1. Why is this distinction important?
It is crucial for a company to be aware of the difference between equity and debt. This will assist a company to make informed investment decisions that will be helpful for the growth of the company. When a company advocates increasing funds through capital the task could be tiring and complex if the risks associated with raising capital is not well assessed. A company is required to be conversant with different methods of raising capital to ensure poor investments decisions are avoided (Pratt, 2011). Debt financing are loans given to a company at an interest to be paid back within a specified period. Equity financing on the other hand involves raising capital by selling a part of its ownership of the company.
Therefore, before a company decides to raise funds it is crucial to decide whether to use debt or equity financing. If a company has a firm operating history and sufficient assets, debt financing may be applicable in this scenario. The company can take advantage of debt financing especially when interest rates are low (Pratt, 2011). On the other hand if a company is new in the market and cannot afford to take debt financing the company may opt to embark on equity financing. Equity financing involves shareholders purchasing a part of the company and the company then investment wisely in the money raised so that the shareholders can gain from their investments. Therefore identifying the difference between debt and equity is crucial to ensure wise decisions are made with regard to investment.
2. Why is there a problem with determining whether a particular financial instrument is a liability or equity?
A financial instrument is a tradable asset of any type. It can be either in cash form or in asset depending with the needs of the company. Establishing whether a financial instrument is debt or equity is a complex task since the financial instruments has the characteristics of both debt and equity. In addition, financial instruments have a complex relation with regard to liability or equity (Pratt, 2011). A financial instrument can only be considered to equity if the instrument involves no contractual responsibility to provide cash or another financial asset. According to IAS 32, a financial instrument can be either classified as a liability or equity with accordance to agreement and certain requirements that arise on liquidation (Pratt, 2011). The difficult part is for any company to make the decision before making any agreement.
The company is also required to make the decision before realization of the appropriate instrument. For instance, consider when the company issues preference shares that pay a constant rate of dividends and have a constant redemption trait at a future date, the preference shares therefore have a contractual agreement and can thus to be liability (Pratt, 2011). Nonetheless, preference shares that do not have a constant maturity and the issuer is without contractual agreement to make any payment, the preference shares will therefore be regarded as equity. Therefore, with accordance to the illustration, preference shares can be regarded as either liability or equity depending with the contraction terms and obligation. Thus, it is normally problematic when determining if an instrument is a liability or a debt (Pratt, 2011). The agreements required to be adhered are sometimes not clear and an investor may find it difficult to make an informed decisions before investing.
3. How do you account for instruments with both debt and equity components?
When accounting whether an instrument is a debt or equity the company one is required to check the contractual obligation related to the instrument. For instance, preference shares have the characteristics of both debt and equity and the difference can be identified through the contractual agreement. For a preference share to be considered as a debt, its contractual obligation requires it to have a longer maturity period. This will automatically classify the preference share as a debt (Pratt, 2011). On the other hand, if the preference share has a short period with regard t maturity the preference share is termed being an equity share. Therefore, it all depends with the terms included in the contractual agreement.
4. Is an obligation to issue or repurchase stock a liability or equity?
An obligation to issue or repurchase stock is considered as equity. This is because the liabilities have a longer maturity period in addition they require security on issuance. When issuing stock or when repurchasing stock, no interest payment is related to the stock (Pratt, 2011). Furthermore, the shareholders and investors do not have a financial obligation to the company. Unlike liabilities that require interest payments and the investors are obliged to offer some form of asset as security, when issuing or repurchasing stock an obligation is regarded as equity.
5. What are two alternatives: to account for the instrument as entirely a liability or entirely an equity instrument?
To account whether an instrument is entirely a liability or entirely an equity debt equity ratio alternative can be applied. The debt equity ratio shows the proportion of shareholders’ equity and debt applied to finance a company’s assets. In addition, the alternatives assist companies and investors to decide whether to invest in equity or debt. The alternative is easily applicable and one is able to make informed decisions without being at risk of making any mistake (Pratt, 2011). The other alternative is to analyze the characteristics of both debt and equity.
The characteristics will assist an individual or a company to make informed decisions prior to investing. When one opts to invest in equity finance, no interest is required and the maturity period is shorter. Whereas debt financing has a longer maturing period and one has to pay interest. In addition, the debt financing requires collateral for one to be offered a loan. For a company to attain loan financing it has to have enough assets to qualify for debt financing (Pratt, 2011). Therefore, to account whether an instrument is entirely a liability or equity the two alternatives can be used. For instance, preference shares have the characteristics of both debt and equity to determine whether they can be considered as debt or equity. Debt equity ratio can therefore be applied to determine whether the share is a debt or equity. In addition, the characteristics of preference shares in relation to contractual agreement (Pratt, 2011). When a preference share has a long-term maturity, it is considered as a debt and when the preference share has a short-term maturity period it is considered as an equity finance.
6. What is “mezzanine” debt?
A mezzanine debt is a type of hybrid debt, which has the traits of both debt and equity. The debt is normally for six years with interest being paid in the first three years. The debt is a type of unsecured loan that does not require collateral. Mezzanine debt has fixed equity instruments, which are used to add value of the subordinated debt and permit flexibility when transacting with bondholders (Pratt, 2011).
References
Pratt, J. (2011). Financial accounting in an economic context. Hoboken, NJ: Wiley.
