THE MASTERS OF FINANCE

Running head: MASTERS OF FINANCE
Masters of Finance
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1MASTERS OF FINANCE
Importance of understanding the impact of classification of classification of financial
instrument as debt or equity in financial sstatements
Introduction:
When a financial instrument is issued by an organization, there must be a
determination of classification under either liability (debt) or equity. Such determination
carries an instant and noteworthy effect on the company’s financial position and
performance. The classification of liability creates an impact on the company’s gearing ratios
and usually contributes to treatment of any payment as interest and may be charged to income
(Weygandt, Kimmel and Kieso 2019). Classifying of equity helps in avoiding this effect but
the investors may perceive it adversely if it is noticed as weakening their current interests in
equity. Having a better understanding of classification procedure and its impact is considered
as critical issue for management and may be kept in mind at the time of assessing the
alternative financial options.
Discussion:
The process of classifying the “debt and equity” in an organization’s “statement of
financial position” is not generally considered easy for the financial report preparers.
Majority of the financial instruments carries both the features and brings out results that can
contribute to inconsistency in reporting. The “IAS 32” helps in clarifying the description of
“financial assets”, “financial liabilities” and “equity”. By doing this, it helps in eliminating
the existence of uncertainty when recording these financial instrument (Schroeder, Clark and
Cathey 2019). The purpose of “IAS 32, presentation” is to lay down the principles for
recording the liabilities or equities in the financial instrument and also for offsetting the
“financial liabilities” and “assets”.

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Arrangement of “financial instrument” by the issuer as either the “debt or equity”
can result in noteworthy effect on the corporation’s gearing ratio, debt covenants and
business earnings. Correctly classifying the equity can help in avoiding these impact but
might be perceived in a negative manner if it is found to be diluting the current equity interest
(Henderson et al. 2015). The difference between “debt and equity” is also important where a
company issues monetary instrument to raise the funds to settle a business arrangement by
using cash or as the “part consideration” in a business arrangement.
Having a better understanding of the characteristics of classification rules and
probable impacts is regarded important for administration and they must bear in mind while
assessing the alternate financing possibilities. The classification of liability commonly leads
to any payment being considered as interest and charged to income that may ultimately create
an impact on the company’s ability to pay dividends on the equity shares (Harrison, Horngren
and Thomas 2014). An important aspect of debt is that the issuer is under obligation of
delivering either cash or another economic asset to holder. The contractual requirement might
originate from the obligation to pay the “principal or interest or dividends”. Such type
contractual responsibility might be recognised explicitly or indirectly but based on the terms
of arrangement. For instance, a bond which necessitates the issuer to make payment of
interest and redeem the bond in exchange of cash is categorized as debt.
On the contrary to above explanation, equity is regarded as any type of agreement
which indicates an outstanding interest in the company’s asset after making all the deduction
of its liabilities. A “financial instrument” is regarded as “equity instrument” only when the
instrument does not comprises of any contractual obligations to provide cash or alternative
monetary asset to another company and if the instrument might be settled inside the own
“equity instruments” of the issuers (Schaltegger and Burritt 2017). For example, ordinary
shares, where all the payments are based on the decision of issuer, they are categorized as

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equity of the issuer. The arrangement cannot be considered very simple. For instance, it is
necessary to convert the preference shares into certain number of ordinary shares on the static
date or upon the occurrence of any event which is certain to happen, must be categorized as
equity.
An agreement cannot be treated as equity instrument completely since it might result
in receipt or distribution of the company’s own equity instrument. The classification of such
type of agreement is very much reliant on whether or not there is any kind of variance in any
number of equity shares that is delivered or the variance in the sum of cash or financial assets
received (Kimmel et al. 2016). An agreement which is established by an organization
receiving or distributing any kind of fixed number of its own equity instrument in exchange
for a fixed sum of cash or other monetary asset is regarded as an “equity instrument”.
Classifying the financial instrument either as equity or debt is simply based on the
“principle of substance” over form. There are two exemptions from this principle which is
certain recognizable instrument only when it meets specific criteria and specific objectives
originating from liquidation (Warren and Jones 2018). There are also some instrument that
are structured with the objective of attaining specific tax, bookkeeping or supervisory results
based on the effect that their constituent can be problematic to assess.
An organization is required to take decision in order to classify the instrument while
initially recognizing the instrument. The arrangement is not changed afterwards on the basis
of altered situations (Levi and Segal 2015). For instance, this implies that a redeemable
preference shares, where a request for redemption can be made by holder, which is then
recorded as debt although lawfully it might be a share of issuer.
In ascertaining whether an obligatory “redeemable preference share” amounts to a
“financial liability” or an “equity instrument” it is important to inspect the specific

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“contractual rights” that is attached with the instrument’s principal and returning
components. An important feature which differentiates a liability from the “equity
instrument” is based on the fact the issuer do not have any unqualified right to avoid delivery
of cash or other type of “financial asset” for settling the “contractual obligation”. The IAS
32 necessitates an organization to set off the “financial assets and liabilities” in the balance
sheet only when the company presently has the lawfully enforceable right of off-setting and
aims either to settle the “asset and liability” on “net basis” or to realise the liability and asset
concurrently.
Conclusion:
On arriving at the conclusion it can be stated that the classification of financial
instrument is clearly regarded as the challenging issue in practice. The application of IAS 32
makes the use of principle based definition to define the financial liability and equity. The
study conclusively shows that irrespective of whether an instrument is classified as either
financial liability or equity it creates a direct impact on the company’s reported outcome and
financial position. Understanding the procedure of classification and its impact is hence
regarded as a critical issue for the management and should be borne in mind when assessing
the available alternative financial options.

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References:
Harrison Jr, W.T., Horngren, C.T. and Thomas, C.W., 2014. Financial accounting. Pearson
Education.
Henderson, S., Peirson, G., Herbohn, K. and Howieson, B., 2015. Issues in financial
accounting. Pearson Higher Education AU.
Kimmel, P.D., Weygandt, J.J., Kieso, D.E. and Trenholm, B., 2016. Financial Accounting.
Wiley Custom Learning Solutions.
Levi, S. and Segal, B., 2015. The Impact of Debt-Equity Reporting Classifications on the
Firm's Decision to Issue Hybrid Securities. European Accounting Review, 24(4), pp.801-822.
Schaltegger, S. and Burritt, R., 2017. Contemporary environmental accounting: issues,
concepts and practice. Routledge.
Schroeder, R.G., Clark, M.W. and Cathey, J.M., 2019. Financial accounting theory and
analysis: text and cases. John Wiley & Sons.
Warren, C. and Jones, J., 2018. Corporate financial accounting. Cengage Learning.
Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2019. Financial accounting. Wiley.