Question

Companies often enter into financial instruments that straddle the line between liability and equity classification in the financial statements. These instruments are becoming increasingly common and complex as markets evolve. Although based on sound fundamentals, the model for distinguishing liabilities from equity can be difficult to apply— determining classification challenges. This is, in part, because the model can result in different classification for instruments with minor differences in contractual terms. And, classification is not solely a balance sheet matter. It also drives whether or not the income statement is impacted.

Q1:

What effect does the classification of an instrument as either debt or equity have on a firm's capital structure (Balance Sheet and debt ratios, cost of borrowing)?

Q2:

What are some features of instruments that help classify as debt or equity?

Answer 1

Q1.

Effects	DEBT	EQUITY
Balance sheet	Liabilities increases	Shareholders equity increases
Debt Ratios	Increases( as Debt > Equity)	Decreases(as Debt < Equity)
Cost of borrowing	Decrseases ( As debt carries lower return and also there is Tax saving on interest portion)	Increases( As Equity Investors requires higher return on borrowings)

Q2. Features that help toclassify as Debt or Equity are as follws:-

A. Whether the Instrument is issued for a specified peiod or for an indefinite period, As debt is issued for a particular period and equity i s issued for an indefinite period.

B. Cost of borrowing is higher or lower, As debt generally have lower cost than Equity.

C. Whether there is requirement of periodic payment of stated interest or there is no such requirement, As debt carries a periodic payment of interest whereas Equity do not require periodic payments they are entitled for dividend as and when Directors declare dividend.