## Learning Outcomes

- Explain when a financial instrument is recognised under IFRS 9.
- Distinguish financial assets, financial liabilities and equity instruments.
- Apply the business model test to financial asset classification.
- Apply the SPPI test to debt investments and identify common failures.
- Classify financial assets as amortised cost, FVOCI or FVTPL.
- Explain why equity investments are treated differently from debt investments.
- Avoid common ACCA FR errors in classifying loan notes, shares and linked investments.

## ACCA Financial Reporting (FR) Syllabus

In ACCA FR, financial instruments are tested at a practical accounting level. You may be asked to identify a financial instrument, decide whether it is a financial asset, financial liability or equity instrument, classify it under IFRS 9, and then apply the correct measurement and gain or loss treatment.

- Recognise financial instruments when the entity becomes party to the contract.
- Identify common financial instruments such as cash, trade receivables, loans, loan notes, shares and payables.
- Classify debt financial assets using the business model and SPPI tests.
- Recognise that equity investments are measured at fair value, usually through profit or loss.
- Distinguish amortised cost, FVOCI and FVTPL classifications.
- Understand that financial liabilities are usually measured at amortised cost unless specific exceptions apply.
- Apply exam logic to short scenarios involving bonds, loan notes and market-linked investments.

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. When does IFRS 9 require a financial asset or financial liability to be recognised?
2. What two tests must a debt financial asset pass to be measured at amortised cost?
3. A company buys a loan note whose returns are linked to a stock market index. Does it pass the SPPI test?
4. What is the default IFRS 9 classification for an investment in ordinary shares?
5. Does the business model test apply to financial liabilities?

## Introduction

IFRS 9 Financial Instruments sets out how financial assets and financial liabilities are recognised, classified and measured. For ACCA FR, the most exam-relevant issue is often the classification of financial assets, especially debt investments such as loan notes and bonds. The classification matters because it determines whether subsequent measurement is at amortised cost, FVOCI or FVTPL, and where gains and losses are reported.

The business model and SPPI tests are central to the classification of debt financial assets. In a typical FR question, the scenario may say that an entity has bought a loan note, intends to hold it, may sell it if cash is needed, or receives returns linked to an index. Your task is to translate those facts into the correct IFRS 9 classification.

> **Key Term: Financial instrument**
> A contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

Common examples include cash, trade receivables, trade payables, bank loans, loan notes, bonds, investments in shares and convertible loan notes. Physical assets such as inventory and property are not financial instruments because they do not give one party a contractual right to receive cash or another financial asset from another party.

### Recognition and the basic categories of financial instruments

IFRS 9 requires an entity to recognise a financial asset or financial liability when it becomes party to the contractual provisions of the instrument. In simple terms, recognition occurs when the contract creates enforceable rights and obligations.

For example, if a company issues a loan note, it has entered into a contract to pay cash in the future, so it recognises a financial liability. The investor who buys the loan note recognises a financial asset because it has a contractual right to receive cash.

> **Key Term: Financial asset**
> Cash, an equity instrument of another entity, or a contractual right to receive cash or another financial asset.

Trade receivables are financial assets because the seller has a contractual right to receive cash from the customer. Loan note investments are also financial assets because the investor has a right to interest and principal cash flows.

> **Key Term: Financial liability**
> A contractual obligation to deliver cash or another financial asset to another entity.

Trade payables, bank loans and most redeemable loan notes are financial liabilities. For the issuer, a promise to repay cash is not equity merely because the instrument is called “preference shares” or “loan stock”. Substance is tested by asking whether the issuer has a contractual obligation to transfer cash.

> **Key Term: Equity instrument**
> A contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

Ordinary shares issued by a company are normally equity instruments from the issuer’s point of view. From the investor’s point of view, those shares are financial assets.

Financial assets and financial liabilities are treated differently under IFRS 9:

- Financial assets are classified mainly by looking at the business model and the contractual cash flows.
- Financial liabilities are generally measured at amortised cost, unless they are held for trading, are derivatives, or are designated at FVTPL where permitted.
- Equity investments held as assets are measured at fair value, with changes normally taken to profit or loss unless an election is made for certain non-trading equity investments to take changes to OCI.

> **Test Tip:**
> In FR questions, first decide whose accounts you are preparing. A loan note is a liability for the issuer but a financial asset for the investor. The accounting answer can change completely depending on the entity’s role.

### The business model test: how the asset is managed

The business model test asks how the entity manages a group of financial assets to generate cash flows. It is not based purely on management’s stated intention for one individual asset. Instead, it considers how the assets are managed in practice, using evidence such as reporting to management, frequency of sales, risk management and how performance is assessed.

> **Key Term: Business model**
> The way an entity manages financial assets in order to generate cash flows, such as collecting contractual cash flows, selling assets, or both.

IFRS 9 uses the business model test only for financial assets that are debt-type instruments. It does not apply to ordinary share investments, because shares do not have contractual principal and interest cash flows.

There are three main business model outcomes for debt financial assets.

First, the asset may be held to collect contractual cash flows. This means the entity’s aim is to hold the asset and receive the agreed interest and principal payments. A simple example is a company buying a five-year loan note and planning to hold it until maturity to receive annual interest and repayment of principal.

This model can still allow some sales. For example, occasional sales due to a rise in credit risk may still be consistent with holding assets to collect cash flows. However, frequent buying and selling to benefit from fair value changes would not fit this model.

Second, the asset may be held both to collect contractual cash flows and to sell. In this case, both collecting cash flows and selling financial assets are key to achieving the business model. For example, a treasury department may hold bonds to collect interest but also sell some bonds to manage liquidity needs.

Third, the asset may be managed on another basis, such as trading or performance management on a fair value basis. In that case, it does not meet either of the first two models and is classified at FVTPL.

> **Key Term: Contractual cash flows**
> The cash receipts or payments that arise from the terms of a financial instrument, such as interest and repayment of principal.

The business model test must be applied before deciding the final classification, but passing a suitable business model test is not enough. The asset must also pass the SPPI test.

> **Exam Warning:**
> Do not classify a debt investment at amortised cost just because the entity says it “intends to hold it”. You must also check whether the contractual cash flows are only principal and interest.

### The SPPI test: principal and interest only

SPPI stands for “solely payments of principal and interest”. The test asks whether the contractual terms of the debt asset give rise on specified dates to cash flows that are only payments of principal and interest on the principal outstanding.

> **Key Term: SPPI test**
> The IFRS 9 test that asks whether a debt financial asset’s contractual cash flows are solely payments of principal and interest.
>
> **Key Term: Principal**
> The fair value of the financial asset at initial recognition, adjusted over time for repayments.
>
> **Key Term: Interest**
> Consideration for the time value of money, credit risk, other basic lending risks and costs, and a profit margin.

A plain fixed-rate loan usually passes SPPI. For example, an entity buys a $1 million loan note that pays 6% annual interest and repays $1 million at maturity. The investor receives interest and repayment of principal only, so the SPPI test is passed.

A variable-rate loan can also pass SPPI if the variable rate reflects basic lending features, such as market interest rates plus a credit margin. The fact that interest changes does not automatically cause failure. The key question is what the return is linked to.

A zero-coupon bond may also pass SPPI. Although no cash interest is paid each year, the investor receives a return through the difference between the issue price and the redemption amount. If that return represents basic lending interest, the cash flows can still be principal and interest.

In contrast, the SPPI test fails where the holder’s return is linked to something other than basic lending risks and costs. Examples include:

- a loan note where interest is linked to the issuer’s profit;
- a bond whose return varies with a stock market index;
- a debt instrument linked to a commodity price, such as gold or oil;
- a convertible loan note held as an investment, where the holder can convert into shares;
- an instrument where cash flows vary with the value of the issuer’s shares.

These features expose the investor to risks or returns that are not merely time value of money and credit risk. Therefore, the asset fails SPPI and is classified at FVTPL.

For example, suppose Penfold Co buys a five-year loan note for $500,000. It receives fixed annual interest and repayment of principal at maturity. If Penfold holds the asset to collect the contractual cash flows, the asset may be measured at amortised cost. However, if the same loan note pays interest based on the movement in a share price index, it fails SPPI. It would be classified at FVTPL, even if Penfold intends to hold it for five years.

> **Test Tip:**
> In an exam scenario, scan the contractual terms for words such as “linked to profits”, “linked to an index”, “convertible into shares”, or “based on commodity prices”. These are strong indicators that SPPI may fail.

For financial assets with embedded derivative-type features, IFRS 9 does not normally split the asset into a host asset and embedded derivative. Instead, the whole financial asset is assessed under the SPPI test. If the whole instrument fails, it is measured at FVTPL.

This is a common exam trap with convertible loan notes. If the question is about the issuer, IAS 32 may require a split between liability and equity components. If the question is about the holder of the convertible loan note as an investment, the conversion feature usually means the contractual cash flows are not only principal and interest, so the financial asset is measured at FVTPL.

### Classification outcomes for financial assets

Once you have applied both tests, classification follows a clear decision path.

A debt financial asset is measured at amortised cost if:

- the business model is to hold the asset to collect contractual cash flows; and
- the SPPI test is passed.

> **Key Term: Amortised cost**
> A measurement basis that uses the effective interest method to allocate interest income or expense over the life of a financial asset or liability.

Under amortised cost, the asset is initially recorded at fair value plus directly attributable transaction costs. Interest income is calculated using the effective interest rate. Cash receipts reduce the carrying amount as appropriate. This classification is common for trade receivables and loan note investments held to maturity.

A debt financial asset is measured at FVOCI if:

- the business model is both to collect contractual cash flows and to sell financial assets; and
- the SPPI test is passed.

> **Key Term: FVOCI**
> Fair value measurement with qualifying gains and losses reported in OCI rather than immediately in profit or loss.

For debt assets at FVOCI, interest income is still calculated using the effective interest method and recognised in profit or loss. Fair value changes are reported in OCI. On disposal, cumulative gains or losses are usually reclassified to profit or loss for debt instruments.

A debt financial asset is measured at FVTPL if it does not qualify for amortised cost or FVOCI. This includes debt assets held for trading, assets managed on a fair value basis, and assets that fail SPPI.

> **Key Term: FVTPL**
> Fair value measurement with gains and losses recognised in profit or loss.

FVTPL is the default “residual” classification for debt financial assets that do not meet the stricter conditions for amortised cost or FVOCI. If an asset fails SPPI, there is no need to keep testing the business model for amortised cost or FVOCI: the classification is FVTPL.

Equity investments are different. Ordinary shares do not contain contractual payments of principal and interest. Therefore, the business model and SPPI tests are not used. Under IFRS 9, investments in equity instruments are measured at fair value. In the absence of an election at initial recognition, changes in fair value go to profit or loss. This is a common ACCA FR objective test point.

For certain equity investments not held for trading, an entity may make an irrevocable election at initial recognition to present fair value changes in OCI. However, for FR purposes, if the question says there is no such election, the answer is fair value through profit or loss.

> **Exam Warning:**
> Do not apply amortised cost to an ordinary share investment. Shares are equity investments from the holder’s point of view and are measured at fair value, usually through profit or loss.

IFRS 9 also permits some financial assets to be designated at FVTPL at initial recognition if doing so reduces or eliminates an accounting mismatch. This is less common in FR questions than the basic business model and SPPI tests, but it explains why a question may state that an asset has been designated at FVTPL.

For financial liabilities, the classification rules are less focused on the business model and SPPI tests. Most financial liabilities, such as trade payables, bank loans and issued loan notes, are measured at amortised cost using the effective interest method. Some liabilities, such as derivative liabilities or liabilities held for trading, are measured at FVTPL.

### Applying the tests in ACCA FR questions

A good exam approach is to follow a fixed sequence.

Step one: identify the instrument. Ask whether it is cash, a receivable, a payable, a loan, a bond, a share investment or another contract.

Step two: identify the reporting entity. The same contract can be a financial asset for one party and a financial liability or equity instrument for another.

Step three: if it is a debt financial asset, apply the SPPI test. Look at what cash flows the investor is entitled to receive. Are they only repayment of principal and basic interest? If not, classify at FVTPL.

Step four: if SPPI is passed, apply the business model test. Is the asset held to collect cash flows, held to collect and sell, or held for trading/fair value management?

Step five: select the classification:

- hold to collect plus SPPI passed: amortised cost;
- hold to collect and sell plus SPPI passed: FVOCI;
- any other debt asset: FVTPL;
- equity investment: fair value, normally FVTPL unless an election is stated.

Consider these short examples.

> **Question:**
> A company buys a five-year loan note at a discount. It carries fixed interest and will be redeemed at par. The company intends to hold it to receive contractual cash flows.
> **Answer:**
> This is a debt financial asset. The cash flows are interest and principal, so SPPI is passed. The business model is hold to collect. Classification: amortised cost.
>
> **Question:**
> A company buys bonds that pay interest and repay principal, but the treasury function both collects interest and regularly sells bonds to manage liquidity.
> **Answer:**
> SPPI is passed. The business model is both collecting cash flows and selling. Classification: FVOCI.
>
> **Question:**
> A company buys a note whose return moves directly with a market index.
> **Answer:**
> The return is not solely principal and interest. SPPI fails. Classification: FVTPL.
>
> **Question:**
> A company buys ordinary shares in another entity and makes no special election at initial recognition.
> **Answer:**
> The investment is an equity financial asset. It is measured at fair value with gains and losses in profit or loss.
IFRS 7 supports this area by requiring disclosure of the significance of financial instruments and the nature and extent of risks arising from them, such as credit risk, liquidity risk and market risk. In FR, detailed disclosure questions are less likely than practical classification and measurement issues, but awareness of IFRS 7 helps explain why users need clear information about financial instrument categories.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- IFRS 9 requires recognition when an entity becomes party to the contractual provisions of a financial instrument.
- A financial instrument creates a financial asset for one entity and a financial liability or equity instrument for another.
- The business model and SPPI tests are used to classify debt financial assets.
- The business model test assesses how groups of financial assets are managed to generate cash flows.
- A hold-to-collect business model can lead to amortised cost if SPPI is passed.
- A hold-to-collect-and-sell business model can lead to FVOCI if SPPI is passed.
- The SPPI test requires cash flows to be solely payments of principal and interest.
- Returns linked to profits, share prices, commodities or market indices usually fail SPPI.
- Debt financial assets that fail SPPI are measured at FVTPL.
- Equity investments are measured at fair value, normally with changes in profit or loss unless an election is stated.
- Most financial liabilities are measured at amortised cost rather than being classified using business model and SPPI tests.
- In FR questions, always identify the reporting entity before deciding whether the instrument is an asset, liability or equity.

## Key Terms and Concepts

- Financial instrument
- Financial asset
- Financial liability
- Equity instrument
- Business model
- Contractual cash flows
- SPPI test
- Principal
- Interest
- Amortised cost
- FVOCI
- FVTPL


Recognition and classification - Business model and SPPI tests