CFM24030 - Accounting for corporate finance: derivative contracts: what is a financial instrument?

The definitions below are essentially the same as those used by all entities preparing accounts under IFRS, New UK GAAP or Old UK GAAP..

A financial instrument is ‘any contract that gives rise to both a financial asset and a financial liability or equity instrument of another entity’, where:

A financial asset is ‘any asset that is:

  • cash;
  • an equity instrument
  • a contractual right:
    • to receive cash or another financial asset from another entity; or
    • to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or
  • a contract that will or may be settled in the entity’s own equity instruments and is
    • a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or
    • a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments

A financial liability is ‘any liability that is:

  • a contractual obligation
    • to deliver cash or another financial asset to another entity’ or
    • to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entitly; or
  • a contract that will or may be settled in the entity’s own equity instruments and is
    • a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
    • a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments…’

An equity instrument is ‘any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.’

A financial instrument must be a contractual asset or liability

A financial instrument must arise from a contractual right. For example, tax liabilities, because these stem from a statutory provision and not from a contract, are not financial liabilities.

Contractual rights and contractual obligations include those that are contingent on the occurrence of future events (e.g. those arising under a financial guarantee).

Note that, for an accountant, the term ‘contract’ has a precise meaning. Although an agreement to purchase an item of plant or machinery is legally a contract, this is initially an unperformed, or executory, contract, which gives rights and obligations to exchange a physical asset for a financial asset. It is only once the item is delivered that a debtor/creditor relationship is brought into existence. This is the point at which the assets and liabilities are recognised.