Ruby Traditions Ltd. Case Study

Overall Problem Identification

Ruby Traditions Ltd (“Ruby”) have perceived preference shares as an equity instrument instead of a compound instrument in Proposal 1 and leaseback as an operating lease instead of a finance lease in Proposal 2 is in favour to enhance the working capital and maintaining the debt-to-asset ratio at a maximum of 65%. However, an incorrect classification on both proposals has a probable consequential impact on assets, liabilities and equity account affecting Ruby’s accuracy in gearing ratios, profits, and debt covenants.

Proposal 1

• Problem Identification

Ruby is classifying the characteristics of a loan into the equity section; a loan as a share. When preference shares are treated as an equity, it will neither be treated as a liability nor the dividend payments will be treated as an expense in Income Statement (“P&L), but as a distribution of profits in Balance Sheet (“B/S”) under equity. As such, debt is lowered, profits increased, retained earnings under equity is increased, Ruby will, therefore, be able to enjoy a lower Debt/Equity Ratio; ultimately leading to a better leverage for financing needs. In addition, since asset increased (cash received from shares issued) but liabilities remain the same – debt- to-asset ratio will be maintained at a maximum of 65% while achieving a better working capital.

• Appropriate Recognition in Accordance with AASB 132

However, since shareholders have both the rights to either convert into an ordinary share or redeem it for cash as well as receiving dividends, this satisfied the characteristics of a compound instrument where it features both debt and equity instruments with reference to AASB 132:29.

When preference shares are allowed to be converted to an ordinary or an equity share, this qualifies the characteristics of AASB 132:16 as an equity instrument. This component is recorded with the residual amount of $705,6001. There is no significant impact on gearing ratio since it gives rise to assets, liabilities and equity.

On top of that, since there is an obligation for Ruby to deliver cash by redeeming the shares back and a contractual obligation to pay dividends, under AASB 132:18, these obligations are classified as a financial liability. At the end of Year 1, in the P&L, finance cost (interest expense) is recorded with $700,0002 and in B/S, a non-current liability of $600,0003. This would increase

expense and liability account, decrease profit and retained earnings (equity account).

According to AASB 139:9, the debt securities that Ruby intends to issue is a Held-to-Maturity security as there is a definite maturity of 10 years, shown in the B/S at amortised cost of

$9,345,0084 after the first year.

• Summary

In summary, in accordance to AASB 132, the financial instrument of Proposal 1 should be classified as a compound instrument instead of an equity instrument since it has features of both a debt and equity characteristics. This option allows a better working capital of $9,400,0005 cash (current asset > current liability), but a Debt-to-Asset ratio of 1.076 or 107%, not achieving to maintain the maximum level of Debt-to-Asset ratio at 65%.

Proposal 2

• Problem Identification

Upon classifying the lease as an operating lease, it is treated like an operating expense. In fact, these expenses are fully tax deductible. Liability and asset is not recognised in B/S but only as a lease expense over the term of the lease in P&L. In addition, Ruby is not obliged to any administrative or running cost. The main benefit of classifying as an operating lease allows Ruby to achieve on maintaining it’s debt-to-asset ratio of not more than 65%. Working capital will be increased as well since the sale of non-current assets allow Ruby to gain cash (increase in asset with no liabilities).

• Appropriate Recognition in Accordance with AASB 117

The lease term is the full economic life of the assets, AASB 117:17, and the present value of

$9,421,1007  is at least substantially 94.211%8  of the fair value. Both of the terms listed has

fulfilled the conditions of AASB 117:10 (c) (d), therefore, it is only appropriate that Ruby recognises the lease as a finance lease instead of an operating lease.

Although the assets are not legally Ruby’s, the appropriate reporting to abide would be to recognise the Property, Plant and Equipment (“PPE”) leased as an asset of $10,000,000 and Finance Lease Obligations as a liability $1,300,000 in the B/S for the initial year. Since payments are made at the beginning of the year, accrued interest of $104,0009 will be credited under current liabilities. Ruby is obliged for any payment related to maintaining and repair the assets. At the end of the year, depreciation expenses (Building) of $400,00010 will be recorded as well.

• Summary

In summary, Ruby should recognise the lease as a finance lease instead of an operating lease in accordance to AASB 117:10 (c) (d). Working Capital with $8,596,00011 will be improved since current assets (cash received from the sale of assets) is higher than current liabilities (accrued interest). Although recognising lease as a finance lease will give rise to non-current liabilities, asset is also increased. This would lessen the liability and therefore, achieve to maintain the debt-to-asset ratio at 51.55%12.