Classifying and Measuring Financial Instruments

Reporting standards for financial instruments can seem complex to navigate.

This article will clearly explain IFRS 9's classification and measurement principles for financial assets and liabilities.

You'll understand the objectives behind these standards, the specific classification categories, how instruments are measured in each category, special considerations like hedge accounting, and what disclosures are required. We'll also overview the transition from old standards and provide key takeaways.

Introduction to Classifying and Measuring Financial Instruments

This section provides an overview of the key concepts and objectives around classifying and measuring financial instruments under IFRS 9 Financial Instruments.

Overview of IFRS 9 Financial Instruments and IAS 39

IFRS 9 replaced IAS 39 Financial Instruments: Recognition and Measurement, establishing new principles for classifying and measuring financial assets and financial liabilities, impairment of financial assets, and hedge accounting.

The key differences between IFRS 9 and IAS 39 include:

Simplified classification of financial assets driven by cash flow characteristics and business model rather than complex rule-based requirements under IAS 39. This provides users with more useful information.
Forward-looking expected credit loss impairment model rather than the incurred loss model under IAS 39. This results in timelier recognition of expected losses.
Revised hedge accounting requirements to better link the economics of risk management with its accounting treatment.

Overall, IFRS 9 aims to provide users of financial statements with more useful information about an entity's expected credit losses and risk management activities.

Understanding the Scope of IFRS 9 and IAS 39

The scope of IFRS 9 applies to all financial instruments within the scope of IAS 39. This includes:

Financial assets such as cash and cash equivalents, trade receivables, investments in debt and equity securities
Financial liabilities such as trade payables, bank borrowings, bonds payable
Derivative financial instruments such as forwards, swaps, options

Certain exemptions apply in limited cases such as interests in subsidiaries, associates, and joint ventures.

Objectives of Financial Instruments: Classification and Measurement

The key objectives around classifying and subsequently measuring financial instruments include:

Reflecting the business model in which assets are managed and their contractual cash flow characteristics
Providing more useful information to users of financial statements about expected losses and risk management
Simplifying accounting requirements while still conveying important information

Appropriate classification and measurement are vital for ensuring the transparency and decision usefulness of financial reporting.

IFRS 9 Summary PDF: A Quick Reference Guide

For those seeking a condensed overview of IFRS 9, summary PDF documents are available from various accounting organizations. These provide the standard's key points in an accessible, downloadable format.

What are the classification of financing instruments?

Financial instruments can be classified into two main types:

Cash instruments - These include assets like cash, account receivables, marketable securities, etc. They have a known fixed cash flow value associated with them. Examples include treasury bills, commercial paper, etc.
Derivative instruments - These derive their value from an underlying asset. They do not have a fixed cash flow but instead derive values based on changes in the underlying. Examples include forwards, futures, options, swaps, etc.

Financial instruments can also be classified based on whether they are debt or equity instruments:

Debt instruments - These include assets like bonds, debentures, bank deposits, etc. There is an associated cash obligation that needs to be repaid by the issuer.
Equity instruments - These include assets like common stocks that represent ownership interest in an entity. There is no obligation to repay.

Foreign exchange instruments like currency forwards, futures and options make up a separate unique class of financial instruments. Their values are derived from underlying foreign exchange rates.

In summary, key financial instrument classifications are:

Cash vs Derivative
Debt vs Equity
Foreign Exchange

Proper classification is important for accounting and reporting standards. It determines how instruments are measured, presented and disclosed in financial statements.

What does IFRS 9 financial instruments deals with measurement and classification?

IFRS 9 deals with the classification and measurement of financial instruments. Some key points:

IFRS 9 divides financial assets into two main categories - those measured at amortized cost and those measured at fair value. The classification depends on the business model and cash flow characteristics.
Financial assets measured at amortized cost include assets held to collect contractual cash flows like loans, trade receivables etc. These are initially measured at fair value plus transaction costs and subsequently measured at amortized cost using the effective interest method.
Financial assets measured at fair value include assets held for trading like derivatives or assets specifically designated at fair value. These are measured at fair value with changes recognized in profit and loss.
Equity instruments are generally measured at fair value. However, entities have an irrevocable option on an instrument-by-instrument basis to present changes in fair value of non-trading equities in other comprehensive income.
Financial liabilities are generally measured at amortized cost, except for trading liabilities and liabilities designated at fair value through profit or loss.

So in summary, IFRS 9 provides classification and measurement models for financial assets and liabilities to reflect an entity's business model and cash flow characteristics. This aims to provide users of the financial statements with more useful information.

What are the classifications and measurement of financial assets?

IFRS 9 classifies financial assets into three main categories for measurement purposes:

Amortized cost
Fair value through other comprehensive income (FVOCI)
Fair value through profit or loss (FVTPL)

The classification of financial assets under IFRS 9 is based on two criteria:

The entity's business model for managing the financial assets
The contractual cash flow characteristics of the financial assets

Amortized Cost

Financial assets are measured at amortized cost if they meet both of the following conditions:

They are held within a business model whose objective is to hold assets to collect contractual cash flows
The contractual terms give rise to cash flows that are solely payments of principal and interest (SPPI) on the principal amount outstanding

Examples of financial assets measured at amortized cost include trade receivables, loans receivable, and debt investments held to maturity.

Fair Value through Other Comprehensive Income (FVOCI)

Financial assets are measured at FVOCI if they meet both of the following conditions:

They are held within a business model whose objective is to hold assets to collect contractual cash flows and sell the assets
The contractual terms give rise to cash flows that are solely payments of principal and interest (SPPI) on the principal amount outstanding

An example is a debt investment that is held for collection of contractual cash flows and for sale. Gains or losses realized on the sale of such assets are transferred from OCI to profit or loss.

Fair Value through Profit or Loss (FVTPL)

All other financial assets that do not meet the criteria for amortized cost or FVOCI are measured at fair value through profit or loss. These include:

Assets held for trading
Assets managed on a fair value basis
Assets whose cash flows do not represent solely payments of principal and interest
Equity investments

Gains or losses on these assets are recognized in profit or loss.

How are financial instruments measured?

Financial instruments are measured based on their classification under IFRS 9. There are three main measurement categories:

Amortized Cost

Financial assets are measured at amortized cost if they meet both of the following conditions:

They are held within a business model whose objective is to hold assets to collect contractual cash flows.
The contractual terms give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding.

Examples of financial assets measured at amortized cost include loans, trade receivables, and held-to-maturity debt securities.

Fair Value through Other Comprehensive Income (FVTOCI)

Financial assets are measured at FVTOCI if they meet both of the following conditions:

They are held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets.
The contractual terms give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding.

An example is a debt investment security held within a business model aimed at collecting contractual cash flows and selling securities.

Fair Value through Profit or Loss (FVTPL)

All other financial assets are measured at fair value through profit or loss. These include derivatives, equity investments, and assets held for trading.

Gains and losses on assets measured at FVTPL are recognized in profit or loss.

So in summary, the measurement approach depends on the business model and contractual cash flow characteristics of the financial asset. Amortized cost and FVTOCI apply only when specific conditions are met regarding those factors.

Essential Principles for Classifying Financial Instruments

Business Model Assessment for Classification

Under IFRS 9, an entity's business model for managing financial assets is critical in determining their classification and subsequent measurement. The business model assessment involves evaluating how groups of financial assets are managed together to generate cash flows.

There are three business model classifications:

Hold to collect - Financial assets held with the objective of collecting contractual cash flows
Hold to collect and sell - Assets held to collect cash flows and sell the assets
Other - Assets not fitting into the above categories, managed on a fair value basis

The assessment requires judgment based on relevant evidence about past sales, how risks are evaluated, manager compensation, and more. Proper classification is essential for accurate financial reporting.

Contractual Cash Flow Characteristics Test

In addition to the business model assessment, IFRS 9 also requires a contractual cash flow characteristics test to determine classification. This test evaluates if the financial asset contains:

Solely payments of principal and interest (SPPI) - Entitling the holder to fixed or variable interest payments. Instruments with SPPI cash flows may be measured at amortized cost or fair value through other comprehensive income depending on business model
Other - Assets not meeting SPPI criterion. These are measured at fair value through profit or loss

Derivatives and many structured instruments often have cash flows not considered SPPI, requiring fair value measurement.

Fair Value Measurement Principles (IFRS 13)

IFRS 13 outlines principles for measuring fair value across IFRS standards, including IFRS 9 financial instruments:

Fair value assumes an orderly transaction between market participants under current market conditions
Quoted prices in active markets are the best evidence of fair value
When unavailable, valuation techniques maximizing relevant observable inputs are used
At initial recognition, the transaction price is usually fair value

These principles guide many fair value measurements for financial instruments.

The Role of Amortized Cost in Classification

Financial assets meeting both the business model and contractual cash flow test may qualify for amortized cost measurement. This involves initially recognizing the instrument at fair value then subsequently measuring at amortized cost using the effective interest rate method.

Key aspects include:

Reflecting interest revenue in profit or loss over the relevant time period
Recognizing impairment based on expected credit losses

Amortized cost provides useful information on financial instruments held for collection or payment, rather than assessing fair value changes.

Measurement of Financial Instruments Post-Classification

This section outlines the subsequent measurement principles for financial assets depending on their classification category under IFRS 9.

Financial Assets at Fair Value Through Profit or Loss: Examples and Measurement

Financial assets classified as fair value through profit or loss (FVPL) include:

Debt instruments that do not qualify for measurement at amortized cost or FVOCI
Equity instruments held for trading
Equity instruments for which the entity has not elected to recognize fair value gains and losses through OCI

For example, a publicly traded bond that does not meet the "solely payments of principal and interest" (SPPI) criterion would be classified as FVPL.

These instruments are measured at fair value with changes recognized in profit or loss. This allows timely recognition of fair value gains and losses.

Financial Assets at Amortised Cost: Example and Implications

Financial assets measured at amortized cost include debt instruments like loans and bonds that meet both:

SPPI criterion
Business model test (held to collect contractual cash flows)

For instance, a simple corporate bond held in a hold-to-collect business model would likely qualify for amortized cost measurement.

These assets are measured at fair value initially plus transaction costs. Subsequently, they are measured at amortized cost using the effective interest method less impairment. This generally smooths out the asset's return over its life.

Fair Value Through Other Comprehensive Income (FVOCI) Assets: Recognition and Revaluation

Certain debt instruments where cash flows are solely payments of principal and interest can be classified as FVOCI if they are held in a hold to collect and sell business model.

For example, a corporate bond held to collect cash flows and sell could be FVOCI.

These are measured similar to FVPL assets initially, but fair value changes are recognized in OCI, not profit/loss. This reduces accounting mismatches in profit/loss.

Impairment of Financial Instruments: The Expected Credit Loss Model

IFRS 9 requires entities to record expected credit losses (ECL) on financial assets not measured at FVPL. This includes assets measured at amortized cost and FVOCI.

Entities must record 12-month ECL on initial recognition. If credit risk increases significantly, lifetime ECL is recorded instead. This model accounts for expected losses earlier in an asset's life.

Objective, reasonable, and supportable information that includes forward-looking elements must support ECL estimates. This includes past events, current conditions, and forecasts of future conditions.

Special Considerations in Financial Instruments Measurement

Financial instruments can be complex, with specific accounting rules and considerations that affect their measurement and reporting. Two key areas that warrant close attention are hedge accounting and credit risk.

Financial Instruments: Hedge Accounting and Its Impact

Hedge accounting allows companies to mitigate volatility in earnings caused by changes in fair value or cash flows. There are specific criteria to qualify for hedge accounting:

The hedging relationship must be formally designated and documented at inception
There must be an economic relationship between the hedged item and hedging instrument
The hedge must be highly effective in offsetting risk

When these criteria are met, gains and losses on the hedging instrument can be matched against those of the hedged item. This avoids recognizing the volatility in profit or loss.

However, the complex rules create certain impacts:

Costs of compliance and maintaining appropriate documentation
Restrictions on hedging instruments and strategies available
Potential to fail hedge effectiveness testing

As such, the benefits of applying hedge accounting should be weighed against these considerations.

Credit Risk in Liability Measurement: An Analysis

The measurement of financial liabilities is also affected by credit risk, but in the opposite way as assets. IFRS 13 requires the fair value of liabilities to reflect the risk that an entity will not fulfill its obligations.

Specifically, fair value incorporates:

A credit valuation adjustment (CVA): An adjustment to reflect counterparty credit risk
A debit valuation adjustment (DVA): An adjustment to reflect the reporting entity's own credit risk

Incorporating credit risk means financial liabilities are measured based on current market pricing. As credit risk changes, so does the fair value measurement.

Proper assessment of an entity's credit risk is therefore needed for the appropriate measurement of financial liabilities.

Curing of a Credit-Impaired Financial Asset: The IFRS 9 Approach

IFRS 9 allows credit-impaired assets to be "cured" back to stage 1 or 2 classification in certain scenarios. This occurs when the credit risk improves such that the asset is no longer considered credit-impaired.

However, strict criteria must be met, including:

The asset has shown significant credit improvement
The customer has paid all past due amounts
The customer is expected to fulfill all future contractual cash flows

Additionally, a probation period must pass before the asset is reclassified to stage 1 or 2.

Meeting these conditions allows companies to measure assets based on appropriate credit risk, avoiding overstatement.

Establishing a Hedge Relationship in Finance: Criteria and Documentation

To qualify for hedge accounting, strict criteria must be met per IAS 39 and IFRS 9:

Formal designation and documentation of the hedge relationship
Detail of the hedging instrument, hedged item, nature of risk, and how effectiveness will be assessed
Ongoing evidence that the hedge has and will continue to be highly effective

Without appropriate documentation and periodic testing, the ability to apply hedge accounting is lost. This may introduce unwanted volatility into financial statements.

As such, both initial and ongoing policies and procedures are vital to properly establish hedge relationships in financial reporting.

Disclosure and Presentation of Financial Instruments

IFRS 7 Financial Instruments: Disclosures and Reporting Requirements

IFRS 7 outlines comprehensive disclosure requirements for financial instruments, including information about:

The significance of financial instruments for an entity's financial position and performance
The nature and extent of risks arising from financial instruments, including credit risk, liquidity risk, and market risk
How those risks are managed

Key disclosures cover areas like fair values, reclassifications, collateral, allowances for credit losses, and details of hedging relationships. These aim to provide transparency into the use and impact of financial instruments on a company's financial health.

IAS 32 Financial Instruments: Presentation and Its Significance

IAS 32 sets out principles for presenting financial instruments as financial liabilities or equity on the balance sheet. Key aspects include:

Classifying financial instruments as financial assets, financial liabilities or equity instruments
Offsetting financial assets and liabilities
Accounting for compound financial instruments with liability and equity components

Proper classification and presentation is vital for accurate reporting of leverage and capital structure. It also impacts key ratios like debt-to-equity. Compliance helps ensure comparability across companies.

Disclosures—Transfers of Financial Assets: Amendments to IFRS 7

Amendments to IFRS 7 mandate additional disclosures for transferred financial assets like securitizations. Key details include:

Nature of the transferred assets
Risks and rewards retained
A description of the relationship between transferred assets and associated liabilities
Fair values of assets/liabilities if the transfer doesn't qualify for derecognition

This improves transparency around risk exposures relating to transferred assets.

Risk Management and Financial Instruments: A Disclosure Perspective

IFRS 7 requires extensive disclosures concerning an entity's exposure to risks from financial instruments and how those risks are managed. Required disclosures include:

Risk management objectives, policies and processes
Quantitative sensitivity analysis for each type of market risk (e.g. interest rate, currency, equity price risk)
Credit risk exposure analysis including credit quality and concentration risk

Such disclosures provide greater visibility into the market, credit and liquidity risk profiles associated with companies' use of financial instruments.

Transition to IFRS 9: Implementation and Post-implementation Review

Transitioning from IAS 39 to IFRS 9: A Step-by-Step Guide

The transition from IAS 39 to IFRS 9 involves several key steps:

Determine the appropriate classification of financial assets under IFRS 9 based on the business model and contractual cash flow characteristics. This includes assessing whether assets will be measured at amortized cost, fair value through profit or loss (FVTPL), or fair value through other comprehensive income (FVOCI).
Assess the need and eligibility for hedge accounting under IFRS 9. This involves analyzing whether existing hedge relationships qualify under the new standard and if any new hedge accounting relationships should be designated.
Calculate expected credit losses under the new impairment model in IFRS 9. This forward-looking model generally results in earlier recognition of losses compared to the incurred loss model under IAS 39.
Determine transition adjustments and update accounting policies, processes, controls, and systems to comply with IFRS 9 requirements.
Provide extensive disclosures on transition effects in the first IFRS financial statements.

Post-implementation Review of IFRS 9—Impairment Considerations

The post-implementation review of IFRS 9 found that the new impairment model generally works as intended by providing more timely recognition of expected losses. However, some key considerations were noted:

Complexity of multiple forward-looking scenarios and probability weightings in expected loss calculations. Simplified approaches may be warranted for some smaller financial institutions.
Difficulty in incorporating reasonable and supportable information that is available without undue cost or effort. Additional guidance may be helpful here.
Challenges in determining when a significant increase in credit risk has occurred. More examples of techniques that can address this issue would be useful.

Overall, no fundamental issues were found, but the feedback will inform potential narrow-scope standard-setting activities.

IBOR Reform and its Effects on Financial Reporting—Phases 1 and 2

The IBOR reform has impacted financial reporting in two phases:

Phase 1 reliefs provide temporary exceptions that enable hedge accounting to continue during the period of uncertainty before replacement rates are known.

Phase 2 addresses issues once an alternative benchmark rate is identified, including:

Accounting for changes in the basis for determining contractual cash flows as a result of reform
Updating effective interest rate calculations
Continuing hedge accounting even when changes are required to comply with reform

The amendments aim to provide useful information to investors during this reform without imposing undue costs.

The IFRS Taxonomy reflects recent amendments to IFRS Standards, including:

Updates to IFRS 9, IFRS 7, and IFRS 4 to address the impact of IBOR reform
Adding elements related to covid-19-related rent concessions beyond June 2021
Incorporating the classification, measurement, and impairment requirements of IFRS 17 Insurance Contracts

The updates enable structured electronic reporting by early adopters of amendments and facilitate comparison between entities that apply or do not apply the new requirements.

Conclusion and Key Takeaways on Financial Instruments Classification and Measurement

In closing, the key objectives of IFRS 9's financial instruments classification and measurement standards are to simplify the existing guidance, provide users with more useful information about expected credit losses and risk exposure, and align accounting more closely with risk management activities.

Revisiting the Core Objectives of IFRS 9 Classification and Measurement

The core objectives of IFRS 9's classification and measurement requirements are:

Simplify the accounting for financial instruments by having two primary measurement categories (amortized cost and fair value) instead of the four categories under IAS 39
Provide more useful information to users of financial statements about expected credit losses on financial assets and an entity's risk exposures through earlier recognition of credit losses
Align classification of financial assets with the entity's business model for managing those assets
Reduce complexity by allowing entities to make accounting policy choices based on their business model and the nature of their cash flows

The Importance of Accurate Financial Instruments Classification for Stakeholders

Accurate classification of financial instruments is essential for providing investors, regulators, and other stakeholders with transparency into a company's business model, risk profile, and expected performance of financial assets. Key benefits include:

Enables analysis of profit drivers and credit risk exposures
Supports valuation and investment decision making
Allows assessment of capital adequacy under regulatory frameworks
Promotes comparability across entities

Reflections on the Transition from IAS 39 to IFRS 9

The transition from IAS 39 to IFRS 9 posed some challenges due to the need to reassess classification of existing portfolios, implement expected credit loss models, and align systems/processes. However, most entities report the long-term benefits outweigh the upfront costs. Key lessons learned include carefully planning the implementation early, involving both finance and risk teams, and continually refining loss estimation methodologies.

Future Directions and Ongoing Developments in Financial Instruments Reporting

Looking ahead, areas of focus include assessing the need for further guidance on determining business models, enhancing disclosures on risk management strategies, expanding guidance on fair value measurement, and continuing to align standards across jurisdictions globally.

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