An obligation arising from a contract to deliver cash or another financial asset to another entity is a financial liability. A financial liability may also arise from a derivative instrument. Today, we shall not discuss derivative financial instruments.
Financial liability is essentially a contractual obligation. Therefore, an obligation arising from the operation of law (e.g. income tax liability) is not a financial liability. Similarly, a constructive obligation, which arises from the pattern of past practices or a current specific statement by the management, is not a financial liability. Deferred revenue (e.g. advances from customers) is not a financial liability because the contractual obligation is to deliver goods or services. Simple examples of financial liability are borrowings from another entity or public, trade creditors, and security deposit received from contractors.
Equity and liability
Correct classification of financial instruments in the balance sheet into equity and liability is important for assessing the financial position of an entity. An incorrect classification distorts the gearing ratio.
According to IAS 32, an equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. On the other hand, a liability gives rise to an unconditional obligation to deliver cash or another financial asset to the counter party. The classification of a financial instrument into equity and liability hinges on whether the entity has or has not an unconditional discretion to decide whether to deliver cash or another financial asset to the counter party. If, the financial instrument provides the entity an unconditional discretion, the financial instrument is equity.
Therefore, Equity share issued by a company is an equity instrument because the company has no obligation to repay the contributed capital, which is the face value of the share and the share premium. Rather, the law prohibits such repayment. When an entity issues equity shares, it does not undertake an obligation, settlement of which will result in outflow of cash or another financial asset.
Net profit earned by a company belongs to shareholders. But an individual shareholder cannot claim distribution of her share in the net profit. Shareholders collectively decide when and what part of the net profit is to be distributed to shareholders. In a way, the company has an unconditional discretion to decide the timing and the amount of profit to be distributed to shareholders. Therefore, retained profit is a part of equity.
Redeemable preference shares
Redeemable preference share is not an equity instrument. It is a liability because the company has no option but to repay the capital. Under IAS 32, redeemable preference shares are presented as debt in the balance sheet and preference dividend is presented as interest in the profit and loss account. In India, companies are allowed to issue only redeemable preference shares. Therefore, In India preference shares will always be classified as debt. However, it is not that all preference shares are liabilities. It is important to examine the contract carefully and decide whether the instrument should be classified as equity or liability.
Settlement by issuing own equity shares
Companies sometime enter into a contract to pay against supply of goods and services by issuing its own shares. As a general principle, a contract that will be settled by an entity delivering a fixed number of its own equity shares for no future consideration is an equity instrument. For example if the contract stipulates that the company will issue 1,000 equity shares against supply of 100 units of goods, the claim of the suppliers is recognised as equity. A contract that will be settled by an entity delivering a variable number of its own shares whose value equals a fixed amount or an amount based on changes in an underlying variable (e.g. a commodity price) is a financial liability. The financial liability extinguishes on issue of equity shares and the amount of share capital and share premium in the balance sheet increase.
Compound instruments
Convertible debenture, which gives the holder the right to convert the debenture into equity at a later date, is an example of compound instrument. It has two components debt and equity. IAS 32 requires that two components in a compound instrument should be recognised in the balance sheet separately. Indian GAAP does not require separate recognition.
