Brief facts of enquiry:
The Accounting Standards Board (the Board) received an enquiry wherein a Non-Banking Finance Company (NBFC) requested guidance about the classification of interest-bearing subordinated loans as ‘equity’ or ‘liability’ under the provisions of Non-Banking Finance Companies (Establishment and Regulation) Rules, 2003 and the applicable accounting and reporting standards.
Opinion:
The Board noted that an NBFC is required to prepare statutory financial statements in accordance with the requirements of the:
•International Financial Reporting Standards (IFRS Standards) as adopted by Securities & Exchange Commission of Pakistan (SECP) under the Companies Act, 2017 (Companies Act);
•Provisions and directives of the Companies Act;
•Non-Banking Finance Companies (Establishment and Regulation) Rules, 2003 (NBFC Rules); and
•Non-Banking Finance Companies and Notified Regulations, 2008 (NBFC Regulations).
Further, where requirements of NBFC Rules, NBFC Regulations and Companies Act differ from IFRS Standards, such requirements shall prevail over the IFRS Standards.
The Board observed that clause (xix) of Rule 2 of the NBFC Rules provides an ‘inclusive’ definition of equity. This definition includes subordinated loans as a component of equity. On the other hand, the NBFC Rules do not define a financial liability.
The Board also noted that Rule 7(d) of NBFC Rules requires an NBFC to comply with the requirements of IFRS Standards notified under the Companies Act. The Board accordingly observed that for statutory financial reporting purposes, IFRS Standards would determine the classification of a subordinated loan (either as equity, liability or a compound instrument).
Under the IFRS Standards, IAS 32 Financial Instruments: Presentation, deals with the classification criteria of a subordinated loan as debt or equity.
IAS 32 does not classify a financial instrument between equity and financial liability on the basis of its legal form. Instead, it considers the substance of the financial instrument, and applies the definitions to the instrument’s contractual rights and obligations.
Based on the classification criteria set forth for financial liability and equity under IAS 32, a subordinated loan would fulfill the classification criteria of equity if it does not include:
•Any contractual obligation to deliver cash or another financial asset to another entity; or
•Contractual obligation to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the NBFC. and;
If the contract will or may be settled in NBFC’s own equity instruments, it is:
•a non-derivative that includes no contractual obligation for the NBFC to deliver a variable number of its own equity instruments; or;
•a derivative that will be settled only by the NBFC exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments.
In principle, the specific terms and conditions of each subordinated loan agreement (i.e. substance rather than form) would determine the classification of a subordinated loan as equity or liability under IAS 32.
An NBFC while applying IFRS Standards would generally classify a subordinated loan as a financial liability as it would be required to settle the principal and interest through transfer of economic resources (i.e. cash). A mere subordination of a loan to all the other indebtedness and payment of interest and principal in compliance with equity and capital adequacy requirements, do not overcome the definition and classification conditions of a financial liability of IAS 32.
The Board (based on the Technical Services Department’s limited review of the audited financial statements of a sample of NBFCs) also noted that as a general practice, NBFCs classify their subordinated loans as financial liability or equity in accordance with the requirements of IAS 32.
The Board concluded that an NBFC while preparing statutory financial statements under the Companies Act should apply the requirements of IFRS Standards to classify a subordinated loan as equity or liability (or a compound instrument).
(Issued in July, 2020)