EQUITY OR LIABILITY?
Singapore Airlines Limited (SIA) recently issued S$3.5 billion of mandatory convertible bonds (MCB), together with S$5.3 billion of ordinary shares under its Rights Issue. One major accounting issue is whether the MCB should be presented as “equity” or as “liability” in SIA’s financial statements.
Very briefly, the MCB were issued in the denomination of S$1 each, amounting to approximately S$3.5 billion. Upon maturity (which is 10 years from the issue date), SIA will convert the MCB into approximately 1.3 billion of its ordinary shares (based on the ratio of 0.373 ordinary shares for each MCB, calculated as the “final accredited principal amount” of S$1.806 divided by the “conversion price” of S$4.84). Before the maturity date, SIA has the option to redeem the MCB based on the accreted principal amount (which is calculated to give the MCB holders an annualised yield of between 4% and 6% compounded on a semi-annual basis). No interest or dividend is payable by SIA on the MCB.
The presentation of the MCB as equity or as liability is a major accounting issue because it has significant impact on SIA’s balance sheets and income statements.
- Balance sheet impact
To illustrate the balance sheet impact, based on SIA’s 31 March 2019 balance sheet figures, if the MCB are presented as equity (with consequential increases in shareholders’ equity by S$8.8 billion (including the S$5.3 billion rights shares) and assets by S$8.8 billion), SIA’s debt-asset ratio will be 29.5% and its debt-equity ratio will be 42.7%. However, if the MCB are presented as liability (with consequential increases in shareholders’ equity by S$5.3 billion, liability by S$3.5 billion, and assets by S$8.8 billion), SIA’s debt-asset ratio and debt-equity ratio will respectively jump to 40.5% and 69.6%. This may impact SIA’s ability to raise additional financing and the cost of such financing in future.
- Income statement impact
On its impact on the income statement, if the MCB are presented as equity, both the Singapore and international accounting standards provide that there will be no charge to the income statements. However, if the MCB are presented as liability (and given that there is an implicit 4% cost, semi-annually compounded, during the first four years, and which increases to 5% during the fifth to seventh year, and 6% during the eighth to 10th year), then there will be an interest charge of S$141 million in the first-year income statement (the interest charge increases each subsequent year and will be S$374 million in the 10th-year income statement). This will substantially reduce the reported profit (or increase the reported loss) of SIA for each of the next 10 years.
APPLICATION OF FINANCIAL REPORTING STANDARDS
The issue of whether a financial instrument should be presented as equity or liability is governed by SFRS(I) 1-32 Financial Instruments: Presentation, which is based on International Accounting Standard 32 Financial Instruments: Presentation issued by the International Accounting Standards Board. There are two sections in SFRS(I) 1-32 that are relevant to SIA’s MCB, namely, (i) “Compound financial instruments” (paragraphs 28-32), and (ii) “Instruments settleable in the issuer’s own equity instruments” (paragraphs 16(b) and 21-24).
- Compound financial instrument
A “compound financial instrument” is a financial instrument that contains both a liability and an equity component. A common example of a compound financial instrument is the “convertible bond”, where an entity issues a financial liability and grants an option to the holder of the instrument to convert it into an equity instrument of the entity. For compound financial instruments, SFRS(I) 1-32 requires the issuer to bifurcate the instrument into its liability and equity components and present the liability component as liability, and the equity component as equity, in the balance sheet.
At first glance, SIA’s MCB seem to be compound financial instruments. If so, then SIA would have to present the MCB as partly liability and partly equity in its balance sheet.
However, a more detailed analysis of the MCB shows that they are not compound financial instruments. This is because, when SIA issued the MCB, it had not granted the MCB holders the option to convert the MCB into ordinary shares. The conversion option is exercisable by SIA (the issuer), and not by the MCB holders.
- Instruments settleable in the issuer’s own equity instruments
SIA’s MCB are, in fact, “instruments settleable in the issuer’s own equity instruments” (ISOEI). This is because, at maturity date, the MCB will be converted into ordinary shares (that is, settled by SIA issuing its own ordinary shares).
It should be noted that not all ISOEI are equity instruments. SFRS(I) 1-32 specifically provides that an ISOEI is an equity instrument if and only if it “includes no contractual obligation for the issuer to deliver a variable number of its own equity instrument” (paragraph 16 (b); emphasis added). Thus, for an ISOEI to be classified as equity, it must be a case where the instrument will be settled by the issuer issuing a fixed number of its own equity instruments (this is what is referred to as “fixed for fixed” in accounting practice).
It is easy to understand the above provisions of SFRS(I) 1-32. If the accounting standard were to allow all ISOEI to be accounted for as equity instruments, then entities would want to structure most if not all their liabilities as ISOEI and account for them as equity to take advantage of the positive, albeit distorted, impact on financial statements. Where an entity may use a variable number of its own equity instrument to settle a contract, for example, to issue 10 million of its shares if the market price is S$1 per share, and to issue five million of its shares if the market price is S$2 per share, to settle a contract of S$10 million, the contract does not evidence a residual interest in the entity’s net assets, and therefore does not meet the definition of “equity”. That is the reason why accounting standards do not allow instruments that are settleable in variable number of issuer’s own equity instruments to be accounted for as equity.
For SIA’s MCB, in accordance with the terms and conditions in the Offer Information Statement, they will be converted into 1.3 billion ordinary shares on maturity date (assuming none of the MCB were redeemed, or purchased and cancelled, and there is no dilution of the conversion price), regardless of the market price of SIA’s ordinary shares on that date. Thus, SIA’s MCB are “instruments settleable in the issuer’s own equity instruments” that will be settled by SIA issuing a “fixed” number of its ordinary shares.
Therefore, SIA’s MCB are “equity instruments” and should be accounted for as “equity” under SFRS(I) 1-32.
How about the redemption option? As spelt out in the Offer Information Statement, the redemption option is held by SIA (the issuer) and not by the MCB holders. In this case, SIA does not have any obligation to make cash payment on the MCB until and unless it announces its decision to redeem the MCB. Thus, SIA does not have any “liability” to account for until and unless it exercises the redemption option. (This is very similar to the redeemable preference shares issued by DBS Bank where the redemption option is held by DBS, and the redeemable preference shares are appropriately accounted for by DBS as equity, as DBS does not have obligation (and therefore no liability to account for) until and unless DBS exercises its redemption option.)
From the analysis, it is clear that SIA’s MCB are equity instruments and should be accounted for as “equity” in SIA’s financial statements. This conclusion is also consistent with SIA’s stand as expressed in its Response to Questions from Shareholders dated 29 April 2020.
Look out for Prof Ng’s next article, “SIA’s Mandatory Convertible Bonds: From The Investors’ Perspective”, in the October issue of IS Chartered Accountant Journal.
Ng Eng Juan is Professor in Accounting, Singapore University of Social Sciences.