For a bank reporting under IRS, you may see it classify some of its financial assets under the fair value through the p and l category.

What's this all about? Well, it's about financial assets held for trading financial assets that have been purchased with the intention to sell them in the near term for classification of assets into this category.

Firstly, we need to look at the business model.

This is about how the bank intends to manage the financial assets for FE TPL L.

If the asset doesn't fall under the heading hold to collect or hold to collect and sell, then it can't be classified respectively as am or price, cost, or fair value through other comprehensive income.

This alone is strong enough evidence to tell the bank that the financial asset must be held at a fair value and any changes in fair value will directly hit the p and l.

But if there was any doubt, then we can proceed to the second test, the cashflow test.

If the cash flows aren't solely payments of principle and interest, then failing this test alone also means the financial asset must be held at fair value and any changes in fair value will directly hit the p and l.

A great example where the cashflow test might be relevant is for a convertible bond.

Imagine a convertible bond paying a 2% coupon that can be converted into shares at any point. Between now and its maturity, the market interest rate is 4%.

So how come the convertible bond is paying interest of only 2%? Well, it's because the investors are attracted by the option to convert into equity and therefore happier to receive less interest.

You could say, therefore, that the coupon rate is not wholly reflective of the interest return that the investor would want if the convertible option wasn't there, and therefore, as a result, the cash flows are not solely payments of interest and principle.

They're impacted by this embedded conversion option.

So the asset has failed the cashflow characteristics test and therefore must be classified as fair value through the p and l.