A financial instrument issued by an entity must be classified either as a liability or equity. The classification has a momentous impact on the financial report of the body. Liability affects the gearing ratio of a company and thus typical outcomes in payments is considered as interest and imposed on earnings (Lo, 2009). On the other hand, classification of Equity negate these effects that may be rendered detrimental by shareholders. Equity is believed to dilute shareholders’ available interests on equity. These three financial instruments; Redeemable stock, stock options and convertible bonds have different characteristics, and they bring issues how to differentiate between instruments of debt and equity.
The second alternative is the most preferred. Issuers should account for an instrument as consisting of a liability component and an equity component which should be estimated separately. According to Lo (2009), the equity component is dependent on the profits that an organization is receiving after investing the amount shared with the business and the obligation of paying all investors by giving them a separate equity. Financial apparatuses that exhibit both features of liability and capital such as convertible bonds obligate the issuer to conduct cash payment on liability and issue stock.
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Issuing of stock is an equity instrument. The alternatives offered are to either justify the instrument as liability exclusively or an instrument of equity. This is dependent on the components that guide the parties during the issuance, which should be accounted individually for both the liability and equity components. Convertible bonds are the only current instruments that do have tangibly divisible elements (Lo, 2009). For example, issued bonds having separable stock buying allows for consideration as part of debt and equity. Liability component is determined by discounting the expected cash flows of bonds which is similar to the rate of debt instrument without offering a conversion option.
In conclusion, it is critical for the management to understand the classification process and the impacts it generates. The classification will help during evaluation of alternative options for financing.
References
Lo, Y. M. (2009). Liability or equity? A practical guide to the classification of financial instruments under IAS 32. Grant Thornton Taiwan . Retrieved on 19 October 2017, from http://www.grantthornton.tw/en/article-page/liability-or-equity/.
