As per Ind AS 109, financial assets should be classified as one of the following:

  1. Amortised cost
  2. Fair value through other comprehensive income or
  3. Fair value through profit or loss

Classification is based on the analysis of the following two key factors:

  1. The entity’s business model for managing the financial assets and
  2. Contractual cash flow characteristics of the financial assets.

For an instrument that does not have a defined maturity period, the financial asset should be classified as either fair value through profit or loss or fair value through other comprehensive income.

For a debt security (since it has a pre-defined maturity period), all the three types of classification as mentioned above is possible viz., Amortised cost, Fair value through other comprehensive income or Fair value through profit or loss.
Key criteria to be examined for the purpose of classification of financial assets:

1) The entity’s business model: The business model of the entity should be analysed to find out if the financial asset is held with the objective to collect contractual cash flows that are solely payment of principal and interest or to collect such contractual cash flows as well as to buy or sell such financial asset. The business model objective should be analysed at the portfolio or sub-portfolio level and not on instrument-by- instrument basis. Such analysis should not be conducted at the entity level either, as the entity may have multiple business models to achieve different objectives for different sets of portfolios.

2) SPPI Criterion: The next key test to be performed is the test to find out if the contractual cash flows represent solely payment of principal and interest only. To understand the significance of this test, one need to have a very thorough knowledge of what is meant by both principal as well as interest. The standard specifies that principal is the fair value of the financial asset on initial recognition. Interest is primarily a consideration for the time value of money and includes the consideration for the credit risk associated with the financial asset. Interest also includes consideration for the other basic lending risks and costs including the profit margin.

If the financial asset is held with the business model objective to collect contractual cash flows that represent solely payment of principal and interest, then such a financial asset should be measured at amortised cost.

If the business model objective is to collect both the contractual cash flows as well as to buy and sell such financial assets, the financial asset should be classified as fair value through other comprehensive income, provided the contractual cash flows represent solely payment of principal and interest.

If the contractual cash flows do not represent solely payment of principal or interest or if the financial asset is held with the business model objective, i.e. neither to collect the contractual cash flows nor to buy or sell such financial assets, then the classification should be fair value through profit and loss account.

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