The treatment of some preferred shares in financial statements is changing for fiscal years ending in 2005. The change will address the Canadian Accounting Standards Board’s concerns about whether securities issued by a company are equity or liabilities.

Securities affected by the new standard are those for which holders receive, on maturity, either a set amount or an equivalent value in common shares. Since the “obligation” is fixed, they will be treated as liabilities in fiscal 2005.

Securities that at maturity will be settled with either cash or a set number of common shares — the value of which will depend on the market price at the time of settlement — will continue to be treated as equity.
Because the dividends from preferred shares that are now considered liabilities will be treated as an expense and included in the income statement, the change affects the interest expense and net income figures.
It also changes the liabilities and total equity numbers, with impact on key ratios such as debt/equity.

Return on common shareholders’ equity will not, however, be affected because preferred dividends have always been subtracted to arrive at net income applicable to common shares, and preferred shares are not included in common shareholders’ equity.

Companies are required to restate prior financial statements.

The CASB came out with the new guidelines in January 2004 to provide a long lead time in case companies wanted to refinance, says Peter Martin, director of accounting standards at the Canadian Institute of Chartered Accountants.

In a somewhat related move, the CASB has also proposed a new standard for the calculation of fully diluted shares to be implemented in fiscal years ending in 2006.
At that time, all securities that may settle in shares will have to be included in the calculation. The CICA is working with both the U.S. Financial Accounting Standards Board and the International Accounting Standards Board to come up with a harmonized standard.

The banks — with their Oct. 31 fiscal yearends — are the first out of the gate. In the first quarter ended Jan. 31, 2005, the five major banks were all affected. In the case of TD Bank Financial Group, all preferred shares are now considered liabilities; for the others, some issues remain equity.

The impact on first-quarter net income ranged from less than 1% for Royal Bank of Canada and Bank of Nova Scotia to 4.9% for CIBC. The impact depends both on the amount of preferred shares that are no longer considered equity and the dividends associated with the shares. CIBC had to put $1 billion in preferred shares into liabilities.
The dividends associated with that increased interest expenses by $108 million. TD had $1.3 billion in preferred shares that are now liabilities, and the associated dividends increased its interest expenses by $78 million. As TD also had a slightly higher net income for 2004, the impact was only 3.4%. IE