Embedded derivatives (IFRS 9)

Publication date: 23 Apr 2018

Resources (This includes links to the latest standards, drafts, PwC interpretations, tools and practice aids for this topic)

Latest developments

In July 2014, the IASB published IFRS 9, 'Financial instruments', the complete version of IFRS 9, 'Financial Instruments', which replaces the guidance in IAS 39. This final version includes requirements on the classification and measurement of financial assets and liabilities; it also includes an expected credit losses model that replaces the incurred loss impairment model used today. This version includes the hedge accounting amendments released in November 2013. The new standard is effective 1 January 2018, and was endorsed by the EU in November 2016, with early application permitted.

IFRS 9 does not change the accounting for embedded derivatives identified in financial liabilities or other non-financial host contracts. However, the requirement to separate embedded derivatives from financial assets has been removed. Embedded derivatives present in financial assets are now considered in the contractual cash flow test in determining the appropriate classification and measurement of the asset in its entirety in IFRS 9.

Overview

Some financial instruments and other contracts combine a derivative and a non-derivative host contract in a single contract. The derivative part of the contract is referred to as an 'embedded derivative'. Its effect is that some of the contract's cash flows vary in a similar way to a stand-alone derivative. For example, the principal amount of a bond may vary with changes in a stock market index. In this case, the embedded derivative is an equity derivative on the relevant stock market index.

A financial asset host that is within the scope of IFRS 9 is not assessed for embedded derivatives, because the solely payments of principal and interest (SPPI) criterion is applied to the entire hybrid contract to determine the appropriate measurement category. Embedded derivatives that are not 'closely related' to the host contract are separated and accounted for as stand-alone derivatives (that is, measured at fair value, with changes in fair value recognised in profit or loss). An embedded derivative is not 'closely related' if its economic characteristics and risks are different from those of the rest of the contract. IFRS 9 sets out many examples to help determine when this test is (and is not) met.

Analysing contracts for potential embedded derivatives is one of the more challenging aspects of IFRS 9.

 
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