
Think for a moment about what keeps the global economy alive. It’s not just factories, oil, or data, it’s agreements. A farmer agrees to repay the bank once the harvest is sold. A start-up agrees to give investors a share of tomorrow’s profits. A customer agrees to pay you next month for goods delivered today. These agreements, the contracts, claims, and ownership interests that pass through invisible hands every second, are what accountants call financial instruments.
If the agreement gives you the right to receive cash, like a trade receivable, a loan you’ve given, or a bond you hold, it’s a financial asset. If it requires you to pay cash, like a bank loan you owe or a note you’ve issued, it’s a financial liability. Equity, such as shares in a company, is also a financial instrument, representing ownership in an enterprise rather than an obligation to pay. Even a derivative (say, a forward to buy dollars in three months) is a financial instrument; the contract itself has value the moment you sign it.
Here’s the problem: for decades, accounting rules weren’t very good at showing the truth about these agreements. They often revealed the risks too late. During the 2008 financial crisis, investors discovered that balance sheets were hiding rot beneath shiny surfaces. Banks looked healthier than they really were; until they weren’t.
That failure gave birth to IFRS 9 Financial Instruments, a standard that reshaped how companies tell the story of their agreements. If IAS 39 was a rearview mirror, showing us what went wrong yesterday, then IFRS 9 is a set of headlights: not perfect, sometimes dazzling, but pointing forward into the road ahead.
So, what changed? IFRS 9 introduced two big ideas:
1. Classify financial assets by business model and cash flows. In other words, do you hold an asset to trade, to collect payments, or both? The answer determines how it is measured.
2. Recognise expected credit losses early. No more waiting until a loan has already gone bad. Now, banks and businesses must account for the possibility of default from day one, booking provisions while the agreement is still active.
In short, IFRS 9 forces companies to face the reality of their agreements sooner, not later. It may not prevent every crisis, but it shines more light on the road ahead than the rules that came before.
Meet BlueWave Ltd | A Company of Agreements
BlueWave manufactures audio gear. Its balance sheet is a map of agreements: €50,000 customers owe for last month’s sales (receivables); a €500,000 bank loan it must repay; €1 million in government bonds; and a small stake in a risky tech start-up. Under IFRS 9, BlueWave records each agreement only when the contract is binding; no wishful thinking, just signed, legally binding obligations.
But IFRS 9 doesn’t stop there. It asks a tougher question: What will you do with this asset, and what exactly does it pay you? The answer determines the measurement path: Amortised Cost, FVOCI, or FVTPL. And guarding these paths is the SPPI test; it checks whether the cash flows are just principal and interest, or something more complex.
Let’s walk through BlueWave’s balance sheet:
• Amortised Cost → BlueWave sells €50,000 worth of audio gear on credit. The receivable is simple: the customer will pay cash, nothing more. Since BlueWave’s only aim is to collect the money owed, this asset sits at amortised cost, steadily unwinding as payments come in.
• FVOCI → BlueWave also holds €1 million in government bonds. The plan is to collect the interest but also keep the option to sell if rates change. That “hold and sell” strategy means these bonds are measured at FVOCI; their value changes with the market, but the ups and downs sit in “Other Comprehensive Income” until the bonds are sold.
• FVTPL → Finally, BlueWave owns a small stake in a risky tech start-up. Its value jumps around daily with the market. Here, the SPPI test fails; cash flows aren’t just principal and interest. So, this investment goes to FVTPL, with gains and losses hitting profit or loss immediately.
Each agreement looks different. Some are safe and steady. Some are risky but exciting. IFRS 9 asks BlueWave one simple question: “What are you really doing with these agreements?”
The answer determines how each agreement is measured, reported, and understood, turning a balance sheet from a static snapshot into a story about strategy, risk, and the future.
The Gatekeeper | SPPI in Plain English
At the heart of IFRS 9 sits a simple but powerful test: SPPI – Solely Payments of Principal and Interest.
Think of it as the basic-lending check. It asks: “Is this financial asset really just a loan in disguise, or is it something else?”
What do we mean by “Principal” and “Interest”?
• Principal → The amount of money you originally invested or lent. It’s the base you expect to get back.
• Interest → The fair price of lending. In accounting, that “fair price” isn’t just random, it covers:
1. Time value of money – a euro today is worth more than a euro tomorrow.
2, Credit risk – the chance the borrower might not pay you back.
3. Basic lending costs – administrative costs, funding costs.
4. Profit margin – a straightforward return for taking the deal.
If an asset’s cash flows are only principal and this type of plain interest, on whatever amount is outstanding, then it passes SPPI.
If the cash flows are tied to other risks (equity prices, commodity prices, leveraged indices) or twist the time-value logic, then it fails SPPI.
Why does SPPI matter?
SPPI isn’t asking whether the instrument is “safe” or “risky.”
It’s asking: “What exactly does the contract pay, and why?”
• A risky borrower can still issue an SPPI-pass loan (principal + interest, but with higher margins).
• A very safe borrower could issue a structured note tied to stock prices, that’s an SPPI-fail.
In other words: SPPI looks at the nature of the cash flows, not the probability of repayment.
SPPI in Action | Vivid Contrasts
• SPPI-Pass | A loan at EURIBOR + 1% with a simple cap and floor. This is still plain lending, interest adjusts with the market but stays true to time value.
• SPPI-Pass | An inflation-linked bond that simply adjusts principal for inflation, with protection against losing your money. The adjustment just preserves real value, still plain lending.
• SPPI-Fail | A bond whose repayment depends on a tech stock index. That’s equity risk in disguise, not lending.
• SPPI-Fail | An inverse floater that pays less interest when rates rise. The time-value logic is upside down.
• SPPI-Pass | A loan with a standard prepayment clause (borrower can repay early with reasonable compensation). This doesn’t ruin the lending nature, still passes.
Sometimes, regulators set interest rates by law. In those cases, the regulated rate often works as a practical proxy for time value, usually an SPPI-pass, if it broadly reflects the cost of time.
Special Case | Slicing the Pie
Imagine a large pool of loans sliced into senior and junior tranches:
• The senior tranche gets repaid first – lower risk.
• The junior tranche gets what’s left – higher risk.
SPPI asks: “Does your slice still look like plain lending?”
• Senior slice passes if:
– Its own terms are principal + interest.
– The pool is made of SPPI assets.
– The slice isn’t taking more risk than the pool.
• If the pool can morph into non-SPPI assets, the slice fails, straight to FVTPL.
How SPPI Shapes BlueWave’s Choices
Now, let’s step into BlueWave Ltd.’s shoes. Each of its agreements must face the gatekeeper.
1. Supplier Loan (€100,000)
• Floating market rate + margin.
• Standard prepayment clause.
• Pure principal and interest.
SPPI-pass.
If BlueWave’s business model is simply “hold and collect,” this loan is measured at Amortised Cost, accruing interest, reduced with repayments, and carrying an expected-loss allowance.
2. Government Bonds (€1 million)
• Plain interest and principal (SPPI-pass).
• Business model: collect interest but also sell if cash is needed.
FVOCI.
Interest and credit losses go to profit. Fair-value swings sit in OCI until sale, then recycle into profit.
3. Start-up Equity
• No fixed repayments, no plain interest.
• Value swings with market sentiment.
SPPI-fail by design.
Default category: FVTPL, with gains/losses flowing through profit or loss.
(Optional path: if BlueWave makes the irrevocable FVOCI election for long-term, non-trading equities, fair-value changes go to OCI with no recycling, but dividends still go to profit.)
4. Structured Note
• Coupon looks normal, but principal repayment depends on a tech index.
SPPI-fail.
Regardless of BlueWave’s intentions, the cash-flow structure pushes it into FVTPL.
The Three Faces of an Agreement
The genius, and the headache, of IFRS 9 lies in its three ways of classifying financial assets. Each path reflects both what the contract pays and what the company intends to do with it. Think of them as three different “faces” of the same agreement. Let’s follow BlueWave’s journey.
1. The Patient Collector | Amortised Cost
BlueWave lends €100,000 to one of its suppliers, expecting nothing fancy, just interest and repayment of the loan. This is the purest form of a financial asset.
• SPPI test: Passes easily (just principal + plain interest).
• Business model: Hold to collect.
IFRS 9 says: measure at Amortised Cost.
That means:
• Start with the original loan amount.
• Add interest income (calculated using the effective interest method).
• Deduct repayments as they come in.
• Record an allowance for expected credit losses.
The asset sits on the balance sheet at a gradually adjusted value, quietly unwinding until it disappears when fully paid.
Analogy: It’s like a parent lending money for university: “I’ll give you this, but I expect it back, with a fair thank-you.” Straightforward, predictable, low drama.
2.The Watchful Investor | FVOCI
Next, BlueWave invests €1 million in government bonds. These are plain principal-and-interest instruments, but the strategy is more flexible. Management wants the interest income but also keeps the door open to sell if needed.
• SPPI test: Passes (plain lending cash flows).
• Business model: Collect and sell.
IFRS 9 says: measure at Fair Value through Other Comprehensive Income (FVOCI).
That means:
• Interest income and expected credit losses go through profit and loss.
• Changes in market value go into Other Comprehensive Income (OCI), a separate equity bucket.
• If the bonds are sold, the accumulated gains or losses are “recycled” into profit and loss.
Analogy: It’s like keeping money in a savings bond but knowing you might cash it early if life takes a turn. Sometimes you hold, sometimes you sell, but both matters.
This category acknowledges reality: many businesses want flexibility, not rigidity.
3. The Opportunistic Trader | FVTPL
Finally, BlueWave buys shares in a buzzing start-up. There are no fixed repayments, no plain interest. The value swings daily with market sentiment.
• SPPI test: Fails (not principal + interest).
• Business model: Doesn’t matter, once SPPI fails, it can’t be Amortised Cost or FVOCI.
IFRS 9 says: measure at Fair Value through Profit or Loss (FVTPL).
That means:
• The asset is always shown at fair value.
• Every change in value goes straight into profit or loss, immediately impacting the income statement.
Analogy: This is the high-stakes table of finance: volatile, exciting, and brutally transparent. IFRS 9 insists that the ups and downs appear in real time, with no hiding.
(Note: for certain long-term, non-trading equities, companies can make a one-off election to put them into FVOCI, fair-value changes in OCI, no recycling, dividends still in profit. But that’s the exception, not the rule.)
Pulling It All Together
The classification logic always follows two steps:
1. Business model → Are you holding to collect, to collect-and-sell, or to trade?
2. SPPI test → Are the cash flows just principal + interest, or something more exotic?
If the asset fails SPPI, the story ends → straight to FVTPL.
If it passes, then the business model decides between Amortised Cost and FVOCI.
The Crystal Ball | Expected Credit Losses (ECL)
IFRS 9’s second revolution is about time. Under the old IAS 39 rules, companies like BlueWave only booked losses after a customer defaulted, far too late to warn anyone.
Now, losses are recognised from day one. That €50,000 receivable from a retailer? Even on the first day, BlueWave records a small expected-loss allowance. If risk rises, the allowance grows.
The accounts become more cautious, and more sensitive to the economic weather. IFRS 9 asks businesses to hold an umbrella before the rain starts falling.
In a later article, we’ll unpack how this works in practice, the three stages, the 12-month vs. lifetime horizon, and the modelling challenges companies face.
Liabilities | When You Owe the World
So far, we’ve focused on BlueWave’s assets, agreements where it expects to receive money. But what about when BlueWave is the one making agreements to pay? That’s the world of financial liabilities.
The Straight Road | Amortised Cost
Most of the time, liabilities are simpler than assets.
• BlueWave borrows €500,000 from a bank to finance its factory. The agreement is plain: repay principal plus interest over time.
• IFRS 9 says: measure it at Amortised Cost.
– Start with the original loan amount.
– Add interest expense over time (using the effective interest rate).
– Deduct repayments as they are made.
Analogy: Like a mortgage. Predictable, step-by-step, gradually paid down.
The Exotic Path | FVTPL
But sometimes liabilities aren’t so ordinary.
• Suppose BlueWave issues a structured note where repayment depends on the performance of a tech stock index.
• The cash flows are no longer plain lending, they include equity risk.
• IFRS 9 says: such liabilities go to Fair Value Through Profit or Loss (FVTPL).
That means every change in the note’s value (as markets move) flows through profit or loss. Transparency, no hiding.
The Credit Risk Twist
There’s a strange accounting problem here: what if BlueWave’s own creditworthiness worsens?
• If investors think BlueWave might default, the market value of its debt
• In theory, that would look like a “gain” in profit or loss, because BlueWave could buy back its debt more cheaply.
• But that’s misleading: a weaker company shouldn’t look more profitable just because the market has lost faith in it.
To fix this, IFRS 9 requires that the portion of value change due to own credit risk goes into Other Comprehensive Income (OCI), not profit.
Analogy: It’s like your bank telling you, “We won’t call it a win just because people think you’re more likely to go bankrupt.”
Quick Summary for Liabilities
• Amortised Cost → Default category. Plain loans and borrowings.
• FVTPL → Exotic, structured, or designated liabilities.
• Own credit risk adjustment → If at FVTPL, changes due to BlueWave’s credit risk bypass profit and sit in OCI.
BlueWave’s Liability Story
• Bank Loan (€500k) | Standard repayment. Lives at Amortised Cost.
• Structured Note (equity-linked) | Market-linked, non-SPPI. Goes to FVTPL.
• Fair Value Adjustment | If investors worry about BlueWave’s default risk, that portion of change is parked in OCI, so losses of confidence don’t masquerade as profits.
Why This Matters Beyond the Numbers
IFRS 9 isn’t just about cleaner books, it’s about cleaner strategy.
For BlueWave, the impact runs deeper than accounting entries:
• Banks that lend to it must hold more capital, since provisions are larger and recognised earlier. Lending decisions tighten.
• Product designers strip out exotic features to avoid failing the SPPI test; cash flows must look like basic lending.
• Investors rethink FVOCI equity investments, since gains parked in equity never recycle into profit.
• Treasurers align hedge accounting more closely with actual risk management, reducing accounting mismatches.
But the biggest change comes inside the company. IFRS 9 demands better systems, richer data, and stronger governance. Expected Credit Losses are only as reliable as the forecasts behind them. That means boards and audit committees must step up, not just signing off, but challenging assumptions, interrogating models, and testing resilience.
The message is clear: IFRS 9 pushes businesses to tell the truth about their financial agreements sooner, manage risks more transparently, and weave accounting into strategy.
This article was prepared by the AccountingWise.