What Are Financial Instruments, and Why Should You Care?

4 Jul

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If your eyes glaze over when you hear the words “financial instruments”, you’re not alone. It sounds like something reserved for investment bankers or hedge fund managers, not accountants and bookkeepers working with everyday businesses.

But here’s the thing: if you’ve ever raised an invoice, paid a supplier, taken out a loan, or recorded a bank transaction—you’ve already dealt with financial instruments. And if you’re doing independent reviews or preparing AFS under the IFRS for SMEs Standard, then understanding how to classify, recognise, measure, and disclose these instruments isn’t optional. It’s essential.

So, let’s break it down.

What Exactly Is a Financial Instrument?

A financial instrument is just a fancy term for a contract that results in a financial asset for one party and a financial liability (or equity instrument) for another.

In other words, it’s an agreement where one person is expecting to receive money (an asset), and the other is expecting to pay it (a liability).

Here are some basic examples that you’ll come across regularly:

Why SMEs and Their Accountants Should Care

You might think “Sure, but isn’t this already handled in our accounting software?” Technically yes—but classification matters. Why?

Because:

It affects how you measure the asset or liability—at cost, amortised cost, or fair value.
It determines what you disclose in the notes to the financial statements.
It impacts the review or audit process, especially if something has been incorrectly classified or measured.
It helps you spot risks early—like whether your client’s debtors are impaired or their interest-free loans need adjusting.

Also, when you're the Accounting Officer or Independent Reviewer for a Close Corporation or SME, getting this wrong could undermine the reliability of the AFS. Worse still, it could expose you to professional liability.

The Two Paths of Section 11: Basic vs Complex Instruments

Section 11 of the IFRS for SMEs is split into two parts:

Part I: Basic Financial Instruments
Part II: Other Financial Instruments

Here’s a quick way to think about it:

If your client is a school, a mechanic, or a small manufacturer with a Nedbank loan, a few customers and suppliers, and some cash in the bank—you’re almost certainly only dealing with Part I.

But if your client has entered into a contract to buy maize futures or took out a loan with interest linked to the JSE All Share Index—you’ve got a Part II situation, and things get more technical.

A Quick Test, Basic or Not?

Let’s play a quick “Is it basic?” game. You’re the accountant for a local bakery. Which of the following are basic financial instruments under Part I?

A bank overdraft for R80,000
Trade receivables from retail customers
An investment in ordinary shares on the JSE
A 3-year fixed interest loan from a supplier
An option to buy flour at a fixed price in six months

Answers:
1 – ✔️ Basic
2 – ✔️ Basic
3 – ❌ Not basic (falls under Part II – complex, unless it meets specific criteria)
4 – ✔️ Basic (provided it meets the conditions of para 11.9)
5 – ❌ Not basic (it’s a derivative)

How Classification Affects Practice

Let’s say you classify something as basic. You’re required to:

Recognise it when you become a party to the contract.
Initially measure it at transaction price.
Subsequently measure it using amortised cost (unless it’s equity shares that must be measured at cost or fair value).
Test for impairment if it’s a financial asset.
Disclose it in the financial statements based on its type (trade receivables, loans, etc.).

Misclassify it, and you might:

Understate fair value losses,
Skip required disclosures,
Miss impairment losses on loans, or
Mislead the Independent Reviewer or SARS.

Final Thought

Financial instruments might sound intimidating, but when you strip away the terminology, it’s just about understanding how money is promised and paid between parties.

If you can follow an invoice, a loan, or a bank transaction—you can grasp Section 11. And over the next few articles, we’ll make sure you do.

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