Basics of Financial Instruments: The meaning of a financial instrument

The Joint Working Committee's Draft Accounting Standard defines a financial instrument as follows:

An equity interest is defined as financial instrument that represents a residual interest in the assets of an enterprise after deducting all its liabilities.

Cash

Includes demand deposits. Thus all deposits callable at notice are treated as cash.

Equity instrument

Is the residual interest in the assets of an enterprise. The meaning of equity interest is not limited to corporate bodies. An interest in a partnership or an association of persons in the nature of ownership interest is an equity instrument. Likewise, junior interest in a special purpose vehicle will also an equity instrument.

Obligations/ assets that are settled by financial instruments

Clause (c) of the definition above is understandably the most important part of the definition. A financial instrument is one which is settled by delivering a financial instrument - this seems like a circular definition, but given the fact that cash is also treated as a financial instrument, there should be no difficulty understanding it. Thus, a corporate bond is an obligation to deliver cash on the part of the bond issuer and a right to receive interest and principal with the bondholder, and is therefore, a financial instrument. By the same token, a loan is a financial instrument.

The consideration by the recipient of the financial instrument is the release of the obligation of the counterparty.

Exchange of financial instruments

The only difference between clause (c) and clause (d) is that clause (.c) covers right of one party which is obligation of the other party. Clause (d) covers an exchange - such that both the parties receive a financial instrument.

Examples of financial instruments:

• Financial investments
• Listed and unlisted debt securities
• Listed equity securities
• 'Private equity' and other unlisted equity investments
• Originated and purchased loans
• Repurchase agreements and securities lending/borrowing transactions
• Financial assets held for trading
• Derivative instruments (whether held for trading or hedging purposes)
• Trade and other receivables
• Cash and cash equivalents
• Trading liabilities (short positions and derivatives with negative fair values)
• Trade and other payables and accruals
• Current and long-term bank borrowings
• Bonds, debentures and notes issued.

Thus, the definition includes a wide spectrum of assets and liabilities of entities, and contrary to popular impression, is not limited to "investments" or merely "capital market instruments".

This is the reason why the accounting standard on financial instruments is not merely relevant to financial entities but equally to non-financial entities.

Examples of contracts which are not financial instruments:

• Non-monetary or physical assets
• Intangible assets
• Own equity instruments - equity of the issuing enterprise, options in equity, treasury shares
• Insurance contracts, that is, contracts to indemnify a loss incurred by someone. Applicable, however, to financial assets and liabilities of insurance companies.
• Financial guarantees
• Weather derivatives
• Commodity contracts: Commodity contracts that either cannot be settled in cash or which are expected to be settled by commodity exchange are not financial instruments. If a commodity contract is expected to be cash settled, it will be included in the definition of financial instrument.