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) addresses this classification process. Although IAS 32's approach is founded upon principles, its outcomes sometimes 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 instruments. Instead, it focuses on the instruments' 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 sometimes result in instruments that intuitively seem like equity being accounted for as liabilities.
Partially in recognition of these problems, the International Accounting Standards Board issued amendments to IAS 32 in 2008 which depart from the core principles of the Standard. The amendments, which are effective for periods beginning on or after 1 January 2009, bring relief from certain problems but at the expense of complicating the classification process.
We are pleased to publish this guide Liability or equity? A practical guide to the classification of financial instruments under IAS 32 which offers extensive insights into the more problematic aspects of debt and equity classification under IAS 32, including those that are expected to arise from the amendments published in 2008.
For further information on the guide or the issues raised in it, please contact us.