Classification of financial assets

Financial assets are mainly of two types, equity instruments and debt instruments. However, there are three measurement categories of financial assets in which financial assets are classified.

It is important to understand the basis for classifying the financial assets into the correct measurement categories. If the financial assets are classified incorrectly, it will result in subsequent accounting being inaccurate and erroneous. 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

Investments in equity instruments are measured at fair value, therefore, there are two classification options 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, they cannot be reclassified as FVTPL investments subsequently. Under FVOCI category, investments in equity instruments are carried at fair value and any changes in fair value are taken to the statement of comprehensive income. Dividend income is recorded in statement of profit or loss.

Classification of debt instruments

Following two factors are evaluated to determine the classification of financial assets which are debt instruments.

  • Business model of the entity
  • Contractual cash flows of the financial asset (SPPI contractual cash flows test)

Amortized cost

If both of the following conditions are met, financial asset (debt instrument) is classified as financial asset measured at amortized cost.

  • the entity’s business model is to hold the financial asset and obtain benefits by collecting the contractual cash flows associated with the financial asset; and
  • the contractual cash flows arising from the financial asset are solely payments of principal and interest (SPPI).

Fair value through other comprehensive income (FVOCI)

If both of the following conditions are met, financial asset (debt instrument) is classified as financial asset measured at fair value through other comprehensive income (FVOCI).

  • the entity’s business model is to obtain benefit from both holding the financial asset to collect the contractual cash flows associated with the financial asset and selling the financial asset; and
  • the contractual cash flows arising from the financial asset are solely payments of principal and interest (SPPI).

Fair value through profit or loss (FVTPL)

It is a residual measurement category, which means that financial assets (debt instruments) which do not meet the classification requirements of financial assets at amortized cost and FVOCI are classified as financial assets measured at FVTPL. All financial assets held for trading are classified under this category.