Financial instruments I: classification, measurement and liability or equity

Financial instruments are where accounting meets legal drafting. Small changes in a contract's wording, such as a clause that links an interest rate to a sustainability target or a put option held by a minority shareholder, can change an instrument's classification, its measurement basis and the volatility of reported profit. IFRS 9 Financial Instruments and IAS 32 Financial Instruments: Presentation provide the rules, and both have recently been amended or are under review. This lesson takes Tamarind Bay's portfolio of financial assets, its convertible notes and the put option over the non-controlling interest in Harrow Creek, and works through the classification judgments.

Classifying financial assets

IFRS 9 classifies financial assets into three measurement categories on the basis of two tests. The business model test asks how the entity manages a group of assets to generate cash flows: by collecting contractual cash flows (hold to collect), by both collecting and selling (hold to collect and sell), or otherwise, for example by trading. The contractual cash flow characteristics test, usually called the SPPI test, asks whether the contractual terms give rise on specified dates to cash flows that are solely payments of principal and interest on the principal outstanding, consistent with a basic lending arrangement. A debt instrument that passes SPPI and is held to collect is measured at amortized cost; one that passes SPPI and is held to collect and sell is measured at fair value through other comprehensive income (FVOCI), with gains and losses recycled to profit or loss on derecognition; everything else is measured at fair value through profit or loss (FVTPL). Equity investments are at FVTPL unless, for an equity investment that is not held for trading, the entity makes an irrevocable election at initial recognition to present fair value changes in OCI, in which case they are never recycled, even on sale.

# Classifying Tamarind Bay's financial instruments under IFRS 9 and US GAAP (invented facts).
instruments = [
    # name, cash flows SPPI?, business model, equity?, FVOCI election?
    ("Loan to supplier, ESG-linked margin step", True, "hold to collect", False, False),
    ("Term deposits", True, "hold to collect", False, False),
    ("Government bonds, liquidity portfolio", True, "collect and sell", False, False),
    ("Listed shares, strategic stake", None, None, True, True),
    ("Unlisted fund units (puttable)", False, "hold to collect", False, False),
]
def ifrs9(sppi, bm, equity, oci):
    if equity: return "FVOCI (election, no recycling)" if oci else "FVTPL"
    if not sppi: return "FVTPL (fails SPPI)"
    return {"hold to collect": "Amortized cost", "collect and sell": "FVOCI (recycled)"}.get(bm, "FVTPL")
def usgaap(name, equity):
    if equity: return "Fair value through net income (ASC 321)"
    if "Loan" in name: return "Amortized cost, held for investment (ASC 310)"
    if "bonds" in name: return "Available-for-sale (ASC 320)"
    if "fund" in name: return "Fair value through net income (ASC 321)"
    return "Amortized cost (cash equivalent or deposit)"
for name, sppi, bm, eq, oci in instruments:
    print(f"{name}\n   IFRS 9 : {ifrs9(sppi, bm, eq, oci)}\n   US GAAP: {usgaap(name, eq)}")
# Convertible notes issued January 1, 2025: 300.0, 5 years, 4.5% coupon; straight debt rate 6.5%
face, coupon, n, mkt = 300.0, 0.045, 5, 0.065
liab = sum(face * coupon / (1 + mkt) ** t for t in range(1, n + 1)) + face / (1 + mkt) ** n
print("\nConvertible notes at issue")
print(f"  IAS 32 split: liability {liab:.2f}, equity component {face - liab:.2f}")
print(f"  ASC 470-20 after ASU 2020-06: single liability {face:.2f}, no equity component")
bal = liab
for yr in (2025, 2026):
    i = bal * mkt; bal += i - face * coupon
    print(f"  {yr}: IFRS interest {i:.2f} (liability {bal:.2f}); US GAAP interest {face * coupon:.2f}")

Loan to supplier, ESG-linked margin step
   IFRS 9 : Amortized cost
   US GAAP: Amortized cost, held for investment (ASC 310)
Term deposits
   IFRS 9 : Amortized cost
   US GAAP: Amortized cost (cash equivalent or deposit)
Government bonds, liquidity portfolio
   IFRS 9 : FVOCI (recycled)
   US GAAP: Available-for-sale (ASC 320)
Listed shares, strategic stake
   IFRS 9 : FVOCI (election, no recycling)
   US GAAP: Fair value through net income (ASC 321)
Unlisted fund units (puttable)
   IFRS 9 : FVTPL (fails SPPI)
   US GAAP: Fair value through net income (ASC 321)

Convertible notes at issue
  IAS 32 split: liability 275.07, equity component 24.93
  ASC 470-20 after ASU 2020-06: single liability 300.00, no equity component
  2025: IFRS interest 17.88 (liability 279.45); US GAAP interest 13.50
  2026: IFRS interest 18.16 (liability 284.11); US GAAP interest 13.50

The ESG-linked supplier loan

In 2026 Tamarind Bay lent 25.0 million to its largest packaging supplier, repayable over five years, to fund a plant that makes recyclable trays. The interest rate is a benchmark plus 3.00 per cent, reduced by 0.25 per cent if the supplier meets an annual target for recycled content verified by an independent auditor, and increased by 0.25 per cent if it misses the target. Does a margin that varies with a sustainability target fail the SPPI test, forcing the loan to FVTPL?

Before 2026 this was a contested question, because a payment linked to an event that is not a basic lending risk, such as achieving an environmental target, can introduce variability that is inconsistent with a basic lending arrangement. The IASB's May 2024 Amendments to the Classification and Measurement of Financial Instruments, effective for annual periods beginning on or after January 1, 2026, clarify the answer. A contingent feature does not cause a failure of SPPI if the contingent event is specific to the debtor, as the supplier's own recycled content target is, and the resulting cash flows would not be significantly different from those of an otherwise identical instrument without the feature. A swing of 0.25 per cent on a 3.00 per cent margin is not significantly different, so the loan passes SPPI and, held to collect, is measured at amortized cost. The amendments also require new disclosures for instruments with contingent features and for equity investments designated at FVOCI, and they permit an entity to derecognize a financial liability settled through an electronic payment system before the settlement date if specified conditions are met. 2026 is the first year Tamarind Bay applies them.

Getting this right matters for volatility. If the loan were at FVTPL, every change in market interest rates and in the supplier's credit spread would flow through profit each quarter. Many banks and corporates now issue and hold sustainability-linked loans, and their classification was one of the main reasons the IASB made the 2024 amendments.

Equity investments and the FVOCI election

Tamarind Bay holds a 4 per cent stake in a listed company that develops compostable packaging, acquired in 2025 for 18.0 million as part of a strategic partnership. At initial recognition it elected to present fair value changes in OCI, because the stake is a long-term strategic holding and management did not want its share price swings in profit. The election has two consequences that are easy to forget. Gains and losses in OCI are never recycled to profit or loss, even when the shares are sold; the accumulated amount may be transferred within equity. And dividends are recognized in profit or loss unless they clearly represent a recovery of part of the cost. The election is irrevocable and made instrument by instrument.

Liability or equity: the convertible notes

In January 2025 Tamarind Bay issued 300.0 million of five-year convertible notes with a 4.5 per cent coupon. Each 1,000 note converts into 41.67 shares, a fixed number, at the holder's option. Under IAS 32, an instrument that contains both a contractual obligation to deliver cash and an option for the holder to convert into a fixed number of the issuer's own shares is a compound instrument. The issuer separates it into a liability component, measured at the fair value of a similar liability without the conversion option, and an equity component, measured as the residual. With a straight-debt rate of 6.5 per cent, the liability component was 275.07 million and the equity component 24.93 million. The liability accretes to face value over five years at 6.5 per cent, so interest expense in 2026 is 18.16 million, well above the 13.5 million cash coupon. The equity component is never remeasured.

The fixed-for-fixed condition is central. The conversion option is equity only if it will be settled by exchanging a fixed amount of cash or another financial asset for a fixed number of the issuer's own equity instruments. Anti-dilution adjustments that preserve the relative rights of holders and shareholders, such as adjustments for share splits, are generally consistent with the condition, but adjustments that compensate holders for changes in the share price, or settlement options that allow the issuer to pay cash or a variable number of shares, can make the option a derivative liability measured at fair value through profit or loss. Drafting conversion terms without consulting the accounting team is a common source of surprises.

Puttable non-controlling interests

When Tamarind Bay bought 80 per cent of Harrow Creek in 2024, it wrote a put option giving the founding family the right to sell their remaining 20 per cent to Tamarind Bay in 2029 at a price based on a multiple of EBITDA. Under IAS 32, a contract that contains an obligation for an entity to purchase its own equity instruments for cash gives rise to a financial liability for the present value of the redemption amount, even though the obligation is conditional on the holder exercising. Shares in a subsidiary held by non-controlling shareholders are equity instruments of the group, so Tamarind Bay recognizes a gross liability for the estimated redemption price, about 31 million at the end of 2026. Practice has varied on the other side of the entry, whether to derecognize the NCI or debit another component of equity, and on where remeasurement goes.

The IASB's Financial Instruments with Characteristics of Equity (FICE) project aims to address these inconsistencies. Its November 2023 exposure draft proposed clarifications on the fixed-for-fixed condition, obligations to purchase own equity instruments such as NCI puts, contingent settlement provisions and shareholder discretion, together with new presentation and disclosure requirements. At its September 2026 meeting the IASB tentatively decided, among other things, that when an entity first recognizes a liability for an NCI put, it should determine whether it already has access to the returns of ownership; if not, the debit should reduce NCI without derecognizing it and be presented as a separate line deducted from gross NCI, and remeasurement gains and losses on the liability should be recognized in profit or loss. Measurement of the liability was still under discussion, and no effective date had been set. Tamarind Bay's current policy follows the most common existing practice and will be revisited when the amendments are issued.

Supplier finance arrangements

Tamarind Bay's largest retail customers, and Tamarind Bay itself with its own suppliers, use supplier finance or reverse factoring programmes: a bank pays the supplier early at a discount and Tamarind Bay pays the bank on an extended due date. The classification question is whether Tamarind Bay's obligation remains a trade payable, within working capital and operating cash flows, or has become a borrowing from the bank, within debt and financing cash flows. The answer depends on whether the terms are substantially different from ordinary trade payables, such as a payment term extended well beyond industry norms or security provided to the bank. Because these programmes can make operating cash flow look better and hide debt, both boards added disclosure requirements effective from 2024: the terms of the arrangements, the carrying amounts of the related liabilities and the portion already paid by the finance providers, the range of payment due dates, and non-cash changes. Tamarind Bay's programme extends payment terms from 60 to 90 days, within industry practice, so the liabilities, about 64 million at year end, remain trade payables with the required disclosures.

ASPE and the framework compared

ASPE Section 3856 is much simpler: most financial assets and liabilities are measured at amortized cost, equity investments quoted in an active market at fair value, and other equity investments at cost less impairment. It contains special rules for shares issued in tax planning arrangements, such as retractable preferred shares issued in an estate freeze, which may be presented as equity if specified conditions are met even though the holder can demand redemption. Harrow Creek's financial instruments are mainly receivables, payables and a bank loan, so the conversion to the group's IFRS policies is minor.