QUESTION 2
(30 marks)
This question has two parts
Part A
The difference between debt and equity in an entity's statement of financial position is not
easily distinguishable for preparers of financial statements. Some financial instruments may
have both features, which can lead to inconsistency of reporting. The International
Accounting Standards Board (IASB) has agreed that greater clarity may be required in its
definitions of assets and liabilities for debt instruments. It is thought that defining the nature
of liabilities would help the IASB'sthinking on the difference between financial instruments
classified as equity and liabilities.
REQUIRED:
(i) Discussthe key classification differences between debt and equity under International
Financial Reporting Standards.
Note. Examples should be given to illustrate your answer. (12 marks)
(ii) Explain why it is important for entities to understand the impact of the classification of a
financial instrument as debt or equity in the financial statements. (6 marks)
Part B
The directors of Avis, a public limited company, are reviewing the financial statements of two
entities which are acquisition targets, Olynpia and Rocky.They have asked for clarification on
the treatment of the following financial instruments within the financial statements of the
entities.
Olynpia has two classes of shares: A and B shares. A shares are Olynpia's ordinary shares and
are correctly classed as equity. B shares are not mandatorily redeemable shares but contain
a call option allowing Olynpia to repurchase them. Dividends are payable on the B shares if,
and only if, dividends have been paid on the A ordinary shares. The terms of the B shares are
such that dividends are payable at a rate equal to that of the A ordinary shares. Additionally,
Olynpia has also issued share options which give the counterparty rights to buy a fixed
number of its B shares for a fixed amount of $10 million. The contract can be settled only by
the issuance of shares for cash by Olynpia.
Rockyhas in issuetwo classesof shares: A shares and Bshares. A shares are correctly classified
as equity. Two million B shares of nominal value of $1 each are in issue. The B shares are
redeemable in two years' time. Rocky has a choice as to the method of redemption of the B
shares. It may either redeem the B shares for cash at their nominal value or it may issue one
million A shares in settlement. A shares are currently valued at $10 per share. The lowest
price for Rocky's A shares since its formation has been $5 per share.
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