What is characterized as an 'equity instrument'?

An equity instrument is best characterized as a contract documenting a residual interest in an entity's assets after all liabilities have been settled. This definition aligns with the fundamental role of equity instruments, which represents ownership in a company. When an entity issues equity instruments, such as common or preferred stocks, it gives investors a claim on earnings and assets, though this claim is subordinate to that of creditors.

Options that describe a debt liability, a financial asset secured by collateral, or a short-term investment instrument do not reflect the nature of equity. Debt liabilities indicate borrowed funds that need to be repaid, while assets secured by collateral involve a promise to pay backed by specific assets as security. Short-term investment instruments typically refer to securities intended for short-duration holding, which also does not capture the essence of equity ownership or residual claims against an entity's net assets. As such, the definition of an equity instrument is distinctly tied to the ownership interest it provides in a company’s residual assets, confirming that it is the correct characterization.