For Preference Shares, When Is Debt Classified As Equity?

International Accounting Standard (IAS) 32 Financial Instruments: Presentation defines rules for when a financial instrument is to be classified as equity or liability. Its revised version was issued back in 2003 but, in recent years, its instructions for classification have become less and less simple. In this article I will provide some guidance insofar as that is possible, given that case-by-case details can often alter the classification.

The substance over form principle vs. legal form

According to IAS 32, preference shares can be classified as equity, liability, or a combination of the two. The entity must classify the financial instrument when initially recognising it (IAS 32.15) based on the substance over form principle. In general, this principle requires issuers to measure and present the economic impact of the financial instrument and to state its commercial purpose—but it does not oblige them to consider local business laws. This can cause confusion because sometimes local laws call for different classifications than the accounting requirements do.

For example, a preference share that is redeemable only at the holder's request may be accounted for as debt even though legally it is a share of the issuer. This could be because the substance of the terms and conditions requires the issuer to deliver cash or another financial asset to settle a contractual obligation.

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).

Classifying instruments in accordance with IAS 32

Here, the pivotal action is determining whether or not the preference share issuer has to deliver cash (or another financial asset) to the holder. For that you must consider:

Are the shares redeemable at a fixed date? Are the shares redeemable at the option of the holder? Is the issuer obliged to make payments in the form either of interest or dividends? Do the terms and conditions oblige the issuer to distribute a specific percentage of profits? If the answer is yes to all of the above, then the preference shares would most probably be...

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