FINANCIAL INSTRUMENTS

A financial instrument gives rise to a financial

asset of one entity and a financial liability or
equity instrument of another.

Three accounting standards deal with financial

instruments:
a. IAS 32 Financial Instruments: Presentation,
which deals with:
i. The classification of financial instruments
between liabilities and equity
ii. Presentation of certain compound instruments
(instruments combining debt and equity)
b. IFRS 7 Financial Instruments: Disclosure
C. IFRS 9 Financial Instruments. IFRS 9 deals
with:
1. Recognition and derecognition
ii. Measurement of financial instruments
iii. Impairment
iv. Hedging

Definitions
Financial instrument. Any contract that gives
rise to both a financial asset of one entity and a
financial liability or equity instrument of another
entity
Financial asset. Any asset that is:
a. Cash
b. An equity instrument of another entity
c. A contractual right to receive cash or
another financial asset from another entity; or
to exchange financial instruments with
another entity under conditions that are
potentially favorable to the entity
Financial liability. Any liability that is:
a. A contractual obligation:
i. To deliver cash or another financial asset to
another entity, or
ii. To exchange financial instruments with
another entity under conditions that are
potentially unfavorable.
Equity instrument. Any contract that
evidences a residual interest in the assets of
an entity after deducting all of its liabilities.
We should clarify some points arising from
these definitions. First, one or two terms above
should be themselves defined:
a. A contract need not be in writing, but it must
comprise an agreement that has 'clear
economic consequences' and which the parties
to it cannot avoid, usually because the
agreement is enforceable in law.
b. An entity here could be an individual,
partners, incorporated body or government
agency.
Examples of financial assets include:
a. Trade receivables
b. Options
C. Shares (when held as an investment)
Examples of financial liabilities include:
a. Trade payables
b. Debenture loans payable
c. Redeemable preference (non-equity) shares
IAS 32 makes it clear that the following items are
not financial instruments:
a. Physical assets, (e.g. inventories, property,
plant and equipment, leased assets and intangible
assets) (patents, trademarks etc.)
b. Prepaid expenses, deferred revenue, and
most warranty obligations
C. Liabilities or assets that are not contractual
in nature
Illustration. Definitions
a. Physical assets: Control of these creates an
opportunity to generate an inflow of cash or
other assets, but it does not give rise to a
present right to receive cash or other
financial assets.
b. Prepaid expenses, etc.: The future
economic benefit is the receipt of
goods/services rather than the right to receive
Contingent rights and obligations meet the
definition of financial assets and financial liabilities
respectively, even though many do not qualify for
recognition in financial statements. This is
because the contractual rights or obligations exist
because of a past transaction or event (e.g.
assumption of a guarantee).
PRESENTATION OF FINANCIAL
INSTRUMENTS
The objective of IAS 32 is to establish principles
for presenting financial instruments or equity.
Scope
IAS 32 should be applied in the presentation
and disclosure of all types of financial
instruments.
Liabilities and Equity
The main principle of IAS 32 is that financial
instruments should be presented according to
their substance, not merely their legal form. In
particular, entities which issue financial
The classification of a financial instrument as a
liability or as equity depends on the following:
1. The substance of the contractual arrangement
on initial recognition
2. The definitions of a financial liability and an
equity instrument
How should a financial liability be distinguished
from an equity instrument? The critical feature of a
liability is an obligation to transfer economic
benefit. Therefore, a financial instrument is a
financial liability if there is a contractual obligation
on the issuer either to deliver cash or another
financial asset to the holder or to exchange
another financial instrument with the holder under
Where the above critical feature is not met,
then the financial instrument is an equity
instrument. IAS 32 explains that although the
holder of an equity instrument may be entitled
to a pro rata share of any distributions out of
equity, the issuer does not have a contractual
obligation to make such a distribution. For
instance, a company is not obliged to pay a
dividend to its ordinary shareholders. Although
substance and legal form are often consistent
with each other, this is not always the case. In
particular a financial instrument may have the
legal form of equity, but in substance it is in fact
a liability. Other instruments may combine
features of both equity instruments and
For example, many entities issue preference
shares which must be redeemed by the issuer
for a fixed (or determinable) amount at a fixed
(or determinable) future date.
Alternatively, the holder may have the right to
require the issuer to redeem the shares at or
after a certain date for a fixed amount. In such
cases, the issuer has an obligation
Therefore, the instrument is a financial liability
and should be classified as such.
Compound Financial Instruments
Some financial instruments contain both a
liability and an equity element. In such cases,
IAS 32 requires the component parts of the
instrument to be classified separately, according
to the substance of the contractual arrangement
and the definitions of a financial liability and an
equity instrument.
One of the most common types of compound
instrument is convertible debt. This creates a
primary financial liability of the issuer and grants
an option to the holder of the instrument to
convert it into an equity instrument (usually
ordinary shares) of the issuer. This is the
Although in theory there are several possible
ways of calculating the split, IAS 32 requires
the following method:
a. Calculate the value for the liability
component.
b. Deduct this from the instrument as a whole
to leave a residual value for the equity
component
The reasoning behind this approach is that an
entity's equity is its residual interest in its
assets amount after deducting all its liabilities.
The sum of the carrying amounts assigned to
liability and equity will always be equal to the