Is It Basic or Not? How to Classify Financial Instruments Under Section 11

16 Jul

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If there’s one thing Section 11 of the IFRS for SMEs Accounting Standard wants you to get right, it’s this: know whether you’re dealing with a basic or complex financial instrument. Everything else, how you measure it, when you impair it, what you disclose, flows from that first decision.

But if you’ve ever found yourself staring at a loan agreement or share certificate wondering which “part” of Section 11 it belongs in, you’re not alone. This article will break down the rules in paragraphs 11.8 and 11.9 (and their siblings) and give you a simple, practical way to decide: Part I (basic) or Part II (other)?

What Makes a Financial Instrument “Basic”?

The Standard defines basic financial instruments in paragraph 11.8 and provides a detailed checklist of conditions in paragraphs 11.9 and 11.9ZA. In plain English, an instrument is “basic” if it:

Involves cash or straightforward lending arrangements, and
Has simple, predictable cash flows (like interest and capital repayments),
Without features that introduce market risk, volatility or complex options.

Paragraph 11.8: What Qualifies as Basic?

Here’s what the standard says must be accounted for under Part I (Basic Financial Instruments):

Cash
Think of bank balances, petty cash, and physical note nothing fancy here.
Debt instruments like:

Trade receivables and payables,
Notes or loans receivable/payable,
Bonds or debentures,
...provided they meet the rules in paragraph 11.9 or 11.9ZA (we’ll explain those below).

Loan commitments that:

Cannot be settled net in cash (i.e. not derivatives), and
Will result in a basic loan if executed.

Shares that are:

Non-convertible preference shares (i.e. can’t be turned into ordinary shares), or
Non-puttable ordinary/preference shares, meaning the investor can’t demand the issuer buy them back.

If you’re nodding along thinking, “That sounds like my clients’ balance sheets”, you’re right. Most SMEs only deal with these.

Paragraph 11.9: The Conditions for a Basic Debt Instrument

Now let’s look at the conditions a loan, note, or bond must meet to qualify as “basic.” There are four key conditions:

Condition A: Predictable Interest

The returns must be either:

A fixed amount (e.g. 10% annual interest),
A fixed rate, or
A variable rate tied to a market indicator, like JIBAR or SONIA.

🚫 Not allowed: rates that depend on the share price of a listed company or the price of gold.

Example (✔️ Basic): A 3-year loan at prime + 1%
Example (❌ Not basic): A loan where interest depends on the JSE All Share Index.

Condition B: No Risk of Losing Capital or Interest

The instrument must not have a clause that allows the borrower to withhold repayment of capital or interest.

Example (✔️ Basic): A normal loan agreement with fixed repayments.
Example (❌ Not basic): A convertible debenture that allows the borrower to repay using equity shares—this introduces equity risk and uncertainty.

Condition C: Repayment Options Must Be Straightforward

The borrower or lender can repay early or demand early repayment only in specific situations like:

A credit downgrade,
A change in control,
Tax or legal changes.

Example (✔️ Basic): A loan allows early repayment if SARS changes the tax treatment.
Example (❌ Not basic): A loan where the lender can demand early repayment if the market interest rate changes.

Condition D: No Hidden Variables

There must be no conditions that make returns or repayments unpredictable, except as allowed in (A) and (C) above.

What If One Condition Fails?

Good question. Paragraph 11.9ZA gives you a lifeline. Even if the instrument doesn’t meet all of 11.9(a)–(d), it can still be “basic” if:

“The contractual terms give rise on specified dates to cash flows that are solely payments of principal and interest.”

But what’s interest here? It includes:

Compensation for the time value of money,
Credit risk,
Liquidity risk,
Administrative costs, and
A profit margin.

This is known as the SPPI test (Solely Payments of Principal and Interest). If there’s any exposure to other risks, like equity prices, inflation indexing, or commodities, you’re out of basic territory.

Examples to Lock It In

Let’s work through a few:

Red Flags That You Might Be in Part II

Here are some warning signs that the instrument may fall under Part II (complex instruments):

It can be settled in cash or net rather than through delivery (a hallmark of derivatives).
It has conversion options, embedded derivatives, or exotic clauses.
Returns depend on equity prices, commodity prices, or other market variables.
The client doesn’t understand it (if they can't explain the cash flows, it’s probably not basic).
It’s part of a hedging arrangement or financial guarantee contract.

Final Thought

Getting the classification right is more than ticking a box, it impacts measurement, disclosure, and whether the financials can be trusted.

If you’re working with typical SMEs, selling goods, paying suppliers, taking out bank loans, you’ll mostly be in Part I. But always check the conditions. When in doubt, revisit paragraph 11.9 and ask: Are the cash flows simple, predictable, and based on lending arrangements only? If yes, it’s probably basic. If not, welcome to Part II. Don’t panic, but proceed carefully.

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