What is exactly financial instrument? Financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. In this definition, “contract” refers to an agreement between two parties that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law. An asset or liability that is not contractual (e.g., an obligation to pay income taxes) is not a financial instrument even though it may result in the receipt or delivery of cash. The term “financial instrument” encompasses equity instruments, financial assets, and financial liabilities. And, Equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities [IAS 32, Financial Instrument: Presentation].  These three terms all have specific definitions that help entities determine which items should be accounted for as financial instruments described in detail through this post.

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Back to definition of financial instrument mentioned on the paraprace of this post; this definition reflects the basic accounting equation that states that equity equals assets less liabilities.

Examples of equity instruments includes:

  • Ordinary shares (that cannot be put back to the issuer by the holder)
  • Preference shares (that cannot be redeemed by the holder or provide for nondiscretionary dividends
  • Warrants or written call options (that allow the holder to subscribe for—or purchase—a
    fixed number of nonputtable ordinary shares in exchange for a fixed amount of cash or another financial asset)

The definition of an equity instrument is brief and succinct, but the definitions offinancial asset” and “financial liability” are more complex.

 

Financial Instruments Definitions and Examples Summary

Summarized IAS 32 definitions for those terms follow:

[1]. Financial asset. Any asset that is:

  • Cash;
  • An equity instrument of another entity;
  • A contractual right to receive cash or another financial asset from another entity, or to exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity; or
  • A contract that may or will be settled in the entity’s own equity instrument and is not classified as an equity instrument of the entity (discussed below).

Examples of assets that meet the definition of a financial asset are:

  • Cash, above
  • Investment in shares or other equity instrument issued by other entities, see (b) above
  • Receivables, see (c) above
  • Loans to other entities, see above
  • Investments in bonds and other debt instruments issued by other entities, see (c) above
  • Derivative financial assets, see above
  • Some derivatives on own equity, see above

 

[2]. Financial Liability. Any liability that is:

  • A contractual obligation to deliver cash or another financial asset to another entity; or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity; or
  • A contract that will or may be settled in the entity’s own equity instruments and is not classified as an equity instrument of the entity (discussed below).

Examples of liabilities that meet the definition of financial liabilities are:

  • Payables (e.g., trade payables), see above
  • Loans from other entities, see above
  • Issued bonds and other debt instruments issued by the entity, see (a) above
  • Derivative financial liabilities, see above
  • Obligations to deliver own shares worth a fixed amount of cash, see (b) above
  • Some derivatives on own equity, see above

It follows from the definitions that these assets and liabilities are not financial instruments:

  • Physical assets (e.g., inventories, property, plant, and equipment). Control of physical assets creates an opportunity to generate a cash inflow but does not give rise to a present right to receive cash or another financial asset.
  • Leased assets. Control of leased assets creates an opportunity to generate a cash inflow but does not give rise to a present right to receive cash or another financial asset.
  • Intangible assets (e.g., patents and trademarks). Control of intangible assets creates an opportunity to generate a cash inflow but does not give rise to a present right to receive cash or another financial asset.
  • Prepaid expenses. Such assets are associated with the receipt of goods or services. They do not give rise to a present right to receive cash or another financial asset.
  • Deferred revenue. Such liabilities are associated with the future delivery of goods or services. They do not give rise to a contractual obligation to pay cash or another financial asset.
  • Warranty obligations. Such liabilities are associated with the future delivery of goods or services. They do not give rise to a contractual obligation to pay cash or another financial asset.
  • Income tax liabilities (or assets). Such liabilities (or assets) are not contractual but are imposed by statutory requirements.
  • Constructive obligations. Such obligations do not arise from contracts. (A constructive obligation is defined by IAS 37 as an obligation that derives from an entity’s actions where: (a) by an established pattern of past practice, published policies, or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and (b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities).

 

Apart from items that meet the definition of financial instruments, IAS 32, IAS 39, and IFRS 7 also apply to some contracts that do not meet the definition of a financial instrument but have characteristics similar to derivative financial instruments. This expands the scope of IAS 32, IAS 39, and IFRS 7 to contracts to purchase or sell nonfinancial items (e.g., gold, electricity, or gas) at a future date when, and only when, a contract has both of these two characteristics: (a) it can be settled net in cash or some other financial instrument, and (b) it is not for receipt or delivery of the nonfinancial item in accordance with the entity’s expected purchase, sale, or usage requirements.

 Unlike IAS 39, IAS 32 has no scope exception for an entity’s issued equity instruments that are classified in the equity section of the balance sheet (e.g., an entity’s share capital).

 

Case Example

This case illustrates how to apply the definition of a financial instrument and the scope of IAS 32.

Company A is evaluating whether each of these items is a financial instrument and whether it should be accounted for under IAS 32:
(a) Cash deposited in banks
(b) Gold bullion deposited in banks
(c) Trade accounts receivable
(d) Investments in debt instruments
(e) Investments in equity instruments, where Company A does not have significant influence over the investee
(f) Investments in equity instruments, where Company A has significant influence over the investee
(g) Prepaid expenses
(h) Finance lease receivables or payables
(i) Deferred revenue
(j) Statutory tax liabilities
(k) Provision for estimated litigation losses
(l) An electricity purchase contract that can be net settled in cash
(m) Issued debt instruments
(n) Issued equity instruments
Required:

Help Company A to determine (1) which of the above items meet the definition of a financial instrument and (2) which of the above items fall within the scope of IAS 32.

Solution:

(a) Yes, cash deposited in a bank is a financial instrument. If an entity deposits cash in a bank, it is a financial asset of the entity and a financial liability of the bank, because the bank has a contractual obligation to repay the cash to the entity. It falls within the scope of IAS 32.

(b) No, gold is not a financial instrument. It is a commodity. It is outside the scope of IAS 32.

(c) Yes, a trade accounts receivable is a financial instrument. Trade accounts receivable is a financial asset because the holder has a contractual right to receive cash. It falls within the scope of IAS 32.

(d) Yes, an investment in a debt instrument is a financial instrument. Investments in debt instruments are financial assets because the investor has a contractual right to receive cash. It falls within the scope of IAS 32.

(e) Yes, an investment in an equity instrument is a financial instrument. Investments in equity instruments are financial assets because the investor holds an equity instrument issued by another entity. It falls within the scope of IAS 32.

(f) While an investment in an equity instrument is a financial instrument (a financial asset), if the investor has significant influence, joint control or control over the investee, the investment generally is scoped out of IAS 32 and instead accounted for as an investment in an associate, joint venture, or subsidiary.

(g) No, prepaid expenses are not financial instruments because they will not result in the delivery or exchange of cash or other financial instruments. They are outside the scope of IAS 32.

(h) Yes, finance lease receivables or payables are financial instruments. They are within the scope of IAS 32. (However, they are scoped out of IAS 39 except for recognition and measurement of impairment of finance lease receivables.)

(i) No, deferred revenue does not meet the definition of a financial instrument. Deferred revenue is outside the scope of IAS 32.

(j) No, deferred taxes do not meet the definition of a financial instrument, because they do not arise from contractual rights or obligations, but from statutory requirements. They are outside the scope of IAS 32.

(k) No, provisions do not meet the definition of a financial instrument, because they do not arise as a result of contractual rights or obligations. They are outside the scope of IAS 32.

(l) Even though an electricity purchase contract does not meet the definition of a financial instrument, it is included in the scope of IAS 32 (and IAS 39) if it can be settled net in cash unless it will be settled by delivery to meet the entity’s normal purchase, sale, or usage requirements.

(m) Yes, an issued debt instrument meets the definition of a financial liability. It is within the scope of IAS 32.

(n) Yes, an issued equity instrument is a financial instrument that falls within the scope of IAS 32. However, although an issued equity instrument meets the definition of a financial instrument, there is a specific scope exception for issued equity instruments in IAS 39.