OPTIONALLY CONVERTIBLE REDEEMABLE PREFERENCE SHARES
Optionally convertible preference shares are those preference shares that have an option to be converted into equity shares. The option of conversion lies either with the company or with the shareholder or it may be a combination of both.
According to the provisions laid down in Section 55 of the Companies Act 2013 any company limited for shares, if authorized by the articles of association [AOA] of the company may issue preferred shares which are liable to be redeemed within the timeframe of 20 years from the date of their issue. The company can redeem its preference shares only on the terms on which they were issued or as varied after due approval of preference shareholders under section 48 of the Act.
When can preference shares be redeemed?
The preference shares may be redeemed:
- At a predetermined time or upon the occurrence of a particular event;
- At any time with the Company’s discretion;
- At any time at the discretion of the shareholders.
• When the option of conversion of redeemable preference shares is with shareholders, assuming that they will not convert it into equity shares, thus it will be treated as debt for the company.
• When the option of conversion of redeemable preference shares is with the company, assuming that they will convert it into equity shares, it will be treated as equity for the company.
Section 133 of the companies act, 2013 empowers the central government to prescribe accounting standards regarding and after examination of the recommendations made by the National Financial Reporting Authority. IAS 32 states the definition of financial assets, financial liabilities, and equity.
Are the preference shares debt or equity? The main feature of debt is that the issuer is obliged to deliver either cash or another financial asset to the holder.
What is a financial instrument?
A financial instrument is an instrument only if an instrument includes no contractual obligation to deliver cash or another financial asset to another person, and if the instrument will or may be settled in the issuer’s equity instruments.
Illustration – preference shares without fixed maturity, and where the issuer does not have a contractual obligation to make the payment are equity.
The classification is not relatively changed based on changed circumstances. For example, in the case of redeemable preference shares, where the holder can request redemption, is termed as debt even though legally it might be a share of the issuer.
The following questions help in determining whether to consider the preference shares as debt or equity?
- Is the share redeemable at a fixed date and time?
- Is the share redeemable at the option of the shareholder?
- Is the issuer bind to make payments in either form of interest or dividends?
- Are dividends non-discretionary in nature?
- Does terms and conditions bind the issuer to distribute a certain percentage of profits?
- Is there a limited life of the instrument?
If the answer is positive i.e. a yes to all of the above questions, then the preference shares would most probably be classified as a financial liability (debt), because it would appear that the issuer does not have an unconditional right to avoid delivering cash or another financial asset to settle an obligation.
On the other hand, if all answers are negative, and there is, therefore, no mandatory payment clause in the contract, this may result in classification as equity because the entity may delay payment in the event of liquidation.
If the answers are a mixture of yes and no both, then the classification will vary by case.
Hence, one must analyze the details of the contract thoroughly before deciding on the classification of a financial instrument, because even a small detail could cause a change of direction.