IFRS defines a financial instrument as a contract that gives rise to a financial asset of one entity, and a financial liability or equity instrument of another entity.
Derivatives are financial instruments for which the value is derived based on some underlying factor (Interest rate, exchange rate, commodity price, security price or credit rating) and for which little or no initial investment is required.
Financial instruments are generally recognised when the entity becomes a party to the contractual provisions of the instrument. In general, the two basic alternative ways that financial instruments are measured subsequent to initial acquisition are fair value or amortised cost.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly market transaction.
The amortised cost of a financial asset (or liability) is the amount at which it was initially recognised, minus any principal repayments, plus or minus any amortisation of discount or premium, and minus any reduction for impairment.
Under IFRS, financial assets are subsequently measured at amortised cost if the asset’s cash flows occur on specified dates and consist solely of principal and interest, and if the business model is to hold the asset to maturity. The concept is similar in US GAAP, where this category of asset is referred to as held-to-maturity.
For financial instruments measured at fair value, the two basic alternatives in how net changes in fair value are recognised are (1) as profit or loss on the income statement, or (2) as other comprehensive income (loss), which bypasses the income statement.
Note that these alternatives refer to unrealised changes in fair value, that is, changes in the value of a financial asset that has not been sold and is still owned at the end of the period. Unrealised gains and losses also are referred to as holding period gains and losses. Realised gains or losses as a result of a sale are reported on the income statement.
