ACCA Technical Article : IFRS 9 - What is a financial instrument

What are financial assets under IFRS 9 & whats their Classification 

(1) Financial assets at fair value through profit or loss (FVTPL)
This is the normal default classification for financial assets and will apply to all financial assets unless they are designated to be measured and accounted for in any other way. This classification includes any financial assets held for trading purposes and also derivatives, unless they are part of a properly designated hedging arrangement. Debt instruments will be classified to be measured and accounted for at FVTPL unless they have been correctly designated to be measured at amortised cost (see later). Initial recognition at fair value is normally cost incurred and this will exclude transactions costs, which are charged to profit or loss as incurred. Remeasurement to fair value takes place at each reporting date, with any movement in fair value taken to profit or loss for the year, which effectively incorporates an annual impairment review.

(2) Financial assets at fair value through other comprehensive income (FVTOCI)
This classification applies to equity instruments and simple debt instruments and must be designated upon initial recognition. It will be applicable to financial assets that an entity holds within a business model whose objective is achieved by both collecting the contractual cash flows and selling the financial assets. The contractual cash flows will usually be collected on a specific date will consist of payments of principle and interest. Initial recognition at fair value would normally include the associated transaction costs of purchase. The accounting treatment automatically incorporates an impairment review, with any change in fair value taken to other comprehensive income in the year.

Upon derecognition, any gain or loss is based upon the carrying amount at the date of disposal. One important point is that there is no recycling of any amounts previously taken to equity in earlier accounting periods. Instead, at derecognition, an entity may choose to make an equity transfer from other components of equity to retained earnings as any amounts previously taken to equity can now be regarded as having been realised.

(3) Financial assets measured at amortised cost
This classification can apply only to debt instruments and must be designated upon initial recognition. For the designation to be effective, the financial asset must pass two tests as follows:

• The business model test – to pass this test, the entity must be holding the financial asset to collect in the contractual cash flows associated with that financial asset. If this is not the case, such as the financial asset being held and then traded to take advantage of changes in fair value, then the test is failed and the financial asset reverts to the default classification to be measured at FVTPL.
• The cash flow characteristics test – to pass this test, the contractual cash flows collected must consist solely of payment of interest and capital. If this is not the case, the test is failed and the financial asset reverts to the default classification to be measured at FVTPL.

One example of a financial asset that would fail this test is a convertible bond. While there is receipt of the nominal rate of interest payable by the bond issuer, and the bond will be converted into shares or cash at a later date, the cash flows are affected by the fact that the bond holder has a choice to make at some later date – either to receive shares or cash at the time the bond is redeemed. The nominal rate of interest received will be lower than for an equivalent financial asset without conversion rights to reflect the right of choice the bondholder will make at some later date.

This classification of financial asset requires annual review for evidence of possible impairment and, if there is evidence, there must be an impairment review. Any impairment identified must be charged to profit or loss in full immediately.

One problem that may arise in relation to financial assets measured at fair value is whether a reliable fair value can be determined at the reporting date. For exchange-traded financial assets, such as equity shares in a listed entity, this may be a relatively straightforward process. If, however, the financial assets in question are not traded on an exchange, there may be no definitive method to determine fair value at a particular date. This could result in the exercise of judgment or discretion, which could undermine the reliability or relevance of any amounts accounted for as a fair value.

Illustration 1 – classification and measurement of financial assets
An entity, Suarez, purchased a five-year bond on 1 January 2010 at a cost of $5m with annual interest of 5%, which is also the effective rate, payable on 31 December annually. At the reporting date of 31 December 2010 interest has been received as expected and the market rate of interest is now 6%.

Required:
Account for the financial asset at 31 December 2010 on the basis that:
(i) it is classified as FVTPL, and
(ii) it is classified to be measured at amortised cost, on the assumption it passes the necessary tests and has been properly designated at initial recognition.

Answer:
(i) If classified as FVTPL
This requires that the fair value of the bond is measured based upon expected future cash flows discounted at the current market rate of interest of 6% as follows: