Financial Instruments with Characteristics of Equity

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marea
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Financial Instruments with Characteristics of Equity

Post by marea »

Hello everyone,

I need your help on a following scenario:

A company issues preference shares redeemable on liquidation with fixed cumulative dividends.
In my view, the fixed cumulative dividends meet the definition of a liability, and maybe split accounting would apply or is this an equity instrument?

I am aware that the IASB currently has a proposal to treat such instruments as liability, but I think this has not been implemented yet.

Any suggestions/help would be greatly appriceated.
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Marek Muc
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Re: Financial Instruments with Characteristics of Equity

Post by Marek Muc »

And apart from liquidation, is it a regular share?
marea
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Re: Financial Instruments with Characteristics of Equity

Post by marea »

Could you please explain, what do you mean with "regular" share?

If dividends are paid in due course, the outstanding cummulative amount (if any) from preference shares must be paid first before ordinary shares.
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Marek Muc
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Re: Financial Instruments with Characteristics of Equity

Post by Marek Muc »

Regular shares don't receive any payments other than dividends at full discretion of the company

I don't understand what you mean by outstanding cummulative amount
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exIFRS
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Re: Financial Instruments with Characteristics of Equity

Post by exIFRS »

If the company liquidates do the preference share get any cumulative dividend and/or capital return ahead of the ordinary shareholders?
marea
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Re: Financial Instruments with Characteristics of Equity

Post by marea »

@Marek, by cumulative I mean the fixed % of dividends related to prefernce shares that has not been paid out yet. Holders of preference shares are entiteled to a specific % of dividends every year. In substance they are interests IMO.

@ exIFRS, yes preference shares have hifger seniority than ordinary shares on liquidation
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Marek Muc
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Re: Financial Instruments with Characteristics of Equity

Post by Marek Muc »

By % of dividends, you mean % of the face value of shares? If so, those shares are financial liabilities in their entirety
JRSB
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Re: Financial Instruments with Characteristics of Equity

Post by JRSB »

We appear to be discussing cumulative preference shares, paying a fixed coupon which, if not paid in a given year, are payable in future years (as distinct from non-cumulative).
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Re: Financial Instruments with Characteristics of Equity

Post by JRSB »

Presumably they are irredeemable?
marea
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Re: Financial Instruments with Characteristics of Equity

Post by marea »

Yes, there is no redemption date, and if the dividends are not paid in a given year they are payable in future years.They are not discretional by the issuer of the shares but madatory.

I was thinking that in case of split accounting, if we take the discount rate that is the same as the % of the dividends, then the entire amount would be recognised as a liability. There would not be any equity component.

What do you think?
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Re: Financial Instruments with Characteristics of Equity

Post by JRSB »

Personally I thought such a device was equity but I'm happy to be led.
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Marek Muc
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Re: Financial Instruments with Characteristics of Equity

Post by Marek Muc »

To me they are financial liabilites in their entirety, there's fixed coupon , there's no 'residual interest in the assets after deducting all of its liabilities'

Plus:
https://ifrscommunity.com/knowledge-bas ... etual-debt
marea
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Re: Financial Instruments with Characteristics of Equity

Post by marea »

To me, in this case, the non-discretional dividends represent a financial liability. If they are discounted with the market rate that is equal to the "coupon" rate, the liability is equal to the amount received/invested, and there is no equity component. If the discount rate is higher than the “coupon”, the difference between the proceeds and the calculated liability represents the equity component.

However, I would be happy to hear where in the standard I could find the explanation that the entire proceeds should be accounted for as equity.
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Marek Muc
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Re: Financial Instruments with Characteristics of Equity

Post by Marek Muc »

Have a look a references in this section

https://ifrscommunity.com/knowledge-bas ... iquidation

And simply put, these shares do not meet the definition of equity, there's no 'residual interest in the assets after deducting all of its liabilities'
marea
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Re: Financial Instruments with Characteristics of Equity

Post by marea »

Thank you Marek. Will have a look at it.

Another thing came into my mind. What if in the case of liquidation the shareholders of preference shares receive their original investmet first, and thereafter they receive the residual on a pro rata share. So this part is similar to regular shares. Any idea how to calculate this component.
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Re: Financial Instruments with Characteristics of Equity

Post by marea »

I think this should probably be reflected in the higher discount rate, which would then have as the outcome the calculation of the liability and equity component.
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Re: Financial Instruments with Characteristics of Equity

Post by JRSB »

ok.
The instrument has both equity and liability elements.
The liability element is calculated as the present value of
the future contractual cash flows, discounted at a market
rate of interest for a similar liability that does not have the
associated equity component. The interest expense will
be calculated using the effective interest method and
charged to profit or loss each year.
The equity element is calculated as any residual value,
i.e. the difference between the proceeds from the issue
of the shares less the liability component. The amount
calculated as equity would be zero where the dividend
represents a market rate of return and the instrument is
issued at fair value.
marea
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Re: Financial Instruments with Characteristics of Equity

Post by marea »

Thank you both for your help :-).
Everything is clear now.
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Marek Muc
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Re: Financial Instruments with Characteristics of Equity

Post by Marek Muc »

Which part is the equity part in your opinion, JRSB?
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exIFRS
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Re: Financial Instruments with Characteristics of Equity

Post by exIFRS »

I have a slightly different view I am afraid, but I am concerned I may not fully understand the terms. Based on what I understand I believe the terms of the dividend do not make it a liability. The fact it is cumulative is not important, what is important is can the entity avoid paying it. From what I understand of what was said earlier the only stipulation is that the dividend on preference shares must be paid before any dividends are paid to ordinary shareholders?

The key paragraph is IAS32.17 which states (edited, emphasis added):
"a critical feature in differentiating a financial liability from an equity instrument is the existence of a contractual obligation of one party to the financial instrument (the issuer) either to deliver cash or another financial asset to the other party (the holder) ... Although the holder of an equity instrument may be entitled to receive a pro rata share of any dividends or other distributions of equity, the issuer does not have a contractual obligation to make such distributions because it cannot be required to deliver cash or another financial asset to another party.
This is emphasised in the application guidance IAS 32.AG26 (edited, emphasis added):
"When distributions to holders of the preference shares, whether cumulative or non‑cumulative, are at the discretion of the issuer, the shares are equity instruments. The classification of a preference share as an equity instrument or a financial liability is not affected by, for example:
(a) a history of making distributions;
(b) an intention to make distributions in the future;
(c) a possible negative impact on the price of ordinary shares of the issuer if distributions are not made (because of restrictions on paying dividends on the ordinary shares if dividends are not paid on the preference shares);
...
(e) an issuer’s expectation of a profit or loss for a period"
I thought the ranking on liquidation was more of an issue, but I think I was distracted by para 16 that is only dealing with puttable financial instruments, which there do not appear to be. The BC to IAS 32.BC18 states:
The Board also concluded that contingent settlement provisions that would apply only in the event of liquidation of an entity should not influence the classification of the instrument because to do so would be inconsistent with a going concern assumption. A contingent settlement provision that provides for payment in cash or another financial asset only on the liquidation of the entity is similar to an equity instrument that has priority in liquidation and therefore should be ignored in classifying the instrument.
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Re: Financial Instruments with Characteristics of Equity

Post by JRSB »

PS my previous post was taken from ICAEW (UK's leading accounting professional body)
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exIFRS
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Re: Financial Instruments with Characteristics of Equity

Post by exIFRS »

PS my previous post was taken from ICAEW (UK's leading accounting professional body)
I had come across the same document when looking at this, but it hinges on the dividend being "non-discretionary" which is not necessarily the same as cumulative?

https://www.icaew.com/technical/financi ... er-frs-102
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Re: Financial Instruments with Characteristics of Equity

Post by JRSB »

The whole 'cumulative' thing confuses this. The fact that it is cumulative suggests that actual payment is optional in any given year, which following through suggests that ultimately the cumulative unpaid coupon ('dividend') may only truly be payable at winding up, in preference to ordinary shareholders but after 'ordinary creditors' (presumably?) which perhaps illustrates the grey area. In insolvency law, would all trading creditors have to receive 100% return before a penny went to the preference shareholders? Or are they part of the creditors group?
marea
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Re: Financial Instruments with Characteristics of Equity

Post by marea »

Apparently, there is still room for discussion :-)

@ JRSB that is a valid point.

@exIFRS
“I had come across the same document when looking at this, but it hinges on the dividend being "non-discretionary" which is not necessarily the same as cumulative?”
Which part of dividends do you refer to? If the fixed amount of dividends is non-discretional and cumulative it is a liability IMO.

Regarding the pro rata share of the net assets of the entity only on liquidation. Would IAS 32.AG14C apply in this case, so the preference shares would not be classified as equity?
“An instrument that has a preferential right on liquidation of the entity is not an instrument with an entitlement to a pro rata share of the net assets of the entity. For example, an instrument has a preferential right on liquidation if it entitles the holder to a fixed dividend on liquidation, in addition to a share of the entity’s net assets, when other instruments in the subordinate class with a right to a pro rata share of the net assets of the entity do not have the same right on liquidation.”
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Re: Financial Instruments with Characteristics of Equity

Post by exIFRS »

If the only condition is that the dividend only has to be paid before the ordinary shareholders get a dividend it is deemed to be discretionary. The organization has the discretion of if and when to pay a dividend because it has discretion as to whether or not to pay an ordinary dividend. This is the point of AG26(c) as discussed in my earlier post.

My understanding is the AG14C is specific to certain financial instruments that contains puts, and I am not sure that these paragraphs apply to outlined circumstance.

BC 7 Talks about these types of instruments: " The Board decided that a financial instrument that gives the holder the right to put the instrument back to the entity for cash or another financial asset is a financial liability of the entity. Such financial instruments are commonly issued by mutual funds, unit trusts, co‑operative and similar entities, often with the redemption amount being equal to a proportionate share in the net assets of the entity. Although the legal form of such financial instruments often includes a right to the residual interest in the assets of an entity available to holders of such instruments, the inclusion of an option for the holder to put the instrument back to the entity for cash or another financial asset means that the instrument meets the definition of a financial liability."

BC55 and beyond then deal with the 2008 amendments which effectively say, okay in certain circumstances these puttable financial instruments can be treated as equity.
marea
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Re: Financial Instruments with Characteristics of Equity

Post by marea »

exIFRS wrote: 29 Nov 2020, 09:38 If the only condition is that the dividend only has to be paid before the ordinary shareholders get a dividend it is deemed to be discretionary
But what if the terms are that preference shares are entiteled to an annual fixed dividend. In my view such dividend is non-discretional, the issuer has not the option but a contractual obligation to pay the fixed amount of dividends related to preference shares, because it is my understanding that even when there are no other dividends paid preference shares get their dividend and if not paid out they acumulate in future years. Here, AG26(d) might apply.

What do you think?

Regardung IAS 32.AG14C I missed the fact that it relates to puttable instruments. Thank you for the hint.
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Marek Muc
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Re: Financial Instruments with Characteristics of Equity

Post by Marek Muc »

perhaps we don't have the same understanding of facts,

What I understood is that entity is contractually obliged to 'accrue' dividend on preference shares. It doesn't have to pay it each year, but ultimately all accrued but unpaid dividends have to be paid. So only timing is at the discretion of the entity, but amounts are not. This makes it a liability IMO.
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Re: Financial Instruments with Characteristics of Equity

Post by JRSB »

Marek - if all those accrued coupons ultimately are secondary to 'ordinary creditors', in, say, a liquidation, then that is tantamount to equity (the unpaid coupons having the effect of giving the holder a slightly increased interest in the residual assets). I'm not clear on the legal situation though.
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Marek Muc
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Re: Financial Instruments with Characteristics of Equity

Post by Marek Muc »

On liquidation, equity holders receive cash on a pro rata basis of what's left after paying all creditors
These preference shareholders (if I understand correctly) are entitled to receive all previously accrued dividends which were not at the discretion of the entity, but set contractually. So preference shareholders are also creditors on liquidation, they receive fixed amount of cash before equity holders can even see a penny
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