By Team IFRS & Valuation Services (firstname.lastname@example.org) (email@example.com)
As India moves into Indian Accounting Standards (Ind AS), one standard which the accountants will be wary about is the Ind AS 109: Financial Instruments. This standard is an adaption of the International Financial Reporting Standard 9. Ind AS 109 specifically provides for the manner in which the financial assets and financial liabilities are to be dealt with the books of the accounts. This standard itself is incomplete, as to draw a meaningful conclusion to any matter relating to financial asset or financial liability, one will also have to refer to the Ind AS 32.
Ind AS 109 can be divided into various parts namely, classification and measurement of financial instruments, de-recognition of financial assets and financial liabilities, fair valuation of financial instruments, impairment measurements etc.
In this article, however, we intend to capture the requirements relating to classification and reclassification of financial assets and financial liabilities as per the standard.
What are Financial Assets, Financial Liabilities and Equity?
Before moving into an extensive discussion on the topic, it is necessary to have a fair idea about what aforesaid words. The terms financial instruments, financial assets, financial liabilities and equity have been defined in Ind AS 32.
Ind AS 32 contains a broad definition of the term financial instruments to mean – any contract that gives rise to a financial asset of one entity and a financial liability or equity of another entity.
The definition can be broken down to the following:
- There must be a contract;
- The contract must give rise to a financial asset for one entity; and
- The contract must give rise to a financial liability of equity of another entity.
While the first point is self-explanatory, emphasis must be given to the phrases financial asset, financial liability and equity. Each of these have been defined in Ind AS 32 and the same have been discussed at length below.
The term financial asset has been defined in the following manner:
A Financial Asset as any asset that is:
(b) an equity instrument of another entity;
(c) a contractual right:
(i) to receive cash or another financial asset from another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or
(d) a contract that will or may be settled in the entity’s own equity instruments.
Therefore, examples of financial asset can be investments in equity instruments, investments in debt instruments, trade receivables, cash and cash equivalents, derivative financial assets and so on.
The term financial liability has been defined in the following manner:
A financial liability is any liability that is:
(a) a contractual obligation :
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or
(b) a contract that will or may be settled in the entity’s own equity instruments.
Examples of financial liability can be trade payables, loans, bank overdrafts, bills payables and so on.
Lastly, the standard defines equity instrument in the following manner:
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
Therefore, any contract which gives the holder of the instrument the right over the residual interest in the net assets of an entity is an equity instrument. The definition of equity instrument may seem very subjective which could make determination of presence of equity instrument very difficult. However, the following parameters may be considered in order whether the nature of instrument is that of an equity instrument or not:
- There must be a contract;
- The contract must give rise to a financial asset for the other party;
- The contract does not give rise to a financial liability to the reporting entity.
Alternatively, we can say that, once the first two points are fulfilled, the meaning of the term equity instrument can be deduced from the definition of financial liability. That is to say, anything which is not a financial liability for the reporting entity is an equity instrument. Therefore, the term equity instrument can be also be defined in the following manner:
- There is no obligation to deliver cash or other financial asset or to exchange financial asset or financial liability; and
- The issuer will exchange fixed amount of cash or another financial asset for a fixed number of its own equity instruments.
After having a vivid talk over the financial instruments and painting a fair idea with the help of examples, setting of the premise is appropriate to move on to the crux of the discussion on classification and reclassification of financial instruments as per the Ind AS.
Principles of classification of a financial asset
Chapter 4 of Ind AS 109 deals with the classification of financial instruments and their re classification. A financial asset can be categorized into either of the three buckets provided the entity, has at initial recognition, not designated irrevocably to show changes in fair value through profit and loss statement. The three buckets are:
- Amortised Cost ( AC)
- Fair Value through Other Comprehensive Income ( FVOCI)
- Fair Value through Profit and Loss ( FVTPL)
Therefore, broadly there are two measurement heads – Amortised Cost and Fair Value. If Fair Value approach is adopted, any movement in fair value has to be routed either through Other Comprehensive Income (OCI) or Statement of Profit or Loss. Thus, the three buckets as stated above.
In order to choose the bucket, there are two tests to be taken. They are:
- Business model test
- SPPI Test
Business model test
- An entity’s business model is determined keeping in mind how groups of financial assets are managed together to achieve a particular business objective. The entity’s business model does not depend on management’s intentions for an individual instrument. Accordingly, this condition is not an instrument-by instrument approach to classification and should be determined on a higher level of aggregation. At the same time, classification should not be determined at a reporting level also. This is because it would not be pragmatic to look at the entire reporting level of entity to decide the classification of financial assets as there could arise a need to subdivided approach. Similarly, in some circumstances, it may be appropriate to separate a portfolio of financial assets into sub portfolios in order to reflect the level at which an entity manages those financial assets.
- It may be required to look at the frequency, value and timing of sales of prior period to understand the intention of the management about its business model. Past sales plus future sales projection should both be given due consideration to assess the business model of the entity. However, the business model should not be decided on the basis of situations that are not reasonably expected to occur like “worst” case scenarios or “best” case scenarios.
- Although the objective of an entity’s business model may be to hold financial assets in order to collect contractual cash flows, the entity need not hold all of those instruments until maturity. Thus, even if a sale is forecasted in future, it does not mean that the business model needs to be revised.
- The following are the situations when sales expected in future, do not change the business objective of holding financial assets to collect contractual cash flows:
- When credit risk associated with asset increases based on reasonable and supportable information which are forward- looking.
- When sales are done to manage credit concentration risk which are infrequent in nature and insignificant in value. However, if the sale is frequent in nature and significant in value, then the management shall assess the nature of sales to determine if the business model needs to be revamped or not.
- If sales is done close to maturity where the amount closely numbers around the approximate collection of remaining cash flows.
- If sales are infrequent in nature to fund the unanticipated needs, resembling worst case scenario, even if the value is significant.
- When derivatives are entered into to modify cash flows.
- When the asset is sold off during securitization to an SPV, then on a consolidated level, such sale does not affect the business model.
SPPI test means that the contractual cash flows comprise of nothing but principal and interest payments, that is, solely payments for principal and interest. The two components principal and interest are described in the Standard as below:
- Principal is said to be the fair value of the financial asset at initial recognition.
- Interest is said to consist of consideration for the time value of money, for the credit risk associated with the principal amount outstanding during a particular period of time and for other basic lending risks and costs, as well as a profit margin.
Examples of contractual terms that result in cash flows consisting only Interest and Principal under SPPI Test:
- A “variable” interest rate consisting of consideration for the
- time value of money,
- the credit risk associated with the principal amount outstanding during a particular period of time and
- other basic lending risks and costs, as well as a profit margin.
The following examples fall under this :
- A bond with a stated maturity date: Payments of principal and interest on the principal amount outstanding are linked to an inflation index of the currency in which the instrument is issued. The inflation link is not leveraged and the principal is protected.
- A variable interest rate instrument: The instrument has a stated maturity date that permits the borrower to choose the market interest rate on an ongoing basis. For example, at each interest rate reset date, the borrower can choose to pay three-month LIBOR for a three-month term or one-month LIBOR for a one-month term.
- A bond with a stated maturity date and pays a variable market interest rate. That variable interest rate is capped.
- Pre payable instrument wherein the contractual terms say that:
- The issuer is permitted to pre pay an instrument, or
- The holder is permitted to put a debt instrument back to the issuer before maturity, and
- The prepayment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding, and
- The same contain “reasonable additional compensation” for early termination of the contract.
- Extension option in an instrument wherein the contractual terms say that:
- The holder can extend the term of a debt instrument, and
- The terms of the extension option result in contractual cash flows during the extension period that are solely payments of principal and interest on the principal amount outstanding, and
- The same contain “reasonable additional compensation” for early termination of the contract.
- A full recourse loan secured by collateral.
The diagram inserted below gives a bird’s eye view for the rules to be followed for classification of a financial asset:
Taking a cue from the above diagram, it can be clarified that:
- If the SPPI test is not passed, then the asset is by default classified to FVTPL bucket
- If the SPPI test is satisfied, and the financial asset is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows, then the asset will be classified into AC bucket.
- If the SPPI test is satisfied, and the financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets, then the asset will be classified into FVOCI bucket.
- If the SPPI test is satisfied and the financial asset is held within a business model whose objective is achieved either by holding the financial asset or by both holding and selling the financial asset, then the asset shall be classified into FVTPL bucket.
Designating a financial asset at Fair Value through Profit or Loss
Para 4.1.5 of the Ind AS 109 states that an option is granted to the entity wherein it can irrevocably elect to classify financial assets as designated to be FVTPL, at the initial recognition itself. However, this can be done basis the need to eliminate measurement or recognition inconsistency referred to as “accounting mismatch”. This means, had some other bases been used to record financial assets, it would have resulted in measurement inconsistency. The choice is similar to choosing an accounting policy and the same is allowed to eliminate or significantly reduce inconsistency and thus result in more relevant information.
Special points for assets classified as FVTPL.
- Assets held for trading shall be classified as FVTPL.
- If the entity manages the fair value of assets and sells them only to realize the fair value, then the business model test classifies the same into FVTPL bucket.
- If the portfolio of assets is managed by evaluating its fair value, then the asset will be classified as FVTPL.
Investment in Equity instruments
Investments in Equity shall be classified as Fair Value always. The question may arise as to whether the same will be fair valued by recognizing changes in OCI or PL.
Equity instruments that are held for trading are classified into FVTPL bucket. The dividend income is recognized in profit or loss.
However, para 4.1.4 provides that an entity may make an irrevocable election at initial recognition, for equity instruments, that would otherwise be classified as FVTPL, to recognize changes in its fair value in OCI.
In such a case, dividends are recognized in profit and loss account unless they represent a recovery of a part of the cost of an investment. There is no re cycling of amounts from OCI to profit or loss, for example, in the event of sale of investments. There are no impairment requirements as well. However, the entity can transfer cumulative gain or loss within equity.
Principles of classification of a financial liability
- All the financial liabilities should be subsequently measured at amortised cost except in the following cases:
- Financial liabilities at fair value through profit or loss. Such liabilities, including derivatives that are liabilities, shall be subsequently measured at fair value. Also, instruments that are held for trading are measured at fair value.
- Financial liabilities that arise when a transfer of a financial asset does not qualify for de-recognition or when the continuing involvement approach applies.
- Financial guarantee contracts. After initial recognition, at subsequent measurement an issuer of such a contract shall record it at a higher of:
- the amount of the loss allowance determined
- the amount initially recognized, less, when appropriate, the cumulative amount of income recognised in accordance with the principles of Ind AS115.
- Commitments to provide a loan at a below-market interest rate.
- Contingent consideration recognised by an acquirer in a business combination to which Ind AS103 applies. Such contingent consideration shall subsequently be measured at fair value with changes recognised in profit or loss.
- If doing so results in more relevant information, an entity can, at initial recognition, irrevocably designate to record a financial liability at FVTPL. In such a case, any fair value changes arising related to credit risk, shall be recorded as changes arising in OCI. Other fair value changes shall be recorded as changes in Profit or Loss.
Can financial instruments be re-classified?
A financial asset is allowed to be re-classified only when an entity has changed its business model to manage its financial assets. The change in business model should be infrequent.
However, a financial liability cannot be re classified in any condition.
The following are the conditions that qualify for a change in business model:
- The change should be determined by Senior Management by referring to the internal or external scenario changes which is significant in nature and demonstrable to the external parties.
Example:- When an entity acquires /disposes/terminates a business- change in an entity’s business model will occur as the entity either begins or ceases to perform an activity that is significant to its operations.
The following cannot be considered as change in business model:
- Change in intention related to particular financial assets.
- The temporary disappearance of a particular market for financial assets.
- A transfer of financial assets between parts of the entity with different business models.
The following are not re-classifications as per the standard that will impact the assessment of business models:
- An item that was previously a designated and effective hedging instrument in a cash flow hedge or net investment hedge no longer qualifies as such.
- An item becomes a designated and effective hedging instrument in a cash flow hedge or net investment hedge; and
- Changes in measurement.
The classification, measurement and impairment provision of Ind AS 109 have significant implications on reporting of financial assets and liabilities by corporates. It requires increased use of fair value techniques for valuing financial instruments.
To summarise, the standard presents the classification criteria in two tests namely – Business Model test and SPPI test on the basis of which an asset can be measured at amortised cost, or FVOCI or FVTPL. The classification of financial liability into different buckets is also well talked about above. The standard also mentions the criteria of re classification as discussed above.