Financial Asset Classification: Amortised Cost, FVOCI and FVTPL

A financial asset takes one of three routes, and the business does not simply choose. Two tests decide: what the business's model for holding the asset is, and whether the asset's contractual cash flows are solely payments of principal and interest. Together they place the holding at amortised cost, at fair value through other comprehensive income, or at fair value through profit or loss, and the route settles where every later gain appears.

Once a business has bought a financial asset, two separate questions have to be answered before a single rupee of it can be reported. The accounts then measure the holding one of three ways for the whole of its life, and the choice of route is what decides whether a movement in its market price reaches profit, reaches a separate section of the performance statement, or is never recognised at all. None of those three outcomes is more honest than the others. The three routes are three answers to the same question, and a reader has to know which answer is in front of them.

Three earlier ideas carry into this one. Amortised cost as a measurement basis, set against fair value, was established when stock measurement was covered. The test that separates a financial liability from an equity instrument was established for the issuer. The same contract seen from the other side raises a related but different question: how the holder carries what the issuer wrote. Other comprehensive income has been named. Both tests, applied in order, settle the route, and the route settles where a gain lands. The most confusing thing in the subject comes last: one kind of holding sends its accumulated movement into profit on disposal and another kind never does.

Anjani Stationers Private Limited holds no financial assets of this kind at all. Its Rs 5,00,000 of cash and cash equivalents is cash, its Rs 86,00,000 of net receivables is a different subject, and its Rs 21,00,000 holding in Chitra Binding Works is a subsidiary carried at cost in the standalone accounts rather than an investment being measured under these rules.

What are the two tests, and which one is about the instrument?

The two tests are less strange than their names, so start with the everyday shape of them. Imagine a woman who buys gold for her daughter's wedding and a jeweller who buys the same gold to sell next week. Identical metal, identical purity, identical price. Only one of them is going to sell, so only one of them cares what the gold would fetch today. The gold has not changed. The difference lies in what each person is doing with the gold, and that difference is worth recording.

The gold example cannot show the second half. Suppose the woman had instead lent Rs 50,000 to a neighbour who promised to repay it with a stated amount of interest on stated dates. The loan produces two things and only two: her money back, and a charge for time. Compare it with a share in the neighbour's shop. A share produces whatever the shop turns out to be worth. Both are things she holds. Only one of them is a promise of principal and interest, and no amount of intention on her part can turn the second into the first.

The two tests have formal names. The business model testThe question of what a business does with assets of a particular kind: holds them to collect the payments due on them, holds them both to collect and to sell, or something else. It is assessed for a group of assets, not one at a time, and reflects what the business actually does rather than what it says. asks how the business uses assets of this kind. Three answers are worth naming: the business holds them to collect the contractual cash flows, holds them both to collect and to sell, or does neither. The third answer covers holdings acquired to be traded and everything else that does not fit the first two. The cash flow testThe question of whether an instrument's contractual terms give rise, on specified dates, to cash flows that are solely payments of principal and interest on the principal outstanding. Often written as the SPPI test. It is a question about the contract, not about the holder. asks something entirely different: do the contractual terms of the instrument give rise, on specified dates, to cash flows that are solely payments of principal and interest on the principal outstanding?

The business model test is a question about the holder and the cash flow test is a question about the instrument, and confusing which is which is the source of almost every classification error a reader will meet. The distinction has a consequence that can be acted on. A business can change its answer to the first test by changing what it actually does, and that change is visible, deliberate and rare. The second test reads a contract somebody else drafted, so no business can change its answer to that one at all. Both must be satisfied before either of the first two routes is available. Fail the cash flow test and the business model becomes irrelevant, however clearly the business states its intentions.

How do the two tests place a holding on one of the three routes?

Put the two tests on two edges of a grid and the three routes fall out of it without anybody choosing anything. Along one edge sit the three business model answers. Along the other sit the two possible answers to the cash flow test. Six cells, three outcomes, and one of them fills an entire column on its own.

Work the passing column first. A holding whose contractual cash flows are solely principal and interest, held in a business model whose purpose is to collect those cash flows, is measured at amortised costA measurement basis under which a holding is carried at what was paid for it, adjusted for interest recognised and cash received, rather than at what it would fetch today. The carrying amount is a record of what has happened to the instrument.. The same holding in a business model whose purpose is both to collect the cash flows and to sell is measured at fair value through other comprehensive incomeOften shortened to FVOCI. The holding is carried at fair value on the balance sheet, but the movement in that fair value is reported in other comprehensive income rather than in profit. Interest still goes to profit.. Both purposes are real, and the measurement has to serve both. And the same holding in a business model that is neither of those goes to fair value through profit or lossOften shortened to FVTPL. The holding is carried at fair value on the balance sheet and every movement in that fair value goes straight into profit for the period, alongside any interest or dividend received..

The failing column has only one answer in it, top to bottom: an instrument that fails the cash flow test goes to fair value through profit or loss regardless of what the business intends to do with it. There is one refinement inside that column and it is a genuine choice rather than a consequence. For certain equity investments that are not held for trading, a business may elect, at the point it first recognises the holding, to present the movements in other comprehensive income instead. The election is irrevocable, it is made holding by holding, and it carries a consequence set out further below that catches a great many readers out.

What is Amortised Cost Accounting, worked across fourteen months?

Amortised cost is the route people think they understand and then cannot compute, so work it rather than accept the name. Amortised cost has four moving parts and they always run in the same order. The holding starts at an amount: what was paid for it, including the costs directly attributable to acquiring it. There is an effective interest rateThe rate that exactly discounts the estimated future cash receipts of an instrument to its carrying amount at initial recognition. It spreads every fee, discount and premium over the life of the instrument rather than recognising them when they are paid.. The rate ties what was paid to what will be received across the whole life. There is interest recognised each period, computed by applying that rate to the carrying amount at the start of the period. And cash actually received reduces the carrying amount when it arrives.

Take the hypothetical Rs 10,00,000 fixed deposit maturing in fourteen months. Anjani Stationers holds no such deposit. Give it an assumed effective interest rate of 0.6 per cent per month. A different rate would move every figure in the table below, and the arithmetic behind them would not change at all. Assume the deposit is cumulative, so nothing is paid out until maturity. The carrying amount then starts at Rs 10,00,000, and every month the business recognises interest of 0.6 per cent of the amount currently carried. No cash arrives to take that interest away, so it is added to the carrying amount.

Read the table in two directions and it reconciles both ways. Down the interest column, the fourteen monthly amounts total Rs 87,356. Across the life, Rs 10,00,000 was paid out and Rs 10,87,356 came back. The difference is exactly Rs 87,356, the same figure again. The effective interest rate imposes one discipline: every rupee of difference between what went out and what came in is recognised as interest, spread across the periods in which the money was at work, and nothing is left over at the end.

Notice the interest amounts rising, from Rs 6,000 in month one to Rs 6,485 in month fourteen. The rise is not a rate change. The rate is fixed at 0.6 per cent throughout. The amount rises because the rate is applied to the carrying amount, and the carrying amount is growing as unpaid interest accumulates inside it. Compare the alternative: if the same deposit paid its interest out in cash every month, each payment would remove exactly what had been added, the carrying amount would sit at Rs 10,00,000 for all fourteen months, and the total interest would be fourteen payments of Rs 6,000, or Rs 84,000. The Rs 3,356 difference between Rs 87,356 and Rs 84,000 is interest earned on interest that was left in place.

Under amortised cost the carrying amount is a history of what has happened to the instrument rather than a price. A movement in what the deposit could be sold for today therefore changes the accounts by exactly nothing. Take month eight. The carrying amount at the end of that month is Rs 10,49,020. Suppose that at the same date, entirely hypothetically, deposits of this kind were being written at better terms, so a buyer would pay only Rs 10,30,000 for this one. The balance sheet still reports Rs 10,49,020. The business is not going to sell the deposit, and the contractual amounts it will collect have not changed by a rupee. No loss of Rs 19,020 is recognised, nowhere in profit and nowhere in other comprehensive income. Had the identical deposit been measured at fair value through profit or loss, that Rs 19,020 would have gone straight through the profit figure. Same deposit, same bank, same month.

Where do the gains and losses go under each route?

Three routes, four kinds of movement, and every combination has exactly one answer. Once a movement can be placed, any investment note in any set of accounts can be read without looking anything up. The twelve combinations are worth committing to memory.

Interest and dividend income behaves the same way everywhere: it goes to profit under all three routes. Under amortised cost and under fair value through other comprehensive income, the interest figure is the one produced by the effective interest rate rather than the cash coupon. Both routes therefore report the same interest on the same instrument even though their balance sheets differ. The movement in market value is where the routes separate. Under amortised cost it is recognised nowhere at all. Under fair value through other comprehensive income it is recognised, but outside profit, in the section of the performance statement that sits below it. Under fair value through profit or loss it lands inside profit with everything else.

The balance sheet under amortised cost carries a history and the balance sheet under either fair value route carries a price, and a reader who knows only the route already knows which of those two things they are looking at. A reader who sees a holding on the balance sheet at fair value through profit or loss knows the figure is a current estimate of what it would fetch, and knows that any change in it has already passed through the profit they are reading. A reader who sees a holding at amortised cost knows the figure is what was paid adjusted for what has been recognised and received since, and knows that the current market estimate, whatever it is, is somewhere else entirely or nowhere at all.

What happens to the accumulated movement when the holding is finally sold?

One thing in this subject trips up more readers than anything else, and it is worth slowing down for. Two holdings can both sit at fair value through other comprehensive income. Both can accumulate the same movement in the same place. And on the day each is sold, one of them sends that accumulated amount into profit and the other one never does, not on the day of sale and not on any day afterwards.

RecyclingMoving an amount that was previously recognised in other comprehensive income into profit in a later period, usually when the holding is disposed of. Also called reclassification to profit or loss. Some items recycle and some never do. is the name for that transfer. A debt instrument measured at fair value through other comprehensive income recycles: while it is held, its fair value movements build up in a reserve outside profit, and when it is disposed of, the whole accumulated amount is moved out of that reserve and into profit for the period of disposal. The logic is that this business model contemplated selling from the start, so the result of selling belongs in the profit figure. The consequence is that over the whole life of the holding, cumulative profit under this route ends up identical to cumulative profit under fair value through profit or loss. Only the timing differed.

An equity investment for which the business made the election never recycles, so the accumulated movement stays outside profit permanently and a gain of Rs 36,000 that a reader can see plainly in the accounts will never once appear in any profit figure the business reports. The amount is not lost. The gain stays within equity, and a business may move it from one reserve to another within equity on disposal. But it does not pass through profit on the way, ever. The election is therefore a choice with a consequence rather than a presentation preference: a business that elects this treatment for a holding has decided, permanently and at the outset, that the eventual result of holding it will never be part of reported profit.

What happens to two businesses holding exactly the same thing?

Take the cleanest possible comparison. Two businesses, both invented for this example, each holding an identical hypothetical Rs 10,00,000 debt instrument bought on the same day. Over the period each receives Rs 72,000 of cash income and each sees the market value of the holding rise by Rs 36,000. Nothing whatsoever differs between the two holdings. The business model differs: the first holds assets of this kind both to collect and to sell, so its holding is at fair value through other comprehensive income; the second holds assets of this kind for neither of those purposes, so its holding is at fair value through profit or loss.

The first business reports profit of Rs 72,000 from the holding and other comprehensive income of Rs 36,000. The second reports profit of Rs 1,08,000 and other comprehensive income of nil. Set those side by side and the first business appears to have had a considerably worse period on the measure most readers look at first. Its profit is a third lower on an identical holding producing identical cash.

The two lines added together come to Rs 1,08,000 in each business. The classification routes move income between statements and create none of it. Cash is identical too. The same Rs 72,000 arrived in each business on the same dates and the same Rs 36,000 of value was created in each. Not one rupee was generated or destroyed by the choice of route, and the reader who compares only the profit line has been told a true thing about presentation and mistaken it for a fact about performance.

At the worked default, with the business model set to hold to collect and the cash flow test passing, the route derived is amortised cost, lifetime profit is Rs 1,08,000, other comprehensive income is nil and total comprehensive income is Rs 1,08,000. Switch the business model to hold to collect and sell and the route becomes fair value through other comprehensive income. The Rs 36,000 that built up outside profit is recycled into it on disposal, so the lifetime figures do not change at all. Switch the cash flow test to failing and the route becomes fair value through profit or loss whatever the business model says, with lifetime profit still Rs 1,08,000. Only the elected equity route breaks the pattern: profit falls to Rs 72,000 and Rs 36,000 sits permanently in other comprehensive income. Drag the slider to minus Rs 60,000 and the elected route reports profit of Rs 72,000 against total comprehensive income of Rs 12,000. Profit and total comprehensive income are answering two different questions, and nothing on the panel shows it more plainly.

Can a business change route once it has chosen?

Almost never, and the reason is worth stating outright. A business reclassifies financial assets only when its business model for a whole class of assets has actually changed. Such a change is expected to be very infrequent. The change is applied from a date after it happens rather than backwards, so prior periods are not restated, and it has to be disclosed. ReclassificationMoving a financial asset from one measurement route to another after initial classification. Permitted only where the business model for a class of assets has genuinely changed, applied from a later date rather than retrospectively, and disclosed. is not available for a change of mind about a single holding, and it is not available at all in response to what the movements turned out to be.

The rule is deliberately hard because a freely available reclassification would let a business decide where its gains and losses appear after it had already seen what they were. Follow that through and the mischief is obvious. A business sitting on a large unrealised loss inside profit would move the holding to a route that reports movements outside profit. A business sitting on a large unrealised gain outside profit would move it to a route that reports movements inside profit, and would do so in a quarter when profit needed help. The presentation would have been chosen with the answer already in hand, so the information would still be true in every particular and completely useless for comparison. The gate turns instead on a genuine change in how a business uses a whole class of assets, rather than on what a particular holding did, and that is what stops the mischief.

How do the four hypothetical holdings actually route?

Now run the tests on the labelled hypothetical portfolio used across this whole sequence. Anjani Stationers holds none of these. Its investment line contains only the Rs 21,00,000 holding in Chitra Binding Works. The Chitra Binding Works holding is a subsidiary carried at cost in the standalone accounts and is not measured under these rules at all. The four holdings below are teaching material and total Rs 23,00,000.

The Rs 6,00,000 debt fund fails the cash flow test and therefore cannot reach amortised cost by any route at all, however firmly the business intends to hold it and collect. The reason is worth sitting with. Money placed in a fixed deposit gives the holder a contractual claim on the bank: return of the principal, and interest on the principal outstanding, on specified dates. Nobody owes the holder of a fund unit principal or interest, so a unit in a debt fund carries no such promise. The unit carries a proportionate claim on whatever a pool of assets turns out to be worth on redemption. The pool may hold instruments that themselves pay principal and interest, and that changes nothing about the unit. The word debt in the name of the fund describes what the fund invests in, not what the unit promises.

The everyday version runs like this. Rs 20,000 lent to a shopkeeper against a written promise of repayment with a stated charge is a claim on the shopkeeper. Rs 20,000 put into a chit arrangement that lends to twenty shopkeepers is a share of the pot. Every underlying loan in the pot looks exactly like the first one, and the share is still something entirely different. The claim is on the pot, and the pot is worth whatever it is worth.

Who reads a classification note, and what do they actually do with it?

Three different people open the investment note in the same week, and none of them wants the same thing from it.

A lender reads the route before it reads the investment total, an analyst restates two businesses onto the same basis before comparing a single growth rate, and a finance controller in Vaidehi Rao's position reads the route at the moment of purchase rather than at the year end. The election cannot be made later. Take each in turn. The lender's question is whether a reported investment figure is a price or a history. A price and a history behave differently when the lender needs the money. A holding carried at amortised cost may be worth appreciably less than its carried figure, as the month eight example showed: Rs 10,49,020 on the balance sheet against Rs 10,30,000 a buyer would pay. A holding carried at fair value carries no such gap on the reporting date, though it may have moved since. The lender is not accusing anybody of anything. The lender is asking which of the two numbers it is holding.

The analyst's use is the comparison problem drawn above. Two businesses reporting Rs 72,000 and Rs 1,08,000 of profit on identical holdings will show different profit growth, different margins and different returns on capital, and every one of those differences is presentational. The discipline is to find the classification policy note, find the amounts recognised in other comprehensive income, and add them back before comparing. The restatement costs a few minutes and removes a difference that has nothing to do with how either business traded.

And a finance controller has the most time-critical use of the three. The equity election has to be made when the holding is first recognised, and it cannot be revisited afterwards. So a business buying a stake in a supplier faces a permanent decision on the day of purchase, before anybody knows what the holding will do: send its future movements through profit, where they will make reported profit swing with something unconnected to trading, or send them outside profit permanently, where they will never appear in a profit figure even when the stake is eventually sold at a large gain. Neither answer is right. The wrong outcome is discovering on the day of sale that the decision was made years ago by somebody who did not know it was a decision.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited and Vaidehi Rao are invented.
Educational material. Not advice on any investment, tax, budget or market position.