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When does debt seem to be equity? - Coggle Diagram
When does debt seem to be equity?
liability
classification as liability can have effects on
reported earnings
debt covenants
gearing ratio
normally results in any payments being treated as interest which will be charged to earnings, and will have impact on the ability to pay dividends
key feature of debt
the issuer is obliged to deliver either cash or another financial asset to the holder
contractual obligation
may arise from requirement to repay principal or interest or dividends
may be established explicitly or indirectly
must be established through the terms and conditions of the financial instrument
for example
any variability in the amount of cash or own equity instruments that will be delivered or received. this will either be financial asset or liability
where a contract requires the entity to deliver as many of the entity’s own equity instruments as are equal in value to a certain amount
holder of the contract would be indifferent whether it received cash or shares to the value of that amount
other factors
to determine if it is a financial liability
is redemption at the option of the instrument holder?
is there a limited life to the instrument?
is redemption triggered by a future uncertain event that is beyond the control of both the holder and issuer of the instrument?
are dividends non-discretionary?
Economic necessity does not result in a financial liability being classified as a liability
equity
classification as equity can avoid all of that but it is seen as being negative if it dilutes the existing equity interest
any contract that evidences a residual interest in the entity’s assets after deducting all of its liabilities
only if
instrument includes no contractual obligation to deliver cash or another financial asset to another entity, and
instrument will or may be settled in the issuer's own equity instruments
For example
ordinary shares, where all the payments are at the discretion of the issuer
preference shares required to be converted into a fixed number of ordinary shares on a fixed date, or on the occurrence of an event that is certain to occur
‘fixed for fixed’ requirement
contract that will be settled by the entity receiving or delivering a fixed number of its own equity instruments in exchange for a fixed amount of cash, or another financial asset
other factors that may result in the instrument being classified as equity
whether the shares are non-redeemable,
whether there is no liquidation date or
where the dividends are discretionary.
Rights issues
when the price is denominated in a currency other than the entity’s functional currency
entity is listed in more than one jurisdiction, or
required to do so by law or regulation
A fixed price in a non-functional currency would normally fail the fixed number of shares for a fixed amount of cash requirement in IAS 32 to be treated as an equity instrument
As a result, it is treated as an exception in IAS 32 and therefore treated as equity.
classification of the financial instrument as either a liability or as equity
based on the principle of substance over form
Two exceptions from this principle
certain puttable instruments meeting specific criteria
certain obligations arising on liquidation
entity must make the decision as to the classification of the instrument at the time that the instrument is initially recognised
The classification is not subsequently changed based on changed circumstances
For example, this means that a redeemable preference share, where the holder can request redemption, is accounted for as debt even though legally it may be a share of the issuer.
determining whether a mandatorily redeemable preference share is a financial liability or an equity instrument
examine
return element
particular contractual rights attached to the instrument's principal
critical feature that distinguishes a liability from an equity instrument
issuer does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation
'Split accounting'
measure the liability and the equity components upon initial recognition of the instrument
The fair value of the consideration in respect of the liability component is measured at the fair value of a similar liability that does not have any associated equity conversion option
The equity component is assigned the residual amount
offsetting financial asset and liability
only when
the entity currently has a legally enforceable right of set-off, and
intends either to settle the asset and liability on a net basis, or
to realise the asset and settle the liability simultaneously
right of set-off must not be contingent on a future event and must be immediately available
must be legally enforceable for all the parties in the normal course of business, as well as in the event of default, insolvency or bankruptcy
Netting agreements, where the legal right of offset is only enforceable on the occurrence of some future event – such as default of a party – do not meet the offsetting requirements
Discussion Paper DP/2018/1 Financial Instruments with Characteristics of Equity
allow the Board to investigate challenges that have been encountered when IAS 32 has been applied in practice
Specifically, it addresses issues relating to the classification of both simple bonds and ordinary shares and the limited disclosures that users are faced with when such financial instruments are used
It is anticipated that the direction of this research project will be concluded during 2020