Accounting for corporate finance: key concepts: financial instrument, financial assets, financial liabilities: meaning of 'contract'
Contracts and contractual rights
The terms ‘contract’, ‘contractual right’ and ‘contractual obligation’ are fundamental to the definition of financial instrument, financial asset and financial liability.
The reference to a ‘contract’ is to an agreement between two or more parties that has clear economic consequences and which the parties have little, if any, discretion to avoid, usually because the agreement is enforceable at law. Contracts, and thus financial instruments, may take a variety of forms and need not be in writing. Contractual rights and contractual obligations are rights and obligations that arise out of a contract. Assets and liabilities that are not contractual in nature are not financial assets or financial liabilities.
Most contracts give rise to a variety of rights and obligations, and the rights and obligations arising from a contract will often change or be added to as the contract is performed. Some of these rights and obligations may fall within the definition of a financial instrument and some may not. For example, an unperformed contract for the purchase or sale of a tangible asset usually gives rise to rights and obligations to exchange a physical asset for a financial asset (although it is possible that if the contract is breached, the exchange will involve the payment of compensation). These rights and obligations do not represent a financial instrument. Under the same contract, once the physical asset has been delivered, a debtor or creditor will usually arise and this will be a financial instrument.
‘Contractual rights’ and ‘contractual obligations’ encompass both rights and obligations that are contingent on the occurrence of a future event and those that are not. Examples of contingent rights and obligations are those arising under a financial guarantee. Such a guarantee meets the definition of a financial instrument since it gives rise to both a liability for the guarantor (the contractual obligation to pay the lender if the borrower defaults) and an asset for the lender (the contractual right to receive cash from the guarantor if the borrower defaults).
Examples of contracts outside and inside the scope of IAS 39 and Sections 11/12 of FRS 102 are given at CFM21090.