Accounting for Derivatives. Ramirez Juan

contracts are outside the scope of IFRS 9.

1.1.1 Financial Asset Categories

      A financial asset is any asset that is cash, a contractual right to receive cash or some other financial asset, a contractual right to exchange financial instruments with another entity under conditions that are potentially favourable, or an equity instrument of another entity. Financial assets include derivatives with a fair value favourable to the entity.

IFRS 9 considers three categories of financial assets (see Figures 1.2 and 1.3):

      • At amortised cost. This category consists of debt investments that meet both the business model test (i.e., the investment is managed to hold it in order to collect contractual cash flows) and the contractual cash flow test (the contractual terms give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding), and for which the fair value option (FVO) is not applied.

      • At fair value through other comprehensive income (FVOCI). This category consists of debt investments that meet both the business model test and the contractual cash flow test, but that are managed to sell them as well. It also consists of equity investments not held for trading for which the entity chooses not to classify them at fair value through profit or loss.

      • At fair value through profit or loss (FVTPL). This category consists of financial assets that are neither measured at amortised cost nor at FVOCI.

Figure 1.2 IFRS 9 financial assets classification categories – summary flowchart.

Figure 1.3 Contractual cash flows modification test.

      The classification of an instrument is determined on initial recognition. Reclassifications are made only upon a change in an entity's business model, and are expected to be very infrequent. No other reclassifications are permitted.

1.1.2 Financial Assets at Amortised Cost

      A financial asset qualifies for amortised cost measurement only if it meets both of the following criteria:

      • Business model test. The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows.

      • Contractual cash flows test. The contractual cash flows of the financial represent solely payments of principal and interest.

      This is a mandatory classification, unless the fair value option is applied. Financial assets in the amortised cost category include non-callable debt (i.e. loans, bonds and most trade receivables), callable debt (provided that if it is called the holder would recover substantially all of debt's carrying amount) and senior tranches of pass-through asset-backed securities.

      If a financial asset does not meet any of the two conditions above it is measured at FVTPL. If both conditions are met but the sale of the financial asset is also integral to the business model, it is recognised at FVOCI.

      Even if an asset is eligible for classification at amortised cost or at FVOCI, management also has the option – the FVO – to designate a financial asset at FVTPL if doing so reduces or eliminates a measurement or recognition inconsistency (commonly referred to as “accounting mismatch”).

      Business Model Test

      If the entity's objective is to hold the asset to collect the contractual cash flows, then it will meet the first criterion to qualify for amortised cost. The entity's business model does not depend on management's intentions for the individual asset, but rather on the basis of how an entity manages the portfolio of debt instruments. Examples of factors to consider when assessing the business model for a portfolio are:

      • the way the assets are managed;

      • how performance of the business is reported to the entity's key management personnel;

      • how management is compensated (whether the compensation is based on the fair value of the assets managed); and

      • the historical frequency, timing and volume of sales in prior periods, the reasons for these sales (such as credit deterioration), and expectations about future sales activity.

      IFRS 9 indicates that sales due to deterioration of the credit quality of the financial assets so that they no longer meet the entity's documented investment policy would be consistent with the amortised cost business model. Sales that occur for other reasons may also be consistent with the amortised cost business model if they are infrequent (even if significant) or insignificant (even if frequent), or if the sales take place close to the maturity of the financial asset and the proceeds from the sale approximate the collection of the remaining contractual cash flows. For example, an entity could sell one financial asset that results in a large gain and this would not necessarily fail the business model test due to its significant effect on profit or loss unless it was the entity's business model to sell financial assets to maximise returns.

      If an entity is unsure of the business model for the debt investments, the default category would be at FVTPL.

      Example: Liquidity portfolio

      A bank holds financial assets in a portfolio to meet liquidity needs in a “stress case” scenario that is deemed to occur only infrequently. Sales are not expected except in a liquidity stress situation. The bank also monitors the fair value of the assets in the portfolio to ensure that the cash amount that would be realised if a sale is required would be sufficient to meet liquidity needs. In this case (i.e., where the “stress case” is deemed to be rare), the bank's business model is to hold the financial assets to collect contractual cash flows.

      In contrast, if the bank holds financial assets in a portfolio to meet everyday liquidity needs and that involves recurring and significant sales activity, the objective is not to hold to collect the contractual cash flows. However, if the objective of the regulator is for the bank to demonstrate liquidity, the bank could consider other ways to demonstrate liquidity that would allow the portfolio to still qualify for amortised cost (e.g., entering into a repurchase agreement for the debt investments)

      In addition, if the bank is required by the regulator to routinely sell significant volumes of financial assets in a portfolio to demonstrate the assets are liquid, the bank's business model is not to hold to collect contractual cash flows (the fact that this requirement is imposed by a third party is not relevant to the analysis).

      Example: Financial assets backing insurance contracts

      An insurer holds financial assets in a portfolio to fund insurance contract liabilities. The insurer uses the proceeds from the contractual cash flows to settle the insurance liabilities as they come due. There is also rebalancing of the portfolio on a regular basis as estimates of the cash flows to fund the insurance liabilities are not always predictable.

      The objective of the insurer's business model is both to hold the financial assets to collect contractual cash flows to fund liabilities as they come due and to sell to maintain the desired profile in the asset portfolio. In this case, the insurer holds financial assets with a dual objective to fund insurance liabilities and maintain the desired profile of the asset portfolio. This portfolio would fail the business model test of holding to collect contractual cash flows but would likely qualify for FVOCI subject to the contractual cash flow test.

      Contractual Cash Flows Test

      If the financial asset's contractual terms give rise on specified dates to cash flows that are “solely payments of principal and interest on the principal amount outstanding” (SPPI), then it will meet the second criterion to qualify for amortised cost.

       Interest is defined as “consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time”. The assessment