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22.1.1 Extract from FRS 102 – Section 22.1-22.2.
22.2 Classification of an instrument as liability or equity.
22.2.1 Extract from FRS 102 – Section 22.3.
22.2.2.1 Definition of financial liability.
22.2.2.2 Definition of equity.
22.2.3 Accounting treatment of instruments classified as debt
22.2.5 Treatment of dividend on instruments classified as equity.
22.2.6 Examples illustrating whether an instrument meets the definition of debt or equity.
22.2.6.1 Redeemable preference shares at option of the holder with mandatory coupon.
22.2.6.2 Non-redeemable preference shares with mandatory coupon at market rate.
22.2.6.4 Shares/loan notes redeemable at the option of the holder
22.2.6.5 Non-redeemable preference shares with discretionary dividend.
22.2.6.6 Redeemable preference shares at option of issuer with discretionary dividend.
22.2.6.7 Redeemable preference shares at option of issuer with mandatory.
22.2.6.9.1 Treatment of difference between present value ad actual amount subscribed for
22.2.6.13 Fixed for fixed arrangement
22.2.6.14 Equity issued in return for a forward contract to issue foreign currency.
22.3.2.2 Contingency element is not genuine.
22.3.2.3 contingency occurring on liquidation.
22.3.2.5 Examples of uncertain future/changed events outside the control of the issuer
22.3.2.6 Example of instruments to be classified as a debt or equity.
22.4 Original issue of shares or other equity instruments.
22.4.1 Extract from FRS 102 – Section 22.7-22.10.
22.4.2 OmniPro comment – Accounting treatment
22.4.2.4 Examples of share issues – accounting treatment
22.5 Exercise of options, rights and warrants.
22.5.1 Extract from FRS 102 – Section 22.11.
22.6 Capitalisation or bonus issues of shares and share splits.
22.6.1 Extract from FRS 102 – Section 22.12.
22.7.1 Extract from FRS 102 – Section 22.13-22.15.
22.7.2.1 Determining the split of debt and equity.
22.7.2.2 Treatment of transaction cost
22.7.2.3 Subsequent revisions.
22.7.2.4 Accounting for the liability.
22.7.2.5 Examples of compound financial instruments.
22.7.2.6 Compound Financial instrument example.
22.7.2.7 Accounting for the convertible option once exercised or option to exercise is not taken.
22.7.2.8 Allocation of transaction costs.
22.8.1 Extract from FRS 102 – Section 22.17-22.18.
22.8.2.1 Distribution of shares classified in equity.
22.8.2.2 Distributions on shares classified as debt (i.e. On shares classified on debt)
22.8.2.3 Disclosure of fair value of non-cash distributions.
22.9 Non-controlling interest and transactions in shares of a consolidated subsidiary.
22.9.1 Extract from FRS 102 – Section 22.19.
22.9.2.2 Accounting for acquiring a further controlling interest
22.9.2.3 Accounting for disposals of controlling interests but controlling interest retained.
22.10.1.1 Statement of changes in equity.
22.10.1.2 Accounting Policies.
22.10.1.3 Note to the financial statements.
22.10.1.4 Notes in relation to dividends
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22.3 Classification of an instrument as liability or equity where contingency exists
22.3.1 Extract from FRS 102 – Section 22.3A-22.5
22.3A A financial instrument, where the issuer does not have the unconditional right to avoid settling in cash or by delivery of another financial asset (or otherwise to settle it in such a way that it would be a financial liability) and where settlement is dependent on the occurrence or non-occurrence of uncertain future events beyond the control of the issuer and the holder, is a financial liability of the issuer unless:
(a) the part of the contingent settlement provision that could require settlement in cash or another financial asset (or otherwise in such a way that it would be a financial liability) is not genuine;
(b) the issuer can be required to settle the obligation in cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability) only in the event of liquidation of the issuer; or
(c) the instrument has all the features and meets the conditions in paragraph 22.4.
22.4 Some financial instruments that meet the definition of a liability are classified as equity because they represent the residual interest in the net assets of the entity:
(a) A puttable instrument is a financial instrument that gives the holder the right to sell that instrument back to the issuer for cash or another financial asset or is automatically redeemed or repurchased by the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder. A puttable instrument that has all of the following features is classified as an equity instrument:
(i) It entitles the holder to a pro rata share of the entity’s net assets in the event of the entity’s liquidation. The entity’s net assets are those assets that remain after deducting all other claims on its assets.
(ii) The instrument is in the class of instruments that is subordinate to all other classes of instruments.
(iii) All financial instruments in the class of instruments that is subordinate to all other classes of instruments have identical features.
(iv) Apart from the contractual obligation for the issuer to repurchase or redeem the instrument for cash or another financial asset, the instrument does not include any contractual obligation to deliver cash or another financial asset to another entity, or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity, and it is not a contract that will or may be settled in the entity’s own equity instruments as set out in paragraph 22.3(b) of the definition of a financial liability.
(v) The total expected cash flows attributable to the instrument over the life of the instrument are based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognized and unrecognised net assets of the entity over the life of the instrument (excluding any effects of the instrument).
(b) Instruments, or components of instruments, that are subordinate to all other classes of instruments are classified as equity if they impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation.
22.5 The following are examples of instruments that are either classified as liabilities or equity:
(a) An instrument of the type described in paragraph 22.4(b) is classified as a liability if the distribution of net assets on liquidation is subject to a maximum amount (a ceiling). For example, if on liquidation the holders of the instrument receive a pro rata share of the net assets, but this amount is limited to a ceiling and the excess net assets are distributed to a charity organisation or the government, the instrument is not classified as equity.
(b) A puttable instrument is classified as equity if, when the put option is exercised, the holder receives a pro rata share of the net assets of the entity determined by:
(i) dividing the entity’s net assets on liquidation into units of equal amounts; AND
(ii) multiplying that amount by the number of the units held by the financial instrument holder.
However, if the holder is entitled to an amount measured on some other basis the instrument is classified as a liability.
(c) An instrument is classified as a liability if it obliges the entity to make payments to the holder before liquidation, such as a mandatory dividend.
(d) A puttable instrument that is classified as equity in a subsidiary’s financial statements is classified as a liability in the consolidated financial statements.
(e) A preference share that provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date or gives the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount, is a financial liability see example at 22.2.6.
22.3.2 OmniPro comment
22.3.2.1 Overview
Section 22.3A of FRS 102 makes it clear where the issuer has no unconditional right to avoid settlement and where settlement is dependant on the occurrence or non-occurrence of future events which are not within the control of the issuer see 22.3.2.5, then the instrument is a financial liability unless:
- The contingent settlement is not genuine (see 22.3.2.2); or
- The issuer is only required to settle on liquidation (see 22.3.2.3); or
- The instrument has all of the features stated in section 22.4 of FRS 102 (see 22.3.2.4).
See 22.3.2.5 for further examples.
When assessing whether a future contingency which may result in a need to transfer cash or other financial assets exist, one will need to look at all of the facts and circumstances. In essence an assessment will have to be made as to whether the user can take steps to avoid transferring cash or a financial liability.
Example 13 B: Future contingency amount
Equity A issued CU 10000 preference shares of CU 1 each. The right of the shares state that a coupon of 8% is payable annually. However, if the proceeds of this share issue are issued in compliance with what the funds were provided for (e.g. an agreed business plan) and a certification is obtained from a third party confirming that the coupon will be reset to 3% and this will be back dated from inception.
Looking at the facts here the question arises; can entity A control whether the funds are applied for the specific purpose. In this case as the entity has the power to ensure the money is applied for the stated purpose and therefore that certification of same will be obtained, then the entity has control as to whether an 8% or a 3% rate will be applied. As it is in the best interest of the entity to apply the funds to the stated purpose and it is reasonable this is to be done then the entity should only accrue the 3% from inception. In this case these preference shares would be classified as a financial liability and a dividend would be accrued at 3% as opposed to 8%.
Example 13 C: Future contingency
An instrument is issued stating it is redeemable if the entity is sold. Here the contingency is the future sale. As it is within the control of the entity as to whether or not it is to be sold, then this instrument would not be classified as a financial liability and instead classified as equity in line with section 22.3A of FRS 102.
If in this example the calculations stated that the instrument issued would not be repayable if the company was sold within 2 years, then in this case as the entity cannot force any other party to purchase it, the contingency is not within the control of the entity and therefore instrument should be classified as a financial liability.
22.3.2.2 Contingency element is not genuine
Section 22.3A(a) of FRS 102 states where a future event is not genuine then it is ignored. This could take to mean an event which is very unlikely to happen.
22.3.2.3 Contingency occurring on liquidation
In relation to 22.3A(b) of FRS 102, where this will arise is where the instrument provides a right to redemption on the liquidation of the company and has no other mandatory rights. See example 11 at 22.2.6.11 for application of this guidance. However, where the contingency/future event for redemption is on the company entering receivership or administration then this instrument would be classified as a financial liability and not meet the definition of equity.
22.3.2.4 Exceptions to an instrument being classified as a financial liability –as only represent residual interest in net assets
Section 22.4 of FRS 102 provides rules where initially one would believe an instrument should be classified as a financial liability but in fact these must be classified as equity as the instrument only represents the residual interest in the assets of the company – such situations arise (and the instruments are classified as equity as opposed to debt) where;
- As per section 22.4(a) of FRS 102, where a puttable instrument is issued which gives the holder the right to have it redeemed for cash or other financial assets on the occurrence of an uncertain future event or the death or retirement of the instrument holder and all the following conditions exist;
(i) It entitles the holder to a pro rata share of the net assets in the event of the entity’s liquidation (note if preferential rights exist on liquidation then this condition is not met)
(ii) The instrument is in the class of instruments that is subordinate to all other classes of instruments.
(iii) All financial instruments in the class of instruments that is subordinate to all other classes of instruments have identical features, Identical features would mean all instruments in a class:
- Have the same formula
- Rank equally in liquidation
- Have identical voting rights
- Have all other identical features
(iv) Apart from the contractual obligation for the issuer to repurchase or redeem the instrument for cash or another financial asset, the instrument does not include any contractual obligation to deliver cash or another financial asset to another entity, or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity, and it is not a contract that will or may be settled in the entity’s own equity instruments as set out in paragraph 22.3(b) of the definition of a financial liability. Note an instrument that is a compound instrument would not meet this requirement.
(v) The total expected cash flows attributable to the instrument over the life of the instrument are based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognized and unrecognised net assets of the entity over the life of the instrument (excluding any effects of the instrument).
- As per Section 22.4(b) of FRS 102 Instruments, or components of instruments, that are subordinate to all other classes of instruments are classified as equity if they impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation.
In relation to Section 22.3A(c) of FRS 102 which refers to Section 22.4(a)(i), this refers to instances where the holder has the right to redeem the instrument issued only on a liquidation. The instrument in effect must not have any other mandatory clauses and should only be entitled to the net assets on a winding up after all other creditors are paid up. The key point is that the assets are divided equally amongst the ordinary shareholders. If they provide rights to more than the ordinary shareholders, then they would not be treated as equity but as financial liabilities.
In relation to Section 22.4 (b) of FRS 102 this relates to instances where an entity has been set up for a sole purpose and will be liquidated at a set date. Hence these would be classed as equity in the financial statements. However, as per Section 22.5(a) of FRS 102 where there is a cap set on what can be received then it would be treated as a financial liability.
22.3.2.5 Examples of uncertain future/changed events outside the control of the issuer
Examples of circumstances where uncertain future events are beyond the control of the issuer are where redemption, payment, settlement etc is dependent on:
- Changes in the issuer’s performance indicators such as revenue, gross margin, EBITA etc.
- Changes in interest rates
- Changes in tax laws
Where such events exist in the shares issued, they should be classed as a financial liability as the issuer cannot avoid delivering the cash etc on the occurrence of these events. An example is a share/loan rate issued with rights stating that where profits are made above CU20,000, then a dividend of 10% of the profit should be paid. As the issuer or the holder cannot influence the profit made, once the condition is met it must be paid. In this instance it is likely this liability would have to be accounted for under section 12 of FRS 102 and fair valued as it would be complex (assuming it is permitted to be fair valued under IFRS and company law as stated at section 12.8 of FRS 102)
22.3.2.6 Example of instruments to be classified as a debt or equity
The following are examples of items to be classified as debt or equity as per section 22.5 of FRS 102:
(a) An instrument which is subordinate to all other classes of instruments is classified as a liability (which is the exception to Section 22.4(b) of FRS 102) if the distribution of net assets on liquidation is subject to a maximum amount (a ceiling). For example, if on liquidation the holders of the instrument receive a pro rata share of the net assets, but this amount is limited to a ceiling and the excess net assets are distributed to a charity organisation or the government, the instrument is not classified as equity.
(b) A puttable instrument is classified as equity if, when the put option is exercised, the holder receives a pro rata share of the net assets of the entity determined by:
(i) dividing the entity’s net assets on liquidation into units of equal amounts; AND
(ii) multiplying that amount by the number of the units held by the financial instrument holder.
However, if the holder is entitled to an amount measured on some other basis the instrument is classified as a liability.
(c) An instrument is classified as a liability if it obliges the entity to make payments to the holder before liquidation, such as a mandatory dividend. See example within 22.2.6.
(d) A puttable instrument that is classified as equity in a subsidiary’s financial statements is classified as a liability in the consolidated financial statements.
(e) A preference share that provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date or gives the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount, is a financial liability see example at 22.2.6.
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Examples
Example 1: Redeemable preference shares at option of the holder with mandatory coupon.
Example 2: Non-redeemable preference shares with mandatory coupon at market rate.
Example 4: Shares redeemable at the option of the holder
Example 5: Non-redeemable preference shares with discretionary dividend.
Example 6: Redeemable preference shares at option of issuer with discretionary dividend.
Example 7: Redeemable preference shares at option of issuer with mandatory dividend.
Example 13: Fixed for fixed arrangement
Example 13A: Application of Section 22.3(b)(ii) of FRS 102.
Example 13B: Future contingency amount
Example 13C: Future contingency.
Example 14: Accounting treatment on original issue of shares.
Example 15: Accounting treatment on original issue of shares – left as unpaid.
Example 16: Capitalisation/bonus issue.
Example 17: Accounting treatment for a compound financial instrument
Example 18: compound instrument where conversion is chosen.
Example 19: compound instrument where conversion is chosen.
Example 20: Accounting for transaction costs in acquiring a compound financial instrument
Example 21: Acquiring a further controlling interest
Example 22: Acquiring a further controlling interest
Example 23: Disposing of controlling interest but controlling interest retained.
Example 24: Extract of Statement of Changes in Equity from financial statements.
Example 25: Extract from accounting policies note.
Example 26: Extract from notes to the financial statements – liability
Example 27: Extract from notes to the financial statements – share capital
Example 28: Extract from notes to the financial statements – dividends on equity shares.
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