QUESTION 34 Illustration 24: Conversion ratio changes under independent scenarios On 1 January 2018, STAL Limited subscribes to convertible preference shares of ATAL Limited. The preference shares are convertible as below: Convertible 1:1 if another strategic investor invests in the issuer within one year Convertible 1.5:1: if an IPO is successfully completed within 2 years Convertible 2:1: if a binding agreement for sale of majority stake by equity shareholders is entered into within 3 years Convertible 3:1: if none of these events occur in 3 years’ time. Examine whether the financial instrument will be classified as equity.

Solution

To determine whether the financial instrument will be classified as equity or not, we need to consider the relevant accounting standards. According to IAS 32 Financial Instruments: Presentation, an equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. A financial instrument will be classified as equity if it meets the following criteria:

  1. It includes no contractual obligation to deliver cash or other financial assets or to exchange financial assets or liabilities with another party under conditions that are potentially unfavorable to the entity.
  2. Any residual interest in the assets of the entity is divided among the instrument's holders in proportion to the number of instruments held.
  3. There is no contractual obligation to pay dividends.

Now let's apply these criteria to the convertible preference shares of ATAL Limited held by STAL Limited:

  1. The conversion ratio varies based on specific independent scenarios. There is no contractual obligation to deliver cash or other financial assets or to exchange financial assets or liabilities with another party under conditions that are potentially unfavorable to the entity. This criterion is met because the conversion ratio only determines the number of equity shares that STAL Limited will receive upon conversion, and there is no other obligation associated with the convertible preference shares.
  2. Any residual interest in the assets of the entity is divided among the instrument's holders in proportion to the number of instruments held. This criterion is also met because upon conversion, STAL Limited will receive a proportionate share of the equity in ATAL Limited.
  3. There is no contractual obligation to pay dividends. This criterion is not relevant in this case because the question does not provide information about dividend payments.

Based on the above analysis, the convertible preference shares of ATAL Limited held by STAL Limited meet the criteria for classification as equity.

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