IFRS 9 Financial Instruments: Classification and Measurement of Financial Assets and Liabilities

IFRS 9 Financial Instruments: Classification and Measurement

By Sai Manikanta Pedamallu (ACCA, CMA US, CSCA US, CGMA, ACMA, Dip IFRS, M.Com, MBA, MA)

Lead Instructor, Global Fin X | www.globalfinx.in/manikanta

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IFRS 9 is one of the most consequential standards in financial reporting. It replaced IAS 39, which was widely considered unworkable. The IAS 39 categories, loans and receivables, held-to-maturity, available-for-sale, fair value through profit or loss, were rigid, rule-driven, and produced outcomes that did not always reflect economic reality. IFRS 9 replaced all of that with a logic-based classification framework driven by two questions: how is the asset managed, and what do its cash flows look like?

This post covers classification and measurement of financial assets and financial liabilities under IFRS 9. Impairment (the expected credit loss model) is Post 18. Hedge accounting is Post 19. IFRS 9 in Indian banking is Post 20.

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What Is a Financial Instrument

Before classification, you need to know what you are classifying.

A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Three components:

Financial asset: cash, an equity instrument of another entity, a contractual right to receive cash or another financial asset, or a contractual right to exchange financial instruments under potentially favourable conditions.

Financial liability: a contractual obligation to deliver cash or another financial asset, or to exchange financial instruments under potentially unfavourable conditions.

Equity instrument: any contract that evidences a residual interest in the assets of an entity after deducting all liabilities.

Recognising what falls inside this definition is the first practical skill. Trade receivables are financial assets. Prepayments are not (no contractual right to receive cash; you receive goods or services). Inventory is not. A lease liability under IFRS 16 is a financial liability. A provision under IAS 37 may or may not be depending on whether it involves an obligation to deliver cash.

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Classification of Financial Assets: The Two-Test Framework

IFRS 9 classifies financial assets based on two criteria applied together:

• The business model within which the financial asset is held
• The contractual cash flow characteristics of the financial asset (the SPPI test)

Both tests must be applied. The outcome of both together determines the classification category.

Test 1: The Business Model Test

The business model is determined at a level that reflects how groups of financial assets are managed, not instrument by instrument. It is based on how management actually manages the assets, evidenced by observable facts: how performance is evaluated, how managers are compensated, how risks are managed, and how cash flows are generated.

Three business models exist under IFRS 9:

Hold to collect: the objective is to hold financial assets to collect contractual cash flows. Sales are incidental, not a primary objective. Some sales are consistent with this model: sales of credit-impaired assets, sales close to maturity, or infrequent sales in response to an increase in credit risk. Frequent, high-volume sales are not consistent.

Hold to collect and sell: the objective is achieved both by collecting contractual cash flows and by selling assets. Both activities are integral to the strategy, not incidental. A bank managing a liquidity portfolio that holds bonds and sells them periodically to meet liquidity needs operates in this model.

Other (residual): everything else. Assets managed with the objective of realising cash flows through sale. Trading portfolios. This model results in FVTPL classification.

The business model is an observable fact, not a stated intention. An entity cannot designate a portfolio as hold-to-collect if the actual evidence, frequency of sales, manager incentives, performance measurement, shows it is actively trading.

Indian context: SBI manages its statutory liquidity ratio (SLR) portfolio of government securities primarily to meet RBI's SLR requirements. It holds them to collect interest and may sell selectively to manage liquidity. This is a hold-to-collect or hold-to-collect-and-sell model depending on the frequency and significance of sales. Infosys manages a treasury portfolio of fixed deposits and liquid mutual funds with the objective of generating returns on surplus cash, with active reallocation between instruments. Depending on the specific instruments, the business model may be hold-to-collect (fixed deposits held to maturity) or other (liquid funds with frequent redemptions).

Test 2: The SPPI Test

SPPI stands for Solely Payments of Principal and Interest. The contractual cash flows of a financial asset must represent solely payments of principal and interest on the outstanding principal amount for the asset to qualify for amortised cost or FVOCI. If the cash flows include anything else, the asset is FVTPL.

Principal is the fair value of the financial asset at initial recognition. Over time, as repayments are made, principal outstanding reduces.

Interest is compensation for the time value of money and for credit risk on the outstanding principal. It can also include compensation for other basic lending risks (liquidity risk, administrative costs) and a profit margin.

Cash flows pass the SPPI test when they represent a basic lending arrangement. They fail when:

• They are linked to equity performance or an equity index (not interest on principal)
• They involve leverage (the cash flows are disproportionate to changes in underlying economic conditions)
• The instrument is a convertible bond (conversion feature introduces non-SPPI cash flows)
• The cash flows depend on complex contractual features unrelated to basic lending risks

What passes SPPI:

• Fixed-rate bonds and loans
• Floating rate loans tied to a benchmark rate (MIBOR, SOFR) plus a spread
• Loans with prepayment features, provided the prepayment amount approximates unpaid principal plus interest (reasonable compensation for early termination)
• Inflation-linked instruments where inflation adjustment relates to the time value of money in the currency of the instrument

What fails SPPI:

• Convertible bonds (the equity conversion feature creates non-SPPI cash flows)
• Loans whose interest rate resets inversely to market rates (inverse floaters)
• Instruments with leverage features
• Equity-linked notes where returns depend on equity indices
• Instruments with contingent features that can modify cash flows based on ESG targets or non-lending factors (subject to the 2024 amendments on ESG-linked features)

Indian context: A plain vanilla bank loan by HDFC Bank to a corporate borrower at MIBOR plus 200 basis points passes SPPI. A structured note issued by an NBFC with returns linked to the Nifty 50 index fails SPPI. An optionally convertible debenture issued by a startup, where the investor can convert to equity, may fail SPPI because the conversion option introduces non-basic-lending cash flows into the instrument's contractual terms.

The Classification Matrix

Equity instruments: equity instruments never pass SPPI (they represent a residual interest, not a payment of principal and interest). They are always FVTPL by default, with an irrevocable option to designate them at FVOCI without recycling.

Mandatory FVTPL: any financial asset that does not qualify for amortised cost or FVOCI must be measured at FVTPL. There is also a fair value option: an entity may irrevocably designate a financial asset as FVTPL at initial recognition if doing so eliminates or significantly reduces an accounting mismatch that would otherwise arise.

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Measurement of Financial Assets

Initial Measurement

All financial assets are initially measured at fair value. For assets not at FVTPL, transaction costs are added to the initial fair value. For FVTPL assets, transaction costs are expensed immediately.

For most assets, fair value at initial recognition equals the transaction price. But when the transaction price differs from fair value (for example, a below-market rate loan), the asset is recognised at fair value and the difference is recognised immediately as a gain or loss, or deferred depending on the nature of the transaction.

Subsequent Measurement: Amortised Cost

Amortised cost assets are measured using the effective interest method. The effective interest rate (EIR) is the rate that exactly discounts estimated future cash flows to the asset's gross carrying amount at initial recognition.

Interest income is recognised in profit or loss using the EIR. Expected credit losses are recognised as impairment (covered in Post 18). Foreign exchange differences on the monetary asset are recognised in profit or loss.

Worked example: corporate bond at amortised cost

Tata Motors holds a 3-year corporate bond issued by a steel company. Face value: Rs. 100 crore. Coupon: 8% annually. Purchase price: Rs. 97 crore (at a discount, yielding approximately 9.1%). Business model: hold to collect. SPPI: passes. Classification: amortised cost.

The EIR is 9.1% (approximately). Each year, interest income recognised = carrying amount × 9.1%. The carrying amount increases from Rs. 97 crore toward Rs. 100 crore at maturity as the discount unwinds. The 8% coupon received in cash each year is the cash flow; the EIR interest income is the P&L recognition amount. The difference accretes the carrying amount.

Rounding aside, the bond accretes to Rs. 100 crore at maturity. This is the amortised cost mechanics.

Subsequent Measurement: FVOCI (Debt Instruments, with Recycling)

FVOCI debt instruments are measured at fair value on the balance sheet. But the P&L treatment mirrors amortised cost: interest income is recognised using the EIR, impairment is recognised in profit or loss (same ECL model as amortised cost), and foreign exchange differences on amortised cost are in profit or loss.

The difference between the fair value carrying amount and what the amortised cost carrying amount would have been goes to OCI. When the asset is sold or derecognised, the cumulative OCI balance recycles into profit or loss.

This category is designed for portfolios where selling is part of the strategy but the portfolio has the character of a lending portfolio. Indian banks managing their SLR bond portfolios often use this category for bonds they may sell to manage liquidity but that otherwise bear basic lending cash flows.

The key insight: the P&L impact of a FVOCI debt instrument is identical to an amortised cost asset during the holding period. The OCI balance absorbs fair value volatility without hitting profit or loss. On sale, the recycled OCI converts to profit or loss, showing the total gain or loss over the holding period.

Subsequent Measurement: FVTPL

Fair value changes go directly to profit or loss. No OCI buffer. No amortised cost mechanics. The full fair value change each period hits the income statement.

This produces volatility. For trading portfolios this is appropriate. For assets classified here because they failed SPPI or are in an "other" business model, the volatility is the price of the classification.

Dividends from FVTPL equity investments are recognised in profit or loss when the right to receive payment is established.

FVOCI for Equity Instruments: The Irrevocable Election (No Recycling)

An entity can irrevocably elect, on an instrument-by-instrument basis, to present changes in fair value of an equity investment in OCI rather than profit or loss. The election is available only if the instrument is not held for trading and is not contingent consideration in a business combination.

Key feature: no recycling. When the investment is sold, the cumulative OCI balance does not go to profit or loss. It stays in equity (can be transferred to retained earnings within equity). Dividends from these instruments are recognised in profit or loss.

This election is used for strategic equity holdings where the entity does not want fair value volatility running through its income statement. Indian banks holding cross-shareholding stakes, industrial groups holding minority stakes in associates that do not qualify for equity method accounting, and insurance companies holding equity portfolios use this election.

The no-recycling feature has a practical implication: on disposal, the gain or loss is never in profit or loss. An entity that holds a Rs. 500 crore equity investment at FVOCI (no recycling), which appreciates to Rs. 800 crore before sale, never recognises that Rs. 300 crore gain in profit or loss. Analysts need to know this to understand the total return on such investments.

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Reclassification of Financial Assets

Reclassification between categories is permitted but only when an entity changes its business model for managing financial assets. This must be a significant change, observable to external parties, and not a routine response to market conditions.

Examples of genuine business model changes: a bank decides to exit a particular lending segment and moves the portfolio from hold-to-collect to held-for-sale; an entity acquires a new business line that changes the purpose of a specific portfolio.

Reclassification is applied prospectively from the reclassification date. No restatement. Prior period gains or losses already recognised are not reversed.

Reclassification is expected to be infrequent. The emphasis in IFRS 9 on business model determination at initial recognition is designed to minimise subsequent reclassifications. An entity that reclassifies frequently has almost certainly been misclassifying from the start.

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Classification and Measurement of Financial Liabilities

Financial liabilities are simpler than financial assets under IFRS 9. The classification changes from IAS 39 are minimal. The main change is the treatment of own credit risk for liabilities designated at FVTPL.

Two Categories

Amortised cost: the default for almost all financial liabilities. Trade payables, bank loans, bonds issued, lease liabilities (IFRS 16). Initially recognised at fair value less transaction costs. Subsequently measured using the EIR method. Interest expense recognised in profit or loss.

FVTPL: either mandatorily (derivatives, financial liabilities held for trading) or through the fair value option (FVO). The FVO allows an entity to irrevocably designate a financial liability at FVTPL at initial recognition when:

• Doing so eliminates or significantly reduces an accounting mismatch, or
• The liability contains an embedded derivative that would otherwise require bifurcation, or
• It is managed and evaluated on a fair value basis

Own Credit Risk: The Critical Change from IAS 39

Under IAS 39, if an entity designated a financial liability at FVTPL, all fair value changes, including those caused by changes in the entity's own credit risk, went to profit or loss. This produced a counterintuitive result: when a company's credit quality deteriorated (increased default risk), the fair value of its liabilities fell, producing a gain in profit or loss. A company in financial distress could report a P&L gain because the market was pricing in the possibility it might not repay its debt. The IASB acknowledged this was wrong.

Under IFRS 9, for financial liabilities designated at FVTPL, the change in fair value attributable to changes in the entity's own credit risk goes to OCI, not profit or loss. The remaining change in fair value (driven by market interest rates, other factors) goes to profit or loss as before. The OCI balance for own credit risk changes is never recycled to profit or loss.

Worked example: own credit risk

Axis Bank designates a structured note it has issued at FVTPL. During the year, the note's fair value decreases by Rs. 50 crore. Rs. 30 crore of this decrease is due to rising market interest rates. Rs. 20 crore is due to deterioration in Axis Bank's own credit quality (wider credit spreads on its debt).

Under IFRS 9:

• Rs. 30 crore gain (liability decrease due to market rates): profit or loss
• Rs. 20 crore gain (liability decrease due to own credit deterioration): OCI, no recycling

The income statement shows a Rs. 30 crore gain. The equity shows a Rs. 20 crore OCI credit. The counterintuitive profit from the entity's own credit deterioration does not hit earnings.

Hybrid Financial Liabilities: Bifurcation

Financial liabilities containing embedded derivatives must still be bifurcated under IFRS 9 (unlike financial assets, where the whole instrument is classified without bifurcation). The host contract is classified as a financial liability (usually amortised cost). The embedded derivative is separated and measured at FVTPL.

Common examples: convertible bonds (the conversion option is bifurcated as an equity or derivative component), bonds with embedded equity options, structured deposits where the return is linked to an equity index.

Indian context: CCPS (compulsorily convertible preference shares) issued by Indian startups and growth companies require careful analysis. If the conversion terms are at a fixed ratio, the conversion feature may be equity (IAS 32 governs classification of the instrument as a whole as debt or equity). If conversion is at variable terms linked to a future equity raise valuation, the instrument may have an embedded derivative requiring bifurcation.

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The Fair Value Option for Financial Assets and Liabilities

IFRS 9 permits irrevocable designation at FVTPL for both assets and liabilities to eliminate accounting mismatches. The FVO is designed for situations where measuring an asset and its associated liability at different bases (one at fair value, one at amortised cost) creates artificial volatility in the income statement.

Classic FVO scenario: a bank holds a loan portfolio (otherwise measured at amortised cost) that it has economically hedged with interest rate swaps (measured at FVTPL). Without FVO, the loan fair value changes do not hit P&L but the swap fair value changes do, creating volatility. Designating the loans at FVTPL under FVO eliminates the mismatch: both the loans and the swaps are at FVTPL, and fair value changes offset in P&L.

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Embedded Derivatives in Financial Assets

Under IAS 39, embedded derivatives in financial assets were separated from the host contract and measured at FVTPL. Under IFRS 9, this bifurcation requirement is eliminated for financial assets. Instead, the entire hybrid instrument is classified based on the business model and SPPI test applied to the whole contract.

If the embedded feature causes the contractual cash flows to fail SPPI, the whole instrument is FVTPL. No separation needed.

This simplification was operationally significant. Hybrid instruments that previously required two entries (host at amortised cost, derivative at FVTPL) are now one entry, classified based on the overall cash flow characteristics.

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Ind AS 109 vs IFRS 9: Classification and Measurement Differences

Ind AS 109 is substantially converged with IFRS 9 on classification and measurement. The framework is identical.

The RBI overlay is the most significant practical difference. Indian banks prepare financial statements under Ind AS 109 but are also subject to RBI's prudential norms for income recognition, asset classification (IRAC norms), and provisioning. Where Ind AS 109's ECL provisioning differs from RBI's mandatory provisioning requirements, the higher of the two provisions applies. This creates a dual-track provisioning system that most Indian bank auditors manage carefully at year end.

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What Big 4 Auditors Focus On

Business model documentation. Auditors test whether the stated business model is supported by observable evidence: sales data, manager briefings, performance measurement documents, investment policy statements. An entity that states hold-to-collect but has a pattern of frequent material sales faces a challenge.

SPPI assessment completeness. Auditors review whether all financial assets have been assessed for SPPI, not just the obvious cases. Structured instruments, complex loans, and instruments with contingent features (prepayment options, extension options, interest rate caps and floors) all require explicit SPPI analysis documented in working papers.

Own credit risk separation. For entities with FVTPL financial liabilities, auditors check that the own credit risk component has been correctly separated from the total fair value change and routed to OCI rather than profit or loss.

Reclassification completeness. Auditors assess whether any business model changes that occurred during the year have been identified and whether reclassifications have been processed correctly from the reclassification date.

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Dip IFRS Exam Angle

Classification is consistently tested. Expect scenario questions with a list of financial assets and the requirement to classify each, explaining the business model and SPPI test outcome for each.

The most commonly tested traps:

Equity instruments defaulting to FVTPL: students sometimes classify equity as FVOCI automatically. FVOCI for equity requires an explicit irrevocable designation. Without it, equity is FVTPL.

FVOCI recycling vs no recycling: debt instruments at FVOCI recycle to P&L on disposal. Equity instruments designated at FVOCI do not recycle. This distinction is a standard exam question.

Own credit risk: given a scenario where a company's credit quality changes and it has a liability at FVTPL, the question tests whether the credit risk component goes to OCI or P&L. Answer: OCI under IFRS 9.

Business model at portfolio level, not instrument level: a student who assesses business model for each individual instrument rather than the portfolio of assets managed together may reach the wrong conclusion.

Know the classification matrix cold. Know SPPI: what passes, what fails, and why. Know the FVOCI equity election and its no-recycling consequence. Know own credit risk for FVTPL liabilities.

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FAQ

Can an entity change its designation of an equity investment from FVTPL to FVOCI?

No. The FVOCI designation for equity is irrevocable and must be made at initial recognition. It cannot be changed after recognition.

Does the SPPI test apply to equity instruments?

No. Equity instruments are outside the SPPI test. They are always FVTPL unless designated at FVOCI on initial recognition.

What is the difference between FVOCI debt and FVOCI equity?

Debt at FVOCI: recycling on disposal, ECL applied, interest via EIR. Equity at FVOCI: no recycling, no ECL, dividends to P&L.

Can the FVO be revoked after initial designation?

No. All IFRS 9 elections, FVO, FVOCI equity designation, are irrevocable.

Is a bank guarantee a financial liability under IFRS 9?

Yes. A financial guarantee contract is a financial liability. IFRS 9 requires measurement at the higher of the ECL amount and the amount initially recognised less cumulative amortisation.

How does reclassification affect the EIR?

When an asset is reclassified from amortised cost or FVOCI to FVTPL, the fair value at the reclassification date becomes the new carrying amount. When reclassified from FVTPL to amortised cost, the fair value at reclassification becomes the new gross carrying amount, and a new EIR is established from that date.

Does IFRS 9 apply to investments in subsidiaries and associates?

No. Investments in subsidiaries, associates, and joint ventures measured under IFRS 10, IAS 27, or IAS 28 are outside IFRS 9's scope.

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This is Post 17 of the Global Fin X IFRS Series. Previous: IFRS 15 vs IAS 18. Next: IFRS 9 Part 2: The Expected Credit Loss Model.