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ACCA Strategic Professional · Strategic Business Reporting (International) · Analysis and interpretation of financial and non-financial information and measurement of performance

Vela Co's finance director wishes to improve reported gearing before a loan covenant test by reclassifying redeemable preference shares with a mandatory redemption date as equity. Debt is $300m and equity is $600m, and the preference shares are $100m. Under IFRS Accounting Standards, what is the correct response?

The shares must be classified as a financial liability because redemption is mandatory, creating a contractual obligation to pay cash. Debt becomes $400m and debt to equity is 66.7%. Presenting them as equity to flatter a covenant would be misleading and unethical.

  1. AAccept the reclassification, since the legal form is share capital
  2. BClassify the shares as a financial liability, giving debt of $400m and gearing (debt to equity) of 66.7% on equity of $600mCorrect
  3. CClassify half as equity and half as liability to reflect uncertainty
  4. DClassify as equity but disclose the redemption in the notes

Explanation

Shares with a mandatory redemption requirement create a contractual obligation to deliver cash, so IAS 32 requires liability classification. Debt rises to $400m and gearing is 400/600 = 66.7% if equity is unchanged at $600m, and presenting them as equity would be misleading and raise an ethical concern. Splitting them equally has no basis in the standard.

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