Classification of financial assets
Under the principles of IND AS 109, a financial asset may be classified under two categories:
At amortised cost:
An asset (other than equity instrument) that meets the below mentioned conditions:
The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows;
The contractual cash terms of the financial asset give rise to cash flows on specific dates that are solely payments of principal and interest on the principal amount outstanding;
The entity has not invoked the fair value option for measurement of financial asset to reduce an accounting or measurement mismatch.
An entity’s business model approach is determined on a higher level, rather than an asset-by-asset basis. Further, the entity may have different assets (portfolio of assets) for business purposes. Accordingly, it may not be right to identify the business model on an entity’s level either. The entity may comprise of a portfolio of assets which is collected on the basis of contractual cash flows, and of a portfolio of assets in which it trades.
AV Ltd, a banking company, issues loans to various customers in retail business. A customer, having taken a 20 years loan, decides to pay off the loan in 5 years’ time. AV Ltd cannot refuse the pre-payment, and would receive the money due from the customer.
In the above case, although AV Ltd realizes the money well before the due date, the recovery is made essentially in form of contractual cash flows (collected by way of recovery of interest and principal during first 5 years, and recovery of balance principal at the end of 5th year). Hence, the loan asset is shown as amortised cost in the books of AV Ltd.
AV Ltd gives loan to various clients in the retail sector. If someone does not pay the Instalment, AV Ltd would follow different measures to recover money. It may further mean to recover money by selling off the collateral. Even in this case, the business model of AV Ltd is essentially recovery of money through recovery of interest and principal amount.
2. Financial assets measured at Fair value:
Any financial asset not measured at amortised cost is measured at fair value.
* Any investment in equity is necessarily measured at fair value. This is so because equity investments do not have a maturity.
IND AS 109 provides that changes in the value of a financial asset measured at fair value, but not held for trading purposes, may be done through Other Comprehensive Income. However, this choice has to be made by the entity at the time of initial recognition of the asset. This decision is irrevocable, and cannot be changed later.
AV Ltd invests $ 1 million in shares of T Ltd. AV Ltd holds these shares for a longer term, rather than trading into these shares. On reporting date, the value of the investment is $1.2 million. In this case, the investment is reported at $1.2 million. However, the gain of $200,000 may be shown through OCI rather than showing as a part of Income statement.
However, if the intentions of the entity appear as if the entity is trading into these shares, the classification would be done as an investment at fair value. Any changes in the value are to be routed through Income statement.
AV Ltd has invested into the shares of T Ltd. AV Ltd invests into the shares with an intention to sell these shares when the prices rise significantly.
In the above case, the investment in shares is considered as at fair value, and changes are shown through Income statement.
Even though it may be difficult to measure the fair value of investment because the investment is not quoted, IFRS 9 requires an entity to measure the value through valuation principles and does not advocate the use of cost method. (For example, investment in shares of an unlisted company).
Equity instruments that are not held for trading purposes, an entity can choose (instrument-by-instrument), to recognise profit and losses in OCI. Dividend income on these instruments though, is recognised in Income statement.
Examples of financial assets under different categories:
AV Ltd invests in 3 years’ redeemable preference shares of T Ltd. AV Ltd holds these shares until maturity and recovers the cash flows through dividend and principal repayment.
In the above case, the shares are considered to be valued at amortised cost since the maturity of these shares is certain after 3 years.
AV Ltd invests in bonds of T Ltd. The intention is to hold these bonds for a longer term. However, AV Ltd decided to value the investment at fair value routed through profit and loss.
In the above case, although the investment is made in bonds with intent to hold them for a long term, the entity’s decision to measure these at fair value would mean that changes therein are measured through income statement.
AV Ltd has receivables of $5 million from T Ltd. The business model of AV Ltd is to sell off the receivables portfolio to 3rd party and recover money the moment sales are made.
In the above case, the business model of AV Ltd is not to collect contractual cash flows, but trade into these receivables. Accordingly, these assets are shown as a part of trading assets (changes in fair value reported through income statement).
AV Ltd has invested in debentures of T Ltd. AV Ltd has an intention to hold these debentures until maturity. However, if AV Ltd identifies a substantial gain, it may sell off the debentures to realise the gain.
In the above case, although AV Ltd thinks of holding the debentures for a long term (until maturity), it is likely to sell these debentures if substantial gains arise during the period before maturity. In this case, the debentures are assumed to be not held for collection of contractual cash flows.
A perpetual debt (with no maturity) is considered at amortised cost.
A debt instrument convertible into equity shares of the entity is considered at fair value, rather than at amortised cost. The recovery is not necessarily coming through contractual cash flows in form of principal and interest.