Preference shares

[Leo]

Hi,

1. A preference shares which gives the issuer the choice either to settle in cash for deliver a variable number of ordinary shares based on the fair value of an ordinary share at conversion date, is an equity instrument or a liability?

My view it's a liability, notwithstanding that the issuer can avoid paying cash, it will be settled by a variable number of shares does not meet the fixed for fixed criterion.

2. A preference shares which gives the issuer the choice either to settle in cash for deliver a fixed number of an ordinary share at conversion date, is an equity instrument or a liability?

My view it's a Equity instrument, because the issuer can avoid paying cash, and it will be settled by a fixed number of shares that meets the fixed for fixed criterion.

In summary, for a preference shares to be treated as an equity instrument, 1. the issuer can avoid to pay cash or another financial asset and 2. the instrument is either not convertible into ordinary shares or convertible into a fixed number of ordinary shares.

Do you agree?

[Ketan Marwah]

Hi Leo,

Would suggest to reconsider your opinion in point 1. If the option to redeem lies solely with the issuer without a contractual obligation, these shares are classified as equity.

As per IAS 32.16, the redeemable preference shares (referred as RPS hereafter) is to be classified as equity if and only if, both conditions (a) and (b) below are met:

(a) The RPS includes NO 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 issuer of the RPS.

(b) If the RPS will or may be settled in the issuer's own equity instruments, it is;

(i) a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or

(ii) a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments.

As per IAS 32.18 (a) , the RPS is to be classified as liability if the RPS provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed date or gives the holder the right to require the issuer to redeem at a particular date and for a fixed or determinable amount.

P.S. However, in some cases, the instrument's legal form can supersede the substance over form principle. For example if a local law, regulation, or the entity's governing charter gives the issuer of the instrument an unconditional right to avoid redemption—in such cases, the instrument could be classified as equity (IFRIC 2.5-8).

[Leo]

What should I reconsider based on what you just sent? Didn't it say that if it's not fixed for fixed, it's not an equity?

[Ketan Marwah]

An instrument is classified as an equity instrument when an entity is obliged to deliver a fixed number of its own equity instruments for fixed consideration, a principle known as the ‘fixed-for-fixed’ criterion whereas in the case you mentioned since the option to redeem lies with the issuer therefore there is no contractual obligation on the issuer. Consequently, F2F test doesn't apply in this situation. You have classified it to be a liability for the issuer but for the reason that there is no contractual obligation on the issuer to deliver cash or variable number of ordinary shares, it should be classified as equity instead.

[Leo]

if they don't deliver cash they will deliver variable number of shares and vice versa

[Ketan Marwah]

Is the redemption/settlement set to take place on a specific date? I am trying to confirm the obligation on the issuer.

[Leo]

Is there a distinction between, "at anytime before and upon maturity" and "at anytime"?

[Ketan Marwah]

The date has to be "determinable" at least if not fixed. Generally speaking, "at anytime before and upon maturity" comes across as a determinable value as against a simple "at anytime" choice of the issuer.
IAS 32.AG27(a): If the contract requires the entity to purchase (redeem) its own shares for cash or another financial asset at a fixed or determinable date or on demand, the entity also recognizes a financial liability for the present value of the redemption amount (with the exception of instruments that have all the features and meet the conditions in paragraphs 16A and 16B or paragraphs 16C and 16D).

To determine whether a preference share is a liability or an equity instrument, the standard definitions should be applied. For instance, if a preference share holder has the option to redeem their shares, or if redemption is mandatory, these shares are considered financial liabilities (IAS 32.18(a)). However, if the option to redeem lies solely with the issuer without a contractual obligation, these shares are classified as equity.

[Leo]

So you are saying, in this case, if it's convertible at anytime by the issuer, it's equity.

[Ketan Marwah]

I conveyed the general meaning that I was able to understand of the term "anytime by the issuer" but it is worth researching the term even more to establish whether there is a contractual obligation upon the issuer to redeem the preference shares or not. As an example, sometime even upon liquidation is definitive and the obligation arises because liquidation either is certain to occur and outside the control of the entity (for example, a limited life entity) as stated in IAS 32.16C.

Anyhow we started the thread with your question where the focus was placed on the form of settlement (fixed/variable) for equity/liability classification but I guess it is clear from our discussion that both the criteria's stated under IAS 32.16 should be fulfilled to classify the FI as Equity.

[Leo]

Thanks Ketan,

the case in this thread, where the issuer has the option to convert the prefs into cash or a variable number of shares anytime, without redemption date, is considered as an equity instrument, even if the issuer chose to convert the prefs one day after the shares are issued.

However, if there is a fixed maturity date, then, it's liability, is that correct?

[Ketan Marwah]

I would almost agree with your understanding with a caveat that the two of us should trudge cautiously on the interpretation of the word "anytime" . If "anytime" could be determined then that would obligate the issuer.

[Leo]

well, in that case, I believe that could be argued either way, which gives the issuer more freedom.

[Leo]

Looking at the definition of an equity instrument under IAS 32, it says:

The instrument is an equity instrument if, and only if, both conditions are met:
(a) no contractual obligation to be settled in cash
(b) if the instrument will or may be settled in the issuer's own equity instrument, it is [...].

In the case here, the issuer has an option to either settled in cash or it's own equity instrument. Even if that is "at anytime", it does not exclude the issuer from a possible settlement in its own equity instrument.

My point is, yes, the issuer does not have the obligation to settle in cash because they have an option to settled in shares. However, point (b) in the definition above does not mention contractual obligation. And it seems that if the issuer "may" settle in its own shares (variable number), than it's not an equity instrument.

Bringing it back to our discussion, I think even it's "at anytime", i.e., the issuer can settled the prefs either in cash or in a variable number of its own shares at anytime, it's still not an equity instrument, because (b) above is not satisfied, i.e., the issuer may settled the prefs in a variable number of its own shares.

Does it make sense?

[Ketan Marwah]

Please refer IAS 32.16(b)(i) where it is mentioned that a non-derivative contract will qualify for equity classification only where there is no contractual obligation for the issuer to deliver a variable number of its own equity instruments. In the stated case, is the entity really obligated to deliver variable number of it'S own shares- remember the choice of settlement is with the issuer anytime it wants to? So, neither does the entity have a contractual obligation to settle in cash nor is it obligated to settle in variable numbers of it's own instruments therefore it makes it an equity classification.

[Leo]

Thanks Ketan.