The classification of the financial instrument as either a liability or as equity is based on the principle of substance over form. Two exceptions from this principle are certain puttable instruments meeting specific criteria and certain obligations arising on liquidation. Some instruments have been structured with the intention of achieving particular tax, accounting or regulatory outcomes, with the effect that their substance can be difficult to evaluate.

　　The entity must make the decision as to the classification of the instrument at the time that the instrument is initially recognised. The classification is not subsequently changed based on changed circumstances. For example, this means that a redeemable preference share, where the holder can request redemption, is accounted for as debt even though legally it may be a share of the issuer.

　　In determining whether a mandatorily redeemable preference share is a financial liability or an equity instrument, it is necessary to examine the particular contractual rights attached to the instrument's principal and return elements. The critical feature that distinguishes a liability from an equity instrument is the fact that the issuer does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation. Such a contractual obligation could be established explicitly or indirectly. However, the obligation must be established through the terms and conditions of the financial instrument. Economic necessity does not result in a financial liability being classified as a liability. Similarly, a restriction on the ability of an entity to satisfy a contractual obligation, such as the company not having sufficient distributable profits or reserves, does not negate the entity's contractual obligation.

　　Some instruments are structured to contain elements of both a liability and equity in a single instrument. Such instruments – for example, bonds that are convertible into a fixed number of equity shares and carry interest – are accounted for as separate liability and equity components. 'Split accounting' is used to measure the liability and the equity components upon initial recognition of the instrument. This method allocates the fair value of the consideration for the compound instrument into its liability and equity components. The fair value of the consideration in respect of the liability component is measured at the fair value of a similar liability that does not have any associated equity conversion option. The equity component is assigned the residual amount.

　　IAS 32 requires an entity to offset a financial asset and financial liability in the statement of financial position only when the entity currently has a legally enforceable right of set-off and intends either to settle the asset and liability on a net basis or to realise the asset and settle the liability simultaneously. An amendment to IAS 32 has clarified that the right of set-off must not be contingent on a future event and must be immediately available. It also must be legally enforceable for all the parties in the normal course of business, as well as in the event of default, insolvency or bankruptcy. Netting agreements, where the legal right of offset is only enforceable on the occurrence of some future event – such as default of a party – do not meet the offsetting requirements.

　　Rights issues can still be classified as equity when the price is denominated in a currency other than the entity’s functional currency. The price of the right is denominated in currencies other than the issuer’s functional currency, when the entity is listed in more than one jurisdiction or is required to do so by law or regulation. A fixed price in a non-functional currency would normally fail the fixed number of shares for a fixed amount of cash requirement in IAS 32 to be treated as an equity instrument. As a result, it is treated as an exception in IAS 32 and therefore treated as equity.