Question 1) our client has obtained a loan that has an option to convert to shares at the end of its 6-year term. Should we account for this under section 12 of FRS 102 as a non-basic financial instrument or is there more to consider?
There is more to consider here, although you can end up looking to section 12 of FRS 102.
The first assessment to make is whether the conversion option gives rise to an element of equity in the instrument. FRS 102 section 22.3(b)(i) tells us that where an entity could be required to deliver a variable number of its own shares, this meets the definition of a liability. By contrast, a requirement to deliver a fixed number of shares meets the definition of equity.
This means that if the conversion option is fixed for fixed in nature, ie. a known number of shares could need to be issued, then we have a compound instrument to account for. For the accounting we look to section 22.13 to 22.15 and the example in the appendix of section 22. We will need to allocate the proceeds for the instrument between the liability and equity elements. This is first done by determining the fair value of a similar liability without the conversion option – this gives us the value to allocate to the liability element. The residual amount remaining of the transaction price (deemed to be the fair value of the instrument as a whole on issue date) is allocated to the equity element. If a market rate of interest is attached to the instrument despite the conversion option, then the residual amount to be allocated to the equity element may be nil.
If the conversion option means that a variable number of shares could be issued, for instance because the number of shares to settle a conversion would vary depending on the prevailing share price at the time, then the conversion element would meet the definition of a liability. This means we have 2 elements of the instrument, both of which are liabilities. Where this is the case, we typically have a non-basic financial instrument so would look to account for this at fair value under section 12 of FRS 102. In this situation there is no need to allocate the proceeds to the two components of the instrument.
Additional resources:
Question 2) we have a client that was previously a large company: however, following the amendments to the company size thresholds in the Companies Act 2006, it will now be classified as a medium sized company. Does my client need to continue to include Streamlined Energy and Carbon Reporting (SECR) disclosures within the Directors’ Report?
For the statutory financial statements the company is a medium entity, however, to understand the SECR disclosure requirements we will need to consider the qualifying conditions within the 2018 SECR Regulations on these reporting requirements.
When the regulations came into effect on 1 April 2019 the qualifying conditions for reporting were aligned to the large company qualifying conditions within the Companies Act. However, the regulations are separate from the Companies Act and whilst the qualifying conditions have been increased in the Companies Act there have been no equivalent amendments to the qualifying conditions in the regulations on SECR.
The implication of this is a company can qualify as a medium company in accordance the Companies Act however would also be required to include SECR disclosures within the Directors’ Report where it has also met two or more of the qualifying conditions in the regulations for SECR.
Additional resources:
- The Companies (Directors’ Report) and Limited Liability Partnerships (Energy and Carbon Report) Regulations 2018
- Carbon and energy reporting
Question 3) we have a client that manufactures products for sale. The cost of inventory includes the raw material costs and direct labour costs. Are there additional costs that are to be included in the cost of inventory?
The cost of inventory as referenced in 13.5 of FRS 102 shall include all costs of purchase, costs of conversion and other costs incurred in bringing the inventory to their present location and condition.
Therefore, in addition to direct costs such as raw materials and direct labour costs, additional costs must be included that are part of the cost of conversion such as production overheads. These costs will include both fixed and variable production overheads.
Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production. These costs may include:
- depreciation and maintenance of a factory building and production equipment;
- rent of factory buildings and production equipment; and
- management and administration so far as it relates to the production
Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production such as indirect materials and labour.
FRS 102 also includes in 13.13 examples of costs that are not to be included in the cost of inventory and to be expensed as incurred. These include abnormal amounts of wasted materials, storage costs not part of the production process, and selling costs.
