Presentation of Financial Instruments

Presentation of Financial Instruments - Liability vs. Equity

Because investors rely on accounting information to make their investment decisions, it is important for accounting information to present items according to their substance, and not merely their legal form. Some financial instruments have the legal form of equity but are in substance, liabilities.

Under IFRS the issuer should classify the instrument, or its component parts, as a financial liability or equity in accordance with the ‘substance’ of contractual arrangement on initial recognition, and the definitions of financial liability and an equity instrument. The classification is made at the date of issue and is not revised later.

The critical feature in differentiating a financial liability from an equity instrument is the existence of a contractual obligation on one party to the financial instrument (the issuer) either to deliver cash or another financial asset to the other party (the holder) or to exchange another financial instrument with the holder under potentially unfavorable conditions.

Note that a restriction on the ability of the issuer to satisfy an obligation, such as lack of access to foreign currency to repay a foreign currency loan, does not negate the existence of liability.

Scenario: An obligation to pay dividends

IStaR Ltd. issues 100,000 preference shares with a fixed rate of dividend @ 7% at par for INR 1 million. According to the terms of the contract, the directors of IStaR Ltd. have to compulsorily pay dividend following the date of issue.

Solution:

In substance, ‘preference share’ issue is a liability as IStaR Ltd. has a contractual obligation to deliver cash to the holder of preference shares by way of dividends. In short, only if the distributions to the holders of preference shares, whether cumulative or non-cumulative, are at the discretion of the issuer, then the shares are equity instruments.

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