When an entity acquires a financial asset it acquires equity in another entity (eg investment in ordinary shares) or a debt asset (eg an investment in debentures, trade receivables).
Financial assets have to be classified and accounted for in one of three categories:
Initially financial assets are measured at fair value plus, in the case of a financial asset not at FVTPL, transaction costs.
Subsequent measurement is then at either Fair Value or Amortised cost, depending on the category of financial assets.
Equity investments have to be measured at fair value in the statement of financial position. The default position for equity investments is that the gains and losses arising are recognised in income (FVTPL). However, there is an election that equity investments can at inception be irrevocably classified and accounted as at FVTOCI, so that gains and losses arising are recognised in other comprehensive income, thus creating an equity reserve, while dividend income is still recognised in income. Such an election cannot be made if the equity investment is acquired for trading. On disposal of an equity investment accounted for as FVTOCI, the gain or loss to be recognised in income is the difference between the sale proceeds and the carrying value. Gains or losses previously recognised in other comprehensive income cannot be recycled to income as part of the gain on disposal.
A financial asset that is a debt instrument will be subsequently accounted for using amortised cost if it meets two simple tests. These two tests are the business model test and the cash flow test.
These tests are designed to ensure that the fair value of the asset is irrelevant, as even if interest rates fall – causing the fair value to raise – then the asset will still be passively held to receive interest and capital and not be sold on.
However, even if the asset meets the two tests there is still a fair value option to designate it as FVTPL. Further discussion of this designation is however beyond the scope of this publication.