What it means
The word instrument is used in finance as a general label for the things that investors buy, sell and hold. Shares represent ownership in a company, bonds represent a loan to a borrower, and derivatives are contracts whose value depends on something else, such as an interest rate or a commodity price.
Cash itself and bank deposits are also treated as financial instruments in accounting. A useful way to think about it is that every instrument is a two-sided agreement.
For one party it is a financial asset, which is something of value that will bring money in. For the other party it is a financial liability or an equity claim, which is something that must be paid or shared.
Instruments are usually grouped by type. Debt instruments, such as loans and bonds, promise repayment with interest, while equity instruments, such as shares, give a claim on what is left after debts are paid.
Derivative instruments, such as options and swaps, are agreements that gain or lose value as an underlying price moves. Accounting standards require companies to record instruments on the balance sheet and to measure them in a specific way.
Some are carried at cost and others at fair value, which is the price at which the instrument could be sold in an orderly transaction between market participants. The measurement choice affects reported profit, so it is worth understanding when reading a set of accounts.
Businesses use instruments for raising money, investing spare cash and managing risk. A company may issue bonds to fund a factory, hold money market instruments to earn interest on surplus cash, or use a currency forward, which fixes an exchange rate for a future date, to protect against swings.
The word is also used in a looser sense, as in a legal instrument, which means a formal written document such as a deed or a promissory note. In a finance setting the context normally makes it clear that the meaning is a tradable contract or asset.
In practice
Real-world examples.
Example
A software company needs $5,000,000 to expand and issues bonds to investors. The bonds are a debt instrument for the company, which must repay the principal and interest, and a financial asset for each investor who buys them.
Example
An exporter expects to receive payment in euros in three months and signs a forward contract with its bank to sell those euros at a fixed rate. The forward is a derivative instrument that removes the exchange rate risk from the sale.
Example
A manufacturer places $2,000,000 of surplus cash in a short-term treasury bill. The bill is a money market instrument that earns a small, low-risk return and can be turned back into cash easily.
Case study
Seen in the real world.
Greywell Components is an illustrative, fictional manufacturer with a simple balance sheet: cash, receivables and a bank loan. When its new finance director arrived, she asked for a list of every financial instrument the company held or owed, and the team found more than anyone expected.
The list included the bank loan, a supplier note payable over two years, a currency forward signed by the sales team and a small holding of money market units bought with surplus cash. The currency forward had been signed informally and never recorded, even though its value had moved against the company by $45,000.
The director added the forward to the books at fair value and introduced a policy requiring finance sign-off before any new contract was signed. In this illustrative story, the exercise showed that the company had been taking financial risks without realising it, and the clean list became the basis for its risk reporting.
Watch out
Common mistakes.
- Thinking instruments are only things traded on stock markets, when loans, deposits and trade receivables are financial instruments too.
- Ignoring derivatives that have no up-front price, such as a forward, because no money changes hands when they are signed.
- Using the word instrument and the word security as if they were identical, when security usually means a tradable instrument and instrument is the wider term.
Questions
People also ask.
Is cash a financial instrument?
Yes, in accounting terms cash is treated as a financial asset, and the contract to receive cash is also an instrument.
What is the difference between a primary and a derivative instrument?
A primary instrument, such as a share or a bond, stands on its own, while a derivative takes its value from some other asset, rate or index.
Why does the type of instrument matter for the accounts?
Each type may be measured and reported differently, for example at cost or at fair value, which changes the profit and the balance sheet.
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