Due to a fairly high rate of innovation and to more stringent regulatory requirements (capital adequacy ratio, etc.), it is becoming more and more difficult to clearly differentiate some debt instruments from capital stock instruments.

In order to give or restate a few guidelines, the French Institute of Chartered Accountants has recently published a position paper. Some efforts have also been made in this area at an international level (cf. Draft E 48 from IASC).

Capital stock is defined as follows: a financial instrument is considered as capital stock when the provisions of the contract and the business analysis of the issue combine the following features:

(1) the instrument is not reimbursable, redemption is under the exclusive control of the issuer or redemption is completed through the issuance or attribution of another capital stock instrument


(2) no rewards are due and then considered as liabilities in the case of absence of profits.

This definition supports a substance over form analysis, which is different from the definition which results from the French rules. When feature (2) is not fulfilled, instruments belong to the section "other capital stock", which is not the same as capital stock.

(1) Therefore, for example an instrument should not be classified as capital stock when the issuer does not have true control over redemption or when there is in fact redemption from a business point of view, even if the instrument legally has all the characteristics of a capital stock instrument.

True control over redemption means that the issuer can choose the redemption date if any himself. Any trigger event or any underlying constraint, such as progressive interest which would lead the issuer to reimburse instruments at a cost becoming much higher than the market rate, would contribute to a lack of control. Consequently features such as no maturity date and redemption on the issuer's decision are not sufficient on their own.

Redemption from a business point of view: a financial instrument would not be classified as capital stock when redemption is made on the basis of out-of-market interest rates and then instalments. Perpetuals with out-of-market interest rates would not be suitable.

Redemption through issuance or attribution of a capital instrument:

This provision slightly enlarges a little bit the opportunities for financial instruments to be classified as capital stock. However, this is only possible if feature (2) is fulfilled.

(2) Capital stock rewards (such as dividends) are paid only when of the issuer's profits allow this. These rewards are not considered as liabilities, as the trigger event for the determination of their amounts and their payment is the profit made by the issuer.

When the determination of these rewards does not depend on the profits of the company, the rewards are considered as liabilities, even if the payment is postponed until the issuer has returned to a profit making situation. In this case, the instrument is not considered as capital stock. If feature (1) is fulfilled, it would be classified as other capital stock. Bonds reimbursable in capital stocks (O.R.A.) would then be considered as "other capital stock", as there is redemption through issuance of new stock but interest is paid regardless of the profits of the issuer.

These concepts result from a position paper of the French Institute for Chartered Accountants. This position paper is not a rule and given the different provisions of the French Code, it could be implemented for consolidated financial statements. Capital stock is defined very restrictively for individual financial statements and capital stock instruments not included in to the list given by the French Code would be classified as "other capital stock" here. However, this position paper gives some very useful conceptual guidelines which should be applied in order to assess the qualification of any financial instrument.

For more information, please contact Olivier DRION on
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