IFRS 9 Classification Criteria (for beginners)

A Comprehensive Guide to Classification Criteria under IFRS 9

This world is a beautiful place... for those who create and focus on beautiful memories. Similarly, IFRS 9 is a beautiful standard for those who focus on what it is trying to achieve... fair presentation.

Irrespective of whether you agree with any aspect of this ridiculous analogy, as accountants we must all agree on making accounting simple.

Understanding the rationale

But before we dive in, let's have a beautiful bird's eye view of what we are trying to achieve.

We can carry an asset either at cost model or at fair valuation model.

Think of PPE.

There are 2 fundamental models:

• When carried at cost model PPE is depreciated and impaired (including reversals) but not revalued.
• When carried at revaluation model PPE is depreciated and impaired (including reversals) and also revalued.

Similarly, financial assets may also be carried at either cost model or fair value model.

When financial assets are carried at cost model, it is called amortised cost model. And changes due to amortization go through PnL. (Just like changes due to depreciation in PPE go through PnL)

However, when financial assets are carried at fair value model, any change in fair value should either be reflected in Pnl or in Other comprehensive income. But which income do you choose to better reflect the change in value of the financial asset?

That's a million dollar question

As a rule of thumb is: if it is closely related to the entity's performance, it should go through PnL otherwise it should go through OCI.

Finally, you got it now!

That's where classification criteria comes in.

Introduction to IFRS 9 Classification

In this article, we will focus on financial assets.

Essentially, the criteria says that we will have to pass our lovely financial assets through 2 tests.

Don't worry, these tests won't hurt our financial asset. Nevertheless, these harmless tests have the following intimidating names:

• Cash flow characteristic test (also called SPPI test)
• Business model test

Business Model Assessment

One of the key drivers of classification under IFRS 9 is the business model of the entity. This assessment is based on how an entity manages its financial assets to generate cash flows. The objective is to determine whether the assets are held to collect contractual cash flows, to sell, or both.

Types of Business Models

• Hold to Collect: If the entity’s objective is to hold the financial asset to collect the contractual cash flows, the asset can be measured at amortized cost. This is the case, for example, with loans or receivables that are expected to be held until maturity.
• Hold to Collect and Sell: When the entity’s business model involves both collecting contractual cash flows and selling the financial assets, the asset can be classified as FVOCI. An example is a portfolio of bonds that the entity may sell when the market conditions are favorable.
• Other Business Models: If the financial asset is held for purposes other than collecting contractual cash flows or selling (e.g., held for trading or for short-term speculative purposes), the asset will be classified as FVTPL.

Determining the Business Model

The business model assessment is not based on a single transaction nor on the "intention of the management", but rather on how an entity manages a portfolio of assets collectively. It should reflect the entity’s objectives and strategy, rather than mere intentions for individual assets. Evidence that can be used to assess the business model includes:

Past and expected future sales of financial assets.

• Risk management policies and practices.
• Performance evaluation measures.

Contractual Cash Flow Characteristics (SPPI Test)

The second criterion for classification is the contractual cash flow characteristics of the financial asset. IFRS 9 requires that financial assets pass the SPPI test to be classified as either amortized cost or FVOCI.

What is the SPPI Test?

The SPPI test determines whether the contractual cash flows of the financial asset are solely payments of principal and interest on the principal amount outstanding. In simpler terms, the asset must have predictable cash flows that represent a basic lending arrangement where the entity is compensated for:

• Time value of money.
• Credit risk associated with the principal.
• Other basic lending risks (e.g., liquidity, cost of funding).

Assets that Fail the SPPI Test

If the contractual terms introduce exposure to risks or volatility beyond what is typically expected in a basic lending arrangement, the asset will fail the SPPI test. For example:

• Equity investments (unless elected for FVOCI).
• Financial instruments with embedded derivatives that change cash flow behavior.

In such cases, the asset will be classified as FVTPL, where all changes in fair value are recorded in profit or loss.

Now that we have understood the underlying rationale, and both the tests, it is now time to unveil the classification criteria you were so eagerly waiting for.

Overview of Classification Categories

Under IFRS 9, financial assets are classified into one of three categories:

• Amortized Cost
• Fair Value through Other Comprehensive Income (FVOCI)
• Fair Value through Profit or Loss (FVTPL)

Each category has distinct implications for how financial assets are measured and how changes in their value are recognized in the financial statements.

Amortized Cost (AC)

Financial assets are measured at amortized cost if:

• The asset is held in a business model whose objective is to collect contractual cash flows; and
• The contractual terms give rise to cash flows that are solely payments of principal and interest (SPPI) on the principal amount outstanding.

In this classification, assets are recognized at their initial cost minus principal repayments, plus or minus the cumulative amortization of any difference between the initial amount and the maturity amount. Interest income is recognized using the effective interest rate method, and impairment losses are recognized using the Expected Credit Loss (ECL) model.

Fair Value through Other Comprehensive Income (FVOCI)

Financial assets are measured at FVOCI if:

• The asset is held in a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets; and
• The contractual terms result in cash flows that are solely payments of principal and interest (SPPI).

For assets classified under FVOCI, they are initially measured at fair value, and subsequent changes in fair value are recognized in other comprehensive income (OCI). However, interest income, impairment losses, and foreign exchange gains and losses are recognized in profit or loss. When the asset is sold, the cumulative gain or loss previously recognized in OCI is reclassified to profit or loss.

Fair Value through Profit or Loss (FVTPL)

All other financial assets that do not meet the criteria for amortized cost or FVOCI are classified as FVTPL. This includes:

• Assets that are held for trading.
• Assets where the business model is not to hold the asset for contractual cash flows or for sale (e.g., speculative investments).
• Equity investments that are not elected to be measured at FVOCI.

For FVTPL, financial assets are initially measured at fair value, and subsequent changes in fair value are recognized directly in profit or loss.

Election to Classify Equity Instruments at FVOCI

Irrespective of whether you are into politics, you can not defy the importance of elections.

And if you are deep into politics, you would know election is usually a show to mask the selection made by the elite. It is like choosing between 2 soaps, both are harmful for yourskin and both are produced by large corporations.

Similarly, IFRS 9 also offers a selection-type election.

Under IFRS 9, entities have an irrevocable election to present changes in the fair value of certain equity investments in OCI instead of profit or loss. This election can be made at the time of initial recognition for each individual investment.

However, it is important to note that dividends received on these equity instruments will still be recognized in profit or loss, and when the asset is sold, the gain or loss accumulated in OCI is not recycled to profit or loss, unlike debt instruments at FVOCI.

Conclusion

The classification and measurement of financial assets under IFRS 9 require careful consideration of both the business model and the contractual cash flow characteristics.

Understanding these criteria is crucial for entities to ensure compliance with IFRS 9 and to align their financial reporting with the standard’s objectives of improving transparency and comparability.

Once you understand the underlying rationale and the tests involved, you will find that this criteria is simpler than you thought to apply in practice.

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