Financial Instruments: Definitions (IAS 32)

Definitions essential in accounting for financial instruments are set out in IAS 32.

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).

A financial asset is any asset that is (IAS 32.11):

(a) cash (see IAS 32.AG3 for more discussion);

(b) an equity instrument of another entity;

(c) a contractual right:

(i) to receive cash or another financial asset from another entity; or

(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity

(d) a contract that will or may be settled in the entity’s own equity instruments and is:

(i) 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

(ii) 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.

A financial liability is any liability that is (IAS 32.11):

(a) a contractual obligation:

(i) to deliver cash or another financial asset to another entity; or

(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity;

or

(b) a contract that will or may be settled in the entity’s own equity instruments and is:

(i) 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

(ii) 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.

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.

Contracts to buy or sell non-financial items (e.g. a contract to buy commodities) do not meet the definition of a financial instrument, as they don’t give rise to a financial asset to neither of the parties (i.e. the party paying cash will receive physical asset which is not a financial asset as discussed above). However:

  • when these kind of contracts are eligible to be settled net or by exchanging financial instruments (usually contracts on commodities) or
  • for similar contracts entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin

such contracts are accounted for as if they were financial instruments. However, this statement does not apply if such contracts were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements  (IAS 32.8-10,AG20-AG23). This is often referred to as the ‘own use exemption’. See paragraph IFRS 9.2.6 and IFRS 9.BA.2 for more discussion and IFRS 9 IG A.1 for implementation guidance.

When the delivery or receipt of the physical asset has taken place and the payment is deferred beyond that point, a financial instrument arises representing a common trade payable and a trade receivable.

A common challenge in applying the ‘own use’ exemption discussed above is posed by contracts for variable volume. For example, it may be argued that when a company that buys electrical energy on the market and sells it to end customers has de facto written an option to the customer, as the customer decides how many units they want to buy. In practice, the most common approach is that these kind of contracts are accounted for as ‘own use’ contracts (i.e. not recognised and measured at fair value) because they are not capable of being settled net by the customer (the option holder), as the customer can’t store it or easily realise the purchases for cash.

IFRS 9 contains a ‘fair value option’ for contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, even if these contracts were entered into for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements (IFRS 9.2.5).

Financial instruments include also derivatives such as financial options, futures and forwards, interest rate swaps and currency swaps. See the discussion on derivatives contained in paragraphs IAS 32.AG15-AG19. Derivatives are also discussed in more detail in IFRS 9.

See other pages relating to financial instruments:

© 2018-2020 Marek Muc

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