When an entity issues a financial instrument, it must determine its classification either as a liability (debt) or as equity. That determination has an immediate and significant effect on the entity’s reported results and financial position. Liability classification affects an entity’s gearing ratios and typically results in any payments being treated as interest and charged to earnings.
Equity classification avoids these impacts but may be perceived negatively by investors if it is seen as diluting their existing equity interests. Understanding the classification process and its effects is therefore a critical issue for management and must be kept in mind when evaluating alternative financing options.
"Liability or equity? A practical guide to the classification of financial instruments under IAS 32" explains the principles for determining whether the issuer of a financial instrument should classify the instrument as a liability, equity or a compound instrument. The guide sets out the classification process in IAS 32 ‘Financial Instruments: Presentation’ (IAS 32) and draws out a number of practical application problems that are often encountered.