The Main Classifications for Financial Assets under IFRS 9

The International Financial Reporting Standard (IFRS) 9, Financial Instruments, introduced a comprehensive framework for the classification and measurement of financial assets. This standard, which replaced IAS 39, aims to simplify and improve the accounting for financial instruments, providing more relevant and transparent information to users of financial statements. Under IFRS 9, financial assets are classified into three main categories based on the entity's business model for managing the assets and the contractual cash flow characteristics of the financial asset. These classifications are:

1. Amortized Cost
2. Fair Value Through Other Comprehensive Income (FVOCI)
3. Fair Value Through Profit or Loss (FVTPL)

Each classification has specific criteria and implications for how financial assets are measured and reported. Below, we explore these classifications in detail, including their definitions, criteria, and practical implications.

1. Amortized Cost

The amortized cost classification is designed for financial assets that are held within a business model whose objective is to collect contractual cash flows, and where those cash flows consist solely of payments of principal and interest (SPPI).

Criteria for Classification

• Business Model Test: The financial asset must be held within a business model whose objective is to collect contractual cash flows. This means the entity intends to hold the asset to maturity and derive value primarily from the contractual cash flows rather than from selling the asset.
• Cash Flow Characteristics Test: The contractual cash flows of the financial asset must consist solely of payments of principal and interest (SPPI). This ensures that the cash flows are predictable and aligned with the definition of a basic lending arrangement.

Measurement and Reporting

• Financial assets classified at amortized cost are measured using the effective interest method. This involves discounting future cash flows at the asset's effective interest rate and recognizing interest income over the asset's life.
• Impairment is assessed using the expected credit loss (ECL) model, which requires entities to recognize lifetime expected credit losses for financial assets that have experienced a significant increase in credit risk.

Examples

• Loans and receivables, such as trade receivables or loans to customers, are typically classified at amortized cost if they meet the SPPI criteria and are held within a business model focused on collecting cash flows.
• Debt instruments, such as bonds or notes, may also qualify if they meet the criteria.

2. Fair Value Through Other Comprehensive Income (FVOCI)

The FVOCI classification is a hybrid approach that combines elements of fair value measurement with the recognition of changes in value in other comprehensive income (OCI). This classification is applicable to financial assets that are held within a business model that includes both collecting contractual cash flows and selling the assets, or to certain equity investments.

Criteria for Classification

• Business Model Test: The financial asset must be held within a business model that has the dual objective of collecting contractual cash flows and selling the asset. This means the entity may sell the asset to manage liquidity or respond to changes in market conditions.
• Cash Flow Characteristics Test: For debt instruments, the contractual cash flows must still meet the SPPI criteria. For equity investments, this classification is optional and applies only if the entity elects to recognize changes in fair value in OCI.

Measurement and Reporting

• Financial assets classified at FVOCI are measured at fair value, with changes in fair value recognized in other comprehensive income. This avoids volatility in profit or loss.
• For debt instruments, interest income is recognized in profit or loss using the effective interest method, similar to amortized cost.
• For equity investments, dividends are recognized in profit or loss, but changes in fair value are recognized in OCI and are not recycled to profit or loss upon disposal.

Examples

• Debt instruments, such as bonds, may be classified at FVOCI if they meet the SPPI criteria and are held within a business model that includes both collecting cash flows and selling the asset.
• Equity investments, such as shares in other companies, may be classified at FVOCI if the entity elects this option.

3. Fair Value Through Profit or Loss (FVTPL)

The FVTPL classification is the default category for financial assets that do not meet the criteria for amortized cost or FVOCI. This classification is also used for financial assets held for trading or where the entity has elected to measure the asset at fair value.

Criteria for Classification

• Business Model Test: The financial asset does not meet the criteria for amortized cost or FVOCI. This includes assets held for trading, such as those bought and sold for short-term profit, or assets managed on a fair value basis.
• Cash Flow Characteristics Test: If the contractual cash flows do not meet the SPPI criteria, the asset must be classified at FVTPL. Additionally, the entity may elect to classify certain financial assets at FVTPL to reduce accounting mismatches or simplify reporting.

Measurement and Reporting

• Financial assets classified at FVTPL are measured at fair value, with changes in fair value recognized in profit or loss. This results in greater volatility in reported earnings.
• Interest income and dividends are also recognized in profit or loss.

Examples

• Derivatives, such as options or swaps, are typically classified at FVTPL because they do not meet the SPPI criteria.
• Equity investments that are held for trading or where the entity has elected FVTPL are also classified under this category.

Key Considerations in Classification

1. Business Model Assessment

   • The classification of financial assets under IFRS 9 heavily depends on the entity's business model for managing the assets. This requires judgment and a clear understanding of the entity's objectives and strategies.
   • A business model may include multiple objectives, such as collecting cash flows and selling assets, but the primary objective must be clearly defined.

2. SPPI Test

   • The SPPI test ensures that the cash flows of a financial asset are consistent with a basic lending arrangement. This excludes assets with cash flows linked to equity returns, commodity prices, or other non-interest-based variables.

3. Fair Value Option

   • Entities have the option to designate certain financial assets at FVTPL to reduce accounting mismatches or simplify reporting. This is particularly relevant for hybrid instruments or portfolios managed on a fair value basis.

4. Impairment Requirements

   • IFRS 9 introduced a forward-looking expected credit loss (ECL) model for impairment. This applies to financial assets measured at amortized cost or FVOCI and requires entities to recognize credit losses earlier than under previous standards.

Practical Implications

The classification of financial assets under IFRS 9 has significant implications for financial reporting, risk management, and decision-making:

• Volatility in Financial Statements: Assets classified at FVTPL introduce volatility in profit or loss, while FVOCI assets reduce volatility by recognizing changes in fair value in OCI.
• Impact on Capital and Liquidity: The classification affects regulatory capital requirements and liquidity management, as different classifications may influence how assets are valued and reported.
• Investor Perception: Transparent and consistent classification enhances investor confidence by providing a clearer picture of an entity's financial position and performance.

Conclusion

The classification of financial assets under IFRS 9 is a critical aspect of financial reporting that requires careful consideration of an entity's business model and the characteristics of the financial assets. By categorizing financial assets into amortized cost, FVOCI, or FVTPL, IFRS 9 ensures that financial statements provide relevant and reliable information to users. Entities must exercise judgment in applying the criteria and remain mindful of the practical implications for their financial reporting and risk management practices.