodically enjoy doing, to the sublime creakiness of the equity accounting model. For partial background, IAS 28.12 says that when potential voting rights or other derivatives containing potential voting rights exist, an entity’s interest in an associate or a joint venture is determined solely on the basis of existing ownership interests and does not reflect the possible exercise or conversion of potential voting rights and other derivative instruments. But then, IAS.13 states: “In some circumstances, an entity has, in substance, an existing ownership as a result of a transaction that currently gives it access to the returns associated with an ownership interest. In such circumstances, the proportion allocated to the entity is determined by taking into account the eventual exercise of those potential voting rights and other derivative instruments that currently give the entity access to the returns.”
Against that backdrop, the group considered whether Company A’s share of equity-method income or loss from Company B should reflect the preferred shares. On the one hand, preferred shareholders are more limited than equity shareholders in their exposure to investee losses – they aren’t obligated to fund those losses, and the value of preferred shares doesn’t generally fluctuate to the same extent. On the other hand, given the conversion rights and lack of protection in the event of liquidation, they seem to constitute some kind of ownership right.
Most group members thought the preferred shares shouldn’t be reflected, putting weight on their current non-voting status and the resulting inability to influence the investee to distribute returns. Others considered the voting rights to be a separate issue, viewing the preferred shares as economically similar to the common shares based on the features described in the fact pattern. I would probably have voted that latter way myself, although there’s little more to that judgment than intuitively preferring one masked singer over another: all that such questions truly reveal is the weakness of the model. Even if you think it’s useful to identify entities over which “significant influence” exists, I don’t believe the IASB has ever persuasively addressed why fair value wouldn’t still constitute a more relevant measurement basis for them (especially given the seemingly endless pile of finicky application questions that have to be addressed in making equity accounting “work”). Perhaps (for the sake of argument) the IASB could continue to address an issuer’s generally greater strategic interest in investees over which it has significant influence by retaining the current requirements for disclosing summarized financial information of those investees. But really, at this point, this part of the accounting model looks like a relic.
Anyway, the group went on to tweak the fact pattern, giving the preferred shares a liquidation preference over common shareholders as first-priority and an entitlement to annual dividend payments based on a set coupon rate, with no provision for discretionary dividends (while retaining conversion rights into common shares). This tipped the consensus toward excluding them from the equity accounting calculation – “the preferred shares do not represent existing ownership rights when considering features such as non-voting, liquidation preference over common shareholders, and the required dividend payments based on a coupon rate.” In general terms, this combination of terms serves to push them into seeming more debt-like (across an intervening grey area). This is the group’s final summation:
- Overall, the Group’s discussion raises awareness about whether preferred shares represent existing ownership rights to be considered when calculating the investor’s share in investee’s income or loss under the equity method of accounting. Some Group members observed that the diverse views…can be attributed to a lack of guidance in IAS 28 on what constitutes a present ownership interest. They thought this could be raised as a topic in the IASB’s agenda consultation. The AcSB Chair commented the Board is aware of the issues associated with applying the equity method of accounting in IAS 28. The Board will consider the Group’s discussion when drafting its response to the IASB’s agenda consultation request. No further action was recommended to the Board.
So they’re aware of the issues associated with equity accounting. Something would be very wrong if they weren’t!
The opinions expressed are solely those of the author