Classification of Preference Shares

Facts of the Case:
Redeemable Preference Shares with cumulative dividend issued by company to its Holding Company. Due to losses, company was not able to pay dividend on preference shares and on date of redemption both cumulative dividend as well as share value is outstanding. Holding company is in liquidation also, so no claim is made by holding company on date of redemption.

Issue/Query:
Where this Preference Shares will be shown in Financial Statement as Liability or Equity or both (as determined in subsequent measurement). Accumulative dividend not paid is shown as Contingent Liability. Whether the preference shares not redeemed will also be shown as contingent liability?

Response:
1. Preference Shares will be presented as financial liability at amortised cost

2. Neither the accumulated dividend nor the redemption liability shall be disclosed as contingent liability

Basis for Response:
1. Paragraph 11 of Ind AS 32 Financial Instruments: Presentation defines Financial liability as under:
“A financial liability is any liability that is:
a. A contractual obligation:
i. To deliver cash or another financial asset to another entity; or
ii. To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or
b. A contract that will or may be settled in the entity’s own equity instruments and is:
i. A non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
ii. A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entity’s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. Apart from the aforesaid, the equity conversion option embedded in a convertible bond denominated in foreign currency to acquire a fixed number of the entity’s own equity instruments is an equity instrument if the exercise price is fixed in any currency. Also for these purposes the entity’s own equity instruments  do not include puttable financial instruments that are classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraph 16C or 16D, or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments.
As an exception, an instrument that meets the definition of a financial liability is classified as an equity instrument if it has all the features and meets the conditions in paragraphs 16A and 16B or paragraphs 16C and 16D.

2. The preference shares are redeemable and cumulative. Therefore, the company has an obligation to deliver cash. Accordingly, the instrument is a financial liability and shall be presented as such. The accumulated dividend not paid is not a contingent liability. The dividend cash flows are included in the effective interest rate calculation and thus are recognised as interest on effective interest method.

3. Paragraph 3.3.1 of Ind AS 109 states as under:
“An entity shall remove a financial liability (or a part of financial liability) from its balance sheet when, and only when, it is extinguished – ie when the obligation specified in the contract is discharged or cancelled or expires.”

4. The preference liability shall be derecognised from balance sheet when, and only when, it extinguished. As the preference shares and the accumulated dividend have not been redeemed or the holder has not waived its right to such amount, the preference share liability cannot be derecognised. The event of the holder going into liquidation does not give rise to derecognition event unless the liquidator waives right of the company to claim the amount from subsidiary company.

5. Paragraph 2 of Ind AS 37, Provisions, Contingent Liabilities and Contingent Assets, states as follows:
“This Standard does not apply to financial instruments (including guarantees) that are within the scope of Ind AS 109, Financial Instruments.”

6. As the preference share liability is within the scope of Ind AS 109, neither the dividend cash flow nor the redemption cash flow shall be disclosed as contingent liability.