Module 6 : Financial instruments
Redeemable Preference Shares
If you’re studying CPA Financial Reporting and up to Module 6 – Financial instruments… you’ll know it is a complex area at the best of times. In this blog, I have pre-empted some common questions I receive from KnowledgEquity students on the topic of classifying redeemable preference shares.
Redeemable preference shares can be classified as equity, a financial liability or a combination of the two. The rule to determining the correct classification is very simple. You need to consider the ‘essence’ of the transaction and which party is carrying the risks and rewards. If the issuer of the shares carries the risks and rewards, then it would be a financial liability in the records of the issuer. If the holder of the shares carries the risks and rewards, then it would be an equity instrument in the records of the issuer.
Consider the following example:
I issue 100 redeemable preference shares each worth $100. This means that I get $10,000 (100 x $100).
How would you classify this under the following situations?
- The shares are redeemable after 3 years.
- The holder has the option to convert to a variable number of ordinary shares so that the FV on conversion is equal to the issue price of the preference share.
- The holder has the option to convert to 3 ordinary shares for each preference share.
The answers are as follows:
Situation 1 – The shares are (in essence) a loan. The holders gave me $10,000 and it will be redeemed in 3 years, meaning that I will have to pay it back to the holders of the preference shares. So there is an obligation on me to pay back that 10,000. Therefore, this should be treated as a financial liability.
Situation 2 – In this instance the holder is not at risk because the holder will get FV equal to what he or she paid me, when those redeemable preference shares were purchased ($100 per share).
So, if the ordinary share price is 2 cents, then the holder will get 5,000 (100/0.02) ordinary shares.
If the ordinary share price is $20, the holder will get 5 ordinary shares (100/20).
So whether the ordinary shares perform well or badly, it does not affect the holder. Since the holder will still get $100 dollars worth of ordinary shares because the shares are variable to maintain the FV of the redeemable share price at issue date.
In this situation, the issuer (me) carries the risks. If the ordinary share price drops, I will have to pay more ordinary shares and if the price is good, then I would pay less ordinary shares. This is a liability with an equity component. Liability because I am carrying the risks but it has an equity component because of the conversion into ordinary shares option.
Situation 3 – In this third situation, the holder can convert for a fixed number of shares. That is, only 3 ordinary shares for every preference share.
If the ordinary shares are worth 2 cents, the holder will only get 6 cents (2 cents x 3) even though he paid $100 for a redeemable share.
If the ordinary shares are worth $120, then the holder would get $360 ($120 x 3) even though he only paid $100 for the redeemable share. In this instance, the holder is carrying the risks and rewards. Hence, for the issuer, this is an equity instrument with a liability component.
To help you classify redeemable preference shares, you can use my KnowledgEquity flowchart here: Classification of redeemable preference shares 2017.
It is as simple as that. If you use my flowcharts in Module 6, you cannot go wrong!
In KnowledgEquity’s Financial Reporting Support for your CPA course, there are short explanatory videos, practice exams, module quizzes, webinars and flowcharts to help you embed your knowledge and be able to understand the subject. These are available as part of our Financial Reporting courses. Once you have concepts like these embedded in your knowledge data bank, you will be ready to take on your CPA exam!