Classification of financial assets
Categories of financial assets under IFRS 9
IFRS 9 classifies financial assets into categories as presented in the table below (IFRS 220.127.116.11). Measurement is discussed on a separate page.
A classification of financial assets is made on the basis of both (IFRS 18.104.22.168):
- the entity’s business model for managing financial assets and
- the contractual cash flow characteristics of the financial asset.
A financial asset should be measured at amortised cost if both of the following conditions are met (IFRS 22.214.171.124):
- the financial asset is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows and
- the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding (‘SPPI‘ criterion).
However, if the condition (a) above is not met and instead a financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets, then such an asset is measured at fair value through other comprehensive with cumulative gains/losses recycled to P/L on derecognition – ‘FVOCI with recycling’ (IFRS 126.96.36.199A). This is of course true when the SPPI criterion is met (point (b) above).
When a financial asset does not fall into any of the two categories listed above, it is measured at fair value through profit or loss – ‘FVTPL’ (IFRS 188.8.131.52).
However, for equity instruments that are not held for trading and are not a contingent consideration relating to business combination, an entity may make an irrevocable election at initial recognition to present changes in fair value in other comprehensive income without recycling to P/L on derecognition – ‘FVOCI no recycling‘ – see below for more discussion (IFRS 184.108.40.206; 5.7.5).
On top of all the requirements above, IFRS 9 allows an entity to irrevocably designate, at initial recognition, a financial asset to the category measured at FVTPL if doing so eliminates or significantly reduces a measurement or recognition inconsistency (‘accounting mismatch’) (IFRS 220.127.116.11).
The classification criteria for financial assets described above should be applied to the entire hybrid contract, i.e. host and embedded derivative together (IFRS 18.104.22.168).
The chart below summarises the classification process for financial assets discussed above. Discussion on different aspects of this classification follows.
Entity’s business model for managing financial assets
A very good discussion on the entity’s business model for managing financial assets, with examples, is contained in paragraphs IFRS 9.B4.1.1 to B.4.1.6.
One of the important takeaways is that if sales of financial assets are made due to an increase in the assets’ credit risk, it is not inconsistent, irrespective of their frequency and value, with a business model whose objective is to collect contractual cash flows from financial assets, because the credit quality of financial assets is relevant to the entity’s ability to collect contractual cash flows (IFRS 9.B4.1.3A). Additionally, sales that occur for other reasons, such as sales made to manage credit concentration risk, may also be consistent with a collect-contractual -cash-flows business model, especially if those sales are infrequent (even if significant in value) or insignificant in value both individually and in aggregate (even if frequent) (IFRS 9.B4.1.3B).
When financial assets are not held within a business model whose objective is to hold assets to collect contractual cash flows or within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets, they are measured at FVTPL. This includes, but is not limited to, financial assets held for trading (IFRS 9. B4.1.5-6).
Contractual cash flow characteristics (‘SPPI test’)
Overview of the SPPI test
Assessment of contractual cash flow characteristics aims to determine whether these cash flows are solely payments of principal and interest on the principal amount outstanding, hence the acronym SPPI. Assets that fail this test must be measured at FVTPL. This is because amortised cost information is presented in P/L for assets measured at amortised cost (obviously) but also for assets measured at FVOCI and, as the IASB has stated, the amortised cost measurement attribute provides relevant and useful information only for financial assets with ‘simple’ contractual cash flows (9.BC4.158). More complex cash flows require a valuation overlay to contractual cash flows (i.e. fair value) to ensure that the reported financial information provides useful information (IFRS 9.BC4.172).
Examples of instruments that pass the SPPI test are given in paragraph IFRS 9.B4.1.13 and of those that fail SPPI test are given in paragraphs IFRS 9.B4.1.14 and B4.1.16.
Principal is defined as the fair value of the financial asset at initial recognition. Obviously, principal amount may change over the life of the financial asset, e.g. if there are repayments of principal (IFRS 22.214.171.124(a); B4.1.7B). It is important to note that principal as understood by IFRS 9 for the SPPI test is not the same as face value of an instrument. In real life, however, the terms principal and face value are used interchangeably.
Example: principal vs. face value in the SPPI test
Entity A acquires a bond which has face value of $1,000 and annual coupon of 5%. Due to decline of interest rates, the bond is trading at $1,020 and entity paid this much for this bond (i.e. its fair value). The principal of this bond, in the meaning used by IFRS 9, is therefore $1,020.
Interest is understood as consideration for (IFRS 126.96.36.199(b)):
- time value of money,
- credit risk associated with the principal amount outstanding,
- other basic lending risks and costs, and
- profit margin.
On the other hand, if contractual terms introduce exposure to risks or volatility in the contractual cash flows that is unrelated to a basic lending arrangement, such as exposure to changes in equity prices or commodity prices, they do not give rise to contractual cash flows that are solely payments of principal and the SPPI test is failed (IFRS 9. B4.1.7A).
In general, the market in which the transaction occurs is relevant to the assessment of the time value of money element. For example, in Europe it is common to reference interest rates to LIBOR and in the United States it is common to reference interest rates to the prime rate (IFRS 9.BC4.178). If the time value of money element is modified (‘imperfect’), for example interest rate resets every month to a one-year rate, additional assessment is needed to determine whether the SPPI test is met as described in paragraphs IFRS 9.B4.1.9A-E.
Prepayable financial assets
Paragraph IFRS 9.B4.1.12 provides an exception to the general criteria that allows certain instruments with contractual prepayment features to pass the SPPI test. This exception applies, inter alia, to many purchased credit-impaired financial assets and financial assets originated at below-market interest rates (IFRS 9.BC4.193-195).
Financial assets and liabilities held for trading
A financial asset or a financial liability is classified as held for trading if all the following criteria are met (IFRS 9.Appendix A):
- it is acquired or incurred principally for the purpose of selling or repurchasing it in the near term;
- on initial recognition it is part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking (see also IFRS 9 IG.B.11); or
- it is a derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument).
IFRS 9 further clarifies that trading generally reflects active and frequent buying and selling, and financial instruments held for trading generally are used with the objective of generating a profit from short-term fluctuations in price or dealer’s margin (IFRS 9.BA.6). Examples of financial liabilities held for trading are given in paragraph IFRS 9.BA.7.
When a financial asset or a financial liability is classified as held for trading, it is measured at FVTPL.
Option to designate a financial asset at FVTPL
Under paragraph IFRS 188.8.131.52, an entity can, at initial recognition, irrevocably designate a financial asset as measured at FVTPL if doing so eliminates or significantly reduces a measurement or recognition inconsistency (‘accounting mismatch’).
The notion of an accounting mismatch necessarily involves two propositions. First, an entity has particular assets and liabilities that are measured, or on which gains and losses are recognised, inconsistently; second, there is a perceived economic relationship between those assets and liabilities. For example, a liability may be considered to be related to an asset when they share a risk that gives rise to opposite changes in fair value that tend to offset, or when the entity considers that the liability funds the asset (IFRS 9. BCZ4.61). Paragraph IFRS 9.B4.1.30 gives examples when these conditions could be met. For practical purposes, the entity need not enter into all of the assets and liabilities giving rise to the accounting mismatch at exactly the same time (IFRS 9.B4.1.31).
It is possible to designate only some of a number of similar financial assets or similar financial liabilities if doing so achieves a greater reduction in accounting mismatch, but it is not allowed to designate only a component of a financial instrument (e.g. a specified risk) or its proportion (IFRS 9.B4.1.32).
Hybrid contract with non-financial asset as a host
IFRS 9 gives also a fair value option for hybrid contracts containing embedded derivatives where a non-financial asset is the host (IFRS 184.108.40.206). IASB notes that the measurement of a whole hybrid contract at FVTPL can be easier than separating embedded derivatives (IFRS 9.B4.3.9). However, this option is not allowed if any of the conditions set out in IFRS 220.127.116.11 applies (see IFRS 9.BCZ4.70 for more discussion).
Option to designate an equity instrument at FVOCI (no recycling)
At initial recognition, an entity may make an irrevocable election to present in OCI subsequent changes in the fair value of an investment in an equity instrument within the scope of IFRS 9 that is neither held for trading nor contingent consideration recognised by an acquirer in a business combination (IFRS 18.104.22.168).
Definition of equity instruments is covered in IAS 32. Note that specific treatment of certain puttable instruments as equity covered in IAS 32 does not apply to the option available for the holder discussed here (IFRS 9.BC5.21). See also May 2017 IFRIC update for more discussion.
Reclassification of financial assets
When, and only when, an entity changes its business model for managing financial assets it should reclassify all affected financial assets based on general classification criteria (IFRS 22.214.171.124). Reclassification is accounted for prospectively from the reclassification date which is the first day of the first reporting period following the change in business model that results in an entity reclassifying financial assets (IFRS 126.96.36.199).
Changes in business model are, by definition, very infrequent. Such changes are determined by the entity’s senior management as a result of external or internal changes and must be significant to the entity’s operations and demonstrable to external parties. Accordingly, a change in an entity’s business model will occur only when an entity either begins or ceases to perform an activity that is significant to its operations; for example, when the entity has acquired, disposed of or terminated a business line (IFRS 9.B4.4.1).
Examples of changes in business model that warrant a reclassification are given in paragraph IFRS 9.B4.4.1, whereas examples of circumstances that are not changes in business model under IFRS 9 are given in paragraph IFRS 9.B4.4.3.
Reclassification of financial liabilities is not allowed (IFRS 188.8.131.52).
As mentioned above, reclassification of financial assets is accounted for prospectively, therefore any previously recognised gains, losses (including impairment) or interest is not restated (IFRS 184.108.40.206).
Paragraphs IFRS 220.127.116.11-7 and IFRS 9.B5.6.1-2 provide guidance on accounting for reclassifications between specific categories.
Disclosure requirements relating to reclassification of financial assets are set out in paragraphs IFRS 7.12B-D.
Classification of financial liabilities
Categories of financial liabilities under IFRS 9
Financial liabilities are classified into one of the following categories (IFRS 18.104.22.168):
- measured at amortised cost
- measured at fair value through profit or loss (‘FVTPL’)
- designated at fair value through profit or loss (‘FVTPL’)
The starting point is that a liability is measured at amortised cost, unless it is a financial liability held for trading or designated at FVTPL.
Furthermore, specific measurement requirements are given for (IFRS 22.214.171.124):
- financial guarantee contracts,
- commitments to provide a loan at a below-market interest rate,
- contingent consideration recognised by an acquirer in a business combination and
- financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition or when the continuing involvement approach applies.
Liabilities designated at FVTPL
An entity may, at initial recognition, irrevocably designate a financial liability as measured at fair value through profit or loss when:
- it contains embedded derivatives (with certain conditions as set out in paragraph IFRS 126.96.36.199) or
- doing so eliminates accounting mismatch, or
- a group of financial liabilities or financial assets and financial liabilities is managed and its performance is evaluated on a fair value basis (IFRS 188.8.131.52).
Embedded derivatives are discussed on a separate page.
Accounting mismatch is discussed above.
Financial liability managed on a fair value basis
This option to designate financial liabilities to me measured at FVTPL applies when an entity manages and evaluates the performance of a group of financial liabilities or financial assets and financial liabilities in such a way that measuring that group at FVTPL results in more relevant information. The focus is on the way the entity manages and evaluates performance, instead of on the nature of its financial instruments (IFRS 9.B4.1.33).
The following conditions must be met in order to use this option (IFRS 184.108.40.206(b)):
- an entity must have a documented risk management or investment strategy (see also IFRS 9. B4.1.36) and
- information about the group of financial liabilities (and financial assets if applicable) is provided internally on that basis to the entity’s key management personnel.
Note that such an option is not explicitly available for financial assets, but this is because financial assets measured on a fair value basis would fall into FVTPL category based on the business model criterion, so there is no need for such an option.
More about financial instruments
See other pages relating to financial instruments:
Scope of IAS 32
Financial Instruments: Definitions
Derivatives and Embedded Derivatives: Definitions and Characteristics
Classification of Financial Assets and Financial Liabilities
Measurement of Financial Instruments
Amortised Cost and Effective Interest Rate
Impairment of Financial Assets
Derecognition of Financial Assets
Derecognition of Financial Liabilities
Offsetting of Financial Instruments
Financial Liabilities vs Equity
IFRS 7 Financial Instruments: Disclosures