Why a lease liability, a pension liability and a bank loan are treated very differently on the new income statement
If there is one classification outcome under IFRS 18 that will surprise finance teams the first time they walk through it, it's this: not every liability that generates interest expense qualifies for the financing category. A bank loan does. A lease liability, in most circumstances, does not, or at least, not fully. This is the puzzle at the heart of the financing category, the third of the three categories we're covering individually in this series (after operating and investing). Getting it right requires a single, disciplined first step: classifying every relevant liability into one of two buckets.
Step One: Is This a ‘Pure Financing’ Liability?
IFRS 18.59 requires entities to distinguish between two types of liabilities:
- Liabilities that arise from transactions that involve only the raising of finance, sometimes referred to informally as ‘pure financing’ liabilities.
- Liabilities that arise from transactions that do not involve only the raising of finance, everything else.
The test for the first bucket, set out in IFRS 18.B50, is deliberately narrow: a liability only qualifies as pure financing if the entity (a) receives finance in the form of cash, the extinguishment of a financial liability, or its own equity instruments, and (b) will, at a later date, return cash or its own equity instruments in exchange. Notice what is missing from that description, goods, services, a right-of-use asset, or employee labour. If the entity received anything other than cash-like finance, the liability fails the pure financing test.
Examples of pure financing liabilities
- Debentures, loans, notes, bonds and mortgages settled in cash.
- Liabilities under supplier finance (reverse factoring) arrangements where the original trade payable is derecognised.
- Bonds settled through delivery of the entity's own shares.
- An obligation to repurchase the entity's own equity instruments.
For Pure Financing Liabilities: The Financing Category Captures (Almost) Everything
Where a liability passes the pure financing test, IFRS 18.60 casts a wide net over what gets classified in the financing category:
- Income and expenses from the initial and subsequent measurement of the liability, including on derecognition (interest expense, fair value gains and losses, dividends on shares classified as liabilities).
- Incremental expenses directly attributable to issuing or extinguishing the liability, such as transaction costs.
This is the intuitive part of the standard, a straightforward bank loan or bond generates interest expense, and that interest expense sits squarely in financing.
For Everything Else: A Much Narrower Door into Financing
This is where IFRS 18 departs sharply from what many preparers expect. For liabilities that do not arise from transactions that involve only the raising of finance, IFRS 18.61 permits only two, narrowly defined items of income and expense into the financing category:
- Interest income and expenses, but only if the entity separately identifies such amounts for the purpose of applying another IFRS Accounting Standard's requirements (for example, the effective interest method).
- Income and expenses arising from changes in interest rates, again, only if identified for the purpose of applying other requirements.
Anything else relating to that liability defaults to the operating category. This is exactly why lease liabilities, contract liabilities, defined benefit pension liabilities and most provisions end up generating interest-type expense that is classified in financing (because it is separately identified interest under IFRS 16, IAS 19 or IAS 37), while other movements on those same liabilities, remeasurements, modifications, non-interest components , stay in operating.
Worked examples of ‘not pure financing’ liabilities
| Liability | Why it fails the pure financing test | What lands in financing |
|---|---|---|
| Payables for goods or services (IFRS 9) | The entity received goods or services, not cash-like finance. | Interest expense on the payable, if separately identified. |
| Contract liabilities with a significant financing component (IFRS 15) | The entity received cash but will settle by delivering goods or services, not cash. | Interest expense on the financing component. |
| Lease liabilities (IFRS 16) | The entity received a right-of-use asset, not cash-like finance. | Interest expense on the lease liability. |
| Defined benefit pension liabilities (IAS 19) | The entity received employee services, not cash-like finance. | Net interest expense (income) on the net defined benefit liability (asset). |
| Decommissioning / restoration provisions (IAS 37) | The entity received an asset (increase in carrying amount), not cash-like finance. | Unwinding of the discount (increase in the provision from the passage of time and discount-rate changes). |
A Note on Supplier Finance and Derecognition
One subtlety worth flagging: if, as part of a supplier finance arrangement, an entity derecognises a trade payable and recognises a new liability under that arrangement, the income and expenses arising from that derecognition are classified in the operating category , not financing, even though the new liability may itself later qualify as pure financing going forward.
The IAS 23 Interaction: Capitalised Borrowing Costs Escape the Categorisation Entirely
A practically important point for capital-intensive businesses: once borrowing costs are capitalised into the carrying amount of a qualifying asset under IAS 23, for example, interest incurred during the multi-year construction of a head office building , those costs are no longer presented as interest expense in profit or loss at all. They have been ‘re-characterised’ as part of the asset's cost. IFRS 18's financing category classification requirements simply do not apply to amounts that never hit profit or loss as interest in the first place; capitalised borrowing costs will instead flow through as depreciation, within whichever category the resulting asset's income and expenses are classified (typically operating, for an owner-occupied building).
Financing and the Mandatory Subtotals
Recall from our overview blog that IFRS 18 requires two mandatory subtotals: operating profit and profit or loss before financing and income taxes. The financing category sits below both of these, it is the bridge between ‘profit before financing and income taxes’ and ‘profit before tax’. This is deliberate: the IASB wants users to be able to see, cleanly, how much of an entity's profit is being absorbed by the cost of how the business happens to be funded, separately from its operating and investing performance.
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Exception to flag Profit or loss before financing and income taxes is a mandatory subtotal for most entities, but an exception applies for entities that provide financing to customers as a main business activity and make a particular accounting policy election. We cover this exception in detail in our blog on specified main business activities. |
Practical Steps for Preparers
- Build a liability register that tags every class of liability as either 'pure financing' or 'not pure financing' under the IFRS 18.B50 test , this becomes the foundation for financing category classification going forward.
- Confirm which interest-bearing, non-pure-financing liabilities have interest amounts 'separately identified' under other standards (leases, pensions, provisions) , only those identified amounts qualify for financing.
- Review supplier finance / reverse factoring arrangements carefully, given the specific derecognition guidance.
- Coordinate with capital projects teams to ensure capitalised borrowing costs under IAS 23 are correctly excluded from the financing category classification exercise.
The Comprehensive Financing Category Checklist
Financing is the most tightly bounded of the three active-judgement categories , only two liability types feed into it, and the second type admits a much narrower range of income and expense. The table below consolidates the financing category items referenced across IFRS 18's application guidance.
| Liability type | Income and expenses classified in financing |
|---|---|
| Pure financing, bank loans, notes, bonds, mortgages (cash-settled) | Interest expense (effective interest method); fair value gains and losses (if FVTPL); incremental transaction costs on issue/extinguishment; gains/losses on early settlement or derecognition. |
| Pure financing, bonds settled through delivery of own shares | Interest expense; fair value gains and losses; modification gains and losses. |
| Pure financing, obligation to repurchase own equity instruments | Fair value gains and losses; unwinding of any discount. |
| Pure financing, supplier finance / reverse factoring liability (post-derecognition of original payable) | Interest expense; fair value gains and losses (derecognition gain/loss on the original payable is operating, not financing, see note below). |
| Non-pure financing, trade payables for goods/services (IFRS 9) | Interest expense, only if separately identified under IFRS 9's effective interest requirements. |
| Non-pure financing, contract liabilities with significant financing component (IFRS 15) | Interest expense on the identified financing component only. |
| Non-pure financing, lease liabilities (IFRS 16) | Interest expense on the lease liability, calculated under the effective interest method. |
| Non-pure financing, defined benefit pension liabilities (IAS 19) | Net interest expense (income) on the net defined benefit liability (asset). |
| Non-pure financing, decommissioning, restoration and other provisions (IAS 37) | Unwinding of the discount, the increase in the provision from the passage of time and from changes in the discount rate. |
| Hybrid contracts, host liability component (embedded derivative separated) | Interest income/expense and income/expenses from changes in interest rates, applying the same pure vs. non-pure test to the host liability alone. |
How This Populates a Real Statement of Profit or Loss
Rounding out the illustrative manufacturing entity used throughout this series, here is how financing category items bridge from profit before financing and income taxes down to profit before tax (illustrative figures, AED 000s):
| Line item | 20X7 | Liability type | |
|---|---|---|---|
| Profit before financing and income taxes (brought forward) | 3,735 | Mandatory subtotal from operating + investing | |
| Interest expense on bank loans | (310) | Pure financing | |
| Interest expense on lease liabilities | (85) | Non-pure financing, identified interest only | |
| Net interest cost on defined benefit pension liability | (25) | Non-pure financing, identified interest only | |
| Profit before tax | 3,315 | Additional subtotal | |
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Note on the supplier finance example above If an entity derecognises a trade payable and recognises a new liability under a supplier finance arrangement, the gain or loss on that derecognition is classified in operating, it is only the subsequent interest expense on the new arrangement that becomes a financing category item. |
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Foreign Exchange and Derivatives: Two More Wrinkles in the Financing Story
Two further complications commonly touch the financing category and deserve at least a mention here, even though each has enough nuance to merit deeper treatment on its own. First, foreign exchange differences arising on monetary items are not automatically classified in financing simply because they are ‘financial’ in flavour, IFRS 18 requires foreign exchange differences to be classified in the same category as the income and expenses from the underlying item that gave rise to them. An exchange difference on a trade payable, for instance, follows the trade payable into operating; an exchange difference on a pure financing bank loan follows that loan into financing. Second, gains and losses on derivatives and designated hedging instruments are classified based on the purpose of the derivative and, where hedge accounting applies, by reference to the classification of the hedged item , a derivative economically hedging financing-category interest rate risk will generally also be classified in financing, while a derivative hedging an operating exposure follows the hedged item into operating.
Why the Financing Category Signals Something Real About Capital Structure
Beyond compliance, the financing category has genuine analytical value. Because ‘profit or loss before financing and income taxes’ strips out financing-category items entirely, analysts comparing two companies with identical operating and investing performance but very different capital structures , one funded mostly by equity, the other heavily leveraged with bank debt , can now see that difference isolated cleanly in a single, standardised subtotal, rather than having to reverse-engineer it from inconsistently labelled ‘finance costs’ lines that varied in composition from company to company under IAS 1. This is precisely the kind of comparability gain the IASB's Primary Financial Statements project set out to deliver.
Conclusion
The financing category is a useful reminder that IFRS 18 rewards precision over intuition. ‘It generates interest expense’ is not, on its own, enough to land a liability in the financing category, the far more important question is whether the underlying transaction did nothing more than raise finance. Lease liabilities, pension liabilities and provisions will, for most entities, only contribute their interest component to financing, with everything else about them sitting in operating. Getting this distinction embedded correctly into your systems and chart of accounts now will save considerable pain closer to the 1 January 2027 effective date.
With operating, investing and financing now covered individually, the next blog in this series turns to a topic that changes the classification rules for all three: entities with specified main business activities.
Untangling which liabilities are genuinely ‘pure financing’ and which are not is one of the trickier calls under IFRS 18 and getting it wrong can ripple through your subtotals for years to come. CLA Emirates’ IFRS advisory UAE team can help you build a liability-by-liability classification framework now, so your systems and chart of accounts are ready well ahead of the 1 January 2027 effective date.
