Financial Instruments — Due Process Document

Date recorded:

The Board discussed issues raised by the staff about the scope of the proposed due process document on financial instruments.

Scope

After discussion, the Board agreed that the scope of the due process document should be based on a common definition of financial instruments, rather than instruments with similar probable outcomes. The latter alternative was seen as too wide and potentially would scope in items that the Board did not intend to.

The Board agreed that the Invitation to Comment should discuss whether noncontractual obligations to deliver cash (or other financial instruments) and rights to receive cash (or other financial instruments) should be part of the definition of a financial instrument.

Definition of a financial instrument

The staff proposed and then discussed a definition of financial instruments:

A financial instrument is defined as:

  1. cash;
  2. evidence representing a residual or other ownership interest in an entity;
  3. a contractual obligation of one party to deliver a financial instrument to a second party and a corresponding contractual right of the second party to require receipt of that financial instrument in exchange for no consideration other than release from the obligation; or
  4. a contractual obligation of one party to exchange financial instruments with a second party and a contractual right of the second party to require an exchange of financial instruments with the first party.

A financial asset is a financial instrument that is an asset.

A financial liability is a financial instrument that is a liability.

A financial instrument classified by an entity in the equity section of its balance sheet (or statement of financial position) is neither a financial asset nor a financial liability to that entity.

Ownership interests

The proposed definition is based on that in FAS 107 Disclosures about Fair Value of Financial Instruments, which refers to evidence of ownership interests with no reference to contracts. The Board agreed that the approach taken in FAS 107 is clearer and hence preferable. That is, to specifically include ownership interests and include contracts requiring the delivery and exchange of ownership interests with other delivery and exchange contracts.

Symmetry of contractual rights and obligations

The Board agreed that the contractual obligation of one entity to deliver creates another entity's contractual right to receive, and that exchange contracts create rights and obligations for both parties.

Reference to cash and financial instruments in contracts that are financial instruments

The Board agreed that a separate reference to cash was not needed. IAS 32 and Statement 107 explicitly refer to obligations to deliver cash or financial instruments and rights to receive cash or financial instruments-even though cash has previously been specified as a financial instrument.

Grouping of delivery and exchange rights and obligations

Statement 107 states that:

A financial instrument is defined as a contract that both:

  1. Imposes on one entity a contractual obligation (1) to deliver cash or another financial instrument to a second entity or (2) to exchange other financial instruments on potentially unfavourable terms with the second entity; and
  2. Conveys to that second entity a contractual right (1) to receive cash or another financial instrument from the first entity or (2) to exchange other financial instruments on potentially favourable terms with the first entity.

The Board agreed that it was both clearer and more logical to group the two sides of the contract (the right and obligation to deliver or exchange) together.

References to favourable and unfavourable contracts

The Board agreed that the reference to 'favourable' and 'unfavourable' was not necessary to ascertain whether something is an asset or a liability. The due process document could describe a financial asset as a financial instrument that is an asset (and similarly that a financial liability is a financial instrument that is a liability).

Right to require delivery or exchange

The Board agreed that the right to require receipt or exchange is what creates a right to an economic resource, and hence creates an asset (rather then the ability to simply receive or exchange).

Inclusion of components of non-financial contracts

The Board agreed that the definition of a delivery contract could be improved by stating that the right to receive a financial instrument in a delivery contract is the only form of consideration to be received in exchange for releasing the other party from its obligation.

Multiple element contracts

After discussion the Board agreed that they wished to view multiple element contracts as separate sets of rights and obligations. Some Board members were not convinced and would explore a 'whole instrument approach' with the staff.

Possible adjustments to scope

The Board agreed to exclude the following items from the scope of the due process document:

Matters being considered in other current projects:

  • Investments in consolidated subsidiaries, consolidated variable interest entities (FASB only), and associates (equity method investees in FASB terms) or joint ventures
  • Contingent consideration in business combinations
  • Leases
  • Royalty contracts and other contracts for rights to use assets (revenue recognition issues)
  • Pensions and other post employment benefits
  • Financial instruments classified as equity by the reporting entity
  • Insurance and related contracts
Addressed by other recent Standards:
  • Financial instruments and derivatives related to share-based payments

The Board agreed to include the following:

  • Contracts that are financial instruments by definition but are not recognized under current GAAP (for example, loan commitments, letters of credit)
  • Intra-group balances [in the context of separate financial statements]
  • Financial instrument servicing contracts

The Board noted that 'strategic investments' are within the scope of financial instruments generally and will not be considered as a separate type of financial asset.

The Board concluded that contracts that are very similar to related financial instrument contracts should not be included in the scope of the due process document.

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