Accounting for corporate finance: key concepts: financial instrument, financial assets, financial liabilities
Meaning of financial instrument, financial asset and financial liability
IAS 32/39 introduced the concept of a ‘financial instrument’. This concept was mirrored in FRS 25/26 under Old UK GAAP. It is now also incorporated in New UK GAAP through FRS 101 (via IAS 32/39) and FRS 102. In each case the definition is similar.
A ‘financial instrument’ is defined as any ‘contract’ that gives rise to both a ‘financial asset’ of one entity and a ‘financial liability’ or ‘equity instrument’ of another entity.
The meaning of a contract in this context is discussed at CFM21080.
In very broad terms, financial assets will, or will likely, lead to a company receiving cash in the future. Financial liabilities will, or will likely, lead to a company paying out cash in the future. But the cash may be received, or paid, via a whole chain of contractual rights or obligations. For example, a company may hold an option to acquire a convertible bond that can be converted into shares that can be sold for cash. So the definitions of financial asset and financial liability in IAS 32 and its equivalent, section 22 of FRS 102, are in general terms.
Examples of financial assets and financial liabilities are at CFM21070.
Common examples of financial assets representing a contractual right to receive cash in the future and corresponding financial liabilities representing a contractual obligation to deliver cash in the future are:
- trade receivables and payables;
- accounts, notes and loans receivable and payable;
- bonds and other debt instruments held or issued.
In each case, one party’s contractual right to receive (or obligation to pay) cash is matched by the other party’s corresponding obligation to pay (or right to receive), meaning that each case is an example of a financial instrument.
The meaning of equity instrumentis discussed at CFM21100.
A derivativeis a particular type of financial instrument whose value changes in response to changes in the value of some underlying subject matter. At any given time, a derivative may be either a financial asset or a financial liability of a company. There is more about derivatives at CFM24200
Most derivatives stand alone. But some financial instruments (for example a convertible bond held by a company) are ‘hybrid instruments’ that combine a non-derivative ‘host contract’ with an ‘embedded derivative’. There is more about embedded derivatives at CFM25030.