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Hi! Good day, we just had a debate regarding this question. Almost all of us had different answers. May I know how you would answer this and why? Thank you so much!
Charlemagne Inc. has in issue P500,000 6% preference shares, which are redeemable at the option of the holder. The preference shares have been in issue for over 10 years and none of them has ever been redeemed. The entity has treated the P30,000 annual payment as a deduction from equity. Is this treatment correct, according to IAS 32 Financial Instruments: Presentation?
a. yes, because shares are equity and the annual payment is a dividend
b. no, because the annual payment must be separated into dividend and interest components
c. no, because the preference shares should be classified as a financial liability and the annual payment is interest
d. yes, because although the preference shares appear to be a liability the substance of the arrangement is that they are equity; in practice they are unlikely ever to be redeemed
I am a bit confused by the argument that because they are unlikely to be redeemed, even if true, that they should not be treated as effectively irredeemable debt.
Looking at the substance of the transaction, these shares are a financial liability. It is the shareholder’s right to redeem them whenever they want, not the company’s.
So if they do exercise their right, company will have no escape. It will be legally “obligated to transfer cash” to whoever has redeemed them, which makes it a financial liability.
The fact that no one has redeemed them yet has no impact on the substance of transaction.
I hope this helps.