A perpetual debt instrument has no requirement to repay the principle – so why is it sometimes classified as a liability?
When an entity issues a perpetual 'debt' it must first understand all the features to determine whether the instrument is a liability, equity or a compound financial instrument. This then drives whether gains and losses are recognised in equity or in the income statement.
The basics
What's a perpetual debt instrument?
Perpetual debt instruments (such as perpetual bonds, debentures and capital notes) normally provide the holder with the contractual right to receive payments in respect of interest at fixed dates extending into the indefinite future. The holder often has no right to receive a return of principal or might have a right under terms that make it unlikely or far in the future.
Liability or equity?
Where the issuer has discretion over making payments (both principal and interest) this will give rise to equity classification. This is the case even when it is likely that the payments will be made. Classification under IAS 32 is not influenced by the issuer's intentions or compulsion to make a payment.
Where there are mandatory payments, the contractual obligation must be recognised as a financial liability. This would be the case if the principal is returned at any point in the future. It is also the case even if the only mandatory payments are termed interest payments that are paid in perpetuity. Let's take a look at an example.
An entity issues an instrument requiring it to make annual payments in perpetuity equal to a stated interest rate of 8% applied to a stated par or principal amount of C1m. Assuming a market rate of 8% when issued, the instrument is classified as a liability in its entirety at the net present value of the interest payments. In this case, the holder and issuer have a financial asset and a financial liability, respectively.
Measurement of contractual interest
Contractual cash flows of a financial instrument can vary over time, for example, with changes in the applicable interest rate. Interest expense is recognised using the effective interest rate method (EIR) as required by IAS 39 (assuming it is not classified as at fair value through profit or loss).
In effect, interest is recognised at a constant rate over the term of the financial instrument.Where the interest is paid to perpetuity, this means that at each reporting date, the debt instrument will be recorded at its principal amount, which is also its amortised cost.
Treatment of transaction costs
If the entity incurs transaction costs, the debt instrument will be recorded in each reporting period at its initial amount, which is the amount received less transaction costs. The result is that the transaction costs are never amortised, but reflected in the carrying amount indefinitely.
In practice
Perpetual debt comes in a variety of different forms but it is often just 'normal' debt repackaged. A common way to achieve repayment of the principle is through a high rate of interest for a number of years (the primary period) and a negligible amount into perpetuity.
If interest was simply charged to profit or loss based on the contractual terms, the entity would bear an artificially high interest expense during the primary period and little or no interest expense thereafter to perpetuity. This treatment might reflect the form of the loan agreement, but not its substance. From an economic perspective, some or all of the interest payments are repayment of principal. Let's take a look at an example.
An entity issues a perpetual bond for C100,000 on which interest at 14% is paid annually for the first ten years and thereafter at a nominal rate of 0.125%.
Substance
The bond has little or no value at the end of the ten year period. The principal amount is repaid, in effect, over the initial ten year primary period. Consequently, the interest payments during the primary period represent a payment for interest and repayment of principal.
Remaining balance
Interest continues to be recognised on the carrying amount of the debt instrument on an effective interest rate method. Although the carrying value at the end of year ten is small, an amount of C100,000 may be repayable should the entity go into liquidation. In practice, however, there will usually be arrangements to enable the entity to repurchase the debt instrument for a nominal amount and, therefore, extinguish any liability.
What else should you consider?
Disclosure – maturity analysis
It is difficult to determine how, if at all, to include amounts in the required IFRS 7 maturity analysis which requires a maturity analysis for non-derivative financial liabilities that shows the remaining contractual maturities. For example, in the case of perpetual bonds where the issuer has a call option to redeem the bond, the issuer has discretion over the repayment of the principal. Until the option is exercised, the bond's contractual terms are that it is a non-redeemable perpetual bond. Once the call option is exercised, the bond's contractual terms are changed and the bond has a maturity date. If the call option was not exercised, then the undiscounted cash flows would be paid in perpetuity.
If the instrument pays contractual interest to perpetuity, the payments are disclosed in the period that they will be paid but this raises the question of what amount should be shown in the last time band. IFRS 7 does not deal explicitly with such a situation so a number of alternative approaches could be applied. One would be to include the principal amount in the last time band. Another option would be not to include any cash flows in the last time band, but disclose the principal amount in time band entitled 'no maturity'.Whatever form of disclosure is chosen, this is an area where it will be important to provide a clear narrative description of the instrument's terms.
Classification from the holder's perspective
From the perspective of the holder of a perpetual debt instrument, if the financial instrument pays interest for an indefinite period, the instrument would not qualify for held to maturity because there is no maturity date.Whether the instrument is classified as available for sale or held for trading will depend on the facts and circumstances.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
