The purpose of this report is to list the arguments against elimination of the distinction between
debt and equity in the company’s financial structure. The distinction between debt and equity is
associated with certain combination of characteristic that include the presence of an obligation to
sacrifice future economic benefits, maturity and voting rights. The critical feature that distinguishes a
liability from an equity instrument is the obligation to deliver cash or another financial asset to the
holder. “The contractual obligation may arise from a requirement to repay principal or interest and
may be established explicitly or indirectly but through the terms of the agreement (ACCA, 2014).”
However, different capital instruments introduced over the years have features of both debt and
equity, which causes difficulties in their classification.
Proprietary theory of equity states that there is no “fundamental distinction between a legal entity
and its owners and that main purpose of financial statements is to report information useful for the
owners (Riahi-Belkaoui, 2004)”. According to this theory, the accounting equation is viewed as
Assets–Liabilities= Proprietor’s Equity and its main objective is to determine and analyze the
proprietor’s net worth. Potential effects of capital classification rules have significant impact on the
amount of net assets that is credited to all the shareholders of the entity.
On the other hand, finance theory views the entity as the sum of economic resources (funds) and
related obligations and restrictions in the use of these resources. Accounting equation is viewed as
Assets=Restriction of assets. This theory is asset centered and measures the performance of the
company in terms of sources and dispositions of funds.
All providers of capital are most interested in entity’s ability to generate future cash flows. The
importance of capital structure is best reflected in the requirement for each company to divide its
cash flows into payments of interest to debt holders and residual component that can be distributed
as dividend to shareholders. Classification of financial instruments also has important impact on the
following accounting measures and cash payments associated with them:
 Entity’s gearing ratio
 Reported earnings
 Debt covenants
Proper capital structure influences company’s performance in several ways. Firstly, it minimizes the
entity’s cost of capital by determination of most appropriate mix of different funds. Secondly,
adequate capital gearing increases the chances to attract new investment opportunities because it
maintains the confidence of debt suppliers. Eventually, improved performance and growth
opportunities will lead to increase in share price and maximization of the market value of the
company.
After analyzing the distinction between debt and equity, it is justifiable to conclude that defining two
different classes of capital on the credit side of the balance sheet provides decision-useful
information for the users of financial statements.

References

1. Schroeder R., Clark M., Cathey J., 2011, Financial accounting, theory and analysis-text and cases
10 th edition, John Wiley and Sons
2. Riahi-Belkaoui A., 2004, Accounting theory, Thomson publishing p.215-217

3. ACCA Global, 2014, When does debt seem to be equity? Available at:
http://www.accaglobal.com/in/en/student/exam-support-resources/professional-
exams-study-resources/p2/technical-articles/when-does-debt-seem-to-be-equity-.html

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