Treatment of preference shares

[Polz87]

The treatment of preference shares doesn't seem to be clear cut. In a balance sheet would preference share capital be included under non current liabilities or under equity?

Similarly would you include the preference share capital as debt when calculating gearing?

 

[Lynn Birchall]

Hi

In a balance sheet, preference share capital would appear as equity rather than as a non-current liabilities.

When calculating gearing, there's more variety. It's perhaps usual to include any preference share capital as debt rather than equity when calculating gearing. However, treating it as equity should also be ok. The main thing with gearing is to be consistent, eg if doing a comparison between two companies or between two points in time, to adopt consistent treatment.

Hope this clarifies
Lynn

 

[Polz87]

The Acted notes for CT2 didn't seem to clarify this. I would have thought that the preference share capital would have come under long term liabilities, due to the debt-like nature of preference shares. There seem to have been a few questions over the years asking why preference shares could be thought of as debt....

 

[Simon James]

The treatment of preference shares is quite a complex and controversial topic. They may be treated differently for accounting purposes v. capital adequacy or solvency purposes. The "proper" treatment depends on the nature of the instrument. The relevant accounting rule is IAS 32 (outlined below).

As Lynn says, as far as CT2 is concerned, preference shares are normally shown as equity, but for analysis of accounts, preference shares rank ahead of ordinary shareholders and normally pay a fixed dividend - so they look and feel like debt and so can be treated like debt.

Classification as Liability or Equity

The fundamental principle of IAS 32 is that a financial instrument should be classified as either a financial liability or an equity instrument according to the substance of the contract, not its legal form, and the definitions of financial liability and equity instrument. Two exceptions from this principle are certain puttable instruments meeting specific criteria and certain obligations arising on liquidation (see below). The entity must make the decision at the time the instrument is initially recognised. The classification is not subsequently changed based on changed circumstances. [IAS 32.15]

A financial instrument is an equity instrument only if (a) the instrument includes no contractual obligation to deliver cash or another financial asset to another entity and (b) if the instrument will or may be settled in the issuer's own equity instruments, it is either:

• a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or
• a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments. [IAS 32.16]

Illustration – preference shares

If an entity issues preference (preferred) shares that pay a fixed rate of dividend and that have a mandatory redemption feature at a future date, the substance is that they are a contractual obligation to deliver cash and, therefore, should be recognised as a liability. [IAS 32.18(a)] In contrast, preference shares that do not have a fixed maturity, and where the issuer does not have a contractual obligation to make any payment are equity. In this example even though both instruments are legally termed preference shares they have different contractual terms and one is a financial liability while the other is equity.