Before diving deep into the subject of discussion, let us first understand clearly what financial instrument is. A financial instrument (also called financial security) is a document (real or virtual) representing a legally admissible agreement involving any monetary value. It is a legal document through which an entity or an individual with a surplus fund (otherwise called the investor) can invest (or put its fund) in another entity in need of fund (otherwise called investee). The issuer of the instrument is the investee, while the holder is the investor. Hence, financial instrument is a contract that gives rise to financial asset on the side of the investor and financial liability or equity on the side of the investee.

According to IAS 32 paragraph 11, the main attribute of liability instruments is the obligation to transfer an economic benefit to the holders (i.e., investors) of the financial instrument. In other words, it creates a contractual obligation on the issuer (i.e., investee) to deliver cash or another financial asset to the older or to exchange another financial instrument with the holder under an unfavourable condition to the issuer. On the other hand, IAS 32 paragraph 17 defines equity instruments as those that give the holders a right to a share of the company’s distributions but does not create an obligation for the issuer to make such distribution.

This leads us to the accounting principle of “substance over form”. Substance over form simply means that the transaction reported in the financial statements should reflect the economic substance of the transaction rather than its legal form. There are times that the substance of a transaction and the legal form may align in accounting for financial instruments, but this is not always the case. There are instances where the legal form of holding or issuing a financial instrument is not consistent with underlying economic substance. In other words, a financial instrument may have the legal form of equity, but in substance, it is a liability and vice versa. Some other financial instruments combine the feature of both equity and liability and are called hybrid financial instruments.

This article aims to explain hybrid financial instruments and how to report them accurately in line with the provision of the International Financial Reporting Standards (IFRS). Let us define a hybrid instrument. A hybrid instrument is a financial instrument with features of liability and equity. This means that from initial recognition, a financial instrument can be either a liability or equity based on the economic substance of the transaction. An example of hybrid instrument is preference share; if we look from a legal prism we would take it as an equity instrument, however, sometimes (take note, not every time) they are seen as liability when we look at it from the prism of economic substance of the transaction. They are like figure “6” that when flipped upside down we see figure “9”. However, the conceptual framework of financial reporting requires that transaction must be reported based on substance and not just the legal form. This article will attempt to demystify how to account for hybrid instruments when it is liability or equity. 

We must be careful not to confuse hybrid instruments with compound instruments. As earlier defined, hybrid instruments have the features of both liability or equity but not the two at the same time. On the other hand, compound instruments are intrinsically composed of liability and equity elements. They have variable and fixed income components where a certain portion is a liability, and the other is equity. They are also referred to as designers’ instruments because management designs them to achieve a particular corporate goal, such as to manage the capital structure and cost of capital. Examples are convertible loans, convertible debenture, convertible bonds, convertible preference shares, options, warrants, Mezzanine loan and In-kind toggle Note. Although, it can be argued that compound instruments are also a kind of hybrid instrument, but for the purpose of simplicity, it is better to separate them as defined above.

Hybrid financial instruments and their accounting treatment

1. Preference share

Preference shares, also referred to as preferred stock, are type of shares that pay fixed dividend to their holders before equity shareholders dividends are issued. Although preferred shareholders are not eligible for voting right in the organisation, they usually receive preferred dividends. In the event of liquidation, preference shareholders are entitled to be paid from the company’s assets before equity shareholders. A preference share is a hybrid instrument because it has debt and equity features. There are three categories of preference shares: convertible preference shares, redeemable preference shares and irredeemable preference shares.

i. Convertible preference shares: These are preference shares that can be converted to equity share capital in the future at the instance of the preference shareholder (but sometimes at the instance of the issuer. It is a compound instrument, and not a hybrid instrument, because it is composed of both equity and liability right from the inception of the contract.

ii. Redeemable preference shares: These are preference shares in which settlement is required. That is, the issuer must provide the regular preference dividend and pay the principal amount invested upon maturity. Hence, since repayment or settlement is required preference share is recognised as a liability instrument and not equity, contrary to the legal recognition of preference shares as equity.

iii. Irredeemable preference shares: These are preference shares in which settlement of the principal amount invested by the holder of the security is not required. Hence, they are usually taken as an equity instrument. However, it is instructive to note that not all irredeemable preference shares qualify to be recognised as equity instruments. This fact brings us to the two types of irredeemable preference shares:

• Cumulative irredeemable preference shares: This are financial instruments that allows dividends unpaid in a year to accumulate to subsequent years when payment would be made. This simply means that when dividend is not paid to the shareholders in a year of low profit or loss position, the dividend due would be carried forward to a future year (regardless of how long it takes) when the company will be able to pay. All the outstanding dividends from previous years must be paid and shareholders can never lose their entitlement because the company has an obligation to pay dividend. Notice that here, the substance of this arrangement looks more like debt than equity and the instrument would be recognised as a liability.

• Non-cumulative irredeemable preference shares: These are preference shares whereby unpaid dividends in a year that the company has insufficient profit will not be carried forward to a future year of sufficient profit. In the year of sufficient profit, the company (or issuer) only pays the current year dividend to the preference shareholders and all previously unpaid dividends are lost forever. Hence it is said that the dividend is not cumulative, that is, it does not accumulate to future years. From the above explanation, we can see clearly that the economic substance of this arrangement looks more like equity than debt and this class of dividend would be accounted for as an equity instrument in the financial statement.

Preference shares are referred to as hybrid financial instruments because they have features of liability and equity, and at initial recognition, we should identify them based on the economic substance of the transaction. Redeemable preference shares and cumulative irredeemable preference shares are accounted for as liability while non-cumulative irredeemable preference shares are accounted for as equity in line with the provision of IAS 32.

Example: Finance and the Megatrends Limited issues two categories of preference shares: Class A preference shares are 10% irredeemable preference shares that mandate the company to pay dividends annually to the shareholders, and in a year of default, the dividend would accumulate forward to the year of sufficient fund. Class B preference shares are 10% irredeemable preference shares are unpaid in one year will not be carried forward to subsequent years. Provide the accounting treatment to these classes of instruments at initial recognition.

Class A preference shares

Class A shares carry obligations to pay an annual dividend (mandatory annual dividend and dividend payment on principal amount invested), and any unpaid dividend should be carried forward, so they should be treated as a liability. 

Debit: Asset – Bank/Cash/Receivables

Credit: Liability – Class A preference shares

Class B preference shares

Class B dividend payment is discretionary and non-cumulative; hence it will be treated as equity.

Debit: Asset – Bank/Cash/Receivables

Credit: Equity – Share capital (and share premium is necessary)

2. Deposit for shares

Deposit for shares usually arises when the company shareholders or potential shareholders contribute more funds into the business than the existing authorised and issued share capital. They do this because they want to be given priority whenever the company issues new shares. This is recognised as a hybrid instrument because it has the features of liability and equity, depending on the substance of the transaction. To properly account for this type of transaction in line with the provision of the standards, we must ask these two questions:

i. Will the depositor receive contractual cash flow from the amount deposited in the form of interest payment and principal repayment if the company did not issue shares after a certain period of time?

ii. Will the depositor not receive contractual cash flow in the form of interest or principal repayment irrespective of how long it takes the company to issue new shares?

If the answer is “Yes” to question 1 and “No” to question 2, deposit for shares should be accounted for as a liability at initial recognition in line with the provision of IAS 32. Here is my suggested accounting entry:

Debit: Asset – Bank/Cash/Receivables

Credit: Liability – Deposit for shares

However, if the answer is “No” to question 1 and “Yes” to question 2, the deposit for shares should be recognised as equity at initial recognition in line with the provision of IAS 32. Here is my suggested accounting entry:

Debit: Asset – Bank/Cash/Receivables

Credit: Equity – Deposit for shares

3. Capital Note

Capital notes are financial instruments with features of debt and equity. There are two forms of capital notes: the capital notes that are similar to convertible securities, which gives the holder the right to convert to shares at a future date. They are like warrants, except that they often do not have an expiration date or an exercise price. The second type of capital note is a bond with a very long maturity horizon reaching several decades, sometimes more than 50 or even 100 years. They have equity features because of their very long maturity period but unlike equity securities, capital notes would eventually mature at some point. Hence, although debt, they have features of equity embedded into them.

However, since their maturity is usually in the very distance future, capital notes are accounted for as part of equity for practical purposes. Banks and other financial institutions typically issue this bond to satisfy regulatory demands regarding capital requirements and are treated as close to equity because they both reinforce the bank’s capital.