IFRS 9 (i): classification and measurement

A bank loan, a share, a bond, a trade receivable and a forward contract are all financial instruments. They look very different, but one standard decides how each is recorded: International Financial Reporting Standard (IFRS) 9, Financial Instruments. The big question for any financial asset is simple. Is the company holding it to collect the cash it promises, to collect and sell it, or to trade it?

The answer, together with the shape of the cash flows, decides whether the asset sits at amortised cost or at fair value, and where the gains and losses go.

This topic covers the scope of IFRS 9 and derivatives, initial recognition and transaction costs, amortised cost and the effective interest method, classification of financial assets, the two tests, subsequent measurement of debt and equity assets, financial liabilities, own credit risk, financial guarantees, embedded derivatives, derecognition and reclassification. The next topic covers impairment. The one after covers hedge accounting. International Accounting Standard (IAS) 32 covers presentation and IFRS 7 covers disclosure.

Key terms in plain English

Syllabus check

IFRS 9 is examinable under syllabus area B (financial assets). This topic covers:

• recognition, initial measurement, classification and subsequent measurement of financial assets and liabilities;
• embedded derivatives, derecognition and reclassification.

Impairment and hedge accounting are covered in the next two topics.

CAMA 2020 and financial instruments

The Companies and Allied Matters Act 2020 (CAMA 2020) requires statements that follow IFRS and give a true and fair view.

Scope and derivatives

IFRS 9 applies to all financial assets and liabilities except those covered by another standard: interests in subsidiaries, associates and joint ventures (IFRS 10, IAS 27, IAS 28), own equity instruments (IAS 32), leases (IFRS 16, though IFRS 9 covers impairment of lease receivables and derecognition of lease liabilities), insurance contracts (IFRS 17), and employee benefits.

Contracts to buy or sell a non-financial item for the entity’s own use are outside IFRS 9 if delivery is expected and made. But inside it if they can be settled net in cash (by terms, past practice, or because the item is readily convertible to cash).

Derivatives

Derivatives are measured at fair value through profit or loss unless they are designated in a hedge. For example, a forward to buy USD 1,000 at ₦3,500 when the spot rate becomes ₦4,000 is an asset of ₦500,000 (before discounting). If the spot becomes ₦3,200, it is a liability of ₦300,000.

Financial guarantee contracts

A guarantee within IFRS 9 is a financial liability. It is initially measured at fair value. Afterwards it is measured at the higher of the expected credit loss allowance and the amount initially recognised less the cumulative income recognised under IFRS 15.

For example, a parent guarantees a subsidiary’s ₦50m four-year loan and the guarantee has a fair value of ₦1.6m. Each year ₦0.4m is released to profit or loss while the subsidiary performs. If the subsidiary defaults, the liability is increased to the expected payout.

Initial recognition and measurement

• An asset or liability is recognised only when the entity becomes a party to the contract. It is not enough that an inflow or outflow is probable.
• It is measured at fair value, normally the transaction price. Trade receivables without a significant financing component are measured at the transaction price under IFRS 15.
• If the fair value differs from the price, a day-one gain or loss is recognised in profit or loss only if the fair value is evidenced by a Level 1 quoted price or a technique using only observable inputs. Otherwise it is deferred. If the difference is really a payment for something else, such as a staff benefit in an interest-free loan to an employee, it is accounted for as that item.
• For a regular way purchase or sale of a listed share, the entity may use trade date or settlement date accounting, applied consistently to each category of asset.

Transaction costs

Directly attributable costs (fees, commissions, levies) are expensed immediately for items at fair value through profit or loss. For all other items they are added to the initial carrying amount (asset) or deducted from it (liability) and spread through the effective interest rate (or left in the fair value for FVOCI).

Note: ICAN’s notes say that regular way purchases of fair value through profit or loss assets are at trade date and others have a choice. IFRS 9 allows the choice for every category, applied consistently, so ours is slightly different from ICAN’s.

Amortised cost and the effective interest method

Amortised cost = initial amount − principal repaid ± cumulative amortisation of the difference between the initial amount and the maturity amount (using the effective interest rate) − any loss allowance (assets only). It equals the present value of the remaining contractual cash flows discounted at the original effective rate.

Each year: opening balance + interest at the effective rate (profit or loss) − cash paid or received = closing balance. Interest recognised need not equal the coupon. A borrower reports an interest expense and a liability. A lender reports interest income on the gross carrying amount and a separate loss allowance. The effective rate is set at initial recognition and is not changed.

It ignores expected credit losses (except for credit-impaired assets bought or originated, next topic).

Classification of financial assets

Leveraged returns, equity or commodity indexation and similar features normally fail SPPI. If sales are more than infrequent or insignificant, the hold-to-collect model may not apply. Different portfolios can have different business models.

Designations

• An asset that would be at amortised cost or FVOCI may be designated at FVTPL at initial recognition if this removes or significantly reduces an accounting mismatch.
• An equity investment that is not held for trading may be irrevocably elected at initial recognition to be at FVOCI.

Subsequent measurement of assets

Foreign currency debt at FVOCI. Under IAS 21, the amortised cost of a monetary item is translated at the closing rate and the exchange difference is in profit or loss. Then the difference between fair value and translated amortised cost is the fair value movement in other comprehensive income. Keep the two layers separate.

Note: ICAN’s foreign currency worked example for this topic is not consistent. It translates the coupon at ₦6 in one line but its balancing exchange difference is based on ₦7, and in the last year it opens from fair value instead of amortised cost. We do not copy it.

In the exam, translate amortised cost at the closing rate, put the difference in profit or loss, and then put the fair value difference in other comprehensive income.

Financial liabilities

All financial liabilities are at amortised cost except:

• derivative liabilities and written options (FVTPL);
• liabilities arising on a transfer that fails derecognition;
• financial guarantees and loan commitments (their own rules, above); and
• liabilities irrevocably designated at FVTPL on day one, either to remove an accounting mismatch or because they are managed with derivatives at fair value.

For a liability designated at FVTPL, the part of the fair value change caused by own credit risk goes to other comprehensive income (and is not recycled), and the rest to profit or loss, unless this creates an accounting mismatch. This avoids a profit when the entity’s own credit standing worsens. Liabilities are never reclassified.

Embedded derivatives

A hybrid has a host contract and an embedded derivative.

1. If the host is a financial asset within IFRS 9, do not separate. Classify the whole hybrid by the two tests (it will often fail SPPI and go to FVTPL).
2. Otherwise (for example a liability or a non-financial host), separate if the embedded feature is not closely related to the host, a separate contract on the same terms would be a derivative. The hybrid is not already at FVTPL.
3. A separated derivative is measured at FVTPL and the host follows its own standard.

Example: a five-year ₦25m loan with interest linked to the price of Brent crude. The host is a liability and oil price risk is not closely related to interest rate risk. A separate oil swap would be a derivative. The embedded derivative is separated at FVTPL and the host loan is at amortised cost.

Derecognition

Financial assets

1. Have the contractual rights to the cash flows expired? If yes, derecognise.
2. Has the asset been transferred? If not, keep it.
3. Have substantially all the risks and rewards been transferred? If yes, derecognise. If substantially none, keep the asset.
4. If some are kept, has control been lost (the transferee can sell the asset to a third party without restriction)? If yes, derecognise and recognise any continuing involvement. If not, continue to recognise to the extent of continuing involvement.

IFRS 9 gives no numerical threshold for “substantially all”. ICAN uses 90% and 10% as a practical guide.

Financial liabilities

Derecognise when, and only when, the obligation is discharged, cancelled or expires, or is replaced by a substantially different liability. A modification is substantial if the present value of the new cash flows (including fees paid net of fees received), discounted at the original effective rate, differs by at least 10% from the present value of the remaining original cash flows.

Then the old liability is derecognised, the new liability is recognised at fair value and the difference goes to profit or loss. Settling a debt with shares: the difference between the carrying amount and the fair value of the shares is a gain or loss (International Financial Reporting Interpretations Committee (IFRIC) 19).

Reclassification

Reclassify financial assets only when the business model changes, which is expected to be rare. It is applied prospectively from the first day of the next reporting period. Past gains, losses and interest are not restated. Liabilities cannot be reclassified. Equity elected to FVOCI cannot be reclassified.

The rules in more depth

Why the business model matters

The way an entity manages an asset determines how its cash flows are really generated. A loan held to collect interest is measured by the cash promised. A trading position is measured by its market price.

Why amortised cost ignores market moves

The entity will collect fixed contractual amounts. Intervening changes in market value will not change what is collected, so they are not recognised.

Why equity at FVOCI is never recycled

The standard chose that profit or loss should never show gains and losses on strategic equity holdings, and chose not to require impairment because the fair value is already in other comprehensive income.

Effect on analysis

Fair value gains in other comprehensive income do not appear in earnings per share. Two companies holding the same bonds can show different profit if their business models differ.

Worked examples

1. Fair value.
   ₦1,000,000 ÷ 1.10 = ₦909,091.
2. Dr financial asset ₦909,091; Dr profit or loss (day-one loss) ₦90,909; Cr cash ₦1,000,000. (If the loan is to an employee, the ₦90,909 is a staff benefit expense.)
3. Over the year the discount unwinds as interest income: ₦90,909 at the effective rate.

1. FVTPL: expense the ₦300. Year-end gain ₦10,000 in profit or loss. On sale, gain ₦10,000 in profit or loss.
2. FVOCI election: cost ₦30,300. Year-end gain ₦9,700 (40,000 − 30,300) in other comprehensive income. On sale, Dr cash ₦50,000; Cr investment ₦40,000; Cr other comprehensive income ₦10,000. Nothing goes to profit or loss. The cumulative ₦19,700 in the reserve may be transferred within equity.

Note: ICAN’s worked solution for the FVOCI case credits the ₦10,000 on sale to profit or loss. For an equity election, all fair value changes, including the gain from the last year-end to the sale, are in other comprehensive income, so ours is slightly different. In the exam, state that there is no recycling for an elected equity investment.

Total interest = ₦17.0m. This is the coupons of ₦15m plus the ₦2m discount unwound. A borrower issuing the same bond records the same figures as interest expense on a liability.

Note: ICAN rounds the rate to 11.67% and shows year 2 interest as ₦5.65m. At 11.67% the figure would be ₦5.67m, and the exact rate is 11.65%. The totals agree. In the exam, state the rate you are given and show the table.

1. Interest income (5.59, 5.66) is in profit or loss.
2. On sale: carrying amount is the fair value of ₦49.50m.
   Gain on sale = ₦50.00m − ₦49.50m = ₦0.50m in profit or loss.
3. Recycle the reserve: Dr other comprehensive income ₦0.25m; Cr profit or loss ₦0.25m.
4. Total profit or loss on disposal = ₦0.75m = proceeds ₦50.00m less amortised cost ₦49.25m.

Note: ICAN’s disposal entry uses the amortised cost of ₦49.25m as the carrying amount and also recycles ₦0.25m, which gives ₦1.0m and double counts the gain. Ours is slightly different. The carrying amount of a FVOCI asset is its fair value.

1. Dr liability ₦100,000.
2. Cr other comprehensive income ₦40,000 (own credit, not recycled).
3. Cr profit or loss ₦60,000.

1. (a) Change = (10.0 − 8.7) ÷ 10.0 = 13%, which is at least 10%.
   Derecognise the old liability.
   Recognise the new one at ₦8.9m.
   Gain = ₦10.0m − ₦8.9m = ₦1.1m in profit or loss.
2. (b) Dr loan ₦3.0m; Cr share capital and premium ₦2.8m; Cr gain ₦0.2m.

1. Dr financial asset ₦800,000; Cr profit or loss ₦800,000.
2. The assets are now at fair value, the old effective rate and impairment accounting stop, and later changes go to profit or loss.

How to score full marks

• Apply the tests in order: business model, then SPPI. State the result.
• State the category and what it means for gains, losses, interest and transaction costs.
• Show the amortised cost table with opening, interest, cash and closing for each year.
• For FVOCI, split interest (profit or loss) from fair value changes (other comprehensive income), and recycle on disposal of debt only.
• For liabilities, check for derivatives, designations and own credit risk.
• For hybrids, follow the separation steps.
• For derecognition, run the four steps for assets and the 10% test for liabilities.

Common mistakes in the exam

• Applying only one of the two classification tests.
• Expensing transaction costs for amortised cost assets, or capitalising them for FVTPL.
• Recognising interest equal to the coupon instead of at the effective rate.
• Recycling the gains on an equity investment elected to FVOCI.
• Using amortised cost as the carrying amount on disposal of an FVOCI asset.
• Reclassifying a liability, or reclassifying assets when only the intention for one item changes.
• Separating an embedded derivative from a financial asset host.
• Applying the 10% test with the market rate instead of the original effective rate.

Quick revision

• Business model and SPPI: hold to collect gives amortised cost, collect and sell gives FVOCI, other gives FVTPL.
• Equity: FVTPL, or an irrevocable FVOCI election with no recycling and no impairment.
• Costs: expense for FVTPL, capitalise otherwise.
• Amortised cost: effective rate on the opening balance. Interest is not the coupon.
• Liabilities: amortised cost, except derivatives and designated items. Own credit goes to other comprehensive income.
• Embedded derivatives: no separation from asset hosts. Separate if not closely related for other hosts.
• Derecognition: rights expire, risks and rewards, control. Liabilities: 10% test.
• Reclassify only on a change of business model, from the first day of the next period.
• CAMA 2020: ss. 377(1), 378, 374(1), 385, 404(7).

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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