ACCOUNTING FOR CONTRACTS OVER HUGE GROUP LIMITED’S OWN EQUITY INSTRUMENTS: AN ETHNOGRAPHIC CASE STUDY

Introduction

Whether I shall turn out to be ultimately accurate in my counsel offered to the Board of Directors of Huge Group Limited (Huge) and their auditors Horwath Leveton Boner (HLB) will in the end be determined by the JSE Limited (JSE), the GAAP Monitoring Panel (GMP) and by the users of financial information disclosed in their annual financial statements. The purpose of this ethnographic case study was to explore and describe the process in respect of the accounting for financial instruments in respect of contracts for difference and single stock futures with the underlying security being its own share entered into by and to examine the problems and obstacles that occurred when implementing their preferred accounting treatment.

The study also makes a contribution towards the need for accounting research to become more explanatory of accounting wherein theory is both informed, and is developed by observation. This is achieved by developing grounded theory from the data. Only a few years ago, the last thing on a structured financier’s list of worries was how to ensure the structure complied with accounting standards. The accounting rules were ‘flexible’ to say the least, if in fact any rules existed at all. Not many structured finance, specialised funding or treasury professionals had ever entertained the idea that accounting would affect economic bottom-line business decisions. There has been a revolution in accounting, especially in the financial instruments field. More complex rules have replaced the long-established accounting principles; prudence has been replaced by neutrality; the income statement has now become volatile ground; and, accounting significantly influences economic decisions.

The input from technical accountants has significantly increased and accounting risk management has become a specific part of the product development process. It is useless spending hundreds of hours on a deal only to find out later that the accounting does not work and that major changes are necessary. The accounting procedure needs to be considered at every step and it needs to become an integral part of structuring the deal.

Background

Huge entered into a single stock future contract with the underlying security being its own shares. The first transaction of its kind to take place in South Africa. The JSE rules and regulations made provision for one method of settlement of Huge’s SSF contract which is – by physical delivery. As a result Huge have only one option under this contract and that is to repurchase their own shares on expiry of the SSF contract. The question of how to account for this type of transaction is not specifically dealt with by IFRS. It must be noted that it is a contravention of South African company law not to comply with IFRS.

The purpose of this ethnographic case study was to explore and describe the process in respect of the accounting for financial instruments adopted by Huge Group Limited and to examine the problems and obstacles that occurred when implementing their chosen accounting treatment.

The research is predicated on the belief that a sound appreciation of the role and potential impact of accounting can only be developed by reference to the particular setting within which it is embedded (Hopwood, 1983). This kind of research, in general, does not seek to test a prior hypothesis. Rather, it seeks to theorise through the data in an inductive manner.

The paper commences with a brief review of the existing literature on culture and accounting practices and accounting in religious organisations. The paper then explains the use of ethnography and grounded theory as the interpretive research methodology. An overview of the organisations selected for the in-depth case studies is provided followed by a discussion of the findings from the study and the theoretical perspectives that have emerged.

The Actors

The Regulator

The JSE was established in 1887, and is the only stock exchange in South Africa. The JSE is registered in terms of the Securities Services Act, 2004, which is the general controlling Act in this regard. The GMP’s role is to advise the JSE about alleged cases of non-compliance International Financial Reporting Standards (IFRS), the JSE Listings Requirements and the Companies Act for listed companies.

The Client

Huge Group is listed on the Johannesburg Securities Exchange on the Alt-x (Alternative Exchange). The company listed on the Alt-X on 08 August 2007. This is the second year of financial results. The company is listed in the Technology Equipment and Hardware sector of the Alt-X. The company carries on business as a provider of least cost routing services in the telecoms industry in South and Southern Africa (AWP, 2009). Huge Group Limited has two wholly owned subsidiary companies namely Huge Telecoms (Pty) Ltd and Centracell (Pty) Ltd as well two unlisted investments one a joint venture and the other an Associate. The company has a joint venture investment and an Associate investment.

The company is owned by a wide number of shareholders due to its listing in the JSE. Major shareholders are James Herbst, Anton Potgieter, Vincent Mokholo (BEE) and B Morel's all executive directors of the company (AWP, 2009).

The Researcher

I am the IFRS advisor to the Huge Group Limited. To begin my life as an IFRS Advisor I record that I was accredited by the JSE Limited in October 2008 having provided the JSE with adequate information to demonstrate I had spent at least 800 hours performing practical and interpretive IFRS consulting over the past 12 months and I had a comprehensive working knowledge of IFRS (BULLETIN 3 of 2008 – Rule 15.4 [JSE Listing Requirements]).

The IFRS consulting must include a combination of review of financial statements before being issued, advising internal and external clients on the interpretation or application of IFRS, providing practical training on IFRS and other practical matters (Amoils, 2008).

It has been remarked (Amoils, 2008) that these new requirements are being introduced to enhance market protection. Several factors precipitated this, such as the increasing complexity of International Financial Reporting Standards (IFRS), the introduction of an alternative reporting framework for privately held companies (IFRS for SMEs) and difficulties experienced in the quality of work performed by auditors - evident from GAAP Monitoring Panel cases. I need to say nothing here other than to emphasise that IFRS advisors are subject to the JSE’s powers for censure and penalties. The maximum fine is R5million (JSE, Listing Requirements – Rule 1.20 (c)).

Justification

There is no shortage of guidance on how to account for financial instruments. The style of this guidance varies; some paraphrase the paragraphs in the standards while others go into more detail with practical examples. However, not all of the practical examples, even those produced by the standard setters themselves, follow a transparent logic – they are therefore difficult to understand, let alone implement. Furthermore, the complexity and variety of financial instruments also means that not every situation is covered by the pages of guidance issued by the standard setters. This case study is largely aimed at structured finance, specialised funding and liquidity, and treasury specialists, as well as accountants in these fields.

The case study aims to extract from the two thousand or so pages of the accounting rules and regulations the essential parts that would be most relevant to structured deals and present the issues and solutions in a way that the practitioner can easily understand. This case study has not been written to provide an exhaustive list of accounting rules and regulations, which in most cases would be irrelevant. However, it has been written to provide a practical guide for a specialist who needs to understand the most important accounting risks within a proposed transaction as the transaction is structured.

Research Methodology

Methodology - The Ethnographic Research Design

This study will utilize the ethnographic research tradition. This design emerged from the field of anthropology, primarily from the contributions of Bronislaw Malinowski, Robert Park and Franz Boas (Jacob, 1987; Kirk & Miller, 1986). The intent of ethnographic research is to obtain a holistic picture of the subject of study with emphasis on portraying the everyday experiences of Individuals by observing them (Fraenkel & Wallen, 1990). The role of the researcher as the primary data collection instrument necessitates the identification of personal values, assumptions and biases at the outset of the study. The investigator's contribution to the research setting can be useful and positive rather than detrimental (Locke 1987).

Interpretive methodology using ethnographic methods of inquiry enables an understanding of the accounting treatment for financial instruments in its proper context. Ethnography attempts an explanation or a `thick' description of meanings (Geertz, 1973) and in this case the meanings of accounting practices (Power, 1993).

An ethnographic study of accounting practices for financial instruments should therefore consider the subjective nature of human understanding and the complexity of human relationships in applying International Financial Reporting Standards.

Russell (1996) describes an interpretive methodology as a research process which is iterative, involving ongoing analysis and reflection through stages of exploration of an initial problem focus. The researcher gradually discovers the issues and questions of centrality to the informants and develops an emergent theoretical perspective. Through further reflection and data analysis the researcher eventually develops a theoretical understanding of the problem being studied.

Method – Case Study

The central aim of this method is to construct theory, rather than theory testing, by grounding the theory in a rigorous observation of the phenomenon. Analysis of the data is itself an emergent process. The researcher seeks gradually to develop empathy with the data, to understand how to interpret the various data sources. Case studies inevitably encounter problems of generalisability, but if the research methodology is sufficiently rigorous, these problems may be, at least partially, overcome. A well-constructed grounded theory should meet the criteria of generality in judging the applicability of the theory to a phenomenon. If the data upon which the theory is based is comprehensive and the interpretations conceptual and broad, then the theory should be abstract enough and include sufficient variation to make it applicable to a variety of contexts related to that phenomenon (Strauss and Corbin, 1990).

The Research Process

The research findings are presented using an adapted version of Russell’s (1996) model of the interpretive research process.

Initial Problem Focus

Around June 2008, the price of Huge Group Limited’s (Huge) ordinary share was trading around 395 cents per share. It was noted that the forward earnings yield (or return on investment) in a Huge Group ordinary share exceeded the forward cost of debt capital. At the time Huge’s problem was raising traditional debt to fund the repurchases own their own shares. So Huge decided to make use of the JSE's SAFEX-guaranteed single stock futures (“SSF”) mechanism, and general contracts for difference (“CFD”) mechanisms available in the market. Herbst, and Executive Chairman Anton Potgieter, therefore agreed to effectively bond their existing shares in Huge Group via SSF contracts, in order to provide the company with the means of repurchasing its own shares and making other capital investments.

Their decision to gain exposure to the ordinary shares in the company was an intelligent way to hedge the cash-flow risk of the repurchase of the company's share some time in the future. SSFs also provided Huge Group with a quick way of getting access to very cheap funding, funding that was effectively provided at a rate of prime less 3% with no guarantees or surety-ships required, and with limited security requirements. In a nutshell, Huge Group's use of SSFs ensured that the future repurchase of ordinary shares is pegged at a known price, and as such, Huge Group has hedged itself against the cash-flow risk of a rising stock price and a continually shifting goal post.

IAS 32.33 explains that the cost of an entity's own equity instruments that it has reacquired ('treasury shares') is deducted from equity. Gain or loss is not recognised on the purchase, sale, issue, or cancellation of treasury shares. This statement embodies the essence of the issue surrounding the accounting treatment of the SSFs that have been entered into by Huge Group Limited. The JSE have declared that upon expiry of the SSF contracts entered into by Huge may only be settled on a gross physical basis.

In terms of the above discussion the question that needs to be resolved is whether the SSF contracts entered into by Huge have the characteristics to indicate that these contracts should be treated as an equity instrument and reflected in the financial statements as an imitation share repurchase or should the SSFs be treated as a financial asset as held for trading and measured at fair value through profit or loss. The financial asset as held for trading versus equity distinction is important. Put simply: If an instrument is a financial asset as held for trading the accounting will impact on the profits for the period. If an instrument is equity: the proceeds received are credited directly to equity and are not remeasured - it is not subject to IAS 39 accounting by the issuer and there will be no impact on profit or loss for the period.

Initial Data

The collection of the data for this study took place during the annual audit of Huge Group Limited for the financial year end 28 February 2009. The researcher’s involvement was that of the IFRS advisor to Huge Group Limited and the Engagement Quality Control Reviewer (EQCR) to their auditors Horwath Leveton Boner (HLB). International Standard on Quality Control (ISQC) 1 “Quality Control for Firms that Perform Audits and Reviews of Financial Statements and Other Assurance and Related Services Engagements” P 35 states that the audit firm shall establish policies and procedures requiring, for appropriate engagements, an engagement quality control review that provides an objective evaluation of the significant judgments made by the engagement team. P39 states that the audit firm shall establish policies and procedures to address the appointment of an engagement quality control reviewer. The accounting treatment of Huge Group’s SSF contracts over their own shares would constitute complex and controversial that would require not only the services of an quality control reviewer but in addition the services of an IFRS expert in form of the IFRS advisor. I was requested by the management of Huge Group and HLB to act in both capacities. I was therefore entrusted to oversee the entire audit of Huge Group Limited and ensure that accounting treatment was in compliance with company law. I was in a unique position to be able to observe and sign off on the entire audit process and the accounting treatment of the SSF contracts.

Contracts for Difference

CFDs are a leveraged product requiring a deposit of cash collateral rather than the payment of the full value of the underlying position. Effectively cash is being borrowed by the long counterparty and lent by the short counterparty to finance the purchase or short sale of the underlying security. Although CFDs replicate the economic movements of the underlying securities they convey no right or interest in the securities nor entitle holders to any voting rights or STC credits associated with them. A Contract for Differences is a two way hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. In substance the contract is between two parties, buyer and seller, stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (If the difference is negative, then the buyer pays instead to the seller.)

For example, when applied to equities, such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares. CFD on a company's shares will specify the price of the shares when the contract was started. The contract is an agreement to pay out cash on the difference between the starting share price and when the contract is closed. CFDs can be used to gamble on shares falling (going short) as well as rising (going long). CFD on a company's shares will specify the price of the shares when the contract was started. The contract is an agreement to pay out cash on the difference between the starting share price and when the contract is closed. CFDs can be used to gamble on shares falling (going short) as well as rising (going long).

In consequence of the above discussion there can be no doubt that a contract for difference is a derivative financial instrument that is held for trading and therefore the accounting for a Contract of Differences is relatively simple. IAS 39 defines held for trading as: held for the purpose of selling in the short term or for which there is a recent pattern of short-term profit taking are held for trading. IAS 39.55 states that a gain or loss arising from a change in the fair value of a financial asset or financial liability that is not part of a hedging relationship shall be recognised shall be recognised in profit or loss. In simple terms all contracts for difference must be recognized at fair value on the reporting date.

The gain or loss on the contract is recognized in income as it occurs. This loss appears in the financial statements in the amount of R 7,686.704.

Single Stock Futures

Standard Bank has acquired a certain number of Huge Group Shares. As Huge Group Huge were expecting an increase in their own share price in the near future it was decided to investment their own ordinary shares by repurchasing them from Standard Bank.

To hedge its position Huge purchased 84,055 SSF contracts in their own shares via SAFEX. In terms of the contract, the futures will be purchased at a level of 3.62 per share. At year-end, (27 Feb 09), the mark-to-market account stood at R17,881,162 debit. This debit represented a fair value write down of the SSFs. This loss appears in the financial statements in the amount of R17,881,162.

To date: The company has indicated an intention to repurchase shares at some point in the future. No indication has been made as to when the contracts will be finally settled or how many times the contracts will be rolled over before being settled. The SSFs have rolled three times. On the 18th Of December, 18th of March and 18th of June - They will continue to roll every three months. Huge Group is exposed to 80 455 Single Stock Futures Contracts (i.e. each contract represents 100 shares) (100:1). The yearend of Huge is 28 February. At year there had only been one rollover.

The rollover day for a futures contract is one of the most misunderstood features in trading these contracts. The expiration day is easily understood. That day is when the futures contract must be settled. On expiry the underlying SSF contracts would require a physical delivery of Huge; own shares to them. To date and also at financial year end settlement on a gross physical basis had yet been effected. To affect this the normal process is to roll the SSF contract over into the next quarterly period to keep the trade open. Standard Bank has to buy back their contracts and sell a new one to Huge with a longer term but the same strike price and the same number of shares. If the roll over does not change the terms substantially then derecognition of the SSF contracts in Huge’s accounting records does not occur. The question arises as to why Huge decided not settle on a gross physical basis, but rather to extend their SSF contracts by affecting a rollover? At year end there had only been one rollover. If the sole reason for entering into the SSFs was to repurchase their own shares then why have they not done so at the first expiry date?

Due the impact of the global financial crisis and event not foreseen by the global business community the SSFs are well out of the money. The share price dropped to a level well beyond the strike price of R3.62. This meant that Huge could re-purchase their own share on the JSE for an amount well below the strike price and this would have a severe cash flow implications. Huge were legally bound on expiry to pay a huge premium for their own shares. Huge were probably speculating the share price would improve in relation to the strike price hence the rollover. In addition Huge may have been able to afford to take possession of their own shares just yet due to cash flow problems.

Huge at 18 December had not yet complied with Section 85 of the Companies Act, so legally they could not take delivery of their own shares. It is submitted that these conditions existed at each of the following rollovers. In discussions with the directors the rollovers of the SSF contracts would continue indefinitely until the above conditions were improved.

On Thursday, 19 March 2009 a public announcement stated the Huge board acted without the required JSE shareholder approval in entering the SSF contracts. If this is the case Huge were unable to take possession of their own share on any of the expiry dates and therefore had no alternative but to roll the SSFs contracts over. Whatever the reasons by rolling over their future positions in my opinion Huge have entered into a scheme to improve their position and delay the physical delivery of their own shares. This is trading and therefore the SSFs are held for trading.

Data and emergent research questions

As the research proceeded it became evident that the regulator has become increasingly insistent that Huge in some form should disclose the SSF contracts as an imitation share repurchase. However at a meeting with the regulator I submitted the following technical opinion and stated that under no circumstances was this opinion going to be changed. The following discussion outlines this opinion and the resultant regulator’s response.

The IFRS Advisor’s Opinion

IAS 39.AG14 states that trading generally reflects active and frequent buying and selling, of financial instruments. Trading is not investing; it’s speculating. Speculating is defined as assuming a business risk with the hope of profiting from market fluctuations. Successful speculating requires analyzing situations, predicting outcomes, and putting your money on the side of the trade on which way you think the market is going to go, up or down. Huge’s conduct clearly satisfies the definition of speculating. These conditions in my opinion suggest overwhelmingly that the single stock futures entered into by Huge to repurchase their own shares at an uncertain date in the future cannot and should not be classified as equity instruments until such date that Huge de facto take delivery of their shares after complying with Section 85 of the Companies Act and the requirements of the JSE.

A contract is not an equity instrument solely because it may result in the receipt or delivery of the entity's own equity instruments. IAS 32 emphasizes that a contractual obligation, including one arising from a derivative financial instrument, that will or may result in the future receipt or delivery of the issuer's own equity instruments, but does not meet the certain conditions is not an equity instrument. IAS 32 does not deal directly with SSFs however there is adequate discussion in IAS 32 as to whether a financial instrument should be classified as held for trading or as an equity instruments. The rule in IAS 32 for classification of items as held for trading or equity is essentially simple. A holder of a financial instrument must classify the instrument (or its component parts) on initial recognition in accordance with the substance of the contractual arrangement. It is conceded that substance and form are 'commonly', but not always, the same. In reality the substance is determined, if not by the legal form, then certainly by the precise legal rights of the holder of the financial instrument concerned. Ultimately, the key determinant of whether an instrument is held for trading or an equity instrument is whether the financial instrument displays the characteristics of an equity instrument as indicated by the substance of the futures contract.

It is important to note the emphasis of IAS 32 is on the contractual rights and obligations arising from the terms of an instrument, rather than on the probability of those rights and obligations leading to an outflow of cash or other resources from the entity.

The discussion in the above paragraph requires a detailed understanding of contractual rights and obligations arising from the terms of the SSF contracts entered into by Huge. According to the JSE’s own guidelines on SSFs one can exit a futures contract before the expiry date. At 14:00 two business days prior to the expiry of an SSF contract if the holder hasn’t elected to roll the SSF into a longer-dated contract. This is exactly what Huge has done. Single Stock Futures Contract Specifications of the JSE state that single stock futures contracts may be physically settled as contemplated in paragraph (a) of the definition of “futures contract” in rule 2.10 and, in terms of rule 8.40.7, at the expiry date and time referred to in clause 6 or that Single stock futures contracts may be cash settled as contemplated in paragraph (b) of the definition of “futures contract” in rule 2.10 and at the expiry date and time referred to in clause 6. Simply put physically settled in terms of Rule 8.40.7 and cash settled in terms of Rule 8.40.3. However as the SSFs have deemed to be physically delivered this feature constitutes the only mode of settlement on expiry.

Whatever the rights and obligations under the SSF contracts, these contracts have been extended and rolled over three times to date. The SSFs are alive and are being traded by Huge, if this was not the case they would have expired and Huge would have had to take delivery of their own shares. This has de facto not happened.

By rolling over the futures position Huge are waiting for the market to improve and reduce the differential between the strike price and share price, and this is trading. Sometimes a derivative financial instrument gives one party a choice about how the instrument is to be settled (either the issuer or the holder may decide whether it wants to settle net in cash or by exchanging shares for cash) (IAS 39 (AC 125).26–.27).

If this is the case, it is a financial asset or liability (not an equity instrument) unless settlement of all the alternatives would result in it being an equity instrument. The underlying contract for a futures trade would require a physical delivery, and to avoid this the normal process is to close out the contract, which basically means make a financial settlement, in advance of the designated expiration date. An alternative to closing the contract is to roll it over into the next quarterly period if you want to keep the trade open. The expiring contract can be traded. In other words when the substance of the contract includes various provisions as described that one party has a choice to request a settlement option, this results in a derivative, regardless whether the holder or issuer has the choice over settlement. Such derivatives accounted for as such under IAS 39. In respect of SSF purchased via SAFEX, SSF contracts can be traded before expiry closed out using equal and opposite trades, and rolled over. These various forms of settlement can all be affected before expiry and are available for choosing by the holder (Huge). Hence there is clearly a choice on how the SSFs are settled. One must understand the designation by the JSE that Huge’s SSFs are physically delivered can only be enforced on expiry. That’s the date the parties to the transaction agree to effect delivery and terminate the contract. This agreement to date has not yet taken place and it appears based on the evidence that is not going to take place in the near future.

Contract and contractual refer to an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law. The evidence as presented suggests that there many mechanisms which allow for an indefinite delay or in never taking delivery of their own shares before expiry.

As such the SSFs in applying the substance of the overall SAFEX and JSE contract specifications and derivative rules cannot be classified as an equity instrument. As stated previously Huge may never take delivery of their own shares under the SSFs. There is persuasive evidence of this. First there are the three rollovers to date. If Huge’s intention was to repurchase their own shares why was thus not done on the first expiry? This suggests speculation. Cash flow problems which are clearly a problem at Huge has ensured that Huge delays physical delivery until the share price approximates the strike price. Legally, as discussed they were unable to take delivery of the own shares. The Companies Act requires the annual financial statements to fairly present. The term “fairly present” is a rather subjective one, and therefore difficult to apply in practice. It is therefore submitted that fair presentation should be assessed against the Framework of accounting. It means that the information that is disclosed in the financial statements will give a faithful representation of the events it purports to represent (or would reasonably be expected to represent). All items that impact on the financial position and/or results of an entity should therefore be represented in the financial statements in an appropriate manner. Financial states should provide relevant information to ensure fair presentation.

Relevant information is information that is useful and can therefore influence the economic decisions of users by helping them to evaluate past, present or future events, or confirming or correcting their past evaluations. Such information can enable users to make more accurate forecasts regarding specific events, or can supply feedback on previous expectations. Relevant information, therefore, has one or both of the characteristics of feedback value or predictive value.

To fairly present the financial impact of the SSF contracts entered into by Huge the question that needs to be addressed is whether by accounting for the SSF contracts as held for trading fair value through profit and loss faithful representation and relevance have not been achieved. This in my opinion can only materialize if the SSFs display the characteristics of an equity instrument and there is absolute certainty via the substance of the SSF contracts that Huge would in fact take delivery of their own shares and could not be therefore held under any circumstances held for trading.

IAS 32 defines an equity instrument as any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. The notion of a residual is literally meaningful only in the event of corporate liquidation, when the firm would cash out its assets and distribute them to satisfy all claims. This raises the questions of whether Huge as a result of their SSF contracts could be classified as a claimholder. Is there sufficient evidence in terms of the SSF contracts to establish Huge as a claimholder? Do the SSF contracts serve in any way as legally enforceable evidence of the right of ownership in Huge, to enable Huge to reflect a share repurchase?

In my professional opinion the answer to these questions is no, and consequently the SSF contracts do not display any characteristics of equity sufficient to suggest that they could be classified as an equity instrument. To classify Huge group’s SSF contracts would be not faithfully represent the substance of the contract specifications that apply to a Huge SSF.

Emerging theoretical perspectives

The interpretive methodology which informs this research (Russell, 1996) requires an iterative approach to theory development whereby initial theoretical perspectives are tested by reference back to the research site. In this way a deep theoretical understanding, or grounded theory, of the phenomenon is constructed. The emergent theoretical perspective is an important stage in this construction as it brings together theory and empirical data to develop a theoretical understanding which can be tested and further developed. The following section outlines the emergent theoretical perspective of the relationship the application of International Financial Reporting Standards and South African company law.

South African company law makes provision that the financial statements of company’s must comply with financial reporting standards, and fairly present its financial position and the results of its operations. The main premise of financial reporting standards is that their application with additional disclosure when necessary is presumed to result in financial statements that achieve a fair presentation. This presumption raises the question as to why the Companies Act requires separate compliance with financial reporting standards and fair presentation.

The intention of the legislation is clear: only by preparing financial statements in compliance with financial reporting standards and ensuring that they fairly present the effects of transactions can they comply with the provisions of the Companies Act.

The requirement to prepare financial statements in conformity the provisions of the Companies Act is not apparent from a plain reading of the legislation as confusion exists as to which provision is dominant in respect of preparing financial statements: financial reporting standards or fair presentation.

This research paper attempts to reconcile the apparent contradictory and duplication of the legal provisions for preparing financial statements by detailing the principles of the law regarding the preparation of financial statements.

The preparation of financial statements has been the domain of auditors and accountants who are interpreting whether financial statements comply with financial reporting standards with little or no concern whether the financial statements are legally compliant. As a result financial reporting standards have become the overriding provision upon which financial statements are being prepared; with absolute no regard as to whether fair presentation has been achieved. Financial reporting standards have not eliminated the one basic limitation of the financial reporting system, i.e. the possibility of different accounting treatments being applied to essentially the same facts and can lead to significant variations in reported profits. This flexibility of financial reporting standards and the auditor and accountant’s unwillingness to consider fair presentation and the faithful representation of the effects of transactions potentially creates liabilities for directors which never existed before.

Faithful representation refers to the nature of the information contained in the financial reports. It means that the information that is disclosed in the financial statements will give a faithful representation of the events it purports to represent (or would reasonably be expected to represent). All items that impact on the financial position and/or results of an entity should therefore be represented in the financial statements in an appropriate manner. It is stated in paragraph 34 of the Framework that most financial information is subject to the risk of not being entirely faithfully representative in that it does not necessarily portray what it purports to portray.

The accounting treatment of liabilities (such as loans or bonds) and equity instruments (such as shares, stock or warrants) by their issuer was not historically regarded as presenting significant problems. Essentially the accounting was dictated by the legal form of the instrument, since the traditional distinction between equity and liabilities is clear.

The issue of equity creates an ownership interest in a company, remunerated by dividends, which are accounted for as a distribution of retained profit, not a charge made in arriving at the result for a particular period.

Liabilities, such as loan finance, on the other hand, are remunerated by interest, which is charged in the income statement as an expense. In general, lenders rank before shareholders in priority of claims over the assets of the company, although in practice there may also be differential rights between different categories of lenders and classes of shareholders. The two forms of finance often have different tax implications, both for the investor and the investee.

In economic terms, however, the distinction between share and loan capital can be far less clear-cut than the legal categorisation would suggest. For example, a redeemable preference share could be considered to be, in substance, much more like a liability than equity. Conversely, many would argue that a bond which can never be repaid but which will be mandatorily converted into ordinary shares deserves to be thought of as being more in the nature of equity than of debt, even before conversion has occurred.

The accounting profession has not always found it easy to decide how to balance competing considerations of substance and form in accounting for these instruments, especially since the fundamental distinction between debt and equity is rooted in form to begin with.

The rule in IAS 32 for classification of items as financial liabilities or equity is essentially simple. An issuer of a financial instrument must classify the instrument (or its component parts) on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument. The application of this principle in practice, however, is often far from straightforward. IAS 32 requires the issuer of a financial instrument to classify a financial instrument by reference to its substance rather than its legal form, although it is conceded that substance and form are 'commonly', but not always, the same. Typical examples of instruments that are equity in legal form but liabilities in substance are certain types of preference share and units in open-ended funds, unit trusts and similar entities. Conversely, a number of entities have issued instruments which behave in all practical respects as perpetual (or even redeemable) debt, but which IAS 32 requires to be classified as equity.

Ultimately, the classification of preference shares redeemable only at the holder's option or not redeemable according to their terms must be determined by the other rights that attach to them. IAS 32 requires the classification to be based on an assessment of the substance of the contractual arrangements and the definitions of a financial liability and an equity instrument.' If the share establishes a contractual right to a dividend, subject only to restrictions on payment of dividends in the relevant jurisdiction, it contains a financial liability in respect of the dividends.

This would lead to a 'split accounting' treatment whereby the net present value of the right to receive dividends would be shown as a liability and the balance of the issue proceeds as equity. In such a case, it is quite likely that the issue proceeds would be equivalent to the fair value (at the date of issue) of dividends payable in perpetuity, such that the entire proceeds would be classified as a financial liability.

IAS 32 restricts the role of 'substance' to consideration of the contractual terms of an instrument, and that anything outside the contractual terms is not considered for the purpose of assessing whether an instrument should be classified as a liability under IAS 32.

Coleman J stated in Novick v Comair Holdings Ltd – “The first point to be made is that accountancy is not an exact science. It is a system of recording the transactions of business enterprises, and of presenting accounts or financial statements relating to those transactions, and to the affairs of the enterprises, in accordance with certain conventions which are professionally recognised, and reasonably well known in the world of commerce, although they undergo evolutionary change from time to time. Those conventions, although they require strict adherence to the literal truth in respect of some items reflected in accounts, do not require it in relation to others; it is indeed an accounting convention that, in respect of some items in a balance sheet, a reflection of the literal truth is neither expected nor sanctioned”.

Thus, in relation to a set of accounts it is seldom meaningful to ask whether what they reflect is true. That was recognised by the framers of the Companies Act 61 of 1973, who have provided in s 286(3) a standard to which the annual financial statements of a company must conform. It is not therefore required that the financial statements be 'true' or "accurate'.

In South Africa the common perception amongst auditors and preparers of financial statements that they must be prepared in terms of IFRS without due consideration to fair presentation and faithful representation is in essence a contravention of South African company law.

Conclusion

Derivatives are here to stay. It is difficult to imagine managing finances or conducting business without them these days. But they are not to be trifled with. Many are highly complex and behave in sometimes unpredictable ways. And new architectures are being developed continually. Yesterday’s derivatives have advanced through many generations of innovation so that, today, a request that would once have produced the financial equivalent of a slingshot will now beget a nuclear device.

Populating the derivatives world are a band of risk takers who, oddly enough, frequently trade to transfer risk to others. But most people are risk-averse, and this includes nearly the entire spectrum of management within companies that use derivatives. Their aim is to avoid becoming a casualty of that process. Despite best efforts, that aspiration may be defeated. The best defense against this career risk is effective supervision of the derivatives activity so that calamities do not occur.

This case study has sought to provide some guidance toward that end. If any further reinforcement is needed, the Huge Group’s debacle that was detailed in this case study should dispel any illusions that derivatives disasters cannot happen to nice people who think they are good managers.