A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of an other entity.
The definition of a financial instrument describes financial instruments as contracts, and therefore financial instruments are in essence pieces of paper.
For example, an entity that sells goods on credit issues an invoice (piece of paper). This invoice (piece of paper) represents a financial instrument and in particular a financial asset – the debtor or receivable. The piece of paper (the invoice) received by the customer or buyer in turn represents a financial liability – the creditor or payable.
Another example is when an entity raises capital by issuing shares. The entity that acquires the shares has a financial asset – an investment. The issuing entity that raised finance has an equity instrument – issued share capital.
A further example is when an entity raises finance by issuing debentures. The entity that purchases the debentures – ie lends the money – has a financial asset – an investment. The issuer of the debenture – ie the borrower who has raised the finance – has a financial liability.
So financial instrument accounting, in simple terms is referring to how we account for investments in shares, investments in debentures and debtors or receivables (financial assets), how we account for trade creditors and other payables and long-term loans (financial liabilities) and how we account for issued share capital (equity instruments). (Note: financial instruments do also include derivatives, but this is beyond the scope the this publication).