Financial instrument in essence is simply a contract that will ultimately result in financial asset in the hands of one party and corresponding financial liability in the hands of another party to the same contract.
For example, invoice, bill receivable, promissory note, cheques are well known examples of financial instruments. However, the distinguishing factor between financial instrument and other contracts is that financial instrument needs to give rise to financial asset/liabilities instead of receiving tangible asset or settling obligation in kind.
For many students it appears to be a new contract but it really is not new as quite in the early topics of accounting we have seen examples of financial instruments but without mentioning this name.
- When goods are sold on credit then buyer and seller enter in to a contract to make the payment at a future date. Under this contract seller gains the right to receive cash (financial asset) and buyer is under an obligation to pay cash (financial liability). Thus credit transaction of sale/purchase give rise to financial instrument. In other words trade receivables and trade payables are a result of financial instrument. Document of contract in this case will be invoice.
- In loan agreements lender and borrower enters in to a contract under which lender has the right to receive specific sum of money and borrower is under an obligation to pay specific sum of money. Thus lending/borrowing gives to financial instrument. Document of contract in this case will be loan agreement.
- In case of lease, lessor has the right to receive rentals whereas lessee agrees to pay rentals at a specific date in agreed upon intervals. Thus lease agreement is an example of financial instrument.
- One entity issued debentures (loan notes) to raise finance. The person subscribing to the bonds will be called holder of the bond. Whereas the entity issuing such bond will be called issuer of the bond. Bonds in the hands of holder are his investment and thus holds the right receive interest (if any) and the principal amount at maturity date. Whereas the entity issuing the debentures is under an obligation to pay interest (if any) and the principal amount at maturity date.
In examples above we observe that parties settle the contract through receipt/payment of cash. However, it is not necessary that financial instruments are settled in terms of cash alone. Cash is not the only type of financial asset.
- An entity borrowed a long term loan from bank. On maturity date instead of paying cash, entity issued ordinary shares to the bank that are accepted by the bank as settlement. In this case although cash is not paid but still liability is settled as bank has accepted to take shares as consideration. Shares are also a type financial asset.
- Entity issued convertible bonds under which the holder has the right to either receive the cash at the date of maturity or to have the bonds converted in ordinary shares before maturity date. In this case if the holder exercise his right of conversion then liability will stand settled on conversion of bonds to shares without any cash flow happening.