What is a financial instrument? Let’s start with understanding it. A financial instrument is a contract between two parties that gives rise to a financial asset of one party and a financial liability or equity of the other party.
Firstly, a financial instrument must have a contractual arrangement. For instance, income tax payable by an entity has the characteristics of financial liability for the entity, and it also has the characteristics of financial asset for the Income Tax Department. But is it a financial instrument? No, as this is a statutory obligation and not a contractual obligation, therefore, it is not a financial instrument. Definitions of financial assets, financial liabilities and equity instruments are given below.
Any asset that is either:
- Contractual right to receive cash
- Contractual right to receive another financial asset
- Contractual right to exchange a financial instrument under favorable conditions, or
- An equity instrument of another entity
Examples of financial assets include cash and cash equivalents, accounts receivable, investment in debentures, investment in bonds and treasury certificates, investment in ordinary shares of another entity etc.
Any liability that is either:
- Contractual obligation to pay cash
- Contractual obligation to transfer another financial asset
- Contractual obligation to exchange a financial instrument under unfavorable conditions, or
- Contractual obligation that will or may be settled in the form of an entity’s own equity instruments (for example, convertible loan)
Examples of financial liabilities include accounts payable, loans payable, debentures, bonds payable, redeemable preference shares etc.
Any instrument issued by an entity that gives a contractual right to the net assets of the entity (ownership rights) to the instrument holder. For example, ordinary shares of an entity are equity instruments.
Investments in financial instruments
Entities invest money in financial instruments mainly to earn investment income. An entity either intends to hold financial assets to earn interest income or dividend income, or purchases financial assets to earn capital gains by selling the financial assets. Depending on the individual circumstances of an entity, these investments can be long term or short term. By nature, financial instruments are mainly categorized into following categories:
- Equity instruments
- Debt instruments
These instruments are explained in our next chapter “Types of financial instruments”.