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Part C: Classification of financial assets

and financial liabilities
Introduction
Part C looks at the classification of financial assets and financial liabilities, which affects how
these assets and liabilities are to be measured. This part applies the principles from IFRS 9,
and concludes with the rules for reclassification of financial assets and financial liabilities.

Relevant paragraphs
To assist in understanding certain sections in this part, you may be referred to relevant paragraphs
in IFRS 9 or IAS 32. You may wish to read these paragraphs as directed.

Classification of financial assets

Paragraph 4.1.1 of IFRS 9 requires entities to classify financial assets upon initial recognition,
to be subsequently measured at either amortised cost or fair value on the basis of both:
• the entity’s business model for managing the financial assets
• the contractual cash flow characteristics of the financial asset.

The exception to this requirement is where entities apply the option in para. 4.1.5 of IFRS 9,
under which it is possible to designate one or more financial assets as measured at fair value
through P&L. This election is irrevocable and is only applicable when applying the fair value
through P&L eliminates or significantly reduces measurement or recognition inconsistency
(this is sometimes described as an accounting mismatch) that would otherwise arise from
measuring assets and liabilities or recognising gains and losses on different bases.

Paragraph 4.1.2 of IFRS 9 requires entities to measure a financial asset at amortised cost when
both of the following conditions are met:
• The asset is held within a business model whose objective is to hold assets in order to collect
the contractual cash flows.
• The contractual terms of the financial asset give rise (on specified dates) to cash flows that
are solely payments of principal and interest on the principal amount outstanding.

Paragraph 4.1.2A of IFRS 9 states a financial asset is to be measured at fair value through OCI
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when both of the following conditions are met:

1. The asset is held within a business model whose objective is achieved by both collecting
contractual cash flows and selling financial assets.
2. The contractual terms of the financial asset give rise (on specified dates) to cash flows that
are solely payments of principal and interest on the principal amount outstanding.

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The distinction between paras 4.1.2 and 4.1.2A of IFRS 9, and whether a financial asset is
measured at amortised cost or at fair value through OCI, is the entity’s business model for
managing financial assets. An entity’s business model refers to how groups (or portfolios) of
financial assets are managed by an entity to generate cash flows. In particular, the entity’s
business model for a portfolio of financial assets determines whether cash flows generated from
that portfolio will result from collecting contractual cash flows, selling financial assets or both
(paras B4.1.2 and B4.1.2A of IFRS 9). When the objective of the business model is to hold assets
in order to collect contractual cash flows, a financial asset in that portfolio is to be measured at
amortised cost. When the objective of the business model is to both collect contractual cash
flows and sell financial assets, a financial asset in that portfolio is to be measured at fair value
through OCI. Further discussion of an entity’s business model for managing financial assets is
provided below.

Paragraph 4.1.4 of IFRS 9 states that a financial asset will be measured at fair value through P&L in
cases where it does not meet the requirements to be measured at amortised cost or at fair value
though OCI. When an entity has an investment in equity instruments, rather than measuring the
investment at fair value through P&L, the entity can make an irrevocable election when it initially
recognises the investment to present fair value movements in OCI. An entity cannot choose
this option for investments in equity instruments that are held for trading, and it also cannot
be contingent consideration of an acquirer in a business combination to which IFRS 3 applies
(IFRS 9, para. 5.7.5). Business combinations were discussed in Module 5.

Table 6.2 summarises the categories for financial assets under IFRS 9. There is also an option
for entities to apply fair value to one or more financial assets when this would eliminate or
significantly reduce the accounting mismatch (IFRS 9, para. 4.1.5). This decision is made at
initial recognition and is irrevocable.

Table 6.2: Summary of financial asset categories as per IFRS 9 Financial Instruments
classification requirements

Financial asset Classification

Financial assets held within a business model Amortised cost

(whose objective is to hold assets in order to
collect contractual cash flows), and that have
contractual terms that give rise (on specified dates)
to cash flows that are solely payments of principal
and interest on the principal amount

Financial assets held within a business model Fair value through OCI
(whose objective is to both collect contractual
cash flows and sell financial assets), and that have
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contractual terms that give rise (on specified dates)

to cash flows that are solely payments of principal
and interest on the principal amount

All other financial assets (including derivatives) Fair value through P&L

Irrevocable decision for investments in equity Fair value through OCI

instruments to show fair value movements in OCI
Dividends received are recognised in P&L

Source: Adapted from IFRS Foundation 2017, IFRS 9 Financial Instruments,

in 2017 IFRS Standards, IFRS Foundation, London.

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Business model
The linking of classification with an entity’s business model is consistent with the approach used
by the IASB in other standards, such as IFRS 8 Operating Segments. The term ‘business model’
is not defined in IFRS 9 but it is described in paras B4.1.1 as ‘the business model as
determined by the entity’s key management personnel’.

The key management personnel, as defined in IAS 24 Related Party Disclosures, are the
group members who determine an entity’s business model. The decision is not made on an
instrument-by-instrument basis but at a higher level. However, it is not necessary to make the
decision at the entity level, as it is possible for an entity to hold portfolios of financial assets
with different objectives.

Example 6.9: Multiple business models

The key management personnel of Split Money Maker Ltd (Split) have formulated two business models,
one to hold financial instruments to collect their contractual cash flows (the 'hold' model) and another
to trade financial instruments for speculative, profit-making, purposes (the 'trade’ model). Split holds
investments in government treasury notes under the ‘hold’ model to collect their contractual cash
flows. It also has investments in shares that it actively trades on a regular basis under the ‘trade’
model, trying to make gains from price movements. Each of these models is distinct and the financial
instruments allocated to each model will have different classification options available dependent on
the model used to manage them.

IFRS 9 allows entities to make some sales of financial assets in a portfolio classified as ‘held
with the intention to collect the contractual cash flows’ provided such sales are not a frequent
occurrence and, where they are, that the entity reassesses the classification (para. B4.1.3). IFRS 9
does not define ‘frequent’ or ‘infrequent’. In a similar way, sales may align with the objective
of holding financial assets to collect contractual cash flows if made close to the maturity and
the proceeds from the sales do not differ significantly from the collection of the remaining
contractual cash flows (IFRS 9, para. B4.1.3.).

Contractual cash flows that are solely payments of principal

and interest on the principal amount outstanding
IFRS 9, para. 4.1.3, states that ‘interest is consideration for the time value of money and for the
credit risk associated with the principal amount outstanding during a particular period of time’.
Therefore, where interest represents more than this, the financial asset cannot be measured at
amortised cost.

Paragraph B4.1.9 of IFRS 9 discusses leverage and describes it as a contractual cash flow
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characteristic of some financial assets that increases the variability of the contractual cash flows,
with the result that they do not have the economic characteristics of interest.

Paragraphs B4.1.13 and B4.1.14 of IFRS 9 provide examples of instruments that would meet
the test of contractual cash flows that do represent solely payments of interest and principal,
and others that do not meet the test.

Example 6.10: Contractual cash flows test

1. James and Kellee agree to a variable rate loan of $500 000 to finance the acquisition of a house.
The variable rate of interest is reset each month based on LIBOR (London Interbank Offered Rate).
2. Troy and Megan also agree to a variable rate loan of $500 000 to finance the acquisition of a house.
The variable rate of interest is reset each month based on 1.5 times LIBOR.

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The loan to James and Kellee would satisfy the sole payments of interest and principal test in IFRS 9,
but the loan to Troy and Megan would not. The reset rate of 1.5 times LIBOR introduces leverage and
means the payments Troy and Megan will make on their loan are more than just payment of interest
and principal.

Paragraphs B4.1.10–11 of IFRS 9 discuss the impact of early repayment, extensions to repayment and
changes to the payments during the life of the instrument. In all cases the test to apply is: Do the
payments still represent solely payments of interest and principal before and after the changes to
the conditions?

In respect of contingent payments and repayments of interest and principal, IFRS 9 requires:
(a) the provision is ‘not contingent on future events, other than to protect’ (IFRS 9, para. BC4.183 (a)):
(i) the holder against the credit deterioration of the issuer (e.g. defaults, credit downgrades or
loan covenant violations), or a change in control of the issuer (IFRS 9, para. B4.1.10), or
(ii) the holder or issuer against changes in relevant taxation or law (IFRS 9, para. B4.1.7A and
B4.1.10)
(b) the ‘prepayment amount substantially represents unpaid amounts of principal and interest
on the principal amount outstanding, which may include reasonable additional compensation
for the early termination of the contract’ (IFRS 9, para. B4.1.11(b)).

➤➤Question 6.5
Determine whether the following instruments satisfy the sole payments of interest and principal
requirement in IFRS 9.
(a) A bond that is convertible into shares of the issuer and the return on the bond is linked to
the return on the issuer’s shares.

(b) A variable rate loan where the rate is reset every three months based on movements in the
CPI index.
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Check your work against the suggested answer at the end of the module.

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Example 6.11: Business model and contractual cash flows test

Entity A must fund a major purchase of machinery ($10m) in four years’ time as part of a capital renewal
program. To fund the program the CFO is considering two approaches to investing the surplus
funds prior to the capital expenditure and seeks your input as financial controller in the accounting
classification for each approach. The approaches are as follows:
1. To invest in 90-day bank bills, which are continuously rolled into new bills until the capital
expenditure funds are required. Some bills may be sold dependent on the timing of the capital
expenditure. However, any gains or losses would be insignificant due to the short-term nature
of the bills.
2. To invest in medium- to long-term bonds so as to optimise interest income, and then sell these
bonds when the capital expenditure funds are required.

As financial controller, you advise that the first approach would be classified as amortised cost as the
contractual cash flows consist of solely interest and principal, and the business objective is solely to
collect interest and principal. It is expected that there may be some sales at the end of the program but
the gains and losses will be insignificant and effectively reflect the proceeds that would approximate
the collection of the remaining contractual cash flows. However, the second approach would cause
the financial asset to be classified as fair value through OCI because, while the contractual cash flows
consist of solely interest and principal, the business objective is to both collect the cash flows and sell
the assets so as to optimise income.

Option to designate a financial asset at fair value through

profit or loss
As discussed earlier, para. 4.1.5 of IFRS 9 allows entities to make an irrevocable decision to
designate a financial asset at fair value through P&L. This designation is conditional on the fact
that it must eliminate or significantly reduce a measurement or recognition inconsistency that
would otherwise arise from measuring assets and liabilities or recognising gains and losses
on different bases. This inconsistency may arise because the current measurement model is
a mixed attribute model, whereby some elements may be measured at cost and others at
fair value. As a result, there may be measurement inconsistency when the assets and liabilities
are closely linked, as they would be for an insurer. In such a case, the entity can elect to use fair
value and avoid the measurement inconsistency, but this is an irrevocable decision.

The designation does not have to be applied to all financial assets but must be applied
consistently each period to those financial assets so designated. It may also be applied to
groups of financial assets, as discussed.

If you wish to explore this topic further you may now read paras 4.1.1–5, B4.1.1–19 and B4.1.27–36
of IFRS 9.
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Classification of financial liabilities

Paragraph 4.2.1 of IFRS 9 requires all financial liabilities to be classified and subsequently
measured at amortised cost, except for:
(a) financial liabilities at fair value through P&L. These liabilities, including derivatives,
are subsequently measured at fair value.
(b) financial liabilities that arise when a transfer of a financial asset (as discussed in Part B)
does not qualify for derecognition, or when the continuing involvement approach applies.
The example in Part B—where the transferor transfers $5 million worth of debtors to
another entity but guarantees the transferee for all losses of bad debts up to $1 million—
gives rise to a financial liability for the transferor of $1 million.

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(c) financial guarantee contracts as defined in Appendix A, which refers to a guarantee

where the guarantor is now required to make payments to the lender based on some
form of default by the original borrower. Such contracts are to be measured—unless (a)
or (b) above apply—at the higher of the amount determined in accordance with IAS 37
Provisions, Contingent Liabilities and Contingent Assets and the amount initially recognised.
(d) commitments to provide a loan at a below-market interest rate. The commitments are
measured—unless (a) above applies—in a similar way to the financial guarantee contracts.
(e) contingent consideration of an acquirer in a business combination to which IFRS 3
Business Combinations applies. Such contingent consideration shall subsequently be
measured at fair value.

Option to designate a financial liability at fair value through

profit or loss
Paragraph 4.2.2(a) of IFRS 9 allows entities to classify a financial liability as at fair value through
P&L where it also eliminates or significantly reduces measurement or recognition inconsistency
that would otherwise arise from measuring assets and liabilities or recognising gains and losses
on different bases. This is consistent with the treatment of financial assets.

Paragraph 4.2.2(b) of IFRS 9 allows the same irrevocable decision to be made where a group
of financial liabilities or financial assets and financial liabilities is managed, and its performance
evaluated on a fair value basis in accordance with documented risk management or investment
strategy. An example would be a superannuation fund or a property trust that holds assets used
entirely to meet the obligations of the entity. Hence, the key management personnel of the entity
use fair values as the only relevant measure, and actively manage its assets and liabilities based
on movements in fair values.

If you wish to explore this topic further you may now read paras 4.2.1–2 and B4.1.27–36 of IFRS 9.

Embedded derivatives
As previously noted, derivatives are classified as at fair value through P&L unless the derivative
is subject to hedge accounting. Classifying a derivative at fair value through P&L means it is
measured at fair value with gains or losses arising from changes in fair value recognised in profit
or loss. Derivatives can also be embedded in financial assets or financial liabilities, as well as non-
financial contracts. Embedded derivatives have specific accounting requirements under IFRS 9.

What is an embedded derivative?

The terminology for assessing the accounting treatment of an embedded derivative is
summarised in Table 6.3. An embedded derivative is a component of a hybrid instrument that
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also includes a non-derivative host contract.

Table 6.3: Embedded derivative terminology

Component Terminology

Derivative Embedded derivative

Non-derivative Host contract

Total Hybrid instrument

Source: CPA Australia 2017.

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Derivatives are highly leveraged financial instruments, changing the risk profile and cash flows of
the entities that use contracts with embedded derivatives. For example, a contract to purchase
a machine in AUD can expose the company to foreign exchange movements if it includes a
rise and fall clause for foreign exchange rates. A host contract can take any form of contract,
including a sale or purchase agreement.

In accordance with IFRS 9, it must be determined whether an embedded derivative needs to

be separated from the host contract and recognised at fair value through P&L.

Do embedded derivatives need to be separated?

Not all embedded derivatives need to be separated from the host contract. Under IFRS 9,
there is no separation of embedded derivatives in financial assets.

The process of identifying embedded derivatives and determining whether they need to be
separated in accordance with para. 4.3.3 of IFRS 9 is determined by the following questions:
• Is the host contract measured at fair value through P&L?
• Does the embedded derivative meet the definition of a derivative on a stand-alone basis?
• Is the embedded derivative clearly and closely related to the host contract?

The process is summarised in Figure 6.1 and described in the following text.

Figure 6.1: Identifying embedded derivatives

2.
3.
1. Does the
No Yes Is the embedded No
Is the host embedded Separate
derivative closely
contract fair derivative meet the accounting
related to the
valued? definition on a
host contract?
stand-alone basis?

Yes No Yes

No separate accounting under IFRS 9 Financial Instruments

Source: CPA Australia 2017.

Step 1: Is the host contract fair valued?

If a host contract is already classified as at fair value through P&L, there is no need to separate
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the embedded derivative. The value of the embedded derivative will already be reflected in the
value of the host contract.

Step 2: Does the embedded derivative meet the definition on a stand-alone basis?
Does the potential embedded derivative that has been identified meet the definition of a
derivative on its own? For example, a CPI clause in a lease agreement would be regarded as an
embedded derivative because it satisfies the three characteristics of the definition of a derivative
IFRS 9, Appendix A.

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Step 3: Is the embedded derivative closely related to the host contract?

The embedded derivative does not need to be separated when it is closely related to the
host contract. Assessing whether it is closely related requires an analysis of the economic
characteristics and risks of the host contract to determine whether the embedded derivative
changes the nature of the risks involved in the host contract.

If an embedded derivative is not closely related to the host contract, it must be separated
from the host contract and accounted for at fair value through P&L. If the embedded
derivative is separated, the host instrument must also be accounted for in accordance with
the appropriate IFRS.

For example, company Hybrid issues a three-year debt instrument with a principal amount
of $10 000 000 indexed to the share price of Company No-relative, which is a publicly traded
company not related in any way to Hybrid. At maturity, the holder of the instrument will receive
the principal amount (plus any appreciation or minus any depreciation in the fair value of 200 000
shares of Company No-relative) with changes in fair value measured from the date of the
issuance of the debt instrument. No separate interest payments are made. The last sale price
at the issuance date of Company No-relative shares, to which the debt instrument is indexed,
is $50 per share.

The instrument is not itself a derivative because it requires an initial net investment equal to the
notional amount of $10 000 000. The derivative definition in IFRS 9 Appendix A, states that one
of the characteristics of a derivative is that ‘it requires no initial net investment or an initial net
investment that is smaller than would be required for other types of contracts that would be
expected to have a similar response to changes in market factors’.

The host contract is a debt instrument because the instrument has a stated maturity and the issuer
is obligated to pay the holder an amount determined by reference to the share price of Company
No-relative at maturity. Also, the holder has none of the rights of a shareholder, such as the ability
to vote at company annual general meetings or receive dividend distributions to shareholders.
This is similar to issuing a debenture bond.

The embedded derivative is an equity-based derivative that:

• would satisfy the definition of a stand-alone derivative
• is not economically closely related to the debt instrument, and hence must be separated
from the host contract unless the host contract is classified at fair value though profit or loss.

IFRS 9, para. 4.3.5, permits the entire hybrid contract to be accounted for at fair value through
P&L, except where the embedded derivative does not significantly alter cash flows or where it
is clear that the embedded derivative and the host contract are closely related. Where an entity
is required but unable to separate an embedded derivative from its host contract, either at MODULE 6
acquisition or at a subsequent reporting date, it should account for the whole instrument at fair
value through P&L. It would be unusual that the embedded derivative could not be separated,
but this may be the case—for example, where the market for the derivative does not exist,
making it impossible to value the embedded derivative in isolation.

The following example illustrates two embedded derivative scenarios, with one where the
embedded derivative is closely related to the host contract and the other not closely related.

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Example 6.12: Examples of embedded derivatives

The Australian Government Department of Defence enters into a contract to purchase military
equipment from a US supplier. The supplier is willing to accept payment in a fixed amount of USD or
the Malaysian ringgit equivalent of the USD amount, and so offers these payment alternatives to the
Australian Government. The government analyses the accounting impact of each payment option
and determines:
1. the fixed payment of USD creates a USD currency derivative, as the amount of Australian currency
required to settle the contract will depend on movements in the AUD/USD exchange rate. In this
case the embedded derivative is closely related to the host contract, as the payment is made in
the functional currency of the supplier and this currency risk is what would normally be expected
when purchasing from a US supplier.
2. the Malaysian ringgit payment option adds a currency which is the functional currency of neither
the buyer nor the seller. Therefore, the embedded derivative would not be closely related to the
host contract and would have to be accounted for separately under IFRS 9. This would mean
carrying the embedded derivative at fair value, taking changes in fair value to P&L.

If you wish to explore this topic further you may now read paras 4.3.1–7 and B4.3.1–10 of IFRS 9.

Reclassification
In IFRS 9, the only circumstances where it is permissible to reclassify a financial asset is where an
entity changes its business model (IFRS9, para. 4.4.1). It is stated that this is expected to be rare,
and para. B4.4.1 of IFRS 9 provides two examples of a change in a business model.

Situations provided in para. B4.4.3 of IFRS 9 that are not examples of a change in a business
model include:
• where an entity transfers financial assets between different portfolios
• where a market for financial assets temporarily disappears
• where an entity changes its intention to hold a financial asset.

Financial liabilities are not permitted to be reclassified in accordance with IFRS 9, para. 4.4.2.

If you wish to explore this topic further you may now read paras 4.4.1–3 and B4.4.1–3 of IFRS 9.
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Summary
Part C discussed the classification of financial assets and financial liabilities. Financial assets are
classified as at amortised cost, fair value through OCI or fair value through P&L. To be classified
as at amortised cost, the financial asset must be held within a business model whose objective is
to hold assets in order to collect contractual cash flows, and the contractual terms of the financial
asset must give rise on specified dates to cash flows that are solely payments of principal and
interest on the principal amount. All other financial assets are classified at fair value. The exception
is where an irrevocable decision is taken to classify a financial asset that would otherwise qualify
for amortised costs, at fair value through P&L due to an accounting mismatch.

Financial liabilities are classified at either amortised cost or fair value through P&L. For a financial
liability to be classified as fair value through P&L, there needs to be an accounting mismatch.

The other categories of financial assets and liabilities are financial guarantee contracts and
commitments to provide a loan at a below market interest rate.

Part C then discussed embedded derivatives and considered the treatment both when the
host contract is, and is not, an asset within the scope of IFRS 9. Part C concluded specifying
that reclassification of financial assets is only permitted when there is a change in the entity’s
business model, and that changes are not permitted for financial liabilities.

Having studied the classification of financial assets and liabilities, Part D now turns to
measurement of financial assets and liabilities, as outlined in IFRS 9.

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Part D: Measurement
Introduction
Part C looked at the classification of financial assets and financial liabilities, which in turn
determines the appropriate measurement method. Part D now considers the measurement
of financial assets, financial liabilities and investments in equity securities, and references the
principles from IFRS 9 where relevant. The specific issue of hedge accounting is considered
in Part E.

Relevant paragraphs
To assist in understanding certain sections in this part, you may be referred to relevant paragraphs
in IFRS 9, IFRS 7 or IAS 32. You may wish to read these paragraphs as directed.

Initial measurement
Paragraph 5.1.1 of IFRS 9 states that all financial assets and financial liabilities should be initially
measured at fair value. For financial instruments that are not measured at fair value through P&L,
the amount shall include transaction costs that are directly attributable to the acquisition or issue
of the financial asset or financial liability. Such transaction costs are added to the fair value for a
financial asset and deducted from the fair value for a financial liability.

‘Fair value’ is defined, in Appendix A of IFRS 9, as the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date. The term ‘fair value’ is also used in other standards, and is a term with which
one should be familiar.

Fair value, including the requirements of IFRS 13 Fair Value Measurement, is discussed in detail in
Module 1. IFRS 13 prescribes a fair value measurement hierarchy, which includes three levels for
inputs to fair value measurement:
• Level 1 inputs refer to quoted prices for identical assets.
• Level 2 inputs refer to inputs where there are no significant unobservable inputs, such as
a quoted price for comparable assets.
• Level 3 inputs refer to valuation models with significant unobservable inputs that must
be estimated.

Paragraph 5.1.1A of IFRS 9 directs readers to para. B5.1.2A for the way to account for any
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financial asset or financial liability that has a fair value different from the transaction price.

Essentially, there are two possible treatments when this arises, as outlined below:
1. Where there are no unobservable inputs in the valuation, such that the fair value is
determined by reference to an active market price for an identical asset or liability (this is a
Level 1 measure of fair value) or another valuation technique that uses observable inputs,
then the difference between the fair value and the transaction price is recognised as a gain
or loss.
2. In all other cases, the difference is deferred and recognised over time based on the change
in a factor such as the unwinding of a discount over time.

If you wish to explore this topic further you may now read paras 5.1.1–1A and B5.1.1–2A of IFRS 9.

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Subsequent measurement of financial assets

The subsequent measurement of financial assets is determined by their classification, which was
discussed in Part C and is summarised in Table 6.2.

Example 6.13: C
 alculating the effective interest rate for an
instrument measured at amortised cost
Calculating the effective interest rate of a financial instrument is relatively simple in concept,
but unfortunately there is no simple formula that will calculate it.

Financial calculators, software, and trial and error are the primary methods for calculating the rate.
The rate is simply a discount rate that discounts all future cash flows to the amount of cash received
or paid at the present date.

Consider a bank that lends money and charges an establishment fee. If the bank intends to measure
this instrument at amortised cost, that establishment fee must be recognised as an adjustment to the
effective interest rate of the instrument. If the bank lent JPY 1000 for two years at an interest rate of
2 per cent and charged an additional JPY 10 to establish the loan, the effective interest rate would
solve the following discounting formula:

 1   1   1 
1010 = 20 ×  + 20 × 2
+ 1000 × 2
 1 + RATE   (1 + RATE )   (1 + RATE ) 

Using the original rate of 2 per cent does not work because that discounts to JPY 1000. The discount
rate needs to be decreased in order to increase the present value (PV) of the cash flows. Using a
rate of 1 per cent provides a discounted value of JPY 1020, so clearly 1 per cent is too low. Splitting
the difference between the two rates and using a rate of 1.5 per cent gives a discounted value
that, when rounded up, equals JPY 1010. Using the Goal Seek function in Microsoft Excel (or a
financial calculator) yields an exact rate of 1.49 per cent.

Example 6.14 illustrates how the effective interest rate is used in amortised cost measurement.

If you wish to explore this topic further you may now read paras 5.4.1–3 of IFRS 9.

Impairment of financial assets carried at amortised cost

An asset is impaired when its carrying amount is greater than its recoverable amount. This applies
to both financial and non-financial assets. Impairment losses for non-financial assets are dealt
with in IAS 36 Impairment of Assets (this is discussed in Module 7). For financial assets carried
at amortised cost, an entity recognises impairment for expected credit losses, even if there
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is currently no indication of impairment (IFRS 9, para. 5.5.1).

Impairment of financial assets carried at amortised cost is intended to prevent financial assets
being carried at values that might no longer represent their true value, given changes in
economic factors. Considering that amortised cost financial assets are those the entity intends
to collect cash flows from, it is vitally important that users are able to assess whether those
cash flows will actually flow to the entity. Consider a bank with a large mortgage portfolio.
If a significant portion of that portfolio resided in an economic area experiencing a significant
downturn, the bank might not collect all the cash flows it intended. From a user perspective,
this is reflected through impairment.

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Impairment proceeds on a three-stage basis dependent on the credit status of the financial
instrument.

Stage 1––If the credit risk has not increased significantly since initial recognition, then 12 months
of expected credit losses are recognised (IFRS 9, para. 5.5.5). Effective interest is computed on
the gross amortised cost base (IFRS 9, para. 5.4.1).

Stage 2––If the risk of default has significantly increased since the initial recognition, an entity
is required to recognise the ‘lifetime expected credit loss’ on a financial instrument (IFRS 9,
para. 5.5.3). Effective interest is computed on the gross amortised cost base (IFRS 9, para. 5.4.1).

Stage 3––If the financial instrument is ‘credit impaired’, an entity is required to recognise the
‘lifetime expected credit loss’ on a financial instrument. Effective interest is computed net of
impairment losses (IFRS 9, para. 5.4.1b).

Example 6.14: Impairment of a financial asset

An entity has a note receivable and, in June 20X2, it is notified by the issuer that it will only be able to
pay $110 000 at maturity. It is unlikely that the entity will receive any more after this date. The entity’s
initial estimate of 12 months of credit losses is $2000. The following details are available:

$
Issue price of the note on 1.7.20X0 100 000
Maturity value of the note on 30.6.20X3 133 100

No interest is paid on the note. The effective interest rate is the rate that discounts $133 100 in three
years to a PV of $100 000, that is 10 per cent.

The following journal entries are recorded for the note:

Dr Cr
1.7.20X0 $ $
Note receivable 100 000
Cash 100 000

Record the acquisition of the note at cost, being the fair value of purchase consideration (IFRS 9, para. 5.1.1).
This is also equal to $133 100, discounted at the effective interest rate to a PV of $100 000.

Dr Cr
30.6.20X1 (reporting date) $ $
Note receivable 10 000
Interest revenue 10 000

The PV of the note increases to $110 000, which is the PV of $133 100 due in two years. The increase
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represents interest revenue.

Impairment loss 2 000

Provision for expected credit loss 2 000

As credit risk has not increased significantly, under Stage 1 record the 12 months of expected credit losses.

30.6.20X2 (reporting date)

Note receivable 11 000
Interest revenue 11 000

The PV of the note increases to $121 000, which is the PV of $133 100 due in one year.

Provision for expected credit loss 2 000

Impairment loss 2 000

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Reverse expected credit loss provision as the instrument is in Stage 3, and raise an impairment loss
as shown below.

Impairment loss 21 000

Provision for impairment 21 000

As the counterparty is ‘credit impaired’ under Stage 3, impairment loss is based on the expected
recovery using the initial discount rate of 10 per cent, based on final expected cash flow of $110 000.
PV at 30 June 20X2 is $100 000.

30.6.20X3 (reporting date)

Cash 110 000
Provision for impairment 21 000
Interest revenue 10 000
Note receivable 121 000

Proceeds are recovered as advised. Impairment loss provision is eliminated and interest is earned at
the effective interest rate at inception.

If you wish to explore this topic further you may now read paras 5.4.1, 5.5.1, 5.5.3 and 5.5.5 and
definition of ‘credit impaired financial asset’ and ‘credit loss’ Appendix A of IFRS 9.

Subsequent measurement of financial liabilities

The subsequent measurement of financial liabilities is also determined by their classification,
which was discussed in Part C and is summarised in Table 6.4.

Table 6.4: Measurement requirements of IFRS 9 Financial Instruments for

financial liabilities

Financial liability Measurement

Financial liabilities Amortised cost

Financial liabilities at fair value through (P&L) Fair value

Financial guarantee contracts Higher of amount determined from applying

the impairment provisions under IFRS 9 and the
amount initially recognised less cumulative income
recognised in accordance with IFRS 15

Loan commitments at below market interest rates Higher of amount determined from the impairment MODULE 6
provisions under IFRS 9 and the amount initially
recognised less cumulative income recognised in
accordance with IFRS 15

Financial liability designated as a hedged item Apply the hedge accounting rules from IFRS 9,
which are covered in Part E

Source: Adapted from IFRS Foundation 2017, IFRS 9 Financial Instruments,

in 2017 IFRS Standards, IFRS Foundation, London.

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Example 6.15: Amortised cost measurement of a

financial liability
China General Manufacturing Company (CGMC) requires additional funding to expand its product
offerings into Australia. Accordingly, on 1 January 20X3 it obtains a three-year loan of 5 000 000
Chinese Yuan (CNY) at an interest rate of 4.5 per cent. Interest payments are made annually in arrears.
CGMC is required to pay CNY 180 000 to establish the loan, which the bank deducts from the loan
amount advanced.

CGMC measures the loan at amortised cost and notes that the CNY 180 000 establishment fee is an
integral part of the effective interest rate of the loan. CGMC decides to amortise the establishment
fee over the life of the loan and must therefore adjust the 4.5 per cent real interest rate to account
for this additional expenditure.

Using the formula and financial tools as described in Example 6.13, CGMC calculates the effective
interest rate that discounts all future cash flows to the amortised cost of the loan for CNY 4 820 000
(which is the loan amount net of transaction costs in accordance with para. 5.1.1 of IFRS 9) to be
approximately 5.8 per cent. However, for the purposes of the calculations below the unrounded rate
of 5.8429 per cent is used due to its higher accuracy. Candidates are not expected to calculate this
rate in the exam.

The table below summarises the carrying amount of the loan, the interest expense and contractual
repayment amounts for all three years.

Year Opening balance Repayment Interest expense Closing balance

1 4 820 000 (225 000) 281 627 4 876 627

2 4 876 627 (225 000) 284 936 4 936 563

3 4 936 563 (225 000) 288 437 5 000 000

On initial recognition CGMC recognises the cash received (net of the establishment fee) and recognises
a corresponding liability at fair value less the transaction costs.

Dr Cr
CNY CNY
1 January 20X3
Cash 4 820 000
Financial liability 4 820 000

On 31 December 20X3, CGMC calculates the effective interest expense on the loan based on its
amortised cost. This is: 5.8% × 4 820 000 = 281 627. The cash interest payment is based on the stated
interest rate on the loan amount: 4.5% × 5 000 000 = 225 000. The difference of 56 627 is the amortisation
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of the loan establishment fee in year one.

Dr Cr
CNY CNY
31 December 20X3
Interest expense 281 627
Cash 225 000
Financial liability 56 627

This process is repeated in the next year, based on the new amortised cost of the loan arising from
the above journal entry: CNY 4 820 000 + 56 627 = 4 876 627.

Dr Cr
CNY CNY
31 December 20X4
Interest expense 284 936
Cash 225 000
Financial liability 59 936

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In the final year this process is repeated again, but CGMC then repays the principal amount of
CNY 5 000 000.
Dr Cr
CNY CNY
31 December 20X5
Interest expense 288 437
Cash 225 000
Financial liability 63 437

(To record the interest expense on the loan and amortise the final amount of the establishment fee.)

Financial liability 5 000 000

Cash 5 000 000
(To recognise the repayment of the loan.)

Note that in each year the carrying amount of the loan is gradually increased to the final amount that
will be repayable.

If you wish to explore this topic further you may now read paras 5.3.1–2 of IFRS 9.

Reclassification of financial assets

The requirements for reclassifications of financial assets are straightforward and covered in
paras 5.6.1–3 of IFRS 9. Where an entity satisfies the rule for reclassification—that is, where there
is a new business model—it shall:
• not restate any previously recognised gains and losses
• (where a financial asset is reclassified to fair value) measure fair value at the date of
reclassification and recognise any gain or loss in P&L
• (where a financial asset is reclassified to amortised cost) recognise the fair value at the
reclassification date as the new carrying amount.

Gains and losses

When a financial asset or a financial liability is measured to fair value, the changes in fair value
must be recognised in the accounts. The changes are reported in the P&L for the period in all
cases unless:
• it is part of a hedging relationship, in which case the hedge accounting rules in IFRS 9,
as discussed in Part E are applied to the changes in fair value
• it is a financial asset held within a business model (whose objective is to both collect
contractual cash flows and sell financial assets), and that has contractual terms that give rise
(on specified dates) to cash flows that are solely payments of principal and interest on the
principal amount
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• it is an investment in an equity instrument and the entity has elected the option of reporting
gains and losses in OCI (equity instruments will be discussed in the next part of this section),
or
• it is a financial liability at fair value through P&L, and the gain or loss arises from changes in
the credit risk of the financial liabilities, which must be reported in OCI (this issue is discussed
towards the end of this section).

For financial assets and financial liabilities carried at amortised cost, and which are not part of a
hedging relationship, gains and losses are recognised in the normal manner when the financial
assets and financial liabilities are derecognised or impaired or reclassified in accordance with
para. 5.6.2 of IFRS 9. The amortisation process allows for the recognition of gains and losses
associated with any premium or discount at the date of acquisition.

For financial liabilities and financial assets that are hedged items, hedge accounting (as set out
in IFRS 9) must be used.

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If you wish to explore this topic further you may now read paras 5.7.1–4 of IFRS 9. Please now
attempt Question 6.6 to apply your knowledge of this topic.

➤➤Question 6.6
Jolly Frog Ltd (Jolly Frog) has a portfolio of debt securities that it has been carrying at amortised
cost, as it met the rules in IFRS 9 based on its intent to hold the securities and collect the cash
flows over the terms of the debt securities. On 1 April 20X8, Jolly Frog acquired a financial
services section (Tadpole). Tadpole will have responsibility for managing the securities by selling
and buying based on price movements.
Required:
(a) Jolly Frog wants to apply fair value to the securities since the acquisition of Tadpole. Do you
think Jolly Frog meets the requirements in para. 4.4.1 of IFRS 9? Explain your answer.

(b) Assume Jolly Frog meets the requirement to change to fair value. Prepare the journal entry
for reclassification of the securities by Jolly Frog using the following data, explaining your
reasoning. For the purposes of this question the impairment requirements of IFRS 9 do
not apply.
$
Cost of securities at 1 January 20X7 100 000
Recoverable value of securities at
30 June 20X7 90 000
Allowance for impairment loss 10 000
Fair value of securities at
1 April 20X8 115 000

Dr Cr
$ $
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Check your work against the suggested answer at the end of the module.

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Investments in equity securities

Many entities have investments in other companies that they enter into by acquiring shares in such
companies. Provided the investment is in an equity instrument—as defined in IAS 32, which was
discussed in Part A—then para. 5.7.5 of IFRS 9 is applicable. Paragraph 4.1.4 of IFRS 9 states that
all investments in equity instruments are to be measured at fair value, with no exceptions.

Paragraph 5.7.5 of IFRS 9 allows entities to make an irrevocable election to report subsequent
changes in fair value in OCI for investments in equity securities that are not held for trading.
‘Held for trading’ is defined in IFRS 9, Appendix A ‘Defined terms’, and reflects the concept of
active and frequent buying and selling with the objective of generating a profit from short-term
fluctuations in price or dealer’s margin. This election can be made for each share investment an
entity has and does not have to apply to the entire class of investments in equity securities.

Paragraph B5.2.3 of IFRS 9 indicates that, at times, cost may be an appropriate estimate of
fair value, and this will only apply to unlisted equity securities. Paragraph B5.2.4 of IFRS 9
lists indicators that would suggest that cost is not an appropriate estimate of fair value.
Such conditions include when the investee is performing significantly better or worse than
normal, or when the investee experiences significant internal problems, such as fraud.

If you wish to explore this topic further you may now read paras 5.7.5–6, B5.2.3–6 and B5.7.1
of IFRS 9.

Liabilities designated at fair value through

profit or loss
Paragraph 5.7.7 of IFRS 9 provides the requirements for the treatment of liabilities designated as
at fair value through P&L. Part (a) of the paragraph requires entities to report the change in the
fair value of such liabilities (other than financial guarantees and loan commitments), which are
due to changes in the credit risk of that liability in OCI. Part (b) requires the remaining amount
of the change in fair value to be recognised in P&L.

Hence, it is now necessary to discuss the concept of credit risk. Credit risk is defined in Appendix A
of IFRS 7 as ‘the risk that one party to a financial instrument will cause a financial loss for the other
party by failing to discharge an obligation’. The disclosures about credit risk are covered in Part F.
However, in the context used in IFRS 9, it is not the credit risk of a party but the credit risk of the
financial liability that is the focus. For example, if ABC Ltd issues secured and unsecured debt
instruments, the credit risk of each instrument will be different even though they are issued by MODULE 6
the same entity. The unsecured debt would be a higher credit risk than the secured debt.

Appendix B to IFRS 9 points out that credit risk is different from asset-performance risk (IFRS 9,
para. B5.7.14). It provides an example of a special purpose entity (SPE) that is set up, and the
returns to holders of securities issued by the SPE are based entirely on the cash flows of the SPE’s
underlying assets. When such assets perform poorly, the returns to the SPE investors will decline.
This is due to poor performing assets and not credit risk, and so the entire change of the fair
value of the liability to the SPE investors would be taken to P&L.

Paragraphs B5.7.16–20 of IFRS 9 detail how the credit risk of a financial liability is to be measured
so that an entity is able to separate the fair value changes of a financial liability into an amount
due to credit risk and other factors.

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As an exception to the accounting treatment just outlined, if separating the changes in fair value
related to credit risk would create or enlarge an accounting mismatch in the P&L, then the entity
shall present all of the fair value changes in P&L.

For the purposes of this module, the application of measurement rules to a practical example is
not expected.

If you wish to explore this topic further you may now read paras 5.7.7 and B5.7.13–20 of IFRS 9.

Compound financial instruments

Compound financial instruments, which were referred to earlier in this module, consist of both
equity and liability components. An example of a compound financial instrument is a debenture
bond with an option to convert into an ordinary share by the holder, either at a certain date or at
any time up to a certain date. Such an instrument contains a liability component and an equity
component, and is therefore a good example of a compound instrument.

Component parts of a compound financial instrument are separately classified (IAS 32, para. 28).
According to IAS 32, it is more a matter of substance rather than legal form that liabilities and
equity interests are established by one financial instrument rather than two or more separate
instruments (paras 15 and 18).

IAS 32 requires issuers of instruments such as convertible notes to classify the components as a
financial liability (i.e. a contractual arrangement to deliver cash or other financial assets) and as
an equity instrument (i.e. an option to buy shares of the issuer). Once the component parts are
recognised on the statement of financial position, the classification is not revised, irrespective of
the probability of conversion of the right to purchase shares. If a convertible note is converted
into ordinary shares, the equity component established (when the notes were first issued) can be
reclassified so that the amount becomes part of distributable reserves. The liability component is
extinguished with the issue of new shares.

Component parts are accounted for separately since issuing a financial instrument, like a
convertible note, is in substance the same as issuing debt and options to purchase ordinary
shares. For example, imagine that an entity issues two types of notes, each with a face value of
$1000 and an interest rate of 6 per cent, and both maturing at the same time. The only difference
is that one includes an option for the holder to convert the note to ordinary shares in the
company at any time up to the maturity date. Would you pay the same price for both notes?

The note with the option to convert to shares will command a higher price, which demonstrates
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that the option has a value. This is the major argument for the ‘component parts’ accounting
approach for compound financial instruments. As such, most accounting standards require
the issuer to account separately for the component parts of compound financial instruments.
The holder must account for such financial instruments in accordance with IFRS 9, as discussed
earlier in this module under ‘Embedded derivatives’.

IFRS 9 requires separate measurement of the component parts. IAS 32 requires entities to
first measure the value of the liability component, and the difference between the fair value
of the instrument and the liability value is allocated to the equity component. No gain or loss
is recognised at the time of issue. This means that, at inception, the sum of the individual
component values must equal the value of the instrument as a whole.

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Example 6.16: Initial measurement of a compound instrument

An entity issues 1000 convertible instruments on 1 July 20X6, at a face value of $500 per instrument.
The instruments mature in three years and pay 5 per cent interest annually, in arrears. Each instrument
is convertible into 500 equity instruments at maturity, at the option of the holder. If the holder does not
convert the instrument, the entity will redeem it for face value of $500. At the time the instrument is
issued, the prevailing market rate for a similar instrument (without the conversion feature) is 7 per cent.

Applying para. 28 of IAS 32, the entity determines it has issued a compound financial instrument that
has components of both equity and a liability. To split these components, the entity needs to determine
the fair value of the liability component as discounted using the prevailing market rate of interest.

Present value of the debt component

The debt component is comprised of two cash flow streams:
1. repaying the face value of the instrument at the end of three years (the principal)
2. paying the annual interest coupons.

The fair value of the principal is calculated as follows:

 1 
$500 000 ×  3
=
$408 149
 (1 + 0.07) 

The fair value of the coupon interest payments is calculated as follows:

 1   1   1 
$25 000 ×   1
+ 2
+ 3 
=
$65 608
  (1 + 0.07)   (1 + 0.07)   (1 + 0.07)  

Therefore, the total value of the liability component is $408 149 + $65 608 = $473 757.

Value of the equity component

Clearly, the entity received $500 000 when it issued these instruments (1000 instruments at $500 per
instrument = $500 000), but the value of the liability is only $473 757. The difference of $26 243 is the
value of the conversion option, which is classified as equity.

The journal entry to record the issue of the instruments on 1 July 20X6 is:

Dr Cr
$ $
1 July 20X6
Cash 500 000
Financial liability 473 757
Equity 26 243

The equity component is never revalued. However, the liability component is subsequently accounted
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for as any other financial liability. Its carrying amount will gradually accrete interest, at the prevailing
market rate, until it reaches its redemption amount of $500 000 at the end of its three-year life.

On maturity, assume all holders convert their instruments into equity. On conversion, the entity
extinguishes the liability with a corresponding issue of new equity.

30 June 20X9
Financial liability 500 000
Equity 500 000

If you wish to explore this topic further you may now read paras 28–32, AG30–5 and Illustrative
Example 9 of IAS 32.

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Summary
Part D discussed the measurement of financial assets (including impairment), financial liabilities,
investments in equity instruments and compound financial instruments. The measurement of
the financial assets and financial liabilities (upon initial recognition) is at fair value, plus or minus
transaction costs, when the financial asset or liability is not measured at fair value. Subsequent to
acquisition, financial assets and financial liabilities are measured according to their classification,
as discussed in Part C. For financial assets and financial liabilities that are part of a hedging
relationship, the hedge accounting rules in IFRS 9 apply.

The gains and losses from remeasurement to fair value are included in P&L for all financial assets
and liabilities classified as at fair value through P&L, unless:
• the financial asset or liability is part of a hedge
• it is an investment in an equity instrument where the entity has made an irrevocable decision
to classify such gains and losses in OCI, or
• it is a financial liability designated as at fair value through P&L, and the change is due to
credit risk of the financial liability.

Entities have an irrevocable option to elect to report changes in fair value in OCI rather than P&L.
This election is made on each investment.

The fair value changes for financial liabilities designated as at fair value through P&L are reported
in P&L except where a portion of the fair value change is due to changes in the credit risk of
that liability, in which case such gains or losses are reported in OCI. The only exception to this
requirement arises when the reporting of such gains or losses in OCI results in an accounting
mismatch in P&L.

Gains and losses on financial guarantee contract and loan commitments are reported in full
in P&L.

Part E examines the requirements for hedge accounting in accordance with the principles in IFRS 9.
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