Question

Explain the factors that determine the classification of redeemable preference shares as either an equity or liability

Answer 1

Preference shares are type of equity shares that contain some preferential rights. The holder of the preference shares is entitled to the preferential rights. The preferential rights include voting rights and dividend payments before common stockholders.

Redeemable preference share is a type of preference share where company issuing the preference shares redeems the shares after a certain period of time that is, the company has the right to buyback the shares.

Redeemable preference shares can be termed as a liability or equity. This depends on the condition for redemption of preference shares.

Redeemable preference shares can be termed as Equity in the following scenarios:

1. If the holder has the option to convert the preference shares at the time of redemption.

- In this scenario the price of the ordinary shares is a factor that affects the classification of preference share as equity or liability. It will be termed as liability if the prices of the ordinary shares decreases as the company will have to pay more number of equity shares at the purchase price of preference shares. It is a liability with equity component.

- In the above scenario, if it is decided that a certain quantity of equity shares will be given to the preference share holder for each preference shares then then it is can be termed as equity with liability component as the change in share price will affect the price of shares given to the preference share holder. Here, if the share price rises then the preference shareholder has an advantage of receiving highly valued shares at the price of preference shares at the time of redemption.

2. If the preference shares are redeemable after certain time period.

In this scenario, the preference shares are a liability for the company as the company has to redeem or buyback these shares, after certain time period and paying regular dividends on the same. This creates a financial liability for the company as it is an obligation for the company to redeem these shares.