Question

Tea Ltd is a public company whose common shares are traded in the stock market. Tea recently issued various financial instruments to the public, as described below.

(a) 7% convertible bonds with a face value of $1,000 and maturity date on December 31, 2027. Each bond can be converted into whatever number of Tea’s common shares such that the value of the common shares which the holder receives from conversion is equal to $1,500.   

2. 5% convertible, cumulative, redeemable preference shares. Each preference share can be converted into 5 of Tea’s common shares at the conversion price of $10 per common share. The conversion period is from January 1, 2022 to June 30, 2026. At the date of issue of the convertible preference shares, Tea’s common shares were traded at $50 per share.

If the preference shares are not converted by June 30, 2026, it will be mandatorily redeemed on July 1, 2026 at the redemption price of $300 per share.   

3. 2% perpetual bonds (bonds with no maturity date which pay a stream of interest forever as long as the issuer still exists). The bonds entitle the holders to a 2% interest to be paid annually in arrears on December 31. In addition, the holders can receive the repayment of principal when the issuer (Tea) liquidates in the future.   

Required: Discuss the classification of the financial instruments above.

Answer 1

As per IAS 32 on Presentation of Financial instruments, financial instruments would be classified as a financial liability or an equity based on the substance of the contract. IAS 32 defines a Financial liability and Equity as follows:

A Financial liability is any liability that is:

• a contractual obligation:
  • to deliver cash or another financial asset to another entity; or
  • to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or
• a contract that will or may be settled in the entity's own equity instruments and is
  • a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity's own equity instruments or
  • a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments. For this purpose the entity's own equity instruments do not include: instruments that are themselves contracts for the future receipt or delivery of the entity's own equity instruments; puttable instruments classified as equity or certain liabilities arising on liquidation classified by IAS 32 as equity instruments

Further, an Equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. An instrument would be classified as equity instrument, only if a fixed number of its own common shares are issued for a fixed consideration. The Fixed-for-fixed criterion should be met, for an instrument to be classified as an equity instrument. Otherwise, it would be classified as a financial liability.

Compound financial instrument is a non-derivative financial instrument that contains both a liability and equity component.

In the instant case:

(a) The bonds can be converted into whatever number of Tea’s common shares such that the value of the common shares which the holder receives from conversion is equal to $1,500. A non-derivative contract, involving the issue of variable number of an entity's own equity instruments is a financial liability, as the fixed-for-fixed criterion is not met.  Hence, the aforesaid bonds would be termed as a financial liability.

(b) In the instant case, the the preference shares would be converted into Tea's equity shares. In the event of the holder not exercising the conversion option, the preference shares would be redeemed at a pre-determined price.

Given that the preference shares can be  converted into Tea Ltd's common shares, these bonds effectively comprise of 2 components:

       i) A financial liability, i.e., Tea Ltd's obligation to potentially redeem the preference shares in cash, and

       ii) An equity instrument, i.e., the holder's right to receive dividends if declared and call for fixed number of common shares of Tea Ltd.

Hence , the aforesaid preference shares would be classified as a compound financial instrument.

(c) In the instant case, the bonds would be a financial liability, given the contractual obligation of Tea Ltd to pay interest (cash) perpetually till the time of its liquidation.