ACCOUNTING FOR FINANCIAL INSTRUMENTS

1.0 INTRODUCTION

International Accounting Standards (IAS) defines financial instruments as “any contract that
gives rise to a financial asset of one entity and a financial liability or equity instrument of another
entity. In other words, Financial Instrument is any contract that gives rise to both a financial asset
of one entity and a financial liability or equity instrument of another.
Accounting for financial instruments under IFRS 9 is complex. This publication provides a broad
overview of the current requirements of IAS 32, ‘Financial instruments: Presentation’, IAS 39,
‘Financial instruments: Recognition and measurement’, and IFRS 7, ‘Financial instruments:
Disclosures’. For first-time adopters and other entities in territories transitioning to IFRS, these
standards are likely to change the way they account for financial instruments and will involve
substantial changes to systems processes and documentation.

Financial instruments are contracts for monetary assets that can be purchased, traded, created,
modified, or settled for. In terms of contracts, there is a contractual obligation between involved
parties during a financial instrument transaction.
For example, if a company were to pay cash for a bond, another party is obligated to deliver a
financial instrument for the transaction to be fully completed. One company is obligated to provide
cash, while the other is obligated to provide the bond.

Basic examples of financial instruments are cheques, bonds, securities.

There are typically three types of financial instruments: cash instruments, derivative instruments,
and foreign exchange instruments.

Assets and liabilities in the public sector arise out of both contractual and non-contractual
arrangements. Assets and liabilities arising out of non-contractual arrangements do not meet the
definition of a financial asset or a financial liability. For example, provisions accounted for in
accordance with IPSAS 19, Provisions, Contingent Liabilities and Contingent Assets would
generally not be a financial instrument. Physical assets (such as inventories, property, plant and
equipment), leased assets and intangible assets (such as patents and trademarks) are not financial

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assets. Similarly prepaid assets are not financial assets because they represent economic benefits
in the form of future receipt of goods or services.

1.1 ACCOUNTING STANDARDS DEALING WITH FINANCIAL INSTRUMENTS

IFRS 9 Financial Instruments issued on 24 July 2014 is the IASB's replacement of IAS 39
Financial Instruments: Recognition and Measurement. The Standard includes requirements for
recognition and measurement, impairment, derecognition and general hedge accounting. The
IASB completed its project to replace IAS 39 in phases, adding to the standard as it completed
each phase.

IFRS 9 is effective for annual periods beginning on or after 1 January 2018 with early application
permitted.

IFRS 9 specifies how an entity should classify and measure financial assets, financial liabilities,
and some contracts to buy or sell non-financial items.

IFRS 9 requires an entity to recognize a financial asset or a financial liability in its statement of
financial position when it becomes party to the contractual provisions of the instrument. At initial
recognition, an entity measures a financial asset or a financial liability at its fair value plus or
minus, in the case of a financial asset or a financial liability not at fair value through profit or loss,
transaction costs that are directly attributable to the acquisition or issue of the financial asset or the
financial liability.

IAS 32 Financial Instruments: Presentation outlines the accounting requirements for the presen-
tation of financial instruments, particularly as to the classification of such instruments into
financial assets, financial liabilities and equity instruments. The standard also provides guidance
on the classification of related interest, dividends and gains/losses, and when financial assets and
financial liabilities can be offset.

IAS 32 was reissued in December 2003 and applies to annual periods beginning on or after 1
January 2005.

1.2 DEFINITIONS

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A financial instrument is any asset that retains capital and may be traded on the market.

Cheques, stocks, shares, bonds, futures, and options contracts are all types of financial instruments.

“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.”

– The Association of Chartered Certified Accountants (ACCA)

Financial instruments are certain contracts or any document that acts as financial assets such as
debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills
of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability
to another organization and these solely taken into use for trading purposes.

Financial Asset; Cash/equity instrument is a contractual right to receive a financial asset or

exchange a financial asset or liability with another or a contract that may be settled in entity’s own
equity instruments
Financial Liability is contractual obligation to deliver cash or other financial asset or exchange
financial assets or financial liabilities with another, or a contract that may be settled in the entity’s
own equity instruments.

1.3 ILLUSTRATION ON FINANCIAL ASSETS, FINANCIAL LIABILITIES AND

EQUITY INSTRUMENTS
with references to assets, liabilities and equity instruments, the statement of financial position
immediately comes to mind. Further, the definition describes financial instruments as contracts,
and therefore in essence financial assets, financial liabilities and equity instruments are going
to be illustrated as follows:
For example, when an invoice is issued on the sale of goods on credit, the entity that has sold the
goods has a financial asset – the receivable – while the buyer has to account for a financial liability
– the payable. Another example is when an entity raises finance by issuing equity shares. The entity
that subscribes to the shares has a financial asset – an investment – while the issuer of the shares
who raised finance has to account for an equity instrument – equity share capital.

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A third example is when an entity raises finance by issuing bonds (debentures). The entity that
subscribes to the bonds – i.e. lends the money – has a financial asset – an investment – while the
issuer of the bonds – i.e. the borrower who has raised the finance has to account for the bonds as
a financial liability.
So, when we talk about accounting for financial instruments, in simple terms what we are really
talking about is how we account for investments in shares, investments in bonds and receivables
(financial assets), how we account for trade payables and long-term loans (financial liabilities) and
how we account for equity share capital (equity instruments). (Note: financial instruments do also
include derivatives, but this will not be discussed in this article.)
In considering the rules as to how to account for financial instruments there are various issues
around classification, initial measurement and subsequent measurement.

1.4 CHARACTERISTICS AND FEATURES OF FINANCIAL INSTRUMENTS

• Maturity: Until they mature and are settled, financial instruments have a defined maturity
date or length.
• Yield and return: Depending on their type and nature, different instruments give varying
rates of return, such as interest payments, dividends, or capital appreciation.

These instruments have various characteristics, such as maturity dates, interest rates, payment
schedules, and underlying assets.

The main characteristics of financial instruments are their standardization, provide returns in the
form of dividends, and have a market-linked risk attached.

1.5 TYPES OF FINANCIAL INSTRUMENTS

Financial instruments can be divided into three different classes:

• Cash instruments
• Derivative instruments
• Foreign exchange (Forex) instruments

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a) Cash Instruments

Cash instruments are easily transferable and marketable. Furthermore, market conditions have a
direct impact on the value of these financial instruments. There are two kinds of cash instruments:

• Securities: are monetary financial instruments that trade on the stock market. When you
buy a security (share), you are buying a piece of a publicly traded corporation on the stock
exchange.

• Deposits and loans: are both cash instruments because they reflect monetary assets and
bind both parties to a contract.

b) Derivatives

The underlying asset, such as resources, currency, bonds, stocks, indexes, and so on, determines
the value of derivative instruments. The underlying assets determine the performance of
derivatives instruments.

The most popular types of derivative instruments are as follows:

• Forward Contract - It is a personalized arrangement. It involves the exchange of an

underlying asset between two parties at a certain exchange during a specific time period.

• Future - A derivative contract involving the exchange of derivatives at a predetermined

exchange rate on a future date.

• An option is a kind of derivative contract between two parties. The buyer obtains the right
to buy or sell the underlying asset at a set price for a set length of time. However, there is
no need to use the right.

• SAFE (Synthetic Agreement for Foreign Exchange): This arrangement takes place in the
over-the-counter (OTC) market. It ensures a specific exchange rate for a set length of time.

• Interest Rate Swap: This is a two-party derivative arrangement. It entails the exchange of
interest rates in which one party promises to pay the interest rate on the other party's loans
in various currencies
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c) Foreign Exchange Instruments

Foreign exchange instruments are financial instruments that are represented on the foreign market
and primarily consist of currency agreements and derivatives.

In terms of currency agreements, they can be broken into three categories.

• Spot: The actual exchange of currency in this currency arrangement occurs no later than
the second working day following the original date of the agreement. The currency
exchange is referred to as a spot since it occurs on the spot (within a limited window).

• Outright Forwards: In this currency transaction, the actual exchange of currency occurs
'forwardly' and before the agreed-upon date. This is advantageous in the event of
fluctuating currency rates.

• Currency Swap: The simultaneous purchase and sale of currencies with different set value
dates.

1.5.1 Asset Classification of Financial Instruments

In addition to the previously mentioned classifications, financial instruments can be divided into
two according to asset classes:

a) Equity instruments
b) Debt instruments

A distinction is then made between equity-based financial instruments and debt-based financial
instruments.

Equity-based financial instruments

Equity-based financial instruments are characterized by the fact that the buyer becomes the owner.
The best-known example is company shares, where the investor receives shares in exchange for
money. These financial instruments are used by companies to increase their capital in long term.

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Debt-based financial instruments

Debt-based financial instruments can be divided into short-term and long-term instruments. The
former has a maturity of one year or less; the latter have a maturity of more than one year.

Short-term debt-based financial instruments include, for example, treasury bills, while bonds are
long-term debt-based financial instruments. Both types can be traded in different ways.

1.6 PARTICIPANTS OF FINANIAL INSTRUMENTS

The following are the participants that trade financial instruments

1. Individuals: Individual investors participate in financial markets through

various instruments such as stocks, bonds, mutual funds, exchange-traded funds
(ETFs), options, futures, and currencies.
2. Institutional Investors: These include pension funds, insurance companies,
investment banks, hedge funds, and private equity firms..
3. Banks: Commercial banks, investment banks, and central banks play a crucial
role in financial markets. They provide financing, facilitate transactions, and
offer various financial services such as lending, underwriting, and asset
management.
4. Corporations: Companies participate in financial markets through issuing
stocks and bonds to raise capital for expansion or to fund operations. They may
also engage in currency and commodity trading to manage risks associated with
international trade.
5. Government: Governments participate in financial markets through the issuance
of government bonds and treasury bills to raise funds for public spending. Central
banks also play a significant role by conducting monetary policy, managing
currency exchange rates, and regulating financial institutions.
6. Exchanges: These are marketplaces where buyers and sellers come together to
trade financial instruments. Examples include stock exchanges (e.g., New York
Stock Exchange), commodity exchanges (e.g., Chicago Mercantile Exchange),
and currency exchanges (e.g., Foreign Exchange Market).

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 7. Brokers and Dealers: They act as intermediaries between buyers and sellers,
facilitating the trading of financial instruments. Brokers execute trades on behalf
of clients, while dealers may trade for their own accounts.
8. Rating Agencies: These agencies assess the creditworthiness of issuers and their
financial instruments. Their ratings help investors evaluate the risks associated
with investing in various bonds and other debt instruments.
9. Clearinghouses: Clearinghouses ensure the smooth settlement of trades by
acting as intermediaries between buyers and sellers. They guarantee the
fulfillment of contracts, reducing counterparty risk and ensuring market stability.

These are just a few examples of the participants in financial markets and financial instruments.

1.7 REGULATION OF FINANCIAL INSTRUMENTS

Various types of financial instrument are traded on a regulated market (including stock
exchanges). Trading is carried out through the securities firms that use the trading system. Price
information about the financial instruments is published regularly on their websites, in newspapers
and in other media.). There are also requirements for the size of the company, its business history,
diffusion of ownership and publication of the company’s financial statements. Regulatory norms
are there for governing public issue of shares.

1.8 ADVANTAGES OF FINANCIAL INSTRUMENTS

Financial instruments have two major advantages:

1. LEVERAGE: they can attract additional resources, both public and private. Thus,
leverage “is the sum of the amount of ESIF (European Structural and Investment Funds)
funding and of the additional public and private resources raised divided by the nominal
amount of the ESI Funds contribution”.
2. REVOLVING: it is the capacity of the financial instrument to generate additional flows
of money – either through repayments or through the realization of investments – with the
objective of further reutilization. This revolving nature allows public authorities to benefit
from increased resources.

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 The following are common advantages of financial instruments:

• Overcoming market inefficiencies

Financing is available to target groups that have limited access to financial resources from the
private sector and whose economic activity is important for the achievement of the goals of the
respective EU programme.
Financial instruments are provided under more relaxed terms in comparison to other similar
financial products on the free market.
• Leverage effect
In addition to the public funds, financial instruments mobilise private financing, which increases
the total amount of support available to final recipients.
• Recycling of resources
Resources repaid by the financed projects and potential other income earned by them are re-used
to provide support to other eligible final recipients and projects.
• Fiscal discipline
Resources provided by way of financial instruments are subject to repayment by final recipients.
This results in more efficient use of the public resources compared to grant support and reduces
the likelihood of enterprises becoming dependent on public support.
• Transfer of knowledge and experience
Final recipients can benefit from the expertise of financial intermediaries and other partners from
the private sector in designing economically viable projects.

1.9 DISADVANTAGES OF FINANCIAL INSTRUMENTS

Despite acting as a prime source of financial aid for many, it has a few factors that act as a hurdle
for its users. Let us understand the disadvantages through the points below.

• Liquid assets such as savings accounts balances and other bank deposits are limited for ROI or
investment return. It is high because there are zero restrictions for the withdrawal of deposits in
savings accounts and other bank balances.
• Liquid assets like cash deposits, Money Market Account etc., might disallow organizations from
making a withdrawal for months or years, too, or whatever is specified in the agreement.

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• If an organization wishes to withdraw the money before completing the tenure mentioned in the
agreement, then the same might get penalized or receive lower returns.
• High transactional costs are also a matter of concern for organizations dealing with or wishing to
deal with financial instruments.
• An organization must not over-rely on debts like principal and interest since these are supposed to
be paid on a consequent basis.
• Financial instruments like bonds payout return much less than stocks. Companies can even default
on bonds.
• Some financial instruments like equity capital are a Life-long burden for the company. It acts as a
permanent burden in an organization.

Brief description of the individual instrument –

1. Bonds – Bond is a type of long-term debt instrument in which the issuer owes the holder
debt and is obligated to pay interest (coupon payments) for the specified amount of period
(maturity date) at a later date.
2. Loans – Loan is basically lending money from individuals, organizations, banks, trust etc.
Till the time the entire amount is given back the recipient has to pay interest.
3. Bond Futures – Futures contract is a predetermined contract where the buyer or the seller
agrees to buy or sell something at a predetermined time and a predetermined price in the
future.
4. Options on Bonds – Options give the buyer the right but not the obligation to buy or sell
the underlying asset on the option at a specified date and a specified price.
5. Interest rate swap – It is a type of interest rate derivate which involves exchanging interest
rates between two parties.
6. Interest rate cap and floor – This again is a type of interest rate derivative. In case of interest
rate cap the buyer receives payment if the interest rate exceeds the agreed strike price.
Similarly, for the interest rate floor, the buyer receives payments if the interest rate is lower
than the specified strike price.
7. Exotic derivatives – These are customized derivative products and are complex to the
generally traded vanilla options.

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 8. T bills, Deposits, Certificate of Deposits – Treasury bills popularly known as T bills are
issued by the government and are available for 30,60,90,120,360 days. They are considered
to be very liquid. Deposits can be a savings bank account, current account
9. Foreign exchange instruments – These include currency swaps, foreign exchange options,
foreign exchange swaps and are mainly related to currencies.

CONCLUSION:

There are a lot of financial instruments, but each financial instrument serves the purpose and needs
of an investor. For a risk-averse investor investing in the bond market would be a better option
than investing inequities. Likewise investing in the currency market depends on the choice and
objective of the investor. For some businesses dealing with imports and exports investing in
currencies would be the right option!

Hence, financial instruments are essential in modern economies because they give people,
companies, and governments various tools for capital raising, risk management, and facilitating
financial transactions. People may make wise decisions and successfully cross the complicated
world of finance by being aware of financial instruments' types, purposes, and characteristics.

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REFERENCES:

• International Accounting Standard (IAS) 39

• International Accounting Standard (IAS) 32.11
• Understanding Derivatives (Archived) 2013-12 at the way back machine Federal Resume
Bank of Chicago. Accessed August 2,2015

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