Liability or equity?

When an entity issues a financial instrument, it must classify it as either a liability or equity. This classification significantly impacts the entity’s financial position and results. Liability classification affects gearing ratios and typically results in interest payments charged to earnings. Equity classification avoids these effects but may dilute existing shareholders' interests, potentially leading to negative perceptions from investors. Therefore, understanding the classification process and its effects is crucial for management when evaluating financing options.

IAS 32 ‘Financial Instruments: Presentation’ addresses the classification process, focusing on contractual obligations rather than legal form. This principle-based approach can lead to surprising outcomes, as it may result in instruments that seem like equity being classified as liabilities. Identifying the substance of these obligations can be challenging due to the variety of instruments issued globally. Additionally, amendments to the standard, which depart from its core principles, have further complicated the classification process.

Grant Thornton International, one of the world’s leading networks of independent accounting and consulting firms, has gained extensive insights into debt and equity classification under IAS 32. Through its IFRS team, Grant Thornton develops guidance to ensure consistent application of IFRS across member firms. We’re pleased to share these insights with the second edition of ‘Liability or equity? A practical guide to the classification of financial instruments under IAS 32.’ This edition reflects amendments to IAS 32 and includes guidance on key application issues and challenging 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.