Empowering the economy

Black economic empowerment has revolutionised the South African economy in recent years, but how should BEE deals be accounted for, especially where IFRS 2 is concerned? Kirsty Laschinger writes

South Africa’s miraculous political transformation culminated in the first democratic election in 1994. But even then, some voices - such as Anglo American director and strategic planner, Clem Sunter - were calling for a matching economic transformation to ensure that the country’s political gains could be built upon.

The statistics are sobering: the official unemployment rate stands at 26.5%, whilst the expanded version - which includes disillusioned jobseekers - is closer to 40%. Nearly half the population lives under the poverty line. To government, it was clear that the majority of black people, who had been economically marginalised under the apartheid regime, had to be brought into the economic mainstream in order to ensure the success of South Africa’s new democracy.

Initially, the new Government used moral persuasion to encourage black economic empowerment (BEE). In its simplest form, BEE initially described the sale of equity to black entrepreneurs, usually at a discount to market price.

The 1990s saw pioneer BEE deals, such as Anglo American’s sales of JCI and Johnnic, many of which ended badly. Black entrepreneurs, generally, had limited access to capital and little security for the banks - a situation that prevails today. The early days saw a number of BEE deals unwind after share prices failed to reach the levels needed for the BEE group to settle its debt. This situation still exists and is generally seen as a major hindrance to economic transformation, especially as companies are precluded by the Companies Act from financing purchases of their own shares.

In 2002, the Government forced the mining sector - through a carrot and stick approach involving the future retention of mineral rights - to negotiate a sector empowerment charter, which was gazetted as law. It mandates a minimum level of 26% historically disadvantaged shareholding in all South African mining operations within 10 years and a number of other interventions in staff and enterprise development. Other sectors - including the financial services, construction and ICT industries - have either negotiated charters or are in the process of doing so.

Deals

In 2004, the Broad Based Black Economic Empowerment Act was passed in a bid to force the pace of transformation, which the Government has criticised as being too slow. At this point it was now clear that South Africa Inc could no longer view BEE as an optional extra; it truly had become a case of “adapt or die”. A number of the country’s large companies have concluded empowerment deals, including the big five banks, Old Mutual, Sanlam, Liberty, Harmony, Goldfields, Bidvest, Imperial and Aveng.

Table 1

But the development of BEE has been dogged by a number of issues including, naturally, accounting complexities. Accounting professionals have grappled with how to recognise equity deals that were often concluded at values unrelated to market prices. This, against the backdrop of a world that was moving towards harmonisation of accounting standards and, particularly, scrutinising share-based transactions in the wake of the global corporate excesses in the late 1990s.

In September last year, the South African Institute of Chartered Accountants (SAICA) issued a discussion paper aimed at debating whether or not BEE deals should fall under the ambit of IFRS 2, Share-based Payments.

Linda de Beer, SAICA’s senior executive, Standards, explains that it was important as many BEE deals are structured so that an element is paid through shares and share options. As a result, SAICA argued that it should fall under IFRS 2, but this wasn’t clear as BEE is not an international phenomenon. In de Beer’s view, it would be unhealthy if the issue were not dealt with consistently.

As there has been no standardised accounting treatment, the BEE deals that have been concluded so far have used varying accounting treatments. In general, the discount at which shares have been issued has been written off against shareholders’ funds and options have not been expensed. As a result, company income statements have not reflected the cost of their empowerment programmes.

Graeme Berry, Deloitte’s director - accounting and auditing research and the chairman of SAICA’s BEE sub-committee, says that feedback from SAICA’s original discussion paper was given to the IASB and incorporated into the IFRS 2 exposure draft issued for comment earlier this year. SAICA released an exposure draft (ED 199) of a South African standard that will include BEE deals under the ambit of IFRS 2 in tandem with the IFRS 2 draft.

According to James Luke, a technical audit partner at Ernst & Young, there are two key contentious issues within the ED 199 draft. First, the question was whether BEE credentials are a recognisable asset or have to be expensed. The exposure draft consensus is that BEE credentials are an asset, but one for which the attached future benefits are not certain and so the cost should be treated as an expense. The second issue related to how the restrictions on the tradability of the shares issued to BEE partners should be interpreted. Says Luke: “The consensus in the exposure draft is that a vesting condition is attached to a service that is required by the BEE parties. Lock-in conditions do not in themselves constitute vesting conditions, but rather decrease the fair value of the shares.”

De Beer hopes that both the international and accompanying South African interpretation of IFRS 2 will be finalised before the end of this year, but that depends on the IASB and whether other delaying issues are raised.

In essence, accounting for BEE under IFRS 2 will fully reflect the cost of empowerment to investors in financial statements - especially the income statement. According to Luke, the exposure draft requires companies to recognise the difference between the fair value of the equity instruments issued and the consideration paid by the BEE investor as an intangible that will have to be expensed. (If there is no difference between the fair value of the shares and the consideration then there should be no expense.)

Luke explains that the BEE accounting standard, like IFRS 2, will be retrospectively applied to all equity instruments that were granted after 7 November 2002 and that vest from 1 January 2005. The accounting implications will be that during the vesting period, if any, companies will need to recognise an expense for acquiring the BEE credentials.

According to Berry, whether BEE deals that have already been concluded will fall under IFRS 2 or not will depend on the date the deal was done and whether it is subject to the IFRS 2 transition provisions. He believes that most company financials will be restated, with the BEE deal effect reflected in prior period adjustments.

But Berry raises another issue: the key question now is how to handle BEE accounting. Overall, the South African industry is still evaluating the question, including under what scenarios BEE agreements should be capitalised or expensed immediately. He believes that the standard will deal with most of the issues raised. But, in practice, South African accountants and auditors have found that each deal is unique with its own complexities, particularly in their legal structures.

Overall, the implementation of a BEE accounting standard is consuming a significant amount of time from all the big auditing firms. And the changeover has not been made easier by the fact that IFRS 2 is a new global standard.

Kirsty Laschinger is a freelance writer for a number of South African publications and is a chartered financial analyst.