Preference shares – Debt or Equity?

 

With our deteriorating business environment and increasing insolvencies, businesses are looking to obtain the cheapest finance possible. One very common type of financing that is used is the issue of preference shares. The problem that always raises its head with these is how does one classify preference shares? Is it debt or equity, or both and if so how should the allocation be determined?

One always evaluates the classification of a financial instrument on initial recognition, taking into account the substance (not just the legal form) thereof. The substance of the terms and conditions determines the classification based on the definition of a financial liability and an equity instrument in accordance with the International Accounting Standard 32 Financial Instruments: Presentation (“IAS 32”). If there are elements of the instrument that meet the definition of a financial liability and other elements that meet the definition of an equity instrument, the instrument is considered a compound financial instrument with these components or elements accounted for and classified separately.

A financial liability is basically defined in paragraph 11 of IAS 32 as a contractual obligation to deliver cash or another financial asset. To illustrate, where preference shares require mandatory* redemption by the issuer, this means that the issuer has to repay the capital or “principal” moneys borrowed on the issue of the preference share. There is clearly a requirement to deliver cash and the instrument would definitely have a liability component.  Where the preference shares require dividends or “coupons” to be paid every year (whether accumulated or not) there is also a requirement to deliver cash and, again, the instrument would have a liability component.

An equity instrument is defined in that same paragraph as “any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities.” So, in contrast to the illustrations above, if the instrument does not require mandatory redemption, dividends or coupon payments and it is up to the directors whether or not they redeem the instrument or pay a dividend (usually termed “discretionary”), there is no obligation to deliver cash and there would be no liability component, the whole instrument would then be classified as an equity instrument.

What is important to note is that one must always first calculate the liability component of a preference share and, as per its definition, allocate any remaining portion of its initial fair value, to equity where there is an equity component.

The liability component is calculated as the fair value of a similar liability that does not have an associated equity component.  The fair value of the liability component is determined as the present value of the mandatory dividend and capital payments, discounted to present value at a market-related interest rate.