By nature, financial instruments are mainly categorized into the following types:
- Equity instruments
- Debt instruments
Explanation of types of financial instruments
Equity financial instruments
Any instrument issued by an entity that gives a contractual right to the net assets of the entity (ownership rights) to the instrument holder is known as equity instrument. For example, ordinary shares of an entity are equity instruments.
Accounting of investment in equity instruments depends on the percentage of ownership.
- If an entity holds more than 50% equity shares of another entity, it means that the investing entity has control over the investee entity. In such cases where investing entity holds controlling interests, investee entity becomes the subsidiary of the investing entity (Parent entity). The parent entity will consolidate the results of its subsidiary and prepare consolidated financial statements.
- If an entity holds 20% to 50% equity shares of another entity, it means that the investing entity can exercise significant influence over the investee entity. In such cases, investee entity can be considered as an associate of the investing entity. The investing entity will apply the equity method of accounting to account for the investment in associate.
- If an entity holds less than 20% equity shares of another entity, such investment is classified as fair value through profit or loss (FVTPL) investment or fair value through other comprehensive income (FVOCI) investment. Classification basis and accounting of these equity investments are explained in the next chapters of this section “Financial Instruments”.
Debt financial instruments
Any instrument issued by an entity to raise funds while assuming the contractual obligation to repay the funds raised along with any other costs agreed under the contractual terms (such as finance cost) is known as debt instrument. An entity issuing a debt instrument will record a financial liability in its books of account, whereas an entity investing in debt instruments will record a financial asset in its books of account. Classification basis and accounting of these debt instruments are explained in the next chapters of this section “Financial Instruments”.
Examples of debt instruments include redeemable capital, debenture loans, bonds, treasury certificates etc.
A derivative is a contract between two or more parties which derives its value from an underlying financial assets or some agreed market indices. It just derives its value from changes in the values of underlying assets or indices agreed in the derivative contract. Derivatives are mainly used in hedging, to minimize the risks associated with future fair value changes and future cash flow changes of assets and liabilities.
Examples of derivatives include forward contracts, future contracts, swaps, share options etc.
For detailed understanding of derivatives and accounting of derivatives, please go through our chapter “derivatives”.