Financial Instruments – Summary
- 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. Investments in equity shares are a form of financial asset.
- An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
- A derivative is a financial instrument or other contract with all three of the following characteristics:
Its value changes in response to the change in an underlying.
It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts.
It is settled at a future date.
- Financial instruments are categorized into the following four types: fair value through profit and loss (FVPL), held-to-maturity (HTM), available-for-sale (AFS), and loans and receivables (LAR).
- Investments in equity shares, futures, and equity options are classified only as either fair value through profit and loss or as available-for-sale securities.
- The fair value of a financial asset or liability is the amount for which the financial asset could be exchanged, or the financial liability settled, between knowledgeable, willing parties in an arm’s-length transaction.
- When determining the fair value of a financial instrument, the accounting standards set out a hierarchy to be applied to the valuation.
- An entity should recognize a financial asset on its balance sheet when, and only when, the entity becomes a party to the contractual provisions of the instrument.
- De-recognition of a financial asset or a portion of a financial asset occurs under the current standards when, and only when, the entity loses control of the contractual rights that comprise the financial asset.
- Investments can be in any of three types: physical assets, intangible assets, or financial assets. This book covers accounting concepts involved in investments in financial assets comprising equity, equity futures, and equity options.
- Speculation is the assumption of the risk of loss, in return for the uncertain possibility of a reward. If a particular position involves no risk, the position represents an investment.
Two major accounting standards are U.S. GAAP and IFRS.
- The United States’ generally accepted accounting principles (U.S. GAAP) literature is rule-based.
- The International Financial Reporting Standards (IFRS) are principle-based.
- Because U.S. GAAP is rule-based and also because it has been around for a longer period of time than IFRS, U.S. GAAP literature is more voluminous than IFRS literature.
- The International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) have been committed to converging IFRS and U.S. GAAP since the Norwalk Accord of 2002.
- According to the American Institute of Certified Public Accountants’ (AICPA) web site (www.ifrs.com), as of November 2008, nearly 100 countries require or allow the use of IFRS for the preparation of financial statements by publicly held companies.
- In the United States, the Securities and Exchange Commission (SEC) is considering taking steps to set a date to allow U.S. public companies to use IFRS, and perhaps make its adoption mandatory.