Hybrid securities combine debt and equity characteristics in a single instrument — convertible bonds, redeemable preference shares, perpetual subordinated notes, and similar instruments that don’t fit cleanly into either category. Their accounting classification under IAS 32 determines whether they appear on the balance sheet as a liability, as equity, or split into both components — and that classification has material consequences for reported leverage, interest expense, and equity presentation.
The fundamental principle under IAS 32 is that classification is based on the substance of the contractual arrangements, not the legal form or the name of the instrument. A “share” that carries a mandatory redemption obligation is a financial liability despite being legally issued as equity. The contractual terms — specifically, whether the issuer has an unavoidable obligation to deliver cash or other financial assets — drive the accounting, not what the instrument is called.
The Classification Framework
Under IAS 32, a financial instrument (or a component of it) is classified as a financial liability if it contains a contractual obligation to:
- Deliver cash or another financial asset to another party, or
- Exchange financial assets or liabilities with another party under conditions that are potentially unfavourable to the issuer
If no such obligation exists — if the issuer has full discretion over whether and when to deliver cash — the instrument is equity. The discretion must be genuine: if market conditions, covenants, or other circumstances would compel payment even without a contractual obligation, the instrument may still be a liability in substance.
Redeemable Preference Shares — Mandatory vs Discretionary
Preference shares are the most common area of misclassification. The name “share” implies equity — but the accounting classification depends entirely on the redemption and dividend terms.
| Feature | Classification | Reasoning |
|---|---|---|
| Mandatory redemption at a fixed future date | Financial liability | The issuer has an unavoidable obligation to deliver cash at redemption |
| Redemption at the issuer’s option (discretionary) | Equity | No contractual obligation — the issuer can choose not to redeem |
| Fixed, non-deferrable dividends | Liability (the dividend stream) | The obligation to pay dividends is contractual and unavoidable |
| Dividends at the issuer’s discretion | Equity | The issuer can choose not to declare a dividend without default |
| Mandatorily redeemable + fixed dividends | Entire instrument is a liability | All cash flows are contractually obligated |
Example — misclassification risk A subsidiary issues “5% Cumulative Redeemable Preference Shares” — $500,000 face value, redeemable in 5 years, paying a 5% fixed dividend annually.
Despite the word “share” in the instrument name:
• Mandatory redemption = liability (contractual obligation to deliver $500,000)
• Cumulative fixed dividend = liability (dividends accumulate and must eventually be paid)
The instrument is entirely a financial liability. Classifying it as equity understates leverage and overstates equity — a material misstatement.
Perpetual Notes — The “Discretion to Defer” Test
Perpetual notes (also called perpetual subordinated bonds or hybrid capital notes) have no fixed maturity — they exist indefinitely and pay interest continuously. The key classification question is whether the issuer has genuine discretion to defer or forgo interest payments.
- Interest is deferrable indefinitely without triggering a default: The instrument may be classified as equity. The issuer has no contractual obligation to deliver cash at any particular time.
- Interest is non-deferrable (a contractual obligation each period): The instrument is a financial liability, even though there is no maturity date for the principal.
- Interest deferral is permitted but cumulates and must eventually be paid: The deferred amounts are a liability — the obligation to pay exists, it is just deferred in timing.
💡 Many perpetual notes issued by banks and corporates include “alternative coupon satisfaction mechanisms” — the issuer can satisfy a deferred coupon by issuing shares rather than cash. This complicates classification: is the obligation to deliver cash (liability) or shares (possibly equity)? The answer depends on whether the issuer has genuine discretion over the satisfaction mechanism or whether it would be economically compelled to pay cash in most circumstances.
Convertible Bonds — The Fixed-for-Fixed Test
For a conversion option to be classified as an equity component (rather than a financial liability), it must satisfy the “fixed-for-fixed” test: the option must give the holder the right to convert into a fixed number of shares in exchange for a fixed amount of cash. Only then is the conversion option an equity instrument of the issuer.
If either variable is not fixed, the conversion option is a financial derivative — measured at fair value through profit or loss — not an equity component.
🚩 Foreign currency convertibles: Where a company whose functional currency is SGD issues a GBP-denominated convertible bond that converts into a fixed number of SGD shares, the fixed-for-fixed test fails. From the issuer’s perspective, the conversion delivers a fixed number of shares (fixed) but the GBP proceeds received vary with the SGD/GBP exchange rate (not fixed in the issuer’s functional currency). The conversion option is therefore a financial liability (an embedded derivative measured at fair value through P&L), not equity. This is a common and significant classification error for groups issuing instruments in currencies other than their functional currency.
| Conversion terms | Classification of conversion option |
|---|---|
| Fixed shares for fixed amount (same currency as functional currency) | Equity component |
| Fixed shares for fixed amount in foreign currency | Financial liability (embedded derivative) |
| Variable shares for fixed amount (“fixed value” conversion) | Financial liability |
| Fixed shares for variable amount | Financial liability |
Compound Instruments — Split Accounting
Where a hybrid instrument has both a liability component and an equity component that satisfy the fixed-for-fixed test, IAS 32 requires split accounting: the liability component is measured first (present value of future cash flows at the market rate for equivalent non-convertible debt) and the equity component is the residual (total proceeds less the liability component).
The split accounting methodology and a worked example are covered in the quasi-equity post in this series. The key principle here: the liability component accretes to its face value over the instrument’s life using the effective interest method, generating interest expense each period that exceeds the coupon cash paid.
Consolidation Implications for Groups
For group finance teams, hybrid securities in subsidiaries require assessment at both the entity level and the group level — the classification in the subsidiary’s own accounts may differ from the appropriate presentation in the consolidated statements.
Perpetual notes issued by a subsidiary to external investors: If classified as equity in the subsidiary, they represent an external equity interest in that subsidiary — and should be presented as NCI in the consolidated balance sheet if the investors hold a real economic interest. The coupon payments, if discretionary, are presented as NCI distributions rather than interest expense at group level.
Preference shares in a subsidiary held by the parent: In the subsidiary’s standalone accounts, mandatorily redeemable preference shares held by the parent are a liability. At consolidation, this intercompany instrument is eliminated — the liability in the subsidiary and the receivable (investment or financial asset) in the parent both disappear. If the preference shares pay fixed dividends, the intercompany dividend income in the parent and the dividend expense in the subsidiary are also eliminated.
Hybrid instruments issued to external investors in a subsidiary — leverage ratios: Where a partially-owned subsidiary has issued perpetual notes classified as equity, the group’s leverage ratios are affected by whether these notes are included in or excluded from group net debt. Lenders assessing group leverage may treat them differently from IFRS — specifically calling them “debt-like” in covenant definitions despite the equity classification. This requires explicit discussion in the group’s financial review commentary.
For groups managing hybrid instruments across multiple entities — preference shares, perpetual notes, convertible bonds — tracking classification, NCI impact, and intercompany eliminations requires entity-level and group-level visibility that BrizoConsol supports. Learn more or see it in action →