What Is a Financial Instrument?

A few weeks ago, we published the article about How to Implement IFRS 9 to assist
you with the adoption of the major forthcoming IFRS update.

Many accountants and CFOs are worried about IFRS 9, there are numerous
discussions going on about it, but not everybody has the clear vision about WHAT is
a financial instrument.

Indeed, some items are crystal clear to identify – yes or no.

But some other transactions require careful assessment of the terms in the
contract to conclude whether we deal with the financial instruments and IFRS 9
rules apply.

In today’s article, Mr. Spark Wang and Silvia explain:

1. What the financial instruments are (with a few illustrative examples);

2. The main features of the financial instruments;
3. Where IFRS 9 applies and where it does NOT apply.

What is a financial instrument?

Before we explain what, the financial instrument is, we would like to point out
that the definitions of financial instruments are prescribed in IAS 32 Financial
Instruments: Presentation.

Despite clear definitions in IAS 32 Financial Instruments: Presentation, it’s still

quite difficult to apply IFRS 9, because of the complexity in different scenarios.

For example, it is very tricky to differentiate the perpetual bonds from the
preferred stock, which triggers completely different accounting treatments
subsequently.

So, what is it?

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 par.11)

Please note that unlike other assets or liabilities, financial instruments arise from
the CONTRACT.
Here, the equity instrument is the investment in another entity, so entity’s own
shares are excluded, as well as the interests in the reporting entity’s joint
venture or subsidiary.
Therefore, the financial instrument is a bridging tool between the assets or rights
on one side, and liabilities or equity instruments of another entity on the other
side.

What is a financial asset?

Financial assets are:

 Cash,
 Equity instruments of another entity (e.g. shares),
 Contractual right
o To receive cash or another financial asset of another entity (e.g.
trade receivable);
o To exchange financial assets or financial liabilities with other entities
under potentially favorable conditions (e.g. foreign currency forward
contract with positive outcome – derivative asset)
 Contract settled with variable amount of own equity instruments (very
simplified). If this would be settled with fixed amount of own equity
instruments, then it would have been an equity instrument, not a financial
asset.
Please note that the contractual rights to receive an asset other than cash or a
financial asset of another entity is NOT a financial instrument.

Example – financial instrument or not?

Imagine you ordered XY barrels of petrol with delivery in 3 months at market price
valid at the time of delivery. You have 2 options:

1. You can take physical delivery (=petrol)

2. Instead of physical delivery, you settle in cash (pay or receive the difference
in market prices between the date of the contract and the time of delivery).

If you intend to take physical delivery, then it’s NOT a financial instrument (if you
have no history of similar contracts settling in cash). It’s a regular trading
contract, because you will NOT receive a cash or a financial asset of another
entity.

But, if you intend to settle in cash, then here we go, it’s a financial instrument
and you need to recognize a derivative from the day 1.
What is a financial liability?
Financial liability is:

 A contractual obligation
o To deliver cash or another financial asset to another entity (e.g. loan
taken, ,trade payable), or
o To exchange financial assets or financial liabilities other than the
entity’s own equity under potentially unfavorable conditions.
 Contract settled with variable amount of own equity instruments (very
simplified). If this would be settled with fixed amount of own equity
instruments, then it would have been an equity instrument, not a financial
liability.

Why variable amount, not fixed?

Why is the fixed amount of own equity instruments excluded when defining the
financial assets and liabilities?

It is probably because the nature of such transactions is very close to equity

issuance or repurchase.

Example – liability or equity?

Your company writes 2 options to deliver your own shares:

1. The first option is to deliver your own shares for total value of CU 1 000;
2. The second option is to deliver 100 pieces of your own shares.

Which one is an equity?

Well, clearly option n. 2, because you will deliver fixed amount of your own
shares.
Under option n.1, you deliver variable amount, because precise amount will
depend on the market price of your shares at the time of delivery (CU 1 000
divided by the unit price). Therefore, it’s a financial liability.
What are the main Features of Financial Instruments
According to the characteristics of risks and rewards associated with the financial
instruments, there are three types:

1. Derivatives,
2. Equities (e.g. shares) and
3. Debt instruments (including receivables).

In addition to the three basic instruments, there are hybrid or compound financial
instruments with more complicated features.

The following matrix depicts the main features of the financial instruments in
three dimensions:

1. How to define the Rights and Obligations,

2. Who recognizes Assets or Liabilities for each category of the financial
instruments, and
3. Various subtypes available for the category.
Derivatives
Derivatives are the contracts with negligible or zero initial net value and
subsequent fair value changes depending on the mark to market value of the
underlying assets.

Derivatives can be either asset or liability depending on whether there is a mark to

market gain or loss from the contract.

In addition, the future settlement of derivatives is normally in cash or other types

of financial assets, instead of physical delivery.

Forward, futures, swaps and options are four basic types of the derivatives.
Moreover, there are advanced or exotic derivatives.

Equity instruments
Equity represents both the residual rights of the holders and the issuers’ limited
obligation to stakeholders after total assets deducting total liabilities during
solvency.

However, the residual rights and limited obligations are applicable only during the
issuers’ solvency, which means the issuer of ordinary shares has no obligation to
pay the holder in daily operations.

As per previous discussion, only the equity holder needs to book it under the IFRS 9
as the financial assets, while the equity on the issuer’s side is out of scope of IFRS
9.

Debt instruments
Debt instruments are the contractual rights and obligations with defined terms for
amount and timing to pay.

It must be reminded that the receiver of the debt contract, or the rights owner
should book the debt as assets; while the payer of debt contract should book the
debt as liabilities.

Unlike the equity where the payment by the issuer is only be expected during the
solvency, the debt must be paid when due as prescribed by the debt contracts.
Normally the debts are in the form of deposits, loan, bonds, payables and
receivables.

According to IFRS 9, the debts should be further split into SPPI (Solely Payments of
Principal & Interest) and Non-SPPI, where the interest of the former is mainly
based on time value, credit risk and liquidity risk.
Scope of the IFRS 9 Assets and Liabilities
Until now, we discussed and explain which items ARE within the scope of IFRS 9.

Now, let’s try to list a few items what are NOT within the scope of IFRS 9 and
you should apply some other standard to these items:

 Contract to deliver physical goods or services that is not settled by cash,

cash equivalent, and financial instruments (see the example above).
 Constructive obligations such as deferred income, warranty, or impairment
provision; and statutory obligations such as tax payables; which are all not
contractual.
 Special items with its own standards, such as insurance contracts under IFRS
4, finance lease under IAS 17 , share-based payment under IFRS 2, contract
assets under IFRS 15, and contingent events and provisions under IAS 37.
 Certain loan commitments and finance guarantees that is not booked at the
FVPL. However, potential credit losses are subject to the ECL model like the
finance lease.

Finally, we would like to stress that even if the above items are NOT within the
scope of IFRS 9, this standard can still have some impact on their accounting.
For example, you should account for leases under IAS 17 / IFRS 16, but any
potential impairment of the net investment in the lease in the lessor’s accounts is
still subject to the IFRS 9 expected credit loss model.