There are two types of financial assets, equity instruments and debt instruments. These financial assets are classified into any of the following three measurement categories.
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
It is important to understand the basis for classifying financial assets into the correct measurement categories. If the financial assets are classified incorrectly, it will result in wrong subsequent accounting. This post will help you understand the basis of classification of financial assets.
Let’s discuss the classification basis of both equity instruments and debt instruments.
Classification of equity instruments under IFRS 9
Investments in equity instruments are measured at fair value. Therefore, there are two classification options available i.e., FVTPL or FVOCI. Default classification approach for investments in equity instruments is fair value through profit or loss (FVTPL).
Under FVTPL, investments in equity instruments are carried at fair value and any changes in fair value are taken to the statement of profit or loss.
The go-to category for equity instruments is FVTPL. However, equity instruments not held for trading purposes can be irrevocably classified as financial assets measured at fair value through other comprehensive income (FVOCI). It means that if such equity instruments are classified as FVOCI investments at initial recognition, later on, they cannot be reclassified as FVTPL investments.
Under FVOCI category, investments in equity instruments are carried at fair value and any changes in fair value are recorded as other comprehensive income. Dividend income is recorded in statement of profit or loss.
Classification of debt instruments under IFRS 9
For classification of a financial asset (debt instruments), we need to assess:
- the business model that the entity uses to manage the instrument, and
- whether the cash flows arising from the financial asset represent Solely Payments of Principal and Interest (“SPPI”).
The flowchart below reflects the basic components that help identify this classification.
This assessment occurs at inception; however, the financial assets may be reclassified during its life, which is a rarity though.
As aforementioned, the two factors that help us assess classification are:
- An entity’s business model for managing financial assets i.e., the objective to hold the asset for collecting cash flows only or for collecting cash flows and selling financial assets. This is referred to as the Business Model Assessment (“BMA”); and
- The contractual cash flow characteristic of the financial asset that may give rise to solely payments of principal and interest (“SPPI”) on specified dates.
The Business Model Assessment (“BMA”)
IFRS 9 defines business model as the way an entity manages the groups of financial assets to achieve a particular business objective. It can be to earn steady cash flows in the form of interest payments or generate frequent disposal gains to meet the liquidity needs of the entity, or merely to realise fair value changes. Each portfolio of financial asset can be categorised as such.
The Business Model Assessment is used to classify financial assets based on how the assets are managed to generate cash flows and the ways in which cash flows will be generated. For the purpose, the Standard allows the entities to use either of the two business models:
- Hold-to-collect business model
- Hold-to-collect-and-sell business model
These models are for debt-type financial assets. The table below briefly explains the main characteristics of each model.
If, however, the entity does not intend to hold the financial asset for either of the above, it can be classified as under “Other Business Models”. These business models are mainly evaluated on the basis of their fair value changes. In these models, the collection of contractual cash flows may only be incidental to achieving the business objective and not integral to it.
The Solely Payments of Principal and Interest (“SPPI”) Test
The SPPI contractual cash flows characteristic test is used to determine if the financial assets such as loans and receivables should be classified as measured at amortised cost or FVOCI.
To pass this test, we assess if the contractual cash flows give rise to payments, on specified dates, that are solely of principal and interest on the principal amount outstanding. In case a financial asset fails the SPPI test, it is measured at FVTPL.
The terms ‘principal’ and ‘interest’ are defined below according to IFRS 9:
Principal is the fair value of the financial asset at initial recognition. However, that principal may change over the life of the financial asset (for example, if there are repayments of principal).
Interest consists of consideration for time value of money, for credit risk and for other basic lending risks and costs, as well as a profit margin.
IFRS 9 requires that the contractual cash flows on the principal outstanding should be in the same currency in which the financial asset is denominated. The entity may take into consideration other major factors and specific contractual features for application of the SPPI Test, few of which have been mentioned below:
Under IFRS 9, contractual cash flows that meet the SPPI Test are consistent with the basic lending arrangement. An entity shall carry out an in-depth analysis for each instrument’s contractual features, primarily principal and interest.
Summary – Classification of financial assets under IFRS 9
Following flow chart summarizes the classification of financial assets under IFRS 9.