What is a financial instrument?

Let us start by looking at the definition of a financial instrument, which is that a

financial instrument is a contract that gives rise to a financial asset of one entity and a

financial liability or equity instrument of another entity.

With references to assets, liabilities and equity instruments, the statement of financial

position immediately comes to mind. Further, the definition describes financial

instruments as contracts, and therefore in essence financial assets, financial liabilities

and equity instruments are going to be pieces of paper.

For example, when an invoice is issued on the sale of goods on credit, the entity that

has sold the goods has a financial asset – the receivable – while the buyer has to

account for a financial liability – the payable. Another example is when an entity raises

finance by issuing equity shares. The entity that subscribes to the shares has a

financial asset – an investment – while the issuer of the shares who raised finance has to account for an equity instrument – equity share capital. A third example is when an entity raises finance by issuing bonds (debentures). The entity that subscribes to the bonds – ie lends the money – has a financial asset – an investment – while the issuer of the bonds – ie the borrower who has raised the finance – has to account for the bonds as a financial liability.

So when we talk about accounting for financial instruments, in simple terms what we

are really talking about is how we account for investments in shares, investments in

bonds and receivables (financial assets), how we account for trade payables and

long-term loans (financial liabilities) and how we account for equity share capital

(equity instruments). (Note: financial instruments do also include derivatives, but this

will not be discussed in this article.)

In considering the rules as to how to account for financial instruments there are

various issues around classification, initial measurement and subsequent

measurement.

This article will consider the accounting for equity instruments and financial liabilities.

Both arise when the entity raises finance – ie receives cash in return for issuing a

financial instrument. A subsequent article will consider the accounting for financial

assets.

Distinguishing between debt and equity

For an entity that is raising finance it is important that the instrument is correctly

classified as either a financial liability (debt) or an equity instrument (shares). This

distinction is so important as it will directly affect the calculation of the gearing ratio,

a key measure that the users of the financial statements use to assess the financial

risk of the entity. The distinction will also impact on the measurement of profit as the

finance costs associated with financial liabilities will be charged to the income

statement, thus reducing the reported profit of the entity, while the dividends paid on

equity shares are an appropriation of profit rather than an expense.

When raising finance the instrument issued will be a financial liability, as opposed to

being an equity instrument, where it contains an obligation to repay. Thus, the issue

of a bond (debenture) creates a financial liability as the monies received will have to

be repaid, while the issue of ordinary shares will create an equity instrument. In a

formal sense an equity instrument is any contract that evidences a residual interest in

the assets of an entity after deducting all of its liabilities.

It is possible that a single instrument is issued that contains both debt and equity

elements. An example of this is a convertible bond – ie where the bond contains an

embedded derivative in the form of an option to convert to shares rather than be

repaid in cash. The accounting for this compound financial instrument will be

considered in a subsequent article.

Equity instruments

Equity instruments are initially measured at fair value less any issue costs. In many

legal jurisdictions when equity shares are issued they are recorded at a nominal value, with the excess consideration received recorded in a share premium account and the

issue costs being written off against the share premium.

Example 1: Accounting for the issue of equity

Dravid issues 10,000 $1 ordinary shares for cash consideration of $2.50 each. Issue

costs are $1,000.

Required

Explain and illustrate how the issue of shares is accounted for in the financial

statements of Dravid.

Solution

The entity has raised finance (received cash) by issuing financial instruments.

Ordinary shares have been issued, thus the entity has no obligation to repay the

monies received; rather it has increased the ownership interest in its net assets. As

such, the issue of ordinary share capital creates equity instruments. The issue costs

are written off against share premium. The issue of ordinary shares can thus be

summed up in the following journal entry.