Cumulative nature of the returns on the predilection shares, Financial Accounting

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A changeable instrument is deemed part liability and part equity. IAS 32 necessitate that each part is measured individually on initial recognition. The liability element is measured by estimating the present value of the future cash flows from the instrument (interest and potential redemption) using a discount rate equal to the market rate of interest for a similar instrument with no conversion terms. The equity element is subsequently the balance, calculated as follows: $

PV of the principal amount $10m at 7% redeemable in 5 yrs

$10m x 0.713

7,130,000

PV of the interest annuity at 7% for 5 yrs

(5% x $10m) x 4.100

2,050,000

Total value of liability element

9,180,000

Equity element (balancing figure)

820,000

Total proceeds raised

10,000,000

The equity will not be remeasured, however the liability element will be subsequently remeasured at amortised cost using the effective interest rate of 7%. The total finance cost for the year ended 31 December 2010 is $642,600 (7% x 9,180,000). The coupon rate of interest of 5% has already been charged to profit or loss in the year so a further $142,600 should be recorded:

Dr Finance costs $142,600

Cr Non-current liability $142,600

(b) Preference shares

The substance of the instrument is a debt instrument. IAS 32 requires that any instrument that contains an obligation to transfer economic benefit be classified as a liability. The cumulative nature of the returns on the predilection shares means that the outflow of benefit is inevitable. The predilection shares would then be classified as debt and would in fact increase the gearing of the entity.


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