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.”
The definition of an asset is given in the Financial Statement Concepts section, Section 1000 of the CICA handbook:
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
If the financial asset is cash,
or a receivable for a fixed or determinable amount of cash, then the financial
asset is called monetary.
The definition of a liability also was established in Section 1000:
Augmenting this is the financial liability definition:
“A financial liability is any liability that is a contractual obligation:
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.
The equity definitions are quite short:
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:
There are two major differences between these alternative classifications:
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.