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Classification of an instrument as liability or equity
Extract from FRS 102 – Section 22.3
22.3 Equity is the residual interest in the assets of an entity after deducting all its liabilities. Equity includes investments by the owners of the entity, plus additions to those investments earned through profitable operations and retained for use in the entity’s operations, minus reductions to owners’ investments as a result of unprofitable operations and distributions to owners.
A financial liability is any liability that is:
(a) a contractual obligation:
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavourable to the entity; OR
(b) a contract that will or may be settled in the entity’s own equity instruments and:
(i) under which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; OR
(ii) which will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity’s own equity instruments.
OmniPro comment
As can be seen from the definition of a financial liability in Section 22.3 above, the key question when assessing whether an item is classed as debt or equity is if:
- Ignoring share settlement, the issuer does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation, the obligation meets the definition of a liability with the exception of a puttable instrument and an obligation on liquidation that meet the criteria in Section 22.4 as extracted from the standard below.
NOTE: in relation to the mandatory requirement to pay dividend, it is irrelevant whether the company has distributable reserves to pay the dividend. The dividend should still be accrued in the financial statements. Also in relation to the requirement to repurchase the shares, the fact that the entity has no distributable reserves is not taken into account. Just because there is not distributable reserves or there is insufficient cash, does not prevent the dividend from being accrued. Obviously the dividend cannot be paid to the holder until the company has distributable reserves.
Where a financial instrument is classified as debt, the preference shares paid are classified as an interest cost in the financial statements. The preference dividend which is mandatory where not paid should be accrued as the entity is contractually obliged to pay this in the future.
Where it is classified as equity the dividend paid is posted to equity/profit and loss reserves. A dividend declared on an equity share cannot be accrued unless it has been approved by the members in an AGM prior to the year end. If it has not it should not be accrued.
Shares which are deemed to be debt are usually accounted for in line with Section 11 i.e. at amortised cost or where there is a derivative element under Section 12 at fair value. In nearly all cases they will be valued at amortised cost.
Note in any of the examples below, we use preference shares however the shares could be called whatever they like i.e. ‘A’ ordinary shares, bonds etc., it is the rights attaching to the instrument that matter. The examples below detail the majority of alternatives that entities may come across in practice and explains the points in the standard above.
Example 1: Redeemable preference shares at option of the holder with mandatory coupon
Company A issued 200,000 10% preference shares of CU1 each in return for CU200,000. The rights attaching to the shares are such that:
- 10% dividend must be paid annually in arrears i.e. CU20,000 mandatory
- The preference shares are redeemable at their par value at the option of the holder at some time in the future.
Given that Company A has a contractual obligation to pay a dividend yearly and is contractually obliged to redeem the shares, these shares would be classified as debt in Company A’s financial statements. The journals required on issue would be to:
|
|
CU |
CU |
|
Dr Bank |
200,000 |
|
|
Cr Preference Shares Liability |
|
200,000 |
The journal required at the end of each year for the dividend payable is:
|
|
CU |
CU |
|
Dr Interest Expenses with Preference Dividend |
20,000 |
|
|
Cr Bank/Preference Dividend Accrual |
|
20,000 |
Example 2: Non-redeemable preference shares with mandatory coupon at market rate
Company A issued 200,000 10% preference shares of CU1 each in return for CU200,000. The rights attaching to the shares are such that:
- 10% dividend must be paid annually in arrears i.e. CU20,000 mandatory
- The preference shares are non-redeemeable or redeemable at the option of the issuer (i.e. Company A) at any time
Given that Company A has a contractual obligation to pay/accrue a dividend yearly, these shares would be classified as debt in Company A’s financial statements as the stream of cash flow is into perpetuity. The journals required in this case are the same as example 1.
Example 3: Non-redeemable preference shares with mandatory coupon at non-market rate
Company A issued 200,000 10% preference shares of CU1 each in return for CU200,000. The market coupon rate on such shares should be 12%. The rights attaching to the shares are such that:
- 10% dividend must be paid year on year i.e. CU20,000 mandatory
- The preference shares are non-redeemeable or redeemable at the option of the issuer (i.e. Company A) at any time
In this particular circumstance, there is both a liability and equity component to these shares. This is in effect a compound financial instrument. The liability element being the mandatory dividend payable and equity element being the residual. Therefore a certain element of the proceeds will be shown in equity and liabilities. See section on compound financial instruments below (example 17).
Note if the above example was at market rate but it also contained rights which stated that additional dividends on top of the coupon rate may be paid at the discretion of the board, it would also be a compound instrument and the market rate for an instrument with the additional option would have to be applied so as to ascertain the liability and equity component.
Example 4: Shares redeemeable at the option of the holder
‘Ordinary shares’ that can be converted into debt, based on fair value of the shares at the date of conversion at the option of the holder
Here this is accounted for as a financial liability on the basis that once converted which is at the option of the holder, there is a contractual obligation to redeem for cash, hence the issuer cannot avoid paying in cash.
Example 5: Non redeemable preference shares with discretionary dividend
Company A issued 200,000 preference shares of CU1 each in return for CU200,000. The rights attaching to the shares are such that:
- Dividend is payable at the discretion of the company
- The preference shares are non-redeemable
Given that company A has no contractual obligation to redeem or pay dividends, this should be classified as equity in the financial statements. The journal required on issue of the shares are:
|
|
CU |
CU |
|
Dr Bank |
200,000 |
|
|
Cr Equity –Preference Share Capital |
|
200,000 |
Where a discretionary dividend is paid on these equity shares the journal required is to:
|
|
CU |
CU |
|
Dr Equity-Profit and Loss Reserves |
XXX |
|
|
Cr Bank |
|
XXX |
If the dividend was approved by the members prior to the year end, then the dividend can be accrued
Example 6: Redeemable preference shares at option of issuer with discretionary dividend
Company A issued 200,000 preference shares of CU1 each in return for CU200,000. The rights attaching to the shares are such that:
- Dividend are payable at the discretion of the company
- The preference shares are redeemable at the issuers option at some future date
Given that Company A has no contractual obligation to pay cash, this should be classified as equity in the financial statements. The treatment of any discretionary dividends are posted to equity as in example 5 above. Note even if there was a coupon attached to these preference shares that was only payable at the option of the Company, they would still be classed as equity. Whether the company has a history of paying dividends in the past is irrelevant, it would still be classed as equity as it does not have a contractual obligation to make the dividend payment.
Example 7: Redeemable preference shares at option of issuer with mandatory dividend
Company A issued 200,000 10% preference shares of CU1 each in return for CU200,000. The rights attaching to the shares are such that:
- 10% dividend must be paid annually in arrears i.e. CU20,000 mandatory
- The preference shares are redeemable at the issuers option at some future date
Here assuming the coupon rate of 10%, is the market rate on issue, as Company A has a contractual obligation to pay/accrue a dividend annually, this would be classified as a financial liability. See example 1 for how this would be accounted for if the rate was a non-market rate.
Example 8: Mandatory redeemable preference shares at fixed amount at a fixed or future date with mandatory dividend
Company A issued 200,000 10% preference shares of CU1 each in return for CU200,000. The rights attaching to the shares are such that:
10% dividend must be paid annually in arrears i.e. CU20,000 mandatory
The preference shares are redeemable at a fixed or future date
Given that Company A has a contractual obligation to pay/accrue a dividend yearly, these shares would be classified as debt in Company A’s financial statements. The journals required in this case are the same as example 1.
Example 9: Mandatory redeemable preference shares at fixed amount at a fixed or future date with dividend payable at the discretion of the issuer
Company A issued 200,000 preference shares of CU1 each in return for CU200,000. The rights attaching to the shares are such that:
- Dividend is payable at the discretion of the company
- The preference shares are mandatory redeemable at a fixed or future date
Here this is in fact a compound instrument as it contains both an equity and liability component. The liability component is the present value of the redemption amount and equity component is equal to the proceeds less liability component. Any dividends paid are taken to relate to the equity component. The present value rate that should be used is the rate that would be charged by a bank for period up to the mandatory redemption date on a similar instrument.
For example assume in the above example, it is mandatory redeemable at the end of year 5 and the market rate of interest for a similar loan would be 8%. Then the present value of CU200,000 is CU136,117 (CU200,000/((1.08^5)). Therefore the amount to be recognised as a liability is CU136,117 and the amount to be recognised in equity is CU63,883. The journal required on intial recognition is:
|
|
CU |
CU |
|
Dr Bank |
200,000 |
|
|
Cr Preference Share Liability |
|
136,117 |
|
Cr Equity |
|
63,883 |
The CU136,117 is then amortised at the effective interest rate of 8% over the 5 year period as per below
Therefore the journal that would be posted at end of year 1 would be:
|
|
CU |
CU |
|
Dr Interest Cost |
10,889 |
|
|
Cr Preference Share Liability |
|
10,889 |
If a dividend was declared and paid on these shares of CU10,000 during year 1 for example, the following journal would be posted:
|
|
CU |
CU |
|
Dr Equity-Profit and Loss Reserves |
10,000 |
|
|
Cr Bank |
|
10,000 |
However, where any unpaid dividend is added to the redemption amount and this is included in the share rights, the whole instrument is classed as a liability component i.e. CU200,000 and the dividend accrued increases the liability.
Example 10: Redeemable preference shares at holder’s option at some future date with dividend payable at the discretion of the issuer
Company A issued 200,000 preference shares of CU1 each in return for CU200,000. The rights attaching to the shares are such that:
- Dividend is payable at the discretion of the company
- The preference shares are redeemable at some future date at the option of the holder
Here this is in fact a compound instrument as it contains both an equity and liability component assuming that it does not meet the definition in 22.4 (i.e. a puttable instrument in an entity which has a very limited life in which case it would all be classed as equity). The liability component is the present value of the redemption amount and equity component is equal to the proceeds less liability component. Any dividends paid are taken to relate to the equity component. The present value rate that should be used is the rate that would be charged by a bank for period up to the mandatory redemption date. See example 9 for further details.
However, where any unpaid dividend is added to the redemption amount and this is included in the share rights, the whole instrument is classed as a liability component i.e. CU200,000.
Example 11: Preference shares with dividends payable at the discretion of the issuer and only redeemable on the liquidation of the company
Company A issued 200,000 preference shares of CU1 each in return for CU200,000. The rights attaching to the shares are such that:
- Dividend is payable at the discretion of the company
- The preference shares are redeemable on the liquidation of the company
Here these shares would be classed as equity as per Section 22.3A(b) on the basis that every share becomes repayable on a liquidation even ordinary shares.
If in this example, the shares were redeemable on the appointment of a receiver or administrator these would then be classified as a financial liability.
Example 11A: Preference shares/bonds convertible with a mandatory coupon redeemable at the option at the holder, into a fixed number of ordinary shares at any time up to maturity (see example 17 below).
Application of Section 22.3(b)(i)
In relation to Section 22.3(b)(i) it is clear that where a variable number of shares are to be issued from an entity’s own equity, these are classified as equity. An example of the application of this section is detailed in the example below:
Example 12: Preference shares issued which can be redeemed for no set numbers of share in the future
Company A issued preference shares of CU1 each in return for CU200,000. The shares are redeemable after 5 years at the option of the holder into ordinary shares up to the value of CU200,000 at that date. Assume at the end of year five the price per ordinary share is CU10
In this particular case it is evident that a variable number of shares will be issued to the holder on redemption depending on the value of the company at that date i.e. at the end of year five 10,000 shares will have to be issued (CU200,000/CU10=CU10,000) hence there is variability which dictates that these shares are therefore classed as equity.
Example 13: Fixed for fixed arrangement
An example of where this exemption applies also is where a company receives CU10,000 from another entity/person in return for the company issuing 300 shares in itself in four years time (with no other conditions attached). As the holder will suffer from a loss and benefit from a gain with regard to a fall/uplift in the value of the company, this CU10,000 would be classified as equity on receipt of CU10,000.
Example 13A: Application of Section 22.3(b)(ii)
An example of this type is where a company has entered into a forward contract to issue shares in itself in return for a foreign currency. Hence as the amount of cash is not fixed, it is a financial liability. In addition, as it is not fixed in the company’s functional currency, it is also classed as a financial liability.
Classification of an instrument as liability or equity where contingency exists
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 unfavourable 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.
OmniPro comment
In relation to Section 22.3 examples of circumstances where uncertain future events are beyond the control of the issuer are:
- 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 exists 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 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.
Section 22.3A(a) states that where a future events is not genuine then it is ignored. This could take to mean an event which is very unlikely to happen.
In relation to point 22.3A(b), 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 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.
In relation to Section 22.3A(c) 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) 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) where there is a cap set on what can be received then it would be treated as a financial liability.
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