According to International Financial Reporting Standard No. 9 (IFRS 9), financial instruments are defined as a contract that gives rise to a financial asset in one entity and a financial liability or equity instrument in another entity.
In general terms, it is a contractual agreement between two parties, which involves a purchase-sale contract and an invoice, which generates a commitment of cash inflow or outflow (cash flow).
New classification approach
IFRS 9 establishes new parameters for the classification of financial assets according to their subsequent measurement, based on the characteristics of the contractual cash flows and the business model of the entity from the management of the assets, which achieve the business objectives.
The assets that are identified as financial can be listed as follows:
- Cash and cash equivalents.
- Accounts Receivable.
- Investments in shares.
- Financial Investments (Bonds).
- Debts receivable.
- Accounts receivable for leases.
- Contract assets that are within the scope of IFRS 15.
The liabilities identified as financial can be listed as follows:
- Accounts payable.
- Financial obligations – Such as: Bonds, obligations issued seeking leverage.
Equity instruments are represented by the common shares issued.
Classification and valuation of financial assets
An entity will classify financial assets into 3 categories, as measured below:
The entity classifies the asset at amortized cost when it maintains a business model whose objective is to maintain the financial assets in order to obtain the contractual flows, and within its contractual conditions the financial asset leads to cash flows, where only the payment of principal and interest on the outstanding amount, on a given date (e.g. at maturity), will be remunerated.
These assets are subsequently measured at amortized cost using the effective interest method. The amortized cost is reduced by impairment losses. Interest income, foreign currency translation gains and losses, and impairment are recognized in income. Any gain or loss on derecognition is recognized in income.
Fair value with changes in other comprehensive income (Equity)
A financial asset must be measured at fair value with changes in other comprehensive income if the entity’s management intends to hold the financial asset to obtain the contractual flows and/or keep it for trading, and within its contractual terms the financial asset leads to cash flows, where only the payment of principal and interest on the outstanding amount, on a given date, will be remunerated.
Changes in fair value are recognized in other comprehensive income.
Fair value through profit and loss
An asset must be measured at fair value through profit or loss if the financial assets do not meet the conditions mentioned in the above categories (measured at amortized cost or at fair value through other comprehensive income).
Net gains and losses, including any interest or dividend income, are recognized in income.
For purposes of better application, paragraph 4.1.3 of the standard explains the meaning of principal and interest:
- Principal is the fair value of the financial asset at initial recognition.
- Interest consists of the consideration for the time value of money, for the credit risk associated with the principal amount outstanding during a specific period of time, and for other basic risks and costs of borrowing, as well as a profit margin.
Classification of financial liabilities
Financial liabilities are classified as measured at amortized cost or fair value through profit and loss.
A financial liability is classified at fair value through profit or loss if it is classified as held for trading, is a derivative, or is designated as such upon initial recognition. Financial liabilities at fair value through profit or loss are measured at fair value and net gains and losses, including any interest expense, are recognized in earnings.
An entity will classify all financial liabilities as subsequently measured at amortized cost.
Financial assets are not reclassified after initial recognition unless the Company changes its business model to one that manages financial assets, in which case all affected financial assets are reclassified on the first day of the first reporting period following the change in business model.
Financial liabilities may not be reclassified for any reason after their initial recognition.
Islava Zulema Ruiz Quiroz Bachelor of Public Accounting