CH-2 FINANCAIL ASSETS, FINANCIAL TRANSACTION AND FINANCAIL

INTRMEFDIATION

2.1 The creation of financial assets:

What Is a Financial Asset?

A financial asset is a liquid asset that gets its value from a contractual right or ownership
claim. Cash, stocks, bonds, mutual funds, and bank deposits are all are examples of
financial assets. Unlike land, property, commodities, or other tangible physical assets,
financial assets do not necessarily have inherent physical worth or even a physical form.
Rather, their value reflects factors of supply and demand in the marketplace in which they
trade, as well as the degree of risk they carry.

Understanding a Financial Asset

Most assets are categorized as either real, financial, or intangible. Real assets are physical assets
that draw their value from substances or properties, such as precious metals, land, real estate, and
commodities like soybeans, wheat, oil, and iron.

Intangible assets are the valuable property that is not physical in nature. They include patents,
trademarks, and intellectual property.

Financial assets are in-between the other two assets. Financial assets may seem intangible—non-
physical—with only the stated value on a piece of paper such as a dollar bill or a listing on a
computer screen. What that paper or listing represents, though, is a claim of ownership of an
entity, like a public company, or contractual rights to payments—say, the interest income from a
bond. Financial assets derive their value from a contractual claim on an underlying asset.

This underlying asset may be either real or intangible. Commodities, for example, are the real,
underlying assets that are pinned to such financial assets as commodity futures, contracts, or
some exchange-traded funds (ETFs). Likewise, real estate is the real asset associated with shares
of real estate investment trusts (REITs). REITs are financial assets and are publicly traded
entities that own a portfolio of properties.

The Internal Revenue Service (IRS) requires businesses to report financial and real assets
together as tangible assets for tax purposes. The grouping of tangible assets is separate from
intangible assets.1 2

key takeaways

 A financial asset is a liquid asset that represents—and derives value from—a claim of ownership
of an entity or contractual rights to future payments from an entity.
  A financial asset's worth may be based on an underlying tangible or real asset, but market
supply and demand influence its value as well.
 Stocks, bonds, cash, CDs, and bank deposits are examples of financial assets.

Common Types of Financial Assets

According to the commonly cited definition from the International Financial Reporting
Standards (IFRS), financial assets include:

 Cash
 Equity instruments of an entity—for example a share certificate
 A contractual right to receive a financial asset from another entity—known as a receivable
 The contractual right to exchange financial assets or liabilities with another entity under
favorable conditions
 A contract that will settle in an entity's own equity instruments3

In addition to stocks and receivables, the above definition comprises financial derivatives, bonds,
money market or other account holdings, and equity stakes. Many of these financial assets do not
have a set monetary value until they are converted into cash, especially in the case of stocks
where their value and price fluctuate.

Aside from cash, the more common types of financial assets that investors encounter are:

 Stocks are financial assets with no set ending or expiration date. An investor buying stocks
becomes part-owner of a company and shares in its profits and losses. Stocks may be held
indefinitely or sold to other investors.
 Bonds are one way that companies or governments finance short-term projects. The bondholder
is the lender, and the bonds state how much money is owed, the interest rate being paid, and
the bond's maturity date.
 A certificate of deposit (CD) allows an investor to deposit an amount of money at a bank for a
specified period with a guaranteed interest rate. A CD pays monthly interest and can typically be
held between three months to five years depending on the contract.

Pros and Cons of Highly Liquid Financial Assets

The purest form of financial assets is cash and cash equivalents—checking accounts, savings
accounts, and money market accounts. Liquid accounts are easily turned into funds for paying
bills and covering financial emergencies or pressing demands.

Other varieties of financial assets might not be as liquid. Liquidity is the ability to change a
financial asset into cash quickly. For stocks, it is the ability of an investor to buy or sell holdings
from a ready market. Liquid markets are those where there are plenty of buyers and plenty of
sellers and no extended lag-time in trying to execute a trade.
In the case of equities like stocks and bonds, an investor has to sell and wait for the settlement
date to receive their money—usually two business days. Other financial assets have varying
lengths of settlement.

Maintaining funds in liquid financial assets can result in greater preservation of capital. Money
in bank checking, savings, and CD accounts are insured against loss of up to $250,000 by the
Federal Deposit Insurance Corporation (FDIC) for credit union accounts. If for some reason the
bank fails, your account has dollar-for-dollar coverage up to $250,000. However, since FDIC
covers each financial institution individually, an investor with brokered CDs totaling over
$250,000 in one bank faces losses if the bank becomes insolvent.4

Liquid assets like checking and savings accounts have a limited return on investment (ROI)
capability. ROI is the profit you receive from an asset divided by the cost of owning that asset. In
checking and savings accounts the ROI is minimal. They may provide modest interest income
but, unlike equities, they offer little appreciation. Also, CDs and money market accounts restrict
withdrawals for months or years. When interest rates fall, callable CDs are often called, and
investors end up moving their money to potentially lower-income investments.

2.2 Types of Financial Assets

These all can be classified in different categories according to the features of the cash flow
associated with them.

#1 – Certificate of Deposit (CD)

This financial asset is an agreement between an investor (here, company) and a bank institution
in which the customer (Company) keep a set amount of money deposited in the bank for the
agreed term in exchange for a guaranteed rate of interest.

#2 – Bonds

This financial asset is usually a debt instrument sold by companies or the government to raise
funds for short-term projects. A bond is a legal document that states money the investor has lent
the borrower and the amount when it needs to be paid back (plus interest) and the bond’s
maturity date.

#3 – Stocks

Stocks do not have any maturity date. Investing in stocks of a company means participating in
the ownership of the company and sharing its profits and losses. Stocks belong to shareholders
until and unless they sell them.

#4 – Cash or Cash Equivalent

This type of financial asset is the cash or equivalent reserved with the organization.
#5 – Bank Deposits

These are the cash reserve of the organization with Banks in saving and checking accounts.

#6 – Loans & Receivables

Loans and Receivables are those assets with fixed or determinable payments. For banks, loans
are such assets as they sell them to other parties as their business.

#7 – Derivatives

Derivatives are financial assets whose value is derived from other underlying assets. These are
basically contracts.

All the above assets are liquid assets as they can be converted into their respective values as per
the contractual claims of what they represent. They do not necessarily have inherent physical
worth like land, property, commodities, etc.

Financial Assets Classification

There is no single measurement classification technique that is suitable for all these assets. It can
be classified as Current Assets or Non-Current Assets on a company’s balance sheet.

#1 –  Current Assets

It contains those investment assets which are short term in nature and are liquid investments.

#2 – Non-Current Assets

Non-Current assets like shares of other companies or debt instruments held in portfolio for more
than a year.

Advantages

 Some of these assets, which are highly liquid, can easily be used to pay bills or to cover financial
emergencies. Cash and cash equivalents come under this category. On the other hand, one may
have to wait for the stock to get money as they have to be sold in exchange first, followed by
settlement.
 For investors, it gives them more security when they have more capital parked in liquid assets.
 It serves as a major economic function of financing tangible assets. It becomes possible with the
transfer of funds from those who have a surplus of it to where it is needed for such financing.
 Financial assets distribute the risk as per preferences and risk appetite of the parties involved in
the intangible asset’s investment. It represents legal claims to future cash expected generally at
 a defined maturity and defined rate. The counter-parties involved in the agreement are the
company that will pay the future cash (issuer) and the investors.

Disadvantages and Limitations

 Financial assets (liquid assets) like deposits in savings accounts and checking accounts with
banks are greatly limited when it comes to its return on investment, as there are no restrictions
for their withdrawal.
 Furthermore, these assets like CDs and money market accounts may prevent withdrawal for
months or years as per the agreement, or they are callable.
 It majorly comes with a maturity date in the contract, attempting to cash out assets before
maturity calls for penalties and lower returns.

Important Points

 The value of this asset is determined by the demand and supply of such assets in the market.
 These assets are valued as per the cash required to convert them, which again is decided based
on certain parameters. The value of people’s financial assets can change significantly, especially
in the case they have invested majorly in stocks.
 The measurement of financial assets cannot be done using a single measurement method.
Suppose we measure stocks when investments are small in quantum, the market price can be
considered to measure the value of the stock at that time. However, if a company owns a large
number of shares of other companies, the market price of the share is not relevant because the
investor holding majority shares may not sell them.
 Every financial asset has different risks and returns for its purchaser. For instance, a car
company usually has no idea of the sale of its cars, so the value of stocks of the company may
increase or decrease. A bond can default as issuers may fail to pay back the par value of a bond.
Even cash and savings accounts have risks associated, as inflation may have an impact on
purchasing power.

Conclusion

These are a crucial part of any organization. It always needs to have a good record of its financial
assets so that is can be put to use whenever needed, like in financial emergencies. It is helpful to
keep a check on the availability of such assets.

Each and every financial asset has a different but particular goal for the holder, each has a
different amount of risk associated with it, and thus, returns are also different based on risk for
the purchaser of such asset. Since each type of asset has some reward & risk associated with it,
it’s always advisable to keep a mix of different asset types to have an optimal portfolio. It helps
in the proper functioning of the organization without any dearth of assets.
2.3 Characteristics of financial assets:
What are the characteristics of financial assets ?
There are peculiar characteristics that are inherent in financial assets that are normally used partly to
determine their pricing in the financial markets. These characteristics are identified and discussed
below.
1 Moneyness
The moneyness of the financial assets implies that they are easily convertible to cash within a defined
time and determinable value. The cost of transactions involved in securing funds from them before the
maturity date can be likened to agency cost besides the cost of discounting some of them, which
reduces their face value.  Therefore, these financial instruments are regarded as near money because of
the ease with which they can be traded for cash. Examples are Treasury bills, Treasury certificates, Trade
bills, Commercial papers, and Certificate of Deposits, among others.

2 Divisibility & Denomination

The financial assets are usually made out in denominations depending on the face value that the
corporate organizations and institutions that are using them to raise funds from the financial markets.
The divisibility of such near money refers to the minimum monetary value in which a financial asst can
be liquidated or exchanged for money by the holder.

Divisibility for financial assets is imperative so as to enable both suppliers and borrowers to understand
the magnitude of funds involved in each of them; the borrowers have certain amount to source and the
suppliers will like to know the amount that is required of him to part with for the transaction. It is also
necessary so that a limit cab set for the minimum amount of subscription for each instrument and the
overall amount of subscription that may accrue to a particular investor. For instance, many bonds can
denominated like N1,000 denomination while that of certificate of deposits are denominated form
N500,000.  

3 Reversibility
The financial assets are highly reversible in the sense that they are like deposits in accounts of customers
with the banks. This implies that the cost of investing in the financial assets and getting them back into
cash is negligible. Hence reversibility of financial assets is often regarded as turnaround cost or roundtrip
cost.
The most relevant part of the roundtrip cost as associated with financial assets constitutes what is
known as the ‘bid-ask spread’ in which commissions cost of delivery an asset is entrenched. In the well-
organized financial market there are market makers who take responsibility of assuming risk in
associated with the financial assets while making the market or carrying inventory of financial assets.

Therefore, the spread being charged by the market makers varies in line with financial assets that are
traded.  Some financial assets carry less risk than others; for instance, marketable securities that can
easily be converted into liquid cash with little or no hassles because they are more liquid than other
financial assets. The risk involved in marketable securities or mortgage loan stock cannot be comparable
with risk inherent in bond issue of a fledgling company.

The risk involved in market making is related to market forces that are twofold such as: Variability of the
price; and Thickness of the market.

a) Variability of Price of financial asset 

 This is determined by some measure of dispersion in the price. It implies that the greater the variability
in price, the greater the probability that the market maker may loose in the bargain. For instance, a
speculative stock such as shares will be fraught with much larger short-run variations. On the other
hand, Treasury bills, which government securities (or gilt-edged securities) exhibit stable price with less
short-run variation.        

b) Thickness of the Market for financial asset 

The thickness of the market implies the frequency of transactions on a given financial asset. A thin
market reflects a financial asset that has few trades on a regular or continuous basis, hence the greater
the order flows on it the shorter the time that the asset will be held in the inventory of market makers.
Therefore, such financial asset will exhibit smaller probability of an unfavourable price movement while
it is in the inventory of market makers.    A thick market is associated with market where frequent
transaction on financial assets is being exhibited and this varies from market to market. Hence a
particular market for a financial asset such as shares may be thick while in another such financial asset
may be thin. For instance, the shares of blue-chip firms will exhibit thickness in transactions while the
shares of small companies may exhibit thinness in transactions in a given market situation.

4 Cash
Flow This refers to the return that an investor will derive from holding a financial asset, which invariably
depends on all the cash distributions that the asset will pay holders. This is expressed in terms of the
dividend on shares or coupon yield payments that are associated with bonds.
The return on investment in a financial asset is also affected by the repayment of the principal amount
for a debt instrument and any expected price variation of the stock. In calculation of expected returns
on a financial asset, factors that should be considered include non-cash payments in form of stock
dividend yield and options to purchase additional stock or the distribution of other securities that must
be factored in the  consideration. The issue of inflation implies that there is difference between normal
effective return and real effective return on financial assets.  Therefore, the net real return on financial
assets is the amount of cash returns that are accruable after adjusting the nominal returns against
inflation.  

5 Maturity Period 
In financial parlance, the maturity period refers to the length of time within which the corporate entity
or institution that employs a financial instrument to raise funds will use the funds before its payment
back to the holders of such instrument. For instance, a bond can be held by a corporate entity for a
period of thirty (30) years while that of government can extend to a period of ninety-nine (99) years
before their repayment to the holders.  

There are some financial instruments being traded in the financial markets that may not reach the
stated maturity dates before they are terminated by the corporate entities that use them to raise funds.
There are reasons that may be responsible for such situation which include the following:

Bankruptcy:- a situation in which the company is being unable to meet its external financial obligations
and therefore, declared bankrupt;

Reorganization:- a situation in which the company is restructuring its ownership structure and
operations; and

Call Provision:- the financial instrument being associated with call provision.

The case of call provision implies that the company as the debtor or user of the funds takes
responsibility of setting aside sinking funds with which to redeem the instruments eventually.
The sinking fund is normally made as one of the contractual obligations that are established in the
agreement or indenture regulating the usage of the funds from the financial instrument.

 6 Convertibility
This characteristic implies that a financial asset or instrument can be converted into another class of
asset which will still be held by the corporate entity has original used to raise funds for its operations.
The conversion can take a form of bond being converted to bond, preference shares being converted to
equity shares, and a company bond being converted into equity shares of the company.

 The opportunity for convertibility of financial instruments into another financial assets has to be
entrenched in the covenant which has been written to guide the contractual agreement on the
instrument or to regulate the behaviour of the company using the funds from the instruments.
Nevertheless, such a provision can be negotiated in the course of the usage of the funds by a company
especially when the holders discover that the company is manipulating its operational and financial
records to shortchange them.  
7 Currency 
Financial assets are normally denominated in currencies of the various countries around the world. This
implies financial assets of the Nigerian financial system are denominated in Naira such as Federal
Government Loan Stock, Treasury Bills, Treasury Certificate, Shares and Corporate and State
Government Bonds. Those financial assets in Japan are denominated in Yen, those in the United States
of America are in Dollars, those in United Kingdom are in Pounds Sterling while those in China are in
Yuan, etc.

You have also learned from the initial section of this study unit that financial assets as products of
transactions in the financial markets can be denominated in various currencies particularly the local
currencies of various economies around the world. Nevertheless, there are those financial instruments
that are traded across international boundaries in some countries especially in highly developed capital
markets in US, UK, Japan, France, and South Africa, just to mention but a few. Such financial assets are
usually denominated mainly in American dollars and any other international money that is acceptable
around the world.

Furthermore, it is important for investors to know the currency in which certain financial assets are
denominated when buy them. For instance, the recent ECO Bank shares were denominated in US dollars
when they were offered to the public for subscription. These shares were floated across international
boundaries many countries in Africa. Therefore, the use of an international currency such as the US
dollars made it easier for the bank to handle the transactions in the stock seamlessly. Nevertheless,
subscribers were made to pay the equivalent of their total amount of subscription in their local
currencies. The dividends for these shares are also being paid in US dollars.

Dual currency securities may be issued in some instances. For instance, the EURO Bonds are issued in
dual currencies for ease of transactions by multiple subscriptions by various investors around the world.
Therefore, it is the policy on EURO Bonds to pay interest in one currency while the principal repayment
is effected in another currency.

8 Liquidity
You have learned from above that one of the main characteristics of financial assets is the moneyness of
such instruments which implies that they are easily convertible to cash within a defined time and
determinable value. The cost of transactions involved in securing funds from them before the maturity
date can be likened to agency cost besides the cost of discounting some of them, which reduces their
face value. Hence, these financial instruments are regarded as near money because they are highly
liquid in terms of the ease with which they can be traded for cash. Good examples of highly liquid
financial instruments include Treasury bills, Treasury certificates, Certificate of Deposits, Bills of
Exchange, and shares of blue chip companies, e.g., Shares of Cadbury, First Bank, Guaranty Trust Bank,
etc.

However, there are some financial instruments that cannot be easily converted to cash whenever the
holders need money. Therefore, they are illiquid because the holders may have to retain them till they
are matured; alternatively they can only trade them for very insignificant value in capital markets where
there are jobbers that may be willing to carry them in their stock of securities. Presently there are no
jobbers operating in the Nigerian Stock Exchange, and hence the stock brokers in the Exchange are
usually not willing to trade in financial instruments of weak corporate entities.

 9 Predictable Returns 
The return on financial assets must be predictable for the purpose of their being patronized by
investors. For instance, the investors should be able to know the percentage of interest that are
attached to certain debt instruments before they will be prepared to stake their funds on them. This is
because performance of a company cannot be taken for granted due to the mere fact that top
management and the boards of directors are known to be manipulating the accounting records of their
companies these days.  This is more reason why investors are always very skeptical in patronizing
financial instruments of some corporate entities due to their antecedents in manipulating their
accounting records. The cases of Cadbury in Nigeria and Enron in the US are classical testimonies to the
unwholesome accounting practices in the operations of companies around the world.

However, the returns on bonds, development loan stocks, and preference shares are determinable so
that the investors are aware about the expected returns on their investment. There other government
securities such as Treasury bills and Treasury certificates which are traded in money market that
command fixed returns. The apex bank has the responsibility in their issuance and also their repayment
as well as the payment of their returns to the subscribers. Therefore, State government bonds, Federal
Government development loan stocks, Treasury bills and Treasury certificates are regarded as gilt-edged
securities because their returns as well as principal amount of investment in these securities must be
paid as at when due for settlement.  

The issue of unpredictability of future returns on some securities such as equity shares results from
volatility in earnings by the companies in their operations. However, the unpredictability to future
returns can be measured on how it relates to the level of volatility of a given financial asset. The returns
on equity shares like dividends are the residual payments from the earnings of corporations.
Nevertheless, the attraction in these shares is the possibility of capital appreciation in their value but
subject to the performance of their corporations and capital market operational forces.

10 Tax Status of Returns 

The returns on various financial assets are subject to tax status because they are taxable earnings. The
tax authorities are interested in collection of taxes on earnings from financial assets as securities which
are regarded as incomes for investors. However, the tax status on financial assets varies from one
economy to another.

The rate of such taxes on financial assets is also subject to variation from time to time depending on the
interest of the government which must be adhered to by the tax authorities. The tax status on financial
assets also differs from one type of security to another depending on the nature of the issuing
companies or institutions such as Federal, State, or local government.
2.4 Types of financial transactions

In accounting, the business transaction (also known as financial transaction) is an event that
must be measurable in terms of money and that essentially impacts the financial position of the
business. For example, you run a merchandising business and you sell some goods to a
customer for $500 cash; it is an event that you can measure in terms of money and that impacts
the financial position of your business so it is a transaction. Similarly, you pay $400 cash to your
salesman as his pay. This event is also a transaction because it has a monetary value of $400 and
it has a financial impact on your business. Only those events that can be measured in monetary
terms are included in accounting records of the business.

There may be numerous events related to a business to which we cannot reliably assign a dollar
value. Such conditions or events cannot be called business or financial transactions. For example,
the CEO of a company delivers a motivational lecture to the employees. Undoubtedly, this event
may be of great benefit for the company’s business but we cannot assign a monetary value to it
so it is not a business transaction and therefore cannot become a part of accounting records.

Each transaction is recorded by making a journal entry by a bookkeeper or accountant. Since

each transaction impacts financial position of the business, the bookkeeper or accountant must
make sure that it has been authorized by a responsible person and is properly supported by one or
more source documents before recording it in the journal. A source document is a document that
provides basic information needed to record a transaction in the journal. Usual examples of
source documents include sales invoices, purchase invoices, cash receipts, payment vouchers,
statement of accounts, bills of exchange, promissory notes and any other document containing
the basic transaction details which can be presented as a proof of valid transaction.

Characteristics of a business transaction

From above discussion, we can point out the following five important characteristics of a
valid business transaction that every bookkeeper or accountant must take care of before entering
the transaction in the journal.

1. It is a monetary event.
2. It affects financial position of the business.
3. It belongs to business not to the owner or any other person managing the business.
4. It is initiated by an authorized person.
5. It is supported by a source document.

Types of business transactions

In accounting, the transactions may be classified as:
 1. cash transactions and credit transactions
2. internal transactions and external transactions

(1) Cash and credit transactions

A transaction in which cash is paid or received immediately at the time when transaction occurs
is known as cash transaction. For example, you sell some goods to Mr. John for $50 and Mr.
John immediately pays $50 cash for the goods purchased. It is a cash transaction because
you have immediately received cash for the goods sold to your customer. Similarly, you buy
furniture for your business for $750. You immediately pay $750 cash to the supplier and get the
possession of furniture. It is also a cash transaction.

In today’s modern business world, cash transactions are not limited to the use of currency notes
or coins for making or receiving payments, all transactions made using debit or credit cards
issued by financial institutions are also categorized as cash transactions.

In a credit transaction, the cash does not change the hands immediately at the time when
transaction occurs. In other words, the cash is received or paid at a future date. For example, you
buy some merchandise from your vendor for $1,000. Upon your request, your vendor agrees to
receive the payment of $1,000 for goods sold to you next weak. You take the possession of the
goods and transport them to your store. It is a credit transaction because you have not made the
payment in cash immediately at the time of purchase of goods. Similarly, you sell some goods to
Mr. Sam for $150. Mr. Sam requests you to receive the payment of $150 next month. You agree.
Mr. Sam takes the goods to his home for use. This is also a credit transaction because you have
not received the payment in cash at the time of sale of goods to Mr. Sam.

In today’s business world goods are mostly purchased and sold on credit.

(2) Internal and external transactions

Internal transactions (also known as non-exchange transactions) are those transactions in

which no external parties are involved. These transactions do not involve in the exchange of
values between two parties but the event constituting the transaction is measurable in monetary
terms and impacts the financial position of the business. Examples of such transactions include
recording depreciation of fixed assets and realizing the loss of assets caused by fire etc.

External transactions (also known as exchange transactions) are transactions in which a

business exchanges value with external parties. Normally, all transactions other than internal
transactions are external transactions. These are the usual transactions that a business performs
on daily basis. Examples of external transactions include purchase of goods from suppliers, sale
of goods to customers, purchase of fixed assets for business use, payment of rent to owner,
payment of gas, electricity or water bills, payment of salary to employees etc. Normally, a large
portion of transactions performed by any business consists of external transactions.

Types of Financial Transactions

a financial transaction is one in which there is some sort of activity that changes the value of the assets,
liabilities, or owner's equity of an organization. These types of transactions are two-part transactions
consisting of a buyer and a seller, and they always involve money in some way. Financial transactions in
accounting are recorded in the accounting journal in chronological order.

There are four main types of financial transactions that occur in a business. These four types of
financial transactions are sales, purchases, receipts, and payments. Let's take a minute to learn
about each one:

 Sales are the transactions in which property is transferred from buyer to seller for money
or credit. Sales transactions are recorded in the accounting journal for the seller as a debit
to cash or accounts receivable and a credit to the sales account.
 Purchases are the transactions that are required by a business in order to obtain the goods
or services needed to accomplish the goals of the organization. Purchases made in cash
result in a debit to the inventory account and a credit to cash. If the purchase is made with
a credit account, the debit entry would still be to the inventory account and the credit
entry would be to the accounts payable account.
 Receipts refer to refer to a written acknowledgement of having received or taken into
ones possession a specified amount of goods or money.
 Payments are the transactions that refer to a business receiving money for a good or
service. They are recorded in the accounting journal of the business issuing the payment
as a credit to cash and a debit to accounts payable.

EXAMPLE1:Blue Diamond Company issued 300 shares of $10 par value common stock for $4,500.
Prepare Blue Diamond’s journal entry.

Journal entry:

Cash 4,500

Common stock (300 x $10) 3,000

Paid-in capital in excess of par 1,500