QUESTION 15 Illustration 5: Optionally convertible redeemable preference shares D Limited issues preference shares to G Limited. The holder has an option to convert these preference shares to equity instruments of the issuer anytime up to a period of 10 years. If the option is not exercised by the holder, the preference shares are redeemed at the end of 10 years. Examine the nature of the financial instrument.

Solution

This instrument has two components – (1) contractual obligation that is conditional on holder exercising its right to redeem, and (2) conversion option with the holder.

The first component is a financial liability because the entity does not have the unconditional right to avoid delivering cash. In the section “Compound financial instruments”, we will also analyses the other component – the conversion option with the holder and we will explain the nature of the instrument in its entirety.

The financial instrument in this case is a preference share issued by D Limited to G Limited. The preference share has the following features:

  1. It is optionally convertible, which means that the holder has the option to convert it to equity instruments of the issuer anytime up to a period of 10 years.
  2. If the option is not exercised by the holder, the preference share is redeemable at the end of 10 years.

Based on these features, the preference share can be classified as a compound financial instrument. This is because it has both equity and liability components.

The equity component arises from the option to convert the preference share to equity instruments of the issuer. If the holder exercises the option, the preference share will be converted to equity instruments, and the holder will no longer have a claim on any future dividends or redemption of the preference share.

The liability component arises from the fact that if the holder does not exercise the option to convert the preference share, it will be redeemed by the issuer at the end of 10 years. Until that time, the holder is entitled to receive a fixed rate of return in the form of dividends.

Therefore, the preference share issued by D Limited to G Limited is a compound financial instrument that has both equity and liability components. The nature of the instrument will depend on whether the holder exercises the option to convert the preference share or not. If the option is exercised, it will be classified as an equity instrument, and if not, it will be classified as a financial liability.


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