ACCOUNTING MISMATCH
Overview of the different classifications
Financial assets are essentially classified based on the two basic measurement models of amortised cost and fair value. However, there are actually four formal classifications due to the three possible accounting treatment of the gains or losses under the fair value model:
1. amortised cost (AC)
2. fair value through profit or loss (FVPL)
3. fair value through other comprehensive income for debt instruments (FVOCI - D)
4. fair value through other comprehensive income for equity instruments (FVOCI - E)
Overview of the classification process
Other than cash, financial assets are essentially comprised of debt instruments, investments in equity instruments, and derivatives. Each one of these assets is classified by assessing:
• Its contractual cash flow characteristics (step 1 the CCF test); and
• The business model within which that financial asset is managed (step 2 the BM test).
Step 1 - the CCF test:
The contractual cash flows test involves assessing whether the asset's contractual terms will lead to the entity receiving:
• cash flows on specified dates
• that are solely payments of:
o principal, and
o interest on the principal (SPPI).
Investments in equity instruments (e.g. ordinary shares) fail this test since they do not offer contractual cash flows at all whereas debt instruments (e.g. bonds) would pass.
Step 2 - the BM test:
The business model test involves assessing the business model relevant to the asset to determine the objectives applied in managing that asset. These objectives may be:
• to hold the asset with the principal aim being to sell the asset (hold to sell);
• to collect the contractual cash flows (hold to collect); or
• to collect the contractual cash flows and to sell the asset (hold to collect and sell).
Essentially, the process is as follows:
• If a financial asset does not meet the CCF test (i.e. does not offer contractual cash flows on specified dates that are solely payments of principal and interest), the asset is classified at fair value through profit or loss (FVPL) unless it is an investment in an equity instrument that is not held for trading, in which case the entity can elect to classify it at fair value through other comprehensive income (FVOCI) instead (although this designation can only happen on initial recognition and is irrevocable).
• If the asset does meet the CCF test, our next step is to consider the objective of the business model that will be used to manage the asset. If the objective of the relevant business model is to:
• Simply collect the contractual cash flows, the asset is classified at amortised cost (AC);
• Collect the contractual cash flows and also to sell the asset, then the asset is classified at fair value through other comprehensive income (FVOCI);
• Sell the asset, then the asset is classified at fair value through profit or loss (FVPL).
• If classification at AC or FVOCI would cause an accounting mismatch, the asset may be designated at FVPL instead (although this designation can only happen on initial recognition and is irrevocable).
Classification: Financial assets at amortised cost (IFRS 9.4.1.2)
A financial asset shall be classified as amortised cost (AC) if both the following conditions are met:
• The contractual cash flows: the contractual terms of the asset must give rise to cash flows on specified dates and these cash flows must be solely payments of principal and interest on the principal amount outstanding (i.e. SPPI); &
• The business model: the objective of the business model relevant to this asset must be to collect contractual cash flows (i.e. no intention to trade in the instruments). See IFRS 9.4.1.2
However, a financial asset that meets both these requirements, and should thus be classified at AC, may be designated as fair value through profit or loss (FVPL) instead if classifying at AC would have caused an accounting mismatch.
Classification: Financial assets at fair value through other comprehensive income – debt instruments
A financial asset shall be classified as fair value through other comprehensive income (FVOCI) if both the following conditions are met (which means by implication that the asset will be an investment in some kind of debt instrument e.g. a loan asset):
• The contractual cash flows: the contractual terms of the financial asset must give rise on specified dates to cash flows that are SPPI (i.e. solely payments of principal and interest on the principal amount outstanding); and
• The business model: the objective of the business model relevant to this asset must be to both collect contractual cash flows and sell the asset. See IFRS 9.4.1.2A
However, a financial asset that meets both these requirements, and should thus be classified at FVOCI, may be designated as fair value through profit or loss (FVPL) instead if the FVOCI classification would cause an accounting mismatch. See IFRS 9.4.1.5
Please note that since this classification requires that the asset has contractual cash flows, this classification of FVOCI would include only debt instruments (i.e. it would not include equity or derivative instruments because these do not offer contractual cash flows).
There is a further classification of FVOCI that deals exclusively with equity instruments that the entity has elected to classify at FVOCI. The FVOCI classification that deals only with debt instruments is accounted for differently to the FVOCI classification that deals with equity instruments. For this reason, I will refer to the one classification as FVOCI-debt and the other as FVOCI-equity.
Classification: Financial assets at fair value through profit or loss
The fair value through profit or loss (FVPL) classification is essentially a 'catch-all' classification for financial assets that do not qualify for classification as either amortised cost (AC) or fair value through other comprehensive income (FVOCI). However, financial assets that do meet one of these other classifications (i.e. AC or FVOCI) may be designated as fair value through profit or loss (FVPL) instead if the other classification would have caused an 'accounting mismatch'.
Example of an accounting mismatch: A financial asset is bought in order to offset the risks in a particular financial liability. The liability is measured at fair value but the asset is to be measured at amortised cost. This situation would mean that the gains and losses on the asset and liability would be recognised in different periods and on different bases. To avoid this, one is able to choose to designate the asset to be measured FVPL instead of amortised cost. See IFRS 9.4.1.5
This designation as FVPL due to there being an accounting mismatch may only be made on initial recognition and is irrevocable (i.e. management may not change its mind). See IFRS 9.4.1.5
In summary, a financial asset shall be classified as fair value through profit or loss (FVPL) if:
• it does not meet the criteria for classification at amortised cost (AC) and does not meet the criteria for classification as fair value through other comprehensive income (FVOCI) in other words:
o the contractual terms do not lead to cash flows on specified dates that are solely payments of principal and interest on principal (i.e. the SPPI test fails); and/or
o the model is neither to 'hold to collect ' nor to 'hold to collect and sell' (i.e. the objective of the business model is to 'hold to sell') (i.e. the BM test fails); or
o the entity chooses to designate the asset as FVPL because another classification would have caused an accounting mismatch. See IFRS 9.4.1.4 -5
A financial asset that is an equity investment would fail the SPPI test and thus automatically meet the FVPL classification, but may be classified as FVOCI instead under certain circumstances.
Classification: Financial assets at fair value through other comprehensive income – equity investments (IFRS 9.4.1.2 & IFRS 9.4.1.2A & IFRS 9.4.1.4 & IFRS 9.5.7.5)
The classification of certain equity instruments at fair value through other comprehensive income (FVOCI-equity) is regarded as a fourth classification because the measurement thereof differs from the measurement of the classification of fair value through other comprehensive income (FVOCI-debt)
The FVOCI-debt actually only involves debt instruments and it is a mandatory classification (i.e. if the requirements are met, the debt instrument must be classified at FVOCI). In contrast, the FVOCI-equity classification described in this section involves only investments in equity instruments and is purely an elective classification.
An entity may elect to classify a financial asset as fair value through other comprehensive income for equity instruments (FVOCI - equity) if it:
• is an investment in an equity instrument that is:
o not held for trading; and
o is not 'contingent consideration recognised by an acquirer in a business combination to which IFRS 3 applies'). See IFRS 9.5.7.5 In other words, if a financial asset is an investment in an equity instrument that is held for trading, the entity may not elect to classify it at 'FVOCI-equity' (i.e. it will have to be classified at FVPL).
The reason why this elective classification was introduced was because investments in equity instruments (e.g. ordinary listed shares) would otherwise always be classified as fair value through profit or loss (FVPL). This means that as the relevant share price rises and falls, fair value gains or losses would be recognised in 'profit or loss'.
However, if an entity has no intention to trade in its equity investments, it would generally prefer to present the related fair value gains or losses in 'other comprehensive income' so as to avoid its 'profit or loss' from being needlessly affected. In this case, the entity may thus prefer to classify its equity instrument as fair value through other comprehensive income (FVOCI-equity) instead.
However, a factor that should be considered before electing to classify an equity instrument at FVOCI-equity is that, if and when the equity instrument is eventually sold, the fair value gains or losses previously recognised in 'other comprehensive income' may never be reclassified to 'profit or loss'.
This election to classify the equity investment at FVOCI-equity may only be made on initial recognition and is irrevocable (i.e. management may not change its mind). See IFRS 9.4.1.4
The election is made on an 'instrument-by-instrument' basis. However, judgement is needed in deciding whether one will have to classify all shares within an investee in the same way or whether it is possible to classify some of the shares in an investee as FVOCI-equity and some as FVPL.
Financial assets are essentially classified based on the two basic measurement models of amortised cost and fair value. However, there are actually four formal classifications due to the three possible accounting treatment of the gains or losses under the fair value model:
1. amortised cost (AC)
2. fair value through profit or loss (FVPL)
3. fair value through other comprehensive income for debt instruments (FVOCI - D)
4. fair value through other comprehensive income for equity instruments (FVOCI - E)
Overview of the classification process
Other than cash, financial assets are essentially comprised of debt instruments, investments in equity instruments, and derivatives. Each one of these assets is classified by assessing:
• Its contractual cash flow characteristics (step 1 the CCF test); and
• The business model within which that financial asset is managed (step 2 the BM test).
Step 1 - the CCF test:
The contractual cash flows test involves assessing whether the asset's contractual terms will lead to the entity receiving:
• cash flows on specified dates
• that are solely payments of:
o principal, and
o interest on the principal (SPPI).
Investments in equity instruments (e.g. ordinary shares) fail this test since they do not offer contractual cash flows at all whereas debt instruments (e.g. bonds) would pass.
Step 2 - the BM test:
The business model test involves assessing the business model relevant to the asset to determine the objectives applied in managing that asset. These objectives may be:
• to hold the asset with the principal aim being to sell the asset (hold to sell);
• to collect the contractual cash flows (hold to collect); or
• to collect the contractual cash flows and to sell the asset (hold to collect and sell).
Essentially, the process is as follows:
• If a financial asset does not meet the CCF test (i.e. does not offer contractual cash flows on specified dates that are solely payments of principal and interest), the asset is classified at fair value through profit or loss (FVPL) unless it is an investment in an equity instrument that is not held for trading, in which case the entity can elect to classify it at fair value through other comprehensive income (FVOCI) instead (although this designation can only happen on initial recognition and is irrevocable).
• If the asset does meet the CCF test, our next step is to consider the objective of the business model that will be used to manage the asset. If the objective of the relevant business model is to:
• Simply collect the contractual cash flows, the asset is classified at amortised cost (AC);
• Collect the contractual cash flows and also to sell the asset, then the asset is classified at fair value through other comprehensive income (FVOCI);
• Sell the asset, then the asset is classified at fair value through profit or loss (FVPL).
• If classification at AC or FVOCI would cause an accounting mismatch, the asset may be designated at FVPL instead (although this designation can only happen on initial recognition and is irrevocable).
Classification: Financial assets at amortised cost (IFRS 9.4.1.2)
A financial asset shall be classified as amortised cost (AC) if both the following conditions are met:
• The contractual cash flows: the contractual terms of the asset must give rise to cash flows on specified dates and these cash flows must be solely payments of principal and interest on the principal amount outstanding (i.e. SPPI); &
• The business model: the objective of the business model relevant to this asset must be to collect contractual cash flows (i.e. no intention to trade in the instruments). See IFRS 9.4.1.2
However, a financial asset that meets both these requirements, and should thus be classified at AC, may be designated as fair value through profit or loss (FVPL) instead if classifying at AC would have caused an accounting mismatch.
Classification: Financial assets at fair value through other comprehensive income – debt instruments
A financial asset shall be classified as fair value through other comprehensive income (FVOCI) if both the following conditions are met (which means by implication that the asset will be an investment in some kind of debt instrument e.g. a loan asset):
• The contractual cash flows: the contractual terms of the financial asset must give rise on specified dates to cash flows that are SPPI (i.e. solely payments of principal and interest on the principal amount outstanding); and
• The business model: the objective of the business model relevant to this asset must be to both collect contractual cash flows and sell the asset. See IFRS 9.4.1.2A
However, a financial asset that meets both these requirements, and should thus be classified at FVOCI, may be designated as fair value through profit or loss (FVPL) instead if the FVOCI classification would cause an accounting mismatch. See IFRS 9.4.1.5
Please note that since this classification requires that the asset has contractual cash flows, this classification of FVOCI would include only debt instruments (i.e. it would not include equity or derivative instruments because these do not offer contractual cash flows).
There is a further classification of FVOCI that deals exclusively with equity instruments that the entity has elected to classify at FVOCI. The FVOCI classification that deals only with debt instruments is accounted for differently to the FVOCI classification that deals with equity instruments. For this reason, I will refer to the one classification as FVOCI-debt and the other as FVOCI-equity.
Classification: Financial assets at fair value through profit or loss
The fair value through profit or loss (FVPL) classification is essentially a 'catch-all' classification for financial assets that do not qualify for classification as either amortised cost (AC) or fair value through other comprehensive income (FVOCI). However, financial assets that do meet one of these other classifications (i.e. AC or FVOCI) may be designated as fair value through profit or loss (FVPL) instead if the other classification would have caused an 'accounting mismatch'.
Example of an accounting mismatch: A financial asset is bought in order to offset the risks in a particular financial liability. The liability is measured at fair value but the asset is to be measured at amortised cost. This situation would mean that the gains and losses on the asset and liability would be recognised in different periods and on different bases. To avoid this, one is able to choose to designate the asset to be measured FVPL instead of amortised cost. See IFRS 9.4.1.5
This designation as FVPL due to there being an accounting mismatch may only be made on initial recognition and is irrevocable (i.e. management may not change its mind). See IFRS 9.4.1.5
In summary, a financial asset shall be classified as fair value through profit or loss (FVPL) if:
• it does not meet the criteria for classification at amortised cost (AC) and does not meet the criteria for classification as fair value through other comprehensive income (FVOCI) in other words:
o the contractual terms do not lead to cash flows on specified dates that are solely payments of principal and interest on principal (i.e. the SPPI test fails); and/or
o the model is neither to 'hold to collect ' nor to 'hold to collect and sell' (i.e. the objective of the business model is to 'hold to sell') (i.e. the BM test fails); or
o the entity chooses to designate the asset as FVPL because another classification would have caused an accounting mismatch. See IFRS 9.4.1.4 -5
A financial asset that is an equity investment would fail the SPPI test and thus automatically meet the FVPL classification, but may be classified as FVOCI instead under certain circumstances.
Classification: Financial assets at fair value through other comprehensive income – equity investments (IFRS 9.4.1.2 & IFRS 9.4.1.2A & IFRS 9.4.1.4 & IFRS 9.5.7.5)
The classification of certain equity instruments at fair value through other comprehensive income (FVOCI-equity) is regarded as a fourth classification because the measurement thereof differs from the measurement of the classification of fair value through other comprehensive income (FVOCI-debt)
The FVOCI-debt actually only involves debt instruments and it is a mandatory classification (i.e. if the requirements are met, the debt instrument must be classified at FVOCI). In contrast, the FVOCI-equity classification described in this section involves only investments in equity instruments and is purely an elective classification.
An entity may elect to classify a financial asset as fair value through other comprehensive income for equity instruments (FVOCI - equity) if it:
• is an investment in an equity instrument that is:
o not held for trading; and
o is not 'contingent consideration recognised by an acquirer in a business combination to which IFRS 3 applies'). See IFRS 9.5.7.5 In other words, if a financial asset is an investment in an equity instrument that is held for trading, the entity may not elect to classify it at 'FVOCI-equity' (i.e. it will have to be classified at FVPL).
The reason why this elective classification was introduced was because investments in equity instruments (e.g. ordinary listed shares) would otherwise always be classified as fair value through profit or loss (FVPL). This means that as the relevant share price rises and falls, fair value gains or losses would be recognised in 'profit or loss'.
However, if an entity has no intention to trade in its equity investments, it would generally prefer to present the related fair value gains or losses in 'other comprehensive income' so as to avoid its 'profit or loss' from being needlessly affected. In this case, the entity may thus prefer to classify its equity instrument as fair value through other comprehensive income (FVOCI-equity) instead.
However, a factor that should be considered before electing to classify an equity instrument at FVOCI-equity is that, if and when the equity instrument is eventually sold, the fair value gains or losses previously recognised in 'other comprehensive income' may never be reclassified to 'profit or loss'.
This election to classify the equity investment at FVOCI-equity may only be made on initial recognition and is irrevocable (i.e. management may not change its mind). See IFRS 9.4.1.4
The election is made on an 'instrument-by-instrument' basis. However, judgement is needed in deciding whether one will have to classify all shares within an investee in the same way or whether it is possible to classify some of the shares in an investee as FVOCI-equity and some as FVPL.
Accounting Mismatch
• The contractual cash flow and business models are there simply to classify financial assets.
• The accounting mismatch is not related to the classification process directly but is a consequence of the classification process.
• In other words if one follows the IFRS 9 classification process the outcome of which will be a debit and a credit.
• Where the debit and credit are classified differently, which results in different measurement bases and different profit or loss implications – you have identified a potential accounting mismatch.
• In order to eliminate or reduce these differences management may choose to measure the debit and the credit on the fair value through profit or loss basis.
• The importance of the classification process cannot be underestimated as if the classification is wrong the ability to identify an accounting mismatch is negligible.
• If all financial assets and financial liabilities could be designated fair value through profit or loss there would never be an accounting mismatch.
• However the classification process contains mix of a number of classification bases where fair value through profit or loss will never be allowed, thereby creating the potential for the accounting mismatch.
Example
ABC Ltd, an investment property company, adopts the fair value model to measure its investment properties. The fair value of the investment properties is highly dependent on interest rates.
On 31 December 2018, ABC Ltd took out a R5.000.000 bank loan specifically to finance the purchase of some new investment properties. Fixed interest at the market rate of 6% is charged for the 8-year term of the loan. Transaction costs of R120.000 were incurred.
A bank loan would normally be initially measured at fair value less transaction costs and subsequently at amortized cost.
In the case of ABC Ltd, the initial measurement at fair value less transaction costs on 31 December 2018 would result in a financial liability R4 880 000 (R5 000 000 – R120 000).
Subsequent measurement would then be at amortized cost. An effective interest rate would then need to be calculated to incorporate the 6% interest and the R120 000 transaction costs. This effective interest would be recognized as an expense in P/L from the year ended 31 December 2018.
However, IFRS 9 offers an option to designate a financial liability on initial recognition as at FVTPL in order to eliminate or significantly reduce a measurement or recognition inconsistency (an ‘accounting mismatch’).
This option is available to ABC Ltd here because the bank loan is being used specifically to finance the purchase of investment properties.
Under the accounting policy of ABC Ltd, these investment properties will be measured at fair value with gains or losses recognized in P/L. Therefore, if the loan were measured at amortized cost, there would be a measurement inconsistency.
To eliminate this accounting mismatch, ABC Ltd may choose to designate the bank loan on initial recognition on 31 December 2018 as at FVTPL.
If this option is chosen, the loan will be initially recognized at its fair value of R5 000 000 and the transaction costs of R120 000 will be expensed through profit or loss.
Subsequently, the loan will be measured at fair value with any gains or losses being recognized in profit or loss, in line with the accounting treatment of the investment properties it was used to finance.
An accounting mismatch occurs when gains and losses on two items subject to the same fair value risk are not recognised consistently.
This could occur where, in the absence of the fair value option, a financial asset would be classified as available-for-sale (with most changes in fair value recognised directly in equity) while a related liability is measured at amortised cost (with changes in fair value not recognised).
The entity need not enter into the assets and liabilities at the same time provided that the time gap is reasonable and the remaining transactions are expected to occur.
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