Accounting for financial assets under IFRS
Financial assets under IFRS are classified and measured in one of three ways, namely financial assets at Fair Value Through Profit or Loss (“FVTPL”), financial assets at Fair Value Through Other Comprehensive Income (“FVOCI”), and financial assets at amortised cost.
The thought process for classifying financial assets should depend on whether the financial asset is a debt instrument or an equity instrument, although technically, cash also falls within the definition of a financial asset.
Equity Instruments
The classification of equity instruments is typically at FVTPL, but if the instruments are not held for trading, an entity may designate them irrevocably at inception as FVOCI. In this particular case, fair value changes are booked through Other Comprehensive Income (“OCI”), and upon disposal, any balances in OCI are reclassified to retained earnings, rather than to profit and loss.
Debt Instruments
Debt instruments require an assessment of whether the contractual cash flows of the instrument are solely payments of principal and interest (“SPPI Test”). If not, the SPPI Test is deemed failed and the debt instrument is classified as FVTPL. If the SPPI test is satisfied, one would need to carry out a further test, the business model test. The business model might be primarily the collection of contractual cash flows (‘hold to collect’), in which case the instrument is classified at amortised cost. In this case, the effective interest method is applied and reporting date fair values are ignored for valuation purposes. If the business model is ‘hold to sell’, as evidenced for instance by the frequent trading of such instruments, the debt instrument is classified as FVTPL. Some instruments might be ‘hold to collect and sell’, meaning that both the collection of contractual cash flows and the reselling of the instruments are typical. In this case, the debt instrument is classified as FVOCI. In the case of debt instruments at FVOCI, the preparer needs to apply the effective interest method, adjust for fair values through OCI, and upon disposal, reclassify any OCI balances from OCI to profit and loss.
Also, instruments held to significantly reduce an accounting mismatch may be classified as FVTPL in spite of the above.
Accounting for financial assets under GAPSME
Under GAPSME, the classification and measurement considerations for financial assets change significantly.
Financial assets held for trading, for sale in the short term, or that are part of a portfolio with a profit-making objective are classified as financial assets held for trading (“HFT”) and may be measured at cost or at fair value through profit or loss. This does not apply for derivatives, however, which are always fair valued.
Preparers may designate all other financial assets as available-for-sale (“AFS”). The measurement of AFS depends on the type of instrument. Debt instruments are measured at fair value through equity, or at amortised cost. Investments in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured are measured at cost, whilst other equity instruments may be measured at fair value or at cost.
If the AFS designation option is not taken up, one would need to measure financial assets at amortised cost using the effective interest method if they meet the following definitions:
- The financial assets are unquoted loans or receivables with fixed or determinable payments, in which case the financial assets are classified as loans and receivables (“L&R”).
- The financial assets have fixed or determinable payments and fixed maturity, and the entity has a positive intent and ability to hold them to maturity (“HTM”).
Other financial assets would be classified and measured as AFS.
The audit of financial assets
The audit of financial assets requires us to design our audit procedures in order to obtain sufficient appropriate audit evidence on the client’s financial assets. The extent of work performed will depend on our risk assessment process undertaken during the planning stage of our audit, which would have determined whether our risk of material misstatement within year-end financial assets is low, medium or high.
Our audit procedures would require us to address each of the financial statement assertions that are relevant to financial assets, including:
- Classification
- Completeness
- Existence
- Valuation, and
- Rights and obligations
- Presentation and disclosure
Audit procedures designed to address the classification assertion would include obtaining a list of all investments held by the company at financial year end, and assessing the characteristics of each of these, to ensure they meet the classification criteria for their designation.
To ensure financial assets recorded by the entity at year end are complete, this would require us as auditors to obtain or prepare a summary of investments showing a reconciliation between the opening balance, additions and disposals made during the year, fair value movements (split between fair value movement and foreign exchange movements) and the closing balance at year end. It is important that the arithmetic accuracy of this list is also checked. Furthermore, we would need to confirm that investments included in the portfolio statement provided by client, and those obtained externally, have been appropriately included in the clients general ledger. Any differences identified here would need to be investigated accordingly.
To obtain comfort over the existence of investments held by the entity, this would require us to obtain third party confirmations from custodians / bankers as at the company’s financial year end. Comfort on additions and disposals of investments made during the financial year should also be obtained through vouching of supporting documentation in relation to such additions and disposals.
The valuation assertion is tested to ensure that the investment balances are mathematically correct and their values reflect the true economic value as at the reporting date. Comfort on the valuation of investments is usually obtained through the performance of the following audit procedures:
- Vouching of the year end investment balance to the year end market value as per custodian report / bank confirmation
- Testing of gains and losses on fair value movements, to ensure these have been properly recorded
- Testing of year end market value through independent evaluation and review of similar investments on the market
To obtain comfort over the rights and obligations assertion within the audit of investments, this entails the review of supporting custodian statements to ensure that all investments included within such statement are in the name of the entity being audited. Furthermore, it is imperative that a third party confirmation is obtained from the custodian in order to verify any restrictions in place over the company’s investments.
Finally, the auditor is required to review the company’s financial statements to ensure that investments have been properly classified and appropriately disclosed in the notes to the financial statements.
Should you require further information in relation to the above, please get in touch with John Debattista on jd@zampadebattista.com, Paul Zammit on pz@zampadebattista.com or Janis Hyzler on jh@zampadebattista.com.
Please note that this article is being published for information purposes only. As such, it does not constitute or should not be interpreted or construed as legal advice or guidance. Zampa Debattista does not accept responsibility or liability for any damages arising as a result of using this information as legal advice or guidance.
John Debattista
Partner
