The directors of QRS, a listed entity, have met to discuss the business's medium to long-term financing requirements. Several possibilities were discussed, including the issue of more shares using a rights issue. In many respects this would be the most desirable option because the entity is already quite highly geared. However, the directors are aware of several recent cases where rights issue have not been successful because share prices are currently quite low and many investors are averse to any kind of investment in shares.
Therefore, the directors have turned their attention to other options. The finance director is on sick leave, and so you, her assistant, have been given the task of responding to the following note from the Chief Executive:
Now that we've had a chance to discuss possible financing arrangements, the directors are in agreement that we should structure our issue of financial instruments in order to be able to classify them as equity rather than debt. Any increase in the gearing ratio would be unacceptable. Therefore, we have provisionally decided to make two issues of financial instruments as follows:
(a) An issue of non-redeemable preferred shares to raise $4 million. These shares will carry a fixed interest rate of 6%, and because they are shares they can be classified as equity.
(b) An issue of 6% convertible bonds, issued at par value, to raise $6 million. These bonds will carry a fixed date for conversion in four years' time. Each $100 of debt will be convertible at the holder's option into 120 $1 shares. In our opinion, these bonds can actually be classified as equity immediately, because they are convertible within five years on terms that are favourable to the holder.
Please confirm that these instruments will not increase our gearing ratio should they be issued.
Note: You determine that the market rate available for similar non-convertible bonds is currently 8%.
Required:
Explain to the directors the accounting treatment, in respect of debt/equity classification, required by IAS 32, Financial Instruments: Disclosure and Presentation, for each of the proposed issues, advising them on the acceptability of classifying the instruments as equity. Your explanation should be accompanied by calculations where appropriate.