Companies normally obtain financing for operations from three sources:
1. Borrowing funds (debt)
2. Issuing shares (equity)
3. Using internally generated capital (from retained profits) Sometimes, deciding how to present and classify these sources of financing in the financial statements is easily determined. For example, common stock is considered equity and issued bonds are considered debt. However, certain instruments have mixed attributes of debt and equity. ­Consider the following examples:
• Preferred stock
• Redeemable preferred stock
• Convertible bonds • Bonds with detachable warrants
Required
a. Establish a list of criteria that differentiate debt from equity (e. g., debt pays interest whereas equity pays dividends). For purposes of this part, assume that the debt is a secured loan and that the equity is common stock.
b. F or each of the four instruments noted above, make a list of debt and equity attributes.
c. F or each of the four instruments, discuss and provide your opinion about which instruments should be classified (for financial statement presentation purposes) as a long- term liability and which should be classified as equity. Indicate whether you believe this classification is really important and give your opinion as to why or why not. You may want to obtain copies of the FAS B’s 2007 Preliminary Views, Financial Instruments with Characteristics of Equity and the IAS B’s 2008 Discussion Paper, Financial Instruments with ­Characteristics of Equity.