1.1.1 Financial Asset Categories

A financial asset is any asset that is cash, a contractual right to receive cash or some other financial asset, a contractual right to exchange financial instruments with another entity under conditions that are potentially favourable, or an equity instrument of another entity. Financial assets include derivatives with a fair value favourable to the entity.

IFRS 9 considers three categories of financial assets (see Figures 1.2 and 1.3):

• At amortised cost. This category consists of debt investments that meet both the business model test (i.e., the investment is managed to hold it in order to collect contractual cash flows) and the contractual cash flow test (the contractual terms give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding), and for which the fair value option (FVO) is not applied.
• At fair value through other comprehensive income (FVOCI). This category consists of debt investments that meet both the business model test and the contractual cash flow test, but that are managed to sell them as well. It also consists of equity investments not held for trading for which the entity chooses not to classify them at fair value through profit or loss.
• At fair value through profit or loss (FVTPL). This category consists of financial assets that are neither measured at amortised cost nor at FVOCI.

The classification of an instrument is determined on initial recognition. Reclassifications are made only upon a change in an entity's business model, and are expected to be very infrequent. No other reclassifications are permitted.

1.1.2 Financial Assets at Amortised Cost

A financial asset qualifies for amortised cost measurement only if it meets both of the following criteria:

• Business model test. The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows.
• Contractual cash flows test. The contractual cash flows of the financial represent solely payments of principal and interest.

This is a mandatory classification, unless the fair value option is applied. Financial assets in the amortised cost category include non-callable debt (i.e. loans, bonds and most trade receivables), callable debt (provided that if it is called the holder would recover substantially all of debt's carrying amount) and senior tranches of pass-through asset-backed securities.

If a financial asset does not meet any of the two conditions above it is measured at FVTPL. If both conditions are met but the sale of the financial asset is also integral to the business model, it is recognised at FVOCI.

Even if an asset is eligible for classification at amortised cost or at FVOCI, management also has the option – the FVO – to designate a financial asset at FVTPL if doing so reduces or eliminates a measurement or recognition inconsistency (commonly referred to as “accounting mismatch”).

1.1.3 Financial Assets at Fair Value through Other Comprehensive Income

This category consists of debt investments that meet the contractual cash flows test, for which their business model is held to collect and for sale. This is a mandatory classification, unless the FVO is applied. This category is intended to acknowledge the practical reality that an entity may invest in debt instruments to capture yield but may also sell if, for example, the price is considered advantageous or it is necessary to periodically adjust or rebalance the entity's net risk, duration or liquidity position.

This category also consists of equity investments which are not held for trading. An entity can choose to classify non-trading equity investments in this category on an instrument-by-instrument basis. This is an irrevocable election.

1.1.4 Financial Assets at Fair Value through Profit or Loss

The FVTPL category is in effect the “residual category” for instruments that do not qualify for the amortised cost or FVOCI categories. The following financial assets would be included in the FVTPL category:

• financial assets held for trading;
• financial assets managed on a fair value basis to maximise cash flows through the sale of financial assets such that collecting cash flows is only incidental;
• financial assets managed, and whose performance is evaluated, on a fair value basis;
• financial assets where the collection of cash flows is not integral to achieving the business model objective (but only incidental to it); and
• financial assets that fail the SPPI test.

Derivatives are recognised at FVTPL unless they are a hedging instrument in cash flow hedge or net investment in foreign operation. Therefore, derivatives undesignated or being hedging instruments in fair value hedging relationships are classified at FVTPL. Recognition of derivatives is covered in detail in Chapter 2.

1.1.5 Financial Assets – Initial and Subsequent Recognition

An entity recognises a financial asset when and only when the entity becomes a party to the contractual provisions of a financial instrument. The initial measurement of the financial asset is its fair value, which normally is the consideration given, including directly related transaction costs.

1.1.6 Reclassifications

IFRS 9 requires an entity to reclassify financial assets if and only if the objective of the entity's business model for managing those assets changes. Such changes are expected to be infrequent, and need to be determined by the entity's senior management as a result of internal or external modifications. These modifications have to be significant to the entity's operations and demonstrable to external parties. Reclassification is applied prospectively from the start of the first reporting period following the change in business model.

Both the amortised cost and FVOCI categories require the effective interest rate to be determined at initial recognition. Therefore, when reclassifying a financial asset between the amortised cost and the FVOCI categories, the recognition of interest income would not change and the entity would continue to use the effective interest rate determined at initial recognition. A financial asset reclassified out of the FVOCI category to the amortised cost category would be measured at amortised cost as if it had always been so classified. This will be effected by transferring the cumulative gain or loss previously recognised in OCI out of equity, with an offsetting entry against the fair value carrying amount at the reclassification date.

However, for financial assets at FVTPL, and entity is not required to separately recognise interest income. When reclassifying a financial asset out of the FVTPL category, the effective interest rate would be determined based on the fair value carrying amount at the reclassification date.

1.2.1 Example of Effective Interest Rate Calculation – Fixed Rate Bond

Suppose that an entity issues a bond with the following terms:

The EIR is computed as the rate that exactly discounts estimated future cash payments through the expected life of the financial instrument:

Solving this equation, we get EIR = 9.96%. The amortised cost of the liability at each accounting date is computed as follows:

1.2.2 Effective Interest Rate Calculation – Floating Rate Debt

IFRS 9 does not specify how the EIR is calculated for floating rate debt instruments. The EIR of a floating rate instrument changes as a result of periodic re-estimation of determinable cash flows to reflect movements in market interest rates. Two approaches can be used to calculate the EIR in a floating rate debt instrument:

• calculation based on the actual benchmark rate that was set for the relevant period; or
• calculation using the method employed for fixed rate debt (i.e., estimating the EIR at the beginning of each interest period taking into account the expected interest rates in each future interest period).

When the floating rate instrument is recognised at an amount equal to the principal receivable or payable on maturity, this periodic re-estimation does not have a significant effect on its carrying amount. Therefore, for practical reasons the first approach is used, and in such cases the carrying amount is usually not adjusted at each repricing date, because the impact is generally insignificant. According to this method, the interest income for the period is calculated as follows:

Similarly, for floating rate debt liabilities, the following method is used to calculate interest expense for the period:

The treatment of an acquisition discount or premium on a floating rate instrument depends on the reason for that discount or premium. For example:

• When the discount (or premium) reflects changes in market rates since the last repricing date, it is amortised to the next repricing date.
• When the discount (or premium) results from a change in the credit spread over the floating rate as a result of a change in credit risk, it is amortised over the expected life of the instrument.

IFRS 9 does not prescribe any specific methodology for how transaction costs should be amortised for a floating rate instrument. Any consistent methodology that would establish a reasonable basis for amortisation of the transaction costs may be used. For example, it would be reasonable to determine an amortisation schedule of the transaction costs based on the interest rate in effect at inception. In my view, this approach also could be applied for a floating rate instrument recognised at amortised cost with an embedded derivative that is not separated (e.g., a floating rate bond with a cap). Another reasonable approach would be to linearly amortise the transaction costs over the life of the instrument.

1.3.1 Example of a Fixed Rate Bond at Amortised Cost

Let us assume that the bond was recognised at amortised cost, and that no impairments were recognised. The calculation of the effective interest rate was performed as follows (in EUR millions):

EIR was 5.7447%.

The related accounting entries were as follows:

1.3.2 Example of a Fixed Rate Bond Recognised at FVOCI

Let us assume that the bond was recognised at FVOCI, and that no impairments were recognised. Let us assume further that the fair value of the bond on 31 December 20X0 and 31 December 20X1 was EUR 97 million and EUR 101 million, respectively. The change in the bond's clean fair at each reporting date was:

In order to account for the bond the investor had to keep track of both the bond's amortised cost and its fair value. The bond's amortised cost profile, which was identical to that in the previous example, determined the interest expense to be recognised at each period.

Any difference between the bond's clean fair value (i.e., excluding accrued interest) and its amortised cost was recognised in the FVOCI reserve in OCI.

The related accounting entries were as follows:

1.4.1 Financial Liability Categories

A financial liability is any liability that is a contractual obligation to deliver cash or some other financial asset to another entity or to exchange financial instruments with another entity under conditions that are potentially unfavourable.

Under IFRS 9 there are only two categories of financial liabilities (see Figure 1.5): at amortised cost and at FVTPL. The following table summarises the accounting treatment of each category of financial liabilities:

The category of financial liabilities at FVTPL has two sub-categories: liabilities held for trading and those designated to this category at their inception using the FVO. Financial liabilities classified as held for trading include:

• financial liabilities acquired or incurred principally for the purpose of generating a short-term profit (i.e., held for trading);
• a derivative not designated in a cash flow or net investment hedging relationship, or the ineffective part if designated;
• obligations to deliver securities or other financial assets borrowed by a short seller;
• financial liabilities that are part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit taking.

The following instruments are measured under specific guidance in IFRS 9:

• financial guarantee contracts; and
• commitments to provide a loan at a below market interest rate.

1.4.2 Partial Repurchases of Financial Liabilities

When an entity repurchases own financial liabilities, the repurchased part is derecognised. According to IFRS 9, “if an entity repurchases a part of a financial liability, the entity shall allocate the previous carrying amount of the financial liability between the part that continues to be recognised and the part that is derecognised based on the relative fair values of those parts on the date of the repurchase. The difference between (a) the carrying amount allocated to the part derecognised and (b) the consideration paid, including any non-cash assets transferred or liabilities assumed, for the part derecognised shall be recognised in profit or loss.”

1.4.3 Changes in Credit Risk in Financial Liabilities at FVTPL

The amount of change in the fair value of a liability designated at FVTPL under the FVO that is attributable to changes in credit risk must be presented in other comprehensive income (OCI), unless:

• Presentation of the fair value change in respect of the liability's credit risk in OCI would create or enlarge an accounting mismatch in profit or loss. In this case, the fair value change attributable to changes in credit risk must be recognised in profit or loss. This determination is made at initial recognition of the individual liability and will not be reassessed.

The remainder of the change in fair value is presented in profit or loss.

To determine whether the treatment would create or enlarge an accounting mismatch, the entity must assess whether it expects the effect of the change in the liability's credit risk to be offset in profit or loss by a change in fair value of another financial instrument. In reality, such instances are expected to be rare, unless an entity, for example, holds an asset whose fair value is linked to the fair value of the liability.

The changes in credit risk recognised in OCI are not recycled to profit or loss on settlement of the liability.

The following instruments, when recognised at FVTPL, are not required to isolate the change in fair value attributable to credit risk (i.e., all gains and losses are presented in profit or loss):

• financial guarantee contracts; and
• loan commitments.

Accounting Mismatch

Sometimes a particular market risk that affects a financial asset or a financial liability is hedged with another financial instrument that behaves in an opposite way to movements in such market risk (i.e., an increase in the market variable would increase the fair value of one of the two items while decreasing that of the other item). In this case, the entity would be interested in measuring the financial asset or financial liability at FVTPL to benefit from their natural offsetting. The entity could apply the FVO because it will eliminate or significantly reduce the measurement or recognition inconsistency that would otherwise arise from measuring these assets or liabilities, or recognising the gains and losses on them, on different bases.

1.6 HYBRID AND COMPOUND CONTRACTS

1.6.1 Embedded Derivatives in Assets or Liabilities – Hybrid Instruments

Sometimes, a derivative is “embedded” in an instrument – called a hybrid instrument or hybrid contract – in combination with a host contract. The embedded derivative causes some or all of the contractual cash flows to be modified based on a specified interest rate, a security price, a commodity price, a foreign exchange rate, index of prices or rates, or other variables. The accounting treatment depends on whether the host is a financial asset or a financial liability (see Figure 1.6).

A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument (e.g., an equity warrant attached to a bond), or has a different counterparty, is not an embedded derivative, but a separate financial instrument.

Host Contract is a Financial Liability or a Non-financial Host

When the host contract is either (i) a financial liability within the scope of IFRS 9 or (ii) an instrument not within the scope of IFRS 9, an assessment is performed to determine whether the embedded derivative must be separated from the host (i.e., whether the embedded derivative should be accounted for separately).

IFRS 9 does not require the separation of the embedded derivative (see Figure 1.7):

• if the derivative does not qualify as a derivative if it were free-standing; or
• if the host contract is accounted for at fair value, with changes in fair value recorded in profit and loss; or
• if the economic characteristics and risks of the embedded derivative are closely related to those of the host contract.

Contracts with embedded derivatives to be separated include:

• options to extend the maturity date of fixed rate debt, except when interest rates are reset to market rates;
• any derivative that “leverages” the payments that would otherwise take place under the host contract;
• credit-linked notes, convertible bonds, equity or commodity indexed notes, notes with embedded currency options.

Examples of contracts not requiring separation include:

• debt without leveraged interest rates;
• debt without leveraged inflation;
• debt with vanilla interest rate options (i.e., caps and floors);
• debt with cash flows linked to the creditworthiness of a debtor.

1.6.2 Liability Compound Instruments

The concept of compound instruments is similar to that of hybrid instruments (see Figure 1.8). A hybrid instrument is comprised of a liability component (the host contract) and an embedded derivative, while a compound instrument is comprised of a liability component (the host contract) and an equity component. An example of a compound instrument is a bond issued by the entity that is convertible into a fixed number of shares of the entity, which can be split between:

• a liability component – an obligation to pay the scheduled coupons and, when the bond is not converted, the principal; and
• an equity component – the conversion right by the bondholders (a sold call option on own shares).

Compound instruments are defined in IAS 32. The liability and equity components of a compound instrument are required to be accounted for separately, upon initial recognition, and the separation is not subsequently revised. The split between the two components is implemented in two steps:

1. The fair value of the liability component is calculated, and this fair value establishes the initial carrying amount of the liability component,
2. The fair value of the liability component is deducted from the fair value of the instrument in its entirety, with the residual amount being an equity component.

I have included several cases that cover the accounting of convertible bonds in Chapter 9.