Saturday, July 9, 2022

What are financial instruments?


Welcome to IFRS is easy's flash term for the week

Understanding financial instruments

Have you ever wondered why many fear IFRS 9 as an unnecessarily complex accounting standard? Maybe you also do? But there is no shame in it because everyone has been in that dreadful position before.

Understanding the basics could go a long way in eliminating that fear. And like Emerson said, "if you learn the principles, you can devise your own method."

IFRS 9 whose subject matter is Financial Instruments is one of the three accounting standards that address the accounting treatment of financial instruments. IAS 32 deals with the presentation while IFRS 7 deals with the disclosures.

So what is this financial instrument that we all do talk about?

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.

The above implies that when there is a financial asset, then there must be either a financial liability or an equity instrument on the other end. It is just like the basic accounting principle: assets = liabilities + equity.

Financial instruments can be a financial asset (which is cash or the right to receive cash), a financial liability (which is the obligation to deliver cash), or equity (which is the residual interest in the assets of an entity after deducting all of its liabilities).

Derivatives or Non-derivatives?

Both financial assets and financial liabilities can be non-derivatives or derivatives. However, equity is strictly non-derivative. 

Can you identify which is a financial asset, financial liability, equity, or non-financial instrument below?

  • Trade receivables
  • Trade payables
  • Contract liabilities
  • Loans and borrowings
  • Loans and advances to customers
  • Value added tax payable

Newsflash!!! For practical examples and to watch an explanatory video on the journey to understanding derivatives and financial instruments, see below YouTube video. 

PS: Among other examples within, there's an interesting practical example for you to solve at the end of the video. Join the conversation in the comment section of the video. 

You can also join the QUORA group to ask IFRS questions and also contribute and share knowledge.

Alright, we are back.

Trade receivables
When you sell goods on credit to a customer, you expect to receive cash from the customer in the future. As a result, your trade receivable is a financial asset.

Trade payables
When you buy goods on credit from a vendor, you expect to deliver cash to the vendor in the future. As a result, your trade payable is a financial liability.

Contract liabilities
A contract liability, which is sometimes referred to as a deferred income or an advance payment from customers can arise when you have received cash from the customer but you are yet to deliver goods or render service to the customer. In essence, what you are delivering to the customer is a service, not cash. As a result, your contract liability is not a financial liability.

Loans and borrowings
This arises when an individual or corporate entity borrows funds from a bank and is obligated to pay back the amount borrowed over a period of time. The expectation is that the company will deliver cash in the future. As a result, your loans and borrowings are financial liabilities. 

Loans and advances to customers
This arises when a bank gives cash to customers with the expectation that the customers will pay it back over a period of time. Because the bank is expecting to receive cash, the loans and advances to customers are recorded in the books of the bank as financial assets.

Value-added tax payables
This is referred to as sales tax payable in some countries. It represents a statutory obligation to the government. Because financial instruments are contractual and not statutory, a value-added tax payable is not recognized as a financial liability. It is thus, a non-financial instrument even though there may be an expectation to deliver cash to the government.

I will be happy to receive any questions you may have that are not addressed in the article/video.

Share in the comment section any practical example that you have encountered on your job for others to learn.

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Written by:
Adedamola Otun


  1. Happy to read your post from time to time. Keep up the good work sir. Thanks