Ind AS 109 & 107 Measurement, recognition and discloser of non-convertible redeemable PSC
A Ltd. engaged in business of petroleum refining and sold its product to oil marketing companies. During the year company issued non-convertible redeemable PSC on private placement basis to its holding company B ltd. It is stated that this PSC are mandatory redeemable at face value at any time on a call/put option exercised on mutually agreed terms. So, contractual obligation to deliver cash at redemption exists since instrument requires mandatory redemption. Therefore, instrument qualifies liability and company recognized it as a financial liability under the head Long term borrowings.
Financial liabilities are recognized initially at fair value, which is equal to face value of share Since the effective interest rate for the given instrument is equal to market interest rate. Also, the amortized cost of the preference shares at the end of each reporting period will also be same. Moreover, in subsequent measurement, financial liabilities are measured at amortized cost at the end of accounting periods. The carrying amounts are determined based on the effective interest method. Gains and losses are recognized in profit or loss when the liabilities are derecognized as well as through the effective interest rate (EIR) amortization process. The EIR amortization is included as finance costs in the statement of profit and loss.
Whether the accounting treatment followed by company is correct? If not, what is the correct accounting treatment for the same?
Answer
Since preference shares are mandatorily redeemed, there is a contractual obligation to deliver cash. Therefore, in this situation financial instrument is recognized as a financial liability. Also, the put/call option of preference shares can be exercised at any point of time at face value based on mutually agreed terms, this put/call option treated as embedded derivative closely related to the host contract. Accordingly, this shall be classified as subsequently measured at amortized cost.
As per provision of Ind AS 109 Financial Instruments, initial recognition of financial asset or financial liability shall be measured at fair value plus or minus transaction costs which are directly related to acquisition or issue of the financial asset or financial liability. Moreover, in subsequent measurement, the redeemable preference shares shall be classified as financial liability. Also, the dividend on these redeemable preference shares is in the nature of interest cost. As a result, the future cash flow for payment of dividend shall also be considered while calculating effective rate of interest. Where no transaction cost involved in the above mention case, the effective interest would be equal to dividend. Therefore, in subsequent measurement of financial liability of preference shares is not likely to result in a material difference in the carrying amount of financial liability at the end of each reporting period.
Further the effective interest rate amortization is included in the SOPL as ‘finance costs’. Since preference shares are cumulative in nature, it is appropriate to disclosure of EIR amortization under ‘finance cost’. Furthermore, as per Ind AS 107 Financial Instruments: Disclosures, the company shall make the disclosures regarding comparison of the carrying amount and the fair value of the liability in the Notes.
References
– EAC opinion Query 1, Volume 40
– Opinion finalized on 16th March 2020
– Ind AS 109 & 107
Relevant Extracts from Ind AS 109
5.1.1 Except for trade receivables within the scope of paragraph 5.1.3, at initial recognition, an entity shall measure a financial asset or financial liability at its fair value plus or minus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability.
B5.1.1 The fair value of a financial instrument at initial recognition is normally the transaction price (i.e. the fair value of the consideration given or received, see also paragraph B5.1.2A and Ind AS 113). However, if part of the consideration given or received is for something other than the financial instrument, an entity shall measure the fair value of the financial instrument. For example, the fair value of a long-term loan or receivable that carries no interest can be measured as the present value of all future cash receipts discounted using the prevailing market rate(s) of interest for a similar instrument (similar as to currency, term, type of interest rate and other factors) with a similar credit rating. Any additional amount lent is an expense or a reduction of income unless it qualifies for recognition as some other type of asset.