Classification and measurement (ifrs 9/ias 32) - sppi test a...

Learning Outcomes

After completing this article, you will be able to determine how financial assets and liabilities are classified and measured under IFRS 9 and IAS 32, explain the 'solely payments of principal and interest' (SPPI) test and business model assessment, and apply these principles to distinguish between equity and financial liabilities. You should also be confident in recognizing and explaining the impact of these classifications for ACCA exam scenarios.

ACCA Strategic Business Reporting (SBR) Syllabus

For ACCA Strategic Business Reporting (SBR), you are required to understand the basis for classifying and measuring financial instruments according to IFRS 9 and IAS 32. In your revision, focus on:

• The definitions of financial assets, financial liabilities, and equity instruments
• The classification of financial assets and liabilities at initial recognition
• Application of the SPPI test to assess the nature of cash flows
• Assessment of the business model for managing financial assets
• Reclassification rules and subsequent measurement (amortised cost, fair value through OCI, fair value through profit or loss)
• Differentiating between equity instruments and financial liabilities under IAS 32

Test Your Knowledge

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

1. Which of the following features would most likely cause a debt instrument to fail the SPPI test?
   1. Fixed principal and interest payments
   2. Principal plus interest linked to a fixed benchmark rate
   3. Payments linked to equity returns or commodity prices
   4. Principal plus interest based on time value of money
2. An entity purchases a bond with fixed interest which it may sell before maturity to fund new investments as needed. The business model is best described as:
   1. Hold to collect
   2. Hold to collect and sell
   3. Held for trading
   4. None of the above
3. According to IAS 32, which feature would make a preference share a liability?
   1. Dividends are paid only at the issuer’s discretion
   2. The issuer has a contractual obligation to redeem the shares for cash
   3. No requirement to repay principal
   4. Dividends are non-cumulative

4. True or false? A loan with interest rate payments linked to the debtor’s profitability can be measured at amortised cost under IFRS 9.

Introduction

The classification and measurement of financial assets and liabilities are critical for accurate financial reporting under IFRS. IFRS 9 sets out a model requiring both an assessment of an entity’s business model and an analysis of the asset’s contractual cash flows (the SPPI test). IAS 32, meanwhile, provides the definitions distinguishing financial liabilities from equity instruments, essential for proper presentation. For ACCA SBR, you must know how to apply these tests and assessments, and understand the consequences for subsequent measurement and profit or loss reporting.

Defining Financial Instruments

A financial instrument is any contract that creates a financial asset for one entity and a financial liability or equity instrument for another.

Key Term: Financial asset
A resource with a contractual right to receive cash or another financial asset, or to exchange financial instruments under favorable conditions.

Key Term: Financial liability
A contractual obligation to deliver cash or another financial asset, or to exchange financial instruments under unfavorable conditions.

Key Term: Equity instrument
Any contract that evidences a residual interest in an entity’s net assets after deducting all its liabilities.

Classification of Financial Assets

At initial recognition, financial assets are classified into one of three categories:

• Amortised cost
• Fair value through other comprehensive income (FVOCI)
• Fair value through profit or loss (FVTPL)

The classification depends on two assessments:

1. The business model assessment
2. The SPPI test (Solely Payments of Principal and Interest)

Business Model Assessment

Entities must assess how they manage groups of financial assets. The main business models under IFRS 9 are:

• Hold to collect: The objective is to collect contractual cash flows from assets.
• Hold to collect and sell: Assets are managed both to collect cash flows and to sell.
• Other business models: Includes trading or managing assets for fair value gains.

The business model assessment is made at a portfolio level, not per instrument.

Key Term: Business model assessment
The evaluation of how an entity manages groups of financial assets to achieve specific objectives (e.g., collecting contractual cash flows, selling, or trading).

The SPPI Test

To measure at amortised cost or FVOCI, contractual cash flows must be solely payments of principal and interest on the principal outstanding.

The SPPI test checks whether:

• Principal is simply the fair value at initial recognition, which may increase or decrease over time.
• Interest consists only of consideration for time value of money, credit risk, other basic lending risks, and a profit margin.

If cash flows depend on factors unrelated to a basic lending arrangement (e.g., linkages to equity, commodities, or other variables), the SPPI test fails.

Key Term: SPPI test
A test to determine if the contractual cash flows are solely payments of principal and interest, qualifying for measurement at amortised cost or FVOCI.

If Either Test is Failed

Where the asset does not pass the business model or SPPI test, it must be classified and measured at fair value through profit or loss.

Classification of Financial Liabilities and Equity (IAS 32)

The distinction between liabilities and equity is fundamental for presenting instruments correctly.

• A financial liability exists if the issuer has a contractual obligation to deliver cash (e.g., mandatory redemption, variable payments).
• An equity instrument exists if the instrument evidences only a residual interest (e.g., perpetual shares with discretionary dividends).

Preference shares may be classified as liabilities or equity depending on redemption and payment obligations.

Worked Example 1.1

An entity issues preference shares redeemable at a fixed date for cash, with mandatory coupon payments. How should they be classified under IAS 32?

Answer:
Because the shares require repayment in cash at a set date and have mandatory payments, they are financial liabilities. The issuer has a contractual obligation to deliver cash.

Subsequent Measurement

• Amortised cost: Applies if business model is ‘hold to collect’ and SPPI test is passed. Income and impairment recognized in profit or loss.
• FVOCI: If business model is ‘hold to collect and sell’ and SPPI is passed, fair value changes go to OCI and are recycled on disposal.
• FVTPL: Used when asset fails either test or is held for trading; changes in fair value and income recognized in profit or loss.

Liabilities are generally measured at amortised cost unless held for trading or designated at FVTPL (with specific rules for fair value changes due to own credit risk).

Worked Example 1.2

An entity purchases a bond whose cash flows depend on the performance of a stock index. The intent is to hold for interest collection.

Does this asset qualify for amortised cost measurement?

Answer:
No. Although the intent is to collect payments, the cash flows are not solely principal and interest due to their stock index linkage. The instrument must be measured at fair value through profit or loss.

Worked Example 1.3

A company acquires notes paying fixed interest, allowing sales when liquidity needs arise. Most assets are held to collect payments, but some are sold.

How is the business model classified, and what is the measurement basis?

Answer:
If sales occur infrequently and incidental to collecting cash flows, the business model is ‘hold to collect’ and amortised cost applies. However, if selling is central to the business model, measurement at FVOCI or FVTPL is required depending on SPPI test outcome.

Exam Warning

Always assess both the business model and SPPI test before classifying a financial asset. Do not assume intent to collect alone is sufficient for amortised cost – examine the actual management of the portfolio and the nature of the cash flows.

Reclassification

Reclassification of financial assets after initial recognition occurs only if the business model changes significantly. Reclassification requires reassessment and prospective application; retrospective adjustments are not permitted.

Financial Liability Modifications

Under IAS 32, modifications that do not result in derecognition are accounted for by recalculating amortised cost. Substantial modifications, or those resulting in the expiration of the original liability, require derecognition with any difference recognized in profit or loss.

Summary Table: Classification of Financial Assets

Key Point Checklist

This article has covered the following key knowledge points:

• Define financial asset, financial liability, and equity instrument per IFRS 9/IAS 32
• Apply the business model assessment to financial assets
• Perform the SPPI test for contractual cash flows
• Classify financial assets by both tests and determine measurement basis
• Distinguish liabilities from equity instruments under IAS 32
• Recognize when and how reclassification may occur

Key Terms and Concepts

• Financial asset
• Financial liability
• Equity instrument
• Business model assessment
• SPPI test