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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.
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.
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Share in the comment section any practical example that you have encountered on your job for others to learn.
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Have you ever wondered why many fear IFRS 9 as an unnecessarily complex accounting standard? Maybe you also do? But there is no shame in it because everyone has been in that dreadful position before.
Understanding the basics could go a long way in eliminating that fear. And like Emerson said, "if you learn the principles, you can devise your own method."
IFRS 9 whose subject matter is Financial Instruments is one of the three accounting standards that address the accounting treatment of financial instruments. IAS 32 deals with the presentation while IFRS 7 deals with the disclosures.
So what is this financial instrument that we all do talk about?
A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
The above implies that when there is a financial asset, then there must be either a financial liability or an equity instrument on the other end. It is just like the basic accounting principle: assets = liabilities + equity.
Financial instruments can be a financial asset (which is cash or the right to receive cash), a financial liability (which is the obligation to deliver cash), or equity (which is the residual interest in the assets of an entity after deducting all of its liabilities).
Derivatives or Non-derivatives?
Both financial assets and financial liabilities can be non-derivatives or derivatives. However, equity is strictly non-derivative.
Can you identify which is a financial asset, financial liability, equity, or non-financial instrument below?
Trade receivables
Trade payables
Contract liabilities
Loans and borrowings
Loans and advances to customers
Value added tax payable
Newsflash!!! For practical examples and to watch an explanatory video on the journey to understanding derivatives and financial instruments, see below YouTube video.
PS: Among other examples within, there's an interesting practical example for you to solve at the end of the video. Join the conversation in the comment section of the video.
You can also join the QUORA group to ask IFRS questions and also contribute and share knowledge.
Alright, we are back.
Trade receivables
When you sell goods on credit to a customer, you expect to receive cash from the customer in the future. As a result, your trade receivable is a financial asset.
Trade payables
When you buy goods on credit from a vendor, you expect to deliver cash to the vendor in the future. As a result, your trade payable is a financial liability.
Contract liabilities
A contract liability, which is sometimes referred to as a deferred income or an advance payment from customers can arise when you have received cash from the customer but you are yet to deliver goods or render service to the customer. In essence, what you are delivering to the customer is a service, not cash. As a result, your contract liability is not a financial liability.
Loans and borrowings
This arises when an individual or corporate entity borrows funds from a bank and is obligated to pay back the amount borrowed over a period of time. The expectation is that the company will deliver cash in the future. As a result, your loans and borrowings are financial liabilities.
Loans and advances to customers
This arises when a bank gives cash to customers with the expectation that the customers will pay it back over a period of time. Because the bank is expecting to receive cash, the loans and advances to customers are recorded in the books of the bank as financial assets.
Value-added tax payables
This is referred to as sales tax payable in some countries. It represents a statutory obligation to the government. Because financial instruments are contractual and not statutory, a value-added tax payable is not recognized as a financial liability. It is thus, a non-financial instrument even though there may be an expectation to deliver cash to the government.
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.
Don’t forget to subscribe to our YouTube channel to get all new IFRS analyses. Also, click on the email subscription button on this page so as not to miss any of our blog updates.
