Equity and Liabilities -- A Discussion of IAS 32 and a Critique of the Classification

It is a traditional convention in accounting to distinguish between two classes of claims, liabilities and equity. The International Accounting Standards Board and the Financial Accounting Standards Board have been using a dichotomous classification approach, adhering to this convention. However, over the recent years, this approach has been put under stress. First, there is an ever-growing variety of hybrid financial instruments, some of which designed to exploit this classification approach (accounting arbitrage). Second, the adoption of IFRS in Europe and elsewhere has brought scenarios to light in which the classification approach does not result in decision-useful information. These issues arise when IFRS are applied by entities in legal forms other than a private or public limited company. This essay discusses IAS 32 in the light of the historic origins of the dichotomous classification approach, the recent standard-setting activities and a review of the empirical research. This essay suggests that a reconsideration of the traditional dichotomous classification might be a way forward.