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Article:

IFRS 9 explained – the classification of financial assets

12 June 2017

This month’s article on IFRS 9 Financial Instruments we take a look at how the classification of financial assets is going to change from 1 January 2018.
 

Currently

Under IAS 39, financial assets are classified into one of four categories:

  1. Held to maturity (HTM)
  2. Loans and receivables (LAR)
  3. Fair value through profit or loss (FVTPL)
  4. Available for sale (AFS).
     

Financial assets classified as HTM or LAR are measured at amortised cost whereas those classified as FVTPL or AFS are measured at fair value. The classification decision in IAS 39 is rules based. It also includes complex requirements around the identification of embedded derivatives contained within the host contract which, in certain cases, are required to be separated and measured at FVTPL, while the host contract is measured, for example, at amortised cost.
 

New rules on adoption of IFRS 9

IFRS 9 introduces a more principles based approach to the classification of financial assets which must be classified into one of four categories:

1. Amortised cost

2. FVTPL

3. Fair value through other comprehensive income (FVTOCI) for debt and

4. FVTOCI for equity.
 

Equity investments and derivatives must always be measured at fair value and the general classification category is FVTPL. However, IFRS 9 permits entities to irrevocably elect to classify certain equity investments that are not held for trading as FVTOCI (see the March edition of Business Edge).
 

The classification decision for non-equity financial assets is dependent on two key criteria;

  • The business model within which the asset is held (the business model test) and
  • The contractual cash flows of the asset (the Solely Payments of Principal and Interest ‘SPPI’ test).
     

IFRS 9, therefore, eliminates the IAS 39 requirements around the identification and potential separation of embedded derivatives. Instead it requires entities to determine the appropriate classification based on the financial asset in its entirety. However, it is important to note that the requirements around embedded derivatives still apply to financial liabilities.
 

What is the business model test?

A business model refers to how an entity manages its financial assets in order to generate cash flows and is determined at a level that reflects how groups of financial assets are managed (rather than on an instrument by instrument basis). IFRS 9 identifies three types of business models: ‘hold to collect’, ‘hold to collect and sell’ and ‘other’. If a non-equity financial asset is not held in a ‘hold to collect’ business model, it will not be possible to classify it as amortised cost.
 

What is the SPPI test?

IFRS 9 identifies two different types of cash flows that might arise from the contractual terms of a financial asset:

  • Those that are solely payments of principal and interest i.e. cash flows that are consistent with a ‘basic lending arrangement’, and
  • All other cash flows.

Unlike the business model test, an entity is required to make this assessment on an instrument by instrument basis. If a non-equity financial asset fails the SPPI test, it will not be possible to classify it as amortised cost or as FVTOCI.
 

Non-equity financial assets - interaction between the business model and SPPI tests

BUSINESS MODELS

Hold to collect

Hold to collect and sell

Other

CASH FLOW TYPE

SPPI

Amortised cost

FVTOCI

FVTPL

Other

FVTPL

FVTPL

FVTPL


We will cover the application of the business model and SPPI tests in more detail in future articles. For help and advice on IFRS 9 please get in touch with your usual BDO contact or Dan Taylor.

 

Read more on IFRS9:

IFRS 9 explained – Hedge effectiveness thresholds

IFRS 9 - Impairment and the simplified approach

IFRS 9 Explained – Available For Sale Financial Assets
 

Business Edge Index