Financial instruments – something to be scared of? Part 3.

Aleksandra Sysiak
Audit Manager at RSM Poland

In the previous post we focused on describing and defining various financial instruments under Polish and international balance sheet accounts regulations, as well as the correct classification of debentures. In this article we will take a closer look at the initial recognition of these instruments and their classification in compliance with IFRS 9 guidance.

New approach to financial instruments, i.e. recognition and classification of financial assets and liabilities under IFRS 9

As a rule, recognition of financial assets or liabilities occurs only if a given business entity has become party to the contractual provisions of the instrument. In such case, they are recognised or derecognised as at the day of concluding the transaction or at the day of payment, pursuant to the accepted accounting principles. Technically, it means that the moment of recognising a financial instrument in the account books is usually the date of conclusion of the contract, and its derecognition occurs on the date of payment or contract execution.

While in most cases determining when to recognise or derecognise a financial asset or liability will not pose a problem, it is advisable to focus on the classification of given financial instrument, as IFRS 9 provides a variety of manners in which they may be classified, depending on their nature and other factors associated with a given transaction.

Classification of financial assets

There are 3 ways of classifying financial assets:

• measured after initial recognition at amortised cost;
• measured after initial recognition at fair value through other comprehensive income (result of the measurement is carried to equity);
• measured after initial recognition at fair value through profit or loss.

As a rule, a financial asset is measured at fair value through profit or loss, unless the requirements for the measurement at amortised cost or fair value are fulfilled by other comprehensive income. Some assets, such as derivatives or equities held for trading, due to their nature are automatically classified as measured at fair value through profit or loss. In case of other assets it is necessary to account for the entity’s business model for managing financial assets and nature of cash flows for a given financial asset resulting from the contract.

First of all, the entity carries out the Solely Payment of Principal and Interest test (SPPI) to determine whether contractual cash flows are only the payment of principal and interest on the principal amounts outstanding. It is crucial to establish if the contract is exposed to risks and volatility related to standard contractual terms of loan agreements, such as volatility of share price, raw materials, variable base interest rate.

A typical example of an agreement that would not pass the SPPI test is a loan with a possibility to defer the repayment, however, during the deferment period the interest is not charged. Please see below other examples of instruments that may not pass the SPPI test:

• debentures convertible at fixed price;
• loans with non-standard prepayment option;
• loans with non-standard manner of fixing interest rate or principal instalments;
• loans where interest rate or amount of the principal depends on achieving a certain result or fulfilling certain covenants.

What is meant exactly by failing to pass SPPI test?

In the event of failing the SPPI test, the financial asset is automatically classified as to be measured at fair value through profit or loss. If a given asset passes the SPPI test, we should subsequently carry out the assessment of the business model, i.e. analyse the management of financial assets for generating cash flows and creating value. There may be three resulting scenarios:

1. The purpose of the model is to hold an asset for the sole purpose of generating contractual cash flows – thus, the conditions for measurement at amortised cost are met.
2. The purpose of the model is to generate contractual cash flows and sell financial assets – thus, the conditions for measurement at fair value through other comprehensive income are met.
3. The purpose of the model is neither as described in point 1, nor in point 2 – the instrument is to be measured at fair value through profit or loss.

To better illustrate the above algorithm, please see the below chart:

Classification of financial liabilities

MSSF 9 has not introduced any changes concerning the classification of financial liabilities. They may be recognised as:

• measured at amortised cost;
• measured at fair value through profit or loss.

As a rule, the financial liability is recognised at amortised cost except for items measured at fair value, which include, among others:

• derivatives;
• hybrid contracts, if the contract includes one or more embedded derivatives and the principal contract is not an asset under MSSF 9 and the embedded derivative does not significantly change the cash flows, which would be otherwise required under the terms of the contract, or it is obvious, without carrying out the analysis or upon a cursory analysis carried out when initially examining a similar hybrid instrument, that separation of the embedded derivative(s) is prohibited (e.g. in the event of early repayment embedded in the loan and allowing its holder to repay the loan earlier for the amount close to its amortised cost);
• a group of financial liabilities or financial assets and liabilities that is managed, and its results are assessed based on fair value, according to the documented risk management strategy or investment strategy, and information about this group prepared on this basis is transferred to key management staff within the entity (e.g. the entity’s management board or executive director, if the measurement at fair value provides more useful information).

To sum up

Correct classification of financial instruments is key from the perspective of further measurement that may considerably affect the financial statements, thus, it is extremely important to correctly analyse all financial assets and liabilities held as well as the relevant contract. It usually calls for the engagement of persons responsible for the financial assets management strategy as well as other specialists. It may be useful to consider IFRS 9 Section B, as it contains a detailed instruction on how to proceed at all stages of the classification.