So THIS is IFRS!
I was recently asked to give a morning presentation to the board of a company explaining the concept of IFRS (a morning!). My quandary was how to fit a lifetime of studying this complicated, controversial but fascinating topic into a few hours. At the time I was trying to assist a private company with an IFRS issue so I thought, why not use this problem to illustrate it – they say an example is worth a thousand words (or is it a picture?)
A well established private company, with a dedicated and skilled workforce, decided to go the extra mile by awarding its staff 50% of the company’s equity shares. Three staff members were appointed to the board. Before the share issue, the company’s share capital was 1m shares of R1 each and its reserves were R1m. 1m shares were issued (at a premium of R1 each) to the employees to be held in trust on their behalf. The company lent the trust R2m, interest free, to pay for the shares. The effective date of issue was the first day of the current financial year.
Being a private company there was no liquidity in the shares so the rules of the scheme provide that any staff member can sell his or her shares to any other member after five years and on settlement of the outstanding loan. The company undertook to be a buyer of last resort of any shares (either directly, through a subsidiary company or through the trust) offered by staff members on resignation, retrenchment, death or for whatever other reason after the five year holding period.
The company passed a resolution to declare dividends of 50% of earnings each year, subject to there being enough cash to pay the dividend. The following financial statements were prepared by the company:
The auditors arrived to do their annual stint with their accounting standards nestled in their arm pits. When they saw this transaction they called in the technical partners of the firm. The discussions went something like this:
IAS39.43 requires that financial instruments be fairly valued on initial recognition. Assuming that the loan to the staff trust will be repaid at R100 000 p.a. over the next 20 years and assuming that a fair rate on this loan is 15% p.a., the initial value of the loan is R625933.15.
The adjusting journal entries are:
The loan to the staff trust cannot be classified as held to maturity or a loan or receivable as there are no fixed or determinable payments. The company may choose to classify the loan as a financial asset at fair value through profit or loss or as an available for sale financial asset. Assume that the company opts for the available for sale classification and that the fair rate of return at the end of the year is now 14% p.a.
The adjusting journal entries are:
The standby offer to buy the shares back by the company is deemed to be a share appreciation right in terms of IFRS2. The vesting period is five years. The shares will have to be valued each year and a charge made to the income statement reflecting the employee benefit. A valuation of the shares at the end of the first year was obtained from the auditing firm’s valuation department being R2.65 per share.
The adjusting journal entry in the first year is:
The standby offer to the staff to acquire their shares constitutes a liability in terms of IAS32 so the company must pass an entry debiting equity and crediting a liability. (Can the company use the set-off rule to net the debit loan against the credit loan?) Do you have any idea on how to arrive at a value for such a liability? If all the members of staff died at the year end, the shares would have to be bought back at the net asset value. However, this is an unlikely scenario unless the company manufactures explosives. Another problem is: What is meant by net asset value? The agreement with the staff did not specify whether the net asset value would be based on the consolidated financial statements or the separate financial statements because no one at the time visualised problem 5 below. It was decided to employ actuaries to help solve the measurement problem and attorneys to help solve the definition problem.
Because of a recent amendment to SIC12, employee benefit trusts are now deemed to be subsidiaries and consolidated financial statements will have to be prepared. This results in the following additional problems:
1. The loan from the company will have to be revalued on initial recognition in the books of the trust – see the adjusting journal entries for problem 1.
2. The interest paid on the loan will be raised each year – see the adjusting journal entries for problem 1.
3. The loan liability in the trust cannot be classified as available for sale as this classification does not apply to liabilities. The trust will have to decide whether to leave it at ‘cost’ (the fair value at acquisition), which will cause problems when trying to eliminate it on consolidation, or to fair value it through profit or loss.
4. The shares will be treated as treasury shares so the net asset value per share and the earnings per share will be calculated based only on the holdings of the previous shareholders, which will totally distort the true situation.
5. Because the trust is a party to the put option over the shares held by the staff, it will have to value this derivative each year. This entry will disappear on consolidation as the full liability has already been provided in the company’s balance sheet.
Because of the actuarial fees, attorney’s fees, valuer fees and additional audit fees resulting from all of these complications, the company will have to cancel the dividend for the following year and will probably have to raise a bank overdraft to finance these additional unforeseen costs.
You can imagine how furious management are about this. The problem is that the laws of the land require private companies to comply with Statements of QAAP, which effectively equates to IFRS. I really feel for the auditors as they are caught between trying to provide a meaningful service to the company and its shareholders and having to comply with IFRS under the threat of disciplinary action if they do not. I would have suggested giving the staff a share in the profits without a share in the equity. However, the scorecards doing the rounds in SA require that there must be a share in the equity as well as in the profits.
IFRS was designed to protect the shareholders but it is having exactly the opposite effect in the case of small private companies because of the complications and lack of expertise in these companies to deal with the issues.
So there you have an example of IFRS. Want more?
Charles Hattingh CA(SA), Chartered Financial Analyst and Honorary Professor at the University of the Free State
Copyright South African Institute of Chartered Accountants Mar 2006
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