Accounting treatment for FVOCI Instruments

Accounting treatment for FVOCI Instruments

Is there any difference between the accounting treatment for equity instruments and debt instruments classified as Fair Value Through Other Comprehensive Income (FVOCI)?  The answer is ‘yes’. Frequently participants in my class ask me the underlying reason for such a difference in the accounting treatment when both these types of financial assets are classified as FVOCI.

Equity instruments

The classification criteria for equity instruments and debt instruments are entirely different. Equity instruments can be classified as either Fair Value Through Profit or Loss (FVTPL) or FVOCI. The investor can exercise the choice without undue delay, provided the equity instruments are not meant for trading purposes. There are no other criteria. The important point to note is that the classification is based on the choice exercised by the investor and is not governed by any criteria specified in the standard other than that it should not be meant for trading purposes. The choice however is irrevocable. The unrealised profits or losses from equity instruments that are classified as FVOCI are presented in the other comprehensive income.

Let us examine the reason as to why someone would want to classify an investment in equity investments as FVOCI asset. The predominant reason is to ensure that the fluctuations in the fair value of the equity investments do not affect the profit and loss account. Nevertheless, the unrealised profit on such investments belong to the stakeholders and hence should be reflected as part of the net worth of the shareholders. That is why the unrealised profits are taken to the other comprehensive income reflecting the same as reserves.

If the predominant reason for such a classification is to avoid the volatility in the profit and loss account, then the very purpose of granting such a choice to the investor would be defeated if the requirements where to insist on such profits or losses to be considered in the profit and loss account when such investments are liquidated. In other words, it would be illogical to say that the unrealized profits should be considered in the other comprehensive income, but the realized profits should be considered in profit and loss account. And hence there is no requirement for the realized profits to be routed through the profit and loss account. This is the reason as to why the unrealised profits or losses that are parked in the other comprehensive income is not ploughed back to the profit and loss account even after such investments are liquidated by the investor.

Debt instruments:

For a debt instrument, the classification into FVOCI is predominantly driven by the set of criteria that are specified in the standard. There is no choice that is granted to the investor as in the case of equity investments.

A debt instrument would be classified as Amortized cost asset if it satisfies SPPI test. Further the Business Model Objective should be to hold the asset for collecting contractual cash flows only. An entity should assess whether contractual cash flows are Solely Payments of Principal and Interest (SPPI) on the principal amount outstanding for the currency in which the financial asset is denominated.

If the SPPI test is passed and the business model objective is to collect contractual cash flows and also to sell the same, then the classification is FVOCI. Debt instruments classified as FVOCI, are likely to be sold at any time by the investor. Since it can be sold at any time, the balance sheet should show the fair value of such investment in debt security. The unrealized profit or loss belongs to the shareholders of the company and hence should be reflected in the reserves of the company and more specifically the other comprehensive income.

However, since the debt instrument may or may not be sold, the realisation of profits/loss on such investment is not assured till the time the liquidation happens. And when such a liquidation event happens then the profits/losses are crystalized and should be shown in the profit and loss account.

This is the reason why the unrealized profits/losses are taken to the other comprehensive income initially and when the liquidation happens, the same is ploughed back to the profit and loss account.

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