IFRS 9 TREE DIAGRAM

Effective 2018, IFRS 9 remains a pain in a lot of practitioners’ neck, perhaps because of its “seemingly Gucci-like” provisions and requirements, Lol! As Nigerians would say to IFRS 9, “E choke” (it chokes in English). But most sincerely, the standard isn’t as complex, the provisions are clear. The objective of this article is to deep-dive into IFRS 9 Tree diagram for Classification of Financial Assets. When you are in doubt on how to classify your financial asset, make recourse to this article on the classification of the tree diagram, I promise you would enjoy our usual domestic tutelage. Do you have your cup of tea? Happy reading!

You need to check IAS 32 for the definition of financial instruments as I wouldn’t bore you with the definition. I assume you have a financial asset but cut in the web on how to classify. First is that, you need to check to be sure what you have is either Debt instrument, Equity Instrument, or a Derivative Instrument. Derivative contracts are usually clear and straight forward and derives their value from another underlying asset at a specified date. They also do not involve an initial investment like a debt or equity instrument. A good example here is a forward contract to buy USD at N20 in August, Future impossible tense, yeah? It’s an example. ?

Let’s get back to the tree diagram, so we don’t lose focus.

If you buy a financial asset today, IFRS 9 requires that you measure the asset at fair value and subsequently measure at either amortized costs or fair value. I need to call out the fact that initial recognition is at fair value, this is what differentiate IFRS 9 from other standards. The subsequent measurement at fair value can either be fair value through profit or loss or other comprehensive income.

Confused? Please chillax! We would have a soft landing.

If you buy a financial asset that affords you the right to recoup what you have invested, esteem readers, what you have is a debt instrument. I know you know that for equity instrument your investee company is not obliged to refund your investment, rather it affords you the right to variable returns. On a lighter note, your bride price affords you variable returns (different benefits from marriage) in your marriage, safe to say your wife is an equity investment, hopefully feminists wouldn’t pick exceptions here. Lol!

If I invest in an instrument and I am assured of the right to get back what I ?invested (most times including additional returns at a specified time or date), then what I have bought is a Debt instrument. Therefore, your money market investments, Bonds etc all qualify as Debt instruments.

Shall we focus and go back to classification?

So, I want to do a subsequent recognition for my debt instrument, the standard gives leeway for two measurement bases, Amortized costs or at fair value through other comprehensive income unless I opt to designate at fair value through profit or loss. The gist here is that for debt instrument, entities either do amortized cost or fair value through OCI classification.

I’ll explain!

IFRS 9 requires an entity to measure financial assets at amortized cost if the business model with which an asset is bought is achieved by holding such instruments to collect contractual cashflows with the cashflows being solely payment of principal and interest on the principal outstanding (SPPI). Esteem readers, you would have noticed that two criteria have been set out for amortized costs instruments: the business model test and the cash flow pattern. As usual, I am blowing the trumpet for IASB, there is sense in what they have put together in IFRS 9. If I buy a Bond that has a maturity of say 5 years and the intention with which I bought the instrument is hold it to collect accrued interest plus the principal and not for sales/trading. I would want to amortize of course, meaning; spread the total amount receivable over the tenor of the instrument. This is what IFRS 9 really wants to achieve. ??

If you look to the left of the tree diagram, the first arrow on Debt instrument points down to ask whether the SPPI condition for debt instrument is achieved? Meaning, whether the bond (for example) that you have bought has a cash flow feature that is solely payment of principal and interest.

Bonds sure pass this criterion except for a convertible bond that has a share option (embedded derivative) in it.

Where the SPPI is not met, the tree diagram points at fair value through profit or loss. It then means that a convertible bond for example would be classified as measured at fair value through profit loss, because the SPPI test was not met. What If SPPI test is met? You check the second criterion, business model test!

Is the intention for buying this asset to hold and collect cashflows (SPPI)? Then you should amortize such asset over the maturity period else, you fair value such investment. Remember, the Fair value here for debt instrument is fair value through other comprehensive income. It then means that for all debt instruments entities intend to trade or sell have to be fair valued, this is in tandem with IFRS 13’s exit price definition of fair value. IFRS 13 says fair value if the price with which an asset is disposed, or a liability settled in an orderly transaction between market participants at a certain measurement date. Makes sense? Please re-read and be sure you get the gist.

I had said earlier in this article that debts financial assets are measured at amortized costs or fair value through other comprehensive income unless the asset is designated at as fair value through profit or loss. What comes into mind is what makes one designate an instrument that should by default have been classified as amortized costs or fvtoci at fair value through profit or loss? A clear instance is where doing the default classification leads to a mismatch in accounting. Equities are by default classified at fair value through profit or loss. This would be explained.

It is possible you have a bucket of investment, say an investment vehicle, class or type that comprise significantly of equity investment with minute investment in debt instruments. For instance 98% of a fund type comprise of equity financial asset with 2% investment in debt instrument, cherry-picking such debt instrument to classify as amortized cost or at Fvtoci may lead to accounting mismatch; thus a fair value through profit or loss classification can be maintained. Yeah, that simple!

?Most times equities are bought to enjoy their volatility in their value(fair value), hence held to trade. If I trade, my gain should go to profit or loss, right? The standard endorses this. So, by default equity investments are classified at fvtpl. It is not impossible however that an entity buys an equity investment with reasons other than to sell (could be for other strategic purposes; why entities buy Unquoted equities in practice), the standard advises that the fvtoci option be opted for in the instance. Look to the right of the tree diagram, this explanation would make sense.

I hope the long read is worth your while.

Please keep staying safe, the new Covid variant is gathering momentum.

Your IFRS Pal,

Sobur ‘Lekan Bello

?