How to meet equity requirements established by law?

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When closing a financial year, it can turn out that a company’s equity (net assets) does not meet the requirements set forth in legislation and so the equity must be brought into conformity with the law. Often auditors and lawyers receive queries about these topics, but their perspectives can sometimes vary. That is because financial statements are prepared based on the economic substance of a transaction, not legal form.[1]

Subordinated debt

Legal advisors have often recommended subordinating owners’ loans to increase net assets as one way of bringing equity into line with legal requirements. A subordinated loan is a loan where the repayment is subject to something – i.e., allowed only if certain conditions are met. These conditions are usually either

  1. bringing equity into conformity with legal requirements or
  2. repayment of other creditors’ loans first.

As lawyers see it, this is the owners’ contribution to business, and thus a loan subordinated on such conditions should no longer be recognized as a liability but as equity.

From the accounting view, it would nevertheless not be considered correct to recognize such a subordinated loan as owners’ equity. The economic substance of the loan subordination transaction is that repayment of the loan has been postponed in anticipation of agreed conditions being fulfilled – it isn’t the case that obligation to repay the loan is extinguished. If the issuer of a financial instrument (loan recipient) has a contractual obligation to pay an agreed amount of cash or other financial assets to the holder of the instrument (loan provider), the instrument should be recognised as a financial liability. If the issuer of a financial instrument has no obligation to make payments at the agreed amounts relating to the instrument (instead, the holder of the instrument participates in the profit or net assets of the entity), the financial instrument is an equity instrument.[2]

There are still three options for recognizing a loan granted by the owner in equity. First, waiving the loan, through which the loan recipient incurs income and profit for the accounting period, which increases equity. Second, a non-monetary contribution to share capital along with increasing share premium. Third, a non-monetary contribution to the voluntary reserve.

Voluntary reserve

A voluntary reserve is not among the reserves provided for in legislation. In order for a contribution made to voluntary reserve to be recognizable in accounting under owners’ equity, both formal and substantive conditions must be met.

The main condition as to the form is that the formation of the voluntary reserve, contributions and disbursements to and from the reserve, dissolution of the reserve etc. must be stipulated in the company’s articles of association. The substantive condition is that the provisions of the articles of association must also conform in substance to the conditions for recognizing something under owners’ equity. E.g., if there are no restrictions placed on disbursements from the voluntary reserve that would prevent disbursements from the reserve in a situation where the company’s net assets do not meet the regulatory requirements, such a voluntary reserve is not recognized in owners’ equity – not even if it is specified in the articles of association – because in terms of economic substance it is viewed as a liability.

Other reserves

Other reserves are also a category of owners’ equity found in annual report taxonomy and the Estonian Financial Reporting Standard[3]. In what cases can or should such an entry be used in owners’ equity?

Use of other reserves to increase net assets is tricky. The articles of association do not have to stipulate other reserves, but the other reserves must substantively meet the criteria of equity. As a result, other reserves are more suitable for recognizing agreements between owners or for securing future developments at the company. For example, the owners might agree on launching a new line of business but, since the new sideline could prove unsuccessful, decide to make an allowance corresponding to losses in case of potential failure under “other reserves” in equity. This reduces the amount of distributable profit, constitutes a mutual agreement and signals to readers of the annual report that even if the new business area does fail, the company will still retain sufficient liquidity and net assets for continuing to operate.

Net assets requirements must be met not only at the end of the year but at all times. A non-conformity becoming evident only at the end of the year suggests weak financial management, budgeting and reporting. Contributions to and disbursements from equity involve specific taxation aspects, which makes it advisable to talk transactions through with a tax specialist beforehand. It is hard to solve net assets issue after the balance-sheet date, so it’s worth keeping financial accounting in good order at all times!

[1]Accounting Standards Board Guideline (ASBG) No 1 Section 61

[2]Accounting Standards Board Guideline (ASBG) No 3 Section 50

[3]Accounting Standards Board Guideline (ASBG) No 2 Note 1

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