Definition of Financial Instrument
A 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 (IAS 32.11).
‘Contract’ and ‘contractual’ are an important part of the definitions in the realm of financial instruments. They refer to an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law. Contracts, and therefore financial instruments, may take a variety of forms and need not be in writing (IAS 32.13). Consequently, assets or liabilities that are not contractual are not financial instruments. For example, taxes and levies imposed by governments are not financial liabilities because they are not contractual, they are dealt with by IAS 12 and IFRIC 21 (IAS 32.AG12).
When the ability to exercise a contractual arrangement is contingent on the occurrence of a future event, it is still a financial instrument, e.g. a financial guarantee (IAS 32.AG8).
Lease liabilities and receivables under a finance lease are also financial instruments (IAS 32.AG9).
The following are examples of items that are not financial instruments: intangible assets, inventories, right-of-use assets, prepaid expenses, deferred revenue, warranty obligations (IAS 32.AG10-AG11), gold (IFRS 9.B.1).
Definition of Financial Asset
A financial asset is any asset that is (IAS 32.11):
- cash (see IAS 32.AG3 for more discussion);
- 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 favourable to the entity
- a contract that will or may be settled in the entity’s own equity instruments and is:
- a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or
- a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.
The most common examples of financial assets are bank deposits, shares, trade receivables, loans receivables.
So what is financial asset?
> Cash
An equity instrument is defined by IAS 32 as any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities (IAS 32.11). It is also helpful to look at an equity instrument through a reversed definition of a financial liability discussed above, i.e. whether an instrument in question meets the definition of a financial liability. In short summary, an issuer of an equity instrument does not have an unconditional obligation to deliver cash or other financial instrument or if it has, it is a fixed amount for fixed number of equity instruments.
> An equity instrument of another entity
E.g. An Investment made in the form of equity instrument of another entity is financial asset.
> A contractual right to receive cash or another financial asset from another entity
E.g. A sales Contract.
> A contractual right to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity
E.g. A Contract which gives a right to exchange esisting financial assets with better form of financial assets. Here, we are talking about the contract with the right to exchange financial assets / financial liabilities not just any assets / liabilities.
> A contract that will or may be settled in the entity’s own equity instruments and is a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments.
> A contract that will or may be settled in the entity’s own equity instruments and is a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.
Here
1. the contract may be a derivative or a non-derivative contract (Derivative is a contract that derives its value from the changes in value of an underlying asset. E.g. Forwards, Options, Swaps. )
2. the entity will receive variable number of its own equity instruments under the contract (essentially a buyback)
3. the number of equity instruments the entity will receive is variable i.e. the number of equity instruments in the settlement will be based on the intrinsic value of the entity’s share, hence essentially there is no intrinsic loss in the value of the equity of the entity
These test should be done while testing if a financial instrument contains equity element
is there discretion of dividend like in ordinary shares?
is there intrinsic loss to the ordinary shareholders at the point of conversion of the instrument? fixed=loss to company, variable = no loss to cmpany
is the instrument irredemable?
Defintion of Financial Liability
A financial liability is any liability that is (IAS 32.11):
- 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 unfavourable to the entity;
- OR, a contract that will or may be settled in the entity’s own equity instruments and is:
- a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
- a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.
The most common examples of financial liabilities are trade payables, bank borrowings, issued bonds.
So what is financial liability?
> A contractual obligation to deliver cash or another financial asset to another entity;
E.g. A purchase contract
> A contractual obligation to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity;
E.g. A Contract with an obligation to exchange existing financial assets with inferior form of financial assets. Here, we are talking about the contract with the obligatoin to to exchange financial assets / financial liabilities not just any assets / liabilities.
> A contract that will or may be settled in the entity’s own equity instruments and is a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments;
> A contract that will or may be settled in the entity’s own equity instruments and is a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.
Here
1. the contract may be a derivative or a non-derivative contract (Derivative is a contract that derives its value from the changes in value of an underlying asset. E.g. Forwards, Options, Swaps. )
2. the entity will provide a variable number of its own equity instruments under the contract (essentially a buyback)
3. the number of equity instruments the entity will provide is variable i.e. the number of equity instruments in the settlement will be based on the intrinsic value of the entity’s share, hence essentially there is no intrinsic loss in the value of the equity of the entity
Definition of Equity
An equity instrument is defined by IAS 32 as any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities (IAS 32.11). It is also helpful to look at an equity instrument through a reversed definition of a financial liability discussed above, i.e. whether an instrument in question meets the definition of a financial liability. In short summary, an issuer of an equity instrument does not have an unconditional obligation to deliver cash or other financial instrument or if it has, it is a fixed amount for fixed number of equity instruments.
The most common examples of equity instruments are ordinary shares, but obviously it gets much more complicated than that. The accounting for equity instruments by their issuers is outside the scope of IFRS 9 (IFRS 9.2.1(d)) therefore the recognition and measurement is governed by IAS 32. Obviously, equity instruments held and accounted for by investors are governed by IFRS 9.
Difference between Liability and Equity
IAS 32 establishes principles for distinguishing between liabilities and equity. The substance of the contractual terms of a financial instrument governs its classification, rather than its legal form.
An instrument is a liability when the issuer is or can be required to deliver either cash or another financial asset to the holder. This is the critical feature that distinguishes a liability from equity. An instrument is classified as equity when it represents a residual interest in the net assets of the issuer.
All relevant features need to be considered when classifying a financial instrument. For example:
• The instrument is a liability if the issuer can or will be forced to redeem the instrument.
• The instrument is a liability if the choice of settling a financial instrument in cash or otherwise is contingent on the outcome of circumstances beyond the control of both the issuer and the holder, as the issuer does not have an unconditional right to avoid settlement.
• An instrument is a liability if it includes an option for the holder to put the rights inherent in that instrument back to the issuer for cash or another financial instrument.
However, some instruments that are puttable or impose on the entity an obligation to pay a pro rata share of the net assets of the entity only on liquidation are classified as equity, provided that all of the strict criteria are met.
The treatment of interest, dividends, losses and gains in the income statement follows the classification of the related instrument.
Not all instruments are either debt or equity. Some, known as compound instruments, contain elements of both in a single contract. These instruments, such as bonds that are convertible into equity shares either mandatorily or at the option of the holder, are split into liability and equity components. Each is then accounted for separately. The liability element is determined by fair valuing the cash flows excluding any equity component; the residual is assigned to equity.