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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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22.2 Classification of an Instrument as Liability or Equity
22.2.1 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 unfavorable to the entity; OR
(b) a contract that will or may be settled in the entity’s own equity instruments and is:
(i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; OR
(ii) a derivative that 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.
22.2.2 OmniPro comment
22.2.2.1 Definition of financial liability
As per section 22.3 of FRS 102 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 unfavorable 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.
As can be seen from the definition of a financial liability in Section 22.3 of FRS 102 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 of FRS 102 for further details. where classified as debt See liability under section 22.
22.2.2.2 Definition of Equity
Equity is defined in section 22.3 of FRS 102 in short as being what remains after all debt is paid/all liabilities are taken into consideration. In essence it is the share capital which does not meet the definition of liability plus accumulated profits /less accumulated losses and any other contributions from shareholders
22.2.3 Accounting treatment of instruments classified as debt
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 or it does not meet the definition of basic as stated in section 11.9 of FRS 102 under Section 12 at fair value. In nearly all cases they will be valued at amortised cost however certain state funded organisations do require preference shares to be issued to them where the liability component is considered complex and therefore accounted for under Section 12.
22.2.3.1 Instruments made up of debt and equity – compound financial instruments or an instrument classified as liability and at non-market rates.
Where some of an instrument is made up of debt and some is made up of equity, then the debt element will be accounted for in accordance with section 11 or 12 as stated at 22.2.3 and the equity element accounted for in line with section 22 as detailed at 11.8.2. Where this situation arises, the instrument is known as a compound financial instrument. See an example of the accounting for same at 22.2.6.9 and 22.7.2.6
Where a loan note or shares are subscribed for and a below market rate is charged and these are classified as a liability under section 22, and it meets the definition of a basic financial instrument in section 11 of FRS 102 at 11.5.2, then in line with section 11 rules there is a requirement to present value the cash flow of a market rate of interest. Where the difference between the present value amount and the actual amount subscribed is recognised depends on the facts and circumstances. If the subscriber is an existing shareholder, then the difference should be recognised in equity. Alternatively, if the subscriber is a new investor then it should be recognized in the profit and loss account. See an example at 22.2.6.9 If the debt element does not meet the definition of basic in section 11 and instead it is complex and must be accounted for at fair value under the rules of section 12 (if permitted under IFRS) then the difference would have to go to the profit and loss, it would not be recognised in equity. See section 12 for further details.
22.2.4 Mandatory requirements to pay dividends even if no distributable reserves when classified as a liability
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 however as it is contractually payable, the instance distributable reserves arise then they must be paid.
Where a financial instrument is classified as debt, the dividend/interest accrued or paid on the loan notes preference shares/loan notes 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.
22.2.5 Treatment of dividend on instruments classified as equity
Where the instrument 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. Note if a coupon rate is on a share but it is at the discretion of the issuer as to whether to pay it or not, then these shares would be classified as equity. See example at 22.2.6.6.
22.2.6 Examples illustrating whether an instrument meets the definition of debt or equity
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.
22.2.6.1 Redeemable preference shares at option of the holder with mandatory coupon
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 |
22.2.6.2 Non-redeemable preference shares with mandatory coupon at market rate
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 at 22.2.6.1.
22.2.6.3 Non-redeemable preference shares with mandatory coupon at non-market rate or at market rate with option of entity to pay additional dividends
Example 3: Non-redeemable preference shares with mandatory coupon at non-market rate or at market rate with option of entity to pay
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 present value of the dividend payable into perpetuity 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) at 22.7.2.6 and example 9 at 22.2.6.9.
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. The difference here between 22.2.6.2 and the example here is that the coupon rate was not at a market rate here.
22.2.6.4 Shares/loan notes redeemable at the option of the holder
Example 4: Shares/loan notes redeemable at the option of the holder (i.e. a type of share/loan note which meets the definition of debt)
‘Ordinary shares’ that can be converted into debt (i.e. a type of share /loan note which meets the definition of 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 (meets definition of a liability in section 22.3 of FRS 102).
22.2.6.5 Non-redeemable preference shares with discretionary dividend
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.
22.2.6.6 Redeemable preference shares at option of issuer with discretionary dividend
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, (does not meet the definition of financial liability in section 22.3 of FRS 102) this should be classified as equity in the financial statements. The treatment of any discretionary dividends are posted to equity as in example 5 at 22.2.6.5 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.
22.2.6.7 Redeemable preference shares at option of issuer with mandatory dividend
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 3 at 22.2.6.3 for how this would be accounted for if the rate was a non-market rate.
22.2.6.8 Mandatory redeemable preference shares/loan note at fixed amount at a fixed or future date with mandatory dividend
Example 8: Mandatory redeemable preference shares/loan note 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 and that the must be redeemed in the future, these shares would be classified as debt (section 22.3 of FRS 102) in Company A’s financial statements. The journals required in this case are the same as example 1 at 22.2.6.1.
22.2.6.9 Mandatory redeemable preference shares/loan note at fixed amount at a fixed or future date with dividend payable at the discretion of the issuer
Example 9: Mandatory redeemable preference shares/loan note 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 |
22.2.6.9.1 Treatment of difference between present value ad actual amount subscribed for
NOTE when assessing where the difference between the liability component and the amount given to subscribe for the shares, one needs to assess who the shares are being issued to. If the shares are being issued to an existing shareholder, then the difference will be recognised in equity as in this example – if the shares/loan rate is issued to a new investor then the difference (i.e. CU 63,883 in his example) should be recognised as a gain in the profit and loss account.
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 |
22.2.6.9.2 Impact of dividend added to redemption amount if declared, even if not mandatory dividend.
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.
22.2.6.10 Redeemable preference shares at holder’s option at some future date with dividend payable at the discretion of the issuer
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 section 22.4 of FRS 102 (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 at 22.2.6.9 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.
22.2.6.11 Preference shares with dividends payable at the discretion of the issuer and only redeemable on the liquidation of the company
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) of FRS 102 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.
22.2.6.11A 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 at 27.11.2.6)
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 at 27.11.2.6).
22.2.6.12 Preference shares/loan notes issued which can be redeemed/converted for no set number of shares in the future but based on amount subscribed
Application of Section 22.3(b)(i) of FRS 102
In relation to Section 22.3(b)(i) of FRS 102 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/converted for no set number of shares in the future but based on amount subscribed
Company A issued preference shares/loan notes of CU1 each in return for CU200,000. The shares/loan rates are redeemable/convertible 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. No coupon applies
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 a financial liability (as the holder is guaranteed to get shares equal to the value of original amount subscribed.
NOTE if in the above example the condition stated at inception stated that the preference shares/loan rates could be converted to a set number of shares as opposed to having vairability then this would be accounted for as a compound financial instrument. See example at 22.11.2.6
22.2.6.13 Fixed for fixed arrangement
Example 13: Fixed for fixed arrangement
An example of where this exemption applies 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 (i.e. not mandatory dividend). 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. Another example is where the company issue preference shares/loan notes which are convertible into a fixed number of ordinary shares at a future date.
22.2.6.14 Equity issued in return for a forward contract to issue foreign currency
Example 13A: 14 Equity issued in return for a forward contract to issue foreign currency Application of Section 22.3(b)(ii) of FRS 102
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.
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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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