a particular date for a fixed or determinable amount,
contains a financial liability, since the issuer has an obligation, or potential obligation, to
transfer cash or other financial assets to the holder. This obligation is not negated by the
potential inability of an issuer to redeem a preference share when contractually
required to do so, whether because of a lack of funds, a statutory restriction or
insufficient profits or reserves. [IAS 32.18(a), AG25].
It is more correct to say (in the words of the application guidance) that an instrument
‘contains’ a financial liability than to say (as the main body of the standard does) that it
‘is’ a financial liability. For example, if a preference share is issued on terms that it is
redeemable at the holder’s option but dividends are paid entirely at the issuer’s
discretion, it is only the amount payable on redemption that is a liability. This would
lead to a ‘split accounting’ treatment (see 6 below), whereby, at issue, the net present
value of the amount payable on redemption would be classified as a liability and the
balance of the issue proceeds as equity. [IAS 32.AG37].
Non-discretionary dividends, on the other hand, establish an additional liability
component. In such a case there is a contractual obligation to pay cash in respect of
both the redemption of the principal and the required dividend payments up to the
redemption of the instrument. The liability would be recognised at an amount equal to
the present value of both the redemption amount and the non-discretionary dividends.
Assuming that the dividends were set at market rate, which is generally the case, this
would typically result in an overall liability classification of the whole instrument. While
dividend payments might be set at a fixed percentage of the nominal value, this does not
need to be the case. Any non-discretionary obligation to pay dividends creates a liability
that needs to be recorded on initial recognition of the instrument. If an entity has an
obligation that is non-discretionary, for example to pay out a percentage of it profits,
then that gives rise to a financial liability (see Chapter 42 at 2.1.3 for discussions around
embedded derivatives and non-financial variables specific to one party to the contract).
4.5.2
Instruments redeemable only at the issuer’s option or not redeemable
A preference share (or other instrument) redeemable in cash only at the option of the
issuer does not satisfy the definition of a financial liability in IAS 32, because the issuer
does not have a present or future obligation to transfer financial assets to the shareholders.
In this case, redemption of the shares is solely at the discretion of the issuer. An obligation
may arise, however, when the issuer of the shares exercises its option, usually by formally
notifying the shareholders of an intention to redeem the shares. [IAS 32.AG25].
3506 Chapter 43
Likewise, where preference shares are non-redeemable, there is clearly no financial
liability in respect of the ‘principal’ amount of the shares. In reality there may be little
distinction between shares redeemable at the issuer’s option and non-redeemable shares,
given that in many jurisdictions an entity can ‘repurchase’ its ‘irredeemable’ shares subject
to no greater restrictions than would apply to a ‘redemption’ of ‘redeemable’ shares.
Ultimately, the classification of preference shares redeemable only at the issuer’s option
or not redeemable according to their terms must be determined by the other rights that
attach to them. IAS 32 requires the classification to be based on an assessment of the
substance of the contractual arrangements and the definitions of a financial liability and
an equity instrument. [IAS 32.AG26].
If the share does establish a contractual right to a dividend, subject only to restrictions
on payment of dividends in the relevant jurisdiction, it contains a financial liability in
respect of the dividends. This would lead to a ‘split accounting’ treatment (see 6 below),
whereby the net present value of the right to receive dividends would be shown as a
liability and the balance of the issue proceeds as equity. Where the dividends are set at
a market rate at the date of issue, it is likely that the issue proceeds would be equivalent
to the fair value (at the date of issue) of dividends payable in perpetuity, so that the
entire proceeds would be classified as a financial liability.
However, when redemption of the preference shares and distributions to holders of the
preference shares, whether cumulative or non-cumulative, are at the discretion of the
issuer, the shares are equity instruments. The classification of preference share distributions
as an equity component or a financial liability component is not affected by, for example:
• a history of making distributions;
• an intention to make distributions in the future;
• a possible negative impact on the price of ordinary shares of the issuer if distributions
are not made (because of restrictions on paying dividends on the ordinary shares if
dividends are not paid on the preference shares – see 4.5.3 below);
• the amount of the issuer’s reserves;
• an issuer’s expectation of a profit or loss for a period; or
• an ability or inability of the issuer to influence the amount of its profit or loss for
the period. [IAS 32.AG26].
The treatment of non-redeemable preference shares or other instruments with
preferred rights under IAS 32 is a particularly difficult issue, since such shares often
inhabit the border territory between financial liabilities and equity instruments.
However, the starting point is that a non-redeemable preference share whose dividend
rights are simply that a dividend (whether of a fixed, capped or discretionary amount)
will be paid at the issuing entity’s sole discretion, is equivalent to an ordinary equity
share and therefore appropriately characterised as equity.
Financial instruments: Financial liabilities and equity 3507
4.5.3
Instruments with a ‘dividend blocker’ or a ‘dividend pusher’ clause
4.5.3.A
Instruments with a ‘dividend blocker’
A number of entities have issued non-redeemable instruments (or instruments
redeemable only at the issuer’s option) with the following broad terms:
• a discretionary annual coupon or dividend will be paid up to a capped maximum
amount; and
• unless a full discretionary coupon or dividend is paid to holders of the instrument,
no dividend can be paid to ordinary shareholders.
This restriction on dividend payments to ordinary shareholders is colloquially referred
to as a ‘dividend blocker’ clause. Because payments of annual coupons or dividends are
at the discretion of the issuer and the instrument is non-redeemable, the issuer has an
unconditional right to avoid delivering cash or another financial asset. This is not
negated by the fact that the issuer cannot pay dividends to ordinary shareholders if no
coupon or dividend is paid to the holder of the instruments. The instrument is therefore
classified as equity in its entirety.
The economic reality is that many entities that issue such instruments are able to do so
at a cost not
significantly higher than that of callable perpetual debt. This indicates that
the financial markets regard ‘dividend blocker’ clauses as providing investors with
reasonable security of receiving their ‘discretionary’ coupon or dividend, given the
adverse economic consequences for the entity of not paying it (if sufficiently solvent to
do so), namely:
• the disaffection of ordinary shareholders who could not receive any dividends; and
• the fact that the entity would find it very difficult to raise any similar finance again.
These factors could admit an argument that such instruments are equivalent to
perpetual debt, which give rise to a financial liability of the issuer (see 4.7 below), in all
respects, except that the holder has no right to sue for non-payment of the discretionary
dividend. However, the analysis in IAS 32 is based on the implicit counter-argument
that the position of a holder of an instrument, all payments on which are discretionary,
is equivalent to that of an ordinary shareholder. Ordinary shares do not cease to be
equity instruments simply because an entity that failed to pay dividends to its ordinary
shareholders, when clearly able to do so, would be subject to adverse economic
pressures from those shareholders, and might find it very difficult to raise additional
share capital.
3508 Chapter 43
Aviva has issued instruments with ‘dividend blocker’ clauses that are accounted for as
equity instruments (see, in particular, the final sentences of the Extract).
Extract 43.1: Aviva plc (2017)
Notes to the consolidated financial statements [extract]
34
Direct capital instrument and tier 1 notes [extract]
Notional amount
2017
2016
£m
£m
5.9021% £500 million direct capital instrument – Issued November 2004
500
500
8.25% $650 million fixed rate tier 1 notes – Issued May 2012
-
392
6.875% £210 million STICS – Issued November 2013
231
231
Total
731
1,123
The direct capital instrument (the DCI) was issued on 25 November 2004. The DCI has no fixed redemption date but
the Company may, at its sole option, redeem all (but not part) of the principal amount on 27 July 2020, at which date
the interest rate changes to a variable rate, or on any respective coupon payment date thereafter.
[...]
No interest will accrue on any deferred coupon on the DCI. Interest will accrue on deferred coupons on the STICS at
the then current rate of interest on the STICS.
Deferred coupons on the DCI and the STICS will be satisfied by the issue and sale of ordinary shares in the Company
at their prevailing market value, to a sum as near as practicable to (and at least equal to) the relevant deferred coupons.
In the event of any coupon deferral, the Company will not declare or pay any dividend on its ordinary or preference
share capital. These instruments have been treated as equity. Please refer to accounting policy AE.
4.5.3.B
Instruments with a ‘dividend pusher’
A variation of the financial instrument discussed under 4.5.3.A above is one with a so
called ‘dividend pusher’ clause which, in practice, often comes with the following broad
terms:
• a discretionary annual coupon or dividend will be paid up to a capped maximum
amount;
• payment of the annual coupon or dividend is required if the entity pays dividends
to ordinary shareholders; and
• the instrument is non-redeemable (or redeemable only at the issuer’s option).
The annual coupons or dividends are at the discretion of the issuer and the instrument
is non-redeemable, indicating an unconditional right of the issuer to avoid delivering
cash or another financial asset to the holder of the instrument. Whether the ‘dividend
pusher’ clause introduces a contractual obligation to deliver cash or another financial
asset depends on whether the payments of dividends to ordinary shareholders
(referenced in the dividend pusher clause) are themselves discretionary. In general,
payments of dividends to ordinary shareholders are at the discretion of the issuer of
those shares. The ‘dividend pusher’ clause therefore does not introduce a contractual
obligation, meaning that the issuer has an unconditional right to avoid delivering cash
or another financial asset. Thus the instrument is classified as equity in its entirety.
Financial instruments: Financial liabilities and equity 3509
4.5.4
Perpetual instruments with a ‘step-up’ clause
Some perpetual instruments are issued on terms that they are not required to be
redeemed. However, if they are not redeemed on or before a given future date, any
coupon or dividend paid after that date is increased, usually to a level that would give
rise to a cost of finance higher than the entity would normally expect to incur. This
effectively compels the issuer to redeem the instrument before the increase occurs. A
provision for such an increase in the coupon or dividend is colloquially referred to as a
‘step-up’ clause. A ‘step-up’ clause is often combined with a ‘dividend-blocker’ or
‘dividend pusher’ clause (see 4.5.3.A and 4.5.3.B above).
Paragraph 22 of the version of IAS 32 in issue before its revision in December 2003
(see 1.2 above) specifically addressed ‘step-up’ clauses as follows:
‘A preferred share that does not provide for mandatory redemption or redemption at
the option of the holder may have a contractually provided accelerating dividend such
that, within the foreseeable future, the dividend yield is scheduled to be so high that the
issuer would be economically compelled to redeem the instrument.’11
The Basis for Conclusions to the current version of IAS 32 indicates that this example
was removed because it was insufficiently clear, but there was no intention to alter the
general principle of IAS 32 that an instrument that does not explicitly establish an
obligation to deliver cash or other financial assets may establish an obligation indirectly
through its terms and conditions (see 4.2.3 above). [IAS 32.BC9].
This has led some to suggest that any instrument with a ‘step-up’ clause contains a
financial liability. In our view, however, this is to misunderstand the reason for the
IASB’s decision to delete the old paragraph 22. The ‘confusion’ caused by the paragraph
was that the existence of a step-up clause is in fact irrelevant to the analysis required by
IAS 32. If an instrument, whether redeemable or not, contains a contractual obligation
to pay a coupon or dividend, it is a liability, irrespective of the ‘step-up’ clause.
However, if the coupon or dividend, both before and after the step-up date, is wholly
discretionary, then the instrument is, absent other contractual terms that make it a
liability, an equity instrument, again irrespective of the step-up clause (see 4.5.1
and 4.5.2 above).
This analysis was confirmed by the Interpretations Committee in March 2006 in its
discussion of the classification of an instrument that included a ‘step-up’ dividend clause
that would increase the dividend at a pre-det
ermined date in the future. The
Interpretations Committee agreed that this instrument included no contractual
obligation ever to pay the dividends or to call the instrument and should therefore be
classified as equity under IAS 32.12
4.5.5 Relative
subordination
Some have argued that instruments with ‘dividend-blocker’, ‘dividend-pusher’ or ‘step-
up’ clauses (see 4.5.3 and 4.5.4 above) do not meet the definition of an equity instrument.
Those that take this view point out that paragraph 11 of IAS 32 defines an equity
instrument as ‘any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities’ (see 3 above) – whereas many instruments of the type
described in 4.5.3 and 4.5.4 above are typically entitled only to a return of the amount
3510 Chapter 43
originally subscribed on a winding up, rather than to any ‘residual interest’ in the assets.
However, such an instrument does not meet the definition of a liability either, for all the
reasons set out above.
Moreover, as noted at 4.1 above, IAS 32 paragraph 16 indicates that, in applying the
definition in paragraph 11, an entity concludes that an instrument is equity if and only if
the criteria in paragraph 16 are met. In other words, an instrument is equity if it satisfies
the criteria of paragraph 16, whatever construction might be placed on paragraph 11.
In March 2006, the Interpretations Committee considered various issues relating to the
classification of instruments under IAS 32, and agreed that IAS 32 was clear that the
relative subordination on liquidation of a financial instrument was not relevant to its
classification under IAS 32, even where the instrument ranks above an instrument
classified as a liability.13 This supports the view that an instrument can be classified as
equity even if there are restrictions on participation by its holder in a liquidation or on
winding up.
However, in February 2008, the IASB issued an amendment to IAS 32 (see 1.2 above)
which, in very specific circumstances, requires the relative subordination of an
instrument to be taken into account in determining its classification as debt or equity
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 693
