When are financial instruments measured at amortized cost vs fair value, and what's the impact?

Question

AcadiFi · Accepted Answer

Under IFRS 9 (and similar US GAAP guidance), financial assets are classified into three measurement categories based on two tests: the **business model test** and the **cash flow characteristics test**.

**The Classification Framework**

```mermaid
flowchart TD
    A["Financial Asset"] --> B{"Cash flows = solely principal + interest?"}
    B -->|No| C["FVTPL (Fair Value Through Profit or Loss)"]
    B -->|Yes| D{"Business model?"}
    D -->|"Hold to collect"| E["Amortized Cost"]
    D -->|"Hold to collect AND sell"| F["FVOCI (Fair Value Through OCI)"]
    D -->|"Trading / Other"| C
```

**Category Details**

| Category | Balance Sheet | Unrealized Gains/Losses | Interest Income |
|---|---|---|---|
| Amortized Cost | Amortized cost (using effective interest) | Not recognized until sold/impaired | Effective interest method |
| FVOCI | Fair value | Other Comprehensive Income (OCI) | Effective interest method |
| FVTPL | Fair value | Income statement | Income statement |

**Worked Example -- Crestmont Bank:**

Crestmont purchases a $1,000,000 corporate bond at par, yielding 6%. At year-end, the bond's fair value is $1,020,000.

**If classified as Amortized Cost:**
- Balance sheet: $1,000,000 (no fair value adjustment)
- Income statement: $60,000 interest income
- No unrealized gain recognized

**If classified as FVOCI:**
- Balance sheet: $1,020,000 (fair value)
- Income statement: $60,000 interest income
- OCI: $20,000 unrealized gain (equity, not net income)

**If classified as FVTPL:**
- Balance sheet: $1,020,000 (fair value)
- Income statement: $60,000 interest + $20,000 unrealized gain = $80,000 total

**Key Analytical Implications:**
1. FVTPL creates the most **volatile** earnings because all fair value changes hit the income statement
2. Amortized cost provides the **smoothest** earnings but can hide economic losses
3. FVOCI is a **middle ground** -- fair value on the balance sheet but gains/losses bypass net income

**Equity Instruments Exception:** Under IFRS 9, equity investments that are not held for trading can be irrevocably designated as FVOCI. However, unlike debt instruments, the gains and losses in OCI are **never** recycled to the income statement.

**Exam Tip:** Expect questions asking you to identify the correct classification based on a scenario, or to calculate the income statement impact under different categories.

Test your understanding in our CFA Level I financial instruments practice questions.

When are financial instruments measured at amortized cost vs fair value, and what's the impact?

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Related Questions

Practice Questions

Category	Balance Sheet	Unrealized Gains/Losses	Interest Income
Amortized Cost	Amortized cost (using effective interest)	Not recognized until sold/impaired	Effective interest method
FVOCI	Fair value	Other Comprehensive Income (OCI)	Effective interest method
FVTPL	Fair value	Income statement	Income statement