Financial instruments: amortized cost, FVOCI and FVPL
Financial assets are measured at amortized cost or at fair value. At amortized cost only interest hits profit. At fair value through OCI, interest hits profit and price changes go to other comprehensive income. At fair value through profit or loss, everything hits profit.
Before this: Goodwill: how it is measured and tested
On the exam
- Explain the financial reporting and disclosures related to financial instruments
Explain the reporting and disclosures related to financial instruments. Expect: where an unrealized gain on a given asset is reported, the International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (GAAP) category names, and the trap that US GAAP available-for-sale covers debt only.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
How are financial assets measured?
Two ways: at amortized cost, or at fair value. The measurement basis then decides where changes in fair value are reported.
A financial instrument is a contract that creates a financial asset for one party and a financial liability or equity instrument for another. Here we cover assets a company owns: bonds, loans and shares of other companies. A derivative is a financial instrument whose value depends on an underlying variable such as a price or a rate; derivatives are measured at fair value.
Fair value is the price that would be received to sell an asset in an orderly market transaction. Amortized cost is the amount first recognized, less principal repaid, plus or minus amortization of any discount or premium, less impairment. It ignores market price moves.
If a fair value change is recognized, there are two places it can go. It can go to profit or loss, or to other comprehensive income (OCI), which bypasses the income statement and builds up in equity. These are unrealized gains : the asset has not been sold. A realized gain or loss from a sale is reported in profit.
What are the three categories?
IFRS has three: amortized cost, fair value through OCI and fair value through profit or loss. US GAAP uses older names for debt: held-to-maturity, available-for-sale and trading.
Memorize
- Held-to-maturity is a debt security the company intends and is able to hold to maturity. It is measured at amortized cost, like IFRS debt held to collect contractual cash flows that are only principal and interest. Loans and notes receivable also belong here.
- Available-for-sale debt securities are measured at fair value with changes in OCI. The IFRS counterpart is fair value through other comprehensive income (FVOCI), used for debt when the business model is both to collect cash flows and to sell. IFRS also lets a company make an irrevocable election, when it buys equity shares, to hold them at FVOCI.
- Trading securities are debt securities bought to be sold, measured at fair value with changes in profit. IFRS calls the broader group fair value through profit or loss (FVPL): everything not in the other two categories, plus anything the company irrevocably elects there.
US GAAP differs on equity. Available-for-sale applies to debt only, so equity securities (other than stakes that give significant influence) are carried at fair value through net income.
- Amortized cost Memorize US GAAP: held-to-maturity (debt)
- Interest profit
- Price changes ignored
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- Fair value through OCI Memorize US GAAP: available-for-sale (debt only)
- Interest or dividends profit
- Unrealized gains and losses OCI
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- Fair value through profit or loss Memorize US GAAP: trading debt; all equity
- Interest, dividends and unrealized gains all profit
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In words: interest always reaches profit, and the fair value change reaches profit for FVPL, OCI for FVOCI and neither for amortized cost.
One bond, three answers
The same bond and the same cash give different reported numbers depending on the category.
Classification changes reported profit and its volatility, not the economics. Under FVOCI and FVPL the total comprehensive income is the same (45). When companies use different categories, compare them on comprehensive income.
Exam tip Ask two questions: is the asset at fair value, and if so, is it FVPL? Only if yes does the gain touch net income.
What about financial liabilities?
Most are at amortized cost: loans and bonds payable (next lesson). Liabilities held for trading, derivative liabilities and liabilities under the fair value option are measured at fair value.
Go deeper Why IFRS classifies debt the way it does
IFRS looks at two tests. The business model test asks whether the company holds the asset to collect cash flows, or both collects and sells, or neither. The cash flow test asks whether the contractual cash flows are solely principal and interest. Debt that passes both and is held to collect goes to amortized cost; debt that passes and is held to collect and sell goes to FVOCI; anything else goes to FVPL. IFRS 9 also has an expected credit loss impairment model for amortized cost and FVOCI debt, with losses charged to profit.
Go deeper Recycling and the fair value hierarchy
When a debt security at FVOCI is sold, the accumulated OCI gain or loss is reclassified (recycled) to profit. For IFRS equity at FVOCI, there is no recycling: the gain on sale stays within equity, and only dividends reach profit. Fair values come from a hierarchy: Level 1 (quoted prices in active markets), Level 2 (observable inputs) and Level 3 (unobservable, management estimates). Treat Level 3 numbers with more skepticism, since they carry the most judgment.
Memorize this
MemorizeCategories and where the gain lands
| IFRS category | US GAAP equivalent | Balance sheet | Interest or dividends | Unrealized gain or loss |
|---|---|---|---|---|
| Amortized cost (debt only) | Held-to-maturity | Amortized cost | Profit | Not recognized |
| FVOCI (debt; equity by irrevocable election) | Available-for-sale (debt only) | Fair value | Profit | OCI |
| FVPL (everything else, incl. trading and derivatives) | Trading debt; all equity securities | Fair value | Profit | Profit |
Memory hook Three columns, three destinations: nothing, OCI, profit. Amortized cost ignores price moves; FVOCI parks them; FVPL books them.
Know it cold Interest always reaches profit. Only the unrealized fair value change moves.
MemorizeEquity and liabilities
| Instrument | Measurement |
|---|---|
| US GAAP equity securities (no significant influence) | Fair value, changes in profit |
| IFRS equity | FVPL by default; FVOCI by irrevocable election at purchase |
| Financial liabilities (loans, bonds payable) | Usually amortized cost |
| Liabilities held for trading, derivative liabilities, fair value option | Fair value |
Memory hook US GAAP: available-for-sale is a debt-only category. Equity shares go through net income.
Know it cold Derivatives are measured at fair value.
- Amortized cost Memorize US GAAP: held-to-maturity (debt)
- Interest profit
- Price changes ignored
-
- Fair value through OCI Memorize US GAAP: available-for-sale (debt only)
- Interest or dividends profit
- Unrealized gains and losses OCI
-
- Fair value through profit or loss Memorize US GAAP: trading debt; all equity
- Interest, dividends and unrealized gains all profit
-
Quick example
Coupon income 30 and the bond falls 12 in value. Held at FVPL: profit effect 30 − 12 = 18. At FVOCI or amortized cost: profit effect 30.
- 30−12= 18, the FVPL profit effect
- 30ENTER12− 18, the FVPL profit effect
ENTER enter (on the HP, puts the number on the stack)
Quick example
The same bond at FVOCI: the 12 fall goes to OCI, so OCI is −12 and comprehensive income is 30 − 12 = 18, the same as at FVPL.
- 12+|-+30= 18, comprehensive income
+|- change sign
- 12CHS30+ 18, comprehensive income
CHS change sign
How it is asked
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Net income effect, FVOCI debt
Bond at par 2,000, 4% coupon, FVOCI, year-end fair value 2,060. Effect on net income?
Coupon 80 only; the 60 gain goes to OCI. Answer 80. Adding the gain (140) is the FVPL trap.
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Name the US GAAP category
Debt held to collect interest and principal to maturity: how reported under US GAAP?
Held-to-maturity: amortized cost.
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Which category puts everything in profit?
Which IFRS category reports both interest and unrealized gains in profit or loss?
FVPL. Not FVOCI.
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Equity under US GAAP
Where do unrealized gains on equity shares (no significant influence) go under US GAAP?
Net income. Available-for-sale does not apply to equity.
Exam traps
- Putting FVOCI unrealized gains in net income. They go to OCI.
- Saying US GAAP available-for-sale includes equity shares. It is debt only.
- Reporting held-to-maturity assets at fair value. They stay at amortized cost.
- Leaving out interest: with FVOCI and amortized cost, profit still gets the coupon.
Checkpoint
3 exam-style questions. About 90 seconds each.
1A company buys a bond at par for USD 2,000k with a 4% coupon and classifies it at fair value through other comprehensive income. At year-end the bond's fair value is USD 2,060k. The effect on net income for the year is closest to:
2Under US GAAP, a debt security that the company intends and is able to hold until maturity is reported at:
3Which IFRS category of financial assets reports both interest income and unrealized gains in profit or loss?
Key takeaways
- Amortized cost: interest in profit, no fair value changes.
- FVOCI: interest in profit, fair value changes in OCI.
- FVPL: everything in profit.
- US GAAP names: held-to-maturity, available-for-sale (debt only), trading; equity through net income.
Quick example
Coupon income 30 and the bond falls 12 in value. Held at FVPL: profit effect 30 − 12 = 18. At FVOCI or amortized cost: profit effect 30.
- 30−12= 18, the FVPL profit effect
- 30ENTER12− 18, the FVPL profit effect
ENTER enter (on the HP, puts the number on the stack)
Quick example
The same bond at FVOCI: the 12 fall goes to OCI, so OCI is −12 and comprehensive income is 30 − 12 = 18, the same as at FVPL.
- 12+|-+30= 18, comprehensive income
+|- change sign
- 12CHS30+ 18, comprehensive income
CHS change sign
Questions about this lesson?
Where this comes back
- Non-current liabilities: bonds at amortized cost and deferred taxes Analyzing Balance Sheets
- Bond Valuation: Prices and Yields Fixed Income
- Derivatives and Derivative Markets Derivatives
Questions candidates ask
What is the difference between FVOCI and FVPL?
Both carry the asset at fair value and report interest or dividends in profit. With FVOCI, unrealized gains and losses go to other comprehensive income. With FVPL they go to profit or loss, so reported profit is more volatile.
Where are unrealized gains on available-for-sale securities reported?
In other comprehensive income, under US GAAP, and only for debt securities. They appear in accumulated other comprehensive income within equity, not in net income, until the security is sold.
What is amortized cost for a financial asset?
The initial amount, minus principal repaid, plus or minus amortization of any discount or premium, minus any impairment. It ignores changes in market price, so a held-to-maturity bond bought at par stays at par.
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