Many businesses will be looking at ways of strengthening balance sheets with the introduction of equity.
One solution is a share issue but it is important to ensure that they are classed as equity.
The classification of preference shares in the financial statements of the issuer depends on the terms and rights attached to the shares with regards to redemption and dividends. The classification criteria are set out in FRS 102 section 22 – Liabilities and Equity.
Preference shares are likely to be recognised as a liability when:
- they carry fixed dividend rights where there is a contractual obligation to deliver cash
- they provide for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date
- they give the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount.
The absence of terms stated above is likely to indicate that preference shares may be classified as equity.
Whilst the mandatory nature of dividends or mandatory redemption for cash at the option of the holder indicates that the shares are likely to be classified in part or wholly as a liability, an exemption exists which allows certain instruments that contain an obligation to deliver a pro rata share of net assets only on liquidation to be presented as equity even though they meet the definition of a financial liability. This exception is set out in FRS 102 paragraph 22.4. An example of mandatory dividend may include preference shares with a fixed (and/or cumulative) coupon and those which require a mandatory distribution of a percentage of the profits of the company.
The terms of a preference share may also be set such that it contains both equity and liability elements (ie a compound instrument). In such cases, it is necessary to identify the liability and equity components and account for each separately.
Below is a summary of the recognition and accounting treatment as a quick reference:
| Principal | Dividends | Treatment | |
| 1 | Non-redeemable or redeemable at issuer’s discretion | Discretionary | The instrument is an equity instrument as the entity has no obligation to deliver cash or another financial asset.
Any dividends are shown as a distribution of profit. |
| 2 | Non-redeemable or redeemable at issuer’s discretion | Non-discretionary | 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, ie 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. | |||
| 3 | Redeemable at a fixed date or at the holder’s option | Non-discretionary | The instrument is a financial liability as the entity cannot avoid the outflow of cash. |
| The instrument is recognised at the transaction price, including any transaction costs. Subsequent measurement is at amortised cost using the effective interest method. | |||
| The interest expense on the liability element will be calculated using the effective interest method and charged to profit or loss each year. |
This article has been shared from ACCA In Practice, to whom copyright belongs. Whitefield Tax are an ACCA Member Firm