Your Financial Instruments Fallback Is Gone. Here Is What Replaces It.
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For years, many accountants applying the IFRS for SMEs Standard took a quiet shortcut when it came to financial instruments. When the old Sections 11 and 12 got complicated, there was always an escape hatch: the IAS 39 fallback. If the SME standard did not give you a clear enough answer, you could reach across to the full IFRS standard and apply IAS 39 instead.
That option no longer exists.
The third edition of the IFRS for SMEs Standard has closed the IAS 39 fallback and replaced it with a revised, self-contained Section 11. The good news is that the new section is more logical and better structured than what it replaces. The important news is that you need to understand the new rules before they apply to your first set of comparative figures, which means before 1 January 2026.
What Changed Structurally
Under the second edition, financial instruments were split across two separate sections. Section 11 covered basic financial instruments and Section 12 covered everything else. The split created confusion because the line between "basic" and "other" was not always obvious, and the IAS 39 fallback meant that some entities were not really applying either section in a consistent way.
The third edition merges both sections into a single Section 11. It then divides that section into two parts.
• Part 1 covers financial instruments measured at amortised cost or cost. This is where most everyday SME financial instruments belong: trade receivables, loans made to others, bank balances, trade payables, and straightforward borrowings.
• Part 2 covers financial instruments measured at fair value, derivatives, and more complex arrangements that do not meet the criteria for Part 1.
The question that determines which part applies is whether the instrument passes a new test called the SPPI test. That test is the most important new concept in this section and understanding it is the key to applying the new rules correctly.
The SPPI Test: What It Is and Why It Matters
SPPI stands for Solely Payments of Principal and Interest. The test asks one question: do the contractual cash flows of the financial instrument represent solely payments of principal and interest on the outstanding principal amount?
If the answer is yes, the instrument can be measured at amortised cost and sits in Part 1. If the answer is no, it goes to Part 2 and is generally measured at fair value through profit or loss.
The definition of interest for this purpose is broader than it might seem. Interest includes reasonable compensation for the time value of money, credit risk, liquidity risk, administrative costs associated with holding the instrument, and the lender's profit margin. All of those are consistent with a basic lending arrangement and do not cause an instrument to fail the SPPI test.
What does cause an instrument to fail is exposure to risks that have nothing to do with lending. If the return on a financial instrument is linked to equity prices, commodity prices, a stock index, or any other variable unrelated to the borrower's creditworthiness and the passage of time, it fails the test. Those instruments belong in Part 2.
Here is how the test plays out in practice.
A fixed-rate loan your client made to a supplier at 10% per annum. Passes the SPPI test. The cash flows are principal repayments and interest. Part 1, amortised cost.
A variable-rate loan linked to the prime lending rate plus a margin. Passes. Prime plus a margin is still compensation for time value of money and credit risk. Part 1, amortised cost.
A loan where the interest rate is linked to the performance of a share portfolio. Fails. Equity price exposure is not consistent with a basic lending arrangement. Part 2, fair value.
A convertible loan note where the holder can convert to equity. Likely fails because the conversion feature introduces equity exposure. Part 2, fair value.
A bond with a fixed coupon and a fixed maturity date. Passes, assuming no unusual features. Part 1, amortised cost.
For most SME clients, the SPPI test will be straightforward to apply. Most of the financial instruments that SMEs hold and issue are basic lending arrangements. The test becomes more interesting for clients in sectors like property, mining, or financial services where structured finance or performance-linked instruments are more common.
Prepayment Features: A Clarification That Protects Common Loan Structures
One specific issue that the new Section 11 addresses is prepayment features with what is called negative compensation.
Some loan agreements allow the borrower to repay early, but if they do, the lender receives less than the outstanding principal and accrued interest. In other words, the lender is compensated negatively for the early repayment. This kind of clause is common in fixed-rate lending where the lender faces reinvestment risk if the loan is repaid early.
The clarification in the third edition confirms that even if a loan has this kind of prepayment feature, it can still qualify for amortised cost measurement under Part 1, as long as the negative compensation is small and reasonable relative to the overall lending arrangement.
Without this clarification, many common loan structures would have been pushed into Part 2 and measured at fair value, creating unnecessary volatility in the income statement. The IASB recognised that this was not the right outcome for SMEs and provided the clarification accordingly.
Financial Guarantee Contracts: A New Scope Rule for Group Structures
Financial guarantee contracts have always been a tricky area for SME accountants, particularly in group structures where a holding company guarantees the borrowings of a subsidiary without charging a fee for doing so.
The new Section 11 introduces a specific scope rule for these arrangements. A financial guarantee contract is defined as a contract requiring the issuer to reimburse the holder for a loss incurred because a specified debtor fails to make a payment when due.
In general, financial guarantee contracts fall within Part 2 of Section 11. But there is an important exception. If a financial guarantee contract is issued at nil consideration and the specified debtor is another entity within the same group, the contract falls under Section 21 on Provisions and Contingencies instead.
This matters because it changes both how the guarantee is initially recognised and how it is subsequently measured and disclosed.
Under Section 21, the guarantee is treated as a contingent liability. No amount is recognised on the balance sheet unless it becomes probable that the guarantee will be called. But there are new disclosure requirements that apply immediately, regardless of whether recognition is triggered.
Entities issuing intragroup guarantees at nil consideration must now disclose the nature and business purpose of the guarantee, any uncertainties around the amount or timing of a potential outflow, and the maximum amount they could be required to pay if the guarantee is called. Related party disclosures under Section 33 also apply.
If your client is a holding company that guarantees subsidiary debt as a matter of course, and most holding companies do, these disclosure requirements apply from the first set of financial statements prepared under the third edition.
Initial Measurement: How the New Revenue Standard Changed Things
The fourth significant change in Section 11 relates to initial measurement, and it flows directly from the introduction of the new Section 23 on revenue.
The general rule for initial measurement of a financial instrument is straightforward. Measure it at the transaction price, including any transaction costs, unless it is subsequently measured at fair value through profit or loss.
But two exceptions now apply.
The first exception is for trade receivables. If a financial asset is a trade receivable, the initial measurement follows the rules in Section 23 on revenue rather than the general financial instruments rules. This ensures consistency between how revenue is recognised and how the resulting receivable is initially recorded.
The second exception is for financing transactions. If the arrangement is effectively a financing transaction, meaning the payment terms go significantly beyond normal business terms or the instrument carries a below-market interest rate, the financial asset or liability must be measured at the present value of the future cash flows discounted at a market rate of interest.
A practical example. Your client sells goods to a customer on 24-month interest-free credit. That is a financing transaction. The receivable should not be recorded at the full face value. It should be recorded at the present value of the future payment, and the difference between the face value and the present value is recognised as interest income over the credit period.
There is a simplification available. If at the start of the contract your client expects the customer to pay within 12 months of the goods being delivered, discounting is not required. The face value is used. This covers the majority of everyday trade transactions and prevents unnecessary complexity for standard credit terms.
What the Good News Looks Like
Amid all the change, there are two things that did not change and are worth naming clearly.
The incurred loss model for impairment of financial assets at amortised cost was retained. Under full IFRS, entities must apply the expected credit loss model from IFRS 9, which requires forward-looking estimates and significantly more judgement. The IASB deliberately kept the simpler incurred loss model for SMEs. You recognise impairment when there is objective evidence that a loss has been incurred, not in anticipation of future losses.
Hedge accounting requirements and derecognition requirements were also retained without significant change. If your clients use simple hedging arrangements, the accounting for those does not change under the third edition.
Where to Start
The first step is to go through your client's balance sheet and identify every financial instrument. For each one, apply the SPPI test. Does it represent solely payments of principal and interest? If yes, it belongs in Part 1 at amortised cost. If no, it goes to Part 2 at fair value.
The second step is to look at any intragroup guarantees. If your client is issuing guarantees to group entities at nil consideration, the new disclosure requirements apply and the notes to the financial statements need to be updated.
The third step is to review any trade receivables with extended credit terms. If your client is offering credit beyond normal business terms or at below-market rates, the initial measurement of those receivables needs to reflect the time value of money.
The IAS 39 fallback is gone. The new Section 11 is cleaner, more logical, and better suited to the reality of SME financial instrument arrangements. But it does require you to apply the SPPI test, understand the new scope rules for guarantees, and revisit how some receivables are initially measured. That work needs to happen now, not in 2027.
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