My name is Steve Chen, a fellow member of ACCA and course director at APC (www.globalapc.com) teaching ACCA online courses to students from all around the world. This article will explain business model from investment in debt instruments in IFRS 9 Financial instruments.
Suppose a business acquires debt instruments from other parties, usually known as investment in debt instrument. In that case, it needs to go through two tests (business model and Solely payments of principal and interest/SPPI test) so that the investment in debt instrument can be classified and measured as:
l Amortised cost
l Fair value through profit or loss (FVTPL)
l Fair value through other comprehensive income (FVTOCI)
The SPPI test is straightforward as if the cash flows from the contract only includes cash flows to reflect time value of money, ie in the form of interest and principal payment as well as some reasonable compensation for early termination of contract, the cash flows are deemed to be fixed and it is not likely that the investment should be classified as ‘FVTPL’. In my ACCA FR/SBR courses, I always tell my students if the contractual cash flows include ‘options’, such as convertible bonds, the classification should be at ‘FVTPL’.
However, the business model test seems to be a bit difficult here. The business model test asks a business whether the investment held is for trading purposes or held to maturity, or a combination of both. If the investment in debt instrument is held for trading purposes, such as when an investor buys the debt and when interest rate decreases, the price of the debt (for example, bond) increases, the investor may sell it to enjoy capital gain. In this case, the debt should be classified as FVTPL investment in debt instrument.
When a business usually holds debt to maturity, usually with an aim to collect fixed cash flows mentioned above, the debt should be measured at amortised cost with finance income and dividend received to be recognised each period.
For other types of financial assets, it may comprise different elements in there. For instance, part of debts is held to maturity and part of them are for sale. This is commonly seen in the banking industry where banks loaned to their customers with a right to collect their future interest and principal. However, since a bank has many high-risk businesses such as transactions in derivatives, the bank may set up a special purpose vehicle (SPV) where customers' debts are sold to those SPV to transfer risks. A bank may have the policy to sell part of those debt to SPV and allow the SPV to securitise those debts and trade them in the secondary market (known as asset securitisation). In this case, by considering factors including:
l Frequency of sales of those investments in debt instruments
l Value of sales of those investments in debt instruments
l Whether remuneration of managers is based on fair value changes of the investment portfolio
If it can be demonstrated that the investment portfolio is partly for sale and partly for held to maturity purposes in business practice, the investment in debt instrument can be classified as ‘FVTOCI’ investment in debt instrument.
Hope this article clarifies the technical issue regarding classification of investment in debt instrument. In addition to providing ACCA lectures online, I also wrote articles in ACCA AB magazine. Besides, I am an author of four accounting books. If you are interested in studying ACCA courses with me, please visit my website http://www.globalapc.com for further information where you can find many of my ACCA demo video lectures.