3.1 Classification and Measurement of Financial Instruments
4 min read•august 7, 2024
Financial instruments are crucial in the financial services industry. provides guidance on classifying and measuring these instruments, which can be complex. Understanding the different categories and measurement methods is key to accurate financial reporting.
, , and are vital aspects of accounting for financial instruments. These processes involve assessing business models, contractual cash flows, and . Proper application ensures financial statements reflect the true economic substance of transactions.
Classification of Financial Instruments
Measurement Categories
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- measures financial assets using the and is used when the objective is to collect contractual cash flows consisting solely of payments of principal and interest
- () measures financial assets and liabilities at fair value with changes recognized in profit or loss (, held for trading)
- () measures financial assets at fair value with changes recognized in other comprehensive income and is used when the objective is both collecting contractual cash flows and selling financial assets (equity investments not held for trading)
Embedded Derivatives and Reclassification
- are components of hybrid contracts that meet the definition of a derivative and are accounted for separately from the host contract if certain criteria are met (not closely related to the host, same terms as a freestanding derivative, hybrid instrument not measured at FVTPL)
- of financial assets is required if the business model for managing those assets changes, leading to a change in the measurement category (amortized cost to FVTPL or vice versa)
- Reclassifications are accounted for prospectively from the reclassification date
- Financial liabilities cannot be reclassified
Initial Recognition and Measurement
Initial Recognition Criteria
- Initial occurs when the entity becomes a party to the contractual provisions of the instrument
- Trade date accounting recognizes financial assets on the date the entity commits to purchase or sell the asset
- Settlement date accounting recognizes financial assets on the date the asset is delivered to or by the entity
- Financial instruments are initially measured at fair value plus or minus , unless the instrument is classified as FVTPL (transaction costs expensed)
Classification Tests
- assesses how financial assets are managed to generate cash flows (collecting contractual cash flows, selling financial assets, or both)
- Determined at a portfolio level based on how groups of financial assets are managed together to achieve a particular business objective
- Considers past sales, sales expectations, and management compensation
- assesses whether the contractual terms of the financial asset give rise to cash flows that are solely payments of principal and interest (SPPI) on the principal amount outstanding
- Principal is the fair value of the financial asset at initial recognition
- Interest consists of consideration for the time value of money, , other basic lending risks, and a profit margin
Subsequent Measurement
Measurement after Initial Recognition
- Subsequent measurement depends on the classification of the financial instrument
- Amortized cost: measured using the effective interest method, interest income recognized in profit or loss, impairment losses recognized in profit or loss
- FVTPL: measured at fair value, all changes in fair value recognized in profit or loss
- FVOCI (debt instruments): measured at fair value, interest income, foreign exchange gains/losses, and impairment losses recognized in profit or loss, other changes in fair value recognized in other comprehensive income
- FVOCI (equity instruments): measured at fair value, dividends recognized in profit or loss unless they clearly represent a recovery of part of the cost of the investment, other changes in fair value recognized in other comprehensive income and never reclassified to profit or loss
Fair Value Changes and Impairment
- Fair value changes are recognized in profit or loss for FVTPL instruments and in other comprehensive income for FVOCI instruments
- For FVOCI debt instruments, cumulative gains/losses previously recognized in OCI are reclassified from equity to profit or loss on
- For FVOCI equity instruments, cumulative gains/losses are never reclassified to profit or loss
- Impairment is recognized for financial assets measured at amortized cost and FVOCI debt instruments using the expected credit loss (ECL) model
- ECL is the weighted average of credit losses with the respective risks of a default occurring as the weights
- 12-month ECL: portion of lifetime ECL resulting from default events possible within 12 months after the reporting date
- Lifetime ECL: expected credit losses resulting from all possible default events over the expected life of the financial instrument
Key Terms to Review (25)
Amortized cost: Amortized cost is a method used to value financial instruments by gradually reducing the initial cost of an asset over time through periodic payments or adjustments. This approach reflects the time value of money, as it accounts for the principal and interest associated with the asset, providing a more accurate representation of its current value. The amortized cost method plays a significant role in how financial instruments are classified and measured, particularly when transitioning from older accounting standards to newer ones.
Business model test: The business model test is a framework used to evaluate the appropriateness of a financial institution's business model in relation to its classification and measurement of financial instruments. This test assesses whether the way a financial institution generates income aligns with the characteristics of the financial instruments it holds, ensuring that the classification reflects the entity's intended use and management strategy. This is crucial for determining how these instruments should be measured and reported in financial statements.
Contractual cash flow characteristics test: The contractual cash flow characteristics test is a criterion used to assess the classification of financial assets in terms of how cash flows are generated. It determines whether the cash flows from a financial instrument are solely payments of principal and interest on the principal amount outstanding. This test is crucial for deciding if a financial asset qualifies for amortized cost measurement or must be measured at fair value through profit or loss, impacting how institutions report their financial positions.
Credit Risk: Credit risk is the potential that a borrower will fail to meet their obligations in accordance with agreed terms, leading to financial losses for the lender. This risk is crucial for financial institutions as it directly impacts their ability to generate revenue, maintain liquidity, and manage capital adequacy.
Derecognition: Derecognition refers to the process of removing a financial asset or liability from an entity's balance sheet when certain criteria are met, indicating that the risks and rewards associated with that asset or liability have been transferred. This concept is crucial for accurately reflecting a company’s financial position and results, as it affects how transactions are reported and influences financial analysis and decision-making.
Derivatives: Derivatives are financial contracts whose value is derived from the performance of an underlying asset, index, or rate. They are crucial tools in the financial services industry for managing risk, speculating on future price movements, and enhancing returns through leverage.
Disclosure Requirements: Disclosure requirements refer to the rules and regulations that mandate organizations to provide specific information in their financial statements and reports. These requirements ensure transparency and accountability, enabling stakeholders such as investors, regulators, and analysts to make informed decisions based on a clear understanding of the organization's financial position and performance.
Effective Interest Method: The effective interest method is an accounting approach used to calculate the amortization of financial assets and liabilities, specifically regarding interest income or expense. This method ensures that the interest expense or revenue reflects the actual economic cost or return over the life of the financial instrument, rather than just using a simple interest calculation. It is particularly significant in the classification and measurement of financial instruments, as it enhances accuracy and transparency in reporting.
Embedded Derivatives: Embedded derivatives are components of hybrid financial instruments that include a host contract and a derivative feature. These derivatives modify the cash flows of the host contract, which is typically a debt or equity instrument, and can affect the overall value and risk profile of the financial instrument. Identifying and properly accounting for embedded derivatives is crucial for accurate classification and measurement in financial reporting.
Expected Credit Losses: Expected credit losses refer to the estimated losses that a financial institution anticipates it will incur on its financial assets due to defaults or credit events over a specified period. This concept is crucial for the classification and measurement of financial instruments, as it helps institutions assess the risk associated with their loans and investments, allowing for more accurate financial reporting and risk management. It represents a shift from the incurred loss model to a more proactive approach in recognizing potential losses, which is essential for maintaining financial stability.
Fair Value Through Other Comprehensive Income: Fair value through other comprehensive income (FVOCI) is a financial reporting classification for certain financial assets where changes in fair value are recorded in other comprehensive income rather than in profit or loss. This classification allows for the recognition of unrealized gains and losses without affecting net income, providing a clearer view of an entity's financial performance over time. FVOCI is typically used for debt instruments that are held to collect cash flows and for equity instruments where the investor chooses to present fair value changes in other comprehensive income.
Fair Value Through Profit or Loss: Fair value through profit or loss refers to a financial reporting category where financial assets and liabilities are measured at their fair value, with any changes in that value recognized directly in profit or loss for the period. This approach allows companies to reflect the real-time value of these instruments in their financial statements, making it essential for assessing their financial performance. It is particularly relevant for trading portfolios, derivatives, and other financial instruments that are actively managed or held for trading purposes.
Fvoci: fvoci stands for 'fair value through other comprehensive income', a classification under financial reporting that applies to certain financial instruments. This method allows entities to measure and report financial assets at their fair value, with changes in value recorded in other comprehensive income instead of profit or loss, impacting the entity's equity directly. It's a crucial concept in the classification and measurement of financial instruments as it balances between recognizing gains in a more stable manner while allowing for future profit realization when the asset is sold.
Fvtpl: Fair Value Through Profit or Loss (fvtpl) is a financial reporting classification used for financial instruments that are recorded at their fair value, with changes in value recognized in profit or loss. This classification applies primarily to derivatives and certain equity and debt instruments that a company chooses to manage on a fair value basis, emphasizing the importance of reflecting current market conditions in financial statements.
Hedge Accounting: Hedge accounting is an accounting method used to manage the volatility in financial statements that arises from changes in the value of hedged items and hedging instruments. This approach aligns the timing of recognition for both the hedged item and the hedging instrument, allowing entities to reduce earnings volatility caused by market fluctuations. It is particularly relevant in managing financial risks associated with derivatives and financial instruments, providing a clearer picture of an entity's economic performance.
IFRS 9: IFRS 9 is an international financial reporting standard that provides guidelines for the classification, measurement, impairment, and hedge accounting of financial instruments. It was developed to enhance the transparency and consistency of financial reporting, addressing issues present in previous standards by introducing more forward-looking approaches to credit losses and clearer rules for financial asset classification.
Impairment: Impairment refers to a reduction in the recoverable amount of a financial asset or group of assets below its carrying value on the balance sheet. This concept is crucial as it impacts how financial instruments are classified and measured, determining whether an entity recognizes a loss and adjusts its financial statements accordingly. Impairment ensures that assets are not overstated on the balance sheet, which could mislead stakeholders about the financial health of an entity.
Initial recognition: Initial recognition refers to the point at which a financial instrument is first recorded in the financial statements at its fair value. This process establishes the starting point for all subsequent measurements and classifications of the financial instrument. Understanding initial recognition is crucial as it impacts how financial instruments are subsequently measured, classified, and reported in financial statements.
Market Risk: Market risk is the potential for financial loss due to fluctuations in the market prices of assets, driven by changes in factors such as interest rates, currency exchange rates, and equity prices. This type of risk affects various financial instruments and portfolios, making it crucial for financial institutions and investors to understand and manage it effectively.
Measurement Categories: Measurement categories refer to the classifications used to determine how financial instruments are valued and reported in financial statements. These categories help in assessing the nature of the financial instrument, its intended use, and how changes in value are recognized. By establishing clear measurement categories, organizations can provide more accurate and relevant financial information to stakeholders.
Reclassification: Reclassification is the process of changing the classification of a financial instrument from one category to another, often due to changes in the entity's intention or circumstances. This process is important as it affects how financial instruments are measured and reported in financial statements, influencing both the financial position and performance of an entity.
Recognition: Recognition refers to the process of formally recording and acknowledging the existence of financial assets and liabilities in the financial statements of an entity. This involves determining when a transaction or event qualifies for being recognized, based on criteria such as control, probability of future economic benefits, and reliability of measurement. It is crucial because accurate recognition impacts the financial position and performance of an entity, influencing decisions made by stakeholders.
Risk Management Disclosures: Risk management disclosures are the reports and statements that organizations provide to communicate their exposure to various risks, how they manage those risks, and the effectiveness of their risk management strategies. These disclosures help stakeholders understand the organization's financial health and operational stability by detailing the methods used to identify, assess, and mitigate risks, particularly in relation to financial instruments and credit risk management.
Subsequent Measurement: Subsequent measurement refers to the accounting practice of valuing an asset or liability after its initial recognition. This process is critical for ensuring that financial statements accurately reflect the current value of these items, taking into account changes in market conditions or other factors affecting their worth. It involves various approaches depending on the type of asset or liability, such as fair value or amortized cost, which can significantly influence financial reporting and decision-making.
Transaction costs: Transaction costs are the expenses incurred during the process of buying or selling goods and services, which can include search and information costs, bargaining and decision costs, and policing and enforcement costs. These costs play a crucial role in the financial services industry as they influence the pricing, structure, and efficiency of financial transactions. Understanding transaction costs is essential for evaluating the overall cost-effectiveness of financial instruments and determining optimal investment strategies.