Preference shares

[Leo]

A company issues preference shares. The preference shares carry a discretionary dividend. The preference shareholders have a right to convert the prefs into ordinary shares if agreed by XX% of the pref shareholders. If not converted, preference shares are irredeemable. If converted, it would be converted into a variable number of ordinary shares depending on their fair value.

On the face of it, it appears to be irredeemable prefs with discretionary dividend payments. Hence, the instrument seems to be an equity instrument. However, the conversion feature would provide a redemption obligation for the issuer.

IN that case, is the instrument an equity instrument with an embedded derivative element?

Or is this instrument a liability in its entirety, because a preference shares that are convertible into a variable number of ordinary shares are liability?

[DJP]

I would say financial liability in its entirety. IAS 32 para 26

[kevin.aycardo]

Yeah it's a financial liability in its entirety due to the variable conversion feature.

But if you can change the conversion feature to fixed-for-fixed, it would be an equity instrument of the entity. 'Since both the embedded call option and the host are equity instruments, the entity does not account for the embedded option separately.' [PwC Inform 41.51]

I had a similar issue last year!

[Leo]

Thanks guys!

[Leo]

Just getting back to this, why it cannot be an equity host,I.e., no contractual obligation to pay cash for the redemption feature. And a derivative for the conversion feature?

Ias32 requires an instrument with a conversion feature to be analyzed separately isn't it?

[Ketan Marwah]

Hi, because it is not a hybrid instrument but a liability (It failed the fixed to fixed test to have the equity instrument cooped in a CFI).

Compound financial instrument: that’s the NON-DERIVATIVE financial instrument containing both equity and liability components.
Hybrid financial instrument or hybrid contract is the one containing embedded derivative.

Apply the standard definitions of respective items to determine the classification. Haven't though through fully if the conversion feature could be treated as a non-financial variable (most likely not) but even if one then since it is specific to the party in the contract therefore there is no underlying variable which is essential for the recognition of a derivative.

[Leo]

I think on this one, there is diversity in practice, it can be argued that the redemption feature and the conversion feature should be looked at separately. The redemption feature being an equity instrument, i.e., because no obligation to deliver cash or fixed number of equity instruments. But the conversion feature is a derivative with variable number of equity instruments, treated as a liability.

Therefore, it can be argued that it's a hybrid financial instrument. Don't you agree?

[Ketan Marwah]

The redemption feature being an equity instrument, i.e., because no obligation to deliver cash or fixed number of equity instruments.

How come this is Equity when no fixed to fixed test met?

How come the conversion feature is a derivative? What is the underlying variable?

[Leo]

fixed to fixed is only applicable to non-derivative that is converted into a variable number of equity or derivative converted into a variable number of equity.
So, if you only look at the redemption feature (not the conversion feature) it has no these characteristics, therefore, the fixed to fixed is not applicable.

The conversion feature that converts into shares is a derivative, the question is whether the derivative is classified as equity or liability. Only if the conversion feature allows a conversion into a variable number of shares = the cash amount, that is a non-derivative because the fair value doesn't vary. In that case, IAS.32.11 (b) says that non-derivative that converts into a variable number of shares is still a liability for the issuer.

Another example of a non-derivative is when the redemption feature is mandatorily converted into a fixed or variable number of equity instruments, but it's not our case here. Here we say that the redemption feature is not redeemable mandatorily in cash or in a variable number of shares.

[Ketan Marwah]

I agree with your response on the irredeemable preference shares being classified as equity and no requirement to make the fixed-to-fixed test. It was a hastily raised question from me so thanks for picking up the mistake. I don’t however agree that conversion feature that converts into shares is a derivative. Allow me to clarify:

Conversion features that fail ‘equity’ classification are ‘derivatives’ and not just any conversion feature into shares become a derivative.
All three of the characteristics of a derivative are met from your example, i.e.: a) The value of the conversion feature changes in response to the share price of the issuer b) The investment required to purchase the option is less than would be required to purchase the equivalent number of shares, and c) The conversion feature can or will be exercised at a future date.
Since this instrument has an embedded derivative therefore this is not a compound financial instrument but a hybrid instrument where the host contract is an equity instrument with a derivative embedded within. I don't see a diversity in practice, also, therefore.

[Leo]

Hi Ketan,

My point on diversity in practice is that a preference share/bond that is no mandatorily converted into cash or a variable number of shares but has an option to the holder to convert into a variable number of shares, for some people, e.g., DJP, is a financial liability in its entirety.

As per IAS 32.11, a financial liability is when the following conditions are met:
a) a contractual obligation for the issuing entity to deliver cash or another financial asset to another entity […]; Or
b) a contract that will or may be settled in the entity’s own equity instruments and is 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 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. […]

although the issuer can avoid paying cash, if the holder convert the option, the issuer will or may be settled in entity's own equity instrument and in a variable number. Therefore, it is a financial liability.

I can see that. But a strict application of the IAS 32 analysis would suggest to analyse each feature separately. So the redemption feature is equity and the conversion feature is liability.

That's why I'm saying, "diversity in practice".

[Ketan Marwah]

Hi Leo,

Thanks. I would not agree with that “diversity” though

I would stick to classifying it as a hybrid instrument (equity + derivative liability) and not just liability alone.