Debt vs. equity: insights for audit committees

BoardMatters Quarterly – Volume 8

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Why is the debt/equity classification important?

The classification of an instrument as debt or equity can ruin balance sheets and may have an adverse impact on companies. It is key to determining an entity’s liquidity and solvency. An instrument that is classified as equity under Indian GAAP but reclassified as debt under Ind AS could potentially breach debt covenants. Classification of an instrument as a debt rather than equity would also dent the profit or loss account. Therefore, it is important to understand the classification clearly.

How does Ind-AS help understand the debt/equity classification?

Ind-AS 32 Financial Instruments Presentation establishes principles for presenting financial instruments as liabilities or equity. Its key objective is to depict the economic substance of an instrument and not mere legal form. The economic substance of an instrument is decided based on the legal and contractual rights and the obligations attached to it.

An instrument can be classified as equity if:

  • The issuer has an unconditional right to avoid delivering cash or another financial instrument.
  • If it is settled through own equity instruments, it is for an exchange of a fixed amount of cash for a fixed number of the entity’s own equity instruments (generally known as the “fixed-for-fixed” principle).

In all other cases, it is a financial liability.

Further nuances

Preference shares: A preference share that is redeemable at a future date or redeemable at the option of the holder of the instrument is a financial liability. A preference share that is not redeemable in cash or redeemable only at the option of the issuer does not satisfy the definition of a financial liability.

“Fixed-for-fixed” principle

When a financial instrument is settled through an entity’s own equity instruments, it is classified as an equity instrument only if it is for an exchange of a fixed amount of cash for a fixed number of the entity’s own equity instruments.

Compulsorily convertible preference shares (CCPS): These are preference share that are compulsorily convertible into equity shares.