Financial Instruments

Introduction

The most important investment decisions that an investor come across is the allocation of
funds among the wide range of financial instruments. This decision needs an understanding of
investment characteristic of all asset classes. Accounting has adopted the fair value for the
valuation of financial instruments. However, there are issues that permeate the choice of
evaluation criteria regarding the relevance and reliability of the values generated by this
option and if that impact is perceived by the market.

Objective

The objective of this review is to describe financial instruments and find out the significance
of fair value for financial instruments.

Definition of Financial Instruments

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. Investment in equity shares is a form
of financial instrument (Subramani, 2009). Some common financial instruments comprise
checks, stocks and bonds.

Generally, asset can be defined as any control that has value in an exchange. Assets can be
classified as tangible or intangible. A tangible asset is one whose value depends on particular
physical properties – for instance building, land, or machinery. Intangible asset by the
contrast, represent legal claims to some future benefit. Their value bear no relation to the form
physical or otherwise, in which these claims are recorded. Financial assets are intangible
assets. The claims to future cash are typical benefit or value for financial assets. The entity
has agreed to make future cash payments is called the issuer of the financial instrument; the
owner of the financial instrument is referred to as the investor (Fabozzi, 2002).

According to International Financial Reporting Standard (IFRS7) and International

Accounting Standard (IAS 32 and 39) financial asset is defined as one of the following:

 Cash;

 An equity instrument of another entity;

  A contractual right:

o To receive cash or another financial assets from another entity; or

o To exchange financial assets or financial liabilities with another entity under

conditions that is potentially favourable to entity.

 A contract that will or may be settled in the entity’s own equity instruments and is:

o A non-derivative resulting in receiving a variable number of entity’s own

equity instruments.

o A derivative that will or may be settled other than by exchange of fixed amount
of cash or other financial asset for a fixed number of the entity’s own equity
instrument.

A financial liability is defined as one of the following types;

 A contractual obligation:

o To deliver cash or another financial assets to another entity;

o To exchange financial assets or financial liabilities with another entity under

conditions that are potentially unfavorable to the entity;

 A contract that will or may be settled in entity’s own equity instruments and is:

o A no-derivative resulting in delivering a variable number of entity’s own

equity instruments.

o A derivative that will or may be settled other than by the exchange of fixed
amount of cash or other financial assets for a fixed number of the entity’s own
equity instruments.

An equity instrument

An equity instrument is any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities. An obligation to issue an equity instrument is not a
financial liability because it results in an increase in equity and cannot result in loss to the
entity (Terblanche et al., 2011). Examples of equity instruments include no-puttable equity
shares, some types of preference shares and warrants or written call options that allow the
holder to subscribe for or purchase a fixed number of non-puttable equity shares in the issuing
entity in exchange for a fixed amount of cash or another financial asset.

A financial instrument is an asset instrument if and only if both of the following conditions
are satisfied:

 the instrument does not include the contractual obligation to delivery cash or a financial
asset for another entity, and

 if the instrument can or may be settled with an issuer’s asset instrument, it is

o A non-derivative that does not include contractual obligation for the issuer to
deliver a number of its own capital instruments; or

o A derivative that may only be settled by the issuer by exchanging a set amount of
cash or other financial asset for a set number of its own equity instruments

Classification of financial instruments

Growthorpe (2006) argues that there are several classifications of financial assets such as:

 Fair value through profit or loss

 Loans and receivables;

 Held-to-maturity investment;

 Available-for-scale financial assets.

Fair value through profit or loss – those that are classified as ‘held-for-trading’. This
classification is appropriate where the financial assets are obtained mainly for the purpose of
short-term resale. Those that are held as part of a group of financial assets that are managed
on fair value basis accordance with a document risk management or investments strategy
(Growthorpe, 2006).

Loans and receivables – IAS 39 defines loans and receivables as non-derivative financial
assets with fixed or determinable payment that are not quoted in an active market other than:

 Those that entity intends to sell immediately or in the near term (i.e., those quoted in
an active market), which should be classified as held for trading, and those that the
entity upon initial recognition designates as at fair value through profit or loss.
Held-to-maturity investment – investments are non-derivative financial assets with fixed or
determinable payments and fixed maturity than an entity has the positive intention and ability
to hold to maturity other than:

 Those that the enterprises upon initial recognition designates as at fair value through
profit or loss;

 Those that the entity designates as available for sale and,

 Those that meet the definition of loans and receivables (Bhattacharyya, 2006).

Available-for-sale financial assets – are those no-derivative financial assets that are
designated as AFS, or are not classified as loans and receivables. Available-for-sale are
measured at fair value with fair value gains or losses recognized directly in equity through the
statement of changes in equity and recycled into the income report on sale or impairment of
the asset at which time the cumulative gain or loss previously recognized in equity is
recognized in profit or loss for period (deloitte, 2008).

Derivative Financial Instruments

The international financial report standards (IFRS) by the London-based international

Accounting Standards Board (IASB) defines derivative as a financial instrument whose value
changes in response to a change in the price of an underlying, such as an interest rate,
commodity, security price, or index. The definition also specifies that a derivative instrument
typically requires no initial investment, or one that is smaller than would be needed for
classical contract with similar response to changes in market factors. Derivatives contract is
settled at a future date. By their nature, derivatives exhibit highly variable cash flows. Fair
value is the only relevant basis for their measurement because the historical cost of a
derivative is at most a nominal value.

Niyama and Gomes (2000) argues that derivative is usually defined as financial instrument
(contract) whose value derives from the price or performance of another asset, which can be
an asset stock or goods (Niyama and Gomes, 2000).

Typical derivative instrument include futures, forward, swaps and option multiple variation
and combination. They are either traded on organized exchanges or agreed directly in the
over-the-counter market (Bacon, 2008).
GASBS 53 provides that derivative instruments should be reported on the statement of net
assets and should be measured at their fair value. Fair value should be measured by the market
price if there is an active market for the derivative instrument. If a market price is not
available, a forecast of the expected cash flows may be used, provided that the expected cash
flows are available (Ruppel, 2008).

Fair value

The adoption of the application of fair value measurement of financial instruments came to
be strongly considered for the development of the idea that the financial statement should
present information more adherent to the reality of companies and even somewhat predictive
to assist decision-making of shareholders.

The Financial Accounting Standards Board on its speech 133 (1998) establishes that fair value
is the price in which an asset or a liability could be negotiated between stakeholders
spontaneously. In September 2006 the FASB issued SFAS 157 in which defines that the fair
value is the price that could be received to sell of an asset or transfer of payment of a liability
in a transaction between parties interested in the measurement date.

The International Accounting Standard Board (IASB), through the IAS 39 establish that fair
value would be the amount by which a transaction would have occurred on the date of
measurement, in a transaction motivated by normal business considerations with the
counterparty an unrelated entity.

It can be seen, that there are similarities in the definition of fair value presented in relation to
the trading value of the assets or liability in which the interested parties would be willing to
buy or sell disregarding favors, at the data of measurement. On the other hand, the definitions
are not objective and perceptive about how to obtain fair value, it is discussed whether the fair
value would be the value of purchase or sale.

Classification of fair value

The classification of financial instrument at the fair value is determined by the reference of
the source of inputs used to derive the fair value. This classification was done in three
different levels:

Level 1 - quoted prices (unadjusted) in active markets for identical assets or liabilities;
Level 2 - inputs other than quoted prices included within level 1 that are observable for the
asset or liability, either directly (i.e., as prices) or indirectly (i.e., derived from prices);

Level 3 - inputs for the asset or liability that are not based on observable market data
(unobservable inputs);

Many studies about the relevance of accounting information have been done. Concerning the
significance of the application of fair value, most studies are targeted to financial institutions
due to the representation of financial instruments valued at fair value in several companies. A
book value is considered relevant only if it reflect important and reliable information on stock
price; however the authors admit that the definition of relevance and reliability are complex
(Landsaman et al., 2001).

Discussion

Is awareness of shareholders about fair values useful to investors?

Taking a look at several literature reviews done by different authors, it can be seen that fair
value for financial instrument is very complex and involves discussions about the true
function of financial statements and accounting.

Some studies as Eccher et al., (2001) examined the relevance of fair value in financial
instrument of 257 U.S banks in 1992 and 279 banks in 1993. The results showed that the fair
value for financial instruments were relevant, however, statistics showed that the explanatory
power of the stock price was more pronounced when added the principal value (historical
cost) of the basic operation (Eccher et al., 2001).

As can be seen, all related studies were applied to financial institutions and some have found
the relevance of fair value measurement in the price of actions and others not. The financial
instruments were created to adopt easy methods of valuation of assets or liability and not
complicate the investor.

Conclusion

The points presented in relation to the evaluation criteria by the fair value it can be concluded
that there is a need to conduct more experiential research that will show that the information
generated by this type of principle is relevant, consistent and, is perceived by the users.
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