Financial Instruments: Definitions (IAS 32)

Last updated: 15 February 2024

IAS 32 provides fundamental definitions used in accounting for financial instruments. A financial instrument is defined in IAS 32.11 as any contract that gives rise to a financial asset for one entity and a financial liability or equity instrument for another entity.

The terms ‘contract’ and ‘contractual’ play a significant role in these definitions. They refer to an agreement between two or more parties which has distinct economic implications that parties have minimal, if any, discretion to avoid, usually due to enforceability under law. Financial instruments can take diverse forms and do not necessarily have to be in written form (IAS 32.13). Consequently, any assets or liabilities that are non-contractual do not qualify as financial instruments. For instance, taxes and levies imposed by governments are not considered financial liabilities, as they are not contractual but are instead dealt with by IAS 12 and IFRIC 21 (IAS 32.AG12).

In situations where the execution of a contractual arrangement depends on a future event, it is still considered a financial instrument, such as a financial guarantee (IAS 32.AG8). Lease liabilities and receivables under a finance lease also classify as 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), and gold (IFRS 9.B.1).

Let’s delve deeper.

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Definition of a financial asset

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

(a) cash (refer to IAS 32.AG3 for further discussion);

(b) an equity instrument of another entity;

(c) a contractual right to either:

(i) receive cash or another financial asset from another entity, or

(ii) exchange financial assets or liabilities with another entity under potentially favourable conditions;

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

(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 exchanging a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.

Common examples of financial assets include bank deposits, shares, trade receivables, and loan receivables.

Definition of a financial liability

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

(a) a contractual obligation to either:

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

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

or

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

(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 exchanging a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.

Trade payables, bank borrowings, and issued bonds are common examples of financial liabilities.

Definition of equity

An equity instrument, according to IAS 32.11, is any contract that evidences a residual interest in the assets of an entity after deducting all liabilities. It can also be helpful to consider an equity instrument through the inverse definition of a financial liability mentioned above, that is, whether the instrument in question meets the definition of a financial liability. In brief, the issuer of an equity instrument does not have an unconditional obligation to deliver cash or another financial instrument, or if there is such an obligation, it is a fixed amount for a fixed number of equity instruments. Distinguishing between financial liabilities and equity is discussed in more detail here.

Ordinary shares are the most common examples of equity instruments, though there are many more complex types. The accounting for equity instruments by issuers is not covered under IFRS 9 (IFRS 9.2.1(d)), and hence, recognition and measurement are governed by IAS 32. On the other hand, equity instruments held and accounted for by investors are in the scope of IFRS 9.

Contracts to buy or sell non-financial items and own use contracts

Contracts to buy or sell non-financial items, such as commodities like oil or copper, typically do not meet the definition of a financial instrument as they do not lead to a financial asset for either party. In such contracts, the party paying cash is entitled to receive a physical asset, which is not a financial asset. However, exceptions exist when:

• Such contracts can be settled net or by exchanging financial instruments, typically seen in contracts related to commodities, or
• Entity regularly takes delivery of the underlying assets and sells them shortly thereafter to profit from price fluctuations or dealer’s margin.

In these cases, such contracts are treated as though they were financial instruments (i.e., derivatives), as per IFRS 9.2.4-6.

Own use exemption

An exception to the aforementioned rule is if such contracts were entered into and continue to be held for receiving or delivering a non-financial item in line with the entity’s anticipated purchase, sale or usage requirements (IAS 32.8-10, AG20-AG23, IFRS 9.2.4). This is known as the ‘own use exemption’. For further discussion and implementation guidance, see paragraphs IFRS 9.2.6, IFRS 9.BA.2, and IFRS 9.IG.A.1.

When delivery or receipt of the physical asset has occurred and payment is postponed, a financial instrument arises, representing a typical trade payable and receivable.

Contracts with variable volume

The ‘own use’ exemption can present challenges when applied to contracts with variable volumes. For instance, an entity that buys electricity on the market and sells it to end users might effectively provide an option to the customer, who decides on the quantity to purchase. However, such contracts are typically treated as ‘own use’ contracts (i.e., not recognised and measured at fair value) because the customer (the option holder) can’t store the underlying assets or easily convert the purchases into cash.

Fair value option

IFRS 9 includes 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. This applies even if these contracts were entered into for the purpose of receiving or delivering a non-financial item in accordance with the entity’s anticipated purchase, sale or usage requirements (IFRS 9.2.5).

Power purchase agreements (PPAs)

A Power Purchase Agreement (PPA) is a long-term contract wherein an entity procures electricity directly from a renewable energy generator. In response to global efforts to combat climate change, entities increasingly participate in PPAs, leading to questions about the application of the ‘own use’ exemption.

The IFRS Foundation’s technical staff prepared a comprehensive technical analysis on this topic. The IFRS Interpretations Committee concluded that the principles and requirements in IFRS 9 do not provide an adequate basis for entities to determine the appropriate accounting for PPAs. As a result, the IASB’s project aims to introduce targeted amendments to IFRS 9 concerning the application of IFRS 9.2.4 to PPAs, both physical and virtual.

More about financial instruments

See other pages relating to financial instruments: