Classification of financial assets at amortised cost, at fair value through other comprehensive income (FVOCI) or at fair value through profit or loss (FVPL) is mainly based on the business model assessment and the solely payments of principal and interest (SPPI-) test.
A financial asset is classified into a measurement category at inception and is reclassified only in rare circumstances.
The classification and measurement decision tree supports a structured approach to determine whether cash flows are generated from holding the financial assets, selling the financial assets or both (business model assessment). Then the SPPI check examines all essential instrument features that are relevant for classification.
The available classification and measurement classifications are:
- Financial assets valued at amortised costs,
- Financial assets valued at fair value through other comprehensive income (FVOCI),
- Financial assets valued at fair value through profit or loss (FVPL) [IFRS 9 4.1, IFRS 9 3.1.1].
The existing categories of held-to-maturity, loans and receivables, and available-for-sale. It also removes the exception that allows certain equity investments, and derivatives linked to such investments, to be measured at cost. [IFRS 9 BZC 4.55, IFRS 9 BC5.18]
The following diagram provides an overview of the classification of financial assets into the principal measurement categories, along with the presentation and designation options under IFRS 9.
Are the asset’s contractual cash flows solely principal and interest? Note: see the SPPI Test
Business model questions Note: see business model test
FVTPL Note: Certain credit exposures can also be designated as at FVTPL if a credit derivative that is measured at FVTPL is used to manage the credit risk of all, or a part, of the exposure.
FVCOI (debt instruments) and Amortised cost Note: Subject to an entity’s irrevocable option to designate such a financial asset as at FVTPL on initial recognition if, and only if, such designation eliminates or significantly reduces a measurement or recognition inconsistency.
What type of financial assets would you like to classify: Classification of financial assets
- Debt instruments, Classification of financial assets
- Derivatives, Classification of financial assets
- Equity instruments. Classification of financial assets
Entity’s business model for managing financial assets
A very good discussion on the entity’s business model for managing financial assets, with examples, is contained in paragraphs IFRS 9 B4.1.1 to B.4.1.6.
IFRS 9 requires that all financial assets are subsequently measured at amortized cost, FVOCI or FVPL based on the business model for managing the financial assets and their contractual cash flow characteristics. The business model is determined by the entity’s key management personnel in the way that assets are managed and their performance is reported to them.
The business model is determined at a level that reflects how groups of financial assets are managed together to achieve a particular business objective. It is not an instrument-by-instrument analysis; rather it can be performed at a higher level of aggregation. Classification of financial assets
A single entity can have more than one business model for managing its financial instruments. For example, an entity can hold one portfolio of investments that it manages in order to collect contractual cash flows and another portfolio of investments that it manages in order to sell to realize fair value changes.
In some circumstances, it might be appropriate to separate a portfolio of financial assets into sub-portfolios to reflect how an entity manages those financial assets.
For example, that might be the case if an entity originates or purchases a portfolio of mortgage loans and manages some of the loans with an objective of collecting contractual cash flows and manages the other loans with an objective of selling them.
Another example is a liquidity portfolio where some assets are held for a “stress case” scenario, (that is, holding them to collect contractual cash flows), while the remaining assets are held with the purpose of meeting an entity’s everyday liquidity needs resulting in recurring sales.
It is expected that management will divide portfolios into sub-portfolios in order to reflect the business model. This will be a highly judgmental area as it might be difficult to distinguish within a portfolio which financial assets are held to collect, to collect and sell, or to trade.
An entity’s business model for managing financial assets is a matter of fact and not merely an assertion. It is typically observable through the activities that the entity undertakes to achieve the objective of the business model. The business model for managing financial assets is not determined by a single factor or activity. Instead, management has to consider all relevant evidence that is available at the date of the assessment. Such relevant evidence includes, but is not limited to: Classification of financial assets
- How the performance of the business model (and the financial assets held within) is evaluated and reported to the entity’s key management personnel;
- The risks that affect the performance of the business model (and the financial assets held within) and, in particular, the way that those risks are managed; and
- How managers of the business are compensated (for example, whether the compensation is based on the fair value of the assets managed or the contractual cash flows collected).
Hold to collect business model
If the entity’s objective is to hold the asset (or portfolio of assets) to collect the contractual cash flows, the asset (or the portfolio) will be classified under the hold to collect business model, subject to meeting the SPPI requirements. Classification of financial assets
Although the objective of an entity’s business model might be to hold financial assets in order to collect contractual cash flows, the entity need not hold all of those instruments until maturity. Thus an entity’s business model can be to hold financial assets to collect contractual cash flows even where sales of financial assets occur or are expected to occur in the future.
IFRS 9 provides guidance on the particular considerations that should be taken into account when assessing sales within the hold to collect business model:
- The historical frequency, timing and value of sales. Classification of financial assets
- The reason for the sales (such as credit deterioration). Classification of financial assets
- Expectations about future sales activity. Classification of financial assets
Sales themselves do not determine the business model and therefore cannot be considered in isolation. Rather, information about past sales and expectations about future sales provide evidence related to the entity’s objective for managing the financial assets and, specifically, how cash flows are realized and value is created.
Credit risk management activities aimed at minimizing potential losses due to credit deterioration are not inconsistent with the hold to collect business model. Selling a financial asset because it no longer meets the credit criteria specified in the entity’s documented investment policy is an example of a sale that has occurred due to an increase in credit risk. However, in the absence of such a policy, the entity could demonstrate in other ways that the sale occurred due to an increase in credit risk. Classification of financial assets
Some sales or transfers of financial instruments before maturity not related to credit risk management activities might be consistent with such a business model if they are infrequent (even if significant in value) or insignificant in value either individually or in aggregate (even if frequent). Classification of financial assets
There is no bright line for how many sales constitute “infrequent” or “insignificant”; an entity will need to use judgment based on the facts and circumstances. An increase in the frequency or value of sales in a particular period is not necessarily inconsistent with an objective to hold financial assets in order to collect contractual cash flows, if an entity can explain the reasons for those sales and demonstrate why those sales do not reflect a change in the business model. Classification of financial assets
In addition, sales might be consistent with the objective of holding financial assets in order to collect contractual cash flows if the sales are made close to the maturity of the financial assets and the proceeds from the sales approximate to the collection of the remaining contractual cash flows. Classification of financial assets
One of the important takeaways is that if sales of financial assets are made due to an increase in the assets’ credit risk, it is not inconsistent, irrespective of their frequency and value, with a business model whose objective is to hold financial assets to collect contractual cash flows because the credit quality of financial assets is relevant to the entity’s ability to collect contractual cash flows (IFRS 9 B4.1.3A). Classification of financial assets
Additionally, sales that occur for other reasons, such as sales made to manage credit concentration risk, may also be consistent with a business model whose objective is to hold financial assets in order to collect contractual cash flows, especially if those sales are infrequent (even if significant in value) or insignificant in value both individually and in aggregate (even if frequent) (IFRS 9 B4.1.3B). Classification of financial assets
Hold to collect and sell business model
An entity can hold financial assets in order to achieve a particular objective by both collecting contractual cash flows and selling financial assets; this will qualify for the “hold to collect and sell business model” (also known as the FVOCI business model). The objective of this business model is achieved by collecting contractual cash flows and selling financial assets, unlike the hold to collect business model in which the objective was to only collect contractual cash flows.
Examples of business model objectives that could be consistent with the FVOCI business model are:
- Managing everyday liquidity needs; Classification of financial assets
- Maintaining a particular interest yield profile; and Classification of financial assets
- Matching the duration of the financial assets to the duration of the liabilities that those assets are funding. Classification of financial assets
There is a multitude of business model objectives in practice which qualify for measurement at FVOCI. For example, a bank may hold a portfolio of financial assets for liquidity purposes in stress scenarios, but the regulator requires the bank to demonstrate the liquidity of the assets by regularly selling significant volumes of financial assets.
Alternatively, an insurance company may hold a portfolio of debt instruments to fund its portfolio of insurance contract liabilities and, as the liabilities change over time, the insurer needs to rebalance the portfolio of debt instruments, resulting in frequent and significant sales. In both these cases, holding to collect contractual cash flows and selling financial assets are an integral part of the business model. Hence, the portfolios in these examples are measured at FVOCI. Classification of financial assets
Other business models
When financial assets are not held within a business model whose objective is to hold assets to collect contractual cash flows or within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets, they are measured at FVTPL. This includes, but is not limited to, financial assets held for trading (IFRS 9 B4.1.5-6).
Contractual cash flow characteristics (‘SPPI test’)
Assessment of contractual cash flow characteristics aims to determine whether these cash flows are solely payments of principal and interest on the principal amount outstanding, hence the acronym SPPI. Assets that fail this test must be measured at FVTPL. Classification of financial assets
This is because amortised cost information is presented in P/L for assets measured at amortised cost (obviously) but also for assets measured at FVOCI and, as the IASB has stated, the amortised cost measurement attribute provides relevant and useful information only for financial assets with ‘simple’ contractual cash flows (IFRS 9 BC4.158).
More complex cash flows require a valuation overlay to contractual cash flows (i.e. fair value) to ensure that the reported financial information provides useful information (IFRS 9 BC4.172). Amortised cost measurement is discussed later in this chapter. Classification of financial assets
In addition, IFRS 9 provides presentation and designation options and other specific guidance for certain financial assets, as follows.
Type of financial asset Classification of financial assets
Implications on classification
Financial assets for which designation as at FVTPL eliminates or significantly reduces an accounting mismatch
May be designated as at FVTPL
Investments in equity instruments that are not held for trading Classification of financial assets
Option to present changes in fair value in OCI
Certain credit exposures if a credit derivative that is measured at FVTPL is used to manage the credit risk of all, or a part, of the exposure Classification of financial assets Classification of financial assets
May be designated as at FVTPL
Classification of financial assets
Financial assets that: Classification of financial assets
Measured under specific guidance carried forward from IAS 39, see below
Classification of financial assets
Measured under specific guidance carried forward from IAS 39
Transfers that do not qualify for derecognition [IFRS 9 3.2.15]
When an entity transferred an asset, but has retained substantially all the risks and rewards, the asset is not derecognised. Instead, any proceeds received are recognised as a financial liability. In subsequent periods, an entity recognises income on the transferred asset and expense incurred on the financial liability as if they were separate financial instruments. Classification of financial assets
Note that this is not the same as continuing involvement in transferred assets covered below. C lassification of financial assets
Continuing involvement in transferred assets – associated liabilities measurement [IFRS 9 3.2 17]
When an entity continues to recognise an asset to the extent of its continuing involvement, the entity also recognises an associated liability. Despite the other measurement requirements in IFRS 9, the transferred asset and the associated liability are measured on a basis that reflects the rights and obligations that the entity has retained. The associated liability is measured in such a way that the net carrying amount of the transferred asset and the associated liability is:
- the amortised cost of the rights and obligations retained by the entity, if the transferred asset is measured at amortised cost, or
- equal to the fair value of the rights and obligations retained by the entity when measured on a stand-alone basis, if the transferred asset is measured at fair value.
Classification of financial assets
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