Question

CRITICAL THINKING QUESTION
Please read the case study below on the differences between equity and liabilities. Decide whether the Class A common (ie. ordinary) shares may be disclosed as part of shareholders’ equity. Explain the application of relevant passages from AASB 132 and the Conceptual Framework to the Class A Common Shares, making specific connections between wording in in the standards and framework with the features of the shares.

Using the AREA framework, do you agree or disagree with the classification of the Class A shares as equity? In your answer refer to relevant accounting standards.

ANALYSE: (30-50 words)
- Identify the issue and why it matters. Determine what you need to find out.

RESEARCH: (200-250 words)
- Present relevant facts and evidence, or issues.

EVALUATE & ANSWER: (200-250 words)

- Provide your opinion of the themes or issues you have identified, justified by the evidence you have gathered and evaluated.

Cast study adapted from Gunderson, K.E. (2013) Distinguishing between Liabilities and Equity; Two Mini-Cases for Improving Students’ Critical Thinking Skills in Intermediate Financial Accounting, Journal of the International Academy for Case Studies, 19(3), 51-62.

It was Friday afternoon, and Neil Danford, a new staff accountant at Extua Corporation, had mixed feelings about the memo he just received from the controller of Extua Corporation. Next week he would begin working on a project that could have an immediate impact on the financial position Extua would report to investors and other outside parties. While he was proud to be given such an important assignment, he considered it a bit advanced given that he had only been with Extua Corporation for six months.

Neil was surprised by the esteem his superiors had for him. A circumspect person, Neil felt the other new staff accountants at Extua, who were socially outgoing, would surpass him in climbing the corporate ladder. But his superiors seemed to like his demeanor, and they would sometimes stop by his cubicle to chat, speaking to him as an equal, an intimacy they did not share with the other college graduates.

This new project involved classification of a special type of common stock Extua issued to acquire a company that had previously been one of Extua’s suppliers. Negotiations resulted in an agreed price of $5 million, and the previous owners accepting Class A common shares as payment for their company. Further details about these shares, and other aspects of Extua’s financial structure, are as follows:

At December 31st, 2016 Extua Corporation has various forms of debt outstanding including secured bank loans and debentures. Extua has no preferred stock, but has two types of common shares outstanding, Class C and Class A. There are one hundred million shares of Class C common stock outstanding. Each share entitles the holder to one vote on ballot items at the company’s annual meeting. The shares are transferable without restriction and are actively traded on the Australian Stock Exchange. In addition, Extua had the following Class A Common shares outstanding:

$5 million - Class A Common Stock (100,000 shares of $50 per share)
The shares are non-voting, do not share in dividends, but have liquidation rights at par with the Class C common shares. The shares were issued 1 December 2016 and are subject to mandatory redemption on 1 December 2018 at $57.245 per share, or a total of $5,724,500. The shares will be accreted to their redemption value using the effective interest method. The company may, at its option, pay the $5.7245 million redemption amount in cash, shares of Class C common stock (based on the market price for the common stock at the time of redemption), or any other form of consideration deemed appropriate by the board of directors of the company.

Extua Corporation officials would like to report the Class A Common shares in the shareholders’ equity section on the 30 June 2017 balance sheet. They reason that since the stock is issued in the form of common shares, and since they may discharge their obligation without payment of any cash, it is therefore justified to report these shares as part of shareholders’ equity.

Answer 1

In the provided scenario the problem arising to Mr. Neil clearly can be stated as whether he should classify the $50 million shares worth Class'A' shares as part the company's viz. Extua Corporation' shareholders' equity or not.

Mere fact that such Class 'A' equity shares are issued to the company's past suppliers and that the company does not have any preferred stock does not give it the right to form part of its capital. The relevant extracts of AASB-132 on ''Financial
Instruments: Presentation" :Para 2 (5) defines an equity as -'An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting
all of its liabilities". Thus an equity share capital in a company is defined by an amount represented by owners,capital/fund invested into the company, that helps the company to operate efficiently and plan its future prospectives. In lieu of such equity amount invested, the owner shall get there percentage shareof residual profits and past accumulated residual profits of the company after providing for all tax and other statutory and other liabilties that are due for repayment. Thus any amount to be qualified to be part of owners' equity and common stock must necessarily have following characteristics-

1.Right to vote in the the company's decision making resolutions to the extent of the owners' share.

2.Right to claim for the residual profits after taxes (if any) and paying of other liabilities of the company on the form of dividends.

3. Such ordinary equity shares shall necessary be redemed after paying all the liabilties of the company and if there remains any deficit, then company may call the shareholders to pay unpaid amount of their call money dues. The redemption to these shares can be made in cash as well as in any other form viz. exchange of shares of another company or issuing of convertible debentures etc.

In the given scenario,

Shareholders holding Class 'C' shares do not have the right to dividend of the company as well as they do not bear any voting rights unlike Class 'C' shares issued. Again redemption amount of Class 'A' shares also fixed at $57.245 per share which is solemnly not a charateristic of any ordinary shares as the latter claims for residual profits and reserves after company goes into liquidation.

Hence the Class 'A' shares cannot be considered as part of common stock of the company on the mere basis that they may be redemed using effective interest method or otherwise and not requires any cash outflow, because as cited above such shares may also be redeemed in cash.

Conclusion: On analysing the above it is clear that the Class'A' shares cannot be considered as part of the shareholders'equity of Extua Corporation and will be considered as Non-Current liability stated at its present value which will be restated every year at their amortised value calculated by using the effective interest method.