THE MASTERS OF FINANCE

Running head: MASTERS OF FINANCE
Masters of Finance
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MASTERS OF FINANCE1
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”.

MASTERS OF FINANCE2
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