Financial instruments – Introduction – ACCA (SBR) lectures
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This mistake is that the lecturer answered the question as though the investor has a choice, and that’s why he concluded that the instrument is an equity. The question clearly said the choice lies with Lisa, the issuer; in that case, Lisa will choose the option that it considers more favourable, which is to pay redeem the shares for cash, which therefore makes the B shares a financial liability.
The question was a bit ambiguous in that it gave readers the false impression that Lisa had the choice. However, in real life the choice always lies with the investor. This is because convertible financial instruments such as convertible bonds always offer a lower coupon rate or rate of return in exchange for the value of the option (for the coupon holder) to convert the bond into the issuer’s common stock. Bond issuers (i.e. Lisa) benefit since they can issue debt at lower interest rates than with traditional bond offerings. Investors benefit by a rise in the issuer’s share price, if the issuer’s share price performed poorly there will be no conversion, the investor will accept the sub-par return i.e. cash redemption.
Just to clarify further, although the question described the ‘B’ shares as ‘shares’, the economic substance of the instrument is that of a convertible bond. The redeemable feature is the clue.
The question says Lisa has a choice. The company would be have to be prudent and record it’s potentially worse case scenario i.e. Lisa would make the choice to go for the equity shares as that’s more beneficial. Hence, the company records equity and not liability. If the company had the choice, and not Lisa, then I would expect the company to record a liability.
You are very much right.
Yes, but the investor is not the one choosing. The choice is on the company, and the company would have chosen to settle in shares. The answer to the question is that it would be classified as equity.
Lisa is the issuer of the shares, and not the investor. Lisa is the one making the choice. We should expect Lisa to make a choice more beneficial to it. The option more beneficial to Lisa is the one that requires it to deliver something of lower value. The option to redeem the B shares is likely to cost Lisa $1m. The option to issue one million A shares is likely to cost Lisa $2m. It is obvious that the 1st option, which is the redemption of B shares is more beneficial to Lisa, which is what Lisa is likely to do. As Lisa is likely to pay cash, which is a financial asset, Lisa will have to initially recognise the B shares as a liability.
Question 32 – Avco from the BPP Revision kit September 2020 – June 2021 covers the same scenario, and the correct answer is classify as liability.
Sir, I am having difficulty in watching the videos. I wanted to know if any changes have been made. Thank you
Sir, in the example 1- it clearly says that Lisa has the choice, if so what is beneficial for Lisa is to redeem the shares at nominal value by cash, instead of issuing equity shares.
in case the choice lies with the investor, the instrument can be classified as equity.
kindly correct me, if I am wrong.
Reg,
Anand
You are right. I think the lecturer has mistaken about who actually has the choice in regards to how the shares will be redeemed. As per the question, the choice is with the company and so it will treated as liability.
No. Remember what Chris said you need to analyse the substance and economic reality of the scenario. What would you do if you are the investor? What is the likelihood of the share price falling below its nominal value? If the chance of the share price falling below $1is slim then anyone would take option 2 because it gives greater benefit.