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.
IAS 32 ‘Financial Instruments: Presentation’
IAS 32 ‘Financial Instruments: Presentation’ (IAS 32) addresses this classification process. Although IAS 32’s approach is founded upon principles, its outcomes can sometime seem surprising. This is partly because, unlike previous practice in many jurisdictions around the world, IAS 32 does not look to the legal form of an instrument. Instead, it focuses on the instrument’s contractual obligations.
Identifying the substance of the relevant obligations can itself be challenging, reflecting the huge variety of instruments issued by different types of entities around the world. Moreover, these principles sometime result in instruments that intuitively seem like equity being accounted for as liabilities. As a result, the IASB has made some amendments to the Standard which depart from its core principles, further complicating the classification process.
Liability or equity?
Fortunately the member firms within Grant Thornton International – one of the world’s leading organisations of independently owned and managed accounting and consulting firms – have gained extensive insights into the more problematic aspects of debt and equity classification under IAS 32. Grant Thornton International, through its IFRS team, develops general guidance that supports its member firms’ commitment to high quality, consistent application of IFRS. We are pleased to share these insights by publishing the second edition of ‘Liability or equity? A practical guide to the classification of financial instruments under IAS 32’ (the Guide).
The Guide reflects the collective experience of Grant Thornton International’s IFRS team and member firm IFRS experts. It addresses IAS 32’s key application issues and includes interpretational guidance in certain problematic areas. The second edition of the Guide reflects amendments that have been made to IAS 32 since the Guide was first published and our latest thinking on some of the more problematic areas of interpretation.
The Guide is organised as follows:
- Section A gives an overview of the Guide
- Section B considers the basic principle of financial liability classification. It discusses contractual obligations, how they arise and their effects
- Section C looks at those financial instruments which can be settled in an entity’s own equity instruments and considers whether they should be classified as liabilities or as equity
- Section D addresses the 2008 amendments to IAS 32 relating to puttable instruments and obligations arising on liquidation
- Section E discusses compound financial instruments – instruments which possess both liability and equity components
- Section F considers briefly the IASB’s potential plans for the development of a new model for liability and equity classification.
- Appendices A and B set out the full definitions of ‘financial liability’ and ‘equity’ respectively.
- Appendices C and D discuss certain specific issues raised in the main body of the Guide in further detail.