A financial instrument is cash, evidence of an ownership interest in an entity, or a contract with two limbs that both hold. The first imposes on one entity a contractual obligation to deliver cash or another financial instrument to a second entity, or to exchange other financial instruments with that entity on potentially unfavorable terms. The second conveys to that second entity the matching contractual right, to receive cash or another financial instrument from the first entity, or to exchange other financial instruments with the first entity on potentially favorable terms (FASB Statement No. 107, paragraph 3).
Cash and a stake in another entity stand on their own. Everything else in the class is a contract, and the definition describes that contract from both ends at once. The definition also uses its own term, and the standard says so in the same place. The use is recursive but not circular, because the chain of contractual obligations has to end in the delivery of cash or an ownership interest in an entity (FAS 107, paragraph 3, footnote 2).
One Contract, Two Balance Sheets
No contract qualifies from one side alone. The obligation limb and the right limb are not two tests to pass in turn, they are one instrument written down from each end, so a financial instrument reaches financial statements twice: as a financial asset on the books of the party holding the right, and as a financial liability, or an equity instrument, on the books of the party carrying the obligation.
A note receivable and a note payable are therefore not two facts about the world. They are one agreement, written down from opposite sides of it.
Clients that report under International Financial Reporting Standards work from a definition written from outside the contract rather than from the parties’ ends. 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 (IAS 32, paragraph 11, as endorsed by Commission Regulation (EC) No 1126/2008). That sentence names the three places an instrument can land, and it reaches only contracts. Cash is therefore a financial asset under IAS 32 rather than an instrument in its own right, while the FASB definition lists it as one.
The Disclosure Financial Instruments Switch On
Three disclosures hang off the term. The general disclosure guidance for Subtopic 825-10, Financial Instruments, addresses incremental disclosures about the fair value of financial instruments, concentrations of credit risk of all financial instruments, and market risk of all financial instruments (ASC 825-10-50-1, reproduced in FASB Accounting Standards Update 2016-01).
The class it sweeps is wider than the statements are. All contractual obligations that are financial instruments meet the definition of a liability, and all contractual rights that are financial instruments meet the definition of an asset, although some may not be recognized in financial statements, may be off-balance-sheet, because they fail to meet some other criterion for recognition (FAS 107, paragraph 3, footnotes 1 and 3).
What a private client actually has to disclose here got smaller. Update 2016-01 eliminated the requirement to disclose the fair value of financial instruments measured at amortized cost, meaning carried at cost adjusted over time rather than remeasured to fair value each period, for entities that are not public business entities (FASB Accounting Standards Update 2016-01).
Public business entity is a defined term, and a client meets it by satisfying any one of five criteria rather than by having one relationship with the Securities and Exchange Commission. Being required by the SEC to file or furnish financial statements is the first, and it takes in an entity that files or furnishes them voluntarily. The rest can catch a client with no SEC relationship at all, including one required by the Securities Exchange Act of 1934 to file or furnish financial statements with a regulatory agency other than the SEC, and one that has issued, or is a conduit bond obligor for, securities traded, listed or quoted on an exchange or an over-the-counter market (FASB Accounting Standards Update 2016-01).
Public business entities kept the disclosure and were pushed onto a single basis for it. The same Update requires them to measure that fair value using the exit price notion, consistent with Topic 820, Fair Value Measurement (FASB Accounting Standards Update 2016-01).
How the Fair Value Hierarchy Attaches
Fair value measurement sorts by input, not by method. The fair value hierarchy prioritizes the inputs to valuation techniques, not the valuation techniques themselves (FASB Statement No. 157, paragraph 23). One present value model can therefore produce a Level 2 measurement on one instrument and a Level 3 measurement on the next.
The levels are defined by what the input is. Level 1 inputs are quoted prices, unadjusted, in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability (FAS 157, paragraphs 24, 28 and 30).
The step that catches preparers is the last one rather than the first. The level within which a measurement in its entirety falls is determined by the lowest level input that is significant to that measurement in its entirety (FAS 157, paragraph 22). One significant unobservable input pulls the whole measurement down to Level 3, however observable the rest of the inputs are.
Holding a large position in one instrument changes nothing about the price. Where the reporting entity holds a position in a single financial instrument that trades in an active market, fair value is the quoted price times the quantity held, unadjusted for the size of the position, an adjustment the standard names a blockage factor and prohibits (FAS 157, paragraph 27).
Derivatives Are Inside the Class
A derivative is not a neighbor of the class, it is a member of it, and the standard says so in its opening words: a derivative instrument is a financial instrument or other contract with all three of the following characteristics (FASB Statement No. 133, paragraph 6).
So the definition reaches a derivative, and a derivative’s own recognition and measurement rules sit on top of it. The three characteristics, and the clearing mechanics behind an exchange-traded one, are at future contract; what an unrealized change in value does to the return is at mark to market.
Where the Term Overlaps Financial Asset and Security
A financial instrument and a financial asset are not the same class, and they are not disjoint either. Cash and evidence of an ownership interest in an entity sit in both. Where the instrument is a contract, the financial asset is the right side of it, and the same contract is a financial liability, or an equity instrument, on the other. The asset class itself, and the way the chain of contractual obligations resolves its third limb, is worked out at financial assets.
Financial instrument and security are not the same test, and the two terms come out of different bodies of law. They also overlap. Stock sits in both, as evidence of an ownership interest in an entity under the accounting definition and as an enumerated security under the statute.
Security is mostly a statutory enumeration rather than a functional test, though the list closes with a catch-all that is one. It means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, and a list that runs on through investment contracts, certificates of deposit for a security, and puts, calls and options on a security, on a certificate of deposit, or on a group or index of securities. Only then does it open out into a catch-all for any interest or instrument commonly known as a security, and sweep in certificates of interest or participation in, receipts for, guarantees of, and warrants or rights to subscribe to or purchase any of the foregoing (15 U.S.C. 77b(a)(1)).
A written note between two private parties is a financial instrument under the accounting definition, because it imposes an obligation to deliver cash on one party and conveys the matching right to the other. Whether it is also a security under that enumeration is a separate question with separate consequences, and whether it carries a price you can look up is a third, at marketable security.
Common Questions
Cash and a stake in another entity qualify on their own. The rest are contracts: a bank deposit, a trade receivable and the trade payable facing it, a promissory note, a bond, and a futures contract. Naming them in pairs sits closer to the definition than naming them as holdings, because each one is a single agreement that two parties carry from opposite ends.
The FASB definition does not work in types at all. It sets out cash, evidence of an ownership interest in an entity, and a two-sided contract, and it stops there (FAS 107, paragraph 3). A five-way split such as cash, debt, equity, derivative and foreign exchange sorts instruments by product family, which describes a market rather than deciding an accounting treatment.
Financing instruments are the ones a business issues to raise money rather than holds to store it, and the split is the familiar one between debt and equity. A note or a bond imposes on the issuer an obligation to deliver cash and conveys the matching right to the holder, while shares fall under the second limb of the definition, evidence of an ownership interest in an entity, rather than under any promise to pay (FAS 107, paragraph 3). Money raised either way, seen from the issuer’s own side of the sheet, is financial capital.
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