Accounting: Blurring the lines

The City is always keen to flog a new trend where there’s a few bob in it,
and one of the biggest fashion items in the City has been hybrid bonds. Except,
while banks have been busy talking about hybrid bonds, no UK corporate – at
least at the time of writing – has issued them. UK finance directors have stood
back and watched mainland European corporates tread this route. The most recent
was car maker Porsche, which issued a $1bn hybrid in January this year.

Banks are puzzled over UK plc’s lack of enthusiasm. Several reasons have been
mooted – apart from the more expensive fees that the banks are looking to charge
compared to normal debt issues – including the idea that finance directors don’t
want be the first ones to take this step.

Perhaps the most compelling reason is the lack of regulatory certainty. The
taxman will doubtless look askance, with the corporate tax base already under
siege from private equity gearing up companies with tax deductible debt. And
standard setters are taking an interest.

Hybrid bonds are complex. They are more properly described as debt
instruments with equity characteristics built into the underlying contract. Like
other bonds, hybrids have that killer benefit of tax-deductible interest, but
potentially have less impact on credit ratings because of their equity
characteristics.

The building blocks for hybrids have been transplanted from the financial
institutions’ bond market where banks and insurance companies regularly use
hybrids for regulatory capital purposes. Hybrids made the transition from the
financial sector when Moody’s reassessed its approach and gave credit for the
equity characteristic of a hybrid issued by a non-financial company. For Moody’s
and other agencies, the precise equity credit given will depend on the terms of
the bond.

To see how hybrid bonds are treated at the moment we have to look to IAS32
Financial Instruments: Presentation. To quote from a senior equity analyst:
“Under IAS32, hybrids will usually be treated as debt. However, if the equity
characteristics are sufficiently strong, it will be treated as equity. This can
make analysing companies with such financing in place more difficult, but clear
disclosures and explanation by management should alleviate this problem.”

A further accounting problem arises if the hybrid is swapped from fixed to
floating. Experts suggest that under IAS39 Financial Instruments: Recognition
and Measurement, fair value hedge accounting would be available if the hybrid
was classified as debt, but not if it is classified as equity. So if a corporate
wants to keep the hedge accounting treatment the hybrid must be accounted for as
a liability. That may also (to quote a tax lawyer) support a more robust tax
opinion. How the recent spate of continental European hybrids are accounted for
remains to be seen. With the presence of IFRS there is, in theory, a level
playing field, but there are concerns about consistency of treatment of IFRS
across Europe and this will be an interesting example.

The key accounting point rests on the contractual arrangement. IAS32 sets out
the definitions of a financial liability and equity and requires a financial
instrument to be classified in accordance with the substance of the contractual
arrangement. A critical feature in the accounting treatment is the existence of
a contractual obligation on the part of the issuer to deliver cash or any other
financial assets to the investor. Any such contractual obligation will cause an
instrument to be classified, at least to some extent, as debt.

The IASB itself has recently looked at the issue through its International
Financial Reporting Interpretations Committee (IFRIC). It looked at the
contractual terms of two financial instruments. One contained no obligation ever
to pay dividends or to call the instrument – IFRIC called it equity under IAS32.
The second paid dividends if interest was paid on another (linked) instrument.
IFRIC called that linking an obligation and said it should be classified as a
liability. Indeed IFRIC said that IAS32 is clear and added: “It would not expect
diversity in practice.”

Whether it gets what it expects remains to be seen. After all, the major
selling point of a hybrid is its chameleon-like appearance. Lose that and we’re
back to debt. How to account for hybrids has echoes of a forgotten UK standard
FRS4 Capital Instruments. It was issued in late 1993 to stop a number of scams
where debt was being classed as equity in a bid to improve gearing. FRS4 (which
has now been replaced by FRS25 and FRS26 – which, in turn, are based on IAS32
and IAS39) tried to draw the line between debt and equity. That line seems
increasingly blurred. If the City thinks it can start playing fast and loose
with debt and equity again we may see a similar reaction from those who hold the
standard setting strings today.

From an FD’s perspective, the contradictory requirements of credit rating
agencies, tax advisers and the auditors means that structuring a hybrid to keep
everyone sweet is a fine balancing act. Despite these doubts, in the current
frothy capital market environment who would bet against the hybrid market taking
off?