Chris Ragkavas, BA, MA, FCCA, CGMA
IFRS technical expert, financial consultant.
IFRS 9, the long awaited standard for financial instruments, is applied since 1/1/2018. The purpose of this article is to assist students and practitioners into gaining an insight into the classification/designation of financial assets, one of the mostly affected areas by the new standard.
In simple terms, financial assets are resources of future benefits as any other asset, which due to their nature are subject to some more detailed and technical jargon. In this series of articles, we will deal with simple and mainstream instruments as investments in (equity) shares, receivables, loans and bonds.
For the diehards, I refer quickly to the financial assets definition, as given by IAS 32 Financial Instruments: Presentation, which are adopted by the new standard. An understanding of the most complicated categories referred to, is not necessary, within the context of this series of articles.
Financial asset is any assets that is:
- Cash;
- An equity instrument of another entity;
- A contractual right:
- To receive cash or another financial asset from another entity;
- To exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity;
4. A contract that will or may be settled in the entity’s own equity instruments, and is:
- A non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or
- A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.
Initial recognition
All financial assets are initially recognized at fair value. In all but one category of financial assets, transaction costs are included in the value of the asset. In the residual category (fair value through profit or loss, henceforth FVTPL), transaction costs are expensed.
Investments in unquoted entities are carried at cost, which may be taken to be an appropriate estimate of their fair value. Subsequent indicators that the original cost may not be appropriate of the investment’s fair value, as for example, a significant change of the performance of the investee compared to budgets, plans, or fraud, commercial disputes, litigation, would trigger a fair value measurement of the instrument.
Classification
Classification of financial assets is performed based on two distinct parameters:
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The asset’s “nature”. This is referred to, in the standard as the cash flow test. The entity should identify the sort of economic benefits (cash flows) to be derived from holding an asset. If they are SPPI, i.e. solely payments of principle and interest, the entity will further examine point 2. If the expected benefits fail this test, classification is independent of point 2. The available options are then either fair value through other comprehensive income (FVTOCI), or fair value through profit or loss (FVTPL).
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The entity’s “intention”. Provided the cash flows are indeed SPPI, the entity will determine to which portfolio of financial assets, does the asset at stake, belong to. Classification depends thus, on whether:
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The entity generally intends to keep this asset to maturity (absent exceptions). The classification is then amortized cost.
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The entity wishes to dispose of this asset at will. Even in this case, it is generally expected though, that the portfolio of assets will not be traded on a daily basis. Assets are expected to be held for a longer period, say, 2 or 3 out of 5 years total duration, and then be disposed if the circumstances are suitable. The classification then is FVTOCI.
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Complicated as these criteria may sound, they are very sensible.
Examples
Assume A invests in B’s equity shares. This is a financial asset investment for A. For sure the expected cash flows are not SPPI. There is no need to identify A’s motives for this asset in order to decide if A would classify it at amortized cost.. The cash flows expected are dividends, and sale proceeds. So this asset will definitely be classified at some sort of FV category. Assuming these shares are held for short-term profit taking, i.e. for receipt of dividends and realization of gains on disposal, they would be classified as FVTPL.
If B is a listed subsidiary or an associate though, it is very unlikely that A would dispose of these shares any time soon after acquisition. As fair value is readily determinable at each reporting period, they are classified as FVTOCI. Their values are reflected at each reporting period, and gains and losses are recognized. However, as the intention of the entity is to hold these shares for a longer period, any movements in their fair value are recognized in OCI.
See below a roadmap to classifying/designating financial assets.
Queries, comments, are welcome at [email protected]