Accounting for corporate finance: key concepts: preference shares
Preference shares provide an example of the distinction between financial liabilities and equity made by IAS 32 and Section 22 of New UK GAAP. The issuer must consider whether it has a contractual obligation to transfer cash or other financial assets to the holder of the share.
For example, if under its terms of issue a preference share is mandatorily redeemable on a certain date, the issuing company has a contractual obligation. The preference share will therefore be a financial liability, not an equity instrument.
If the preference share is non-redeemable, but the company has a contractual obligation to pay a dividend, there is a financial liability in respect of the dividends. This will lead to a ‘split accounting’ treatment, whereby the net present value of the obligation to pay dividends would be shown as a liability, and the balance of the issue proceeds as equity. It is likely, however, in such a situation that the entire issue proceeds will be classified as a financial liability. If, however, payment of a dividend is solely at the discretion of the directors (whether or not unpaid dividends accumulate), there is no contractual obligation to make a payment and the preference share should be classified as an equity instrument.
Where a preference share is classified as a financial liability, the preference dividend paid will be shown as ‘interest’ in the company’s income statement see CFM21220. This does not, however, affect the tax treatment of such dividends.