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Classification as a financial liability or equity instrument
Many instruments that have the legal form of equity
are, in substance, liabilities
.
A financial instrument should be classified as a
financial liability or an equity instrument depending
on the substance of the arrangement rather than
the legal form [IAS32.18(R.05)]. Liabilities arise when
the issuer is contractually obligated to deliver
cash or another financial asset to the holder [IAS32.17(R.05)].
An instrument is an equity instrument only if the
issuer has no such obligation, i.e. it has an unconditional
right to avoid settlement in cash or another financial
asset [IAS32.16(R.05)]. The ability to defer payment
is not enough to achieve equity classification,
unless payment can be deferred indefinitely. Generally
an obligation for the entity to deliver its own
shares is not a financial liability because an entity's
own shares are not considered its financial assets.
An exception to this is where an entity is obliged
to deliver a variable number of its own equity instruments
[IAS32.21(R.05)].
The key questions that must be addressed when determining
classification as a financial liability or equity
instrument are therefore:
| a) |
is settlement in
cash or another financial asset neither mandatory
nor at the option of the holder? |
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| b) |
does the issuer have the unconditional
right (i.e. full discretion) to avoid payments
in cash or other financial assets or to defer
payment indefinitely? |
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| c) |
if settlement in cash, another
financial asset or a variable number of shares
is dependent on the outcome of uncertain future
events beyond the issuer's and the holder's
control, is the event that would cause such
settlement extremely rare, highly abnormal and
very unlikely to occur? |
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| d) |
if the instrument is, or may
be, settled in own shares, is the number of
shares that will or may be delivered fixed,
so that the holder is fully exposed to fluctuations
in the issuer's share price? |
These key questions are considered in more detail
below. All relevant terms and facts should be considered
when determining the classification of preference
shares and other complex financial instruments as
financial liabilities or equity instruments.
Obligation to deliver cash or another financial
asset
The obligation to deliver cash or another financial
asset can arise explicitly or indirectly through
the terms and conditions of the financial instrument
[IAS32.20(R.05)] . Classification as a
financial liability follows the substance of a financial
instrument rather than its legal form. For example
preferred shares with a mandatory redemption date,
or that are redeemable at the option of the holder,
give rise to an obligation to deliver cash and therefore
are classified as financial liabilities, even though
they take the legal form of equity [IAS32.18(a)(R.05)]
.
The terms and conditions of a financial instrument
need to be looked at very carefully to establish
the substance of the instrument. For example where
a shareholder has an option to sell (put) its holding
back to the issuer, this will give rise to a financial
liability for the present value of the option's
exercise price - representing the unavoidable obligation
the issuer has to deliver cash to the holder. Even
if dividend payments are at the discretion of the
issuer, the existence of a holder put option will
mean that an instrument, which would otherwise be
classified as equity, will be a financial liability
[IAS32.18(b)(R.05)]. As a result, certain entities, such
as open-ended mutual funds, unit trusts, partnerships
and some co-operatives may have no equity capital,
because all of the instruments they issue are puttable
at the option of the holder. There are illustrative
examples appended to IAS 32R that set out possible
balance sheet and income statement formats for such
entities, to make clear their capital structure
[IAS32.IE.7-8(R.05)].
Unconditional right to avoid payment
Unless an entity has an unconditional right - i.e.
absolute discretion - to avoid delivering cash or
another financial asset, the instrument meets the
definition of a financial liability [IAS32.19(R.05)].
Discretion can exist over either the timing or amount
of any payment. Only if management has discretion
to unilaterally set the amount (including zero)
of any payment and that discretion exists indefinitely
will an instrument be classified as equity. For
example, an ability of the management of the issuer
to unilaterally set the amount of any dividends,
combined with no stated redemption date, might result
in equity classification .
A restriction on the ability of an entity to satisfy
its obligation does not mean the entity has an unconditional
right to avoid payment [IAS32.19(a)(R.05)]. For example,
an instrument that does not require payment if there
are no distributable profits (but does require payments
otherwise) is not an equity instrument. The presence
or absence of distributable profits is not within
management's control, and therefore does not give
management the discretion to avoid payment of dividends
[IAS32.AG25(R.05)] . For similar reasons
the following factors do not affect classification
of a preference share as either a financial liability
or an equity instrument:
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A history of
making distributions |
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An intention to make distributions in the future |
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A possible negative impact
on the price of ordinary shares of the issuer
if distributions are not made |
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The amount of an issuer's
reserves |
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An issuer's expectation
of profit or loss for a period |
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An ability or inability
of the issuer to influence the amounts of its
profit or loss for the period [IAS32.AG26(R.05)]. |
Discretion might relate to only a particular right
attached to a financial instrument - such as the
payment of dividends (interest) or repayment of
principal - rather than to all of its terms. For
example, preference shares might be redeemable only
at the option of the issuer, however if the entity
has no ability to avoid payment of a fixed cumulative
dividend, the instrument is classified as a financial
liability . Consequently each term
and condition of a financial instrument needs to
be reviewed to ascertain whether overall the issuer
has an unconditional right to avoid payment of cash
or another financial asset [IAS32.AG25-26(R.05)].
However there are some instruments where the issuer's
contractual obligation under a particular term,
such as a redemption term, is for less than the
issue proceeds of the entire instrument. Such instruments
are compound instruments, comprising a liability
and an equity component. For example:
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The issuer
of a non-cumulative preference share that is
mandatorily redeemable for cash has discretion
over the payment of dividends before the redemption
date, and the present value of the amount payable
on redemption is less than the issue proceeds. |
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The holder of a non-cumulative redeemable
preference share has the option to redeem
the share for cash, but the issuer has discretion
over the payment of dividends before the redemption
date. In addition, the present value of the
amount payable on redemption is less than
the issue proceeds for the entire instrument. |
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The issuer of a non-cumulative
mandatory convertible preference share (convertible
into a variable number of ordinary shares calculated
to equal a fixed amount) has discretion over
the payment of dividends before the redemption
date, and the present value of the fixed conversion
amount is less than the issue proceeds. |
All of the above instruments are compound instruments,
with the liability component being the present value
of the redemption amount and the equity component
being the remainder. However if in the examples
above any unpaid dividends are added to the redemption
amount (and hence become an obligation for the issuer)
the entire instrument is a liability [IAS32.AG37(R.05)] .
The accounting for compound instruments is discussed
below.
Settlement based on uncertain future events
The terms of some instruments (e.g. some preference
shares) give rise to an obligation to pay cash or
transfer another financial asset only on the occurrence
of one or more uncertain future events. For example,
many instruments will include clauses that trigger
redemption in the event of changes in tax legislation,
changes in regulations, failure to comply with financial
performance measures or covenants, or changes in
capital adequacy. Where the specified events are
beyond the entity's control, the entity does not
have the unconditional right to avoid payment, and
the instrument is classified as a liability. Liability
treatment may be avoided only where an entity can
demonstrate that either:
| a) |
the related contingent
settlement provision is not genuine. An example
may be where settlement is contingent upon the
occurrence of an event that is extremely rare,
highly abnormal and very unlikely to occur [IAS32.AG28(R.05)];
or |
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| b) |
settlement in cash or another financial asset
is only required in the event of liquidation
of the issuer [IAS32.25(R.05)]. |
Settlement in own shares
An entity's own equity instruments do not represent
financial assets of the entity. An entity's obligation
to deliver its own equity instruments is generally
not a financial liability . The exception to this
general principle is that an obligation of an entity
to deliver a variable number of its own equity instruments
(or to exchange a fixed number of its own equity
instruments for a variable amount of cash or other
assets) is a financial liability. In these cases
the entity is using its own shares as currency to
settle an obligation that is either fixed in amount
or that changes with a variable other than the price
of the entity's own shares. As a result the holder
of the contract is not fully exposed to changes
in the entity's share price and the contract does
not evidence a residual interest in the entity's
assets after deducting all of its liabilities [IAS32.21(R.05)].
Perpetual instruments
An entity may issue perpetual bonds or shares,
which provide the holder with the right to receive
interest at fixed dates into the indefinite future,
but with no right to a return of the principal amount.
These perpetual instruments are financial liabilities.
The carrying amount represents the present value
of the stream of mandatory interest payments that
the entity is obliged to pay [IAS32.AG6(R.05)] .
Preference shares issued by subsidiaries
Tax-efficient capital arrangements often use subsidiary
entities to issue shares and then lend the proceeds
to group companies. The interest on the inter-company
loan is generally tax deductible, giving rise to
a tax-efficient structure from the group perspective.
However, investors in preference shares in such
structures usually require protection from equity
risk. This protection will often take the form of
guarantees from the parent or another group entity
of payments on the shares (dividend and/or redemption),
security over certain assets, mandatory payment
of dividends or default conditions. At the group
level all the terms and conditions agreed between
members of the group and the holder are considered
in determining the appropriate classification of
the preference shares. At the subsidiary level no
regard is given to additional terms between other
members of the group and the holder [IAS32.AG29(R.05)].
These additional terms often have the effect of
turning 'equity' at a subsidiary level into liabilities
from the group's perspective.
In the consolidated financial statements any component
of the preference shares issued by subsidiaries
that remains classified as equity at the group level
will be shown within minority interests [IAS32.AG29(R.05)].
Compound financial instruments
Compound financial instruments combine elements
of a financial liability and an equity instrument.
Liabilities that include an equity indexed return
(based on a third party's share price or an equity
index) are not compound instruments, rather they
comprise a host contract (liability) and an embedded
derivative, and are not addressed here . Convertible debt instruments are an
example of a compound instrument [IAS32.AG31(R.05)].
Such instruments pay a coupon, generally at less
than market rates, and provide an option for the
holder of the instrument to convert the instrument
into a fixed number of the entity's own shares.
The accounting treatment of such instruments by
the holder is covered in IAS 39. This chapter deals
only with non-derivative compound instruments from
the perspective of the issuer.
Recognition
The proceeds from issuing convertible debt should
be split into the two relevant components; a loan
at a market rate of interest that is classified
as a financial liability, and a residual amount
(the value of the equity option) that is classified
as an equity instrument. The separation into debt
and equity components is made at the original issuance
of the compound instrument [IAS32.29(R.05)] and is not
changed over time as the likelihood of conversion
changes. Rather the classification will remain until
conversion, maturity of the instrument or some other
transaction (such as induced conversion) [IAS32.30(R.05)].
Initial measurement
The fair value of a compound instrument at issuance
is assigned to its respective debt and equity components
so that no gain or loss arises from recognising
each component separately [IAS32.31(R.05)]. There is
a prescribed method for assigning the fair value
to each component. The fair value of the liability
component is established first, using a market rate
of interest for a similar borrowing that does not
include an equity component. For this purpose a
similar borrowing is one of comparable credit status
and providing substantially the same cash flows
on the same terms. The equity component is determined
by deducting the fair value of the liability component
from the fair value of the compound instrument as
a whole [IAS32.IE.9(R.05)] . This method
reflects the definition of equity instruments as
instruments that evidence a residual interest in
the assets of an entity after deducting all of its
liabilities [IAS32.31(R.05)].
Transaction costs relating to the issue of a compound
instrument are allocated to the liability and equity
components in proportion to the allocation of the
fair value of the instrument upon initial recognition
[IAS32.38(R.05)].
The liability component is also adjusted to include
the value of any other derivatives embedded in the
convertible instrument as a whole (other than the
equity conversion option) [IAS32.31(R.05)]. For example
the liability component of a callable convertible
bond is adjusted to include the value of the embedded
call feature. The equity component is again calculated
as the residual amount, after deducting the liability
component, adjusted to include the embedded call feature,
from the fair value of the instrument as a whole [IAS32.IE.10(R.05)].
Measurement subsequent to initial recognition
The liability element of the compound instrument,
providing it is not classified as at fair value
through profit or loss, is accounted for at amortised
cost
[IAS39.47(R.05)]. This means the initial carrying amount
is accreted, on an effective yield basis, to the
face amount payable at maturity .
The equity element of the compound instrument is
not re-measured or adjusted until conversion, or
the time when the conversion period expires. If
the instrument is converted at maturity:
| a) |
the equity component
remains as equity although it may be transferred
to the appropriate line item within equity,
e.g. share capital and/or paid in capital account,
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| b) |
the liability's carrying amount is derecognised
as a liability component and recognised as
an equity component. |
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| c) |
no gain or loss is recognised
[IAS32.AG32(R.05)]. |
An entity may extinguish a convertible instrument
before maturity, through early redemption or repurchase.
The amount paid on early termination is allocated
to the debt and equity components using the same
method of allocation that is used on initial recognition.
This means the fair value of the instrument as a
whole less the fair value of the liability component
are both recalculated at the date of repurchase
or redemption, with the fair value of the equity
component representing the balancing (or residual)
amount [IAS32.AG33(R.05)]. Any gain or loss on the liability
component is recognised in profit or loss. The amount
of the consideration paid in relation to the equity
component is recognised in equity [IAS32.AG34(R.05)]
[IAS32.IE.11(R.05)].
If however an entity amends the terms of a convertible
instrument, perhaps to induce early conversion,
the difference between the fair value of the consideration
to be paid under the amended terms and that which
would have been paid under the original terms is
all charged to profit or loss at the date when the
terms are amended [IAS32.AG35(R.05)] [IAS32.IE.12(R.05)].
If the conversion option is not exercised and lapses,
the equity element is reclassified to another caption
within shareholders' equity, usually either retained
earnings or a capital reserve. The equity element
is never recognised in the income statement.
Presentation and disclosure
Preference shares, and any components of preference
shares which are compound instruments, should be
presented according to their classification. If
they are classified as liabilities, they should
be presented within current or non-current liabilities
as appropriate; if classified as equity, they are
presented as a separate line item within the equity
section of the balance sheet. All relevant disclosures
for debt and equity instruments are required. When
the balance sheet classification differs from an
instrument's legal form, an entity should describe
the nature of the instrument in the notes to the
financial statements [IAS32.64(R.05)].
Classification of instruments, and components of
compound instruments, will also determine how payments
related to them are reported. For preference shares
classified as liabilities, the 'dividends' represent
cash payments of interest. Unless the instrument
is classified as at fair value through profit or
loss, interest expense is accrued using the effective
interest method as for any other liability at amortised
cost, and is reported within interest expense in
the income statement. Conversely, distributions
on instruments that are classified as equity should
be debited directly to equity, net of any related
tax benefit [IAS32.35(R.05)] [IAS32.AG37(R.05)].
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