IndAS 32-Debt or Equity?
A few practical examples
Complex financial instruments – a brief overview
In today’s financial markets, companies are raising monies by issuing many different types of financial instruments. Private equity firms, institutional investors and banks are investing monies in companies through several instruments with varied characteristics. This is largely done in order to protect themselves from the many risks associated with investing in companies. Some of the instruments that we commonly see are compulsorily convertible debentures or preference shares, optionally convertible instruments, optionally or compulsorily instruments with or without coupons, instruments that are repayable or convertible depending on the outcome of contingent events and so on.
Each of these characteristics is extremely important not only from a commercial perspective but also from an accounting perspective. It is imperative to analyse all the terms of the financial instruments in order to determine their impact on the accounting and presentation of the instrument. Some of these instruments may appear to have the characteristics of an equity instrument but may end up getting classified as liability instrument or a compound financial instrument thereby having a significant impact on its accounting and presentation in the financial statements.
IndAS 32 on ‘Financial Instruments: Presentation’ provides guidance on classification of financial instruments into debt or equity.
In this article I have tried to share a few practical examples relating to the classification of financial instruments from an issuer’s perspective and it is not my intention to do a deep dive into the technical aspects of IndAS 32.
IndAS 32 – Basic Principles of classification
- Classification of a financial instrument as a financial liability or as equity depends on the substance of the instrument rather than its legal form. The instrument’s contractual rights and obligations determine the substance of the instrument.
- An instrument which contains a contractual obligation on the issuing entity to deliver cash or another financial asset to the instrument holder is a financial liability.
- Instruments which may or will be settled in an entity’s own equity instruments are classified according to specific criteria – the ‘fixed’ test for non-derivatives and the ‘fixed for fixed’ test for derivatives.
- Instruments possessing the characteristics of both equity and liability classification are compound instruments. The equity and liability components are accounted for separately.
Debt or equity? – A few practical examples
Implications of classification as debt or equity
- Classification of a financial instrument as either a financial liability or as equity has a direct effect on an entity’s financial statements and reported results and financial position.
- If classified as a liability, any payments made by the issuer on the instrument typically results in it being treated as interest and charged to earnings. This may in turn affect the entity’s net worth and also its ability to pay dividends. Any transaction costs are included in the calculation of the effective interest rate and amortised over the expected life of the instrument. The instrument is presented as a liability in the balance sheet.
- If classified as equity, the adverse impact arising out of classification of an instrument as a liability on reported earnings and net worth can be avoided. It also results in the instrument falling outside the scope of IndAS 109 ‘Financial Instruments’, thereby avoiding the complicated ongoing measurement requirements of that Standard. Any distributions made to the holders of an equity instrument are debited directly to equity. Any transaction costs associated with issue of the equity instruments are deducted from equity.
- Therefore, it is clear that the getting the classification right is important as the consequences could be significant.
Let’s look at a few examples!
Example 1 – Redeemable instruments
Entity X issues 1,000 preference shares at face value of INR 100 each. The holder of the shares has the option to require Entity X to redeem the shares at par at any given time. Are these preference shares classified as equity or liability by Entity X?
These preference shares are classified as a liability. This is because Entity X does not have the ability to avoid the obligation to redeem the shares for cash should the holder exercise his option to redeem the shares.
Example 2 – Mandatory dividends on non-redeemable preference shares
Entity Y issues 1,000 non-redeemable preference shares at face value of INR 100 each. These preference shares carry a mandatory dividend of 9% per annum. The dividend is not discretionary and do not include any other equity features. Are these preference shares classified as equity or liability by Entity Y?
