This article discusses the impact of shareholders’ rights on classifying an instrument as debt or equity.
QUESTION 1
The unconditional right of an entity to avoid delivering cash or another financial asset in settlement of an obligation is crucial in differentiating a financial liability from an equity instrument. The right to declare dividends and/or redeem capital is reserved for the members of the entity in general meeting, under the Companies Act. The effect of such a right may be that the members collectively can require payment of a dividend or buy back capital irrespective of the wishes of management. Even where management has the right to prevent a payment declared by the members, the members will generally have the right to appoint the management, and can therefore appoint management that will not oppose an equity distribution declared by the members or prevent a buy-back of capital. This raises the question whether an entity whose members have such rights should classify all its distributable retained earnings as a financial liability, on the grounds that the members could require earnings to be distributed as dividend, or equity capital (or a portion of it) as financial liability because the shareholders have a right to be repaid, at any time.
Whether shareholders rights to enforce dividend payments or buy-back of equity capital would result in the dividend liability being classified as financial
