(Posted December 2024)
The classification and measurement of basic financial instruments is a commonly tested topic on the CPA Canada Common Final Examination (CFE). This blog summarizes the key technical you need to know when addressing these issues on the CFE and considerations for your writing approach.
Classification and Measurement – IFRS
Under IFRS, financial instruments should be initially recorded at fair value. Fair value is defined under IFRS 13, Fair Value Measurement, as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This means that fair value is defined by market rates of interest. If a financial instrument has a non-market rate of interest, it is carried at a premium or discount that must be brought into income over the term of the instrument.
If the financial instrument will not subsequently be recorded at fair value through profit or loss (FVTPL), the carrying value of the financial instrument should be adjusted for transaction costs directly attributable to the acquisition or issue of the financial instrument. If the financial instrument is subsequently recorded at FVTPL, the transaction costs should be expensed.
There are three main classifications for the subsequent recording of financial assets:
- Amortized cost – This method uses the effective interest rate method. This method can only be selected if the objective of the entity is to hold financial assets to collect contractual cash flows and 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.
- Fair value through other comprehensive income (FVOCI) – Subsequent changes in the fair value of the financial asset are recognized in OCI. This method can only be used if the objective of the entity is achieved by both collecting contractual cash flows and selling financial assets and 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.
- FVTPL – If the financial asset does not fit either of the categories above due to the entity’s objectives or the terms of the asset, the financial asset is categorized as FVTPL. Subsequent changes in the fair value of the financial asset are recognized in profit or loss.
There is an irrevocable election that can be made at initial recognition for equity instruments that would otherwise be measured at FVTPL to present subsequent changes in fair value in OCI.
There are two main classifications for the subsequent recording of financial liabilities:
- Amortized cost – uses the effective interest method. This is applied to all financial liabilities unless FVTPL applies.
- FVTPL – Subsequent changes in the fair value of the financial liability are recognized in profit or loss. This can only be used if the liability is a derivative or the entity elects to use FVTPL.
Classification and Measurement – ASPE
Under ASPE, financial instruments should also be initially recorded at fair value (similar to IFRS). There is an exception to record related party financial instruments at cost.
The transaction cost treatment is also similar in that if the financial instrument will be subsequently recorded at fair value, the transaction costs should be expensed. Otherwise, the carrying value of the financial instrument should be adjusted for transaction costs.
When determining the subsequent recording of financial assets, there are two choices:
- If initially measured at fair value – subsequent measurement is at:
- Fair value recognized through profit and loss if quoted in an active market, is a derivative, or the entity elects to use fair valueCost if not quoted in an active market
- Amortized cost if none of the above applies
- If initially measured at cost – subsequent measurement is at:
- Fair value recognized through profit and loss if it is a derivative or the entity elects to use fair value
- Amortized cost if none of the above applies
Financial liabilities are subsequently measured at fair value recognized in profit and loss if the liability is a derivative or the entity elects to use fair value. Otherwise, they are recorded at amortized cost.
How to Write on the CFE
Financial instruments are a commonly tested topic on the CFE. The CFE will test your ability to discuss how to account for the financial instrument, both initially and subsequently. While you must adapt to the issue and case facts presented, there is a common approach that can be taken to develop sufficient depth in your analysis.
Step 1: Use case facts to support why it is a financial instrument
Use the definitions to support why it is a financial instrument (asset or liability). This may also be because the investor does not have significant influence (link to Investments blog).
Step 2: Discuss valid methods to record the financial instrument initially
Once you have supported the type of financial instrument, you then need to support the initial recording of it. This includes whether recording at fair value is appropriate, and if applicable, whether transaction costs should be capitalized to the financial instrument balance or expensed.
Step 3: Discuss valid methods to record the financial instrument subsequently
Once you determine which method should be used to record the financial instrument initially, you then need to explain how it will be subsequently treated, supported by the relevant case facts.
- Under IFRS, this would be classifying it into the relevant category and explaining how that treatment would apply.
- Under ASPE, there are not the same set categories, but you would still explain which subsequent treatment applies and explain how it would work
Step 4: Other considerations
When given numbers, quantify the impact of the financial instrument on the entity’s financial statements. You may also need to integrate your results into a summary calculation, such as revised financial statements, a materiality calculation, or financial ratios. You also may need to consider any impact of the changes in ownership or control at a subsequent date.
More detailed technical and information on how to write financial instruments issues are included in our Scenario Flowcharts Workbook, which is included in our CFE Prep courses, and in our Competency Map Study Notes publication.