How are financial assets classified under IFRS 9, and what determines whether gains go through P&L or OCI?
I keep getting classification questions wrong. There's amortized cost, FVOCI, and FVPL, but I can't remember the decision criteria. How do the business model test and the contractual cash flow characteristics test work together?
IFRS 9 classifies financial assets into three measurement categories based on two tests applied at initial recognition: the business model test and the contractual cash flow characteristics (SPPI) test.
The Two Tests
Test 1: Business Model -- What is the entity's objective for holding the asset?
- Hold to collect -- The objective is to hold the asset and collect contractual cash flows (not to sell).
- Hold to collect and sell -- The objective is both collecting cash flows and selling assets.
- Other / Trading -- Held for trading, managed on a fair value basis, or neither of the above.
Test 2: SPPI (Solely Payments of Principal and Interest) -- Do the contractual cash flows represent only principal and interest on the principal amount outstanding?
- Basic lending arrangement (fixed or floating rate, standard terms) = passes SPPI.
- Convertible features, equity-linked returns, leverage features = fails SPPI.
Classification Matrix:
| Business Model | SPPI Test | Classification | Measurement |
|---|---|---|---|
| Hold to collect | Pass | Amortized cost | No fair value changes in income |
| Hold to collect and sell | Pass | FVOCI | FV changes in OCI, recycled to P&L on sale |
| Other / Trading | Pass or Fail | FVPL | FV changes in P&L |
| Any model | Fail | FVPL | FV changes in P&L |
Example: Westbrook Asset Management holds three bond portfolios:
- Corporate loan book -- Held to maturity, standard fixed-rate terms. Business model = hold to collect, passes SPPI. Classification: Amortized cost.
- Treasury bond portfolio -- Held for liquidity but regularly sells bonds to rebalance. Business model = hold to collect and sell, passes SPPI. Classification: FVOCI.
- Convertible bond fund -- Holds bonds with equity conversion features. The conversion option means cash flows are not solely P&I. Fails SPPI regardless of business model. Classification: FVPL.
Equity Instruments -- Special Rule
Equity investments (stocks) do not have contractual cash flows of P&I, so they automatically fail the SPPI test and default to FVPL. However, IFRS 9 allows an irrevocable election at initial recognition to classify non-trading equity instruments at FVOCI. Under this election, dividends go to P&L but fair value changes go to OCI and are never recycled to P&L.
Exam Tip: The SPPI test is the gatekeeper. If it fails, the asset goes straight to FVPL regardless of business model. If it passes, the business model determines whether amortized cost or FVOCI applies.
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