The Accounting Standards Board (Board) received an enquiry, where in the Board’s guidance have been sought on the accounting treatment of preference shares in a specific fact pattern.
The fact pattern is summarized below:
(a) A company issued non-voting non-participatory, irredeemable convertible and listed preference shares of Rs. 10 each carrying fixed cumulative preference dividend @ Rs. 10 per annum. The declaration of dividends by the company is mandatory every year. However, the payment of dividend might be somehow late depending on the availability of sufficient cash.
The company shall also have a firm option to convert preference shares into ordinary shares of Rs. 10 each of the company on September 30 of any calendar year up to 2031 in the ratio of 01 ordinary share of Rs. 10 each for 02 preference shares. The preference shares are not redeemable.
(b) Based on above fact pattern the enquirer submitted following queries:
▪Whether preference shares are equity instrument or compound instrument?
▪Whether fixed cumulative preference dividend @ 10% per annum trigger the instrument as compound?
▪If answer to above is yes, how the liability component will be computed?
▪How the liability component will be derecognized / transferred to equity over the term of preference shares i.e.10 years?
▪At the time of issuance of ordinary shares (1 ordinary share of Rs. 10 for 2 PS of Rs. 10 each) whether share premium will be recorded.
▪How current portion of non-current financial liability component will be computed?
The Accounting Standards Board comments and conclusion1.In accordance with IAS 32, Financial Instruments: Presentation, preference shares can be classified as equity, liability, or a combination of the two (i.e. compound instrument)
Classification of preference shares into equity, liability or compound instrument is based on an assessment of the substance of the contractual arrangement and by applying the definitions of financial liability and equity instrument.
2.In the enquired fact pattern, the issuer’s option of converting the non-redeemable preference shares into its ordinary shares within a specified period of time is ‘equity’ component. However, non-redeemable preference shares may contain liability components based on the terms of the contractual arrangement.
3.The preference shares holder’s right to receive dividend (@ Rs. 10 per share) requires consideration to determine whether there is any liability component. The principle for determining liability component is outlined below, and issuer should apply this guidance to the specific contractual arrangement:
a)If the distribution of cumulative dividend is at discretion of the issuer, then non-redeemable preference shares are equity instruments. This is because the discretion gives issuer an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation of dividend.
b)If the distribution of cumulative dividend is not at the discretion of issuer and holder has right to receive the dividend then cumulative dividend is a financial liability. This is because the issuer does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation of dividend.
4.In the enquired fact pattern the distribution of cumulative dividend is mandatory (i.e. issuer of preference shares has a contractual obligation to pay dividend and it cannot avoid this contractual obligation). Based on above guidance cumulative dividend on non-redeemable preference shares is a financial liability.
The equity and liability component would make the non-redeemable convertible preference shares a ‘compound’ financial instrument (instrument contains both equity and liability components).
5.As per IAS 32, the accounting treatment of this compound instrument by an issuer would be as follows:
a)The liability component should be recognized at the fair value, calculated by discounting the dividend payments at market rate of a similar liability that does not have an associated equity component.
b)Difference in the proceeds of the instrument issued (i.e. cash received by issuer from the preference shareholders) and the fair value of the liability (calculated as per (i), above) should be recognized in equity and disclosed as per the requirements of the Companies Act.
Subsequent to the initial recognition, if the issuer converts the preference shares into ordinary shares, on date of conversion:
▪The liability (if any) should be derecognized, and equity should be recognized for the with the same amount.
▪The equity under the preference shares should be transferred to the ordinary share equity. The redemption/conversion by issuing ordinary shares may result in a share premium or discount based on the amount of preference shares equity transferred to the ordinary shares equity.
There would be no gain or loss on conversion.
6.Regarding, the classification of financial liability, the amount that is due to be settled in next twelve months, as per contractual terms, would be classified as current liability. The remaining portion of liability would be non-current, in accordance with IAS 1.
(Issued in November, 2022)