Athens, February 2018
Chris Ragkavas, BA, MA, FCCA, CGMA
IFRS technical expert, financial consultant.
This is the second Part of the series of articles related to the financial assets’ classification/designation. You are kindly advised to read the previous Part, before going through this one.
In the previous Part, I referred to two similar but by far not identical terms, namely classification and designation.
In simple terms, classification is the determination of the category to which an asset belongs, based on the standard’s rules.
Designation is the determination of the category to which an asset belongs, based on the entity’s initiative and within the standard’s allowable boundaries.
A, a bank, originates mortgage loans to its customers. The cash flow test is passed, so it the business model test. These assets would normally be classified and measured at amortized cost.
However, A obtains the funds to originate the loans by issuing bonds of its own. These are financial liabilities of A. These would normally be classified as financial liabilities at amortized cost. However, A buys back from the market (e.g. settles the liabilities to the bond holders) on a regular basis, much sooner than their maturity. Based on this, A must classify these liabilities at FVTPL.
As the liability instruments (bonds) that fund the assets (loans) are measured at FVTPL, measuring the related assets at amortized cost, would give rise, to a so-called accounting mismatch. On this ground, A would also designate the loans at FVTPL.
Reclassification is allowed in limited circumstances, provided the business model changes. Reclassification must be both substantiated and allowed. For example, a portfolio of investments in plain vanilla bonds (giving rise to SPPI) issued by other entities, are originally classified at amortized cost.
Entity X finances bonds issued by entities Y and Z. Duration 7 years, coupon and effective rate: 4.5%.
In year 3, X decides to trade these bonds, where necessary, at will. X would reclassify the instruments out of the amortized cost category and into the FVTOCI.
The exact opposite would occur, in a scenario under reversed terms.
Reclassification of designated items out of the FVTPL category is not allowed, even if the business model changes.
Reclassification of designated equity items out of the FVTOCI category is not allowed, as this designation is irrevocable.
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