Introduction

Publication date: 08 Dec 2017


6.4A.1 IAS 39 classifies all financial assets and financial liabilities into specific categories. The need to classify financial instruments into specific categories arises from the mixed measurement model in IAS 39, under which some financial instruments are carried at amortised cost whilst others are carried at fair value. Consequently, a particular financial instrument’s classification that is carried out at initial recognition drives the subsequent accounting treatment. IAS 39 prescribes four categories for financial assets and two categories for financial liabilities.

6.4A.2 IFRS 9 will replace IAS 39 in its entirety for periods on or after 1 January 2018. IFRS 9 now includes requirements for classification and measurement of financial instruments (both financial assets and financial liabilities), impairment of financial assets and general hedge accounting. IFRS 9 is dealt with in chapter 42.

Classification of financial assets

Publication date: 08 Dec 2017


6.4A.3 IAS 39 has four clearly defined categories of financial assets, as follows:

Financial assets ‘at fair value through profit or loss’.
Held-to-maturity investments.
Loans and receivables.
Available-for-sale financial assets.
[IAS 39 para 9].
 
The classification is important as it dictates how the financial assets and liabilities are subsequently measured in the financial statements. This classification is also relevant when looking at whether embedded derivatives (see chapter 6.3A) need to be bifurcated (split). In the above list, the first and the last items are measured at fair value whilst the remaining two are measured at amortised cost.

Classification of financial assets - Financial assets and liabilities at fair value through profit or loss - Definition

Publication date: 08 Dec 2017


6.4A.4 A financial asset or a financial liability can be classified as at fair value through profit or loss only if it meets either of the following conditions:

Upon initial recognition, it is designated by the entity as at fair value through profit or loss.
It is classified as held-for-trading.
[IAS 39 para 9].

6.4A.5 The fair value through profit or loss category incorporates items that are ‘held-for-trading’. More significantly, it also gives entities the option to classify any financial instrument at fair value with all gains and losses taken to profit and loss in restricted circumstances (see further para 6.4A.6).

Classification of financial assets - Financial assets and liabilities at fair value through profit or loss - Designation at fair value through profit or loss on initial recognition

Publication date: 08 Dec 2017


6.4A.6 An entity may designate a financial asset or a financial liability at fair value through profit or loss on initial recognition only in the following three circumstances:

The designation eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an ‘accounting mismatch’) that would otherwise arise (see para 6.4A.9).
A group of financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy (see para 6.4A.18).
The item proposed to be designated at fair value through profit or loss is a hybrid contract that contains one or more embedded derivatives unless:
  the embedded derivative(s) does not significantly modify the cash flows that otherwise would be required by the contract; or
  it is clear with little or no analysis when a similar hybrid (combined) instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a pre-payment option embedded in a loan that permits the holder to pre-pay the loan for approximately its amortised cost. [IAS 39 para 11A]. See further chapter 6.3A.
[IAS 39 para 9].

6.4A.7 The decision to designate a financial asset or a financial liability at fair value through profit or loss in the above situations is similar to an accounting policy choice where the policy selected is one that provides more relevant information. However, unlike an accounting policy choice, the above designation need not be applied consistently to all similar transactions. [IAS 39 para AG 4C]. In other words, the designation can be applied on an asset-by-asset or a liability-by-liability basis, with the result that different holdings of the same type of asset or liability may be accounted for differently, some using the fair value option and others not. For example, assume an entity expects to issue a number of similar financial liabilities amounting to C100 and expects to acquire a number of similar financial assets amounting to C50 that will be carried at fair value. Provided the criteria are satisfied, the entity may significantly reduce the measurement inconsistency by designating at initial recognition all of the assets but only some of the liabilities (for example, individual liabilities with a combined total of C45) as at fair value through profit or loss. The remaining liabilities amounting to C55 can still be carried at amortised cost.

6.4A.8 The option can be applied only to whole instruments and not to portions, such as component of a debt instrument (that is, changes in value attributable to one risk such as interest rate risk and not credit risk); or proportions (that is, percentages). [IAS 39 para AG 4G]. This is because it may be difficult to isolate and measure the portion of a financial instrument if the portion is affected by more than one risk; the amount recognised in the balance sheet for that portion would be neither fair value nor cost; and the fair value adjustment for the portion may move the carrying amount of an instrument away from its fair value.

Classification of financial assets - Financial assets and liabilities at fair value through profit or loss - Designation at fair value through profit or loss on initial recognition - Accounting mismatch

Publication date: 08 Dec 2017


6.4A.9 IAS 39 imposes a mixed measurement model under which some financial instruments are measured at fair value and others at amortised cost; some gains and losses are recognised in profit or loss and others initially in other comprehensive income. This combination of measurement and recognition requirements can result in inconsistencies (sometimes referred to as an ‘accounting mismatch’) between the accounting for an asset (or group of assets) and a liability (or group of liabilities). An accounting mismatch occurs when assets and liabilities that are economically related (that is, share a risk) are treated inconsistently. This could occur where, in the absence of the fair value option, a financial asset is classified as available-for-sale (with most changes in fair value recognised directly in other comprehensive income), while a related liability is measured at amortised cost (with changes in fair value not recognised). In such circumstances, an entity may conclude that its financial statements would provide more relevant information if both the asset and the liability were classified as at fair value through profit or loss. [IAS 39 para AG 4D].

6.4A.10 As explained above, the use of the fair value option may eliminate measurement anomalies for financial assets and liabilities that provide a natural offset of each other because they share the same risk, but where hedge accounting cannot be used because none of the instruments is a derivative. More importantly, even if some of the instruments are derivatives that could qualify for fair value hedge accounting, classification of both items at fair value through profit or loss achieves the same accounting result whilst avoiding the designation, tracking and assessing of hedge effectiveness that hedge accounting entails. It follows that the use of the fair value option as an alternative to hedge accounting can be of significant benefit to entities. However, such advantage also has a cost. Under the fair value option the entire change in fair value of the asset or liability would fall to be recognised in profit or loss, not simply the change in fair value attributable to the risk that is hedged by an offsetting derivative. As a result, the amount reported in profit or loss under the fair value option is unlikely to be the same as the change in fair value of the hedging derivative. This may lead to greater profit or loss volatility. Furthermore, hedge accounting can be revoked at any time, but the fair value option is irrevocable.

6.4A.11 The IASB has not established a percentage, or a ‘bright line’, for interpreting ‘significant’ in the context of an accounting mismatch. However, the Basis for Conclusion makes it clear that an effectiveness test similar to that used for hedge accounting is not required to demonstrate that a reduction in an accounting mismatch is significant. [IAS 39 BC para 75B]. This means judgement is required to determine when the fair value option should be applied. In this regard, management should look at the objective of the proposed designation as ‘at fair value through profit or loss’. Comparing the accounting impact – that is, the measurement basis and the recognition of gains and losses – of all relevant items (including, for example, any funding that it is not proposed to be designated at fair value through profit or loss) before and after the designation will give an indication of whether an accounting mismatch has been eliminated or significantly reduced.

6.4A.12 Although it is necessary to demonstrate that there is an accounting mismatch, the extent of evidence needed to identify the accounting mismatch for which the fair value option is to be used need not be extensive. It may be possible to use the same evidence for a number of similar transactions, depending on the circumstances – for example, by identifying a particular kind of accounting mismatch that arises from one of the entity’s chosen risk management strategies. It is not necessary to have the extensive documentation required for hedge accounting, but the entity does need to provide evidence that the fair value option was designated at inception. Also, IFRS 7 requires disclosure of the carrying amounts of assets and, separately, liabilities designated as ‘at fair value through profit or loss’. The evidence must, therefore, include precise identification of the assets and liabilities to which the fair value option has been applied.

Example 1 – Fixed rate assets financed by fixed rate debentures

An entity is about to purchase a portfolio of fixed rate assets that will be financed by fixed rate debentures. Both financial assets and financial liabilities are subject to the same interest rate risk that gives rise to opposite changes in fair value that tend to offset each other.

In the absence of the fair value option, the entity may have classified the fixed-rate assets as available-for-sale with gains and losses on changes in fair value recognised in other comprehensive income and the fixed-rate debentures at amortised cost. Reporting both the assets and the liabilities at fair value through profit and loss corrects the measurement inconsistency and produces more relevant information. [IAS 39 para AG 4E(d)(i)].

Example 2 – Fixed rate bond converted to floating rate

An entity purchases a fixed rate bond and immediately enters into an interest rate swap to convert the fixed rate to floating rate.

Instead of claiming hedge accounting, the entity could designate the bond at fair value through profit or loss. Since both the bond and the swap will be measured at fair value through profit or loss, the entity achieves a similar accounting result to if fair value hedge accounting has been applied, but without the added burden of designating, assessing and measuring hedge effectiveness that hedge accounting entails.

It should be noted that the bond is fully fair valued for all risks and not just for the hedged interest rate risk that hedge accounting would require. Furthermore, the fair value option is irrevocable. Hedge accounting is revocable (see chapter 6.8A).

Example 3 – Fixed rate loan offset by derivative liabilities

An entity is about to originate a 10-year fixed rate loan that, if not designated as at fair value through profit or loss, will be measured at amortised cost. The entity also has a nine-year derivative that it regards as related to, and shares the same risk as, the loan. The entity wishes to designate the asset as at fair value through profit or loss to eliminate the measurement and recognition inconsistency with the derivative.

Although, in this example, the relationship does not completely eliminate the economic exposure, the entity can still designate the asset at fair value through profit or loss. The difference in maturities does not prevent the entity from designating the asset at fair value through profit or loss, provided there is a perceived economic relationship between the asset and the derivative. The fair value option does not require the elimination of economic volatility; it requires the elimination or significant reduction of an accounting mismatch. In the above example, the asset is measured at amortised cost and the derivative is measured at fair value, hence the accounting mismatch. Secondly, there is a perceived economic relationship between the asset and liability – for example, they share a risk that gives rise to opposite changes in fair value that tend to offset.

Example 4 – Financing a group of loans with traded bonds

An entity is about to originate a specified group of loans to be financed by issuing traded bonds whose changes in fair value tend to offset each other. The entity expects to regularly buy and sell the bonds but rarely, if ever, to buy and sell the loans.

Reporting both the loans and the bonds at fair value through profit or loss eliminates the inconsistency in the timing of recognition of gains and losses that would otherwise result from measuring them both at amortised cost and recognising a gain or loss each time a bond is repurchased. [IAS 39 para AG 4E(d)(ii)].

Example 5 – Subsidiary’s debt offset by interest rate swap with parent

A subsidiary is about to issue a liability to a third party and enter into a related interest rate swap with its parent. An accounting mismatch exists in the subsidiary’s stand-alone financial statements, and it intends to designate the liability as at fair value through profit or loss.

Although it is appropriate for the subsidiary to designate the liability as at fair value through profit or loss in its individual financial statements, such designation is not possible in the consolidated financial statements. This is because the inter-company swap will be eliminated, and the ‘mismatch’ will not exist in the consolidated financial statements. However, if the parent can identify an external swap or other instrument that gives rise to an accounting mismatch on a consolidated basis, this may justify designating the liability as at fair value through profit or loss in the consolidated financial statements.

6.4A.13 An accounting mismatch need not occur only between related financial assets and financial liabilities. It could also occur between a financial asset and a related liability or between a financial liability and a related asset. In both situations, the entity may use the fair value option on, respectively, the financial asset or financial liability, provided it concludes that the changes in fair value of both items are subject to the same risk and an accounting mismatch will be eliminated or significantly reduced by the designation.

Example – Financial assets offsetting insurance liabilities

An insurer holds financial assets whose fair value exposure offsets that of liabilities under insurance contracts that are measured using techniques that incorporate current market information. The financial assets are not held for trading and would not automatically be measured at fair value.

Reporting both the insurance liabilities at a current value (as permitted by para 24 of IFRS 4) and the financial assets at fair value through profit or loss eliminates the inconsistency that would otherwise result from measuring the insurance liabilities at cost and the financial assets as available-for-sale or at amortised cost. [IAS 39 para AG 4E(b)].

6.4A.14 Designations as at fair value through profit or loss should be made at initial recognition and once made are irrevocable. For practical purposes, the entity need not enter into all of the assets and liabilities giving rise to measurement or recognition inconsistency at exactly the same time. A reasonable delay is permitted provided that each transaction is designated as at fair value through profit or loss at its initial recognition and, at that time, any remaining transactions are expected to occur. [IAS 39 para AG 4F].

6.4A.15 ‘Reasonable delay’ should be assessed on a case-by-case basis, based as to what is reasonable in the circumstances. For example, a ‘reasonable delay’ could be a fairly short period in the case of entering into a derivative to offset some of the risks of an asset. A longer period could be justified if the delay arises from the need to assemble a portfolio of similar assets and arrange their funding. However, all financial assets and liabilities designated as at fair value through profit or loss must be accounted for on this basis from their initial recognition (and not only from the time any offsetting position is entered into).

6.4A.16 It should be noted that if, for some reason, one of the offsetting instruments is de-recognised, for instance, the fixed rate assets in example 1 or the interest rate swap in example 2 in paragraph 6.4A.12 above, the other offsetting instrument – the fixed rate debentures in example 1 or the fixed rate bond in example 2 – would continue to be carried at fair value with gains and losses reported in profit or loss. This is because the designation at fair value through profit or loss at initial recognition is irrevocable, irrespective of whether the initial conditions that permitted the use of the option (to correct an accounting mismatch) still hold.

6.4A.17 IFRS 7 also requires the entity to provide disclosures about financial assets and financial liabilities it has designated as at fair value through profit or loss, including how it has satisfied those conditions. For instruments that qualify for designation as at fair value through profit or loss in accordance with paragraph 6.4A.9 above, the disclosure should include a narrative description of the circumstances underlying the measurement or recognition inconsistency that would arise. [IAS 39 para 9(b); IFRS 7 para B(5)]. See further chapter 6.9A.

Classification of financial assets - Financial assets and liabilities at fair value through profit or loss - Designation at fair value through profit or loss on initial recognition - Group of financial assets and liabilities managed on a fair value basis

Publication date: 08 Dec 2017


6.4A.18 An entity may manage and evaluate the performance of a group of financial assets, financial liabilities or both in such a way that measuring that group at fair value through profit or loss results in more relevant information. Therefore, in order to designate financial instruments at fair value through profit or loss under the second criterion in paragraph 6.4A.6 above, the designation should be based on the manner in which the entity manages and evaluates performance, rather than on the nature of those financial instruments. [IAS 39 para AG 4H]. An entity should designate all eligible financial instruments that are managed and evaluated together. [IAS 39 para AG 4J]. However, designation under this criterion must meet the following two requirements:

The financial instruments are managed and performance evaluated on a fair value basis in accordance with a documented risk management or investment strategy.
Information about the group is provided internally on that basis to the entity’s key management as defined in IAS 24 (for example, the entity’s board of directors and chief executive officer).
[IAS 39 para 9(b)(ii)].

6.4A.19 The requirement that a group of financial assets and liabilities should be managed and performance evaluated on a fair value basis means that management should evaluate the portfolio on a full fair value basis and not on a risk-by-risk basis. For example, an entity that originates fixed interest rate loans and manages the interest rate risk of this portfolio based on the fair value attributable only to interest rate changes will be unable to use the fair value option. This is because the fair value concept is a broader notion than hedge accounting, such that evaluating the portfolio’s performance for only some risks is not sufficient. Therefore, an entity’s risk management policy and the resulting management information should look at the entire change in fair value and not for only some risks to justify the fair value option’s use.

6.4A.20 The required documentation of the entity’s strategy need not be on an item-by-item basis, nor need it be in the level of detail required for hedge accounting. Documentation may be on a portfolio or group basis as long as it clearly identifies the items for which the fair value option is to be used. If the documentation relies on several other pre-existing documents, there needs to be an overall document that references these other documents and clearly demonstrates that the entity manages and evaluates the relevant financial assets or financial liabilities on a fair value basis. The documentation also needs to be sufficient to demonstrate that using the fair value option is consistent with the entity’s risk management or investment strategy. In many cases, the entity’s existing documentation, as approved by key management personnel, should be sufficient for this purpose. For example, if the performance management system for a group – as approved by the entity’s key management personnel – clearly demonstrates that its performance is evaluated on a total return basis, no further documentation is required to demonstrate compliance with the above requirements. [IAS 39 para AG 4K].

6.4A.21 As stated in paragraph 6.4A.17 above, IFRS 7 requires the entity to provide disclosures about financial assets and financial liabilities it has designated as at fair value through profit or loss, including how it has satisfied those conditions. For instruments that qualify for designation as at fair value through profit or loss as a group of financial assets on liabilities, in accordance with paragraph 6.4A.18 above, the disclosure should include a narrative description of how designation as at fair value through profit or loss is consistent with the entity’s documented risk management or investment strategy. [IAS 39 para 9(b); IFRS 7 para B(5)]. See further chapter 6.9A.

Example 1 – Portfolio of financial assets held by venture capital firms

A venture capital organisation invests in a portfolio of financial assets with a view to profiting from their total return in the form of interest or dividends and changes in fair value and evaluates its performance on that basis. Some investments meet the definition of associates and joint ventures, while others do not. None meet the definition of a subsidiary.

IAS 28 and IAS 31 allow such investments to be measured at fair value through profit or loss rather than using equity accounting.

The fair value option allows the other investments, which are also managed and evaluated on a total return basis, but which fall outside the scope of IAS 28 and IAS 31 to be measured at fair value through profit or loss if that is consistent with the manner in which the entity manages and evaluates the performance of these investments. [IAS 39 para AG 4I(a)].

In other words, the entire portfolio can be measured at fair value through profit or loss provided the two requirements of paragraph 6.4A.18 above are met.

Example 2 – Portfolio of financial assets held to back specific liabilities

An entity holds a portfolio of financial assets. The entity manages the portfolio so as to maximise its total return (that is, interest or dividends and changes in fair value) and evaluates its performance on that basis. The portfolio is held to back specific liabilities.

In this situation, the entity may designate the portfolio at fair value through profit or loss, because it is likely that the entity’s strategy to maximise total return would be set by, and information about performance of the portfolio would be provided to, key management on a timely basis. This is so regardless of whether the entity also manages and evaluates the liabilities on a fair value basis. [IAS 39 para AG 4I(c)].

Classification of financial assets - Financial assets and liabilities at fair value through profit or loss - Designation at fair value through profit or loss on initial recognition - Exception

Publication date: 08 Dec 2017


6.4A.22 The fair value option is not available for investments in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured. [IAS 39 para 9]. Therefore, in the absence of a quoted market price in an active market, if the fair value of an equity investment is not reliably measurable, because the range of reasonable fair value estimates is significant and the probabilities of the various estimates within the range cannot be reasonably assessed, an entity is precluded from measuring the instrument at fair value. [IAS 39 paras AG 80, AG 81].

Classification of financial assets - Financial assets and liabilities at fair value through profit or loss - Held-for-trading

Publication date: 08 Dec 2017


6.4A.23 A financial asset is held-for-trading if it is:

acquired or incurred principally for the purpose of selling or repurchasing it in the near-term;
on initial recognition, part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit taking; or
a derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument).
[IAS 39 para 9].

6.4A.24 Financial assets held-for-trading include:

Debt and equity securities that are actively traded by the entity.
Loans and receivables acquired by the entity with the intention of making a short-term profit from price or dealer’s margin.
Securities held under repurchase agreements.
   
Derivatives (see chapter 6.2) are always categorised as held-for-trading, unless they are accounted for as effective hedging instruments.

6.4A.25 Trading generally reflects active and frequent buying and selling and financial instruments held-for-trading generally are used with the objective of generating a profit from short-term fluctuations in price or dealer’s margin. [IAS 39 para AG 14]. Whether an entity holds financial assets to generate profit on short-term differences in prices must be assessed on the basis of the facts and circumstances surrounding the trading activity rather than on the individual transaction’s terms. Evidence of this is based on the frequency of buying and selling, the turnover rate or average holding period of the financial assets included in the portfolio (portfolio churning). All available evidence should be considered to determine whether the entity is involved in trading activities.

6.4A.26 Financial assets that are bought and held principally in a portfolio for the purpose of selling them in the near-term (thus held for only a short period of time) should be classified as trading at acquisition date. Although the term ‘portfolio’ is not explicitly defined in IAS 39, the context in which it is used suggests that a portfolio is a group of financial assets or financial liabilities that are managed together. Also the phrases ‘selling them in the near-term’ and ‘held for only a short period of time’ are not explained in IAS 39. Therefore, in practice, an entity should adopt a suitable definition of these phrases and apply them on a consistent basis to avoid any ambiguity. For example, it is likely that if a security was acquired with the intent of selling it within a few weeks or months, the security would be classified as held-for-trading. After being classified as held-for-trading, a single instrument in a portfolio may in fact be held for a longer period of time, as long as there is evidence of a recent actual pattern of short-term profit taking on financial instruments included in such a portfolio.

Example – Shares held-for-trading

An entity purchased quoted equity shares from the market with the intention of profiting from short-term price fluctuations. The entity held the shares for three years due to a large unexpected downturn in the stock market after which it sold the shares in a more buoyant market.

Since management’s intention at acquisition was to profit from short-term price fluctuations, the entity would have classified the shares as held-for-trading. The fact that after designation the shares were in fact held for a longer term, because the entity was unable to sell the shares at a loss in a bear market, would not frustrate the held-for-trading classification. Indeed, IAS 39 does not limit the period for which such an instrument can be held as long as the principal purpose at acquisition was to sell them in the near-term. Furthermore, as there is no definition of ‘near-term’ it is important for the entity to adopt a suitable definition and apply it consistently as explained in paragraph 6.4A.25 above.

Classification of financial assets - Held-to-maturity investments - Definition

Publication date: 08 Dec 2017


6.4A.27 Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity other than:

Those that the entity upon initial recognition designates as at fair value through profit or loss.
Those that the entity designates as available-for-sale.
Those that meet the definition of loans and receivables.
[IAS 39 para 9].

6.4A.28 For most financial assets, the standard regards fair value as a more appropriate measure than amortised cost. Classifying a security as held-to-maturity means that the enterprise is indifferent to future opportunities to profit from changes in the security’s fair value and intends to accept the debt security’s stipulated contractual cash flows, including the repayment of principal at maturity. The held-to-maturity category is, therefore, an exception. Consequently, its use is restricted to instruments that have specific terms and characteristics and by a number of detailed conditions, largely designed to test whether the entity has genuine intention and ability to hold those instruments to maturity. Also, significant penalties exist for entities that classify an instrument as held-to-maturity, but which is sold before maturity. These issues are considered below.

Classification of financial assets - Held-to-maturity investments - Fixed or determinable payments and fixed maturity

Publication date: 08 Dec 2017


6.4A.29 Instruments classified as held-to-maturity must have fixed or determinable payments and fixed maturity, which means that a contractual arrangement defines the amounts and dates of payments to the holder, such as interest and principal payments. Investments in equity shares have indefinite lives and, therefore, cannot be held-to-maturity financial assets. Other equity instruments, such as share options and warrants, cannot be classified as held-to-maturity because the amounts the holder receives may vary in a manner that is not predetermined. [IAS 39 para AG 17]. It follows that since held-to-maturity financial assets must have fixed maturity, it is mainly debt instruments that fall within this category. A mandatorily redeemable preference share is also, in substance, a debt instrument that may fall within this category.

6.4A.30 The amount of determinable payment of principal or interest is normally established by reference to a source other than the financial instrument, and may involve a calculation. For example, floating rate interest on a financial instrument that is calculated from a reference interest rate such as the LIBOR or a bank’s prime rate, and a principal amount that is linked to a price index such as the market price of a commodity like oil, are examples of determinable cash flows.

Example 1 – Floating rate note

Entity A purchases a note with variable interest rate and a fixed payment at maturity.

The floating rate note could qualify as a held-to-maturity investment since its payments are fixed (the principal) and the interest payments are specified by reference to a market or bench mark rate such as the LIBOR, which is determinable. A held-to-maturity classification for floating rate notes is, however, of little benefit, since its fair value will not change significantly in response to changes in interest rates.

Example 2 – Indexed linked principal payments

Entity A purchases a five-year equity-index-linked note with an original issue price of C10 at a market price of C12 at the time of purchase. The note requires no interest payments before maturity. At maturity, the note requires payment of the original issue price of C10 plus a supplemental redemption amount that depends on whether a specified share price index exceeds a predetermined level at the maturity date. If the share index does not exceed or is equal to the predetermined level, no supplemental redemption amount is paid. If the share index exceeds the predetermined level, the supplemental redemption amount equals the product of 1.15 and the difference between the level of the share index at maturity and the level of the share index when the note was issued divided by the level of the share index at the time of issue. Entity A has the positive intention and ability to hold the note to maturity.

The embedded equity feature is not closely related to the debt host and must be separated. Once the embedded derivative is fair valued and separated, the debt host can be classified as a held-to-maturity investment because it has a fixed payment of C10 and fixed maturity and entity A has the positive intention and ability to hold it to maturity. [IAS 39 para IG B13].

In this example, the purchase price of C12 is allocated between the host debt instrument and the embedded derivative. If, for instance, the fair value of the embedded equity feature at acquisition is C4, the host debt instrument is measured at C8 on initial recognition. In this case, the discount of C2 that is implicit in the host bond (principal of C10 minus the original carrying amount of C8) is amortised to profit or loss over the term to maturity of the note using the effective interest method.

Example 3 – Indexed linked interest

Entity A purchases a bond with a fixed payment at maturity and a fixed maturity date. The interest payments on the bond are indexed to the price of a commodity or equity and the entity has the positive intention and ability to hold the bond to maturity.

The commodity-indexed or equity-indexed interest payments result in an embedded derivative that is not closely related to the bond. Hence, it is necessary to separate the host debt investment (the fixed payment at maturity) from the embedded derivative (the index-linked interest payments).

Once the embedded derivative has been separated, the debt host can be classified as held-to-maturity as it has a fixed payment and a fixed maturity and entity A has the positive intention and ability to hold the bond to maturity. [IAS 39 para IG B14].

Example 4 – Perpetual debt instrument
 
Entity A purchases two perpetual debt instruments X and Y as follows:
 
Instrument X pays an interest rate of 10% per annum for an indefinite period.
Instrument Y pays an interest rate of 16% for the first 10 years and 0% in subsequent periods.
 
Entity A cannot classify instrument X that provides for interest payments for an indefinite period as held-to-maturity, because there is no maturity date. [IAS 39 para AG 17].

As far as instrument Y is concerned, it may be possible to argue from an economic perspective, that the instrument has a fixed maturity of 10 years. This is because the initial amount is amortised to zero over the first ten years using the effective interest method, since a portion of the interest payments represents repayments of the principal amount. The amortised cost is zero after year 10, because the present value of the stream of future cash payments in subsequent periods is zero (there are no further cash payments of either principal or interest in subsequent periods). Since the only cash flows under the terms are fixed interest payments over a period of 10 years, there is a strong argument to support held-to-maturity classification on the grounds that entity A has recovered all of its initial investment and the rights in the event of a liquidation has no value, notwithstanding that the terms do not specify a maturity date.

Classification of financial assets - Held-to-maturity investments - Fixed or determinable payments and fixed maturity - Intent to hold to maturity

Publication date: 08 Dec 2017


6.4A.31 A positive intent to hold financial assets to maturity is a much higher hurdle than simply having no present intention to sell. An entity does not have a positive intention to hold to maturity an investment in a financial asset with a fixed maturity if:

The entity intends to hold the financial asset for an undefined period. In other words, as the entity has not actually defined a period, the positive intent to hold-to-maturity does not exist.
The entity stands ready to sell the financial asset (other than if a situation arises that is non-recurring and could not have been reasonably anticipated by the entity) in response to changes in market interest rates or risks, liquidity needs, changes in the availability of and the yield on alternative investments, changes in financing sources and terms or changes in foreign currency risk. All these situations are indicative that the entity intends to profit from changes in the asset’s fair value and has no intention of holding the financial asset to maturity.
The issuer has a right to settle the financial asset at an amount significantly below its amortised cost. Where this is the case and the issuer is expected to exercise that right, the entity cannot demonstrate a positive intent to hold the financial asset to maturity. See further paragraph 6.4A.33 below.
[IAS 39 para AG 16]

6.4A.32 An entity’s intention to hold a financial asset to maturity is not negated by unusual and unlikely events that could not be anticipated at the time of the original classification. For example, a disaster scenario that is only remotely possible, such as a run on a bank or a similar situation affecting an insurer, is not something that is assessed by an entity in deciding whether it has the positive intention and ability to hold an investment to maturity. [IAS 39 para AG 21].

6.4A.33 A financial asset that is callable by the issuer would satisfy the criteria for classification as a held-to-maturity investment if the holder intends and is able to hold it until it is called or until maturity and the holder would recover substantially all of its carrying amount. This means that if the issuer can call the instrument at or above its carrying amount, the holder’s original classification of the instrument as held-to-maturity is not invalidated because the call option, if exercised, would simply accelerate the asset’s maturity. However, if the financial asset is callable on a basis that would result in the holder not recovering substantially all of its carrying amount, the financial asset cannot be classified as a held-to-maturity investment. Any premium paid and capitalised transaction costs should be considered in determining whether the carrying amount would be substantially recovered. [IAS 39 para AG 18]. If the issuer can call the instrument for an amount substantially different from its carrying amount, potentially, the embedded derivative should be separated (see chapter 6.3A).

6.4A.34 On the other hand, a financial asset that is puttable (that is, the holder has the right to require that the issuer repay or redeem the financial asset before maturity) cannot be classified as a held-to-maturity investment, because paying for a put feature in a financial asset is inconsistent with the positive intent to hold the financial asset until maturity. [IAS 39 para AG 19].

6.4A.35 Similarly, an investment in a convertible bond that is convertible before maturity generally cannot be classified as a held-to-maturity investment, because that would be inconsistent with paying for the conversion feature – the right to convert into equity shares before maturity. [IAS 39 para IG C3]. By paying for the conversion feature in terms of a lower interest rate, the investor hopes to benefit from appreciation in value of the option embedded in the debt security. Therefore, in general, it is unlikely that the investor will be able to assert the positive intent and ability to hold a convertible debt security to maturity and forego the opportunity to profit by exercising the conversion option. Even if the convertible debt is separated into an equity option and a host debt instrument (see chapter 43), it generally still would be contradictory to assert the positive intent and ability to hold the debt host contract to maturity and forego the opportunity to exercise the conversion option. On the other hand, if the conversion option can only be exercised at maturity, it may be possible for the holder to demonstrate positive intent to hold the bond to maturity.

Classification of financial assets - Held-to-maturity investments - Fixed or determinable payments and fixed maturity - Ability to hold to maturity

Publication date: 08 Dec 2017


6.4A.36 It is not sufficient for the entity to demonstrate a positive intent to hold a financial asset to maturity; the entity must also demonstrate its ability to hold such an asset to maturity. An entity cannot demonstrate that ability if:

it does not have the financial resources available to continue to finance the investment until maturity; or
it is subject to an existing legal or other constraint that could frustrate its intention to hold the financial asset to maturity (although as noted in para 6.4A.33 above, an issuer’s call option does not necessarily frustrate this intention).
[IAS 39 para AG 23].
 
For example, it is unlikely that an open ended fund would be able to classify any financial asset as held-to maturity. Management might intend to hold the investments to maturity, but calls for redemption of shares or units could constrain the fund’s ability to hold its investments to maturity.

6.4A.37 An entity’s intention and ability to hold debt instruments to maturity is not necessarily constrained if those instruments have been pledged as collateral or are subject to a repurchase agreement or securities lending agreement. However, an entity does not have the positive intention and ability to hold the debt instruments until maturity if it does not expect to be able to maintain or recover access to the instruments. [IAS 39 para IG B18].

Example – Pledge of held-to-maturity assets as security
 

Entity A requires C18m of cash for its operating activities in 20X7. The entity’s latest cash flow forecast indicates a C2m shortfall. The entity intends to raise the funds required by pledging its investments in bonds, which are classified as held-to-maturity, to a bank to obtain a banking facility.

The bonds can continue to be classified as held-to-maturity provided that the entity is able to fulfil the conditions of the banking facility such that the bank will not exercise the pledge. Short-term liquidity problems do not necessarily undermine the entity’s ability to hold the investments until maturity.

 

Classification of financial assets - Held-to-maturity investments - Fixed or determinable payments and fixed maturity - Assessment of held-to-maturity classification

Publication date: 08 Dec 2017


6.4A.38 An entity should assess its intention and ability to hold its held-to-maturity investments to maturity not only when those financial assets are initially recognised, but also at each subsequent balance sheet date. [IAS 39 para AG 25]. Because an entity is expected not to change its intent about a held-to-maturity security, the requirement to reassess the appropriateness of a security’s classification would necessarily focus on the entity’s ability to hold a security to maturity. Facts and circumstances may change that may cause the entity to lose its ability to hold a debt security to maturity. Unless those facts and circumstances fall within one of the exceptions discussed in paragraph 6.4A.42 below, the entity would be forced to reclassify its held-to-maturity investments to available-for-sale.

Classification of financial assets - Held-to-maturity investments - The tainting rules

Publication date: 08 Dec 2017


6.4A.39 Because management should assert that the criteria for a held-to-maturity investment have been met for each investment, the sale, reclassification or exercise of a put option of certain held-to-maturity securities will call into question (‘taint’) management’s intent to hold all securities in the held-to-maturity category. An entity should not classify any financial assets as held-to-maturity if the entity has, during the current financial year or during the two preceding financial years, sold or reclassified more than an insignificant amount of held-to-maturity investments before maturity. In other words, where an entity during the current financial year has sold or reclassified more than an insignificant amount of held-to-maturity investments before maturity (more than insignificant in relation to the total amount of held-to-maturity investments), it is prohibited from classifying any financial asset as held-to-maturity for a period of two years after the occurrence of this event. Furthermore, all the entity’s held-to-maturity investments, not just investments of a similar type, should be reclassified into the available-for-sale category and measured at fair value (see para 6.4A.77). In a sense, a penalty is imposed for a change in management’s intention. When the prohibition ends (at the end of the second financial year following the tainting), the portfolio becomes ‘cleansed’, and the entity is once more able to assert that it has the intent and ability to hold debt securities to maturity. [IAS 39 paras 9, 54].

6.4A.40 The tainting rules do not apply if only an insignificant amount of held-to-maturity investments is sold or reclassified. The standard does not define what an insignificant amount means, except that it should be measured by reference to the total amount of held-to-maturity investments. Therefore, judgement is needed to assess what is insignificant in each particular situation.

Example 1 – Application of the tainting rules

An entity’s held-to-maturity portfolio consists of a mixture of sterling corporate bonds, treasury bonds and eurodollar bonds. The entity prepares its financial statements to 31 December 20X5. During September 20X5, the entity sold a certain eurodollar bond to realise a large gain.

The fact that the entity has sold one eurodollar investment (not considered insignificant in relation to the total held-to-maturity portfolio) does not mean that only the eurodollar sub-category has been tainted. The tainting rule is very clear. If an entity has sold or reclassified more than an insignificant amount of held-to-maturity investments, the entire portfolio and all remaining investments must be reclassified to the available-for-sale category. [IAS 39 para IG B20]. It follows that sub-classification of securities for the purpose of limiting the impact of sales or transfers of held-to-maturity securities is not acceptable practice.

The reclassification is recorded in the reporting period in which the sales occurred (that is, the year to 31 December 20X5). Furthermore, as explained in paragraph 6.4A.39 above, the entity is prohibited from reclassifying any investments in the held-to-maturity category for two full financial years after 31 December 20X5. This means that any fixed interest securities acquired during 20X6 and 20X7, which could qualify for held-to-maturity classification, cannot be classified as such in those years. The earliest date that the entity is able to classify investments as held-to-maturity is 1 January 20X8 as shown in the diagram below:

cdocuments_and_f_ininst2
 
At 1 January 20X8 when the portfolio becomes cleansed, and it once again becomes appropriate to carry securities at held-to-maturity, the fair value of the affected securities on 1 January 20X8 becomes the new amortised cost. Furthermore, as tainting occurs in the year to 31 December 20X5, the held-to-maturity classification for the comparative period to 31 December 20X4 is not affected.

Example 2 – Regular disposal of small amounts of held-to-maturity securities

Entity X has a portfolio of financial investments that is classified as held-to-maturity. In the current period, it sold small amounts of investments from time to time.

Regular or systematic sales or transfers of immaterial amounts are indicative of management’s intention not to hold financial assets to maturity. The tainting rules would apply and the entity should reclassify all its held-to-maturity investments as available-for-sale and measure them at fair value.

In addition, the entity may not create a sub-category of held-to-maturity in which to hold these investments. (The aim of this sub-categorisation would have been so that the sale of investments prior to maturity from that sub-category did not taint the entire held-to-maturity portfolio.)

Classification of financial assets - Held-to-maturity investments - The tainting rules - Tainting in group situations

Publication date: 08 Dec 2017


6.4A.41 The tainting rules are designed to test an entity’s assertion that it has the positive intent and ability to hold each security to maturity. The rules apply to all entities within a group. Therefore, if a subsidiary operating in a different legal or economic environment sells more than an insignificant amount of held-to-maturity investments, it would preclude the entire group from using the held-to-maturity category. This means that the entity would have to reclassify all its held-to-maturity investments in its consolidated financial statements, unless the sale qualifies for one of the exceptions noted in paragraph 6.4A.42 below. [IAS 39 para IG B21]. Furthermore, at least two full financial years must pass before the entity can again classify financial assets as held-to-maturity in its consolidated financial statements. Sales between group entities generally would not taint the held-to-maturity classification at the group level, but may do so at the individual entity level. As the consequences of breaching the conditions are harsh, entities should carefully consider any plans to sell or transfer before classifying any asset to this category.

Classification of financial assets - Held-to-maturity investments - Exceptions to the tainting rules

Publication date: 08 Dec 2017


6.4A.42 There are a number of exceptions to the tainting rules. As already discussed in paragraph 6.4A.39 above, a sale or reclassification of an insignificant amount of held-to-maturity investment would not result in tainting. Similarly, a sale or reclassification would not taint the rest of the portfolio if it was:

so close to maturity or the financial asset’s call date (for example, less than three months before maturity) that changes in the market rate of interest would not have a significant effect on the financial asset’s fair value;
made after the entity has collected substantially all of the financial asset’s original principal through scheduled payments or pre-payments; or
due to an isolated event that is beyond the entity’s control, is non-recurring and could not have been reasonably anticipated by the entity.
[IAS 39 para 9].

6.4A.43 The conditions referred to in the first and second bullet points above relate to situations in which an entity can be expected to be indifferent whether to hold or sell a financial asset, because movements in interest rates after substantially all of the original principal has been collected or when the instrument is close to maturity will not have a significant impact on its fair value. Accordingly, in such situations, a sale would not affect reported net profit or loss and no price volatility would be expected during the remaining period to maturity. For example, if an entity sells a financial asset less than three months prior to maturity, that would generally qualify for use of this exception because the impact on the fair value of the instrument for a difference between the stated interest rate and the market rate generally would be small for an instrument that matures in three months relative to an instrument that matures in several years.

6.4A.44 The term ‘substantially all’ in the second bullet point of paragraph 6.4A.42 is not defined in IAS 39. The guidance to the previous version of IAS 39 stated that if an entity sells a financial asset after it has collected 90% or more of the financial asset’s original principal through scheduled payments or pre-payments, this would generally qualify for this exception. However, if the entity has collected, say, only 10% of the original principal, that condition clearly is not met. Although the previous guidance has not been carried forward in the revised version, we believe that applying a 90% threshold as a rule of thumb to test whether ‘substantially all’ of the original principal has been collected is acceptable. Clearly, though, it cannot be applied as a hard-and-fast rule and cannot be applied to the de-recognition criteria of IAS 39 (see chapter 44).

6.4A.45 In relation to the last bullet point in paragraph 6.4A.42 above, very few events would qualify as isolated events beyond the entity’s control, that are non-recurring or reasonably unanticipated. A disaster scenario that is only remotely possible, such as a run on a bank or a similar situation affecting an insurer, would qualify as it is not something that would be assessed by an entity in deciding whether it has the positive intention and ability to hold an investment to maturity. [IAS 39 para AG 21]. The consequence is that if the sale or reclassification resulted from an event that is not isolated but within the entity’s control or is potentially recurring or could have been anticipated at the date the held-to-maturity classification was made, this inevitably will cast doubt on the entity’s intent and ability to hold a security to maturity. Consider the following example:

Example – Permitted sales

Entity X has a portfolio of financial assets that is classified as held-to-maturity. In the current period, at the direction of the board of directors, the senior management team has been replaced. The new management wishes to sell a portion of the held-to-maturity financial assets in order to carry out an expansion strategy designated and approved by the board.

A change in management is not identified under the standard as an instance where sales or transfers from held-to-maturity do not compromise the classification as held-to-maturity (see para 6.4A.42 above).

Although the previous management team had been in place since the entity’s inception and entity X had never before undergone a major restructuring, sales in response to a change in management would, nevertheless call into question entity X’s intention to hold remaining held-to-maturity financial assets to maturity. [IAS 39 IG B16].

6.4A.46 In addition to the above, the standard identifies some specific circumstances that may not have been anticipated at the time of the initial held-to-maturity classification and, therefore, would justify the sale of a security classified as held-to-maturity without calling into question management’s intent to hold other debt securities to maturity in the future. Thus a sale or transfer of a held-to-maturity security due to one of the following circumstances would not result in tainting of a held-to-maturity portfolio.

A significant deterioration in the issuer’s creditworthiness (see para 6.4A.47).
Changes in tax laws (see para 6.4A.50).
Major business combination or disposition, such as a sale of a segment (see para 6.4A.51).
Changes in statutory or regulatory requirements (see para 6.4A.53).
[IAS 39 para AG 22].

Classification of financial assets - Held-to-maturity investments - Exceptions to the tainting rules - A significant deterioration in the issuer’s creditworthiness

Publication date: 08 Dec 2017


6.4A.47 A sale due to a significant deterioration in the issuer’s creditworthiness (evident by a downgrade in the issuer’s credit rating by an external rating agency) might not raise a question about the entity’s intention to hold other investments to maturity. However, the significance of deterioration in creditworthiness must be judged by reference to the credit rating at initial recognition. If the rating downgrade in combination with other information provides evidence of impairment (for example, if it becomes probable that all amounts due (principal and interest) will not be collected), the deterioration in creditworthiness often would be regarded as significant. Also, the significant deterioration must not have been reasonably anticipated when the entity classified the investment as held-to-maturity in order to meet the condition in IAS 39. A credit downgrade of a notch within a class or from one rating class to the immediately lower rating class could often be regarded as reasonably anticipated. Therefore, a sale triggered by such a downgrade would result in tainting of the held-to-maturity portfolio. Similarly, a sale as a result of the issuer’s bankruptcy would be regarded as a permitted sale, but not one where the bankruptcy was anticipated at the acquisition date and the investor was, therefore, able to control the outcome. [IAS 39 para IG B15].

6.4A.48 Where a credit rating is not available from an external rating agency to assess a decline in the issuer’s creditworthiness, the entity is permitted to use its internal credit rating system to support the demonstration of significant deterioration in the issuer’s creditworthiness. However, the internal credit rating system must be sufficiently robust to provide a reliable and objective measure of the issuer’s credit rating and changes in those ratings on a consistent basis.

6.4A.49 A sale following a significant deterioration in the issuer’s creditworthiness should normally take place as soon as the entity becomes aware of the credit downgrade and not left until a later date. This is because if the sale or reclassification out of held-to-maturity category is not made immediately or shortly afterwards following the credit downgrade, it provides evidence that the entity is indifferent to the loss incurred in its held-to-maturity portfolio and intends to hold those investments to maturity. If, then a sale occurs many months after the credit downgrade, it is likely to be for reasons other than a credit downgrade.

Classification of financial assets - Held-to-maturity investments - Exceptions to the tainting rules - Changes in tax laws

Publication date: 08 Dec 2017


6.4A.50 A sale following a change in tax law that eliminates or significantly reduces the tax-exempt status of interest on the held-to-maturity investment (but not a change in tax law that revises the marginal tax rates applicable to interest income) would not compromise the classification of held-to-maturity. This is because such a change was not contemplated at the time of the initial classification. On the other hand, if an entity undertakes a sale in anticipation of a change in the tax law that was not substantively enacted at the time of sale or reclassification, the entire held-to-maturity portfolio may well be tainted. Similarly, a sale as a result of change in tax law that revises the marginal tax rates for interest income will taint the entire held-to-maturity portfolio, since the change is likely to affect all debt instruments not simply the ones sold.

Classification of financial assets - Held-to-maturity investments - Exceptions to the tainting rules - Major business combination or disposition

Publication date: 08 Dec 2017


6.4A.51 Following a business combination or disposal of a business segment, it may be necessary for the entity to sell or reclassify some of its own held-to-maturity securities in order to maintain the entity’s existing interest rate risk position or credit risk policy that pre-dated the business combination or disposal. In a business combination, it may also be necessary to sell some of the acquired entity’s held-to-maturity securities, even though all of the acquired securities would be classified anew following such an acquisition. Although a business combination is an event that is within the entity’s control, sales or reclassifications that are necessary to maintain the entity’s existing interest rate risk position or credit risk policy arises as a direct consequence of the business combination or disposition and are not anticipated. Hence, such sales or reclassifications would not taint the entity’s held-to-maturity portfolio.

6.4A.52 On the other hand, sales of held-to-maturity securities to fund an acquisition that is within the entity’s control would taint the portfolio. This is because such sales are not a consequence of the acquisition. Rather, as they have been made to fund the acquisition, they call into question the entity’s intent and ability to hold the investment to maturity. Similarly, a sale in response to an unsolicited tender offer or a sale due to a change in the entity’s business strategy would also taint the held-to-maturity portfolio. This is because such events are unlikely to fall into the category of isolated events that are beyond the entity’s control, are non-recurring events and could not have been reasonably anticipated by the entity.

Classification of financial assets - Held-to-maturity investments - Exceptions to the tainting rules - Changes in statutory or regulatory requirements

Publication date: 08 Dec 2017


6.4A.53 IAS 39 identifies the following situations where sale or reclassification out of the held-to-maturity category necessitated by changes in statutory or regulatory requirements would not call into question the entity’s intent and ability to hold other investments to maturity.

A change in statutory or regulatory requirements significantly modifying either what constitutes a permissible investment or the maximum level of particular types of investments, thereby causing an entity to dispose of a held-to-maturity investment.
A significant increase in the risk weights of held-to-maturity investments used for regulatory risk-based capital purposes.
A significant increase in the industry’s regulatory capital requirements that causes the entity to downsize by selling held-to-maturity investments.
[IAS 39 para AG22(d-f)].

6.4A.54 Sales of held-to-maturity securities resulting from statutory or regulatory requirements that affect the whole regulated industry as set out above are clearly isolated events beyond the entity’s control, are non-recurring and could not have been reasonably anticipated by the entity.

6.4A.55 In relation to the last situation in paragraph 6.4A.53 above, if an entity is forced to downsize to comply with a significant increase in the industry’s capital requirements, the sale of one or more held-to-maturity securities in connection with that downsizing would not call into question the classification of other held-to-maturity securities. Sometimes downsizing may be required to comply with a significant increase in entity-specific capital requirements imposed by regulators. In that situation, it may be difficult for the entity to demonstrate that the regulator’s action could not have been reasonably anticipated at the time of the initial classification. Therefore, in this situation, the entity can avoid tainting only if it can demonstrate that the downsizing results from an increase in capital requirements, which is an isolated event that is beyond its control, is non-recurring and could not have been reasonably anticipated. [IAS 39 para IG B17].

6.4A.56 It follows that blanket sales of held-to-maturity investments made as a matter of course to comply with regulatory capital requirements are not consistent with held-to-maturity accounting. For example, a sale of a held-to-maturity investment to realise gains to replenish regulatory capital depleted by a loan loss provision would taint the entire held-to-maturity portfolio, because realising such a gain is inconsistent with the held-to-maturity classification.

Classification of financial assets - Held-to-maturity investments - Decision tree for classifying financial assets as held-to-maturity

Publication date: 08 Dec 2017


6.4A.57 A decision tree for classifying financial assets as held-to-maturity is shown below.
cdocuments_and_p_fininst

Classification of financial assets - Loans and receivables

Publication date: 08 Dec 2017


6.4A.58 Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market other than:

Those that the entity intends to sell immediately or in the near term, which should be classified as held-for-trading, and those that the entity upon initial recognition designates as at fair value through profit or loss.
Those that the entity upon initial recognition designates as available-for-sale.
Those for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration, which should be classified as available-for-sale.
[IAS 39 para 9].

6.4A.59 Loans and receivables typically arise when an entity provides money, goods or services directly to a debtor with no intention of trading the receivable. Examples include trade receivables, bank deposits and loan assets originated by the entity either directly or by way of syndication/participation arrangements. It also includes loans that are purchased in a secondary market that is not active. Investments in debt securities that are quoted in a non-active market can also be classified as loans and receivables. Assessment as to whether a debt security is quoted in an active market is determined at the security identification number level (for example CUSIP or ISIN). Since the unit of account is deemed to be the individual security, an entity should look at the volume and frequency at which transactions for the specific security occur to make this determination. If there are no regular and actual market transactions for this particular security, then the instrument can be classified as loans and receivables

Example – Bank deposits in other banks

Banks make term deposits with a central bank or other banks. Sometimes, the proof of deposit is negotiable, sometimes not. Even if negotiable, the depositor bank may or may not intend to sell it. Such a deposit meets the definition of loans and receivables, whether or not the proof of deposit is negotiable, unless the depositor bank intends to sell the instrument immediately or in the near term, in which case the deposit is classified as a financial asset held-for-trading. [IAS 39 para IG B23].

6.4A.60 The principal difference between loans and receivables and other financial assets is that loans and receivables are not subject to the tainting provisions that apply to held-to-maturity investments. Consequently, loans and receivables that are not held-for-trading may be measured at amortised cost even if an entity does not have the positive intention and ability to hold the loan asset until maturity.

6.4A.61 Instruments that meet the definition of an equity instrument under IAS 32 cannot be classified as loans and receivables by the holder. On the other hand, if a non-derivative instrument (for example, a preference share) that has the legal form of an equity instrument, but is recorded as a liability by the issuer and it has fixed or determinable payments and is not quoted in an active market, can be classified within loans and receivables by the holder, provided the definition is otherwise met. [IAS 39 para IG B22].

6.4A.62 An interest acquired in a pool of assets that are not loans or receivables (for example, an interest in a mutual fund or a similar fund) cannot be classified as a loan or receivable. [IAS 39 para 9]. The consequence is that a purchase of a securitised asset that consists of a pool of loans and receivables that meets the definition of loans and receivables can be classified as loan and receivables by the holder. However, where an entity securitises its own portfolio of loans and receivables that were classified as loans and receivables before the securitisation and the de-recognition provisions of IAS 39 apply, the securitisation may give rise to a new financial asset that is classified in accordance with the four categories of financial assets. 

Classification of financial assets - Loans and receivables - Debt instruments quoted in an active market

Publication date: 08 Dec 2017


6.4A.63 As stated in paragraph 6.4A.58 above, an entity is not permitted to classify as a loan or receivable an investment in a debt instrument that is quoted in an active market. The IASB considered that the ability to measure a financial asset at amortised cost (as in the case of loans and receivables) is most appropriate when there is no liquid market for the asset. It is less appropriate to extend the category to debt instruments traded in liquid markets. Accordingly, for such investments an amortised cost basis of measurement is only permitted if the entity can demonstrate its positive intention and ability to hold the investments until maturity (for the definition of held to maturity see para 6.4A.27 above). It is likely, therefore, that many originated and purchased investments in quoted bonds would be classified as available-for-sale. 

Classification of financial assets - Available-for-sale financial assets

Publication date: 08 Dec 2017


6.4A.64 Available-for-sale (AFS) financial assets are those non-derivative financial assets that are designated as available-for-sale or are not classified as:

Loans and receivables.
Held-to-maturity investments.
Financial assets at fair value through profit or loss.
[IAS 39 para 9].

6.4A.65 IAS 39 includes a degree of choice, on initial recognition to classify any non-derivative financial asset, except those held-for-trading or designated at fair value through profit or loss, as available-for-sale and, therefore, to measure it at fair value with changes in fair value recognised directly in other comprehensive income.

6.4A.66 Examples of available-for-sale financial assets that are likely to be included in this category are:

Equity investments that are not designated on initial recognition as at fair value through profit and loss.
Financial assets that could have been classified as loans and receivables on initial recognition, but the holder chooses to designate on initial recognition as available-for-sale.
Financial assets where the holder is unable to recover substantially all its initial investment, except through credit deterioration of the issuer.
Puttable quoted debt securities that cannot be classified either as held-to-maturity because they are puttable (see para 6.4A.34 above) or any quoted debt instrument that fails the held-to-maturity criteria (because they may be sold in response to liquidity needs (see para 6.4A.39) or loans and receivables because they are quoted (see para 6.4A.58)).
   
The main issue is, therefore, likely to focus on whether investments quoted in an active market should be classified as fair value through profit or loss or designated as available-for-sale on initial recognition.

Example – Balancing a portfolio

Entity A has an investment portfolio of debt and equity instruments. The documented portfolio management guidelines specify that the portfolio’s equity exposure should be limited to between 30 and 50% of total portfolio value. The portfolio’s investment manager is authorised to balance the portfolio within the designated guidelines by buying and selling equity and debt instruments.

Whether entity A is permitted to classify the instruments as available-for-sale would depend on entity A’s intentions and past practice. If the portfolio manager is authorised to buy and sell instruments to balance the risks in a portfolio, but there is no intention to trade and there is no past practice of trading for short-term profit, the instruments can be classified as available-for-sale. If the portfolio manager actively buys and sells instruments to generate short-term profits, the financial instruments in the portfolio are classified as held-for-trading. [IAS 39 para IG B12].

Classification of financial assets - Reclassification of assets between categories

Publication date: 08 Dec 2017


6.4A.67 Once a financial asset has been classified into a particular category on initial recognition, IAS 39 restricts the circumstances in which it is permissible or necessary to transfer that asset into another category. However, these rules were eased somewhat in October 2008 when the IASB amended IAS 39 to allow reclassification of certain financial assets out of a category requiring fair value measurement (that is, held-for-trading or available-for-sale) and into another category under limited circumstances (see paras 6.4A.77 and 6.4A.84). However, derivatives and financial assets designated as at fair value through profit or loss, as described in paragraph 6.4A.6, are not eligible for this reclassification.

Classification of financial assets - Reclassification of assets between categories - Transfer into and out of fair value through profit or loss

Publication date: 08 Dec 2017


6.4A.68 As explained in paragraph 6.4A.6, entities are permitted to designate on initial recognition any financial asset or financial liability at fair value through profit or loss if it meets the criteria of paragraph 9 of IAS 39. However, to impose discipline on this approach, a financial asset or a financial liability that has been voluntarily designated cannot be transferred out of this category while it is held. A financial asset or a financial liability also cannot be reclassified or designated into this category after initial recognition. [IAS 39 para 50]. Such irrevocable designation at inception prevents ‘cherry picking’, as it is not known at initial recognition whether the asset’s fair value will increase or decrease.

Classification of financial assets - Reclassification of assets between categories - Transfer into and out of held-for-trading

Publication date: 08 Dec 2017


6.4A.69 After initial recognition, a financial asset may not be reclassified into the sub-category held-for-trading from another category. [IAS 39 para 50]. However, as mentioned in paragraph 6.4A.67, from 1 July 2008, this requirement has been relaxed: a non-derivative financial asset can be reclassified out of the sub-category held-for-trading and into another category in the following circumstances:
 
■  If the financial asset meets the definition of loans and receivables at the date of reclassification and the entity at that date has the intent and ability to hold it for the foreseeable future or to maturity. [IAS 39 para 50D]. Note that a financial asset cannot meet the definition of loans and receivables if it is quoted in an active market (see para 6.4A.63) or if it represents an interest in a pool of assets that are not themselves loans and receivables (see para 6.4A.62).
For other financial assets (that is, those that do not meet the definition of loans and receivables) only in rare circumstances, provided that these financial assets are no longer held for the purpose of selling or repurchasing in the near term and meet the definition of the target category. [IAS 39 para 50B].

6.4A.70 Paragraph BC104D of the Basis for Conclusions of the amendment to IAS 39 defines a rare circumstance as arising “from a single event that is unusual and highly unlikely to recur in the near-term”. In its press release announcing the publication of this amendment to IAS 39, the IASB indicated that the deterioration of the world’s financial markets that occurred during the third quarter of 2008 was a possible example of ‘a rare circumstance’.

6.4A.71 At the date of reclassification, the fair value of any financial asset reclassified under these provisions becomes its new cost or amortised cost as applicable. Any gain or loss already recognised in profit or loss is not reversed. [IAS 39 paras 50C, 50F]. Guidance for the subsequent measurement of reclassified financial assets is provided in chapter 6.7A.

6.4A.72 Reclassification is not permissible for derivative financial assets. [IAS 39 para 50(a)]. However, this prohibition does not prevent a derivative that was initially classified as held-for-trading from being designated as a hedging instrument while it is held. Nor does it prevent a derivative that was designated as a hedging instrument from being classified as held-for-trading following revocation of the hedge. [IAS 39 para 50A].

6.4A.73 Although reclassification does not imply any change to the financial instrument’s terms, IFRIC 9 requires an entity to assess whether a contract contains an embedded derivative when it reclassifies a financial asset out of the sub-category of held-for-trading. [IFRIC 9 para 7]. Further guidance is provided in chapter 6.3A.

Classification of financial assets - Reclassification of assets between categories - Transfer into and out of loans and receivables

Publication date: 08 Dec 2017


6.4A.74 As explained in paragraphs 6.4A.69 and 6.4A.79, a non-derivative financial asset may be reclassified out of held-for-trading or available-for-sale and into loans and receivables if it meets the definition of loans and receivables and the entity has the ability and intention to hold it for the foreseeable future or until maturity.

6.4A.75 Additionally, an entity can choose to designate a financial asset that satisfies the loans and receivables definition as available-for-sale only on initial recognition or on the date of transition to IFRS. If an asset is initially designated as a loan and receivable or has been reclassified as a loan and receivable per paragraph 6.4A.69, it may not subsequently be re-designated as available-for-sale or held-for-trading, except as discussed below.

6.4A.76 Different considerations apply if an asset that was initially classified (or reclassified) as a loan and receivable becomes quoted in an active market such that the definition of loans and receivables is no longer met. This case is not specifically covered by IAS 39 and accordingly an entity has an accounting policy choice of reclassifying or not. The chosen policy should be applied consistently. So if an entity chooses reclassification as its accounting policy, it will need to reclassify all loans and receivables that become quoted in an active market as available-for-sale and also reclassify available-for-sale assets to loans and receivables if they are no longer quoted in an active market.

Classification of financial assets - Reclassification of assets between categories - Transfer out of held-to-maturity into available-for-sale

Publication date: 08 Dec 2017


6.4A.77 Where, as a result of a change in intention or ability, it is no longer appropriate to classify an investment as held-to-maturity, it is reclassified as available-for-sale and remeasured at fair value. [IAS 39 para 51]. As explained in paragraph 6.4A.39, a sale or reclassification calls into question management’s intent and ability to hold financial assets to maturity and ‘taints’ the entire portfolio. Therefore, whenever sales or reclassification of more than an insignificant amount of held-to-maturity investments that do not meet any of the conditions of permitted sales set out in paragraph 6.4A.42 occur, any remaining held-to-maturity investments are reclassified as available-for-sale. In such circumstances, the assets are remeasured to fair value, with any difference recognised in other comprehensive income. [IAS 39 para 52]. Guidance for the subsequent measurement of reclassified financial instruments is provided in chapter 6.7A.

Classification of financial assets - Reclassification of assets between categories - Transfer out of available-for-sale into held-to-maturity

Publication date: 08 Dec 2017


6.4A.78 An entity is allowed to reclassify a financial asset from available-for-sale to held-to-maturity, except in periods where the held-to-maturity category is tainted. For example, a quoted loan in an active market that was initially classified as available-for-sale may subsequently be reclassified to held-to-maturity category if the entity intends and has the ability to hold the loan to maturity. Where tainting has occurred, an instrument may only be reclassified into the held-to-maturity category when the tainted held-to-maturity portfolio has been ‘cleansed’ at the end of the second financial year following the tainting (see para 6.4A.39). In this case, the financial asset’s carrying value, that is, its fair value at the date of reclassification, becomes the asset’s new amortised cost. [IAS 39 para 54(a)]. Guidance for the subsequent measurement of reclassified financial assets is provided in chapter 6.7A.

Classification of financial assets - Reclassification of assets between categories - Transfer out of available-for-sale into held-to-maturity - Transfer out of available-for-sale to loans and receivables

Publication date: 08 Dec 2017


6.4A.79 As mentioned in paragraph 6.4A.74, an entity may reclassify a non-derivative financial asset from available-for-sale to loans and receivables if:
 
■  the entity has the intention and ability to hold the asset for the foreseeable future or until maturity; and
the asset meets the definition of loans and receivables. Note that a financial asset cannot meet the definition of loans and receivables if it is quoted in an active market (see para 6.4A.63), if it represents an interest in a pool of assets that are not themselves loans and receivables (see para 6.4A.62), or if the holder may not substantially recover all of its investment other than because of credit deterioration (see para 6.4A.58).
[IAS 39 para 9,50C, 50E].

6.4A.80 At the date of reclassification, the fair value of any financial asset reclassified under these provisions becomes its new cost or amortised cost as applicable. The treatment of any gain or loss already recognised in other comprehensive income depends on whether the asset has a fixed maturity. [IAS 39 paras 50C and 50F]. Further guidance on measurement is provided in chapter 6.7A.

Classification of financial assets - Reclassification of assets between categories - Summary

Publication date: 08 Dec 2017


6.4A.81 The reclassification requirements for financial assets described above are summarised in the following table:

 To category
From category Held-for-tradingDesignated at fair value Loans and receivables Held-to-maturityAvailable-for-sale
Held-for-trading NoYes
(see paras 6.4A.69-6.4A.72)
Yes
(see paras 6.4A.69-6.4A.72)
Yes
(see paras 6.4A.69-6.4A.72)
Designated at fair value No NoNoNo
Loans and receivables NoNo NoYes
(see para 6.4A.76)
Held-to-maturityNoNoNo Yes
(see para 6.4A.77)
Available-for-saleNoNoYes
(see para 6.4A.79)
Yes
(see para 6.4A.78)
 

Classification of financial liabilities

Publication date: 08 Dec 2017


6.4A.82 IAS 39 has two defined categories of financial liabilities, as follows:

Financial liabilities ‘at fair value through profit or loss’.
Other financial liabilities (measured at amortised cost).

6.4A.83 Like financial assets, a financial liability can be classified as at fair value through profit or loss only if it meets either of the following conditions:

Upon initial recognition, it is designated by the entity at fair value through profit or loss.
It is classified as held-for-trading.
[IAS 39 para 9].

Classification of financial liabilities - Designation at fair value through profit or loss on initial recognition

Publication date: 08 Dec 2017


6.4A.84 The criteria for designation at fair value through profit are loss are the same for financial liabilities as for financial assets and are outlined in paragraph 6.4A.6. An entity’s ability to designate a financial instrument at fair value through profit or loss is an option. It does not restrict an entity’s ability to measure a financial liability at amortised cost.

6.4A.85 Where an entity takes the fair value option and measures its own debt at fair value using one of the situations mentioned in paragraph 6.4A.6, changes in the entity’s creditworthiness should be reflected in the fair value measurement of own debt instruments. This issue is addressed in chapter 6.7A. However, the criteria in paragraph 6.4A.6 do provide restrictions around the situations when an entity is able to designate its own financial liabilities at fair value through profit or loss, having been introduced in 2003 following controversy around the previous unrestricted fair value option in IAS 39.

Classification of financial liabilities - Held-for-trading

Publication date: 08 Dec 2017


6.4A.86 A financial liability is held-for-trading if it is:

acquired or incurred principally for the purpose of selling or repurchasing it in the near-term;
part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit taking; or
a derivative (except for a derivative that is a designated and effective hedging instrument).
[IAS 39 para 9].

6.4A.87 Financial liabilities held-for-trading include:

Derivative liabilities that are not accounted for as hedging instruments. For example, it will include derivatives with a negative fair value.
Obligations to deliver financial assets borrowed by a short seller. A short sale is a transaction in which an entity sells securities it does not own, with the intention of buying securities on a future date to cover the sale. Securities borrowed are not recognised on the balance sheet, unless they are sold to third parties, in which case the obligation to return the securities is recorded as a trading liability and measured at fair value and any gains or losses are included in the income statement.
Financial liabilities that are incurred with an intention to repurchase them in the near-term. For example, a quoted debt instrument that the issuer may buy back in the near-term depending on changes in its fair value.
Financial liabilities that are part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent pattern of short-term profit-taking.
 
The fact that a liability is incurred and used to fund trading activities does not mean that the liability is classified as held-for-trading.
[IAS 39 para AG 15].

Classification of financial liabilities - Other financial liabilities

Publication date: 08 Dec 2017


6.4A.88 Financial liabilities that are not classified as at fair value through profit or loss would automatically fall into this category and are measured at amortised cost. Common examples are trade payables, borrowings and customer deposits.

Classification of financial liabilities - Reclassification between categories

Publication date: 08 Dec 2017


6.4A.89 Reclassification of financial liabilities into or out of fair value through profit or loss is prohibited. However, as explained in paragraph 6.4A.72, this prohibition does not apply to derivative financial liabilities that are designated or re-designated as hedging instruments.

Financial guarantee contracts

Publication date: 08 Dec 2017


6.4A.90 Financial guarantee contracts do not fit clearly into any category above if they were not initially classified as at fair value through profit or loss. They seem to form a separate category of their own. This is because subsequent measurement of these contracts, unless designated at inception as at fair value through profit or loss, is not consistent with that of the categories described above. Financial guarantee contracts are defined in chapter 40. Guidance for the measurement of financial guarantee contracts is provided in chapter 6.7A.
 
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