a. Main Distinguishing Features in the Presentation of Debt and Equity (IAS 32)

Under IAS 32, financial instruments are classified as either debt or equity based on the characteristics of the instrument rather than its legal form. Here are the distinguishing features:

1. Debt: Represents a contractual obligation to deliver cash or another financial asset to the holder. For example, bonds or loans that require periodic interest payments and principal repayment are classified as debt.
2. Equity: Reflects a residual interest in the assets of an entity after deducting liabilities. Common shares, for instance, do not obligate the issuer to repay cash but entitle holders to a share of profits and voting rights.
3. Fixed vs. Variable Payments: Debt often requires fixed interest payments, while equity typically allows dividends at the issuer’s discretion.
4. Maturity Date: Debt instruments usually have a specific maturity date for repayment, whereas equity generally has no maturity, representing a perpetual claim on assets.
5. Voting Rights: Equity holders typically have voting rights in the company, unlike debt holders.
6. Classification Based on Substance over Form: A financial instrument may be classified as equity if it includes no contractual obligation to deliver cash, even if it appears similar to debt in form.
7. Convertible Instruments: Instruments like convertible bonds may be classified as debt or equity based on terms (e.g., bonds convertible into a fixed number of shares may be classified as equity).
8. Preference Shares: Preference shares can be classified as equity if dividends are non-mandatory and there is no redemption obligation; otherwise, they are classified as debt.
9. Redemption Provisions: Debt instruments are often redeemable at the option of the issuer or holder, whereas equity instruments may not have such provisions.
10. Impact of Future Events: Instruments classified based on specific future events (e.g., mandatory conversion) require careful assessment under IAS 32 to determine appropriate classification.

Examples: Ordinary shares are equity as they have no obligation for cash repayment. Bonds with fixed interest payments and repayment at maturity are classified as debt.

b. Importance of Correct Classification of Financial Instruments as Debt or Equity

Understanding the impact of classifying a financial instrument as debt or equity is essential for several reasons:

1. Impact on Financial Ratios: Classifying an instrument as debt affects gearing ratios, increasing leverage and potentially impacting investor perceptions.
2. Income Statement Impact: Debt classification requires interest payments to be treated as expenses, reducing profit. Equity classification avoids this impact, as dividends are not recognized as an expense.
3. Investor Confidence: Equity classification is often viewed positively by investors, as it does not dilute earnings. Misclassification can mislead investors about the financial health and capital structure of the entity.
4. Dividends vs. Interest Payments: Debt classification mandates interest payments even in periods of loss, affecting liquidity. Equity, however, allows management discretion over dividend payments based on profitability.
5. Compliance and Reporting Standards: Correct classification ensures compliance with IAS 32 and prevents the need for restatements, which could harm credibility and result in regulatory penalties.