(a) The difference between debt and equity in an entity’s statement of financial position is not easily distinguishable for preparers of financial statements. Some financial instruments may have both features, which can lead to inconsistency of reporting. The International Accounting Standards Board (IASB) has agreed that greater clarity may be required in its definitions of assets and liabilities for debt instruments. It is thought that defining the nature of liabilities would help the IASB’s thinking on the difference between financial instruments classified as equity and liabilities. Required: (i) Discuss the key classification differences between debt and equity under International Financial Reporting Standards. Note: Examples should be given to illustrate your answer. (9 marks) (ii) Explain why it is important for entities to understand the impact of the classification of a financial instrument as debt or equity in the financial statements. (5 marks) (b) The directors of Avco, a public limited company, are reviewing the financial statements of two entities which are acquisition targets, Cavor and Lidan.They have asked for clarification on the treatment of the following financial instruments within the financial statements of the entities. Cavor has two classes of shares: A and B shares. A shares are Cavor’s ordinary shares and are correctly classed as equity. B shares are not mandatorily redeemable shares but contain a call option allowing Cavor to repurchase them. Dividends are payable on the B shares if, and only if, dividends have been paid on the A ordinary shares. The terms of the B shares are such that dividends are payable at a rate equal to that of the A ordinary shares. Additionally, Cavor has also issued share options which give the counterparty rights to buy a fixed number of its B shares for a fixed amount of $10 million. The contract can be settled only by the issuance of shares for cash by Cavor. Lidan has in issue two classes of shares: A shares and B shares. A shares are correctly classified as equity. Two million B shares of nominal value of $1 each are in issue. The B shares are redeemable in two years’ time at the option of Lidan. Lidan has a choice as to the method of redemption of the B shares. It may either redeem the B shares for cash at their nominal value or it may issue one million A shares in settlement. A shares are currently valued at $10 per share. The lowest price for Lidan’s A shares since its formation has been $5 per share. Required: Discuss whether the above arrangements regarding the B shares of each of Cavor and Lidan should be treated as liabilities or equity in the financial statements of the respective issuing companies. (9 marks) Professional marks will be awarded in question 4 for clarity and quality of presentation. (2 marks)