Classifying financial instruments

IFRS 9 (section 4.1) classifies financial assets using two tests applied at initial recognition.

1. Business model — how the entity manages a portfolio of assets to generate cash flows, assessed at the level key management uses, not instrument by instrument: - hold to collect contractual cash flows (sales are incidental — infrequent or insignificant, or close to maturity, or due to credit deterioration); - hold to collect and sell (both collecting and selling are integral, e.g. a liquidity portfolio); - other — managed on a fair value basis, or held for trading.

2. Contractual cash flow characteristics (SPPI) — are the cash flows solely payments of principal and interest on the principal outstanding? Interest must be consideration for the time value of money, credit risk, other basic lending risks and costs, and a profit margin — a basic lending arrangement. Leverage (interest of three times a benchmark rate), returns linked to equity prices or the borrower's revenue, and conversion into shares fail SPPI.

Resulting categories | Business model | SPPI met | Category | |---|---|---| | Hold to collect | Yes | Amortised cost (effective interest; ECL impairment) | | Hold to collect and sell | Yes | FVOCI — interest, ECL and FX in profit or loss; other fair value changes in OCI, reclassified to profit or loss on derecognition | | Anything else, or SPPI fails | — | FVTPL |

Equity investments don't have SPPI cash flows, so they are FVTPL by default. For an equity investment not held for trading, an entity may make an irrevocable election at initial recognition to present fair value changes in OCI. Those gains and losses are never reclassified to profit or loss, even on sale; dividends still go to profit or loss. Derivatives are FVTPL (unless designated in a hedge). An entity may also designate an asset at FVTPL at initial recognition if that eliminates or significantly reduces an accounting mismatch.

FVOCI debt in practice. Suppose a bond costing 100,000 earns 6,000 of effective interest, receives a 5,000 coupon and ends the year at a fair value of 98,000. Amortised cost is 101,000, so interest income of 6,000 goes to profit or loss, and the 3,000 by which fair value falls short of amortised cost is a loss in OCI. The ECL allowance is also charged to profit or loss, with the credit recognised in OCI rather than reducing the carrying amount, which stays at fair value. If the bond is then sold for 98,000, the 3,000 loss accumulated in OCI is reclassified to profit or loss, so profit or loss ends up exactly where amortised cost would have put it (6,000 of interest less a 3,000 loss on sale).

Reclassification happens only when the business model for managing a portfolio changes — expected to be very rare — and is applied prospectively. Most financial liabilities are measured at amortised cost; held-for-trading liabilities and derivatives are FVTPL, and for liabilities designated at FVTPL the change caused by the entity's own credit risk normally goes to OCI.