Question

According to ISAB, Debt investments are accounted either by the amortize cost or by fair value method. To identify the method used there is certain model. Please explain the model and its criteria.

Answer 1

Fair value method for measurement of financial instruments is where the financial instruments are carried at fair value. Fair value is determined using the principles outlined in IFRS 13-Fair Value measurement

Under Amortised costs method, financial instruments are carried at amortised cost. Under amortised cost method, the financial instrument is initially recognised at fair value. For subsequent measurement, interest at market rate is added to the instrument and an collections are reduced.

General principle is to measure all instruments at fair value. Amortised cost measurement is allowed only subject to the following two conditions:

1. SPPI Test (Structured Payments of principal and interest): The instrument should meet the SPPI test, i.e. the contract terms of the financial instrument should clearly outline the cash flows receivable from the investment (timing) and the quantum of cash flows. Further, cash flows should only be on account of pirncipal and interest. Interest is considered to be the compensation for time value of money and credit risk. If the instrument contains any feature, like return linked to any stock market interest or gold rate, or a convertible option, such contractual terms will not satisfy SPPI and therefore, these instruments will be carried at fair value

2. Business Model: Business model of the entity for the SPPI instrument should be to hold the instruments with the objective of collecting cash flows arising from the instrument. The entity should not be holding the instruments for trading. If the instruments are hheld for trading, they need to be carried at fair value. Depending on the frequency of trading, entity has to apply judgement whether the fair valuation movement is required to be carried through profit and loss account or through other comprehensive income.

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