Criteria for classifying as either financial liability or equity
What is the core criteria while classifying a financial instrument as either financial liability or equity?
The core criteria while classifying a financial instrument is to examine whether there exists a future obligation on the part of the entity to part with either cash or any other financial asset of the company while settling a particular contract.
The substance of a financial instrument, rather than its legal form, governs its classification in the entity’s balance sheet. Substance and legal form are commonly consistent, but not always. Some financial instruments take the legal form of equity but are liabilities in substance and others may combine features associated with equity instruments and features associated with financial liabilities. Compulsorily convertible preference shares, eg, provides for mandatory redemption by the issuer only by converting such preference shares into equity shares and as such, the entity does not have any obligation to part with either cash or any other financial asset of the company while redeeming such preference shares.