Redeemable preference shares

[Leo]

HI everyone,

I'd like to run something by you.
A group is composed of Parent A and subsidiary B.
Subsidiary B had issued a redeemable preference shares to a third party. At redemption, subsidiary B can choose either to settle in cash or settle in parent A's shares.
I'd say that the pref shares are classified as equity because there is no obligation to settle in cash. What's your view on this?

[JakobLavrod]

I would agree with this assessment since company B can always do what is most economically preferential.

[Marek Muc]

Yes, but in consolidated financial statements only. It's a liability in B's separate financial statements.

[Leo]

is that because from entity B's perspective, the decision is taken by Parent A, so that entity B doesn't have an unavoidable right to pay cash?

[Marek Muc]

From B's perspective, A's shares aren't B's equity, but financial assets, so neither of the settlement options is in equity (from B's perspective)

[Marek Muc]

PS. also check whether, in consolidated FS, the equity settlement option meets the fixed-for-fixed criterion https://ifrscommunity.com/knowledge-bas ... -criterion

[Leo]

I agree that from entity B's perspective, it's a liability that is because on the face of it, it seems that entity B can choose either to settle the prefs by cash or parent A's share, but in reality it's parent A who's the decision maker, because Parent A owns entity B. Therefore, entity B doesn't have an unavoidable right to pay cash. Thus it's a liability in the individual accounts of entity B.

In case that at redemtpion, entity B chooses asks Parent A to issue it's own shares to settle the prefs instead of paying cash, then, entity B would derecognise the financial liability (prefs) and record a capital contribution (equity), does that make sense?

[Leo]

Hi Marek, thanks for your reply. Please help me to understand, I try to run this by using the GT's decision tree. However, it seems to point into the direction of an equity.

I think if the issuer will not redeem with it's own equity instruments, then, should it classify it as equity? or it's the question 5 redundant? Do you know how question 5 should be interpreted? thanks in advance.

[Leo]

Marek, based on your comment (liability), how should I interpret this comment:

On the contrary, a preference share (or other instrument) redeemable in cash only at the option of the issuer, does not satisfy the definition of a financial liability in IAS 32, because the issuer does not have a present or future obligation to transfer financial assets to the shareholders. [IAS32.AG25]

[Marek Muc]

I'm sorry but currently I don't have time to delve deeper into this, but let's leave this topic open for other Members to chime in.
PS. please provide a link to the GT publication

[JRSB]

That's BDO (eg https://www.bdo.ua/en-gb/insights-1/inf ... tes?feed=1# )

[Leo]

Updating this post with my current view:
- The Sub accounts for the redeemable shares as Equity on the basis that it can avoid delivering cash upon settlement.
- The group account for the redeemable shares as Equity, provided that Parent will deliver a fixed number of its shares for a fixed amount of cash, i.e., the redemption amount of the redeemable notes issued by Sub.

[Leo]

Marek, as you've stated, as per IAS 32, the entity should classify it as liability if it cannot avoid to be cash or another financial asset to the holder. The equity instrument issued by the parent to the holder is considered as a financial asset, so the instrument may be treated as a liability by the sub even the instrument is equity in conso.

However, if its liability, upon redemption, the liability will be reclassfied to equity anyway... any thoughts?

[Leo]

Any thoughts?

[Marek Muc]

I'm sorry but currently I don't have time to delve deeper into this

Still true

[exIFRS]

I realise I am coming in late, so maybe I am misunderstanding the question. AS I think you have concluded in either case it is a liability from B's perspective. You either have to settle in cash or another financial asset (A's shares). If the questions is about the accounting from B's perspective, it depends on what it had to give A in return. The accounting standards are written with an assumption of economic rationality. It is assumed that A would not settle B's debt (by handing over its own shares) for free. That being said I have seen parents do it in certain circumstances, but this is effectively a transfer of resources from A to B. So from B's books the entry could be:

Dr Liability to third party
Cr Liability to A (to be settled through provision of cash or some other resource)

Alternatively
Dr Liability to third party
Cr Gain (it is effectively a gift from the parent)

[Marek Muc]

exIFRS is back? are my eyes deceiving me?

[JRSB]

After a mere 537 days... you have quite a back catalogue to read through exifrs!

[exIFRS]

My "I" key was broken so I could only write FRS and that would just be confusing.

[Marek Muc]

[Leo]

Hi ExIFRS, it's been a while, good to see your post! The initial assessment as whether its classified as equity or liability it's not that straight forward. If I refer to the standard, another entity's equity instrument is a financial asset, thus, issuing equity instruments in exchange of another financial assets, that make itself to liability.

However, If I apply the decision tree (see picture in the chat above), it seems that the second question is No, so should be Equity. that's where I'm a little bit confused.

Is there a case that could be equity in Sub? Understand that it's it's fixed for fixed at the conso level, it's equity from the perspective of the group.

[exIFRS]

Thanks Leo. Honestly I don't see how you even get to Q5. Your answer to Q1 surely has to be yes. You have a liability as per 32.11(a) You have to either hand over cash or a financial instrument (shares in the parent). Either of these is "unfavourable" as given the choice you would rather not do either.

As for Q5, it comes only comes into play if you are certain you don't have a financial liability. Para32.16 repeats the requirements from 32.11(a) at 32.16(a), basically are you doubly sure? In most transactions you are going to see this is because it is a form of fixed share transaction or compound or share-based payments. However, from time to time you may have a parent (particularly if the own 100%) who "loans" a subsidiary money with no interest, and no requirement to every pay it back, you treat this as an equity transaction, even though no shares have changed hands.

[Leo]

that's clear thanks exIFRS.

I'm always confused about the term "unfavourable". You said "Either of these is "unfavourable" as given the choice you would rather not do either." I don't see what unfavourable really means, do you have a practical example? Many thanks

[Marek Muc]

Think of "cash" as including cash and any other financial assets. Also, the shares of another entity are considered "other financial assets". Therefore, in this context, you can bypass the second condition that touches on unfavourable terms.

[Leo]

HI ExIFRS:

Just following up on this matter, and considering the entries you suggested, as follows:

Dr Liability to third party
Cr Liability to A (to be settled through provision of cash or some other resource)

Alternatively
Dr Liability to third party
Cr Gain (it is effectively a gift from the parent)

I guess "Liability to third party" is in the form of cash paid by third party in exchange of the prefs issued by the parent, so that would be in entity B:

Dr Cash
Cr Liability to parent A

Or

Dr Cash
Cr Gain (gift from the parent)

Now, is there a possibility, that if it's a gift, it's considered as a capital contribution in entity B instead of a gain in the P&L. The problem is capital contribution is an element of equity so may not be possible?

[Leo]

Just adding to my last comment, I think it's still possible to treat it as a capital contribution because the initial journal entry is:

Dr Cash
Dr Liability to third party

Only if the parent gives nothing in exchange then, a second entries would be posted as follows:

Dr Liability to third party
Cr Capital contribution

So, the financial liability assessment was done in the first journal entries and is separate from the second entries.