Information regarding financial instruments is vital to stakeholders and operators alike, as it provides insight into the risks related to financial assets and financial obligations including the exposure to risks arising from these to the entity and how they are managed. Such information can influence an investor’s assessment of the financial position and financial performance, as well as provide insight into the amount, timing, and risk of an entity’s future cash flows.
The extent and nature of financial instruments held by firms varies significantly from those that have few financial instruments and those that have many and complex financial instruments. The complexity and extent of the requirements or presentation, recognition, measurement, and disclosures of financial instruments depends on the extent of the entity’s application of financial instruments and of its exposure to risk.
It is common for firms to apply derivatives in managing interest rate risk, credit risk, and risks associated with fluctuating industry prices of investments.
A financial instrument is any contract that gives rise to both a financial asset of one entity and a financial obligation or equity instrument of another entity.
Assets and obligations in firms arise from both contractual and non-contractual arrangements. Assets and obligations arising from non-contractual arrangements are unacceptable when defining a financial asset or a financial obligation. Physical assets, leased assets, and intangible assets are also unacceptable as financial assets. Similarly paid assets are unacceptable because they represent economic benefits in the form of future receipt of goods or assistances.
Constructive obligations are noncontractual and are therefore unacceptable as financial obligations.
A contract is an agreement between two or more parties that has clear economic consequences that the parties have low or no discretion to keep away from, typically because the agreement is enforceable by law. Contracts, and thus financial instruments, take a variety of forms and can be unwritten.
Firms enter arrangements that have the substance of contracts. A firm considers the substance rather than the legal form of an arrangement in determining whether it is a contract that fulfils the definition of a financial instrument. Contracts are generally evidenced by the following (although this could vary from jurisdiction to jurisdiction):
- Contracts involve willing parties entering an arrangement,
- The terms of the contract create rights and obligations for the parties to the contract, and those rights and obligations could result in equal or unequal performance by each party, and
- The remedy for non-performance is enforceable by law.
A financial asset is any asset that is:
- 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 obligations with another entity in conditions that are potentially favourable to the entity.
- A contract that is settled in the entity’s own equity instruments.
Currency (cash) is a financial asset because it represents the medium of exchange and is therefore a basis on which all transactions are measured and recognised in financial statements. A deposit of cash with a bank or similar financial institution is a financial asset because it represents the contractual right of the depositor to obtain cash from the institution or to draw a check or similar instrument on the balance in favour of a creditor in payment of a financial obligation.
Unissued currency is unacceptable as a financial instrument.
Common examples of financial assets representing a contractual right to receive cash in the future:
- Accounts receivable,
- Notes receivable,
- Credits receivable,
- Equity securities, and
- Bonds receivable.
A financial obligation is any obligation that is:
- A contractual obligation:
- To deliver cash or another financial asset to another entity, or
- To exchange financial assets or financial obligations with another entity in conditions that are potentially unfavourable to the entity.
- A contract that is settled in the entity’s own equity instruments.
Common examples of financial obligations representing contractual obligations to deliver cash or another financial asset to another entity in the future are:
- Accounts payable,
- Notes payable,
- Credits payable,
- Bonds payable.
Again, in each circumstance, one party’s obligation to deliver cash or another financial asset is matched by contractual right of another party to receive cash.
One entity’s contractual right to receive cash is matched by the other entity’s corresponding obligation to deliver.
The ability to exercise a contractual right or the requirement to satisfy a contractual obligation is absolute, or contingent on the occurrence of a future event. A contingent right and obligation fulfil the definition of a financial asset and a financial obligation, even though such assets and obligations sometimes are unrecognised in the financial statements.
A financial instrument could require an entity to deliver cash or another financial asset, or otherwise to settle it in such a way that it would be a financial obligation, in the event of the occurrence or non-occurrence of risky future events that are unpreventable by both the issuer and the holder of the instrument such as a change in an interest or exchange rate. The issuer of such an instrument has no unconditional right to steer clear from delivering the cash or another financial asset (or otherwise to settle it in such a way that it would be a financial obligation). Therefore, it is a financial obligation of the issuer and a financial asset of the holder.
Contracts to Purchase or Vend Non-Financial Assets
Contracts for purchasing or vending non-financial assets are unacceptable as financial instruments except
- The contract permits it to be settled net in cash,
- The entity has a practice of settling similar contracts net in cash,
- The entity has a practice of taking delivery and vending the nonfinancial item for a profit, or
- The non-financial item is readily convertible to cash.
Contracts to purchase or vend non-financial items are unacceptable when defining a financial instrument because the contractual right of one party to receive a non-financial asset or assistance and the corresponding obligation of the other party has no establishment of a present right or obligation of either party to receive, deliver, or exchange a financial asset.
Many investment contracts are of this type. Some are standardised in form and trade on organised industries in much the same fashion as some derivative financial instruments.
The ability to purchase or vend an investment contract for cash, the ease with which it can be purchased or vended, and the possibility of negotiating a cash settlement of the obligation to receive or deliver the investment has no alterations on the fundamental character of the contract in a way that creates a financial instrument.
A contract that involves the receipt or delivery of physical assets checks the financial asset of one party and the financial obligation of the other party except any corresponding reimbursement is deferred past the date on which the physical assets are transferred. Such is the situation with the purchase or vend of goods on credit.
Some contracts are investment-linked but are uninvolved with settlement through the physical receipt or delivery of an investment. They specify settlement through cash payments that are determined according to a formula in the contract, rather than through delivery of fixed amounts.
The definition of a financial instrument also encompasses a contract that gives rise to a non-financial asset or non-financial obligation in addition to a financial asset or financial obligation.
Such financial instruments often give one party an option to exchange a financial asset for a non-financial asset.