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HomeAccountingAdvanced Financial ReportingFinancial Instruments (Classification, Recognition, Measurement)

Financial Instruments (Classification, Recognition, Measurement)

Financial instruments are contracts that create a financial asset for one entity and a financial liability or equity instrument for another entity. These instruments may comprise cash, evidence of ownership in an entity, or a contractual right to receive or deliver cash or another financial instrument. They play a crucial role in the global financial system and are utilised by individuals, businesses and governments to manage risk, raise capital and invest for the future.

Financial instruments can be classified into three primary categories: equity instruments, debt instruments and derivative instruments. Equity instruments represent ownership in an entity and encompass ordinary shares, preference shares and other equity securities. Debt instruments represent a contractual obligation to repay borrowed funds and include bonds, loans and other debt securities.

Derivative instruments derive their value from an underlying asset or index and comprise options, futures, forwards and swaps.

Summary

  • Financial instruments are tradable assets that represent a contractual right to receive cash or another financial asset.
  • Financial instruments are classified as either financial assets, financial liabilities, or equity instruments, depending on their characteristics and the entity’s business model for managing them.
  • Recognition of financial instruments involves including them in the statement of financial position when the entity becomes a party to the contractual provisions of the instrument.
  • The measurement of financial instruments is based on their fair value, which is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
  • Fair value accounting measures financial instruments at their current market value, while historical cost accounting measures them at their original purchase price.

Classification of Financial Instruments

The classification of financial instruments is important for financial reporting purposes as it determines how they are measured and presented in the financial statements. Financial instruments are classified as either financial assets, financial liabilities, or equity instruments based on their contractual cash flow characteristics and the business model in which they are managed. Financial assets are classified into one of four categories: financial assets at fair value through profit or loss, held-to-maturity investments, loans and receivables, and available-for-sale financial assets.

Financial liabilities are classified as either financial liabilities at fair value through profit or loss or other financial liabilities. Equity instruments are not classified as either financial assets or financial liabilities. The classification of financial instruments is determined at initial recognition and may change over time if there is a change in the entity’s business model for managing the financial assets or if the contractual cash flow characteristics of the financial instrument change.

Recognition of Financial Instruments

The recognition of financial instruments in the financial statements is based on the principles of the International Financial Reporting Standards (IFRS) and generally accepted accounting principles (GAAP). Financial instruments are recognized in the balance sheet when the entity becomes a party to the contractual provisions of the instrument. For financial assets, recognition occurs when the entity has a legal right to receive cash flows from the instrument.

For financial liabilities, recognition occurs when the entity has a legal obligation to deliver cash flows to the holder of the instrument. Equity instruments are recognized when the entity issues shares or other equity instruments to investors. The recognition of financial instruments is important for providing users of the financial statements with relevant information about the entity’s financial position and performance.

It also ensures that all financial instruments are accounted for in a consistent and transparent manner.

Measurement of Financial Instruments

The measurement of financial instruments is based on their classification and is determined at initial recognition and subsequently at each reporting date. Financial assets and financial liabilities at fair value through profit or loss are measured at fair value, with changes in fair value recognized in profit or loss. Held-to-maturity investments and loans and receivables are measured at amortized cost using the effective interest method.

Available-for-sale financial assets are measured at fair value with changes in fair value recognized in other comprehensive income until the asset is derecognized. Financial liabilities at fair value through profit or loss are measured at fair value, with changes in fair value recognized in profit or loss. Other financial liabilities are measured at amortized cost using the effective interest method.

The measurement of financial instruments is important for providing users of the financial statements with relevant information about the entity’s exposure to market risks and the potential impact on its financial position and performance.

The debate between fair value and historical cost accounting for financial instruments has been ongoing for many years. Fair value accounting measures assets and liabilities at their current market value, while historical cost accounting measures them at their original cost. Proponents of fair value accounting argue that it provides more relevant information to users of the financial statements as it reflects current market conditions and values.

It also provides greater transparency and allows for better risk management as it captures changes in market prices. On the other hand, proponents of historical cost accounting argue that it provides more reliable information as it is based on actual transactions and avoids potential volatility in reported earnings due to changes in market prices. It also provides a more stable measure of an entity’s financial position over time.

Both fair value and historical cost accounting have their advantages and disadvantages, and the choice between the two depends on the specific circumstances of the entity and the needs of its users.

Impairment of Financial Instruments

Impairment of financial instruments occurs when there is a decrease in their value due to credit losses or changes in market conditions. Financial assets measured at amortized cost, held-to-maturity investments, loans and receivables, and available-for-sale financial assets are subject to impairment testing. Impairment is recognized when there is objective evidence that a financial asset is impaired, such as significant financial difficulty of the issuer or borrower, default or delinquency in payments, or significant adverse changes in market conditions.

For financial assets measured at amortized cost and held-to-maturity investments, impairment is measured as the difference between the carrying amount of the asset and the present value of estimated future cash flows discounted at the asset’s original effective interest rate. For available-for-sale financial assets, impairment is measured as the difference between the carrying amount of the asset and its fair value less costs to sell. Impairment of financial instruments is important for providing users of the financial statements with relevant information about the credit risk exposure of the entity and the potential impact on its financial position and performance.

Disclosure Requirements for Financial Instruments

The disclosure requirements for financial instruments are extensive and are designed to provide users of the financial statements with relevant information about an entity’s exposure to risks arising from its use of financial instruments and how it manages those risks. Entities are required to disclose information about the nature and extent of their exposure to risks arising from financial instruments, including credit risk, liquidity risk, and market risk. They are also required to disclose information about their objectives, policies, and processes for managing those risks.

Entities must disclose information about the carrying amounts of different categories of financial instruments, including their classification and measurement basis. They must also disclose information about any significant changes in those amounts during the reporting period. In addition, entities must disclose information about any collateral held as security for their financial instruments, any significant concentrations of credit risk, and any significant restrictions on their ability to transfer funds between different parts of their operations.

The disclosure requirements for financial instruments are important for providing users of the financial statements with a comprehensive understanding of an entity’s exposure to risks arising from its use of financial instruments and how it manages those risks. This information helps users make informed decisions about an entity’s ability to generate cash flows and its exposure to potential losses.

One related article to Financial Instruments (Classification, Recognition, Measurement) is a case study on BG Group, a British multinational oil and gas company. This case study explores how BG Group used financial instruments to manage risk and achieve its strategic objectives. The company’s use of financial instruments for hedging and trading purposes is a practical example of the concepts discussed in the main article. To learn more about how BG Group utilised financial instruments, you can read the full case study here.

FAQs

What are financial instruments?

Financial instruments are contracts that give rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

How are financial instruments classified?

Financial instruments are classified into various categories such as financial assets, financial liabilities, and equity instruments. They can also be classified as either held for trading, held to maturity, available for sale, or at fair value through profit or loss.

How are financial instruments recognized and measured?

Financial instruments are recognized on the balance sheet when an entity becomes a party to the contractual provisions of the instrument. They are measured at fair value, amortized cost, or cost, depending on their classification and the entity’s business model for managing the financial assets.

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