1.1.18 Preference Shares / Redeemable / Convertible

Enquiry:

Due to the amendment in the 4th Schedule to the Companies Ordinance, 1984 which, has made the application of International Accounting Standards mandatory. This includes IAS-32 prescribing the treatment of Preference Shares, which is in contradiction to treatment and classification implied by the Companies Ordinance, 1984.

Whereas Preference Shares / Redeemable / Convertible or otherwise are classified as part of equity if they meet certain criteria in accordance with IAS-32, if the criteria is not met the same are required to be classified as liabilities. The provisions of the Companies Ordinance, 1984 are indicative of the fact that the same are part of the equity.

Some of the facts have been examined below:

1.    Although the 4th Schedule requires adherence to all IASs including IAS-32 there are contradictory provisions in the 4th Schedule itself in this context. Part II-6 pertains to disclosure of requirements of Share Capital and also requires Paid-up Capital to be grouped under Share Capital and Reserves.

2.    In accordance with section 90 of the Companies Ordinance, 1984 different classes of shares as provided by the memorandum and articles of association of the company are categorized as share capital i.e. equity. Return of allotment of shares filed under section 73(1) group both ordinary / preference shares of each class in Paid-up Capital.

3.    Various other provisions of the Companies Ordinance, 1984 and ‘Companies’ Share Capital, (Variation in Rights and Privileges) Rules, 2000’ are indicative of the fact that Preference Shares redeemable, convertible or otherwise are part of Share Capital.

4.    The normal terms of issue of the Redeemable Preference Shares provides options for redemption and conversion into Ordinary Shares. On redemption it will fall within purview of Section 85 of the Companies Ordinance, which requires creation of Capital Redemption Reserves and the latter is part of equity. On conversion it will be converted into class of Ordinary Shares, which is again equity.

5.    Further Schedules are sub-ordinate to the Ordinance; accordingly provisions of the Ordinance take precedence.

6.    It is further observed that IAS-32 does not cater for the situation where redemption reserve is created.

7.    It is also observed that dividend on preference shares are appropriations of profits both from the perspective of the Companies Ordinance and under the tax laws.

Irrespective of the requirements of IAS 32, the Companies Ordinance, 1984 will take precedence. This is similar to the treatment of revaluation surplus under S235 of the Companies Ordinance, 1984 which differs from the requirements of IAS 16.

A number of our clients have already issued Preference Shares / Redeemable / Convertible or otherwise or are in the process of issuing the same. We shall be grateful if you could confirm in this context, taking into consideration the above stated facts that it is appropriate to classify such shares as part of equity.

Alternatively till the resolution of the matter, the companies be allowed to treat and classify them equity for the interim period involving the current audited financial statements in process.

Opinion:

The appropriate Committee of the Institute has examined the above enquiry, regarding the treatment of preference shares and its comments are as under: –

1.    It is important to note that while Section 234 of the Companies Ordinance, 1984 (the Companies Ordinance) makes it obligatory for listed companies to observe IASs as are notified from time to time, the repealed Fourth Schedule to the Ordinance did not bear any direct reference to the mandatory observance of such IASs.

It is significant to note that paragraph 1 of Part-I of the revised fourth schedule carries an overriding stipulation as under:

“The listed companies and their subsidiaries shall follow all the International Accounting standards in regard to accounts and preparation of balance sheet and profit and loss account as are notified for the purpose in the official Gazette by the Commission, under sub-section (3) of section 234 of the companies Ordinance, 1984 (XLVII of 1984)”.

From the aforesaid, it is the Committee’s view that IASs would override anything to the contrary contained in the Fourth Schedule of the Ordinance vis-à-vis accounting treatment and disclosure. Indeed the very revision of the Fourth Schedule, in the Committee’s view, would seem to be premised on the fact that the accounts shall be prepared and disclosed pursuant to IASs read with the said schedule.

2.    Section 90 of the Companies Ordinance read with the Companies’ Share Capital, (Variation in Rights and Privileges) Rules, 2000 and the 4th Schedule to the Companies Ordinance provides for issuance and disclosure of different kinds of share capital and classes therein. If the memorandum and articles of a company so provide, it may issue any class of its share on terms that they shall be redeemed at a fixed date, or over a fixed period of time, or on the occurrence of one or more specified contingencies, or that the shares may be redeemed at the option of the company or the holders of the shares on a fixed date or at any time.

3.    In this regard, Clause 6 of Part II of the 4th Schedule to the Companies Ordinance provides that:

“Share capital and reserves shall be classified under the following sub-heads, namely:-

a.    Issued, subscribed and paid up capital, distinguishing in respect of each class between, –

i.    shares allotted for consideration paid in cash;
ii.    shares allotted for consideration other than cash, showing separately shares issued against property and others (to be specified); and
iii.    shares allotted as bonus shares.

b.    Reserves, distinguishing between capital reserves and revenue reserves.”

4.    On the other hand, Section 85 of the Companies Ordinance deals with redemption of preference share. The gist of the provisions of this section is that the amount required to redeem the redeemable shares may be found out of the profits of the company available for distribution or out of the proceeds of a fresh issue of shares. If shares are redeemed out of the proceeds of a fresh issue of shares, the capital issued or paid up on those shares will replace the redeemed capital. If alternatively, redeemable shares are redeemed out of assets representing a company’s distributable profits, the amount by which its issued share capital is thereby reduced must be transferred from profits or revenue reserves to a special capital reserve known as “the capital redemption reserve fund”, which can itself be reduced only in the same way as paid up share capital. In effect, the amount credited to the capital redemption reserve fund replaces the aggregate nominal values of the redeemed shares, and the transfer from profits or revenue reserves make the amount transferred unavailable for distribution as dividend.

5.    In this regard, the following paragraph of IAS 32 state that:

18     The substance of a financial instrument, rather than its legal form, governs its classification on the entity’s balance sheet. Substance and legal form are commonly consistent, but not always. Some financial instruments take the legal form of equity but are liabilities in substance and others may combine features associated with equity instruments and features associated with financial liabilities. For example:

(a)     a preference share that provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date, or gives the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount, is a financial liability.

20     A financial instrument that does not explicitly establish a contractual obligation to deliver cash or another financial asset may establish an obligation indirectly through its terms and conditions. For example:

(a)     a financial instrument may contain a non-financial obligation that must be settled if, and only if, the entity fails to make distributions or to redeem the instrument. If the entity can avoid a transfer of cash or another financial asset only by settling the non-financial obligation, the financial instrument is a financial liability.

(b)     a financial instrument is a financial liability if it provides that on settlement the entity will deliver either:

(i)     cash or another financial asset; or
(ii)     its own shares whose value is determined to exceed substantially the value of the cash or other financial asset.

Although the entity does not have an explicit contractual obligation to deliver cash or another financial asset, the value of the share settlement alternative is such that the entity will settle in cash. In any event, the holder has in substance been guaranteed receipt of an amount that is at least equal to the cash settlement option.

6.    Hence, in view of above, the Committee is of the opinion that the Securities and Exchange Commission of Pakistan (the SECP), in order to remove the above inconsistencies between the Companies Ordinance and IAS 32, should amend section 85 of the Companies Ordinance by adding a proviso to the effect that for companies which are required to adopt 4th Schedule to the Companies Ordinance in the preparation of their financial statements, the provisions contained in the said schedule relating to redemption shall not apply. This will result in clarifying the circumstances when preference shares should be classified as equity or otherwise to conform to the requirements of the said IAS.

Once this amendment is made to the Companies Ordinance, then the ambiguity regarding the treatment and/or disclosure of preference shares as either equity or debt will be resolved. Accordingly, dividend paid on such preference shares will also be classified as either an appropriation or a charge to the profit and loss account, as the case may be, depending upon the forms governing the issue of preference shares.

7.    However, recognizing that the amendment to the Companies Ordinance could take some time, the SECP, in the meantime, is requested to issue a notification with regard to the treatment and disclosure of preference shares in the financial statements of listed companies.

(January 7, 2006)