Change in preference share status to hit firms' profits

The new standards treat redeemable preference shares - which are currently considered as part of a company's equity - as debt

A number of companies which have a significant amount of preference shares other than compulsory convertible ones, could see their profits going down and debt-equity ratio changing significantly once new accounting standards come into effect.

The new standards treat redeemable preference shares (RPS) - which are currently considered as part of a company's equity - as debt.

Moreover, debt component of Optionally Converted Preference Shares (OCPS) will also be recognised in the balance sheet.

Companies which have a large section of its equity as RPS and OCPS will witness significant alteration in their profit and debt to equity ratio due to this change. As these are treated as equity, they don't figure in profit & loss account of companies.

For example, Zee Entertainment showed RPS balance of Rs 2,017 crore and a debt-equity ratio of zero till March 31, 2014. Whereas, according to the new accounting standards, with Rs 2,017 crore shifting from equity to debt, the debt-equity turns out to be 0.74.

The debt to equity ratio - a measure of company's financial leverage - is calculated by dividing its total liabilities (debt) by stockholders' equity.

Preference shares are different than common stock, as the owner of the former do not have any voting rights. Moreover, preference share owner also gets a fixed dividend from the company before the common stock dividends are paid.

According to the Indian Accounting Standards 32 (Ind-AS 32), RPS will be considered as debt of the company whereas OCPS will be considered as a compound instrument with a significant debt component.

"The debt component in the OCPS can vary from contract to contract and requires detailed analysis," said Ashish Gupta, partner, Walker Chandiok & Co LLP.

Compulsory convertible preference shares will remain equity of the company. There is no standard ideal debt to equity ratio for all companies. It could vary from sector to sector, depending on risks and profitability among other things. For instance, a ratio of 2 may be taken as healthy for a car maker, while a software company may have it as low as 0.5. Whatever is the ideal debt-equity ratio, it would be impacted by the new standards and, hence, also affect the company's borrowing efforts.