CFM21110 - Accounting for corporate finance: key concepts: equity instrument: examples

Financial liability or equity?

Example 1

A Ltd, B Ltd and C Ltd are partners in a partnership, each having initially put up capital of £1 million. Under the terms of the partnership agreement, any of the partners can withdraw from the partnership by giving notice in writing. If a partner does so, the partnership is obliged to pay the withdrawing partner, in cash, the balance standing to that partner’s capital account.

The partner’s capital account represents a financial liability of the partnership, because there is no way the partnership can avoid the outflow of cash. It is irrelevant that the amount repayable to the partner will represent that partner’s residual interest in the partnership assets, and will therefore be more or less than the £1 million invested. The same principle applies where an investor has an unfettered right to redeem for cash his or her interest in an open-ended investment company, unit trust or similar entity.

Example 2

A company issues perpetual debt, repayable only at the issuer’s option (unless the issuing company goes into liquidation). The terms of the debt impose no contractual obligation on the company to make coupon payments: on the coupon dates the company may make an interest payment, but it has the discretion to defer payment of interest until such time as it chooses to redeem the debt.

It may be appropriate for the company to classify the instrument as equity, rather than as a financial liability, since it has no legal or contractual obligation to part with cash (except in the event of a liquidation). There will, however, be a commercial obligation on the company to make regular coupon payments, otherwise investors would not subscribe for the debt. It is likely to be a matter of judgement for the company whether the true substance of the arrangement is debt or equity.