Classification and measurement (ifrs 9/ias 32) - Amortised c...

Learning Outcomes

After reading this article, you will be able to classify financial instruments under IFRS 9 and IAS 32, applying both the business model test and the contractual cash flow characteristics test. You will know how to allocate financial assets to amortised cost, FVOCI, or FVTPL, understand measurement rules for liabilities, and recognise the reporting impact of each category. This will prepare you for exam questions requiring analysis, application, and explanation of classification decisions.

ACCA Strategic Business Reporting (SBR) Syllabus

For ACCA SBR, you are expected to explain and apply the classification and measurement of financial assets and liabilities under IFRS 9 and IAS 32. In your revision, ensure you can:

• Define financial assets, financial liabilities, and equity instruments under IAS 32
• Apply the classification framework of IFRS 9 to financial assets, including the business model and SPPI tests
• Distinguish between amortised cost, fair value through other comprehensive income (FVOCI), and fair value through profit or loss (FVTPL)
• Understand subsequent measurement principles for each category
• Explain the default and optional treatments for equity instruments
• Recognise measurement requirements for financial liabilities
• Identify when and how reclassification applies
• Discuss the consequences of these choices for financial reporting and performance measurement

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which conditions must a debt instrument meet to be measured at amortised cost under IFRS 9?
2. A company purchases listed shares for long-term investment but not for trading. How can it elect to measure these shares, and what does this affect when sold?
3. True or false? Equity investments can only be measured at FVTPL under IFRS 9, with no exceptions.
4. Briefly explain the SPPI test and its role in the classification of financial assets.
5. What type of financial asset classification is required for a bond held for short-term resale?

Introduction

The classification and measurement of financial instruments is central to financial reporting under IFRS 9 and IAS 32, with direct implications for profit, other comprehensive income, and key performance ratios. Before you can measure or present a financial instrument, you must classify it. This decision depends on both the contractual terms of the asset and management’s stated business model. Incorrect classification leads to errors in financial statements and potential misinterpretation by users.

Key Term: Financial Asset
A contractual right to receive cash or another financial asset, or to exchange financial instruments with another party under conditions favourable to the entity.

Key Term: Financial Liability
A contractual obligation to deliver cash or another financial asset, or to exchange financial instruments under conditions unfavourable to the entity.

Key Term: Equity Instrument
Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

Classification Framework

IFRS 9 requires an assessment of financial assets using two main criteria:

1. The business model for managing the asset
2. The contractual characteristics of the asset’s cash flows

Both must be considered together to determine initial classification.

Business Model Test

The business model refers to how the entity manages its financial assets. There are three broad models:

• Hold to collect: Manage assets to collect contractual cash flows only.
• Hold to collect and sell: Manage to both collect cash flows and sell assets.
• Other: All others, such as assets held for trading.

Key Term: Business Model Test
An assessment of how an entity manages groups of financial assets, specifically whether cash flows are collected, assets are sold, or both.

Contractual Cash Flow Characteristics Test (SPPI)

The so-called “SPPI test” determines if contractual cash flows are solely payments of principal and interest on the principal outstanding. Interest here only includes consideration for the time value of money, credit risk, and a normal profit margin.

Key Term: Contractual Cash Flow Characteristics Test
Assessment of whether the asset's contractual terms result in cash flows that are solely payments of principal and interest on principal.

Measurement Categories for Financial Assets

A financial asset is classified into one of three categories at initial recognition:

1. Amortised Cost

A financial asset is measured at amortised cost if:

• The entity’s business model is to hold the asset to collect contractual cash flows
• The cash flows on specified dates are solely payments of principal and interest (SPPI test is met)

Subsequent measurement is at amortised cost using the effective interest rate method. Gains and losses are recognised in profit or loss on derecognition, impairment, or modification.

Key Term: Amortised Cost
The amount at which a financial asset or liability is measured at initial recognition, minus repayments, plus or minus cumulative amortisation and less loss allowances.

2. Fair Value Through Other Comprehensive Income (FVOCI)

A debt instrument is measured at FVOCI if:

• The business model is achieved by both collecting contractual cash flows and selling assets
• The SPPI test is met

Interest income, impairment, and foreign exchange gains or losses are recognised in profit or loss. All other fair value changes go to OCI, recycled to profit or loss when the asset is derecognised.

For equity instruments not held for trading, entities can make an irrevocable election at initial recognition to classify them as FVOCI. All subsequent fair value changes go to OCI, but are never recycled to profit or loss upon sale (instead, they may be reclassified within equity).

Key Term: Fair Value Through Other Comprehensive Income (FVOCI)
A measurement category for financial assets where qualifying changes in fair value are recognised in OCI rather than profit or loss. Recycling rules differ for debt and equity instruments.

3. Fair Value Through Profit or Loss (FVTPL)

All other financial assets are classified as FVTPL, including:

• Assets held for trading
• Assets failing either the business model or SPPI test
• Derivatives

All fair value gains and losses are reported in profit or loss as they arise. This is also the default category for all equity instruments, unless designated as FVOCI.

Key Term: Fair Value Through Profit or Loss (FVTPL)
A category where all fair value changes are recognised immediately in profit or loss.

Classification of Financial Liabilities

Under IAS 32 and IFRS 9, most financial liabilities are measured at amortised cost. Exceptions are:

• Liabilities held for trading or
• Liabilities designated by the entity as at FVTPL

For these, fair value changes are recognised in profit or loss, while changes in fair value due to own credit risk are recognised in OCI.

Applying the Classification Model in Practice

• Always start classification at initial recognition.
• For assets: evaluate the business model and cash flow features to decide between amortised cost, FVOCI, or FVTPL.
• For liabilities: default to amortised cost unless designated or required as FVTPL.

Worked Example 1.1

A retail company invests in bonds paying fixed interest, intending to hold them for interest income but occasionally sells some to manage liquidity.

Question: How should it classify and measure these bonds?

Answer:
The business model is both to collect and to sell (not just hold to collect), and cash flows are SPPI. The bonds are measured at FVOCI. Interest and impairment go to profit or loss; other fair value changes to OCI (recycled to profit or loss on derecognition).

Worked Example 1.2

A company acquires listed shares and does not intend to trade them. At the outset, it elects to measure them at FVOCI.

Question: What is the impact of this classification on disposal of the shares?

Answer:
All fair value changes go to OCI. On disposal, the cumulative gain in OCI may be reclassified within equity, but is not recycled to profit or loss.

Worked Example 1.3

A manufacturer issues a 4-year loan note with a par value of $1 million, but receives proceeds of $950,000 due to transaction costs and discount. Interest of 5% is paid annually.

Question: How is the bond measured and what is recognised each year?

Answer:
The liability is initially recognised at $950,000, then measured at amortised cost. Each year, interest expense is recognised using the effective interest rate, and the difference between interest paid and interest expense increases the carrying value of the liability.

Exam Warning

When classifying a financial asset for exam purposes, clearly state the business model, the results of the SPPI test, and the implications for measurement. Marks may be lost if any step is omitted.

Equity Instruments (Investments)

By default, equity investments are measured at FVTPL. If NOT held for trading, firms may irrevocably designate them at FVOCI on initial recognition. This election affects recycling and presentation of fair value gains or losses.

Reclassification

Financial assets must be reclassified only if the entity’s business model for managing those assets changes. Such changes are rare. Reclassification is accounted for prospectively and is not allowed for changes in intention relating to individual instruments.

Key Term: Reclassification
The process of changing the measurement category of an existing financial asset due to a significant change in the entity’s business model.

Impact on Financial Reporting and Analysis

Classification affects where gains, losses, and impairment appear—in profit or loss or OCI—and whether those effects are recycled on derecognition. It also impacts statement of financial position, the volatility of results, and analyst ratios such as profit margin, gearing, and return on equity.

Summary

Key Point Checklist

This article has covered the following key knowledge points:

• Define financial assets, financial liabilities, and equity instruments per international standards
• Apply the business model test and SPPI test for classification of financial assets
• Distinguish between amortised cost, FVOCI (debt/equity), and FVTPL
• State and apply the correct measurement bases for each category
• Explain when reclassification is required and how it is performed
• Discuss the financial reporting impact of classification decisions

Key Terms and Concepts

• Financial Asset
• Financial Liability
• Equity Instrument
• Business Model Test
• Contractual Cash Flow Characteristics Test
• Amortised Cost
• Fair Value Through Other Comprehensive Income (FVOCI)
• Fair Value Through Profit or Loss (FVTPL)
• Reclassification