Understanding Financial Assets: Definitions & Types

Financial assets refer to assets that arise from contractual agreements on future cash flowsCash Flow Statement​A cash flow Statement contains information on how much cash a company generated and used during a given period. or from owning equity instruments of another entity. Financial instruments refer to a contract that generates a financial asset to one of the parties involved, and an equity instrument or financial liability to the other entity.

A key difference between financial assets and PP&E assetsPP&E (Property, Plant and Equipment)PP&E (Property, Plant, and Equipment) is one of the core non-current assets found on the balance sheet. PP&E is impacted by Capex, – which typically include land, buildings, and machinery – is the existence of a counterparty. Financial assets can be categorized as either current or non-current assets on a company’s balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting..

Measurement of Financial Assets

The most important accounting issue for financial assets involves how to report the values on the balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting.. Considering all financial assets, there is no single measurement technique that is suitable for all assets. When investments are relatively small, the current market price is a relevant measure. However, for a company that owns a majority of shares in another company, the market price is not particularly relevant because the investor doesn’t intend to sell its shares.

In fact, a key factor in the presentation of financial statements is the management’s intent for the investment. For example, the value of a company’s investment in another company’s shares would be shown differently if they were purchased with the intention to hold them for a while and then sell them (e.g., trading) vs. owning a significant percentage (75%) of the company.

The flexibility and uniqueness of different financial assets, however, do not mean that companies can choose any method they want to. Accounting standards specify general guidelines to account for different financial assets. A few guidelines set out by the IFRS are shown below.

Accounting Classification of Financial Assets under IFRS

Type of Financial InstrumentBusiness ModelAccounting ClassificationAccounting TreatmentEquityControlSubsidiaryConsolidationEquityJoint control of assets and liabilitiesJoint operationsProportionate consolidationEquityJoint control of net assetsJoint ventureEquity methodEquitySignificant influenceAssociateEquity methodEquity/DebtRealize changes in valueFair value through profit or loss (FVPL)Fair value, changes recorded through net incomeDebtCollect contractual cash flowsAmortized costAmortized cost method

Equity investments in the first four rows refer to strategic investments. The first row refers to investments wherein a company exercises control (i.e., normally owns >50% of the voting interest) of another company. The proper accounting treatment is to consolidate the financial statements of the investor and the subsidiary into a single set of financials.

In addition, joint control in rows 2 and 3 refer to any contractual arrangement between two or more companies. For joint operations, the appropriate treatment is proportionate consolidation wherein the financial statements are compiled depending on the percentage of ownership. Joint venture classifications and significant influence investments, on the other hand, follow the equity method.

The Equity Method

The Equity method is used for either joint ventures or significant influence investments (i.e., owning 20%-50% voting interest). It either increases or decreases the investment account based on income earnings and dividend payments. This is best illustrated through an example.

On January 1, 2017, XYZ Company acquired 10,000 shares of ABC Company, representing 30% of the shares of ABC, for $100,000. For the year ended December 31, 2017, ABC earns $300,000 of net income. On January 1, 2018, ABC declares and pays a dividend to XYZ company of $20,000.

January 1, 2017

DR Investment in ABC (significant influence)  100,000CR Cash        100,000

December 31, 2017

DR Investment in ABC (significant influence)  90,000CR Investment income 90,000

Because ABC is an associate of XYZ, XYZ can include its portion of the net income (300,000 * 30%) to its ledger.

January 1, 2018

DR Cash 20,000CR Investment in ABC (significant influence)20,000

When dividend payments are received, the investment account is reduced.

Fair Value through Profit or Loss

The FVPL accounting treatment is used for all financial instruments that are intended to be held for sale and NOT to maintain ownership. When these assets are being held, they are always recorded at fair value on the balance sheet, and any changes in the fair value are recorded through the income statement, eventually affecting net income and not other comprehensive income (OCI). All transaction costs associated with the investment are expensed immediately.

Example: XYZ Company purchased an investment on November 1, 2016 for $1,000. At December 31, 2016, the fair value of the investment is $3,000. Transaction costs are 4% of purchases. What are the journal entries?

November 1, 2016

DR Investment (FVPL)1,000CR Cash1,000DR Transaction Expense40CR Cash40

December 31, 2016

DR Investment (FVPL)2,000CR Unrealized Gain2,000

Amortized Cost Method

Finally, the amortized cost method is used to account for debt instruments. These financial assets are intended for collecting contractual cash flows until maturity. Debt instruments are different from FVPL investments because FVPL is intended to be held for a certain period and then sold.

The debt instrument is recorded at its acquisition cost; any premium or discount is amortized over the life of the investment using the effective interest rate method, and transaction costs, if any, are capitalized.

Additional Resources

Thank you for reading CFI’s guide to financial assets. CFI is the official provider of the FMVA Financial Modeling CertificationBecome a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today!, designed to transform anyone into a world-class financial analyst. To advance your career, these additional CFI resources will be helpful:

• Asset ClassAsset ClassAn asset class is a group of similar investment vehicles. They are typically traded in the same financial markets and subject to the same rules and regulations.
• Asset AcquisitionAsset AcquisitionAn asset acquisition is the purchase of a company by buying its assets instead of its stock. It also involves an assumption of certain liabilities.
• Return on Assets & ROA FormulaReturn on Assets & ROA FormulaROA Formula. Return on Assets (ROA) is a type of return on investment (ROI) metric that measures the profitability of a business in relation to its total assets.
• Stockholders EquityStockholders EquityStockholders Equity (also known as Shareholders Equity) is an account on a company's balance sheet that consists of share capital plus