In this essay, I would like to start with a brief explanation about the accounting regulation and standards set for various treatments consists of gaps where the rules are vague or even incomplete. Then, I would like to give a brief introduction about the development of standards set for capital instrument, such as TR677 (ICAEW), FRED 3 and FRS 4. Next, I will go into details examining the problems found in these proposals and standard, especially FRS 4. Coming to this stage, I will divide the problems into two parts.
Firstly, I will point out the inconsistency found in FRS 4 in relation to FRS 5. Secondly, I will try to deal with the practical point of view, pointing out that the FRS 4 consist of practical problems in accounting treatments for shares and debt. Finally, I will conclude that the current standard for complex capital instruments is not sufficient to solve the problems found in its accounting treatments. Hence, a more effective standard must be put forward to regulate the accounting treatment for capital instruments as it is becoming increasingly more complex.
In many countries, accounting regulation is based on a system of detailed rules prescribed in standards and the law. However, rule-based systems can rarely be water-tight. There may be gaps in the rules, and places where the rules are vague or even incomplete. Of equal, if not greater significance is the fact that regulatees may develop schemes which fulfil the letter of the rules, but undermine their spirit. Regulators may find themselves constantly lagging behind the avoidance activities of the regulatees (McBarnet, 1988).
In such circumstances, effective regulation breaks down. For the past ten years, the financial instruments issued by companies have become more and more complex. This has been particularly so since October 1987 which has been a period where equity issues have been difficult and companies have not wanted to increase their capital gearing. Finance has still been required for acquisitions which have continued apace and, as the doors to off balance sheet finance seem to be slowly closing, there has been a need for something more sophisticated.
This has help to promote the development of a number of instruments that can be described as hybrids, i. e. partly equity and partly debt. This period has coincided with developments in accounting to reinforce the concepts of substance over form. The problem with complex instruments is that in a two-dimension balance sheet which includes only debt and equity, it is very difficult to see what the substance is.
Apart from this, resort to sophisticated capital instruments as a way to present their overall financial position in a more favourable light; and designed the instruments in such a way to allow companies to secure access of funds which could be classified as equity rather than debt. At that time, authoritative pronouncements have been limited to a technical release by the ICAEW in 1987 (TR 677). That was effectively a consultative document which was a useful start to a debate, but like any such first short, was the subject of various responses, some supportive and some critical.
Unfortunately, after the responses, the debate was not officially taken further, leaving the TR 677 as a relatively useless document. In December 1992, ASB published FRED 3 which was based on the main proposals set out in the earlier discussion paper. There was a subsequent consultation on one additional matter: the appropriate treatment when debt is renegotiated. Companies in financial difficulties sometimes reach an agreement with lenders which allows them to reduce or defer their future payments of principal or interest under the debt.
In these circumstances, the ASB proposed that the renegotiated debt should be stated at its fair values with a corresponding gain being recognised in the profit and loss account. However, commentators criticised this proposal on the grounds, that it was imprudent; in particular they noted that the amount of the reported gain would be inflated because the discount rate used in valuing the debt would reflect the collapse of the company’s own credit rating, which seemed preversed.
As a result of these comments, the matter was not dealt with in the eventual standards, i. FRS 4, which was issued in December 1993. Apart from this, one topic addressed by many commentators was the assessment of the maturity of debt: that is, how it should be determined whether debt is short-term or long-term. Here the discussion paper proposed a very strict rule: the assessment was to be made by reference to the contractual maturity of the debt, and no consideration was to be given to facilities which would permit it to be re-financed. However, respondents pointed to situations in which such a rule would seem to give anomalous results.
And so FRED 3 proposed that where facilities are held which permit the borrower, in effect, to extend a loan, the maturity of the loan should be assessed by reference to the longest such refinancing permitted. But this does not extend to cases where the loan may be replaced by another. Issuers of commercial paper frequently have back-up facilities to ensure that if further commercial paper cannot be issued to finance the redemption of existing debt, the funds may be obtained from elsewhere.
FRS 4 dealing with capital instruments sets out to ensure that financial statements provide a clear, coherent and consistent treatment in particular with regard to their classification as debt, non- equity shares or equity shares. These are important distinctions and it is not surprising that the ASB’s has not met with universal support. One of the key issues to be considered in FRS 4 must be the presentation of, and commercial rationale for, selecting capital instruments.
On the whole, the disclosure requirements are voluminous and many could confuse readers. Finance directors will always seek instruments that can be treated as equity or quasi-equity in preference to debt. On the other hand, banker will continue to bend their minds to hybrids which avoid being treated as debt. Some commentators do not support that the classification of liabilities in accordance with their strict contractual maturities in circumstances where committed longer-term facilities are available, but from an alternative lender or group of lenders.
To be consistent with FRS 4, all liabilities should be recognised by reference to the substance of funding arrangements rather than their legal form. Insisting that short-term liabilities cannot be reclassified as longer-term where the former are not backed by longer-term committed facilities with the same lender, as FRS 4 does, will result in an inconsistency in the presentation of liabilities between companies, despite the fact that their funding structures have similar commercial substance. Now come to the question of practicality.
Although the basic principles of the standard are relatively simple in nature, the implementation of its principles can be complex and fraught with practical problems. Let’s consider the problems of accounting for shares under FRS 4. Often non-equity shares have cumulative dividends that accrue to the non-equity shareholders even where there are no distributable reserves available out of which to make a distribution. The accounting treatment for cumulative dividends has been changed by FRS 4: before, they were merely noted in the financial statements.
Under the FRS cumulative dividends form part of the share’s finance costs and, as such, are charged to the P & L account with other finance costs to achieve a constant rate on the outstanding instrument. However, the standard did not mention about what should be done with the credit that arises as a result of charging the cumulative dividend to the P & L account as an appropriation when the company has no distributable profits. For instance, it could be credited to liabilities as a dividend payable, but this does not answer – the dividend cannot be declared without distributable reserves from which to make the payment.
In addition, there are no transitional provisions in the standard and, therefore, it appears that the standard’s provisions apply to all instruments that are currently in issue. In principle a prior year adjustment affecting the P & L account will be needed where there is a difference between the dividends shown in the past and the total finance cost charged under FRS 4. However, for many companies there will probably be no need, in practice, to amend their last reported P & L account, because the prior year effect will be immaterial.
If issue costs on equity shares are material and they have been capitalised as part of an investment acquired with those shares, then it will be necessary to make a prior year adjustment to credit these costs to the investment account and to debit them to either the share premium account or the P & L account reserve. Generally, however, such cost will not be material. On the other hand, there are also practical problems with accounting for debt instruments.
Before FRS 4 was introduced, companies that were listed on the stock exchange were require to state the aggregate amounts repayable for bank loan and overdrafts and other borrowings of the company. FRS 4 extends the analysis of the maturity of debts to all companies. However, the standard never mention whether the analysis should be given in aggregate for all debts or by categories of debt, such as, debentures, loans, bank loans, overdraft and other loans. As stated earlier, accounting for negotiation of debt is not included in FRS 4.
The ASB argues that the negotiation was a transaction that effectively resulted in the original loan’s being replaced by a new loan giving rise to raise payments. Therefore, the amount relating to the old, superseded, debt was no longer relevant. Jyoti Ghosh in his paper on Difficulties with debt (Accountancy, August 1994) states that: At the time of renegotiations, the debt should be determined by discounting the revised payments by reference to the rate of interest the company would have expected to pay on a loan of similar characteristics to that resulting from the renegotiations.
Any change in the company’s credit rating since the original loan was made, as well as changes in the general level of interest rates, would be reflected in that rate. As this rate is likely to be higher than the historical effective rate of interest on the original loan, discounting the reduced payments using this rate would make the carrying value of the renegotiated loan smaller and the resulting gain higher – a result that is not intuitively appealing.
Apart from this, under FRS 4, any gain or loss ‘arising on the repurchase or early settlement of debt should be recognised in the P & L account in the period during which the repurchase or early settlement is made. However, an author, Chris Westwick (Accountancy, April 1994), suggested that a ‘gain’ on the repurchase of debt, financed by the issue of a new debt, should not be recognised in the P & L account because it will be offset in future years by higher interest payments on the new borrowing.
Similar arguments apply to repurchases financed by asset sales or the issue of equity. The author further suggests that the ASB needs to consider profit recognition in both the liability and asset situations as part of its statement of principle project, because whether or not there is believed to be a ‘gain’ in such situation will depend in part on the benchmark against which gains are to be measured, i. e. the capital maintenance concept used, either implicitly or explicitly.
In conclusion, by looking at the above loopholes found in the accounting standard for complex capital instrument, it may be argued that a correct approach for capital instruments still has not exist in real term, although ASB may readdress the issue in future. It is this gap in the rules which provided a range of creative accounting opportunities. What was revealed was that investment bankers and lawyers are able to help companies design sophisticated schemes.
Convertible securities provided companies with a way of managing two of the most important accounting ratios – leverage and earnings per share. There are evidence suggests that companies were able to use this to their competitive advantage (Shah, 1997). Not only did regulators have difficulty in effectively restraining such creativity, but analysts and the media were also weak in identifying and exposing the practices publicly. Auditors did not appear to restrain management from implementing their preferred accounting choices, even though they were material and controversial.
Consequently, it can be argued that practising creative accounting is not that difficult, owing to the significant grey area that exists between compliance with the rules and non-compliance or evasion. Finally, we can conclude that the current standard for complex capital instrument is not sufficient to solve the problems found in its accounting treatments. Hence, a more effective standard must be put forward to regulate the accounting treatment for capital instruments which is becoming increasingly more complex.