Financial Instruments: Definitions, Valuation, and Classification

Understanding Financial Instruments

A financial instrument is a contract that gives rise to a financial asset for one entity and a financial liability or equity instrument for another. It may be categorized as:

• A financial asset
• A financial liability
• An equity instrument

An entity shall recognize a financial asset or liability on its balance sheet only when it becomes a party to the contractual provisions of the instrument.

Classification of Financial Assets

For valuation purposes, financial assets are classified into the following categories:

• Loans and receivables: Trade and non-trade loans and receivables.
• Held-to-maturity investments: Negotiable debt securities expected to be held until the reimbursement date.
• Held-for-trading investments: Negotiable securities acquired for short-term sale.
• Available-for-sale financial assets: Negotiable securities that can be sold, though there is no immediate intention to do so.
• Equity investments: Investments in subsidiaries, joint ventures, associated companies, or other entities with the intention of gaining control.

Valuation Principles

Initial valuation: Fair value (transaction price) + transaction costs.
Subsequent valuation: Amortized cost (*Note: Trade receivables due in less than a year are valued at nominal value).

Amortized Cost Defined

The amortized cost of a financial asset is the amount at which the asset is measured at initial recognition, minus principal repayments, plus or minus the cumulative amortization (using the effective interest method) of any difference between the initial amount and the maturity amount.

Effective Interest Method

The effective interest method calculates the amortized cost and allocates interest income over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash receipts through the expected life of the instrument to the book value of the asset.

Held-to-Maturity Investments

Example: Bonds and debentures. These are debt instruments implying a promise to pay back owed money and are transferable.

Fair Value

Fair value is the amount at which an asset could be bought or sold (or a liability incurred or settled) in a current transaction between knowledgeable, unrelated, willing parties, excluding liquidation scenarios.

Financial Liabilities

Financial liabilities are classified differently for presentation on the balance sheet versus valuation in portfolios. For valuation, they are categorized as:

1. Debt and payables
2. Held-for-trading liabilities
3. Other financial liabilities at fair value through profit or loss