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Any Answers Answered: FRS 25/IAS 32

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11th Apr 2011
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In a recent Any Answers thread, Monsoon asked about the treatment of preference shares in accordance with the rules in FRS 25 'Financial Instruments: Presentation' (IAS 32). In response, Steve Collings presents an overview of the key points.

The provisions in both FRS 25 and IAS 32 are identical. Monsoon specifically asked whether the preference should be shown as current or long-term liabilities.

In reply Johnt27 correctly pointed out that the treatment as debt or equity depends on the rights attached to them and essentially if the shareholder has a right to cash in their preference shares, the treatment is debt as opposed to equity. IAS 32 requires the classification of preference shares  to be based on an assessment of the contractual arrangements and the definitions of a financial liability and an equity instrument. 

The area of financial instruments fills accountants with dread, particularly issues such as compound financial instruments (which are more common than people think). This article will look at the issue of preference shares and compound financial instruments, offering examples of how such transactions are accounted for.

We can summarise the treatment of preference shares as follows:
 

Redemption of shares:
Payments of dividends:
Recognition in Accounts As:
Non-redeemable
Discretionary
Equity
Non-redeemable
Non-discretionary
Liability
Redeemable at issuer’s option at some future point in time
Discretionary
Equity 1
Redeemable at issuer’s option at some future point in time
Non-discretionary
Liability plus an embedded call option derivative 2
Contractually redeemable at a fixed/determinable amount at a fixed/determinable date
Discretionary
Compound financial instrument 3
Redeemable at holder’s option at some future point in time
Discretionary
Compound financial instrument
Redeemable at holder’s option at some future point in time
Non-discretionary
Liability plus an embedded put option derivative
1 In this case there is no contractual obligation to pay the holder of the shares cash. Options to redeem the shares for cash do not actually meet the definition of a financial liability. As a result, any dividends paid on these preference shares would be recognised in equity.
2  The entire proceeds would be classified as a liability because the dividends will be set at market rates and as such the proceeds will be equivalent to the fair value, at the date of issue, of the dividends payable to perpetuity. In respect of the issuer call option to redeem the shares for cash, this would be classed as an embedded derivative which may have to be separated using ‘split accounting’ unless the option’s exercise price is approximately the same on each exercise date to the amortised cost of the instrument.
3  Liability portion of the compound instrument is equal to the present value of the redemption amount. Equity amount is equal to the proceeds less liability portion. See later in the article for an example of how to calculate these. Dividends related to equity component are recognised in equity.
You can basically see from the above table that where there is an obligation to pay cash – either on redemption or by way of dividend (interest), preference shares are treated as a liability. 
In respect of preference shares, dividends paid to the holders of the preference shares are not actually taken to dividends via reserves; these are instead treated as finance costs (interest) to the holders of the preference shares.
Illustration
Preference shares are issued to shareholders that pay 10% dividends on an annual basis.
The preference shares contain an obligation to pay cash to the preference shareholders and they should be classified as a financial liability, disclosed as current/non-current dependant on the contractual terms. The 10% dividends should be recognised as a finance cost in the profit and loss account.
Compound financial instruments
A compound financial instrument is a financial instrument which contains a mixture of both debt and equity. Here the problem child is the recognition of the debt portion and the amount to be recognised in equity, so I will illustrate with an example as follows:
Example 1
On 1 April 2006 an 8% convertible loan note with a nominal value of £600,000 was issued at par to Company A Ltd. It is redeemable on 31 March 2010 at par. Alternatively, it may be converted into equity shares on the basis of 100 new shares for each £200 worth of loan note.
An equivalent loan note without the conversion option would carry interest at 10%. Interest of £48,000 (£600,000 x 8%) has already been paid and included as a finance cost in profit and loss.
Present value rates are as follows:
                                                                                                                      Present Values
End of Year
8%
10%
1
0.93
0.91
2
0.86
0.83
3
0.79
0.75
4
0.73
0.68
In this example, there is an option to convert the shares into equity but there is also an obligation to pay cash to the loan note holders (8% interest). There is also the issue that an equivalent loan note without the conversion option would have carried interest at 10%. The loan notes attract interest at a rate of 8% but as it is only an option, in order to calculate the correct amounts to be recognised in debt and equity we have to discount the entire cash flows using a rate of 10%. Using this information the debt and equity amounts can be calculated as follows: 
8% Interest (£600k x 8%)
Factor at a rate of 10%
Present Value (rounded down)
Year 1 2007
48,000
0.91
43,600
Year 2 2008
48,000
0.83
39,800
Year 3 2009
48,000
0.75
36,000
119,400
Year 4 2010 (redemption)
648,000
0.68
440,600
Amount to be recognised as a liability
560,000
Initial proceeds
(600,000)
Amount to be recognised as equity
40,000
Convertible Debt
There are lots of instances in real-life where companies issue financial instruments to other companies which contain an option to enable the loans to be converted into equity shares. This is particularly common in today’s ‘climate’ where such options are being exercised.
Example 2
Company A Ltd received a loan from Company B Ltd amounting to £100,000 in 2006, the terms of which required redemption in 2011. Given the economic difficulties, it was apparent that Company A Ltd was unable to repay the loan at the agreed redemption date. Company B Ltd accepted £100,000 of equity shares in full and final settlement. 
No gain or loss will arise on this transaction as the debt is simply transferred to equity (assuming no premium on the issue of the shares) by:
DR loans              £100,000
CR equity             £100,000
Any premium on the share issue would be transferred to a share premium account.
 Figure 3
Same facts as above, but consider if the fair value of the equity shares issued in exchange were £75,000. In this instance there would be a gain arising on the settlement of the debt and the entries would therefore be:
DR loans             £100,000
CR equity              £75,000
CR P&L                  £25,000 (gain on elimination of debt)
Conclusion
The issue of financial instruments is a very complex area, but where preference dividends are concerned it is important to scrutinise the rights attached to them. In general where the shareholder has an obligation to receive cash (either through redemption or interest) then treat as liability. If the decision to redeem the preference shares or pay dividends is discretionary, then they become equity.
Steve Collings is the audit and technical partner at Leavitt Walmlsey Associates and the author of ‘The Interpretation and Application of International Standards on Auditing’ (Wiley March 2011).
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Image is of a pin up style woman in a red dress with some of her skirt caught in the filing cabinet. She looks surprised.
By Monsoon
12th Apr 2011 11:01

Thanks Steve

Hi Steve,

Thanks so much for taking the time to look at this in detail. Who'd have known it was such a complex question! I have saved this for future reference ;)

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By shrigley
26th Jul 2016 15:38

Hello Steve, I recently asked a similar question but the facts of mine are slightly different; namely that the pref shares have issued/alloted but are unpaid. They appear in this instance as part of the paid up equity of the company. Can this be correct?

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