You are a senior manager (SM) at GLC Inc. (GLC), a registered mid-sized audit firm in Johannesburg where you are well respected for your knowledge of accounting for financial instruments.

You receive the following email from the financial manager at one of your pharmaceutical clients, 'Pandemia Ltd' (Pandemia):

Dear SM

Management at Pandemia are in the process of raising additional funds for the development of our revolutionary new 'Cold-ex' medication. The drug has shown promising results in treating a range of viral diseases but requires additional funding to complete final trials and bring it to market.

Management estimates it will cost approximately R 7 800 000 to complete the trials and we are considering one of the following three options in order to raise the required funds:

1)Corporate Bonds

The issue of Bonds with a nominal value of R7 900 000 and a coupon rate of 13% payable annually in arrears. The market rate for similar bonds is 11.5% pa. The bond would be issued on 1 January 2021 and redeemed on 31 December 2024 at nominal value plus 5%. Transaction costs would amount to R43 250 payable on issue date.

2)Issue of shares

The issue of 5 000 000 ordinary shares at a nominal value of R 1.50 per share. Tranches of shares will be issued in equal amounts to three approved private investment companies at a premium of 7.6%. The transaction would be administered by Lelapa Inc attorneys and would attract transaction costs of R145 000.

3)Preference shares

The issue of 60 000 8% Preference Shares for R130 each on 1 January 2021. Interest on these preference shares is payable semi-annually in arrears on 30 June and 31 December each year. The preference shares are redeemable on 31 December 2024 for R 600 000 in cash and the balance will be converted into 75 000 R1.50 ordinary shares in Pandemia.

At inception, the market related interest rate of similar preference shares is 11%.

We have correctly calculated the following present values at 1 January 2021 until redemption date:

- Present value of the interest and R600 000 cash redemption value @ 8% = R1 645 410

- Present value of the interest and R600 000 cash redemption value @ 11% = R1 577 937

- Present value of interest payments only @ 8% = 120 000

- Present value of interest payments only @ 11% = R92 308

Our finance team is busy discussing the accounting treatment for the above instruments and there is some debate regarding their fundamental classification, particularly with regard to whether they should be classified as equity or liabilities?

Please can you help me with this question? In my opinion, the preference shares are the way to go and it would be much easier for everyone if we simply classify them as equity and be done with it. If you could draft an email to help steer the discussion in that direction, I would very much appreciate it.

Looking forward to hearing from you.

Regards

Financial Manager

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Question 1

With regards to the financial manager's request:

"In my opinion, the preference shares are the way to go and it would be much easier for everyone if we simply classify them as equity and be done with it. If you could draft an email to help steer the discussion in that direction, I would very much appreciate it.'

Discuss the ethical implications of this requestusing the quick test approach.(10)