Chapter 8.2® - Financial Assets & Liabilities - Debt v/s Equity Problem - Examples of Financial Instrument Classification & Retractable Preferred Shares

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Chapter 8.2® - Financial Assets & Liabilities - Debt & Equity Problem - Examples of Financial Instrument Classification & Retractable Preferred Shares

Section 3860 encompasses all types of financial instruments, defined as follows:

“A financial instrument is any contract that gives rise to both a financial assets of one party and a financial liability or equity instrument of another party.”

Financial Assets:

The definition of an asset is given in the Financial Statement Concepts section, Section 1000 of the CICA handbook:

"Assets are economic resources controlled by an entity as a result of past transactions or events and from which future economic benefits may be obtained.”

The definition of a financial asset augments this definition, and creates a sub-classification: not all assets are financial assets. A financial asset is any asset that is

1) cash;

2) a contractual right to receive cash or another financial asset from another party;

3) a contractual right to exchange financial instruments with another party under conditions that are potentially favourable; or

4) an equity instrument of another entity.

If the financial asset is cash, or a receivable for a fixed or determinable amount of cash, then the financial asset is called monetary.

Financial Liabilities:

The definition of a liability also was established in Section 1000:

“Liabilities are obligations of any entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future."

Augmenting this is the financial liability definition:

“A financial liability is any liability that is a contractual obligation:

1) to deliver cash or another financial asset to another party; or

2) to exchange financial instruments with another party under conditions that are potentially unfavourable.

If the financial liability is payable in a fixed or determinable amount of cash, then the financial liability is called monetary.

Financial liabilities are obligations to pay money. Other liabilities, such as warranty liabilities and unearned revenue, are obligations to perform services and this are excluded from the definition of a financial liability.

Equity:

The equity definitions are quite short:

Equity is the ownership interest in the assets of a profit oriented enterprise after deducting its liabilities.

and,

An equity instrument is any contract that evidences residual interest in the assets of an entity after deducting all of its liabilities.

Debt Vs Equity – The General Problem

Assume that a company raises $100,000 by issuing a financial instrument that will pay $6,000 per year to the investor. At the end of the fifth year, the company retires the financial instrument in a transaction in the open market, buying it back at market value of $109,500. The financial statements are affected by whether the instrument is classified as debt or equity. The impact of each classification can be summarized as follows:

Event	Liability	Equity
i) Issuance	- Increase long term liabilities	- Increase shareholder's equity
ii) Annual $6,000 payment	- Increase interest expense - Decrease net income - Decrease retained earnings	- Reduces retained earnings through a dividend distribution - No impact on income statement
iii) Annual $6,000 payment on financial instrument	In operations section	In financing section
iv) Payment of $9,500 premium at retirement	- Recorded as a loss on the income statement	- Reduces shareholders' equity directly with no impact on the income statement
v) $100,000 repayment of initial investment	- Decreases liability	- Decreases shareholders' equity

There are two major differences between these alternative classifications:

1) Reported income is changed by interest payments and gains and losses on retirement when the classification is a liability.

2) The balance sheet classification (i.e., as debt or equity) of the item may be crucial to some corporations.

Examples of Financial Instrument Classification

Retractable Preferred Shares

Most preferred shares have a call provision, whereby the corporation can call in the shares and redeem them at a given price. The call price is specified in the corporate bylaw governing that class of share. Preferred share call provision give management more flexibility in managing the corporation’s capital structure than would be the case without a call provision. These shares are redeemable at the company’s option.

Some preferred shares include the provision that the shares must be redeemed on or before a specified date (term-preference shares), or an option to redeem can be exercised at the option of the shareholder (retractable shares). When redemption is required or is at the option of the holder, then the mandatory final cash payout effectively makes the preferred shares a liability.