How to classify and measure financial instruments

 

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Classification and measurement of financial instruments

If you have a basket filled with 10 apples, 20 oranges, and 50 strawberries, a mathematician will tell you that there are several ways to arrange or combine these fruits based on the pattern you deem fit. 

The decision to classify financial instruments into just 3 categories must have been a hectic one for the IASB because there are thousands of financial instruments around the world.

If you want to understand what financial instruments are, see this article: Understanding financial instruments.

There is no easy way to do this but as usual, the standard IFRS 9 Financial Instruments has laid out a beautiful and almost foolproof way of classifying financial instruments.

Financial instruments are classified into two: Amortised cost and Fair value. 

The fair value can be fair value through profit or loss or fair value through other comprehensive income.

So what does each of these mean?

You know the drill. We have to first define it in line with the applicable accounting standard. Here we go! With respect to IFRS 9:

An amortised cost is the amount at which the financial asset or financial liability is measured at initial recognition minus the principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount and, for financial assets, adjusted for any loss allowance.

What this means is that the amortized cost shows you how the cash flows will look like. It begins with the fair value of your debt instrument and accumulates it with interests and decreases it with payments made. 

If you want to learn how an amortisation schedule is calculated and also gain access to an excel file that shows the workings, see the description box in the YouTube video below. It explains how the amortisation schedule for a staff loan is computed:

So what about fair value? Measuring at fair value means that we are looking at what the market says and discounting and valuing our financial instrument to its present value. 

Whatever changes between the fair value at the reporting date and what it was at the beginning of the year is either taken through profit or loss or through other comprehensive income.

So how can we tell which method to use on our financial assets - Amortised cost, fair value through profit or loss, or fair value through other comprehensive income?

The first thing is to identify the nature of the financial assets that we are considering. 

• If the financial asset is a derivative (debt instrument), measure it at fair value through profit or loss (if not used for hedging), otherwise, use hedge accounting requirements.

• If the financial asset is a non-derivative (investment in equity), measure it at fair value through profit or loss (if held for trading), otherwise, measure it at fair value through other comprehensive income (if not held for trading).

• If the financial asset is a non-derivative (debt instrument), measure it at amortised cost if it passes the contractual cash flows test and it is held till maturity.

• If the financial asset is a non-derivative (debt instrument), measure it at fair value through other comprehensive income if it passes the contractual cash flows test and is held to collect and sell.

• If the financial asset is a non-derivative (debt instrument), measure it at fair value through profit or loss if it fails the contractual cash flows test. Also, even if it passes the contractual cash flows test but the financial asset is held to sell, measure it at fair value through profit or loss.

That may seem like an handful, but if you'd like to learn more about each of these, see YouTube video below for a series that gives detailed explanation with practical examples on the above classification and measurement requirements of IFRS 9.

Yes! You made it to the end.

I will be happy to receive any questions you may have that are not addressed in the article/video.

Share in the comment section any practical example that you have encountered on your job for others to learn.

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Written by:

Adedamola Otun

For: IFRS IS EASY