Question

Cherry Ltd. had the following financial instruments transactions during 2019:

1. Cherry signed a contract with Green Ltd. in October that requires Cherry to deliver its ordinary shares equal in value to HK$1,000,000 on 1 February 2020. The market price of the ordinary share on 31 December is $8 per share. [4 marks]

2. Cherry issued a share option on 1 September to its employees that entitled them to buy 1,000,000 ordinary shares at an exercise price of $10 each in 6-month time. There is a premium of $1 which employees must pay to purchase their option right. All employees immediately pay their $1 premium and take up the share option. The market price of the ordinary share on 31 December is $8 per share. [3 marks]

3. Cherry issued cumulative preference shares, which would be mandatorily redeemable for cash in 5 years, but the dividends would be payable as part of the redemption amount at the redemption date. [3 marks]

Required:

Determine whether these financial instruments should be classified as a financial liability or an equity instrument of Cherry Ltd. Give reasons for your answer.

Answer 1

IAS 32 Financial Instruments: Presentation categorizes Financial liability and Equity instruments. Financial liability is a liability if it is expected to be settled in a net cash or another financial asset through a contractual obligation. This also contains a contractual obligation to receive net cash other than the time of liquidation.

On other other hand equity instruments has residual interest in the net assets of the company at the time of liquidation.

On the basis of above guidance from IAS 32, we can categorize between equity instruments and financial liability.

(1) The Cherry Ltd. is issuing equity instruments in exchange for a consideration. By applying to the shares, Green Ltd. will be the shareholder of the Company and will be entitled for net assets at the time of liquidation. Here the Company is exchanging cash by issuing a fixed no. of own equity shares. Hence this transaction is an equity instrument for the Company.

(2) Here the Company is granting share options to employee as part of their remuneration package. It's like an equity settled share based payment transaction and the Company must alot employee their own equity shares. So this will increase equity in the Company and therefore it is an equity instrument.

(3) In this case the preference is having a mandatory redemption. So the Company has to pay cash at the redemption date and not equity instruments. There is no contractual obligation to deliver equity instruments, so preference shares is a financial liability for the Company and not equity instruments.