Question

Question 10

Is there a consequence for reported profit or loss if a particular financial instrument, for example a preference share, is designated as debt rather than equity? Explain the consequences.

note: can you please write between 300-400 words

thank you

Answer 1

Answer Gains and losses on the financial instruments would generally go directly to profit or loss. However, this will be influenced by whether there is an associated hedge that has been designated as a hedge and that has been deemed to be 'effective'.

company issues two type of shares i.e. common (equity shares) and preferred (preference shares). Equity share holders are not mandatory entitled to the fixed dividend unlike the preference shares. They are known as preferred because in case a Company is unable to pay all dividends, claims to preferred dividends will take precedence over claims to dividend paid on equity.

For example, a preference share that is redeemable only at the holder’s request may be accounted for as debt even though legally it is a share of the issuer. This could be because the substance of the terms and conditions requires the issuer to deliver cash or another financial asset to settle a contractual obligation.

However, in some cases, the instrument’s legal form can supersede the substance over form principle. For example if a local law, regulation, or the entity’s governing charter gives the issuer of the instrument an unconditional right to avoid redemption—in such cases, the instrument could be classified as equity (IFRIC 2.5-8).

Classifying instruments in accordance with IAS 32

Here, the pivotal action is determining whether or not the preference share issuer has to deliver cash (or another financial asset) to the holder. For that you must consider:

• Are the shares redeemable at a fixed date?
• Are the shares redeemable at the option of the holder?
• Is the issuer obliged to make payments in the form either of interest or dividends?
• Do the terms and conditions oblige the issuer to distribute a specific percentage of profits?

If the answer is yes to all of the above, then the preference shares would most probably be classified as a financial liability, because it would seem that the issuer lacks the unconditional right to avoid delivering cash or another financial asset to settle an obligation. On the other hand, if the answers are all negative, and there is thus no mandatory payment clause in the contract, then this may give rise to an equity classification because the entity can delay payment upon liquidation. In this latter case, there is no contractual obligation to deliver cash or another financial asset.

If the answers are a mixture of yes and no, then the classification will vary by case.