What do you think? Are preference shares debt or equity? How should they be recognised in the Balance Sheet?
According to IAS standards, a liability is:
"a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits."
and equity is:
"the residual interest in the assets of the entity after deducting all its liabilities."
So, to determine whether a particular instrument represents an equity or a liability, one must first determine whether a clear, PRESENT obligation exists. If yes, then the transaction is a liability. If no, the transaction may then represent equity. On occasion, a transaction may be made up of a hybrid instrument in which both a liability and an equity component exist. In this case, the liability portion is measured and deducted from the total consideration. The remainder is the equity component.
It is useful to discuss the definition of a preference share.
A preference share is a security issued by a firm in order to raise capital as an alternative financing option to ordinary shares and debt financing. It has features similar to that of equity instruments in that usually it pays dividends to that holder, however there are no voting rights attached. It ranks higher than ordinary or common stock in payment of dividends and capital in the event of liquidation, however it ranks lower than bonds and other contractual debt agreements. Various types of preference shares exist including convertible; participating; redeemable and irredeemable; as well as cumulative and non-cumulative to name a few.
Convertible preference shares: the holder of these shares has the option to convert his shares into a set number of ordinary shares at a point in time in the future.
Participating preference shares: the holder has the opportunity to receive additional dividends and "participate" in the distribution of profits to ordinary shareholders if the firm has reached certain financial goals. The holder will receive their usual dividend according to the terms of the contract.
Redeemable preference shares: these shares are liable to be redeemed at either a fixed point in time of at the firm's or holder's discretion.
Irredeemable preference shares: these are preference shares which are issued for an indefinite period of time, similar to the issue of ordinary shares and will only be redeemed upon winding up or liquidation of the company. The holder may only transfer his stock through sale on the secondary market i.e. stock exchange.
Cumulative preference shares: unpaid dividends accumulate and are paid at a later date e.g. if the company is unable to pay the preference dividend in year 1 due to insufficient available funds, the dividends for year 1 and year 2 will then be paid at the end of year 2 or whenever the company has the means to pay them.
Non-cumulative preference shares: as opposed to cumulative preference shares, these dividends do not accumulate. If unpaid, they lapse and are not made up in subsequent years.
The treatment of preference shares as either debt or equity is therefore not a simple decision. It depends on the rights attached to those shares and the terms of the contractual arrangement.
Redeemable and cumulative preference share are often treated as debt as the dividends are guaranteed and the holder has a right to those dividends and the redemption of their capital. This is assuming that the right to the dividend and/or capital is at either a fixed period in time or at the discretion of the shareholder.
If the company has discretion over the payment of dividends and/or the repayment of capital, then the shares should form part of shareholder's equity as no present obligation exists under which the company must make payments.
Irredeemable preference share, for example, would generally be treated as equity.
It does get a lot more complicated when share are made up of a combination of "types" e.g. irredeemable, cumulative preference shares. In this case, the dividends represent a contractual obligation as, if unpaid, roll over to the following year. The company has no discretion over their payment. This is a debt component and in this case would be measured as the present value of a perpetuity. The fact that they are irredeemable, however, shows that the holder has no control over the redemption of those shares. The represents an equity component. In this case, the debt portion would be measured and deducted from the consideration paid. The remainder would be recognised as the equity component. This is called a hybrid instrument.