October 3rd, 2024
Private Companies: How a Professional Audit Can Help You Reach Your Goals
(authored by RSM CANADA) A private company may strengthen its financial stability, operational efficiency and long-term success by having a regular audit.
Posted on July 19th, 2022 in General Business
The Accounting Standards Board has amended Section 3856 Financial Instruments to restrict instances in which preferred shares that were issued in a tax planning agreement (Income Tax Act Sections 51, 85, 85.1, 86, 87, or 88) are recorded at stated or assigned value. These shares are now referred to as retractable or mandatorily redeemable shares (ROMRS). Instead, these shares would now be presented as a liability (likely a current liability classification) and measured on initial recognition at the redemption amount. These amended rules came into effect for fiscal years beginning on or after January 1, 2021. The December 31, 2021, financial statements are the first time we will be seeing the impact of these new rules.
This will result in material changes to many company’s balance sheets as a new (potentially significant) liability will be recognized, with a corresponding reduction to equity. The equity section would specifically identify this component of equity to enable users to isolate and evaluate the impact of the new rules. In addition, specific disclosures relating to the transaction that resulted in the reduction of equity and recognition of liability would also be required.
There are a few exceptions to these new rules which will allow your company to continue to classify these preferred (ROMRS) shares as equity. For shares issued on or after January 1, 2018, all three of the below criteria need to be met in order to maintain the current equity classification:
It is important to note that the exceptions noted above must be reviewed at each financial statement date. If conditions have changed from the prior year, it may be that the exception is no longer relevant thereby requiring reclassification from equity to liabilities. Shares originally recognized as liabilities cannot subsequently be classified as equity.
If these three conditions are not met, then you must classify the shares as a liability at the redemption amount. Any resulting adjustment is debited to retained earnings or a separate component of equity (i.e. separate account) which will be presented on the balance sheet as a separate component in the equity section.
It is important to note that for shares issued prior to January 1, 2018, only two of the three conditions need to be met in order to maintain equity classification. The condition of only share for share exchange is excluded for ROMRS issued prior to January 1, 2018, meaning ROMRS issued in an asset rollover will qualify for equity classification provided the other two conditions are met.
Assuming you need to reclassify your ROMRS from equity to liabilities, the new standards allow for two alternative transitional provisions.
The cumulative effect of applying the amendments is recorded in opening retained earnings or in a separate component of equity of the earliest period presented. For example, for fiscal December 31, 2021, the cumulative adjustment is recorded as of January 1, 2020. Note, retrospective adjustment is not required for ROMRS that were extinguished prior to the beginning of the fiscal period in which amendments are first applied (i.e. January 1, 2021). For example, assume ROMRS classified as equity are redeemed in May 2020 and amendments adopted January 1, 2021. If those shares do not meet the classification exception, the entity will not be required to apply the new accounting to those redeemed shares in the 2020 financial statements.
Apply at the beginning of the fiscal year in which the amendments are first applied.
With this option, the cumulative effect of applying the amendments is recorded in opening retained earnings or separate component of equity as of January 1, 2021. This option was given to help with the challenges that some ROMRS may have been issued many years ago and we may not have all the details from way back when. These transitional provisions therefore consider control at the adoption date (e.g. January 1, 2021) rather than at the time of the original transaction.
If you are required to treat ROMRS as a liability, any dividend paid on those shares will be reported as an interest expense on the income statement. This will also still be treated as a dividend for filing your income tax return which will cause differences in your taxable income calculation and other reporting requirements with Canada Revenue Agency (i.e. dividend versus interest on a T5).
It is prudent to analyze your company’s balance sheet to determine if any issued ROMRS will require a reclassification to liabilities when the standards become effective for your company or if the exceptions noted above change in the future. If so, the sooner you determine the impact it will have on your balance sheet, the sooner you can start to have conversations with your financial statement users to ensure they are aware of the upcoming changes to your liabilities and equity sections. This will allow you to have an open dialogue with your financing partners to ensure your banking covenant calculations are revisited to ensure the reclassification will not result in a covenant breach.
If you have questions about these new standards or require assistance in determining the impact it will have on your company’s financial statements, please contact your DJB advisor.
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