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FINANCIAL INSTRUMENTS: FINANCIAL ASSETS AND FINANCIAL LIABILITIES

Financial instruments are the lifeblood of modern business. They are the contracts that underpin everything from bank loans and trade receivables to complex derivatives and equity investments. If your business has a bank account, owes money to a supplier, or has invested in another company, you are dealing with financial instruments. Understanding how to account for them is essential for accurate financial reporting and informed decision-making.

Get this wrong, and your financial statements will be misleading. You may misstate profits, misrepresent risk, and face regulatory scrutiny. Get it right, and you unlock a clear picture of your financial position, enabling better strategic decisions and building stakeholder trust. This guide breaks down everything: the definition of financial instruments, the classification and measurement of financial assets and financial liabilities, impairment, derecognition, and practical examples. Let us get into it.

The Pain Points: Why Businesses Struggle with Financial Instruments Accounting

The Complexity of IFRS 9

IFRS 9 is a complex standard that replaced IAS 39. The transition from IAS 39’s multiple classification categories to IFRS 9’s business model and cash flow characteristics approach has been a significant challenge for many businesses. The business model test and the solely payments of principal and interest (SPPI) test require significant judgment. Determining whether an asset is held to collect contractual cash flows, to sell, or both, requires a deep understanding of management’s intent and strategy. Many businesses find this judgment difficult, leading to inconsistent classification and measurement.

The SPPI Test

Many businesses struggle with the SPPI test. This test requires an assessment of whether the contractual terms of a financial asset give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding. This is not always straightforward. Instruments with prepayment features, variable interest rates, or complex embedded derivatives may fail the SPPI test, requiring fair value measurement through profit or loss. The test requires a detailed understanding of the contractual terms and the economic substance of the instrument. This can be challenging, particularly for complex or bespoke financial instruments.

Expected Credit Loss (ECL) Impairment

The ECL model under IFRS 9 represents a significant shift from the incurred loss model under IAS 39. Instead of waiting for a loss event to occur, entities must now recognise expected credit losses based on reasonable and supportable information, including forward-looking information. This requires significant judgment and data. Determining whether credit risk has increased significantly since initial recognition, estimating 12-month or lifetime expected credit losses, and incorporating forward-looking economic scenarios are all complex tasks. Many businesses lack the data and systems to implement the ECL model effectively.

Hedge Accounting

Hedge accounting is complex. It requires documenting the hedging relationship, the risk management objective, and testing for effectiveness. Many businesses struggle to meet the stringent requirements and either do not apply hedge accounting or apply it incorrectly. The complexity of the documentation and testing requirements can be a significant barrier, particularly for smaller entities with limited resources.

Derecognition

Derecognition of financial assets and liabilities is another area of complexity. For financial assets, the determination of whether substantially all risks and rewards have been transferred can be complex. For financial liabilities, assessing whether a modification is substantially different requires the 10% test, which can be challenging to apply in practice. These rules require careful analysis of the terms and conditions of the instruments and the substance of the transactions.

What Are Financial Instruments?

Definition

A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. This definition is broad and encompasses a wide range of assets and liabilities. The key element is the existence of a contract that creates a financial asset for one party and a financial liability or equity instrument for the other.

Key Components

A financial asset is any asset that is cash, an equity instrument of another entity, a contractual right to receive cash or another financial asset from another entity, a contractual right to exchange financial assets or liabilities with another entity under conditions that are potentially favourable, or a contract that will or may be settled in the entity’s own equity instruments.

A financial liability is any liability that is a contractual obligation to deliver cash or another financial asset to another entity, a contractual obligation to exchange financial assets or liabilities with another entity under conditions that are potentially unfavourable, or a contract that will or may be settled in the entity’s own equity instruments.

An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Equity instruments represent ownership interests in an entity and do not give rise to a contractual obligation to deliver cash or another financial asset.

Examples

Financial assets include cash, trade receivables, loans receivable, investments in shares or bonds, and derivatives such as call options held. Financial liabilities include trade payables, bank loans, bonds issued, and derivatives such as put options written. Equity instruments include ordinary shares issued by a company.

Recognition of Financial Instruments

Initial Recognition

An entity recognises a financial asset or a financial liability in its statement of financial position when it becomes a party to the contractual provisions of the instrument. This is the general rule. For example, when a company enters into a loan agreement, it recognises the loan as a liability and the cash received as an asset. The recognition occurs at the point when the entity becomes a party to the contract, not necessarily when cash is exchanged.

Initial Measurement

At initial recognition, an entity measures a financial asset or a financial liability at its fair value plus or minus, in the case of a financial asset or a financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or the financial liability.

For financial assets and liabilities classified at fair value through profit or loss (FVTPL), the initial measurement is at fair value, and transaction costs are expensed. For financial assets and liabilities classified at amortised cost or FVTOCI, the initial measurement is at fair value plus transaction costs. The treatment of transaction costs is an important distinction between the classification categories.

Classification and Measurement of Financial Assets

The Classification Approach

IFRS 9 classifies financial assets into three categories based on two key tests. The first test is the business model test, which asks how the entity manages the financial assets to generate cash flows. The business model is determined at a portfolio level, not at an individual instrument level. The second test is the contractual cash flow characteristics test, also known as the SPPI test, which asks whether the contractual terms give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding.

The business model test considers whether the entity holds assets to collect contractual cash flows, to sell assets, or both. The SPPI test considers whether the contractual cash flows are solely payments of principal and interest. Interest is defined as consideration for the time value of money and the credit risk associated with the principal amount outstanding.

The Three Categories

Amortised Cost: A financial asset is measured at amortised cost if both of the following conditions are met. The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows. The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Examples of assets measured at amortised cost include trade receivables, loans receivable, and held-to-maturity investments. Interest revenue is recognised using the effective interest method, and impairment losses are recognised.

Fair Value Through Other Comprehensive Income (FVTOCI): A financial asset is measured at FVTOCI if both of the following conditions are met. The asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets. The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Examples include some debt instruments where the entity intends to both collect cash flows and sell the asset. Interest revenue is recognised using the effective interest method. Changes in fair value are recognised in OCI, except for impairment, which is recognised in profit or loss. On derecognition, the cumulative gain or loss in OCI is reclassified to profit or loss.

Fair Value Through Profit or Loss (FVTPL): All financial assets that are not classified at amortised cost or FVTOCI are classified as FVTPL. This includes assets held for trading, such as investments acquired for short-term profit. It also includes assets that do not meet the SPPI test, such as complex debt instruments with embedded derivatives. It includes assets where the business model is not to hold to collect or hold to collect and sell. It also includes equity instruments, unless the entity makes an irrevocable election to present fair value changes in OCI. Examples include investments in shares, unless the OCI election is made, derivatives, unless designated as hedging instruments, and debt instruments that fail the SPPI test. Changes in fair value are recognised in profit or loss.

Classification and Measurement of Financial Liabilities

The General Rule

Under IFRS 9, most financial liabilities are classified and subsequently measured at amortised cost. The initial measurement is at fair value less transaction costs. This is the default classification for most financial liabilities, including trade payables, bank loans, and bonds issued.

The Exception: Fair Value Through Profit or Loss (FVTPL)

A financial liability may be classified as FVTPL if it is held for trading, such as derivatives that are liabilities, or if it is designated as at FVTPL under the fair value option, if it would eliminate or significantly reduce an accounting mismatch. Changes in fair value for FVTPL liabilities are recognised in profit or loss. However, for liabilities designated as FVTPL, the change in fair value attributable to changes in the entity’s own credit risk is recognised in OCI.

Financial Liabilities at Amortised Cost

The initial measurement of financial liabilities at amortised cost is at fair value less transaction costs, which represents the net proceeds received. Subsequent measurement is at amortised cost using the effective interest method. Interest expense is calculated using the effective interest rate and recognised in profit or loss.

Worked Example: Financial Liability at Amortised Cost

An entity issues $10 million 5% loan notes on 1 January 20X1, incurring $200,000 issue costs. The loan notes are repayable at a premium of $1 million on 31 December 20X3. The effective interest rate is 8.85%.

In the initial measurement, the entity receives cash of $9.8 million, which is $10 million minus the $200,000 issue costs. This is the initial carrying amount of the liability.

For subsequent measurement using the effective interest method, the liability is increased by the effective interest and decreased by the cash coupon payments. In 20X1, the balance at start is $9,800,000. The effective interest at 8.85% is $867,300. The cash paid as coupon is $500,000. The balance at end is $10,167,300. In 20X2, the balance at start is $10,167,300. The effective interest at 8.85% is $899,806. The cash paid as coupon is $500,000. The balance at end is $10,567,106. In 20X3, the balance at start is $10,567,106. The effective interest at 8.85% is $932,894. The cash paid includes the final coupon of $500,000 and the principal of $10,000,000, totaling $10,500,000. The balance at end is $0.

The journal entries for 20X1 are as follows. On 1 January 20X1, the entity debits Cash for $9,800,000 and credits Loan Payable for $9,800,000. On 31 December 20X1, the entity debits Interest Expense for $867,300 and credits Loan Payable for $867,300. On 31 December 20X1, the entity debits Loan Payable for $500,000 and credits Cash for $500,000.

The explanation is that the issue costs are spread over the life of the instrument through the effective interest method. The liability is gradually increased by the effective interest and decreased by the cash coupon payments. The final payment on 31 December 20X3 is the principal of $10,000,000 plus the premium of $500,000.

Impairment of Financial Assets

The Expected Credit Loss (ECL) Model

IFRS 9 introduces a forward-looking Expected Credit Loss (ECL) model for financial assets measured at amortised cost and FVTOCI (debt instruments). This model requires entities to recognise expected credit losses based on reasonable and supportable information, including past events, current conditions, and forecasts of future economic conditions. The ECL model is a significant departure from the incurred loss model under IAS 39.

Key Terms

Expected Credit Losses (ECL) are the present value of all cash shortfalls, which is the difference between the cash flows that are due to an entity and the cash flows that the entity expects to receive. 12-month ECL is the portion of lifetime expected credit losses that result from default events that are possible within 12 months after the reporting date. Lifetime ECL is expected credit losses that result from all possible default events over the expected life of the financial instrument.

Stages of Impairment

The ECL model distinguishes between three stages for financial assets. Stage 1 applies to financial assets where credit risk has not significantly increased since initial recognition. These assets are considered performing. The loss allowance is 12-month expected credit losses. Interest revenue is calculated on the gross carrying amount.

Stage 2 applies to financial assets where credit risk has significantly increased since initial recognition, but no objective evidence of impairment exists. These assets are considered underperforming. The loss allowance is lifetime expected credit losses. Interest revenue is calculated on the gross carrying amount.

Stage 3 applies to financial assets that are credit-impaired, meaning objective evidence of impairment exists. These assets are considered non-performing. The loss allowance is lifetime expected credit losses. Interest revenue is calculated on the amortised cost basis, which is the gross carrying amount less the loss allowance.

Simplified Approach for Trade Receivables

For trade receivables and contract assets without a significant financing component, entities may use a simplified approach. Under this approach, the loss allowance is always measured at an amount equal to lifetime expected credit losses. This is often calculated using a provision matrix based on historical credit loss experience and forward-looking information. The simplified approach reduces the complexity of applying the ECL model to trade receivables.

Derecognition of Financial Instruments

Derecognition of Financial Assets

Derecognition is the removal of a financial asset from the statement of financial position. An entity derecognises a financial asset when the contractual rights to the cash flows expire, such as when a loan is repaid, or when the asset is transferred. A transfer occurs when the entity transfers the contractual rights to receive the cash flows of the financial asset, or retains the contractual rights but assumes a contractual obligation to pay the cash flows to a third party.

When a financial asset is transferred, the entity must assess whether it has transferred substantially all the risks and rewards of ownership. If substantially all risks and rewards are transferred, the entity derecognises the asset and recognises any resulting gain or loss in profit or loss. If substantially all risks and rewards are retained, the entity continues to recognise the asset, for example, in a repurchase agreement where the entity retains substantially all risks and rewards. If neither transferred nor retained substantially all risks and rewards, the entity assesses whether it has retained control. If control is not retained, the entity derecognises the asset. If control is retained, the entity continues to recognise the asset to the extent of the entity’s continuing involvement.

Derecognition of Financial Liabilities

An entity derecognises a financial liability when the obligation is discharged, cancelled, or expires. An exchange between an existing borrower and lender of debt instruments with substantially different terms is accounted for as extinguishing the original financial liability and recognising a new financial liability. This is a substantial modification.

The 10% test is used to determine whether the terms are substantially different. Terms are substantially different if the present value of the cash flows under the new terms, including any fees paid net of any fees received, when discounted using the original effective interest rate is at least 10 per cent different from the present value of the remaining cash flows of the original financial liability.

Where the terms are not substantially different, the original liability is not derecognised. The liability is restated to the present value of the revised cash flows. The adjustment is recognised in profit or loss.

Reclassification of Financial Assets

When, and only when, an entity changes its business model for managing financial assets, it must reclassify all affected financial assets. Reclassification should be applied prospectively from the reclassification date. The entity should not restate any previously recognised gains, losses or interest already recognised. Financial assets designated at FVTPL and investments in equity measured at FVOCI are not subject to the reclassification requirements of IFRS 9. Financial liabilities are never reclassified.

How Qeeva Advisory Helps You Navigate Financial Instruments

We understand that financial instruments accounting can be complex. Many businesses struggle with classification, measurement, impairment, and disclosure requirements under IFRS 9 and IAS 39. Our professionals specialise in financial reporting, auditing, and advisory services.

Our Advisory Services Nigeria help you understand the complexities of financial instruments. We assist with classification, measurement, impairment, and disclosure requirements under IFRS 9 and IAS 39.

Our Financial Advisory services help you structure financial instruments to achieve your financing and risk management objectives. We assist with debt restructuring, hedging strategies, and capital raising.

Our Risk Management services help you identify, assess, and manage risks associated with financial instruments, including credit risk, market risk, and liquidity risk.

Our Tax Strategies and Planning services help you understand the tax implications of financial instruments. We help you optimise your tax position while ensuring compliance with tax laws.

Our Internal Control Services help you strengthen internal controls over financial instruments, including valuation, impairment, and reporting processes.

And because financial instruments are often complex, our Bookkeeping Services ensure your financial records are accurate and complete, supporting your financial reporting and compliance obligations.

Our Service Methodology

We do not do generic. We do thorough, transparent, and actionable.

Step 1: Financial Instruments Review
We review your financial assets and liabilities, including classification, measurement, and impairment. We identify gaps, risks, and opportunities for improvement. This step draws on our Advisory Services Nigeria expertise.

Step 2: Accounting Policy Development
We help you develop accounting policies for financial instruments that comply with IFRS 9 and IAS 39. We ensure your policies are consistent with your business model and risk management strategies.

Step 3: Impairment Assessment
We help you assess impairment of financial assets under the ECL model. We assist with staging, estimating 12-month and lifetime ECL, and incorporating forward-looking information.

Step 4: Hedge Accounting
We help you design and implement hedge accounting relationships, including documentation, effectiveness testing, and accounting for hedging instruments.

Step 5: Ongoing Monitoring and Support
Financial instruments accounting is not a one-time exercise. We help you monitor changes in the accounting standards, update your policies, and stay current with regulatory developments. We provide ongoing support through our Advisory Services Nigeria , Financial Advisory , and Risk Management services.

Frequently Asked Questions

Q: What is the difference between IFRS 9 and IAS 39?
A: IFRS 9 replaced IAS 39 for annual periods beginning on or after 1 January 2018. IFRS 9 introduced a business model and SPPI test for classification of financial assets, a forward-looking ECL impairment model, and simplified hedge accounting.

Q: What are the three classification categories for financial assets?
A: The three categories are amortised cost, FVTOCI, and FVTPL.

Q: What is the SPPI test?
A: The SPPI test assesses whether the contractual terms of a financial asset give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding.

Q: What is the difference between 12-month ECL and lifetime ECL?
A: 12-month ECL represents expected credit losses from default events within 12 months after the reporting date. Lifetime ECL represents expected credit losses from all possible default events over the expected life of the financial instrument.

Q: When is a financial liability derecognised?
A: A financial liability is derecognised when the obligation is discharged, cancelled, or expires.

Q: How can Qeeva Advisory help with financial instruments?
A: We provide financial instruments review, accounting policy development, impairment assessment, hedge accounting support, and ongoing monitoring to help businesses navigate financial instruments.

The Bottom Line

Financial instruments are a critical part of modern business. Understanding how to classify, measure, and account for them is essential for accurate financial reporting and informed decision-making.

The key is to understand the classification categories. Financial assets are classified based on the business model and SPPI test into amortised cost, FVTOCI, or FVTPL. Financial liabilities are generally measured at amortised cost, except for those designated as FVTPL. Impairment is based on the forward-looking ECL model. Derecognition occurs when the contractual rights expire or the asset is transferred.

Your job is to be prepared. Understand the classification and measurement requirements. Apply the ECL model for impairment. Use the derecognition rules correctly. Seek professional guidance.

With the right approach and the right partner, you can turn financial instruments from a compliance burden into a strategic advantage.

The choice is yours.

Related Services

Our Advisory Services Nigeria are staffed by professionals specialising in financial reporting, auditing, and advisory services.

Our Financial Advisory services help you structure financial instruments to achieve your financing and risk management objectives.

Our Risk Management services help you identify, assess, and manage risks associated with financial instruments.

Our Tax Strategies and Planning services help you understand the tax implications of financial instruments.

Our Internal Control Services help you strengthen internal controls over financial instruments.

Our Bookkeeping Services ensure your financial records are accurate and complete.

Let’s Talk About Your Financial Instruments Accounting

Navigating financial instruments can feel complex. At Qeeva Advisory, we understand the challenges businesses face in accounting for financial assets and liabilities under IFRS 9 and IAS 39.

Whether you need help with classification, measurement, impairment, or disclosure requirements, we are here to support you.

📞 Call us: (+234) 802 320 0801, (+234) 807 576 5799
📧 Email: info@qeeva.com
📍 Visit us: 5, Ishola Bello Close, Off Iyalla Street, Alausa, Ikeja, Lagos, Nigeria

Contact us today to schedule a consultation. Let us help you navigate financial instruments with confidence.

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