On 15 July 2004 the Australian Accounting Standards Board (AASB) approved and issued 40 new accounting standards that largely mirror the International Financial Reporting Standards (IFRS). These new standards are collectively known as the Australian equivalents to International Financial Reporting Standards (AIFRS).
Section 296 of the Corporations Act 2001 requires companies preparing a financial report under Chapter 2M of the Act (generally speaking, public companies, large proprietary companies, registered schemes and other disclosing entities) to prepare their financial report(s) in accordance with the AASB’s accounting standards. Accordingly, statutory accounts will need to be prepared in accordance with AIFRS for reporting periods, including half years, commencing on or after 1 January 2005. For listed entities this means that December balancers will apply AIFRS for the first time in their 30 June 2005 half year report.
The impact of the adoption of AIFRS may also be felt by entities preparing non-statutory financial reports where their governing document stipulates adherence to accounting standards. Furthermore, agreements and business contacts entered into by entities may have terms and conditions which are impacted by AIFRS, such as loan covenants.
Mr Andrew Bristow, Partner at PricewaterhouseCoopers Legal says while the accounting implications of the adoption of AIFRS are relatively well documented, the legal implications are now also demanding the attention of Australia’s financial community. In this article, we highlight several of the key legal issues and risks for entities during the transition. Whilst the examples provided are not exhaustive they will provide you with a starting point to further understand your company’s potential issues.
Key legal issues and risks
Dividends
XYZ Pty Ltd (XYZ) has a 31 December balance date. In the year to 31 December 2004, XYZ made a $25m profit and had an additional $45m in retained earnings. The directors of XYZ determine to pay a final dividend in line with their dividend policy of $12.5m and a special dividend of $12.5m. In the transition to AIFRS, the comparative accounts restate the 2005 profit and retained earnings to $5m and $10m respectively. Can the directors still pay $25m in dividends?
Section 254T of the Corporations Act 2001 requires dividends to be paid out of profits. Therefore, any impact that the adoption of AIFRS will have on a company’s reported profit will also impact on its ability to declare and pay dividends. In the above example, the available profits and retained earnings for distribution will be written down by $55m in the financial reports for the year ended 31 December 2005 causing XYZ to report a loss.
The Australian Securities and Investments Commission (ASIC) has issued guidance regarding the payment of dividends for companies whose reported profits and retained earnings are impacted. It has confirmed that a dividend paid on a reported profit which is restated as a loss in subsequent comparative accounts prepared under AIFRS will not be a breach of section 254T of the Corporations Act. Accordingly, the directors will still be able to pay the dividends, provided they do so before 31 December 2006.
If the directors of XYZ did not pay the $25m in dividends by 31 December 2006 then they would not be able to do so as the available funds for distribution would total only $15m.
Under AIFRS it is possible that profits earned during the period prior to the commencement of AIFRS may be reversed and brought to account in the subsequent year. This has the potential result of a company’s accounts showing the same profit available for distribution in two years. In this case, ASIC has stated that dividends cannot be paid on the same profit in the two years.
Issues may also arise for companies that have cumulative preference share dividend obligations. The payment of such cumulative amounts may well be jeopardised by any impact to retained earnings.
Going forward, the transition to AIFRS may stimulate companies to review their dividend policies to ensure they reflect the new accounting context, the needs of the underlying business and importantly their relations with investors.
Borrowings, capital raising & investments
ABC Pty Ltd (ABC) has a $30m facility with an Australian bank of which $20m is drawn down. The loan facility documentation requires ABC to keep specific financial ratios within certain bounds otherwise ABC will be taken to be in default of its loan. With their current debt levels, the debt to equity ratios are close to the agreed upper limit. On transition to AIFRS, a large series of redeemable preference shares previously issued by ABC are reclassified from equity to debt and as a consequence, the debt to equity ratio upper limit is breached. What options does ABC have?
There are a number of differences between current accounting principles and AIFRS principles which have the potential to negatively impact debt to equity ratios. Some of the changes under AIFRS that may affect the calculation of debt to equity ratios include: the treatment of intangible assets; the re-classification of financial instruments, and the accounting of financial instruments at fair value.
A common implication for companies may be that existing balance sheet equity will be reclassified as debt, for example, reset preference shares may be considered debt under AIFRS. Key financial ratios (such as minimum net assets or debt service to interest cover ratios) within loan and debt documentation could be affected as a consequence and may potentially be breached.
“The need to be proactive is paramount,” says Mr Bristow. “Entities must review their loan documentation and, if necessary, negotiate with their bankers to obtain waivers of rights that accrue to the bank in the event of a breach.” Alternatively, the adoption of AIFRS may necessitate the renegotiation of banking covenants in their entirety.
In the event of renegotiation, careful wording of key financial ratios within the loan or debt documentation should provide companies with some insulation from changes in the accounting standards. For example, the use of “total tangible assets” instead of “total assets” when calculating key financial ratios should nullify the impact of AIFRS’ restrictive valuations of, or derecognition, of intangible assets.
If an entity can clearly demonstrate an ongoing ability to meet its loan repayments then it is unlikely that there will be problems in renegotiating the covenants.
The ability of entities to raise capital may also be impacted on transition to AIFRS given the focus placed on retained earnings. Many companies have disclosed their dividend policy, particularly in respect to preference shares, taking into account a high level of retained earnings. Any reduction in retained earnings could lead to a lower level of security on the payment of such dividends and therefore may force the company to consider higher dividend payout ratios to justify the additional risk for investors. In such cases, it may also be necessary to change the terms of the issue of the securities which may require approval of the various stakeholders.
Similarly, situations may arise where an investor has made the investment on certain rates of return, which under AIFRS may not be met. In such cases, investors may seek to enforce pro-visions in loan documents or shareholder agreements requiring a dilution of a particular shareholder’s interest such that overall the investor’s level of return is met. Certain investors may need to exit an investment because the impact of the changes to the accounting standards are such that the investment is no longer one permitted under its constituent documents, particularly in the case of investment trusts. The alternative to exiting the investment would be for the constituent documents to be amended.
Employee incentive schemes
Mr X is CEO of a listed company. His employment package comprises salary, performance shares and options based on the audited results of the company. In the transition year, the company exceeds its performance targets on a pre-AIFRS basis however, due to the impact of AIFRS, the audited profit is significantly less than anticipated.
In the event that key performance conditions within employee incentive and bonus schemes are not satisfied on transition to AIFRS, significant human resource and legal issues may arise, for example, an entity may argue it is not required to pay the relevant incentives to its employees. Alternatively, a “free kick” may be granted to employees as AIFRS may artificially boost the performance of the entity which could have serious consequences for the financial performance of the entity, earnings per share and so on. These issues should be understood and resolved prior to the end of the relevant period. Modelling will be necessary to evaluate the impact of AIFRS on the existing employee incentive programs.
“Entities may consider varying the form of their entire employee incentive plans to ensure their structure and conditions still measure up from a financial, tax, human resource, investor and legal perspective,” notes Mr Bristow. Such variations often involve a time lag due to the need for careful financial modelling of the incentives and the need for shareholder approvals. This is particularly so if the incentive is payable to an executive director by a listed company or will involve the issue of shares or options.
It is important to note that AIFRS introduces changes to the accounting treatment of employee incentive schemes. Mr Bristow says, to date, entities have been required to disclose these share based payments in their accounts but not recognise the expense in the profit and loss. “On transition to AIFRS, these instruments will be expensed at ‘fair value’ and will accordingly hit the company’s bottom line for the first time.”
Contracts
DEF Ltd (DEF) agrees to purchase QRS Pty Ltd (QRS) for a purchase price of $10m with $5m contingent on the performance of QRS in the three years following completion of the sale. In the second year post-completion, QRS transitions to AIFRS and the reported performance of QRS is impacted by the treatment of certain intangibles. The financial ratios are breached and the earn-out is not paid.
All business contracts or agreements that use financial indicators must be considered for the impact of AIFRS.
As with financial covenants in loan agreements, if the review indicates that the underlying nature of the original deal will be upset, it may be that the terms of the contract will need to be renegotiated. Such renegotiation obviously depends upon both parties being willing to do so. Where one party has, as a result of the change to the accounting standards, been artificially benefited to the detriment of the other, this may not be possible.
“The problem posed above is a classic example as it is common for sale and purchase agreements to include an ‘earn-out’ component as part of the purchase price,” says Mr Bristow. While most earn-out components contemplate the use of Australian accounting standards, in the above situation, the precise wording of the original earn-out clauses, the key definitions, particularly the references to the accounting standards and dispute resolution mechanism will be crucial to evaluating the impact of AIFRS on these arrangements.
Conclusion
As we gain a better understanding of the accounting implications on the transition to AIFRS, the legal implications have come to the fore.
“Entities need to be aware of how AIFRS will affect all facets of their business including their commercial relationships with bankers, suppliers, customers, employees and investors,” advises Mr Bristow. “It is critical that they understand their legal options in respect to varying business contracts where the underlying agreement between parties is fundamentally altered by the transition to AIFRS.” It is imperative that entities take proactive measures to understand and resolve such matters in order to mitigate any negative commercial or business implications. We therefore recommend that as part of the entities’ management of their transition to AIFRS they undertake a thorough “due diligence” review / contract audit of their business agreements and other relevant documents to identify their key legal risks and issues arising from transition and consult, where necessary, with the appropriate specialists to mitigate and resolve such issues.
For more information please contact:
Andrew Bristow
Tel: +612 8266 6807
Fax: +612 8266 6999
Send email | Andrew Bristow, Partner
Andrew is a respected specialist in corporate and commercial law. His areas of expertise include corporate structuring, public and private fundraising, company and business acquisitions, venture capital, corporate governance, internal company administration and employee wealth creation schemes.
Andrew represents clients from a broad spectrum of industries ranging from e-commerce and manufacturing to mining and agriculture. His extensive experience of due diligence investigations enables him to add significant value to all his client’s commercial transactions. |
