Accounting for corporate finance: key concepts: equity instrument
An equity instrument is a contract that evidences a residual interest in the assets of a company after deducting all its liabilities. But an instrument is an equity instrument if, and only if, the instrument includes no contractual obligation
- to deliver cash or another financial asset to another entity, or
- to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the issuer.
Therefore, just because there is a contractual obligation that will or may result in an entitlement to receive shares, it does not automatically mean there is an equity instrument.
There are some examples distinguishing debt and equity at CFM21110.
If the instrument will or may be settled in the company’s own shares, it is not an equity instrument if the shares are being used as a form of ‘cash’. Instead, the instrument will be a financial asset or financial liability.
A start-up company is experiencing severe cash-flow problems. A supplier agrees to supply goods to the value of £1,000 in return for the company issuing to it, in 60 days’ time, shares that have a market value of £1,000. The number of shares that the company must deliver under this contract is variable - it will depend on the market value of its shares at the settlement date.
This contract would be classified as a financial liability, not an equity instrument. In essence it is no different from a contract that requires it to pay £1,000 cash, or to deliver other assets worth £1,000 in exchange for the goods.