The classification of financial instruments as either debt or equity has significant implications for the presentation and measurement on the balance sheet and income statement. This article outlines the various factors you should consider when making your assessment.
The classification of financial instruments as either debt or equity is an important area in financial reporting under International Financial Reporting Standards (IFRS).This determination has significant implications for the presentation and measurement of these instruments on the balance sheet and income statement.
Judgment is required to assess the financial obligation of the issuer.
Key features of the liability and equity are
Features of a liability:
- Obligation to pay cash
- Mandatory redemption
- Puttable instruments @ net asset value (NAV)
- Only a conditional right to avoid
- Indirect obligation
- Settled in a variable number of shares
- Contingent settlement
Features of equity:
- Discretion over cash payments (i.e. no obligation)
- Fixed amount of cash for a fixed amount of shares – the fixed-for-fixed criteria
- Not dependent on:
- Ability to make distributions
- Intention to make distributions
- Negative impact on ordinary shares
- Amount of issuer’s reserves
- Expectation of profits for the period
Key clauses to assess when analysing debt vs equity issues
Dividend or Interest Rights
One key factor in this classification is the presence of dividend or interest rights associated with the instrument. However, it is important to note that the nomenclature of 'dividend' or 'interest' alone no longer determines whether it should be classified as debt or equity.
Mandatory Periodic Dividend or Interest Payable:
When an instrument carries a mandatory periodic dividend or interest payment, it implies a fixed financial obligation on the issuer. However, the mere presence of such payments does not automatically classify the instrument as debt.
The determination of whether it should be classified as debt or equity requires careful evaluation of the terms and conditions, taking into consideration other factors such as redemption rights and other relevant contractual provisions.
Discretionary Dividend or Interest:
In some cases, an issuer may have the discretion to pay dividends or interest to holders of the instrument. These discretionary payments do not create a fixed financial obligation.
Consequently, such instruments are typically classified as equity. The issuer has the flexibility to determine the timing and amount of dividends or interest payments, subject to legal and regulatory restrictions and the availability of distributable reserves.
However, if the dividends are cumulative, then it may have additional implications in determining the appropriate classification of the instrument.
Dividend or Interest Contingent upon the Occurrence of Certain Event:
Certain instruments may include dividend or interest payments contingent upon the occurrence of a specific event. The occurrence of this event triggers the financial obligation of the issuer to make the payment.
Again, the classification of these instruments as debt or equity requires careful analysis of the nature of the contingency and its impact on the financial obligation. If the event is genuine and creates a fixed financial obligation, the instrument may be classified as debt.
Redemption Rights
In addition to dividend or interest rights, the redemption features of an instrument play a significant role in its classification as debt or equity. The following redemption rights should be considered:
Mandatorily Redeemable at a Fixed Date:
If an instrument contains an obligation for the issuer to redeem it at a predetermined date, it generally indicates a financial liability and thus suggests classification as debt. The fixed redemption date creates a contractual obligation for the issuer to repay the principal amount to the holder.
Redeemable at Investor's Discretion:
In some cases, the investor may have the right to redeem the instrument at their discretion. This feature suggests debt classification since the issuer does have an unavoidable obligation to redeem the instrument if the investor chooses to seek redemption which the issuer cannot control.
Redeemable at the Issuer's Discretion:
When the issuer has the right to redeem the instrument at their discretion, the classification depends on the nature of the discretion.
If the discretion is substantive and provides a genuine option for the issuer to avoid redemption, the instrument may be classified as equity. However, if the discretion is illusory and the issuer is likely to exercise it, the instrument may be considered a financial liability (debt).
Illustration of liability vs equity classification under various redemption and interest scenarios
Redemption of principal: Non redeemable
| Payment of dividends (assume all at market rates) | Discretionary | Non-discretionary |
| Type of instrument | Equity | Liability with an embedded call option derivative |
| Reason | There is no contractual obligation to pay cash. An option to redeem the shares for cash does not satisfy the definition of a financial liability. Any dividends paid are recognised in equity | Liability component equal to the present value of the dividend payments to perpetuity. Assuming the dividends are set at market rates, the proceeds will be equivalent to the fair value (at the date of issue) of the dividends payable to perpetuity. Therefore, the entire proceeds are classified as a liability. In addition, because the entire instrument is classified as a liability, the issuer call option to redeem the shares for cash is an embedded derivative (an asset). |
Redemption of principal: Mandatorily redeemable at a fixed or determinable amount at a fixed or future date
| Payment of dividends (assume all at market rates) | Discretionary | Non-discretionary |
| Type of instrument | Compound | Liability |
| Reason | Liability component is equal to the present value of the redemption amount. Equity component is equal to proceeds less liability component. Any dividends paid are related to the equity component and are recognised in equity. If any unpaid dividends are added to the redemption amount, then the whole instrument is a financial liability. | The entity has an obligation to pay cash in respect of both principal and dividends |
Redemption of principal: Redeemable at the holder’s option at some future date
| Payment of dividends (assume all at market rates) | Discretionary | Non-discretionary |
| Type of instrument | Compound | Liability with an embedded put option derivative |
| Reason | Liability component is equal to the present value of the redemption amount. Equity component is equal to proceeds less liability component. Anydividends paid are related to the equity component and are recognised in equity. If any unpaid dividends are added to the redemption amount, then the whole instrument is a financial liability. | There is a contractual obligation to settle in cash for both the principal and dividend components. Additionally, since the entire instrument is classified as a liability, the embedded put option to redeem the shares for cash is an embedded derivative. It is pertinent to note that the embedded derivative may require separation unless the exercise price of the option approximates the instrument's amortised cost at each exercise date. |
Conclusion
Determining whether a financial instrument should be classified as debt or equity under IFRS requires careful judgment, considering various factors beyond the legal form. Evaluating the existence of obligation of the issuer is crucial in classifying instruments and determining the appropriate accounting treatment under IFRS.
