Introduction

AASB132requirestheclassificationoffinancialinstruments,suchas preference shares, to be determined by the substance of the contract which, inturn,isdeterminedbythetermsofthecontractualarrangement.For instance,thesubstanceexpressedinthetermsofthecontract,determines whetherapreference shareissueshouldbeaccounted forasequityoras a liability by the issuer. The Rural Press case provides an example in which the accountingtreatment ledtoachangein thesubstanceofthecontract. Concernsabouthowthecompany'spreferenceshareissuewould be classifiedunderAASB132werethedrivingforcebehindchangestothe contractual terms of the preference shares.

4The CaseRuralPressLimitedissuednon-redeemablepreferenceshareswitha minimum dividend of 1.5 cents per share annum.The preferenceshares had beenclassifiedas equityinaccordancewith accountingstandards prevailing atthetimeofthe2005financialstatements.Thecompanyreceivedthe following advice from its auditors:"The Company has received advice from its Auditors that, asaresultof the introduction of the new Accounting Standard AASB 132 (the Australian equivalentofInternationalAccountingStandardIAS32)dealingwiththe classificationoffinancialinstruments,andtherequirementunderthe constitution of the Company that a dividend of 1.5 cents must be paid on PreferredSharesiftherearesufficientprofitstodoso,itislikelythatan amountbasedonthepresentvalueoffuturedividendsofthis1.5cent minimumpaymentwillberequiredtobetreatedbytheCompanyasa financialliability.Anexpenseequivalenttotheminimumannualdividend paymentwouldsimilarlyneedtoberecognisedeachyear."(Noticeof Meeting of Preferred Shareholders and Notice of Annual General Meeting 21 October 2005, notice dated 20 September 2005.)The auditors had advised that the preference share issue must be treated as aliabilitytotheextentofthepresentvalueoftheminimum1.5centsper sharedividendinperpetuity.Managementdidnotagreewiththeauditors' advicebutproposedanamendmenttothetermsoftheissuetoremove uncertaintyabouttheappropriateaccountingclassificationofthepreference shares.Theproposaltomaketheminimum1.5centspersharedividend discretionarywasacceptedbyshareholders.Thusthequestionofhowto classifyRuralPressLimited'snon-redeemablepreferenceshareswitha minimum1.5centsdividendperannumdidnotariseinanyfinancial statements to which AASB 132 applied.

Required

Assume theshareholders rejectthedirectors'proposal,suchthatthe minimum1.5centspersharedividendstillappliesofthenon-redeemable preference shares.(SQ.7)a)How should the preference shares be accounted for in accordance with AASB 132? (Hint:the relevant principlesto guide this decision are stated inAASB 132, para. 11 definition of a liability, definition of equity; AASB 132, para. 15 requirement to recognise separately the components of an instrument, applying substance over form; AASB 132, para. 28.)You are notrequired to quantify your answer to this part.

5(TQ.4)b)Givenyouranswerto parta),howshouldtheannual1.5centsper share dividend be accounted for? (i.e., as a borrowing cost expense orasadistributionofequity) Explainyouranswer. (Hint:referAASB 132, para. 35-36)(In-Class Activity)c)The directors' actions reflect reluctance to classify the preference shares, oracomponentofthepreferenceshares,asliabilities.Considerthe following summary indicators:The reportedleverage ratio (total liabilities/total assets) = 29%If the preference share issue were classified as a liability the leverage ratio would be= 44%Timesinterestearned[(profitbeforetax+Interestandborrowing costs)/Interest and borrowing costs] using reported figures= 15.8 timesIf all of thepreference share dividend paid in the year ended 30 June 2005 hasbeenaccountedforasaborrowingcost(interestexpense), times interest earned = 3.05 timesExplainowner-managercontractinganddebt-contractingarguments astowhymanagersofsomecompaniesmightpreferfinancial instrumentstobeclassifiedasequityinsteadofbeingclassifiedas liabilities. (Youwill,ofcourse,needtoassumethepresenceofsuch contracts for this purpose.

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