• While scepticism is warranted, there are solid rationales behind the classification of certain perpetual bonds as equities.
• As stated on its cover page, IAS 32 should be read in conjunction with the Conceptual Framework for Financial Reporting.

Since posting my writeup about the peculiar accounting method for perpetual bond distributions by Yinson Holdings Berhad (Yinson), Malakoff Corporation Berhad, PESTECH International Berhad (PESTECH) and Dialog Group Berhad few weeks ago, I am fortunate to have received multiple feedbacks from various stakeholders, including analysts, fund managers, auditors, and investor relations managers. Quite a few of them are insightful which I would like to share here and in the next writeup. Still, my question regarding the compliance with paragraph 10 and 11 of IAS 33/MFRS 133, that is whether those companies’ earnings per share have been computed based on profit attributable to ordinary shareholders, remains unsolved.

Revisiting the Old Debate

To my surprise, many investors are still doubtful about the permissibility of classifying perpetual bonds as equities. The International Accounting Standards Board (IASB) has reaffirmed the permissibility, or more precisely, requirement to do so depending on the terms of perpetual bonds in its meeting agenda on “Obligations that only arise on liquidation of the entity” in February 2021. The accompanying agenda paper 5E and 5F provided the background information needed to understand the rationales for such classifications.

An analyst shared with me an interesting article on the topic published by The Edge Singapore back in March 2019 (link here: https://sg.finance.yahoo.com/news/perpetual-securities-debts-not-equity-022015960.html). In that article titled “Perpetual securities are debts, not equity. Here's why”, the author claimed that perpetual bonds should be classified as liabilities under the International Financial Reporting Standards (IFRS), and accountants had misrepresented those securities as equities. All 11 arguments that I managed to identify from the article are listed below, each followed by my corresponding view.

1.   Perpetual bonds have specified distribution rates and callable dates. Distribution rates may be raised if those bonds are not redeemed after their callable dates, and issuers may be stopped from paying ordinary share dividends if they defer distributions to perpetual bond holders – these “penalties” effectively force repayments.

Higher distribution rates and inability to pay ordinary share dividends incentivise but still do not necessitate redemptions or distribution payments by issuers. IASB has concluded that these “economic compulsions” do not affect the classification of financial instruments back in June 2006.

A counterexample in Malaysia is units in REITs, from which investors expect stable distributions, and on which corporate income tax will be levied if they do not distribute at least 90% of taxable income in each year. If “economic compulsions” affect classification, then these units would have to be accounted for as liabilities rather than as equities.

2.   Some perpetual bonds are secured against their issuer’s assets or are guaranteed unconditionally by their issuer. Shareholders do not have such security or guarantee.

Collaterals and guarantees for equity-classified perpetual bonds are effective only during liquidation of issuers. As emphasised by paragraph BC18 of the Basis for Conclusions on IAS 32, these features should not be considered when classifying financial instruments since financial statements are prepared assuming that the reporting entity will remain in operation.

3.   Some perpetual bonds have sinking funds for the issuer to gradually deposit money for the purpose of redemption on callable dates.

While money deposited into sinking funds has to be paid out, issuers of such equity-classified perpetual bonds have the sole discretion to not deposit money in the first place, else those bonds would have to be classified as liabilities. In the case of perpetual sukuks issued by Yinson and PESTECH, not depositing money into sinking funds will only result in higher subsequent distribution rates, which is only a form of “economic compulsions” as elaborated earlier.

4.   Under IAS 32, an equity-classified financial instrument must include no contractual obligations to exchange financial assets under conditions that are potentially unfavourable to the issuer. Inability to pay ordinary share dividends, pledged assets, sinking fund feature, and stepped-up distribution rates are such conditions.

This refers to paragraph 16(a)(ii) of IAS 32. The preceding paragraph 16(a)(i), which explicitly states that equity-classified instruments must include no obligation to deliver cash (without mentioning “unfavourable conditions”), is actually more relevant for the case of perpetual bonds.

Nonetheless, cash is considered a financial asset as per paragraph AG3. Thus, paragraph 16(a)(ii) may still be applicable.

Issuers of equity-classified perpetual bonds must indeed have no obligations to exchange financial assets, such as redeeming those bonds, under unfavourable terms. Both “obligations” and “unfavourable conditions” go together in this paragraph of IAS 32. However, equity-classified perpetual bond issuers could avoid those unfavourable conditions, for example by paying distributions or making redemptions, hence there is no obligation involved.

5.   “A specific statement could be found [in IAS 32] to assert that a financial instrument is not a financial liability does not mean it is necessarily equity.”

This is correct. Paragraph 11 of IAS 32 defines financial instrument as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity,” while paragraph 15 states that: “The issuer of a financial instrument shall classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity instrument...” However, it is extremely unlikely for perpetual bonds to be classified as assets on the book of their issuers.

6.   Paragraph 11 of IAS 32 defines equity as “any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.” Perpetual bonds do not share the residual interests.

What about the case of equity-classified preference shares with fixed liquidation preference? IAS 32 has not limited equity classification to only instruments with the “most residual” interest. This so-called “narrow-equity approach” to equity classification had been proposed by IASB in their discussion paper on the Conceptual Framework for Financial Reporting published in July 2013, but was abandoned by September 2014.

As seen in paragraph 4.63 and 6.89 of the Conceptual Framework for Financial Reporting, and reinforced in paragraph 19 of agenda paper 5A on the topic of “Features of Claims” issued for IASB Meeting in June 2015, IFRS actually uses the term “residual” to describe how the equity element/building block of financial statements is determined: the “total equity” is not measured directly based on its current value, but rather, derived from the leftover value of assets after all liabilities are determined.

However, some equity classes can have fixed claims on the leftover asset value. Paragraph 4.64 of the Conceptual Framework for Financial Reporting further defines all claims that do not meet the definition of a liability as “equity claims,” some classes of which as according to paragraph 6.89, can be measured directly (equity-classified preference shares and perpetual bonds would fall under this category), although at least one class (for example, ordinary shares) must be measured indirectly.

7.   IAS 32 “clarifies that equity is in the class of financial instruments that are subordinated to all other classes.” Perpetual bonds rank ahead of ordinary shares.

In IAS 32, the condition of being “subordinated to all other classes” applies only to equity-classified puttable instruments and also to equity instruments containing obligations to deliver a pro rata share of issuer’s net assets during liquidation. Both are just subsets of all possible equity instruments, and equity-classified perpetual bonds are not within these subsets.

8.   “To substantiate as equity (AG14E), its attributed cash flows over its life must be based substantially on the profit and loss, ...” [Perpetual bonds’ cash flows are relatively fixed.]

Paragraph AG14E in IAS 32 is an application guidance for paragraph 16A(e), which in turn governs the classification for puttable instruments. As defined in paragraph 16A, puttable instruments are those that involve obligations for repurchase or redemption by the issuer. Redemption of equity-classified perpetual bonds is an option but not obligation of their issuers.

9.   “IAS 32 (AG6) actually defines perpetual debt instruments, such as perpetual bonds, debentures and capital notes… Changing the name “perpetual debts” to “perpetual securities” does not make it equity.”

Paragraph AG6 focuses on the definition of “perpetual” rather than “perpetual debt.” Perpetual bonds, perpetual debentures, and perpetual capital notes are given as examples to illustrate their lack of maturities. The paragraph does not classify all perpetual bonds as liabilities, although some perpetual bonds are indeed liabilities.

Classifying financial instruments based on their names would go against paragraph 18 of IAS 32, which states that “The substance of a financial instrument, rather than its legal form, governs its classification in the entity’s statement of financial position.” An example illustrated in the said paragraph is preference shares, which could be liabilities depending on their terms.

10.   IAS 32 states that the requirement to satisfy a contractual obligation may be absolute or contingent on the occurrence of a future event. A contingent obligation meets the definition of a financial liability, even though such liabilities are not always recognised in the financial statements. “To argue that perps are equity because they lack an “absolute contractual obligation” is wrong and was anticipated in IAS 32.”

This refers to paragraph AG8 of IAS 32. The hint for exclusion has already been provided in the phrase “not always recognised in the financial statements.” Again, quoting paragraph BC18 of the Basis for Conclusions on IAS 32: “However, the Board also concluded that contingent settlement provisions that would apply only in the event of liquidation of an entity should not influence the classification of the instrument because to do so would be inconsistent with a going concern assumption. A contingent settlement provision that provides for payment in cash or another financial asset only on the liquidation of the entity is similar to an equity instrument that has priority in liquidation and therefore should be ignored in classifying the instrument.”

11.   Perpetual bonds include clauses that allow redemption by issuers when there are (1) accounting events that result in those perpetuals not being able to be recorded as equity; (2) tax events that result in additional amount to be paid to the government; and (3) rating events that result in lower credit ratings. These clauses are included because “these companies, their bankers, lawyers and accountants are clearly aware that they may be wrong.”

Accounting standards are being updated constantly and there is always risk that a contract accounted for as an off-balance-sheet item or as an equity today may be required to be recognised as a liability in the future, resulting in potential breach of debt or loan covenant on ratios such as leverage ratio and interest coverage ratio. A case could be seen in IFRS 16 that is effective since 2019, under which lessees have to recognise most operating leases previously left out from their balance sheet. Hence, including a clause for redemption upon the occurrence of such an accounting event is a prudent measure.

Clauses on tax-event redemption could be used to protect the interest of ordinary shareholders by avoiding unnecessary payments to the government. It should be noted that financial reporting and tax accounting are prepared for different users and purposes and are subjected to different standards/rules, hence deviations is a natural result (else effective tax rate should always equal the statutory corporate tax rate). IFRS governs only financial reporting, of which the objective is to “provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity,” as per paragraph 1.2 of the Conceptual Framework for Financial Reporting. In Malaysia, tax accounting is subjected to Income Tax Act 1967, which was set by the government to raise revenue.

Rating-event-related clauses are also commonly found in debt instruments to allow issuers to redeem bonds that have fallen in prices due to rating downgrades and to refinance later at lower rates when their ratings improve, hence these clauses should not be a concern even if present in equity-classified perpetual bonds.

Equity Investors Are Not the Only Users of Financial Statements

From these discussions, it seems that the author has not only misinterpreted the standards but also evaluated the economic substance of perpetual bonds from too-narrow a perspective. It is true that many equity investors treat equity-classified perpetual bonds as debts, as seen in replies received by IASB on its targeted outreach with equity analysts in 2020. However, financial statements prepared under IFRS are intended to provide information from “the perspective of the reporting entity as a whole” and not for any particular group of investors, lenders, or other creditors, as clarified in paragraph 3.8 of the Conceptual Framework for Financial Reporting.

The view of debt analysts could be inferred from feedbacks received for IASB’s discussion paper on financial instruments with characteristics of equity issued in June 2018, when they made up a larger proportion of respondents. IASB’s suggestion to change its classification approach, that would have led to liability-classification of securities with similar features to perpetual bonds, was not welcomed by “many” respondents. One particularly relevant view given is that issuers’ option to cancel coupon payment (in the case of non-cumulative perpetual securities) and lack of obligation to repay principal amount before liquidation would provide a buffer when they experience financial difficulties.

​*This is a loose follow-up to my initial writeup titled "Has Yinson Found the Yellow Brick Road?"

*For follow-ups, see The Edge Singapore's article titled “Revisiting perpetual securities,” and my post titled “Malakoff Corporation Berhad – Part 2: A Gap in Understanding the Gap.”