The nature of an instrument is used to determine both its presentation in the statement of financial position and the presentation of related payments or distributions.
In many financing transactions, it is clear that the instrument is either debt or equity, such as common shares or a plain vanilla term loan. However, when the terms differ from the plain vanilla variety the preparer of the financial statements needs to take a closer look to determine the appropriate presentation.
The concept of distinguishing between debt and equity, which is the primary purpose behind International Accounting Standard (IAS) 32, Financial Instruments: Presentation, is often overlooked.
In some cases, what appears to be equity should actually be classified as debt and in other cases the same instrument may contain both debt and equity components (known as hybrid instruments) and each component should be measured and accounted for separately.
The consequences of getting this wrong are clearly significant.
The simplest definition of a financial liability is a contractual obligation to deliver cash or another financial asset to someone else. It also includes a contract that will or may be settled by either: issuing a variable number of the entity’s own equity instruments in exchange for a fixed (meaning non-derivative) obligation; or issuing a fixed number of the entity’s own equity instruments in exchange for a variable (derivative) obligation.
An equity instrument is an instrument that represents an interest in the entity’s residual net assets, which is therefore after deducting all of its liabilities.
Application of this definition can be a thorny exercise. By way of illustration, this article considers some common examples:
Equity that should properly be classified as debt
Some company’s issue instruments that give the holder of the instrument the right to put it back to the issuer for cash or for another financial asset. Such contracts are referred to as puttable instruments. The put is either exercisable at the option of the holder, or is automatically exercised as a result of some future event, such as the death or retirement of the holder.
Consider shares that are held by a member of management, where the shareholder agreement automatically requires the company to repurchase them in the event of the death of the individual. Such a clause is commonly included in shareholder agreements to retain the close ownership of the company by avoiding shares passing to a spouse or other beneficiary of the estate.
The shareholder agreement therefore creates an obligation for the company to deliver cash. The company has no unconditional ability to avoid delivering cash in this case, meaning these shares now meet the definition of a liability. The effect of this treatment is that any dividends paid on those shares are treated as an expense through profit and loss instead of as a distribution out of retained earnings.
Significantly, the instruments are classified as debt even though the triggering event (the death of the holder) has not yet occurred. This could be considered as something of an exception to IAS 10, Events after the Reporting Period, because the actual obligation of the entity to make the payment did not exist at the reporting period.
Instruments that consist of debt and equity components – Hybrid instruments
Many companies issue debt with an added conversion feature which allows the holder to receive a fixed number of shares of the company in settlement of the debt. Such instruments are often used by early stage companies to entice the lender to enter into the financing by also enabling the lender to share in the future growth in the company.
IAS 32 explicitly states that the component parts of a financial instrument must be considered for classification. In this case, the proceeds received are allocated between the liability and the equity components.
Economically, the addition of the conversion feature means the issuer can pay a lower interest rate for the financing because the conversion feature itself has some value to the lender. Therefore, a market interest rate must be identified for a liability instrument that has the same terms (such as maturity, security, and so on) but with no conversion feature. The present value of the cash flows under the convertible instrument discounted with this market interest rate represents the carrying amount of the liability on initial recognition. The difference between this amount and the proceeds received is the equity component. Any costs of issuing the convertible instrument are also allocated between the two components.
Entities without equity instruments and the classification exception
The effect of IAS 32 is, in some cases, to classify all financial instruments as liabilities such that there is no equity presented on the statement of financial position. This can be the case for certain vehicles where the holder of the instrument has the right to put the instrument back to the entity in exchange for cash.
An exception to the definition of a liability exists for puttable instruments and instruments that entitle the holder to a pro rata share of the net assets on a winding up if certain conditions are met.