The accounting treatment of price return swaps (PRS) has become a hot potato in the capital market as large corporations have successively raised funds ranging from hundreds of billions of won to trillions of won through PRS.
Corporations note that PRS can be treated as equity rather than a liability, but PRS differs in underlying assets, agreements, and rights and obligations with each transaction, making it difficult to present a one-size-fits-all solution. Some say a clear guide is needed, while others warn that hasty uniformity could instead cause side effects.
Samil PwC recently launched a "structured accounting center" to proactively address the issue. Structured finance means designing funding by combining derivatives and special provisions with traditional finance. ChosunBiz met partner Han Jae-sang, who leads the center, on the 30th of last month to discuss PRS accounting treatment and considerations in assessing equity characteristics.
─ What is structured finance, and specifically how does it differ from traditional finance?
"Structured finance refers to a method of raising funds in which the capital demander and supplier enter into a new agreement. Unlike traditional finance, which is limited to issuing common stock, issuing bonds, and borrowing, structured finance mixes in other structures such as derivative contracts. Price return swaps (PRS) are also a form of such derivative contracts.
Tag-along and drag-along clauses in M&A are also included in the realm of structured finance in a broad sense. Financial firms and corporations combine these structures according to their needs, so there is no identical contract."
─ There is debate in the market over whether PRS is equity or a liability. Why is it difficult to create clear accounting guidelines?
"Because the acceptability of certain conditions varies depending on the situation of each financial firm and corporation. Judgments will inevitably differ for each transaction. It is difficult to produce a neat guide because the contents must be assessed comprehensively.
If a guide comes out, it is expected to be provided in the form of examples under certain assumptions, such as 'in this situation, it is this.' It will be difficult to present uniform standards. International Financial Reporting Standards (IFRS) also set principles and use examples."
─ Are there any rules or interpretations that are generally accepted in the market now?
"I think there are still some established rules in the market. Looking at Q&As from the Korea Accounting Standards Board and the Financial Supervisory Service, fairly consistent views have emerged over time. For PRS related to financial instruments, opinions have found a strong liability nature."
─ What does 'financial instrument' mean?
"Let me take stock as an example. The general public sees all stock as a financial instrument, but what accountants call a financial instrument refers to stock of less than 20% with 'no significant influence.' Investments in associates holding more than 20% equity are subject to separate standards and thus are not financial instruments. In other words, the accounting treatment judgment varies depending on which standard applies.
Under accounting standards, if it exceeds 20%, it is deemed to have significant influence absent other rebuttals, and if it exceeds 50%, it is deemed to have control.
(For example, if Company A holds 15% equity in Company B and does PRS using it as collateral, B's equity is classified as a financial instrument in accounting terms, so there is a possibility that PRS should be viewed as a liability. In contrast, if A holds 30% equity in B, A can be seen as having significant influence over B, so PRS is not a financial instrument and has stronger equity characteristics.)"
─ Some corporations were recognized as equity even though they did PRS using equity far below 20% as collateral.
"That is why the structured details must be checked one by one. Saying a PRS on a financial instrument is 100% a liability is not the case.
A liability basically means a contractual obligation under accounting standards. Financial instruments assess this contractual obligation based on 'risks and rewards.'"
─ What conditions are needed to classify PRS as equity even when the underlying is less than 20% equity?
"PRS is a derivative contract, and it is structured so that the issuer receives the volatility of the underlying asset. Only price fluctuations are hedged.
If it is structured so that the investor takes intermediate income such as dividends to raise the investment return, hedging is impossible. The investor can be seen as being substantially exposed to risks and rewards. In such cases, there is room to judge that the equity nature is relatively stronger."
─ PRS can be done via new share issuance or existing share transactions. What differences are there in accounting treatment?
"If you structure PRS while issuing new shares, the key for the issuer is whether the new shares are equity or a liability.
In contrast, if you transact existing shares and do PRS—namely, if Company A holds already issued stock and sells it under a PRS contract to a third party—you must determine, regardless of the issuer, whether 'A's sale transaction is a true sale or a borrowing transaction.'"
─ What specific requirements allow PRS to be viewed as equity when issuing new shares?
"In PRS, new shares are mostly issued in mezzanine forms such as redeemable convertible preferred stock (RCPS) or convertible preferred stock (CPS), not common stock.
In the case of CPS, you must see whether the conversion right meets equity requirements. If the conversion price and conversion quantity are fixed, the equity nature becomes stronger. If they are not fixed, the liability nature becomes stronger.
For RCPS, you additionally need to assess whether 'the redemption right contains an equity element.'"
─ Could you explain more about RCPS? What does it mean that the redemption right has an equity element?
"If the redemption right lies with the issuer (corporation), the issuer has the authority to defer redemption, so the equity nature becomes stronger. In contrast, if the redemption right lies with the investor, the issuer may receive a redemption demand, so the liability nature becomes stronger."
─ Lately, many listed companies place the redemption right with the issuer to achieve equity accounting for PRS.
"Yes. In contrast, startups preparing to list mostly grant the redemption right to investors when raising funds. Because of this, when startups switch to IFRS, the redemption right is classified as a liability and their financial structure can deteriorate. After listing, when equity capital flows in, it is common to resolve this issue through redemption or conversion."
─ Do you think it is better to proceed autonomously in the spirit of IFRS rather than create consistent rules?
"Yes. The accounting standards themselves are consistent, and the interpretations by accounting firms and the Financial Supervisory Service are not significantly different. If a guide comes out and regulates 'this is allowed and that is not,' a herd behavior of applying only the 'allowed' structures will intensify.
As this structure further evolves, the problem may arise that individual judgments are again needed."
─ PRS emerged as an alternative to total return swaps (TRS). Is TRS now falling out of use?
"TRS is being phased out because it is accounted for as a liability and also raises special purpose company (SPC) consolidation issues, yielding little improvement in financial structure. To improve the financial structure, it needs to be accounted for as equity or treated as a sale transaction, and TRS lacks efficacy."
─ Besides PRS, are there any structured finance tools drawing attention these days?
"PRS is only one tool of structured finance. For example, you can split into tranches (senior and junior), create vehicles such as funds, and then structure finance by differentiating decision-making frameworks. Ultimately, it is a contest of ideas about what underlying asset you have and how you will structure it.
Also, what 'underlying asset' to use is important. The underlying asset can be not only financial instruments, associates, and subsidiaries' equity but also real estate."
─ Are there examples of structured finance based on real estate as the underlying asset?
"If you issue the stock of a company that owns real estate and design a PRS structure, the stock price movement can ultimately be linked to changes in the value of the real estate.
Recently, corporate restructuring real estate investment trusts (CR REITs) promoted by the government to resolve unsold units have been used as vehicles for structured finance. There are a few actual cases where construction companies transfer unsold units to CR REITs and securitize them through structured finance."
─ What are the strengths of Samil PwC's structured accounting center?
"If the accounting issues of a structured transaction are not resolved, it is difficult to proceed with the deal itself. Many people approach it as a 'deal' like M&A, but the starting point must be accounting.
To my knowledge, competitors do not yet have such a center. Our center is composed of senior partners and directors who have long handled structured finance-related work.
Our differentiation comes from the vast databases, experience, and know-how we have built up. In a structured transaction, accounting, deals, and tax must be in perfect harmony, and Samil PwC prides itself on having the most reliable top-tier capabilities in all these areas."