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 classified as a financial liability, because it would seem that the issuer lacks the unconditional right to avoid delivering cash or another financial asset to settle an obligation. On the other hand, if the answers are all negative, and there is thus no mandatory payment clause in the contract, then this may give rise to an equity classification because the entity can delay payment upon liquidation. In this latter case, there is no contractual obligation to deliver cash or another financial asset.
If the answers are a mixture of yes and no, then the classification will vary by case.
When preference shares are non-redeemable it is harder to categorise them from their initial application. From my experience, it's generally understood that, as soon as the issuer is obliged to settle the instrument in cash on liquidation, financial liability can be classified. But this is not always a definitive trigger.
Yet another factor that confuses the process is that contracts are not standardised, nor are they tailored to companies' individual business needs. Therefore, their terms and conditions could deviate from those governing the common cases described above and thus mean a different categorisation.
It is problematic that there is no standard application guide for IAS 32. One must examine the details of the contract deeply before deciding on the classification of a financial instrument, since even a tiny detail could cause a change of direction. Hybrid instruments are another story altogether which is why, for simplicity's sake, we have dealt with a more mainstream instrument in this article.
For more insights on IAS 32, read this article on the classification of financial assets as equity.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.