What is FVOCI? Classification and Measurement Rules

Fair Value through Other Comprehensive Income (FVOCI) is an accounting classification for certain financial assets under International Financial Reporting Standards (IFRS). Its function is to report an asset at its current market value on a company’s balance sheet, providing an up-to-date valuation of the company’s holdings.

The defining feature of FVOCI is how it handles changes in an asset’s value. Instead of recording these fluctuations on the Profit or Loss (P&L) statement, most are recognized in a separate component of shareholders’ equity called Other Comprehensive Income (OCI). This allows for reporting current fair values without creating volatility in the company’s reported net income.

The FVOCI Classification Model

For a financial asset to be categorized as FVOCI, it must meet specific criteria outlined in IFRS 9, with rules differing for debt and equity instruments. The classification is determined when the asset is first acquired. It is based on how the company intends to manage the asset and the nature of its cash flows.

Debt instruments, such as corporate or government bonds, must pass two tests to qualify for the FVOCI classification. The first is the “Business Model Test,” which examines the company’s strategy for managing the asset. To pass, the company’s objective must be to both hold the asset to collect its contractual payments and to be able to sell the asset before it matures.

The second requirement is the “Cash Flow Characteristics Test,” also called the “Solely Payments of Principal and Interest” (SPPI) test. This test reviews the asset’s contractual terms to ensure they generate cash flows that are only repayments of the principal and interest on the outstanding balance. If a bond’s payments are linked to other factors, like a stock market index, it would fail the SPPI test.

The classification process for equity instruments, like shares of stock, operates differently and does not involve the business model and SPPI tests. A company can make an irrevocable election at the time of purchase to designate an equity investment as FVOCI. This choice is only available for equity investments not held for trading purposes. Once this election is made, it cannot be reversed.

Measurement of FVOCI Debt Instruments

At initial recognition, the asset is recorded on the balance sheet at its fair value plus any directly attributable transaction costs. These costs might include fees paid to brokers or advisors to acquire the bond.

Subsequent measurement impacts both the P&L statement and OCI. In the P&L statement, the company recognizes interest revenue over the life of the bond, calculated using the effective interest method. Any impairment losses, which are estimates of expected credit losses, are also recognized in the P&L statement.

Simultaneously, the asset is re-measured to its current fair value at each financial reporting date. The difference between the asset’s amortized cost and its new fair value is recognized in OCI. For example, if a bond’s fair value increases due to changes in market interest rates, that unrealized gain is recorded in OCI, bypassing the main income statement.

When the company sells the debt instrument, the cumulative gain or loss that has been recorded in OCI is “recycled.” This means the accumulated amount is reclassified from OCI and moved to the P&L statement. This recycling ensures that the total gain or loss realized over the investment’s life is reflected in the company’s net income.

For example, a company buys a bond for $10,000. At the end of the first year, its fair value is $10,300, and the $300 unrealized gain is recorded in OCI. In the second year, the company sells the bond for $10,500. Upon sale, the total realized gain of $500 is recognized in the P&L statement.

Measurement of FVOCI Equity Instruments

At initial recognition, an equity investment under the FVOCI election is recorded at its fair value plus transaction costs, consistent with the treatment for debt. This establishes the initial carrying amount of the asset on the balance sheet.

For the P&L statement, the only impact during the holding period is the recognition of dividends. When the company receives a dividend from its equity investment, that income is reported in the P&L statement for that period.

All other changes in the equity investment’s fair value are recognized in OCI. At each reporting date, the stock is revalued to its current market price, and the resulting unrealized gain or loss is recorded directly in OCI. Unlike with debt instruments, there is no interest calculation or amortization involved.

The most significant distinction for FVOCI equities arises upon sale. When an equity investment designated as FVOCI is sold, the cumulative gain or loss that has been accumulated in OCI is not recycled to the P&L statement. This prohibition of recycling stands in sharp contrast to the treatment for debt instruments.

Instead of being moved to net income, the amount accumulated in OCI remains within the equity section of the balance sheet. The company may choose to transfer this amount from the OCI reserve to another equity account, such as retained earnings. However, it will never be reported as part of the profit or loss, meaning the realized gains or losses do not impact the company’s reported net income.