Query No. 31

Subject:

Treatment of conversion rights for calculation of diluted EPS. ¹

A. Facts of the Case

1. A flagship company of a major group is manufacturing textiles. The group is one of the largest textile houses in the country with a turnover of about Rs. 2200 crore and employs around 18,000 people. The group has sizeable presence in spinning, weaving, sewing threads, textile processing, acrylic fibre manufacturing and alloy steels.

2. The querist has stated that the company funds its various expansions and modernisations through long-term debt. The lender banks usually have certain covenants (financial and non-financial), which the company is required to adhere to for the tenure of the loan. One of the clauses in the loan agreement of certain banks (the querist has separately provided a copy of a loan agreement with the lender for the perusal of the Committee) is conversion right in case of default (emphasis supplied by the querist). The essence of the said clause is that, in case the company commits default in interest payments and/or repayments due to the bank under the loan facility, it would give the bank the right to convert the whole or part of the outstanding amount of the facility into fully paid-up equity shares of the company at par.

3. The querist has further stated that the Institute of Chartered Accountants of India (ICAI) issued Accounting Standard (AS) 20, ‘Earnings Per Share’, which is applicable to the accounting periods commencing on or after April 1, 2001 and is mandatory in nature to all the companies that are required to give information under Part IV of Schedule VI to the Companies Act, 1956. According to the querist, AS 20 requires disclosure of the basic and diluted earnings per share (EPS) on the face of the profit and loss account in the annual report of the company. As per the querist, for the calculation of diluted EPS, net profit or loss for the period attributable to equity shareholders and the weighted average number of equity shares outstanding during the period should be adjusted for the effects of all dilutive potential equity shares (emphasis supplied by the querist). A potential equity share has been defined under AS 20 as “a financial instrument or other contract that entitles, or may entitle, its holder to equity shares”. Further, the examples of potential equity shares, inter alia, include “shares which would be issued upon the satisfaction of certain conditions resulting from contractual arrangements (contingently issuable shares), such as the acquisition of a business or other assets, or shares issuable under a loan contract upon default of payment of principal or interest, if the contract so provides.”

4. The querist has also stated that although this dilution is conditional, still, in order to comply with the requirements of AS 20, at the time of calculation of the diluted EPS of the company, the company assumes that the entire loan outstanding with the bank for the relevant period is converted into equity shares at par [in accordance with the definition of potential equity shares, “a financial instrument or other contract that entitles, or may entitle, its holder to equity shares”(emphasis supplied by the querist)].

5. According to the querist, disclosure of diluted EPS dilutes the equity and creates a confusion in the minds of investors that either the company has defaulted or has given a commitment to a lender to convert the loan into equity at par. The basic and diluted EPS of the company for the last 2 years is as follows:

Thus, in the view of the querist, EPS gets deteriorated on the dilution basis and does not represent the clear and fair portrayal of the company’s performance, even though the contingent event has not occurred and is not likely to occur, going by the past track record of the company which has never defaulted on a single payment to a financial institution. But, in order to adhere to the requirements of AS 20 (i.e., disclosure of diluted EPS), the company has to calculate and disclose the diluted EPS also. It creates a negative impression about the company’s performance to the existing investors or potential investors. It is not possible for the company to explain this phenomenon to each and every shareholder.

6. Considering the above, as per the querist, disclosing a diluted EPS under the said conversion clause of the lender gives a distorted picture about the company and the company feels that non- incorporation of this clause for the calculation of diluted EPS may not be misleading. Furthermore, this conversion clause is a part of the standard documentation of a few of the major term lenders in the market and every industry would be availing loans from them. However, the querist has noted from the results of these companies that none of such companies appear to reflect the impact of this particular clause in their diluted EPS. The querist, therefore, believes that the interpretation made by the company with regard to this clause may not be correct.

B. Query

7. On the basis of the above, the querist has requested the Expert Advisory Committee to give its interpretation of this clause vis a vis the covenant of conversion clause in the loan documentation and give its opinion on inclusion of this covenant for calculation of diluted EPS. Also, since the company has never defaulted, the querist has argued that this condition of conversion becomes superfluous for the company and has requested that the stipulation regarding the disclosure of the diluted EPS be interpreted in a manner that only companies which have defaulted in payment of debt are required to disclose the same.

C. Points considered by the Committee

8. The Committee while answering the query has considered only the issues raised in paragraph 7 above and has not touched upon any other issue arising from the Facts of the Case, such as, whether the potential equity shares under conversion clause are dilutive or anti-dilutive, etc.

9. The Committee notes from clause (b) of Section 8.3, ‘Other Consequences of Default’ of the agreement of the company with the lender that it provides for the conversion right to the lender and specifically states that if the borrower commits a default in payment or repayment of three consecutive instalments of principal amounts of the loan(s) or interest thereon or any combination thereof, then, the lenders shall have the right to convert at their option the whole of the outstanding amount of the loans into fully paid-up equity shares of the borrower, at par, in the manner specified in the notice of conversion to be given by the lenders to the borrower. The Committee notes the examples of potential equity shares, as given by paragraph 7 of AS 20, which are as follows:

            “7. Examples of potential equity shares are:

(a) …

(d) shares which would be issued upon the satisfaction of certain conditions resulting from contractual arrangements (contingently issuable shares), such as the acquisition of a business or other assets, or shares issuable under a loan contract upon default of payment of principal or interest, if the contract so provides.”

10. The Committee further notes paragraphs 26, 27(b) and 34 of AS 20, which provide as follows:

 “26. For the purpose of calculating diluted earnings per share, the net profit or loss for the period attributable to equity shareholders and the weighted average number of shares outstanding during the period should be adjusted for the effects of all dilutive potential equity shares.

 27. In calculating diluted earnings per share, effect is given to all dilutive potential equity shares that were outstanding during the period, that is:

(a) …

(b) the weighted average number of equity shares outstanding during the period is increased by the weighted average number of additional equity shares which would have been outstanding assuming the conversion of all dilutive potential equity shares.”

 

 “34. Equity shares which are issuable upon the satisfaction of certain conditions resulting from contractual arrangements (contingently issuable shares) are considered outstanding and included in the computation of both the basic earnings per share and diluted earnings per share from the date when the conditions under a contract are met. If the conditions have not been met, for computing the diluted earnings per share, contingently issuable shares are included as of the beginning of the period (or as of the date of the contingent share agreement, if later). The number of contingently issuable shares included in this case in computing the diluted earnings per share is based on the number of shares that would be issuable if the end of the reporting period was the end of the contingency period. Restatement is not permitted if the conditions are not met when the contingency period actually expires subsequent to the end of the reporting period. The provisions of this paragraph apply equally to potential equity shares that are issuable upon the satisfaction of certain conditions (contingently issuable potential equity shares).”

11. The Committee notes from the definition of ‘potential equity share’ (as reproduced in paragraph 3 above) and the above reproduced paragraphs of AS 20 that AS 20 requires adjustment of the net profit attributable to equity shareholders and the weighted average number of shares, for the effects of all dilutive potential equity shares for the purpose of calculating diluted EPS. The Standard does not exempt a dilutive potential equity share from inclusion in the computation of diluted EPS on any ground, e.g., as argued by the querist in paragraph 4 above that the dilution is conditional. In the view of the Committee, the objective of disclosing the diluted EPS is to give an idea to the readers/users of the financial statements about the potential equity shares that may dilute the earnings attributable to the equity shareholders, even though the dilution is conditional and contingent. Moreover, the contingently issuable shares mean those potential equity shares, where there is a possibility of issuance of these shares on fulfillment of certain conditions, even though such circumstances do not exist at present and are not even experienced in the past. Had there been no contingency and the conditions had been met, then these would have been included in the calculation of basic EPS as well. Accordingly, in the view of the Committee, the contingently issuable shares on default of payment of loan or interest, under the conversion clause of the loan agreement, should be included for calculation of diluted EPS. The fact that some other companies are not including the aforesaid conversion rights for the purpose of computing ‘potential equity shares’ is no argument for not considering such shares as ‘potential equity shares’.

D. Opinion

12. On the basis of the above, the Committee is of the opinion that the disclosure of diluted EPS can not be interpreted in the manner to include only those potential equity shares under the conversion clause where the companies have either defaulted in the past or will default in future, in the computation of diluted EPS. Accordingly, the company should include all dilutive potential equity shares, including those shares, which are issuable upon default of payment of loan or interest under a loan agreement, in the calculation of diluted EPS.

¹Opinion finalised by the Committee on 17.1.2007