Introduction

Publication date: 08 Dec 2017


6.3A.1 A derivative instrument that falls within the scope of IAS 39 need not be free-standing. Terms and conditions might be embedded in a financial instrument or non-financial contract (the ‘host’ contract) that behave like a free-standing derivative. These are referred to as embedded derivatives. The combination of the host contract and the embedded derivative is a ‘hybrid instrument’.

6.3A.2 An embedded derivative can arise from deliberate financial engineering, for example to make low interest-rate debt more attractive by including an equity-linked return. In other cases, they arise inadvertently through market practices and common contractual arrangements, such as leases and insurance contracts. Even purchase and sale contracts that qualify as executory contracts might contain embedded derivatives. In fact, they might occur in all sorts of contracts and instruments – the effect or objective being to change the nature of cash flows that otherwise would be required by the host contract and effectively shift financial risks between the parties.

6.3A.3 Analysing non-derivative financial instruments and executory contracts for potential embedded derivatives is one of the more challenging aspects of IAS 39. The challenge does not end there. As will be apparent later, a derivative identified in a host contract needs further evaluation to determine whether it should be accounted for separately as a stand-alone derivative at fair value. Not all embedded derivatives need to be accounted for separately from the host contract.

Definition and key characteristics

Publication date: 08 Dec 2017


6.3A.4 An embedded derivative is a component of a hybrid instrument that also includes a non-derivative host contract – with the effect that some of the cash flows of the hybrid instrument vary in a way similar to a stand-alone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified according to a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. [IAS 39 para 10]. Variation of the cash flows over the contract’s term is a critical indicator of the presence of one or more embedded derivatives. An example of a hybrid instrument is a loan that pays interest based on changes in the FTSE 100 index. The component of the contract that is to repay the principal amount is the host contract – this is the ‘base state’ with a pre-determined term and pre-determined cash flows. The component of the contract that is to pay interest based on changes in the FTSE 100 index is the embedded derivative – this component causes some or all of the cash flows of the host contract to change. The following diagram demonstrates this:
 
fininst054

6.3A.5 A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty from that instrument, is not an embedded derivative, but a separate financial instrument. [IAS 39 para 10]. An example is a bond with a detachable warrant. The owner of the bond-warrant package can exercise the warrant and buy shares for cash but keep the bond. This is unlike an owner of a convertible bond where the owner has to give up the bond in order to exercise the option.

Conditions for separation

Publication date: 08 Dec 2017


6.3A.6 Paragraph 11 of IAS 39 states that an embedded derivative should be separated from the host contract and accounted for as a derivative if all of the following three conditions are met:

the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract;
a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
the hybrid instrument is not measured at fair value with changes in fair value recognised in profit or loss.

6.3A.7 In relation to the third bullet point above, paragraph 11A of IAS 39 states that if a contract contains one or more embedded derivatives, an entity could designate the entire hybrid contract as a financial asset or financial liability at fair value through profit or loss unless:

the embedded derivative(s) does not significantly modify the cash flows that otherwise would be required by the contract; or
it is clear with little or no analysis when a similar hybrid instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a pre-payment option embedded in a loan that permits the holder to pre-pay the loan for approximately its amortised cost.

6.3A.8 The above requirements are summarised in the diagram below.
 
Questions that need to be asked
moa_6_3_8_2016
* If embedded derivative is not separately measurable then the entire instrument shall be recorded at fair value through profit or loss.

6.3A.9 The above requirements aim to ensure that all the underlying risks in an instrument are properly reflected in the accounting. For instance, a debt host contract might contain an embedded derivative that exposes the contract to risks that are non-interest related. If not required to separate the non-interest related exposure from the host debt instrument, entities could achieve an accounting result different from the accounting result achieved if it had issued two separate contracts with the same combined economic effect. Therefore, separation of the embedded derivative not only ensures that the accounting faithfully represents the contract’s underlying nature and its exposure to various risks, but also achieves consistency in accounting compared with free-standing derivatives. Measuring an embedded derivative separately from its host contract requires judgement, and such measurements might be difficult. Therefore, as a practical expedient IAS 39 provides that an embedded derivative need not be separated if it is regarded as closely related to its host contract.

6.3A.10 Although the requirement to separate an embedded derivative from a host contract applies to both parties to a contract (that is, both the issuer and the holder of a hybrid instrument), the two parties to the contract might reach different accounting treatments when applying the decision tree in paragraph 6.3A.8 above. For example, an equity conversion feature embedded in a convertible debt instrument denominated in the functional currency of the issuer is not closely related to the host debt instrument for the holder of the instrument. However, from the issuer’s perspective, the equity conversion option is an equity instrument and excluded from IAS 39’s scope, provided it meets the conditions for classification as equity under IAS 32. [IAS 39 para AG 30(f)].

Interpretation of ‘closely related’

Publication date: 08 Dec 2017


6.3A.11 Once an embedded derivative is identified, it is necessary to consider whether its economic characteristics and risks (that is, the factors that cause the derivative to fluctuate in value) are closely related to the economic characteristics and risks of the host contract. IAS 39 does not provide a definition of ‘closely related’. Instead, the application guidance to the standard provides examples of situations where the embedded derivative is, or is not, closely related to the host contract. Those examples have an underlying theme. They tend to focus attention on the question of whether the underlying economic characteristics and risks of the embedded derivative behave in a manner similar to the host contract’s economic characteristics and risks.

6.3A.12 A key determinant in the closely related assessment process is likely to be risk. Risk in a derivative is determined by the underlying such as interest rate, foreign exchange, prices etc, and by any leverage in the formula for determining settlement. An embedded derivative such as a cap or floor on the interest rate (interest rate risk) that bears a close economic relationship to its host debt contract would be considered closely related. Conversely, when a derivative that is embedded in a debt instrument embodies an equity instrument’s economic characteristics (for example, the derivative has a rate of return that is tied to the DAX 30 index), the economic characteristics of the derivative (equity-price risk) and host contract (interest rate risk) are different. In this situation, the embedded derivative would not be considered closely related to the host contract.

6.3A.13 The following example illustrates that it might be appropriate to take into account quantitative as well as qualitative factors in determining whether the economic characteristics and risks of an embedded derivative are closely related to those of the host contract.

Example – Electricity contract linked to coal prices
 
Entity A, an electricity provider, operates in a country where electricity is not traded on a market, and has a number of electricity contracts that have prices linked to coal prices. Management believes that, from a qualitative perspective, the electricity price is linked to the price of coal, as coal is a major input to the electricity generation process. A quantitative analysis reveals that electricity prices are not directly correlated with coal prices.
 
Whilst coal is an important input in the production of electricity, the price of electricity is driven by many other factors and, therefore, it is important to assess the extent to which the economic characteristics and risks of coal are in practice closely related to those of electricity. A quantitative assessment of correlation might be relevant to this determination and, in this example, it might lead to the conclusion that the coal price is not closely related to the electricity price. The embedded derivative would, therefore, need to be separated.

Interpretation of ‘closely related’ - Leverage embedded features in host contracts

Publication date: 08 Dec 2017


6.3A.14 Leverage embedded features can significantly modify some or all of the cash flows that otherwise would be required by the host contract. IAS 39 does not define the term ‘leverage’, although the term appears in several examples in paragraph AG 33. In general, a hybrid instrument is said to contain embedded leverage features if some or all of its contractually required cash flows, determined by reference to changes in one or more underlyings, are modified in a manner that multiply or otherwise exacerbate the effect of those changes. An example of this would be a lease with payments linked to an inflation index multiplied by a factor of 2.5. The effect of leverage is only relevant for those embedded derivatives that would otherwise be ‘closely related’ to the non-derivative host contract. This is because embedded derivatives that are not ‘closely related’ would have to be separated out from the host contract in any event, irrespective of whether they are considered to be leveraged.

6.3A.15 Although, in general, leverage has a multiplying effect, the standard does not quantify a numerical measure of leverage for closely related embedded derivatives although it does include the notion of at least doubling the holders interest rate of return in relation to embedded derivatives in which the underlying is an interest rate or an interest rate index (see para 6.3A.31 below). In other words, although it might be clear that any embedded feature that leverages the exposure of the host contract to more than an insignificant amount would require separation, no guidance is given as to what would constitute an acceptable threshold. An example of this would be a contract for delivery of paper where the price is linked to a pulp index, transportation index and relevant inflation index where the indices are multiplied by percentages that reflect relative weighting of the cost factor in the production of paper. Such percentages would normally add up to 100%. To support the closely related assertion it has to be demonstrated that this was the normal way to price commercial contracts in the market for paper at the time when the contract was entered into. That could be done, for example, by reference to web sites of relevant industry associations, commodity or goods exchanges, etc. Therefore, judgement should be exercised after considering all relevant facts and circumstances that are specific to the situation.

Identifying the terms of embedded derivatives and host contracts

Publication date: 08 Dec 2017


6.3A.16 Because an assessment of whether an embedded derivative is ‘closely related’ to the host contract requires an understanding of the economic characteristics and risks of both the host contract and the derivative, it is necessary to consider the general principles that might be helpful in identifying the hosts and any derivatives that might be embedded in them.

6.3A.17 Determining the type of host should not cause undue difficulty in practice as its economic characteristics and risks are readily transparent. Common host contracts that have derivatives embedded in them are given below:

Debt instruments.
Equity instruments.
Leases.
Executory contracts such as purchase and sales contracts.
Insurance contracts.
   
The economic characteristics and risks of each of these contracts are considered in the application section below. Other hosts might exist, but as these are likely to be rare they are not considered in this chapter.

6.3A.18 Searching for derivatives embedded in the above hosts might be more challenging. Because few hybrid contracts use the term ‘derivative’, a thorough evaluation of the terms must be performed to determine whether the contract contains an embedded derivative. Certain terms and phrases might indicate the presence of an embedded derivative, including:

Pricing based on a formula.
The right to purchase/sell additional units.
Exchange/exchangeable into.
Indexed to/adjusted by/referenced to.
Premium/strike/limits.
The right to cancel/extend/repurchase/return.

6.3A.19 Another method of determining whether a contract has an embedded derivative is to compare the terms of a contract (such as interest rate, maturity date(s), cancellation provisions, etc) with the corresponding terms of a similar, non-complex contract. In other words, an entity should ascertain whether there are differences between typical market terms and the terms of the contract that is being evaluated. An investigation of differences might uncover an embedded derivative.

6.3A.20 The following list illustrates how the nature of a host contract and embedded derivative might be determined:
 
Instrument Host contract Embedded derivative
Convertible bond Debt instrument Purchased call option on equity securities
Debt paying interest quarterly based on an equity index Debt instrument Four forward contracts per annum on equity index
A two-year fixed-quantity sales contract including maximum and minimum pricing limits Purchase contract Commodity price collar
A two-year fixed-quantity sale contract of mobile phones denominated in GBP between a French seller and German buyer, both with euro functional currencies Purchase contract Foreign currency forward contract

Assessment of closely related criterion

Publication date: 08 Dec 2017


6.3A.21 The assessment of the closely related criterion should be made when the contract is initially recognised, which is usually at inception of the contract. The question arises as to whether this initial assessment should be revisited during the contract’s life. For example, an entity might determine, based on market conditions existing at the date of inception, that an embedded derivative in a host contract is closely related. Subsequently, market conditions change and the entity concludes that the embedded derivative is no longer closely related. The converse situation can also arise. The issue is in which circumstances the entity should make this reassessment.

6.3A.22 The above issue is addressed in IFRIC 9. IFRIC 9 re-confirms the treatment in IAS 39 that an entity should assess whether an embedded derivative is required to be separated from the host contract and accounted for as a derivative when the entity first becomes a party to the contract. This initial assessment is not revised, unless (a) the contractual terms change and the change significantly modifies the expected future cash flows associated with the embedded derivative, the host contract or both relative to the previously expected cash flows on the contract; or (b) a financial asset is reclassified out of the fair value through profit or loss category. [IFRIC 9 para 7]. So, if the market conditions change and the market was the principal factor in determining whether the host contract and the embedded derivative are closely related, no reassessment is required, unless the terms of the contracts are changed and the changes result in the revised expected cash flows being significantly different from the previously expected cash flows.

6.3A.23 Where a financial asset is reclassified out of the fair value through profit or loss category, the assessment for embedded derivatives should be made based on the conditions that existed at the later of (a) when the entity first became a party to the contract and (b) when a change in the terms significantly modifies the cash flows on the contract. This same assessment applies to first-time adopters rather than the conditions existing at the date when the entity transitions to IFRS. [IFRIC 9 para 8].

[The next paragraph is 6.3A.25.]

6.3A.25 Paragraph 16 of IFRS 3 requires a company that acquires another company (the ‘acquirer’) to re-assess all contracts of the acquired entity for embedded derivatives at the acquisition date. This is so that all such contracts (to which the acquirer becomes a party as a result of the acquisition) are accounted for in the same way as if the acquirer had taken them out individually at the time of acquisition. Generally this will result in more embedded derivatives being separated from host contracts in the group’s consolidated financial statements, as compared with the acquired entity’s stand-alone financial statements. This is because the embedded derivative guidance links some of the criteria for separating embedded derivatives to market conditions existing at initial recognition of the host contract. These separated embedded derivatives will be accounted for at fair value through profit or loss in the consolidated financial statements, after the acquisition (unless they are designated in a valid hedge relationship in accordance with IAS 39).

Example – Reassessment of embedded derivative
 
A UK entity entered into an ‘own use’ long-term electricity purchase contract in the late 1980s. At that time, there was no market for electricity but prices for gas and electricity were linked and there was high correlation between the two prices. Hence, the price of the electricity contract was linked to gas prices. Following deregulation of the energy market in the UK in the mid-1990s, the prices of gas and electricity are no longer correlated. On transition to IFRS, the contract has a remaining maturity of two years.
 
When considered at the date of transition to IFRS the price adjustment feature would have been regarded as closely related, reflecting market conditions prevailing at the date the contract was entered into. Given that there were no amendments to the terms of the contract, in accordance with paragraph 6.3A.22 above, the initial assessment is not updated even though over time market conditions have changed and prices of gas and electricity are no longer correlated at the date of transition to IFRS.
 
On the other hand, if the entity entered into a similar contract after deregulation of the energy market, but before transition to IFRS, the price adjustment feature (electricity price in the contract is linked to gas prices and not market price of electricity) would not be regarded as closely related. Therefore, the embedded derivative would have to be separated and accounted for as a derivative at the date of transition to IFRS.

Application of closely related criterion to different types of hosts

Publication date: 08 Dec 2017


6.3A.26 The application guidance to IAS 39 provides examples of situations where the embedded derivative is, or is not, closely related to the host contract. [IAS 39 paras AG 30 to AG 33]. This guidance is not an exhaustive list of contract features or embedded derivatives but does contain many of the common features found in typical host contracts. Judgement will be required to analyse situations that are not included in the standard’s examples. As determining what is closely related can prove challenging in practice, we have supplemented the standard’s examples with additional examples where relevant.

Application of closely related criterion to different types of hosts - Embedded derivatives in debt host contracts

Publication date: 08 Dec 2017


6.3A.27 The most common host for an embedded derivative is a debt contract. However, it is first necessary to identify the host debt in the hybrid instrument. The implementation guidance states that the terms of the host debt instrument should reflect the stated or implied substantive terms of the hybrid instrument. [IAS 39 para IG C1]. For example, if the terms indicate that the host instrument has a stated or predetermined maturity and pays a fixed, floating or zero-coupon rate of interest, then its economic characteristics and risks are those of a debt instrument.

6.3A.28 In the absence of implied or stated terms, the entity makes its own judgement of the terms. However, in exercising such judgement, the entity should not seek out a component that is not specified in the contract. Nor should it establish the terms of the host debt instrument in a manner that would separate an embedded derivative that is not clearly present in the hybrid instrument, that is to say, it cannot create a cash flow that does not exist. For example, if a five-year debt instrument has fixed interest payments of C40,000 annually and a principal payment at maturity of C1 million multiplied by the change in an equity price index, it would be inappropriate to identify a floating rate host contract and an embedded equity swap that has an offsetting floating rate leg in lieu of identifying a fixed rate host. The host contract is a fixed rate debt instrument that pays C40,000 annually, because there are no floating interest rate cash flows in the hybrid instrument. [IAS 39 para IG C1].

6.3A.29 The value of a debt instrument is determined by the interest rate that is associated with the contract. The interest rate stipulated in the debt instrument is usually a function of the following factors:

Risk free interest rate.
Credit risk.
Expected maturity.
Liquidity risk.
   
Thus, embedded derivatives that affect the yield on debt instruments because of any of the above factors would be considered to be closely related (unless they are leveraged or do not change in the same direction as interest rates and fail the test described in para 6.3A.31. A detailed example is the inverse floater in example 3 of para 6.3A.34 below). On the other hand, if the economic characteristics and risks of the embedded derivatives have features that are unrelated to interest rates (such as equity or commodity features), they would not be closely related to the debt host. Examples relating to the application of closely related criterion to a debt host and different embedded derivatives are considered in the following paragraphs.

Application of closely related criterion to different types of hosts - Embedded derivatives in debt host contracts - Index-linked interest payments

Publication date: 08 Dec 2017


6.3A.30 It is common for floating rate loans to be priced off LIBOR or the prime rate index. More complex debt instruments contain embedded interest rate indices that can change the amount of interest that would otherwise be paid or received, such as leveraged inverse floaters, range floaters, etc.

6.3A.31 An embedded derivative in which the underlying is an interest rate or interest rate index that can change the amount of interest that would otherwise be paid or received on an interest-bearing host debt contract (or insurance contract) is closely related to the host contract unless:

the combined instrument can be settled in such a way that the holder would not recover substantially all of its recognised investment; or
the embedded derivative could at least double the holder’s initial rate of return on the host contract and could result in a rate of return that is at least twice what the market return would be for a contract with the same terms as the host contract.
[IAS 39 para AG 33(a)].

Note that this assessment is made when the entity becomes party to the contract and on the basis of market conditions at that time (see para 6.3A.22).

6.3A.32 An example of an instrument meeting the first condition would be a bond callable by the issuer at an amount significantly lower than its issue price. Should the issuer decide to exercise the call option (that is, repurchase the bond) the holder would be required to sell it and, therefore, not recover substantially all of its recognised investment. The first condition that “the holder would not recover substantially all of its recognised investment” is not satisfied if the terms of the combined instrument permit, but do not require, the investor to settle the combined instrument in a manner that causes it not to recover substantially all of its recognised investment and the issuer has no such right (for example, a puttable debt instrument). An embedded interest rate derivative with such terms is regarded as closely related to the interest-bearing host contract. The condition that “the holder would not recover substantially all of its recognised investment” applies to situations in which the holder can be forced to accept settlement at an amount that causes the holder not to recover substantially all of its recognised investment. [IAS 39 para IG C10]. The term ‘substantially all’ is not defined in IAS 39 and, therefore, judgement should be exercised after considering all the relevant facts and circumstances.

6.3A.33 The second condition has two parts. Both these parts should be met for the embedded derivative not to be considered closely related. So, for example, if the embedded derivative feature results in doubling the initial return under a possible future interest rate scenario no matter how remote, but, at the same time, that interest rate scenario would not result in a rate of return that is at least twice what the then-current market return would be for a contract that has the same terms as the host, then only one part of the condition would have been met and the embedded derivative would be regarded as closely related to the host.

6.3A.34 The above provisions are intended to ‘scope in’ embedded derivatives that cause the hybrid instrument to perform less like a debt instrument and more like a derivative (for example, hybrid instruments that are highly leveraged). The following examples illustrate the application of the above guidance to various interest rate index-linked debt instruments.

Example 1 – Floating rate debt
 
Entity A takes out a floating rate loan with a bank. The contractually determined interest rate on the debt is six-month LIBOR plus two percentage points (assuming credit spread is two percentage points).
 
A plain vanilla floating rate instrument with a normal credit spread whose risk free interest rate component (for example, LIBOR) is periodically reset to market interest rate cannot contain an embedded derivative.

Example 2 – Floating rate debt with investor payment provision
 
Entity A issues a floating rate debt instrument with a face value of C50m. The contractually determined interest rate on the debt is six-month LIBOR. However, there is a provision that if six-month LIBOR increases by 200 basis points, the investor will pay C2m to the issuing company.
 
The embedded derivative consists of a contingent payment provision that depends on LIBOR increasing by 200 basis points. The embedded derivative is not separated, because the investor will receive C50m and the C2m payment is not considered to reduce its initial investment substantially. So the first condition in paragraph 6.3A.31 is not met. Furthermore, there is no provision in the contract that causes the investor’s yield to increase to at least twice the initial rate. Therefore, the second condition is not met. The embedded derivative is closely related to the debt host and no separation is necessary. The fact that LIBOR could increase by 200 basis points in a year is simply a condition that triggers the payment, and it is not relevant to determining whether the embedded derivative is closely related.

Example 3 – Leveraged inverse floater
 
Entity A takes out a loan with a bank. The contractually determined interest rate on the debt is calculated as 14.5% − 2.5 × three-month LIBOR (sometimes referred to as a leveraged inverse floater).
 
Three-month LIBOR at inception = 4% giving an initial yield of 4.5%.
 
The embedded derivative has a highly leveraged underlying so either a negative yield or a significantly higher than market yield is possible. This is because, if under a future interest rate scenario three-month LIBOR increases to 8%, the yield would be negative, that is, −9.5% (14.5% − 24%) and the investor would not recover substantially all of its recognised investment. As the first condition in paragraph 6.3A.31 above is satisfied, the embedded derivative is not closely related to the host contract and will be accounted for separately. In practice, sometimes the yield will not be allowed to go negative. To prevent this happening, a floor is often imposed on the coupon rate.
 
Note that in this example there is no need to evaluate the second condition in paragraph 6.3A.31 above. But if it were evaluated the result would be the same, that is, the embedded derivative would not be considered closely related to the host debt contract. This is because, for example, if under a future interest rate scenario, three-month LIBOR falls to 2%, the yield would be 9.5% (14.5% − 5%) which is more than twice the initial yield of 4.5%. In addition, the yield of 9.5% is also likely to be twice the then market yield for a contract with the same terms as the host.

Example 4 – Forward starting interest rate swap
 
Entity A issues a 8% fixed rate debt instrument that matures at the end of year 5. The entity has an option to convert the loan into a variable rate debt at LIBOR + 3% after two years. LIBOR at inception is 5%.
 
The embedded derivative in the above debt host is an option on a forward starting interest rate swap that changes the fixed rate interest payments to floating rate after two years. In order to determine whether the option on the forward starting swap should be accounted for as a separate derivative, it is necessary to apply the second condition in paragraph 6.3A.31 above.
 
If, under a future interest rate scenario (however remote), LIBOR increases to 14%, the increase would more than double the initial return on the investment from 8% to 17% (14% + 3%). However, that interest rate scenario of 14% does not result in a market rate of interest that is twice the current market rate for a contract with the same terms as the host contract, which is only 17% assuming no change in credit rating. As only one part of the second condition in paragraph 6.3A.31 is satisfied, the embedded option on the forward starting interest rate swap is closely related to the debt host and no separation is permitted.

Application of closely related criterion to different types of hosts - Embedded derivatives in debt host contracts - Inflation-linked interest and principal payments

Publication date: 08 Dec 2017


6.3A.35 It is not uncommon for companies to issue a debt instrument where the amount of interest or the principal to be repaid or both is linked to an inflation index. Such inflation escalator clauses are often designed to compensate the holder of the debt for the time value of money. However, they give rise to an embedded derivative and the issue therefore arises of whether this is judged to be closely related to the host debt contract under IAS 39.

6.3A.35.1 Although IAS 39 is silent on the treatment of inflationary adjustments in debt host contracts, in our view it is appropriate to look to the guidance on inflation adjustment features in host lease contracts (in the same way as for executory contracts – see para 6.3A.89). This guidance on leases states that an embedded inflation-related index is closely related to the host lease contract if the index is not leveraged and it relates to inflation in the entity’s own economic environment. [IAS 39 para AG 33(f)]. The application of this principle to lease contracts is considered in paragraph 6.3A.69 onwards below. We believe that similar considerations can be applied to debt instruments.

6.3A.36 Firstly, paragraph AG 33(f) makes it clear that an embedded inflation adjustment in a lease contract would not be closely related if it is considered to be leveraged.  In applying this to inflation-linked debt, the same principles as for leases should be followed (see paras 6.3A.14 to 6.3A.15). If the leverage is greater than one then the indexation is not simply compensating for the time value of money and so is not closely related.

6.3A.37 The second requirement in paragraph AG 33(f) is that the inflation index is a recognised measure of general inflation in the relevant economic environment. If the inflation index relates to a different economic environment to that of the debt, or is not a commonly used measure of general inflation, the underlying inflation index will not be regarded as closely related to the debt host. For example, consider countries in the Eurozone where the interest rate is set by the European Central Bank (ECB). The inflation rate in a particular country within the Eurozone might be different from overall Eurozone inflation due to, for example, differences in national rates of growth, local market regulation, etc. In such a case the debt will include a non-closely related derivative.

6.3A.38 As an alternative to looking to the guidance on inflation adjustment features in host lease contracts in paragraph AG 33(f), a company might choose to perform a qualitative analysis to determine whether the underlying inflation index is closely related. In those circumstances, a quantitative analysis might also provide useful evidence of correlation or otherwise, particularly in a changing economic environment. Such a quantitative analysis could take the form of a regression analysis that demonstrates a statistically significant relationship between the interest rate for the maturity of the debt instrument and the inflation measure specified in that instrument.

6.3A.39 An entity issuing an inflation-linked bond would need to perform the above analysis at inception to determine whether the inflation index is closely related to the host debt instrument. If the above conditions are not met, the embedded derivative would have to be separated from the host contract and accounted for as a derivative.

Example – Inflation-linked bond
 
A UK entity issues an inflation-linked sterling bond that pays a fixed interest of 5% per annum. The return of the principal amount is linked to UK Retail Price Index (RPI), which is a recognised headline measure of inflation in the economic environment of the currency in which the bond is denominated.
 
As the coupon on the bond is 5%, and the underlying principal of the bond is £100, the bond pays £5 interest per annum. If the inflation index increases to 10%, the principal of the bond would then increase to £110 and the interest payment increases to £5.50 (5% × C110).
 
In this example, the principal payment is not leveraged and it is indexed to the headline measure of inflation in the economic environment of the currency in which the bond is denominated and so the inflation index is regarded as closely related to the host debt instrument.

Application of closely related criterion to different types of hosts - Embedded derivatives in debt host contracts - Equity- and commodity-linked interest and principal payments

Publication date: 08 Dec 2017


6.3A.40 Equity-indexed interest or principal payments embedded in a host debt instrument or insurance contract – by which the amount of interest or principal is indexed to the value of equity instruments – are not closely related to the host instrument, because the risks inherent in the host and the embedded derivative are dissimilar. [IAS 39 para AG 30(d)]. Similarly, commodity-indexed interest or principal payments embedded in a host debt instrument or insurance contract – by which the amount of interest or principal is indexed to the price of a commodity (such as gold) – are not closely related to the host instrument, because the risks inherent in the host and the embedded derivative are dissimilar. [IAS 39 para AG 30(e)]. Therefore, where interest and principal payments in a debt instrument are indexed to an equity-index that is not specific to the entity, a commodity index or any other non-financial index, the embedded derivative must be accounted for separately.   

Example 1 – Cash settled put option in a convertible bond
 
Entity A issues convertible bonds to entity H. The term of the bonds is 3 years and the par value is C2m. Each bond pays fixed interest annually at 6% a year and is convertible at any time by entity H until maturity into a fixed number of entity A’s ordinary shares. Entity H also has the option to put the convertible bond back to entity A for cash at par at any time.
 
Entity A has determined that the market rate for a loan with comparable credit status and providing substantially the same cash flows on the same terms, but without the conversion option, is 7%.
 
Entity A’s management should separate the convertible bond’s equity and liability elements. [IAS 32 para 28]. The conversion option is an equity instrument of entity A provided it can only be settled by physical delivery of a fixed number of shares for a fixed amount of cash or other financial assets. It is not accounted for as a derivative. [IAS 39 para 2(d)].
 
Paragraph 49 of IAS 39 states that the fair value of a liability with a demand feature is not less than the amount payable on demand, discounted from the first date that the amount can be required to be paid. Hence entity A would record the liability at its nominal value with any residual consideration received being attributed to the equity component.
 
The option to put the convertible bond back to entity A for cash at par is an embedded derivative. This option is closely related to the host debt instrument, as the exercise price (par) is approximately equal to the bond’s amortised cost before separating the equity element under IAS 32 in this example. [IAS 39 para AG 30(g)].

Example 2 – Call option linked to an equity index
 
An entity issues a debt instrument at par with a term of five years. The debt is callable by the issuer 3 years after issue. If called, the holder will receive a sum that is the greater of the par value of the debt or the par value as adjusted by the percentage increase in the FTSE 100 index.
 
The embedded call option exercisable 3 years after the issue of the debt instrument is not closely related to the debt host as the payoff is indexed to an equity index. The equity-linked feature provides an upside to the investor, linked to an index representing different risks from those of the ordinary debt instrument. Hence, the option should be separated from the host debt instrument and accounted for separately.

Example 3 – Payments linked to the price of a listed share
 
An entity issues a debt instrument at par with a term of five years. The debt is redeemable at par at any time. The loan agreement provides that during the term of the loan the entity will either receive or pay an amount based on the changes in the share price of an unrelated listed company A plc, the reference point being the market price of A plc at the date of issue of the debt instrument.
 
As the interest payments are based on changes in the price of an equity instrument (equity risk), they are not closely related to the host debt instrument (characterised mainly by interest rate and credit risk). Therefore, the embedded equity-linked amounts should be separated by both the issuer and holder of the debt instrument and recorded on the balance sheet at fair value, with changes in fair value recognised in the income statement.
 
The answer would be the same if the interest or principal payments were linked to the movement in an equity index, such as S&P500 and even if they were linked to the market price of the entity’s own shares because the entity’s own shares are an example of an underlying that is a financial variable (see chapter 40 for more details on the definition of a derivative) and the risks inherent in them are dissimilar to interest risk.

Example 4 Equity-linked bond with repayment floor
 
Entity A purchases a one-year debt instrument issued by bank B for its principal amount of C1,000 on the issue date. Bank B will make no interest payments during the life of the instrument. At maturity, entity A will receive the principal amount plus any increase in the S&P 500 index since the issue date. The fair value of an at-the-money European option maturing in one year is C48 at issuance date.
 
Entity A classifies the debt instrument as held-to-maturity.
 
Entity A should recognise the hybrid instrument as a combination of a call option and a zero-coupon debt instrument, having first determined the option contract’s fair value and strike price. [IAS 39 para AG 28].
 
Since entity A only receives increases in the value of the index since the issue date, the embedded option is at the money at the date of issue and its fair value consists only of its time value and no intrinsic value. So its fair value at the issue date is C48 and the balance of the consideration given (C1,000 − C48 = C952) is attributed to the carrying amount of the zero-coupon debt instrument.
 
The zero-coupon host contract should be recognised at amortised cost with interest accreted at the original effective interest rate of 5% to reach C1,000 at maturity. The option should be recognised at its fair value, initially C48 against the benchmark of C1,000, with subsequent gains or losses recognised in the income statement.

Example 5 – Commodity-linked bond
 
A gold mining company issues a debt instrument with a face value of C10m and contingent interest payments in addition to a guaranteed minimum interest payment of 4% per annum. The contingent payments are linked to the price of gold such that an additional interest payment of 0.5% would be paid for every US$25 increase in gold price above US$260. The price of gold at issue date was US$310 per ounce. The market rate for a fixed interest loan without such additional features is 5%.
 
A commodity-linked bond such as the one described above enables the issuer to reduce its financing cost by offering contingent payments to investors, whilst the investor is assured of a guaranteed minimum, but able to participate in any increase in the price of gold.
 
In this situation, the issuer would be viewed as having (a) issued a host debt instrument at a market rate of interest of 5%; and (b) sold a call option contract under which the issuer receives a premium of 1% fixed interest and pays a variable amount that varies with the movement in the gold price above US$260. The option contract is not closely related to the debt instrument as the factors that cause the option to change in value (commodity price risk) are not the same as the factors that cause the debt host to change in value (interest rate risk).
 
The embedded option contract should be separated from the host contract by both the issuer and the holder and recorded on the balance sheet at fair value, with subsequent changes in fair value recognised in the income statement.

6.3A.41 Example 2 in the previous paragraph dealt with call options held by the issuer. A similar treatment arises in circumstances where the holder has the right to put the debt instrument back to the issuer in exchange for an amount of cash or other financial assets that varies on the basis of the change in an equity or commodity index that might increase or decrease. These instruments are commonly referred to as ‘puttable instruments’. Unless the issuer on initial recognition designates the puttable instrument as a financial liability at fair value through profit or loss, it is required to separate an embedded derivative (that is, the indexed payment). [IAS 39 paras AG 30(a), AG 31].

Application of closely related criterion to different types of hosts - Embedded derivatives in debt host contracts - Interest rate caps, floors and collars

Publication date: 08 Dec 2017


6.3A.42 Floating rate securities might have a maximum coupon that is paid at any reset date. The maximum coupon rate is called a cap. For example, suppose for a floating rate note with a coupon of three-month LIBOR + 50 basis points, there is a cap of eight per cent. If the three-month LIBOR at the coupon reset date is eight per cent, then the coupon rate would be eight and a half per cent but the cap would restrict the coupon rate to eight per cent. Therefore, a cap can be attractive to the issuing company as a protection against rises in interest rates. A cap can be thought of as an embedded option requiring no action by the issuer to be protected from a rise in interest rates. Effectively, the bondholder has granted to the issuer the right not to pay more interest than the cap. For granting this privilege, the issuer of the bond (the cap buyer) will have to pay a premium that increases the overall cost of funds. If the relevant/market interest rate rises above the cap strike rate, then in effect payments are made by the cap seller to the cap buyer to compensate for the excess. This means the cap is in the money whenever the strike rate is lower than the relevant/market rate of interest. It is out of the money whenever the strike rate is above the relevant/market rate of interest.

6.3A.43 In contrast, there could be a minimum coupon rate specified for a floating rate security. The minimum coupon rate is called a floor. If the coupon formula provides a coupon rate that is below the floor, the floor rate is paid instead. A floor is the mirror image of a cap. While a cap benefits the issuer if interest rates rise, a floor benefits the bondholder if interest rate falls. As with other options, the buyer must pay a premium to the issuer of the bond (the floor seller) that will reduce the issuer’s overall cost of funds. If the coupon rate falls below the floor strike rate then payments are made by the seller to the buyer to compensate for the shortfall. This means the floor is in the money whenever the strike rate is above the relevant/market rate of interest. It is out of the money whenever the strike rate is lower than the relevant/market rate of interest.

6.3A.44 A floating rate security can have a cap and a floor. This feature is called a collar. The buyer of a collar limits the maximum rate that he will pay and sets a minimum rate that he will pay and, therefore, will be exposed to interest rate movements within a range. As long as interest rates are within this band the buyer of the collar pays floating interest, no compensating payment is made or received by the buyer under the terms of the collar and the collar is said to be out of the money.

6.3A.45 An embedded floor or cap on the interest rate on a debt contract is closely related to the host contract, provided when the instrument is issued:

the floor is at or below the market rate of interest (out of the money); or
the cap is at or above the market rate of interest (out of the money); and
the cap or floor is not leveraged in relation to the host contract.
[IAS 39 para AG 33(b)].

6.3A.45.1 In January 2016 the IFRS Interpretations Committee (IC) discussed the application of this guidance and in particular how to determine the floor or cap rate in the contract and the market rate of interest. The IC clarified that an entity should compare:
 
the overall interest rate floor or cap for the hybrid contract to
the market rate of interest for a similar contract without the interest rate floor or cap (the host contract).
   
The IC observed that overall interest rate floor or cap for the hybrid contract is the benchmark interest rate referenced in the contract plus contractual spreads and if applicable any premiums, discounts or other elements that would be relevant to the calculation of the effective interest rate. When determining the appropriate market rate of interest for the host contract an entity is required to consider all specific terms of the host contract and the relevant spreads (including credit spreads) appropriate for the transaction.

6.3A.45.2 The term ‘market rate of interest’ is linked to the concept of fair value as defined in IFRS 13 Fair Value Measurement and is described as the rate of interest ‘for a similar instrument (similar as to currency, term, type of interest rate and other factors) with a similar credit rating’. As the market rate of the host instrument typically includes a receipt of premium for the floor, it is expected the IFRIC guidance will lead to floors being closely related to host contracts unless they are leveraged. [IAS 39 para AG 64].

6.3A.45.3 The IC also observed that the guidance in IAS 39 para AG 33(b) is applied in a negative interest rate environment in the same way as it would be applied in a positive interest rate environment.

6.3A.46 The assessment of whether the cap or floor is closely related to the host is made when the entity becomes party to the contract and is not revised unless the terms of the debt instrument are changed significantly (see para 6.3A.22 above). An entity would become party to the contract when the debt is issued at inception, bought in the secondary market or on the date of a business combination in which the debt was acquired. It follows from the above that only in-the-money caps and floors when the entity becomes party to the contract or leverage provision would fail the closely related test. Therefore, an interest rate floor embedded in a variable rate debt instrument that was out of the money when the debt instrument was initially recognised would not be separated from the host debt, even if interest rates subsequently fall so that the floor becomes in the money. Similar considerations apply to caps.

Example – Debt subject to an interest rate collar
 
Entity A has borrowed cash from a bank. The debt is interest-bearing at a variable rate, but within a collar. The variable rate on the date of inception of the loan was 7%, the floor was 5% and the cap was 9%.
 
In this situation, the embedded derivative is a collar that modifies the cash flows of variable rate debt if the variable rate moves outside the range of the collar. IAS 39 does not specifically deal with collars in this context, although the guidance relating to caps and floors can be extended to collars (being a combination of a cap and a floor). At the time when the variable rate debt instrument is issued, the interest rate is 7% for a similar contract without the interest rate floor or cap (the host contract). As such, the floor is below the market rate of interest (out of the money), and the cap is above the market rate of interest (out of the money). Also, the collar is not leveraged. Therefore, based on the guidance in chapter 41 paras 32 and 33, the embedded collar is regarded as closely related, and separate accounting for the embedded derivative is prohibited.

Application of closely related criterion to different types of hosts - Embedded derivatives in debt host contracts - Calls, puts and pre-payment options

Publication date: 08 Dec 2017


6.3A.47 The terms of a debt instrument might include an issuer call option (a callable bond), that is, a right of the issuer (but not the investor) to redeem the instrument early and pay a fixed price (generally at a premium over the par value). There might also be other pre-payment features that cause the whole or part of the outstanding principal to be repaid early. Adding call options and/or other pre-payment options should make it less attractive to buyers, since it reduces the potential upside on the bond. As interest rates go down and the bond price increases, the bonds are likely to be called back. Alternatively, the investor might have a put option to force early redemption of the outstanding principal. Such call option, put option and pre-payment features embedded in the debt host are derivatives.

6.3A.48 The application guidance explains that these embedded derivatives are not closely related to the host debt contract, unless the option’s exercise price is approximately equal on each exercise date to the host debt instrument’s amortised cost or the exercise price of a pre-payment option reimburses the lender for an amount up to the approximate present value of lost interest for the remaining term of the host contract. [IAS 39 para AG 30(g)].

Example 1 – Calls and puts in debt instruments
 
An entity issues the following debt instruments:
   
5-year zero coupon debt for proceeds of C7m with a face value of C10m; issue costs are insignificant. The debt is callable by the issuer at its amortised cost calculated on the basis of the effective interest rate method in the event of a change in tax legislation adversely affecting the tax deductions available to the issuer.
5-year zero coupon debt for proceeds of C7m with a face value of C10m; issue costs are insignificant. The debt is puttable at its face value in the event of a change of control of the issuer.
 
Both instruments will be recorded initially at a fair value of C7m, which is the consideration received. The debt will accrete to its final value of C10m at maturity in year 5. Therefore, between inception and maturity the debt’s amortised cost will not be the same as its face value, except in the period close to maturity.
 
For the first instrument, if the debt is called by the issuer at its amortised cost, the call option does not accelerate the repayment of principal as the option’s exercise price is the same as the debt’s amortised cost (the exercise price is not fixed but variable), even though the debt was initially issued at a substantial discount. Therefore, in accordance with paragraph AG 30(g) of IAS 39, the call option is closely related to the debt host and would not be accounted for separately.
 
For the second instrument, if the debt is put back by the holder at its face value before maturity, the put option’s exercise price of C10m (fixed at the outset) would not be the same as the debt’s amortised cost at exercise date. Therefore, in accordance with paragraph AG 30(g) of IAS 39, the put option is not closely related to the debt host. This means that the put option must be separately accounted for. This will result in the initial fair value of C7m being disaggregated into a written put option liability and a host debt contract. The initial carrying amount of the host debt contract will be less than C7m and its effective interest rate will be higher than in the first example.
 
Both debt instruments contain terms that allow the debts to be called or put back on the occurrence of a contingent event (adverse change in tax legislation or change in control). These terms (relating to factors other than interest rate risk and credit risk of the issuer) are not closely related to the debt hosts. However, determining whether the call or the put option is closely related to the host contract is based solely on the difference between the option’s exercise price and the debt’s amortised cost.

Example 2 – Pre-payment option in debt instruments
 
Entity A takes out a fixed rate loan with a bank for C1m. The loan is repayable in quarterly instalments. The debt contains a pre-payment option that could be exercised by entity A on the first day of each quarter. The exercise price is the remaining capital amount outstanding on the debt plus a penalty of C100,000.
 
At inception, entity A would record the financial liability at its fair value of C1m. As entity A makes repayments of capital to the bank, the amortised cost of the debt will change.
 
The exercise price of the pre-payment option at inception is C1m plus the penalty of C100,000. Whether the entity will exercise its option to pre-pay the loan early might depend on a number of reasons, but the level of interest rates is a critical variable. If there is a significant decline in interest rates, any potential gain from early pre-payment might well be more than the cost of the pre-payment (the penalty payable).
 
Given the penalty payable is fixed, the option’s exercise price (outstanding principal + penalty) will always exceed the debt’s amortised cost at each option exercise date as the loan is paid off in instalments. Hence, the pre-payment option is not closely related to the debt host and should be separately accounted for. The fair value of the option would need to be calculated and this will be a positive value to the entity as the value of the pre-payable bond = value of straight bond − value of pre-payment feature. If interest rates decline, the option’s value will increase making it more attractive to the entity to repay the debt early.
 
Sometimes the pre-payment option’s exercise price is a ‘market adjusted value’. A market adjusted value is calculated by discounting the contractual guaranteed amount payable at the end of the specified term to present value using the current market rate that would be offered on a new loan having a maturity period equal to the remaining maturity period of the current loan. As a result, the adjustment necessary to arrive at the market adjusted value could be positive or negative, depending upon market interest rates at each option exercise date. In that situation, the pre-payment option enables the holder simply to cash out of the instrument at fair value at the date of pre-payment. Since the holder receives only the market adjusted value, which is equal to the fair value of the loan at the date of pre-payment, the pre-payment option has a fair value of zero at all times. In fact, on a stand-alone basis, a pre-payment option with a strike price equal to market value would not meet the definition of a derivative, so it cannot be an embedded derivative per paragraph 11 of IAS 39.

6.3A.49 Paragraph AG 30(g) of IAS 39 contains another example of a pre-payment option which would be deemed to be closely related to the host contract. If the pre-payment option reimburses the lender for an amount up to the approximate present value of lost interest for the host contract’s remaining term it is closely related to the host contract. Lost interest is the product of the outstanding principal amount multiplied by the interest differential. The interest differential is the difference between the effective interest rate on the host contract less the effective interest rate that could be obtained by the lender if it invests the principal at the repayment date for the host contract’s remaining term in a similar contract.

6.3A.50 An embedded pre-payment option in an interest-only or principal-only strip (that is, an interest or principal cash flow stream that has been separated and payable at different dates) is closely related to the host contract provided the host contract:

initially resulted from separating the right to receive contractual cash flows of a financial instrument that, in and of itself, did not contain an embedded derivative; and
does not contain any terms not present in the original host debt contract.
[IAS 39 para AG 33(e)].

Application of closely related criterion to different types of hosts - Embedded derivatives in debt host contracts - Term-extending options

Publication date: 08 Dec 2017


6.3A.51 Sometimes clauses are included in debt instruments that allow the issuer to extend the debt’s term beyond its original maturity. An option or automatic provision to extend the remaining term to maturity of a debt instrument is not closely related to the host debt instrument, unless there is a concurrent adjustment to the approximate current market rate of interest at the time of the extension. [IAS 39 para AG 30(c)]. Thus, if there is no reset of interest rates at the time of the extension, the embedded derivative is not closely related to the debt host.

6.3A.52 An alternative view is that the option to extend the term of the debt might be considered a loan commitment. Not all loan commitments fall within the scope of IAS 39, as set out in paragraphs 2(h) and 4 of IAS 39. In particular, only the following loan commitments are within the scope of IAS 39:

Instruments that the entity designates as financial liabilities at fair value through profit or loss.
Loan commitments that can be settled net in cash or by delivering or issuing another financial instrument.
Commitments to provide a loan at a below-market interest rate.
   
Loan commitments that are not in the scope of IAS 39 do not meet the definition of a derivative, as all derivatives must be financial instruments or other contracts within the scope of IAS 39. [IAS 39 paras 9, 11]. Hence, an option to extend the term of a debt instrument that is considered to be a loan commitment, that is, out of the scope of IAS 39 could not be an embedded derivative that needs to be assessed for separation (see para 6.3A.6). The approach adopted (that is, whether to treat an option to extend the term of a debt instrument as only within the embedded derivatives requirements or as also within the requirements for loan commitments) is an accounting policy choice that should be applied consistently.
 
If an issuer has chosen to treat the term extension option as a loan commitment and subsequently chooses to extend the loan then the question arises as to how to account for the change in interest rate. One approach would be to adjust the previous carrying value of the liability and recognise the difference immediately in profit or loss under paragraph AG 8 of IAS 39. That is, the issuer should recalculate the present value of the revised cash flows at the original effective interest rate and recognise the resulting change in carrying amount as a gain or loss in profit or loss.
 
Another approach would be to treat the extension as a new loan drawn down under the loan commitment. The approach adopted (that is, whether to treat the change in interest rates as a change to the carrying value of the instrument or as a new loan) is an accounting policy choice that should be applied consistently.
 
In March 2012, the IFRS IC considered whether term-extending options in fixed rate debt instruments should be separated from the host contract but decided not to add this issue to its agenda at this stage. If the Boards do not address the issue as part of their re-deliberations on IFRS 9, the IFRS IC might revisit it.

Example 1 – Term-extending options not reset to market rates
 
An entity issues 6% fixed rate debt that has a fixed term of 3 years. The entity can extend the debt before its maturity for an additional 2-year period at the same 6% interest.
 
As the entity can extend the debt’s term at the same interest rate and there is no reset to current market rates, the term-extending option is not considered closely related to the debt host.
 
Such term-extending options could be valuable to an entity as it allows the issuer to refinance debt at the same interest rate when market rates are rising. Conversely, if market rates are falling, the entity would not exercise its option to extend. Therefore, the option is a derivative that would need to be accounted for separately at fair value through profit or loss, even though its value is closely related to interest rates that also affect the value of the underlying debt host.
 
The above treatment regarding term-extending options is justified, because otherwise such options could be used to avoid the requirement to bifurcate a derivative in circumstances where the investor might not recover substantially all its initial recorded investment (see further para 6.3A.31 above). Term-extending options in host debts typically involve postponement of the repayment of the principal and, even though such postponement does not cause the failure to recover substantially all of its initial recorded investment, it can significantly reduce the fair value of the recovery of that investment.
 
Alternatively, if the term-extending option was considered to be a loan commitment out of IAS 39’s scope, it would not be separated from the host debt instrument.

Example 2 – Term-extending option reset to market rates
 
An entity issues a 6% fixed rate debt that has a fixed term of 3 years. The company can extend the debt before its maturity for an additional 2-year period, but the rate for the period of extension is the market rate at the time of the extension.
 
As the option to extend the term causes the interest rate to reset to current market rates, the option is regarded as closely related to the host debt. Common sense would also suggest such an option has no real value to the entity other than providing liquidity. This is because if the market interest rate at the time of extension is 8%, the entity cannot extend the term without paying an additional 2% interest anyway. On the other hand, if the market interest rate drops to 4%, the extension is equivalent to taking out a new loan at 4%.

6.3A.53 If an entity issues a debt instrument and the holder of that debt instrument writes a call option on the debt instrument to a third party, the issuer regards the call option as extending the term to maturity of the debt instrument provided the issuer can be required to participate in or facilitate the re-marketing of the debt instrument as a result of the call option being exercised. [IAS 39 para AG 30(c)].

6.3A.54 It is interesting to note that a bond that has a put option is economically no different to one that has a term-extending option, yet IAS 39 prescribes a different treatment for the derivatives embedded in them. Consider the following example:

Example – Comparison of put and extension option
 
An entity purchases two bonds A and B with the following terms:
 
Bond A has a stated maturity of 10 years, but the entity can put it back to the issuer at par after 3 years.
Bond B has a stated maturity of 3 years, but after 3 years the entity can extend the maturity to 10 years (that is, 7 more years) at the same initial rate (that is, the interest rate is not reset to the interest rate at the date of extension).
 
Both bonds are issued by the same issuer at par and have a coupon rate of 6%.
 
Assume also that the following two scenarios exist at the end of year 3:
 
Scenario 1: For the issuer, the interest rate for 7-year debt is at 8%.
 
The holder will put bond A back to the issuer and reinvest the par amount of the bond at 8%.
The holder will not extend the maturity of bond B and, instead, will reinvest the principal at 8%.
 
Scenario 2: For the issuer, the interest rate for 7-year debt is at 4%.
 
The holder will not put bond A back to the issuer and, instead, will continue to receive 6% for the next 7 years.
The holder will extend the term of bond B and continue to receive 6% for the next 7 years.
 
As can be seen from the above, the entity is in the same position with respect to either bond A or bond B. However, IAS 39 prescribes a different treatment for the put and the term extension options embedded in bond A and bond B respectively.
 
As discussed in paragraph 6.3A.48 above, the embedded put option derivative in bond A is regarded as closely related to the bond as the bond’s amortised cost based on the effective interest rate at the end of three years is the same as par, which is also the put option’s exercise price. This is because the expected cash flows would take into account the possibility of the debt being pre-paid early for the purposes of calculating the effective interest rate. [IAS 39 para 9]. Therefore, the embedded put option would not be recognised separately and fair valued.
 
On the other hand, the embedded term extension option is not regarded as closely related to the host debt, because under bond B’s terms the interest rates are not reset when the option is exercised. Therefore, the option would be separated and fair valued. Alternatively, if the embedded term extension option was considered to be a loan commitment outside the scope of IAS 39, the option would not be separated, as it would not meet the definition of a derivative.
 
The above example illustrates that two instruments that are economically similar, but different in form by virtue of the way in which the terms of the embedded options are expressed, can lead to different accounting treatments for the embedded options.
 
To be able to rationalise the apparent conflict in accounting treatment between these two economically identical situations, it is necessary to consider the issuer’s expectation of the instrument’s life for the purposes of the effective interest rate calculation. Thus the issuer will not necessarily follow the legal form of the terms, but the economics in determining whether the instrument has a put option or a term extending option and thus the appropriate accounting treatment.

Application of closely related criterion to different types of hosts - Embedded derivatives in debt host contracts - Credit sensitive payments and credit derivatives

Publication date: 08 Dec 2017


6.3A.55 IAS 39 does not deal specifically with payments based on the creditworthiness of the issuer of an instrument. However, as the stated in paragraph 6.3A.29 above, the creditworthiness of the issuer is a key factor in setting the level of interest rate on the debt instrument. Thus, for debt instruments that provide for the interest rate to be reset if there is a change in the issuer’s published credit rating (say down from A to BBB) or a change in the issuer’s creditworthiness, the embedded derivative is closely related to the debt host, and so would not be separated from the host contract.

Example – Credit sensitive payments
 
Entity A issues a bond with a coupon step-up feature that requires the issuer to pay an additional coupon to bondholders in the event of deterioration in the issuer’s credit rating below a specified level. The coupon payable on the bond will return to the initial fixed rate in the event that the issuer’s credit rating returns to the specified level.
   
The coupon step-up clause meets the definition of a derivative as the value fluctuates in response to an underlying (in this case the credit rating); it requires no initial net investment and it is settled at a future date.
 
The economic characteristics and risks of the embedded derivatives in both cases are closely related to the economic characteristics and risks of the host bond because:
   
both the embedded derivative and the host contract are driven by changes in the indications of the issuer’s credit risk; and
such clauses do not transfer the credit risk to another party external to the original contractual relationships created by the debt instrument (see para 6.3A.56 below).
   
The embedded derivative is not accounted for separately from the host debt contract.

6.3A.56 IAS 39 does deal with credit derivatives that are embedded in host debt instruments. A credit derivative is a financial instrument designed to transfer credit risk from the person exposed to that risk to a person willing to take on that risk. The derivative derives its economic value by reference to a specified debt obligation, often described as the ‘reference asset’.

6.3A.57 Credit derivatives that are embedded in a host debt instrument and allow one party (the ‘beneficiary’) to transfer the credit risk of a particular reference asset, which it might not own, to another party (the ‘guarantor’) are not closely related to the host debt instrument. Such credit derivatives allow the guarantor to assume the credit risk associated with the reference asset without directly owning it. [IAS 39 para AG 30(h)].

Example – Credit-linked note
 
An investment bank issues a credit-linked note to another party (the investor) in return for a consideration equal to the par value of the note. The coupon on the note is linked to the credit risk of a portfolio of third party bonds (the reference assets). In economic terms, the credit-linked note comprises a fixed income instrument with an embedded credit derivative.
 
The embedded credit derivative must be accounted for separately as it is linked to credit risks of debt instruments issued by third parties and not to the credit risk of the host debt instrument issued by the investment bank. The notion of an embedded derivative in a hybrid instrument refers to provisions incorporated into a single contract and not to provisions in separate contracts between different counterparties.

Application of closely related criterion to different types of hosts - Embedded derivatives in debt host contracts - Non-viability clauses

Publication date: 08 Dec 2017


6.3A.57.1 The terms of a debt instrument might include clauses that stipulate that, if the issuer suffers severe financial distress, the entire loan is written down (that is, forgiven). These types of clauses are known as non-viability clauses and in practice are often included in debt instruments issued by banks, where the triggering event is normally the breach of a specified capital ratio or the bank’s regulator judging the bank to be in severe financial distress.

6.3A.57.2 There is no specific guidance in IFRS on how to account for these clauses. The non-viability clause will cause some or all of the cash flows under the debt to be modified; this is because, on occurrence, the entire loan will be forgiven by the holder. An acceptable treatment would be to conclude that the non-viability feature does not meet the definition of an embedded derivative (see para 10 of IAS 39), as the modification is linked only to changes in a non-financial variable specific to a party to the contract (capital ratio). The issuer would apply paragraph AG 8 of IAS 39 (see chapter 6.7A) to reflect changes in the loan’s estimated payments resulting from the non-viability clause.

Application of closely related criterion to different types of hosts - Embedded derivatives in debt host contracts - Equity conversion features

Publication date: 08 Dec 2017


6.3A.58 When an investor holds debt securities that are convertible into the issuer’s equity shares at the investor’s option, the equity conversion feature represents an embedded option written by the issuer on its equity shares. The embedded derivative is not closely related to the host debt instrument from the investor’s perspective. [IAS 39 para IG C3]. From the issuer’s perspective, the written equity conversion option is an equity instrument and excluded from IAS 39’s scope provided it meets the conditions for that classification under IAS 32. [IAS 39 para AG 30(f)]. If, on the other hand, the debt instrument is convertible (or exchangeable) into shares of another entity, both the issuer and the holder would have to separate the embedded derivative from the host contract.

6.3A.59 As the holder of a convertible bond is required to separate the embedded derivative, they cannot account for the debt host contract as a held-to-maturity investment. This is because classification as a held-to-maturity investment would be inconsistent with paying for the conversion feature – the right to convert into equity shares before maturity. However, the investor could classify the bond as an available-for-sale financial asset provided it is not purchased for trading purposes. If classified as available-for-sale (that is, fair value changes are recognised directly in equity until the bond is sold or impaired), the equity conversion option (the embedded derivative) is separated. The accounting for the holder, which is significantly different from the issuer as considered in chapter 6.5, is as follows:

The embedded derivative’s fair value (the equity conversion option from the issuer’s perspective) is calculated first and comprises its time value and its intrinsic value, if any. The option has value on initial recognition even when it is out of the money.
  After initial recognition, the embedded derivative is constantly remeasured at fair value at each balance sheet date and changes in the fair value are recognised in profit or loss, unless the option is part of a cash flow hedging relationship.
   

The carrying value of the host contract (the liability component from the issuer’s perspective) is assigned the residual amount after deducting from the fair value of the instrument as a whole (the consideration paid to acquire the hybrid instrument) the amount separately determined for the embedded derivative.
 
If the convertible bond is measured at fair value with changes in fair value recognised in profit or loss, separating the embedded derivative from the host bond as illustrated above is not permitted. [IAS 39 para IG C3].

6.3A.60 Another type of embedded derivative that is often found in practice relates to a type of funding provided by venture capital entities as illustrated in the example below.

Example – Equity kicker
 
A venture capital entity provides a subordinated loan that, in addition to interest and repayment of principal, contains terms that entitle the venture capital company to receive shares of the borrower free of charge or at a very low price (an ‘equity kicker’) if the borrower undergoes an IPO. As a result of this feature, the interest on the subordinated loan is lower than it would otherwise be.
 
The ‘equity kicker’ meets the definition of a derivative even though the right to receive shares is contingent upon the future listing of the borrower. Paragraph AG 9 of IAS 39 states that a derivative could require a payment as a result of some future event that is unrelated to a notional amount. An ‘equity kicker’ feature is similar to such a derivative except that it does not give a right to a fixed payment, but an option right, if the future event occurs. As the economic characteristics and risks of an equity return are not closely related to the economic characteristics and risks of a host debt instrument, the embedded derivative would be accounted for separately by the venture capital entity. [IAS 39 para IG C4].

Application of closely related criterion to different types of hosts - Embedded derivatives in debt host contracts - Foreign currency features

Publication date: 08 Dec 2017


6.3A.61 An entity might issue debt in a currency other than its functional currency. Such a foreign currency loan is accounted for under IAS 21, which requires foreign currency gains and losses on monetary items to be recognised in profit or loss. As the foreign currency gains or losses are already recognised, a foreign currency derivative embedded in such a host debt instrument is considered closely related and is not separated. This also applies to an embedded foreign currency derivative that provides a stream of principal or interest payments that are denominated in a foreign currency and embedded in a host debt instrument (for example, a dual currency bond). [IAS 39 para AG 33(c)].

Example – Dual currency bond
 
An entity with pound sterling as a functional currency issues a £10m debt instrument that provides for the annual payment of interest in euros and the repayment of principal in pound sterling.
 
This dual currency bond can be viewed as containing a foreign currency swap that converts the pound sterling interest payments to euro interest payments. As discussed above, this embedded swap is not accounted for separately as under IAS 21, any exchange gains and losses arising on the annual euro interest payments due to exchange rate changes are themselves reported in profit or loss. [IAS 21 para 28]. See also the example of the measurement of a dual currency bond in chapter 42.

6.3A.62 Although many embedded foreign currency derivatives will not have to be separated from a foreign currency host debt instrument, some might. Consider the following examples:

Example 1 – Loan with foreign currency option
 
An entity issues a C10m loan at an above average market rate. The entity has the option to repay the loan at par for C10m or a fixed amount in a foreign currency, say €15m.
 
The debt instrument can be viewed as combining a loan at prevailing market interest rates and a foreign currency option. In effect, the issuer has purchased a foreign currency option that allows it to take advantage of changes in foreign currency exchange rates during the outstanding period of the loan. The premium for the option is paid as part of the higher interest cost. Similarly, the lender has written an option that exposes it to foreign currency risk. Because the borrower has the option of repaying the loan in its functional currency or in a foreign currency, the option is not closely related to the debt instrument (that is, it is not directly related to the currency of the loan or the interest rate that applies to that currency). The principle discussed in paragraph 6.3A.61 above does not apply since application of IAS 21 rules for revaluing of monetary items would not lead to revaluation of the foreign currency option. So the embedded foreign currency option should be separated from the host contract and accounted for separately by both parties to the contract. In contrast, if both the principal and the interest payments were made in a foreign currency (that is, if no optionality was involved), there would be no embedded derivative.

Example 2 – Interest payments linked to foreign currency exchange rates
 
An entity issues a £10m debt security at par. Quarterly interest payments, which are payable in pound sterling, are computed based on a formula that is linked to the £/€ exchange rate.
 
In this example, the quarterly interest is not denominated in foreign currency and, therefore, the principle discussed in paragraph 6.3A.61 above does not apply. Since the formula for computing the interest payable on a sterling bond is linked to the £/€ exchange rate and not based on an interest rate or an index based on interest rates, an inflation index or the creditworthiness of the debtor, it is an embedded derivative that is not closely related to the sterling bond. Hence, it should be accounted for separately. The embedded derivative is a forward foreign exchange contract.

Application of closely related criterion to different types of hosts - Embedded derivatives in equity host contracts

Publication date: 08 Dec 2017


6.3A.63 For embedded derivatives in an equity host contract, an analysis should first be performed to determine whether the host contract is an equity host. In carrying out this analysis, it is necessary to determine whether the host contract has any stated or pre-determined maturity and, if not, whether the residual interest represents a residual interest in the entity’s net assets (see chapter 42). Generally, when a host contract encompasses a residual interest that involves the rights of ownership, it is an equity host. The value of an equity instrument is a function of the underlying equity price or index. Therefore, an embedded derivative would need to possess equity characteristics related to the same entity to be regarded as closely related. [IAS 39 para AG 27].

Application of closely related criterion to different types of hosts - Embedded derivatives in equity host contracts - Calls and puts

Publication date: 08 Dec 2017


6.3A.64 A call option embedded in an equity instrument that enables the issuer to re-acquire that equity instrument at a specified price is not closely related to the host equity instrument from the holder’s perspective. From the issuer’s perspective, on the other hand, the call option is an equity instrument provided it meets the conditions for that classification under IAS 32, in which case it is excluded from IAS 39’s scope. [IAS 39 para AG 30(b)].

6.3A.65 A put option that requires the issuer to re-acquire an equity instrument at a specified price is similarly not closely related to the host contract from the holder’s perspective. From the issuer’s perspective, the put option is a written option that gives the counterparty the right to sell the issuer’s own equity instrument to the entity for a fixed price. Under paragraph 23 of IAS 32, the issuer recognises a financial liability equal to the present value of the redemption amount (that is, the present value of the option’s exercise price). See further chapter 43.

6.3A.66 In the case of a puttable instrument that can be put back at any time for cash equal to a proportionate share of the entity’s net asset value (such as units of an open-ended mutual fund or some unit-linked investment products), the effect of separating an embedded derivative and accounting for each component is to measure the combined instrument at the redemption amount that is payable at the balance sheet date if the holder exercised its right to put the instrument back to the issuer. [IAS 39 para AG 32]. This will apply to both the issuer and the investor in such an instrument, but for the issuer it is only relevant if the instrument is classified as a debt instrument in accordance with an amendment to IAS 32 and IAS 1, ‘Puttable financial instruments and obligations arising on liquidation’.

6.3A.67 The treatment of call and put options embedded in preference shares require careful consideration. This is because the terms of the preference share must be analysed first to determine whether the preference shares are more akin to an equity instrument or a debt instrument. Consider the following examples:

Example 1 – Puttable preference shares
 
An entity issues C50m mandatorily redeemable preference shares at par with a fixed dividend of 8% per annum. The preference shares are puttable to the company for cash at par if market interest rate exceeds 12%.
 
The mandatorily redeemable preference shares (including fixed dividend) are a financial liability of the issuer and akin to a debt instrument. Furthermore, the embedded put option’s exercise price, which is par, is approximately equal to the preference’s shares amortised cost. Hence, the put option is considered closely related to the debt host.

Example 2 – Convertible preference shares
 
An entity issues C50m of irredeemable preference shares that give the holders a preferential right to return of capital in a winding up, but which are also convertible into a fixed number of ordinary shares at the holder’s option. Any dividends paid in the year are at the discretion of the issuer.
 
As the preference shares are irredeemable and there is no obligation on the issuer to pay dividends, the shares are equity in nature. The conversion feature represents an embedded written call option on the company’s ordinary shares, which on a free-standing basis would be an equity instrument of the entity. As both the embedded call option and the host are equity instruments, the entity does not account for the embedded option separately. Similarly, the investor would not have to account for the embedded option separately.

Application of closely related criterion to different types of hosts - Embedded derivatives in lease host contracts

Publication date: 08 Dec 2017


6.3A.68 Embedded derivatives might be present in lease host contracts, from the perspective of either the lessor or the lessee.

Application of closely related criterion to different types of hosts - Embedded derivatives in lease host contracts - Inflation indexed rentals

Publication date: 08 Dec 2017


6.3A.69 An embedded derivative in a host lease contract is closely related to the host contract if the embedded derivative is an inflation-related index such as an index of lease payments to a consumer price index provided:

the lease is not leveraged; and
the index relates to inflation in the entity’s own economic environment.
[IAS 39 para AG 33(f)].

6.3A.70 The first bullet point makes it clear that an embedded inflation adjustment in the lease contract would not be closely related if it is considered to be leveraged. In determining whether inflation features embedded in lease contracts are leveraged, the guidance stated in paragraphs 6.3A.14 to 6.3A.15 above should be followed. Generally, lease contracts often stipulate that payments will increase in line with inflation, in which case, the indexed-linked lease payments would not be considered leveraged. Where this is not the case, an inflationary adjustment of greater than one would be considered sufficiently leveraged for the inflation feature to be accounted for separately. This is because, in practice, the market would expect the prices of goods and services to move in line with inflation, all other factors being equal. Therefore, any inflationary adjustments in a lease contract that increase the indexed cash flows by more than the normal rate of inflation are considered to be leveraged.

6.3A.71 The second bullet point in paragraph 6.3A.69 states that the index should relate to inflation in the entity’s own economic environment. IAS 39 is silent as to whether this means the lessee’s or the lessor’s economic environment. It is reasonable to assume that the economic environment that is most relevant to the lease contract is the one in which the leased asset is located, as the inflation index of that economic environment is the one that directly affects the lease rentals and, hence, the leased property’s value. Consequently, the economic environment in which the lessee or the lessor operates is not relevant to the analysis.

Example 1 – Inflation-linked rentals
 
A UK entity leases a property in France. The rentals are paid in euros and increase each year in line with the increase in the rate of inflation in France. The lessor is located in France.
 
The future cash flows (the rental payments) will change in response to changes in the inflation index of France. The embedded inflation indexed payments are not leveraged and relate to the economic environment in which the leased asset is located. Therefore, the inflation adjustment is closely related to the lease contract and separation is not required.
 
Note: this is a lease payable in a currency that is not the functional currency of the UK lessee. Foreign currency features in lease contracts are discussed further in paragraph 6.3A.78 onwards below.

Example 2 – Inflation-linked rentals (leveraged)
 
A UK entity is the tenant in a 10-year lease of a property in the UK with rental payments in pound sterling that are contractually determined for the first year, but thereafter increasing at a rate of one and a half times the change in UK RPI (Retail Price Index).
 
The future cash flows (the rental payments) will change in response to changes in the UK RPI. Since the cash flows change by an amount in excess of the change in RPI, such cash flows are considered to be leveraged as discussed in paragraph 6.3A.70 above. Therefore, the embedded inflation indexed payments would be accounted for separately.
 
A question arises as to whether the embedded derivative should be measured by reference to half times UK RPI or one and a half times UK RPI.
 
Some would favour the former treatment on the grounds that as the leverage portion of the embedded derivative is the amount over and above the change in the UK inflation index, this portion (half times RPI) should be accounted for separately as a derivative. On this basis, the host contract would contain the non-leveraged portion (one times RPI) that is considered to be closely related.
 
However, we consider that splitting the change in the fair value of an indexed-linked derivative between a leveraged amount and a non-leveraged amount is not appropriate for the following reasons:
   
A derivative has a single value and splitting a portion out in the above manner is not permitted under IAS 39.
The leveraged and non-leveraged portions relate to the same risk and, since the inflation is leveraged overall, the entire link to RPI is no longer considered closely related.
The separation creates cash flow patterns that are not evident in the lease contract because, in practice, the actual cash flows would consist of the minimum rentals plus amounts relating to the entire change in the inflation adjustment.
 
For the scenario above, the stated terms of the lease are not clearly fixed or floating. Hence the entity could identify the host contract as either:
 
  a) A fixed rate lease contract. The embedded derivative would then have a fixed receive leg (equal to the payments under the host contract) and a pay leg equal to 1.5 times RPI.
  b) A floating rate lease contract in which the rental resets periodically to reflect changes in the market rate of rentals. The embedded derivative would have a floating receive leg (equal to the market rate rentals) and a pay leg equal to 1.5 times RPI. However, this approach is acceptable only if there is sufficient observable pricing available to determine the floating/market rate of the host, such as a periodic spot market rental.
 
However, in an environment in which market rentals are strongly correlated with changes in RPI, approach b) above might give a similar result to defining the embedded derivative as 0.5 times RPI.

Example 3 – Inflation-linked rentals not related to the entity’s economic environment
 
Facts are the same as in example 1 except that the inflation adjustment relates to a specified US annual inflation rate (for example, Retail Price Index, Consumer Price Index etc). The landlord is a US entity.
 
The future cash flows (the rental payments) will change in response to changes in the US inflation index. The embedded inflation indexed payments, although not leveraged, relate to a different economic environment to that in which the leased asset is located and the UK entity operates. So the inflation indexed payment is not closely related to the lease host contract and would be accounted for separately.

Example 4 – Upward only inflation-linked rentals
 
Entity A is a tenant in a 10-year UK property lease agreement. The rent for the first year is contractually determined at C100,000. The rental payments will change in line with an index of UK prices so if, at the end of year 1, the index had increased by 3%, the rent for year 2 would be C103,000. However, the lease provides that the rent cannot be decreased. So if, during year 2, the index fell by 1%, the rent for year 3 would remain at C103,000. The index shows that UK prices are generally increasing at the inception of the lease (that is, there is UK inflation).
 
The rental payments are linked to an index. They follow that index while it is increasing, but do not follow it if it decreases. This feature is often known as ‘upward only’. This lease contains a floor in the rental payments because of the upward-only feature, so it is necessary to identify whether the floor is in or out of the money at the inception of the lease. Assuming the initial rent is at market rates then, even in a deflationary environment, the floor will be at the money at inception. Therefore the derivative is closely related.

Application of closely related criterion to different types of hosts - Embedded derivatives in lease host contracts - Variable (or contingent) rentals based on related sales

Publication date: 08 Dec 2017


6.3A.72 Lease contracts might include contingent rentals that are based on certain related sales of the lessee. Such a contingent rental-related embedded derivative is considered to be closely related to the lease host contract and would not be accounted for separately. [IAS 39 para AG 33(f)].

Example – Lease rentals related to sales
 
A UK entity leases a property located in the UK. The rentals consist of a base rental of C10,000 plus 5% of the lessee’s sales each month.
 
The rental payments will vary, depending on an underlying, being the entity’s sales.
 
However, as stated above, the portion of the contingent rentals based on related sales is considered to be closely related to the host lease contract. Therefore, the sales related payments should not be separated.

Application of closely related criterion to different types of hosts - Embedded derivatives in lease host contracts - Variable (or contingent) rentals based on a variable interest rate

Publication date: 08 Dec 2017


6.3A.73 Where lease contracts include contingent rentals that are based on variable interest rates, the contingent rental-related embedded derivative is considered to be closely related to the lease host contract and would not be accounted for separately. [IAS 39 para AG 33(f)]. This is because a lease contract is akin to a debt instrument and, therefore, the obligation to make future payments for the use of the asset and the adjustment of those payments to reflect changes in a variable interest rate index such as the LIBOR are considered to be closely related.

Example – Lease rentals indexed to LIBOR
 
A UK entity leases a property located in the UK. The lease rentals are indexed to the UK LIBOR rate. The contract does not contain any leverage feature.
 
The embedded derivative does not need to be separated as the rentals are based on a variable interest rate index of the UK economy.
 
On the other hand, if the rentals were indexed to a variable interest rate of an economic environment that is different from the economic environment in which the leased asset is located, the related embedded derivative would not be regarded as closely related in the same way that a similarly indexed inflation payment would not be regarded as closely related (see para 6.3A.69 above).

Application of closely related criterion to different types of hosts - Embedded derivatives in lease host contracts - Purchase options in lease agreements

Publication date: 08 Dec 2017


6.3A.74 Often lease contracts include an option that allows the lessee to purchase the asset at the end of the lease term. Such a purchase option would not qualify as an embedded derivative for a number of reasons. First, the purchase option is based on a non-financial variable (the underlying price of the leased asset) that is specific to a party to the contract and, hence, currently fails the definition of a derivative. [IAS 39 para AG 12A]. Secondly, in order to exercise the option, the lessee must pay the purchase price in cash and the lessor must physically deliver the leased asset (a non-financial asset). This constitutes gross settlement and, therefore, the option is not a financial instrument. However, if the terms in the contract allow either party to settle net in cash (considered unlikely) or the leased asset is readily convertible into cash (because an active trading market exists for the asset in question and, therefore, it is not specific to a party to the contract), the purchase option could qualify as a derivative (see chapter 40). [IAS 39 para 6].

Application of closely related criterion to different types of hosts - Embedded derivatives in lease host contracts - Term extension or renewal options

Publication date: 08 Dec 2017


6.3A.75 A finance lease is viewed as being equivalent to debt for accounting and disclosure purposes. However, the right to extend the lease term is different from the right to extend the term of a debt instrument. The right to extend the lease is not a right to borrow funds for a further period as would be the case with a debt instrument; rather, the right to extend the lease is a right to use a non-financial asset for an additional period. Furthermore, under IAS 17 the extension term would either be included in the calculation of the minimum lease term if it is reasonably certain that, at the inception of the lease, the lessee will exercise the option; or the renewal would constitute a new lease because the leased asset and the corresponding liability (if either exists) would have been amortised to nil by the end of the original lease term. Therefore, there is no need to separate an embedded derivative. Exercising term extension options under IFRS 16 is not treated as a new lease, but rather as a remeasurement of the previously recognised lease liability and right of use asset. This is covered in chapter 15 para 44.

Application of closely related criterion to different types of hosts - Embedded derivatives in lease host contracts - Residual value guarantee in lease agreements

Publication date: 08 Dec 2017


6.3A.76 Where a lease includes a residual value guarantee, the lessee undertakes to make a payment if the residual value of the asset at the end of the lease falls below a pre-determined amount. A residual value guarantee does not meet the definition of a derivative because it has an underlying (price of the leased asset) that is specific to a party to the contract. In addition, under IAS 17, the gross value amount of any residual value guarantee is treated as part of the minimum lease payments and is accounted for as such. Therefore, it does not need to be accounted for under IAS 39. Under IFRS 16, only amounts which the entity reasonably expects to pay are recognised for residual value guarantees; this is a change from IAS 17 (see further chapter 15 on residual value guarantees).

Application of closely related criterion to different types of hosts - Embedded derivatives in lease host contracts - Termination clause in lease agreements

Publication date: 08 Dec 2017


6.3A.77 Lease agreements are generally irrevocable, that is, the lessee is obliged to lease the asset during the non-cancellable period of the lease. However, the lease might contain an early termination clause that allows the lessee to terminate the contract, but only on the payment of a penalty. This penalty payment (sometimes referred to as the ‘stipulated loss value’) ensures that the lessor will be able to recover its remaining investment in the lease. This situation is similar in substance to a pre-payment option in a debt instrument, which is considered closely related in circumstances where the option’s exercise price is approximately equal to the amortised cost of the debt instrument. See example 2 in paragraph 6.3A.48 above. In that example, where the penalty payment clause had a ‘market adjusted value’ exercise price it had a fair value of zero, until the option was actually exercised.

Application of closely related criterion to different types of hosts - Embedded derivatives in lease host contracts - Lease payments in foreign currencies

Publication date: 08 Dec 2017


6.3A.78 Finance lease contracts that give rise to financial assets in lessors and financial liabilities in lessees are financial instruments. Therefore, as a finance lease denominated in a foreign currency is similar in nature to a foreign currency loan, no separation of the embedded foreign currency derivative is required, because the foreign currency lease receivable and payable are monetary items that are accounted for in accordance with IAS 21. The guidance that applies to foreign currency loans is also applicable to foreign currency finance leases (see para 6.3A.61), that is, the embedded derivative is not separated. This would also apply to leases by lessees under IFRS 16.

6.3A.79 For a lessor, an operating lease under IFRS 16 is not regarded as a financial instrument. Therefore, an operating lease agreement that provides for payments in a foreign currency might contain embedded foreign currency derivatives that require separation. The requirements of paragraph AG 33(g) of IAS 39 addressing embedded foreign currency derivatives in a host contract are relevant to operating leases for a lessor and also for leases of low-value assets and short-term leases of lessees. These are considered in paragraph 6.3A.91 below. That guidance has been applied to the examples given below.

Example 1 – Operating lease rentals denominated in foreign currency
 
A UK company enters into an operating lease for a property in France with a European lessor that is denominated in euros. The functional currency of the lessee and the lessor are the pound sterling and the euro respectively.
 
Paragraph AG 33(d) of IAS 39 provides that contracts, other than financial instruments, that specify payments denominated in the functional currency of any substantial party to the contract are closely related to the host contract.
 
In this example, the lease payments are denominated in the functional currency of the lessor – a substantial party to the contract. Therefore, the embedded derivative is closely related to the host contract and not separated. It is not appropriate to argue that because the payments are in a foreign currency and the UK lessee is exposed to currency risk there is an embedded foreign currency forward converting sterling payments to euros.
 
On the other hand, if the lease payments are denominated in a currency that is unrelated to either party’s functional currency (for example, US dollars), the embedded foreign currency forward should be separated from the host contract (lease contract denominated in euros) and accounted for separately as a derivative. This applies to both parties to the contract under IAS 17.
 
Under IFRS 16, the analysis for lessors would be the same as above for operating leases. However, for lessees under IFRS 16 the foreign currency element will be included in the lease liability recognised on the balance sheet and will be translated under IAS 21, instead of separating an embedded foreign currency derivative, with the exception of short-term leases and leases of low-value assets.

Example 2 – Operating lease rentals denominated in foreign currency
 
On 1 June 20X2 entity A, a Russian oil refinery, entered into an arrangement with entity S to lease a building in Moscow for a 10-year period. The lease is classified as an operating lease. Entity A’s management has determined its functional currency to be the US dollar.
 
Entity S is a property management and development entity located in Russia. Its management has determined its functional currency to be the Russian Rouble.
 
Entity S set the monthly lease repayments in Swiss francs to avoid exposure to any devaluation in the Russian Rouble and to obtain a natural hedge for the repayment of its Swiss franc denominated bonds.
 
As the Swiss franc is neither the functional currency of one of the substantial parties to the lease contract, nor a currency commonly used in Russia, nor the currency in which leases are routinely denominated in the world, the lease contract contains an embedded derivative that is not closely related to the host contract.
 
From entity S’s perspective, the lease contract contains a series of embedded forward contracts to buy Swiss francs against Russian roubles. These embedded derivatives are not closely related to the host contract (lease contract denominated in Russian Rouble) and should be accounted for separately. Entity S might, however, be able to use the separated forward contracts in a formal hedge of the cash flows on its Swiss franc bonds – see chapter 46 on hedging for more details of when this could be permissible. This would be applicable under both IAS 17 and IFRS 16, because the method of accounting has not changed for the lessor.
 
From entity A’s perspective, the lease contract contains a series of embedded forward contracts to sell Swiss francs against US dollars. These embedded derivatives are not closely related to the host contract (lease contract denominated in USD) and, therefore, should be accounted for separately.
 
However, for lessees under IFRS 16 the foreign currency element will be included in the lease liability recognised on the balance sheet and will be translated under IAS 21, instead of separating an embedded foreign currency derivative, with the exception of short-term leases and leases of low-value assets that would follow the treatment set out above.

Example 3 – Subsidiary’s foreign currency lease payments guaranteed by parent
 
A major French operating subsidiary of a US parent enters into a lease with a Swiss company that requires lease payments in US dollars. The lease payments are guaranteed by the US parent. The functional currencies of the respective entities are their local currencies.
 
In this example, the substantial parties to the lease contract are the French lessee and the Swiss lessor. The guarantor is not a substantial party to the contract and, therefore, its functional currency is of no relevance to the analysis (see further para 6.3A.92 below). Since the lease payments are made in US dollars, which is neither the functional currency of the lessee nor the lessor, the embedded foreign currency swap would need to be accounted for separately under IAS 17.
 
Under IFRS 16, the analysis for lessors would be the same as above for operating leases. However, for lessees under IFRS 16, the foreign currency element will be included in the lease liability recognised on the balance sheet and will be translated under IAS 21, instead of separating an embedded foreign currency derivative, with the exception of short-term leases and leases of low-value assets.

Application of closely related criterion to different types of hosts - Embedded derivatives in executory contracts

Publication date: 08 Dec 2017


6.3A.80 Contracts to buy or sell a non-financial asset that qualify as executory contracts, including commitments (for example, take or pay contracts) that are entered into to meet the entity’s expected purchase, sale or usage requirements and are expected to be settled by physical delivery, are not financial instruments. Accordingly, they are scoped out of IAS 39 under the own use purchase or sale exception. [IAS 39 para 5]. However, even though such contracts are not financial instruments, they might contain embedded derivatives. Embedded derivatives might also be present in some service contracts.

6.3A.81 IAS 39 contains little specific guidance relating to derivatives embedded in such contracts, except for features involving foreign currency. Therefore, it is necessary to consider carefully the economic characteristics and risks of such contracts in assessing whether embedded derivatives are present and, if so, whether they should be separately accounted for. Both quantitative and qualitative factors should be considered. Sometimes it might be possible to draw on the guidance discussed above for other host contracts. Indeed, it would not be unreasonable to do so, particularly for features such as pricing adjustments, inflation adjustments and caps, floors and collars on prices and quantities.

Application of closely related criterion to different types of hosts - Embedded derivatives in executory contracts - Price adjustment features

Publication date: 08 Dec 2017


6.3A.82 Normal purchase and sale contracts might contain price clauses that modify the contract’s cash flows. In assessing the closely related criterion for the embedded derivative, it would be necessary to establish whether the underlying in a price adjustment feature incorporated into such a contract is related or unrelated to the cost or fair value of the goods or services being sold or purchased.

Example 1 – Price adjustment linked to market prices of goods purchased
 
An entity (whose functional currency is pound sterling) contracts to purchase 200 tonnes of aluminium from a UK supplier in 12 months’ time. The aluminium is intended for use in the course of business. The purchase price will be the market price at the contract date plus an amount determined by a specified index of aluminium prices. The contract does not contain any leverage feature.
 
The future cash outflows are linked to movements in the market price for aluminium. The purpose of the embedded derivative is to ensure that the price paid for the aluminium is the market price at the date of purchase/supply rather than the date the two parties entered into the supply contract. This ensures that the seller passes any price risk to the entity. As the underlying is related to the price of the aluminium purchased, the derivative is closely related to the aluminium supply contract (host) and would not be accounted for separately.

Example 2 – Coal purchase contract linked to changes in the price of electricity
 
An entity enters into a coal purchase contract that includes a clause that links the price of coal to a pricing formula based on the prevailing electricity price at the date of delivery. The entity purchases the coal for its own use and there are no provisions to settle the contract net.
 
The coal purchase contract is the host contract. The pricing formula that changes the price risk from coal price to electricity price is the embedded derivative. Although coal might be used for the production of electricity, the underlying based on electricity prices is not pertinent to both the changes in the cost and the changes in the fair value of coal. Therefore, the embedded derivative (the electricity price adjustment) is not closely related to the host contract and should be accounted for separately.

Example 3 – Supply contract subject to multiple pricing adjustments
 
An entity has entered into a contract with a customer to sell 10,000 wooden chairs for a period of five years. The price per chair is contractually determined at C100 per chair for the first year and thereafter increases in line with changes in certain indices. 50% of the price of each chair is linked to an index of timber prices, 30% is linked to the UK wage inflation index. So if the timber index rises by 10% and the wage inflation index increases by 5%, the price for each chair will be C106.50 (being C50 × 1.1 + C30 × 1.05 + C20). The sales contract in its entirety does not meet the definition of a derivative as it will be settled by physical delivery in the normal course of business.
 
There are two embedded derivatives contained in this contract, because the price of chairs over the contract term is linked to the two indices (timber and wage inflation). The purpose of these embedded derivatives is to protect the entity’s profit margin over the contract term by ensuring that changes in the prices of inputs are passed on to the end customer.
 
Although both indices are considered to be relevant and pertinent to the cost or fair value of the chairs being sold, they would be considered to be closely related to the host contract if, and only if, the entity can reliably demonstrate that the standard mix of direct material and direct labour for each chair produced is maintained.
 
If the entity is unable to demonstrate reliably the clear linkage, the embedded derivatives might be leveraged (because the percentage of the price linked to each index might not accurately reflect the cost structure). In other words, the magnitude of the price adjustment might cause the price of the host contract to increase by more than an insignificant amount (see para 6.3A.15 above). In that situation, the indexed-linked price adjustments would not be considered to be closely related.

6.3A.83 Where a contract to buy or sell non-financial assets does not qualify for the own use purchase or sale exception, the entire contract would fall to be treated as if it were a financial instrument (and in most cases a derivative). In that situation, as the entire derivative contract would be accounted for at fair value through profit or loss, any derivatives embedded in such contracts would no longer need to be accounted for separately.

Example – Contract not qualifying for ‘normal’ purchase or sale exception
 
An entity enters into a forward contract to purchase 10,000 tonnes of coal. The contract does not qualify for the ‘normal’ purchase or sale exception as there is a provision in the contract for net settlement and the entity’s past practice indicates that it will settle the contract net. Settlement is based on changes in the fair value of coal during the contract’s term plus a payment provision based on a formula linked to prevailing electricity prices.
 
Given that the own use exception does not apply, the entire forward contract to purchase coal will be accounted for as a derivative in accordance with IAS 39 with gains and losses on the entire contract reported in the profit and loss account. Therefore, there is no need to identify separately the leverage payment provision as an embedded derivative.

Application of closely related criterion to different types of hosts - Embedded derivatives in executory contracts - Volume adjustment features

Publication date: 08 Dec 2017


6.3A.84 Many contracts for the supply of goods give the buyer the right to take either a minimum quantity of goods or any amount based on the buyer’s requirements. A minimum annual commitment does not create a derivative as long as the entity expects to purchase all the guaranteed volume for its ‘own use’. If it becomes likely that the entity will not take physical delivery of the product and, instead pay a penalty under the contract based on the market value of the product or some other variable, a derivative or an embedded derivative might arise. Since physical delivery is no longer probable, the derivative would be recorded and measured at fair value through profit and loss. Changes in market price will affect the carrying value until the penalty is paid. If the amount of the penalty payable is fixed or pre-determined, there is no derivative as the penalty’s value remains fixed irrespective of changes in the market value of the product. In other words, the entity will need to provide for the penalty payable once it becomes clear that non-performance is likely.

6.3A.85 If the quantity specified in the contract is more than the entity’s normal usage requirement and the entity intends to net settle part of the contract that it does not need in the normal course of the business, the contract will fail the ‘own use’ exemption. Chapter 40 sets out a number of ways in which the entity can settle the contract net. For example, the entity could take all the quantities specified in the contract and sell on the excess or it could enter into an offsetting contract for the excess quantity. In such situations, the entire contract falls within IAS 39’s scope and should be marked-to-market.

6.3A.86 From the supplier’s perspective, the volume flexibility in the contract can be viewed in two ways. The first is to view the contract as a whole. The contract might include a written option for the element of volume flexibility. The whole contract should be viewed as one instrument and, if the item being supplied (electricity) is readily convertible to cash, entity A would be prevented from classifying the contract as ‘own use’ by paragraph 7 of IAS 39. This states that a written option on a non-financial item that is readily convertible to cash cannot be entered into for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. A second view is that the contract has two components, an ‘own use’ fixed volume host contract outside of IAS 39’s scope for any contractually fixed volume element and an embedded written option potentially within IAS 39’s scope for the volume flexibility element. The latter would be in IAS 39’s scope if the item being supplied (electricity) is readily convertible to cash for the same reason as under the first view. In March 2010, the IFRS IC discussed the issue of volume flexibility and recognised that significant diversity exists in practice. However, the IFRS IC decided not to add the issue to its agenda because of the Board’s project to develop a replacement for IAS 39.

6.3A.87 As explained in chapter 40, such written options have to be accounted for in accordance with IAS 39 if they can be ‘settled net in cash’. ‘Settled net in cash’ in this context means either that the contract allows net settlement or the item that is the subject of the contract is readily convertible into cash.

6.3A.88 Therefore, it is necessary to consider whether the contract contains a written option. A contract will not contain a true written option if the buyer did not pay any premium to receive the option. Receipt of a premium, either at inception or over the contract’s life, to compensate the supplier for the risk that the buyer might not take the optional quantities specified in the contract is one of the distinguishing features of a written option. [IAS 39 para IG F1.3(a), (b)]. Any penalty payable for non-performance by the buyer might be the receipt of a premium. If no premium can be identified, other terms of the contract might need to be examined to determine whether it contains a written option, in particular, whether the buyer is able to secure economic value from the option’s presence. Contracts need to be considered on a case-by-case basis in order to determine whether they contain written options.

Example 1 – Volume adjustment feature with no written option
 
Entity A, a car manufacturer enters into a contract to sell cars to entity B that is engaged in renting cars. The contracts provide for entity A to supply 50 cars of a specific model at a specified future date at a fixed price. Entity B has the option to take between 90% and 110% of the contract quantity. Available market information indicates that a similar contract for 50 cars but without volume flexibility would also be priced at the same fixed price specified in the contract. Entity B cannot monetise the value of the contract by selling on any excess cars in the market.
 
The supply contract would not be considered a written option, as the pricing of the contract is the same as that for a similar contract with no volume flexibility. There is, therefore, no premium associated with the contract. Entity B cannot exercise any value from the option’s presence; the contract is, therefore, not a written option and qualifies for the own-use exemption.

Example 2 – Electricity supply contract containing a written option
 
Entity A, an electricity producer in the United Kingdom where there is an active electricity market, enters into a contract to sell electricity to entity B. The contracts provide for entity A to supply 100 units of electricity at a specified future date to entity B at a fixed price per unit. Entity B has the option to take between 90% and 110% of the contract quantity. The total quantity taken will be priced at C0.21 per unit. Available market information indicates that a similar contract for 100 units of electricity but without volume flexibility would be priced at C0.20 per unit. Entity B is also a supplier of electricity and can, therefore, monetise the contract’s value by selling on any excess power into the market, that is, it can readily convert the electricity contract to cash.
 
The pricing of the contract is not the same as that for a similar contract without volume flexibility. The price per unit includes a premium for the additional risk accepted by entity A in offering volume flexibility. The contract is, therefore, a written option and entity A cannot claim the own-use exemption. In that situation, the contract will be marked-to-market in accordance with IAS 39. As noted above, entity A can view the contract in two ways:
 
■  as a written option in its entirety and hence entity A cannot claim the own-use exemption; in that situation, the contract will be marked-to-market in accordance with IAS 39; or
■  as a fixed volume contract for 90 units of electricity for C0.20 per unit for which the own use exemption could be claimed and a written option for 20 units at C0.21 per unit, which is within IAS 39’s scope.
   
Entity B might not be able to take the own-use exemption if the quantity specified in the contract is more than the entity’s normal usage requirement and the entity intends to net settle part of the contract that it does not need in the normal course of business. The entity could take all of the quantities specified in the contract and sell the excess, or it could enter into an offsetting contract for the excess quantity. From entity B’s perspective in this case, the entire contract falls within IAS 39’s scope as a derivative. See chapter 40 for further details on contracts to buy or sell non-financial assets and contracts that can be settled net.

Application of closely related criterion to different types of hosts - Embedded derivatives in executory contracts - Inflation related features

Publication date: 08 Dec 2017


6.3A.89 It is not uncommon for purchase, sale or long-term service contracts to contain terms that are linked to an inflation index, particularly in periods of rising inflation. Inflation escalator clauses are included in such long-term contracts to protect the seller’s margin in real terms. Although IAS 39 is silent on the treatment of inflationary adjustments in executory contracts, there is no reason, in principle, why the guidance on inflation adjustment features in lease host contracts would not be appropriate for such contracts. That guidance states that an embedded inflation-related index is closely related to the lease host contract if the index is not leveraged and it relates to inflation in the entity’s own economic environment. [IAS 39 para AG 33(f)]. The application of this principle to lease contracts is considered in paragraph 6.3A.69 onwards above. We believe that similar considerations can be applied to purchase, sale and service contracts.

Example – Purchase contract linked to inflation
 
A UK entity contracts to purchase a fixed quantity of raw materials from a UK supplier in 12 months’ time. The raw materials are intended for use in the entity’s business. The purchase price will be the market price at the contract date plus an adjustment for UK RPI from the beginning of the contract. The contract does not contain any leverage feature.
 
The future cash flows are linked to an inflation index that is not leveraged and the index is in the local economic environment. Therefore, the embedded derivative is closely related to the host purchase contract.
 
If, on the other hand, the entity is unable to demonstrate that these goods are to be used in the course of its business, that is, the own use exception does not apply, the entire contract would be treated as a forward purchase contract that would fall to be settled net. In that situation, the forward purchase contract meets the definition of a derivative and, is itself, accounted for at fair value through profit or loss. So there is no need to account separately for any derivatives that might be embedded in it.

Application of closely related criterion to different types of hosts - Embedded derivatives in executory contracts - Caps, floors and collars

Publication date: 08 Dec 2017


6.3A.90 Contracts to buy or sell a non-financial asset might contain provisions that provide for payments to be made at the market price at the time of payment, but set an upper or lower limit or both on the final price to be paid or received. Such caps, floors or collars included in contracts are embedded derivatives. IAS 39 states that provisions included in a contract to purchase or sell an asset (for example, a commodity) that establish a cap and a floor on the price to be paid or received for the asset are closely related to the host contract if both the cap and floor were out of the money and are not leveraged. [IAS 39 para AG 33(b)]. This guidance can be extended to a collar that would be closely related if it was out of the money at inception (see para 6.3A.44 above).

Example – Purchase contract with selling price subject to a cap and a floor
 
A manufacturer enters into a long-term contract to purchase a specified quantity of certain raw materials from a supplier. Under the contract, the supplier will provide the raw materials at the list price prevailing at the delivery date, but within a specified range. For example, the purchase price cannot exceed C20 per kg or fall below C15 per kg. The current list price at inception of the contract is C18 per kg.
 
From the manufacturer’s perspective, the embedded derivatives contained in the purchase contracts are two options; a purchased call option with a strike price of C20 per kg and a written put with a strike price of C15 per kg. These options would each meet the definition of a derivative if they were free-standing, because they have a notional amount (the fixed quantity to be purchased), an underlying (the price per kg), require no initial net investment and will be settled in the future.
 
The economic characteristics and risks of the two options are closely related to the purchase contract, because the options are indexed to the asset’s purchase price that is the subject of the contract and both the embedded cap (cap price of C20 is greater than current list price of C18) and the floor (floor price of C15 is lower than current list price of C18) are out of the money at inception of the contract. Hence, the embedded derivatives are closely related and the host contract can be considered to be a purchase contract that requires delivery of the specified quantity of raw materials at a price equal to the current list price.

Application of closely related criterion to different types of hosts - Embedded derivatives in executory contracts - Foreign currency features

Publication date: 08 Dec 2017


6.3A.91 IAS 39 provides specific guidance for an embedded foreign currency derivative in a host contract that is not a financial instrument (such as a contract for the purchase or sale of a non-financial item where the price is denominated in a foreign currency). The embedded foreign currency derivative  is closely related to the host contract provided it is not leveraged, does not contain an option feature and requires payments denominated in one of the following currencies:

The functional currency of any substantial party to that contract.
The currency in which the price of the related goods or service that is acquired or delivered is routinely denominated in commercial transactions around the world (such as the US dollar for crude oil transactions).
A currency that is commonly used in contracts to purchase or sell non-financial items in the economic environment in which the transaction takes place (for example, a relatively stable and liquid currency that is commonly used in local business transactions or external trade).
[IAS 39 para AG 33(d)].

Foreign currency derivatives embedded in executory contracts sometimes contain option features. So, for example, there might be contracts in which changes in foreign exchange rates affect the cash flows resulting from the contract only if the spot exchange rate at the date of settlement exceeds a certain level. Other foreign currency derivatives contain a cap and/or a floor.

Take the following examples:

Example 1

  • Entity A [functional currency RUB] enters into a contract to purchase equipment from a US supplier [functional currency USD].
  • The contract contains the following pricing mechanism:
    • The price of the equipment is denominated in USD while the actual payment (settlement) will be made in RUB.
    • On the order date, the parties agree to a fixed foreign currency exchange rate (‘contract rate’) and an applicable range of 10% above or below that rate.
    • If at the settlement date the prevailing spot exchange rate is within that range, the ‘contract rate’ will apply.
    • If at the settlement date the prevailing spot exchange rate is outside that range, entity A and its supplier agree to share the difference between the actual spot exchange rate at the settlement date and the ‘contract rate’.

Example 2

  • Entity A [functional currency RUB] enters into a contract to purchase equipment from a US supplier [functional currency USD].
  • The contract contains the following pricing mechanism:
    • The price of the equipment is denominated in USD while the actual payment (settlement) will be made in RUB.
    • Payments will be calculated based on the prevailing spot exchange rate at the date of settlement subject however to a pre-defined cap and floor.
    • If at the settlement date the prevailing spot exchange rate is below the cap but above the floor, that rate will apply.
    • If at the settlement date the prevailing spot exchange rate is above the cap or below the floor, the pre-defined cap or floor applies (that is, the payments are calculated based on a foreign currency exchange rate set in the contract).

Does entity A have to separate the embedded foreign currency derivative?

Yes. In terms of the three conditions for separating an embedded derivative in paragraph 11 of IAS 39/paragraph 4.3.3 of IFRS 9, conditions (b) and (c) are met. This is because the foreign currency derivative that is embedded in the contract meets the definition of a derivative and the executory contract is not measured at fair value through profit or loss. Hence the key question is whether the derivative is closely related to the host contract (condition (a)).

Paragraph AG 33(d) of IAS 39/paragraph B4.3.8(d) of IFRS 9 states that an embedded foreign currency derivative in a host contract that is not a financial instrument (such as a contract for the purchase or sale of a non-financial item where the price is denominated in a foreign currency) is closely related to the host contract provided, inter alia, it does not contain an option feature.

An embedded foreign currency derivative that contains one or more option features is not closely related to the host contract even if all the other criteria in paragraph AG 33(d) of IAS 39/paragraph B4.3.8(d) of IFRS 9 are met. In both the examples above, the embedded derivative contains option features. In example 1, the option feature arises from the sharing of the difference between the actual spot exchange rate at the settlement date and the ‘contract rate’; in example 2, it arises from the cap and the floor.

Accordingly, in both examples the embedded foreign currency derivative are not closely related and hence have to be separated from the host contract. Because they relate to the same risk exposure and are not readily separable and independent of each other, they are accounted for together as a single compound embedded derivative in accordance with paragraph AG 29 of IAS 39/paragraph B4.3.4 of IFRS 9.  


6.3A.92 The term ‘substantial party’ to the contract referred to in the first bullet point above is not explained in IAS 39. Generally, it is taken to mean a party that is acting as principal to the contract, that is, the buyer/seller. A bank that provides a guarantee on behalf of a local importer to a foreign supplier that the buyer will meet its payment obligations in foreign currency under the contract’s terms is not a substantial party to the contract. In addition, the guarantor’s functional currency is of no relevance in determining whether the payments denominated in the foreign currency are closely related to the contract.

6.3A.93 A question also arises in practice as to the efforts one party to a contract needs to employ to determine the functional currency of its counterparty. Generally, there would be a rebuttable presumption that the local currencies of the economic environment in which the counterparties operate would be their functional currencies. In addition, the local currency is always presumed to be commonly used. Therefore, if the contract requires payment in either one of the two local currencies of the counterparties, the condition in the first bullet point above would be met. The position is less clear if payments are denominated in a currency that is not the local currency of either party to the contract. In that situation, the contracting parties would need to determine whether that currency is the functional currency of their counterparty. The guidance for determining functional currency in IAS 21 would need to be considered in determining the functional currency. An entity should not rely on a single indicator such as the currency in which the counterparty’s sales are denominated. Rather, the entity should consider all relevant available information in determining the counterparty’s functional currency.

Example 1 – Payments denominated in the functional currency of a party to the contract
 
A UK entity (whose functional currency is pound sterling) contracts to sell goods to a French purchaser whose functional currency is the euro. The contract will be fulfilled by the physical delivery of goods and payments by the French buyer would be made in euros.
 
In this example, the payment in euros exposes the UK entity to currency risk as the cash flows under the contract will vary with the £/€ exchange rate. The contract can be viewed as a host contract that is denominated in sterling containing an embedded foreign currency swap that converts payments in pound sterling to euros or an embedded foreign currency forward contract to sell pound sterling and buy euros. However, the embedded swap or the forward contract is not separated as the payments are denominated in the functional currency of the French buyer who is a substantial party to the contract.

Example 2 – Payments denominated in a third currency
 
A UK entity (whose functional currency is pounds sterling) contracts to sell goods to a Swiss purchaser whose functional currency is Swiss francs. The contract will be fulfilled by the physical delivery of goods and payments by the Swiss buyer would be made in euros. The goods are not commonly priced in euros.
 
The payment and receipt in euros exposes both substantial parties to the contract to exchange risk. Since the contract requires that payments be denominated in euros, which is not the functional currency of either party to the transaction, the embedded derivative is not closely related and should be accounted for separately at fair value by both the Swiss buyer and the UK seller. From the UK seller’s point of view the embedded derivative would be to buy euros and sell sterling. In the books of the Swiss buyer the embedded derivative would be to sell euros and buy Swiss francs. The nominal amount of the embedded forwards will equal the amount specified under the terms of the supply contract.
 
A particular issue arises for foreign currency embedded derivatives in foreign currency purchase/sale contracts when the embedded derivative is required to be separated under paragraph AG 33(d) of IAS 39. The issue is whether the embedded derivative is a forward contract that matures on the date on which goods are physically delivered, or on the date when cash settlement takes place.
 
Assume that the UK entity enters into the contract with the Swiss buyer to sell goods amounting to €100 on 1 March 20X6 for delivery on 30 June 20X6 and settlement on 31 July 20X6. The goods are not commonly priced in €. The UK entity’s year end is 31 March 20X6. The following data is relevant.
 
Date Event Spot €/£ Forward €/£ (maturity June 20X6) Forward €/£ (maturity July 20X6)
1 Mar 20X6 UK entity enters into a contract to sell goods for €100 0.70 0.725 0.72
31 Mar 20X6 UK entity’s year end. Embedded derivative revalued 0.73 0.745 0.74
30 Jun 20X6 Goods delivered 0.75   0.77
31 Jul 20X6 Invoice amounting to €100 settled 0.78    
   
The UK seller separates the firm commitment to sell goods into two contracts – a host contact to sell goods in pound sterling and an embedded forward contract to buy euro and sell pound sterling with an inception date of 1 March 20X6. But there is some debate regarding the deemed date of settlement/maturity of the embedded derivative.
 
Some take the view that the embedded derivative’s settlement/maturity date is 30 June 20X6 when the goods are delivered. This is because the derivative embedded in the host firm commitment can no longer exist after that date as there is no host contract – the seller having fulfilled its commitment by delivering the goods to the customer. Following performance by the seller, the seller has an unconditional right to receive consideration from the customer. In other words, the embedded derivative is in the sales contract not in the receivable; the derivative being effectively settled by creation of a financial asset (receivable). Under this view, the accounting entries would be as follows:
 
Accounting for sale and embedded derivative

    Dr (Cr)
    Sales Debtors Cash Derivative Profit and loss
Date Transaction £ £ £ £ £
1 Mar 20X6 Embedded derivative – nil fair value          
31 Mar 20X6 Change in fair value of embedded derivative – €100 @ (0.745 – 0.725) – ignoring discounting – there is a gain as, using the forward rate at the balance sheet date, to buy €100  would  cost £74.5 compared to  £72.5 using the contracted forward rate       2.0 (2.0)
30 Jun 20X6 Change in fair value of embedded derivative – €100 @ (0.75 – 0.745)       0.5 (0.5)
30 Jun 20X6 Recording sales at forward rate – 100 @ 0.725 (72.5) 72.5      
30 Jun 20X6 Embedded derivative settled against debtors   2.5   (2.5)  
31 Jul 20X6 Debtor carried at spot rate at 30 June 20X6 settled by receipt of €100 at spot rate – €100 @ 0.78   (75.0) 78   (3.0)

  Effect on profit or loss and balance sheet (72.5) 78 (5.5)

             
Others take the view that the embedded derivative being a forward foreign exchange contract matures at the date of cash settlement because the cash leg of the firm commitment is settled at that date. Under this view, the sale and the corresponding receivable are recognised in local currency using the forward rate when the goods are delivered, that is (C72). The embedded derivative and debtor are settled when cash is received at 30 June 20X6 with any gain or loss arising on settlement recorded in profit or loss. Under this view, the accounting treatment would be as follows:
 
Accounting for sale and embedded derivative
 
    Dr (Cr)
    Sales Debtors Cash Derivative Profit and loss
Date Transaction £ £ £ £ £
1 Mar 20X6 Embedded derivative – nil fair value          
31 Mar 20X6 Change in fair value of embedded derivative – €100 @ (0.74 – 0.72) – ignoring discounting – there is a gain as using the forward rate at the balance sheet date, to buy €100  would cost £74  compared to £72 using the contracted forward rate       2.0 (2.0)
30 Jun 20X6 Change in fair value of embedded derivative – €100 @ (0.77 – 0.74)       3.0 (3.0)
30 Jun 20X Recording sales at forward rate – 100 @ 0.72 (72.0) 72.0      
31 Jul 20X6 Settlement date – receipt of €100 at spot rate – €100 @ 0.78   (72.0) 78 (5.0) (1.0)

  Effect on profit and loss and balance sheet (72.0) 78 (6.0)


Although both views can be sustained, in practice, entities generally tend to adopt the first treatment as they view these types of contract as inherent in future sales.

Example 3 – Payments denominated in the functional currency of a party to the contract, but the functional currency changes subsequently
 
A UK entity (whose functional currency is pound sterling) contracts to sell goods to a Japanese purchaser whose functional currency is the yen. The contract will be fulfilled by the physical delivery of goods and payments by the Japanese buyer would be made in yen. Subsequently, because of changes in economic circumstances, the functional currency of the Japanese buyer changes to US dollars.
 
The UK entity must assess whether the embedded derivative should be separated from the host sales contract and accounted for as a derivative when it first becomes a party to the contract. At that time, the functional currency of the Japanese buyer was the yen. So, no separation of the embedded derivative is required as yen is the functional currency of a substantial party to the contract. The issue is whether this assessment should be revisited following the change in functional currency of the Japanese buyer.
 
As explained in paragraph 6.3A.22 above, IFRIC 9 prohibits reassessment unless there is a change in the contract’s terms that meet certain criteria. In such an instance, reassessment is required. In this example, the contract terms are unchanged. The UK entity will still make payments in yen. Therefore, the embedded derivative continues to be treated as closely related, even though the factors that led to the initial assessment have changed. However, any yen denominated contracts entered into with the Japanese buyer after it changed its functional currency to US dollar would fail the closely related criterion, as they would not be in the functional currency of either party to the contract.
 
The above treatment also applies to the Japanese buyer even though it will be exposed to yen/dollar currency risk when it makes payments under the contract. Such exchange gains and losses will fall to be accounted for in accordance with IAS 21. In other words, as long as the contract terms remain unchanged, the Japanese buyer cannot create an embedded currency exposure that did not exist at the date it became a party to the contract.

Example 4 – Option to make payments in alternative currencies
 
Facts are the same as in example 1 except that the contract contains an option to make payment in either euros or in Swiss francs.
 
In this example, the UK seller has written an option to receive payments in a currency that is not its functional currency and, therefore, exposes it to £/€ or £/Swiss Fr currency risk. Although euro is the functional currency of the other substantial party to the contract, there is no certainty at inception of the contract that settlement will be in euros. Hence, the foreign currency option is not closely related to the host.
 
Similarly, the French buyer has effectively purchased an option to make payments in its own functional currency (euros) or in a foreign currency (Swiss Fr) that exposes it to euros/Swiss Fr currency risk. Although the French buyer has the option to settle the contract in its own currency and eliminate any exchange risk, there is no certainty at inception of the contract that it would eventually exercise that option. Since the contract could also be settled in Swiss francs, the settlement can either be potentially favourable or unfavourable and is not closely related to the purchase contract.
 
Accordingly, the embedded option should be separated from the host contract and accounted for separately by both parties to the contract.

6.3A.94 In relation to the second bullet point in paragraph 6.3A.91 above, the currency in which the price of the related goods or services is routinely denominated in commercial transactions around the world is a currency used for similar transactions all around the world, not just in one local area. For example, if cross-border transactions in natural gas in North America are routinely denominated in US dollars and such transactions are routinely denominated in euros in Europe, neither the US dollar nor the euro is a currency in which natural gas is routinely denominated in commercial transactions around the world. [IAS 39 para IG C9]. Accordingly, apart from crude oil and some metals which are routinely denominated in US dollar in international commerce, very few items, if any, are likely to meet this requirement.

Example – Leveraged foreign currency provision
 
Entity A, whose functional currency is the euro, enters into a contract with entity B, whose functional currency is the Norwegian krone, to purchase oil in six months for US$10m. The host oil contract is not within IAS 39’s scope, because it was entered into and continues to be for the purpose of delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. The oil contract includes a leveraged foreign exchange provision that states that the parties, in addition to the provision of, and payment for, oil will exchange an amount equal to the fluctuation in the exchange rate of the US dollar and Norwegian krone applied to a notional amount of US$10m.
 
The payment provision under the host oil contract of US$10m can be viewed as a foreign currency derivative because the US dollar is neither entity A’s nor entity B’s functional currency. This foreign currency derivative would not be separated, however, because it follows from the second bullet point of paragraph 6.3A.91 above that a crude oil contract that requires payment in US dollars is not regarded as a host contract with a foreign currency derivative.
 
However, the leveraged foreign exchange provision that states that the parties will exchange an amount equal to the fluctuation in the exchange rate of the US dollar and Norwegian krone applied to a notional amount of US$10m is in addition to the required payment for the oil transaction. It is unrelated to the host oil contract and, therefore, should be separated from the host oil contract, and accounted for as an embedded derivative. [IAS 39 para IG C8].

6.3A.95 The third bullet point in paragraph 6.3A.91 refers to a currency that is commonly used in contracts to purchase or sell non-financial items in the economic environment in which the transaction takes place (for example, a relatively stable and liquid currency that is commonly used in local business transactions or external trade). This flexibility was added when IAS 39 was revised so that entities in small or developing economies might find it more convenient to denominate business contracts with entities from other small or developing economies in an internationally liquid currency (such as the US dollar or the euro), rather than the local currency of any parties to the contract.

6.3A.96 Some have interpreted the ‘commonly used’ currency provision to be limited to those countries with small or developing economies and that do not have a currency that is freely convertible and able to be used in commercial transactions as set out in an example in the basis for conclusions in IAS 39. [IAS 39 para BC 39]. However, others have noted that IAS 39 does not limit the application of this exception to these territories, and so they have concluded that it also applies to contracts with entities in developed economies if the ‘commonly used’ criterion is met. For example, economic data supports that the US dollar is used in a wide variety of contracts by Canadian companies. It can be argued that the US dollar is ‘commonly used’ in Canada even though it is not a small developing country. We see the merits of both points of view and, therefore, will accept either interpretation as an accounting policy election to be applied on a consistent basis.

6.3A.97 The standard uses the term ‘commonly used’ to mean a currency that is relatively stable or liquid and commonly used in local business transactions or external trade. A currency is commonly used in local business transactions when monetary amounts are viewed by the general population not in terms of the local currency, but in terms of a relatively stable foreign currency, and prices might be quoted in that foreign currency. [IAS 39 para BC 40]. Indeed, undertaking business transactions in a stable or hard currency is fairly common for entities operating in a hyper-inflationary economy as a protection against inflation. [IAS 29 para 3(b)]. It follows that the currency must be commonly used within the country, not just commonly used within a particular industry or particular market. This is an exemption to the general rule that foreign currency embedded derivatives need to be separated. The exemption’s application should be supported by an appropriate analysis specific to the respective country.

6.3A.98 Many countries around the world use more than one stable or liquid currency in undertaking local business transactions or external trade. Therefore, where such countries undertake transactions in those stable or liquid currencies rather than in their local currencies, the foreign currency derivative would be viewed as closely related to the host contract and would not be accounted for separately. This assessment should be a made on a country by country basis and be supported by a detailed analysis.

Example – Contract denominated in a currency commonly used in local business transactions
 
An entity located in a country with a hyper-inflationary economy contracts to purchase raw materials for use in its manufacturing process. The contract is denominated in US$, a stable currency, and not in the local currency, as most local transactions and external trade are undertaken in US$.
 
The embedded foreign currency derivative (denominated in a currency other than the local currency) does not need to be separated as the contract is denominated in a currency that is commonly used in the local economic environment.
 
If the contract was priced in another international stable currency say the euro rather than the US$, and euro is not a currency that is commonly used in local business transactions, the embedded derivative (euro versus the entity’s functional currency) would have to be separated.

Application of closely related criterion to different types of hosts - Embedded derivatives in executory contracts - Flow chart for identifying embedded derivatives in executory contracts

Publication date: 08 Dec 2017


6.3A.99 As stated previously, IAS 39 provides little or no guidance on derivatives that might be embedded in purchase, sale or service contracts. As identification of such embedded derivatives can be complex, the flow charts given below are to aid in the identification process. It should be noted that the flow chart has been constructed from the discussions undertaken above and is based on a simple executory contract to buy or sell a good, that is, does not need to be assessed for an embedded lease under IFRIC 4. In practice, such contracts might contain other terms and conditions whose interaction with the host is not obvious. Options that allow early termination of a contract by paying a penalty, options to change the quantities to be delivered and options to defer delivery are some examples of terms and condition that can be problematic and would require careful consideration.
 
6_3_99

Application of closely related criterion to different types of hosts - Embedded derivatives in insurance contracts

Publication date: 08 Dec 2017


6.3A.100 In recent years, a growing number of complex insurance products have been developed and many of them might contain embedded derivatives. As stated in chapter 3, derivatives embedded in insurance contracts or in contracts containing discretionary participation features are within IAS 39’s scope. A derivative embedded in an insurance contract is closely related to the host insurance contract if the embedded derivative and host insurance contract are so interdependent that an entity cannot measure the embedded derivative separately (that is, without considering the host contract). [IAS 39 para AG 33(h)]. However, if a policy combines a derivative instrument with an insurance contract thereby creating a hybrid instrument, the embedded derivative might have to be separated from the insurance contract in accordance with IAS 39, unless the embedded derivative itself is an insurance contract. [IFRS 4 para 7].

6.3A.101 Contracts such as equity-indexed annuities, equity-indexed life insurance and embedded guarantees of minimum returns might contain embedded derivatives that are not closely related to the host insurance contract and will have to be separated and accounted for under IAS 39. Much of the guidance discussed above applies to embedded derivatives in insurance contracts as it does to any other contract. However, paragraph 8 of IFRS 4 introduces a major exception to the principle of separation of embedded derivatives that are not closely related to the host contract. IFRS 4 permits an insurer to not separate a policyholder’s embedded put option (also known as a cash surrender option) embedded in a host insurance contract when the option price is a fixed amount or a fixed amount and an interest rate. This exemption applies at all times even when the exercise price differs from the host insurance liability’s carrying amount. The requirement to separate does, however, apply when the surrender value varies in response to a change in an equity or commodity price or index or a similar variable. [IFRS 4 para 8]. Paragraph 9 of IFRS 4 specifies that the same exemption applies to issuers of financial instruments with a discretionary participation feature. This area of accounting for embedded derivatives should always be considered in conjunction with IFRS 4. The implementation guidance to IFRS 4 contains many examples that illustrate the treatment of embedded derivatives contained in insurance contracts. [IFRS 4 paras IG 3, 4].

Accounting for embedded derivatives

Publication date: 08 Dec 2017


6.3A.102 On initial recognition, similar to all financial assets and liabilities, a financial instrument containing an embedded derivative is recognised at its fair value, that is, the fair value of the entire instrument. If the consideration paid / transaction price is not equal to the fair value of the instrument as a whole, then a day 1 gain or loss might arise. Whether such a gain or loss is recognised immediately within profit or loss depends on whether the conditions in paragraph AG 76 of IAS 39 are met (as discussed in further detail in chapter 42). In summary, a day 1 gain or loss is recognised only when the fair value of the entire instrument is evidenced either by other observable current market transactions in the same instrument (without modification or packaging) or by a valuation technique whose variables include only data from observable markets.

6.3A.103 When an embedded derivative is required to be separated from a host contract, the derivative element must be measured at fair value on the balance sheet, with changes in fair value being accounted for through profit or loss, consistent with the accounting for a free-standing derivative. At initial recognition of the embedded derivative, the embedded derivative’s fair value must be determined before that of the host contract. Paragraph AG 28 of IAS 39 states that “The initial carrying amount of the host instrument is the residual after separating the embedded derivative”. The host contract’s carrying value at initial recognition is the difference between the fair value of the hybrid contract as a whole and the embedded derivative’s fair value.  

6.3A.104 While a day 1 gain or loss might arise on the initial recognition of the entire instrument, if the criteria in paragraph AG 76 of IAS 39 are met (see para 6.3A.102), a day 1 gain or loss will not arise as a result of separating the embedded derivative from the host contract.

6.3A.105 Published price quotations in an active market are normally the best evidence of fair value. Valuation techniques are used to determine the derivative’s fair value if there is no active market for the embedded derivative. Valuing a derivative usually involves the exercise of judgement by management in making certain estimates such as the discount rate, extrapolation of future interest rates, foreign exchange rates and so on. The use of estimates for certain valuation parameters is subjective, especially for long-term contracts that are common in the energy industry. Furthermore, certain embedded derivatives, in particular those arising from complex structured products, might contain several underlying variables, making the valuation process complex.

6.3A.106 If an entity is unable to determine reliably the fair value of an embedded derivative on the basis of its terms and conditions (for example, because the embedded derivative is based on an unquoted equity instrument), the embedded derivative’s fair value is the difference between the fair value of the hybrid (combined) instrument and the host contract’s fair value, if those can be determined reliably. [IAS 39 para 13]. If the entity cannot determine the embedded derivative’s fair value using this method either at initial recognition or at a subsequent financial reporting date, the entity should fair value the hybrid (combined) instrument and designate it as at fair value through profit or loss. [IAS 39 paras 12, 13]. Designation of financial instruments is discussed in chapter 42.

Example – Debt instrument that is exchangeable into shares of an unlisted entity
 
An entity issues a debt instrument that is exchangeable into shares of an unlisted entity whose fair value cannot be reliably measured. If the debt instrument is converted the unlisted equity investment would be recorded on the balance sheet at cost in accordance with paragraph 46(c) of IAS 39.
 
In this situation, the equity exchangeable feature is not closely related to the debt host and should be separated. However, although the equity instrument’s fair value cannot be measured reliably, it would not be appropriate to measure the embedded derivative at cost. Instead, the entire combined contract is designated as a financial instrument at fair value through profit or loss. [IAS 39 para 12]. This presumes that the combined contract’s fair value can be measured reliably.
 
The entity might conclude that the combined instrument’s equity component could be sufficiently significant to preclude it from obtaining a reliable estimate of the fair value of the entire instrument. In that case, the combined instrument is measured at cost less impairment. [IAS 39 para IG C.11].
 
It should be noted that as the fair value of the embedded derivative that is linked to, and must be settled by delivery of, the above unlisted equity instrument cannot be measured, the embedded derivative cannot be designated as a hedging instrument. [IAS 39 para AG 96].

6.3A.107 The requirement to identify an embedded derivative in a hybrid instrument, assess whether it should be separated from the host contract and, for those that do need to be separated, measure the derivatives at fair value at initial recognition and subsequently, can be complex or might result in less reliable measures than measuring the entire instrument at fair value through profit or loss.

6.3A.108 Therefore, if a contract contains one or more embedded derivatives, an entity might designate the entire hybrid (combined) contract as a financial asset or financial liability at fair value through profit or loss, unless:

the embedded derivative(s) does not significantly modify the cash flows that otherwise would be required by the contract; or
it is clear with little or no analysis when a similar hybrid (combined) instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a pre-payment option embedded in a loan that permits the holder to pre-pay the loan for approximately its amortised cost.
[IAS 39 para 11A].
 
The option to designate the entire instrument at fair value through profit or loss might be particularly helpful to banks and other entities that issue structured products containing several embedded derivatives

6.3A.109 If an embedded derivative is separated, the host contract should be accounted for in accordance with IAS 39 if it is a financial instrument and in accordance with other appropriate standards if it is not a financial instrument. IAS 39 does not address whether an embedded derivative should be presented separately on the face of the balance sheet. [IAS 39 para 11].

Accounting for embedded derivatives - Separating a non-option-based embedded derivative

Publication date: 08 Dec 2017


6.3A.110 When separating a non-option-based embedded derivative, such as an embedded forward or swap, the standard requires the embedded derivative to be separated from its host contract on the basis of its stated or implied substantive terms, so as to result in it having a fair value of zero at initial recognition. [IAS 39 para AG 28]. If it were permitted to separate embedded non-option derivatives on other terms, a single hybrid instrument could be decomposed into an infinite variety of combinations of host instruments and embedded derivatives. However, as already explained in paragraph 6.3A.28 above, an embedded derivative that is not already clearly present should not be separated, that is a cash flow that does not exist cannot be created (with exception of, for example, assuming a functional currency cash flow in an embedded FX forward contract). If the terms of an embedded forward contract were determined so as to result in a fair value other than zero at the inception of the hybrid instrument, that amount would essentially represent a borrowing or lending. Therefore, it is inappropriate to separate an embedded non-option derivative on terms that result in a fair value other than zero at the inception of the hybrid instrument. [IAS 39 paras IG C1, C2]. This means that the forward price assumed in the embedded derivative should generally be at market rates observed when the embedded derivative is separated.

Example – Separation of a non-option-based derivative to produce zero fair value at inception
 
Entity X advances C900 to entity Y for one year at 6% interest rate and concurrently enters into an equity-based derivative in which it will receive any increase or pay any decrease in the current market price (C100) of entity Z’s equity shares. The current forward price for one year for entity Z’s equity shares is C200. These two transactions (the loan and the derivative) can be bundled into a structured note that could have almost an infinite variety of terms. Three possible contractual terms for the structured note that would be purchased by entity X for C900 are shown below.
 
Entity X to receive at the end of the year C954 plus any excess (minus any shortfall) in the current market price of entity Z’s equity shares over (or under) C200.
Entity X to receive at the end of the year C1,054 plus any excess (minus any shortfall) in the current market price of entity Z’s equity shares over (or under) C300.
Entity X to receive at the end of the year C755 plus any excess (minus any shortfall) in the current market price of entity Z’s equity shares over (or under) C1.
   
All the above terms of the structured note will provide the same cash flows, given a specified market price of entity Z’s shares. If the market price of entity Z’s shares remains at C200 at the end of year 1, entity A will receive C954 under all the three options. Similarly, if the market price of entity Z’s shares increases to C306, entity A will receive C1,060 under all the options.
 
As is apparent, the difference in terms under the above three options are totally arbitrary, because those differences have no impact on the ultimate cash flows under the structured note. Thus those differences are not substantive and should have no influence on how the terms of the embedded derivatives are identified. Therefore, the hybrid instrument’s separation into an embedded derivative and a host debt instrument should be the same for all the three options described above for the structured note.
 
That separation would generally result in the structured note being accounted for as a debt host contract with an initial carrying amount of C900 and a fixed annual interest rate of 6% and an embedded forward contract with C200 forward price, which results in an initial fair value of zero.

Accounting for embedded derivatives - Separating an option-based embedded derivative

Publication date: 08 Dec 2017


6.3A.111 An embedded option-based derivative (such as an embedded put, call, cap, floor or swaption) is separated from its host contract on the basis of the option feature’s stated terms. The initial host instrument’s carrying amount is the residual amount after separating the embedded derivative. [IAS 39 para AG 28].

6.3A.112 The implementation guidance explains that the economic behaviour of a hybrid instrument with an option-based embedded is fundamentally different from a non-option based derivative and depends critically on the strike price (or strike rate) specified for the option feature in the hybrid instrument.

6.3A.113 If an entity were required to identify the terms of an embedded option-based derivative so as to achieve a fair value of the embedded derivative of zero, the strike price (or strike rate) generally would have to be determined so as to result in the option being infinitely out of the money. This would imply a zero probability of the option feature being exercised. However, since the probability of the option feature in a hybrid instrument being exercised generally is not zero, it would be inconsistent with the likely economic behaviour of the hybrid instrument to assume an initial fair value of zero for the embedded derivative. Similarly, if an entity were required to identify the terms of an embedded option-based derivative so as to achieve an intrinsic value of zero for the embedded derivative, the strike price (or strike rate) would have to be assumed to equal the price (or rate) of the underlying variable at the initial recognition of the hybrid instrument. In this case, the option’s fair value would consist only of time value. However, such an assumption would not be consistent with the likely economic behaviour of the hybrid instrument, including the probability of the option feature being exercised, unless the agreed strike price was indeed equal to the price (or rate) of the underlying variable at the initial recognition of the hybrid instrument. [IAS 39 para IG C.2].

6.3A.114 Adjusting the strike price of an option-based embedded derivative, therefore, alters the nature of the hybrid instrument, whereas adjusting the strike price of a forward based embedded derivative does not necessarily alter the nature of the hybrid instrument. For example, if an option based embedded derivative is in the money, that intrinsic value does not represent a lending activity since the option might never be exercised (that is, it might expire out-of-the money due to a change in the underlying). Therefore, the separation of an option-based embedded derivative (including any embedded put, call, cap, floor, caption, floortion or swaption feature in a hybrid instrument) should be based on the stated terms of the option feature documented in the hybrid instrument. As a result, the embedded derivative would not necessarily have a fair value or intrinsic value equal to zero at the initial recognition of the hybrid instrument. [IAS 39 para IG C.2].

Accounting for embedded derivatives - Multiple embedded derivatives

Publication date: 08 Dec 2017


6.3A.115 A host contract might contain more than one embedded derivative. Each derivative must be identified and assessed to see whether they warrant separate accounting. Separate accounting is required where the derivatives relate to different risk exposures and are readily separable and independent of each other. [IAS 39 para AG 29].

6.3A.116 Where it is not possible to value each embedded derivative separately because of inter-dependencies, they should be treated as a single compound embedded derivative and valued in accordance with the guidance discussed in paragraph 6.3A.102 onwards above. [IAS 39 para AG 29].

Example 1 – Callable convertible bond
 
An entity issues 20,000 callable convertible bonds at a total par value of C2 million. Each bond pays fixed interest and is convertible, at the holder’s option, at any time up to maturity into the entity’s ordinary shares. Each bond also contains an embedded call option that gives the bond’s issuer the right to call and redeem the bond at any time before maturity.
 
The bond has two embedded options that are held by different parties. The bond’s holder has the option to convert the bond into a specified number of shares. The issuer has the option to call back the bond and pay an amount generally at a premium over par value.
 
From the issuer’s perspective, the equity conversion option is an equity instrument of the issuer and, therefore, it is outside IAS 39’s scope. Under IAS 32, the issuer must separate the equity and the liability elements of the compound instrument. As far as the issuer’s call option (the right to call and redeem the bond) is concerned, this must be valued separately (using an option pricing model) as it is distinct in character and risk from the written equity conversion option. This value is then included in the liability component before separating the equity component under IAS 32. The call option will need to be accounted for separately unless the option exercise price is approximately equal on each exercise date to the amortised cost of the host debt instrument or reimburses the lender for the present value of lost interest for the remainder of the host contract. [IAS 39 para AG 30(g); IAS 32 paras 31, IE 37].
 
From the holders’ perspective, the purchased call option (to convert) and the written call (to redeem) are interlinked. This is because as the share price increases the issuer is likely to call the bond, thereby depriving the holder of the opportunity to make further returns on the bond. Although the optimal policy is to call the bond when its conversion price is equal to the call price, in practice, companies can establish a variety of call policies such as calling the instant the market value of the convertibles rises above the call price or waiting until the market value is well in excess of the call price. This interaction between the two options implies that they have to be valued together using an option pricing model. The single compound derivative is then accounted for separately from the host plain vanilla bond. Alternatively, the holder can designate the entire bond as at fair value through profit or loss as discussed in paragraph 6.3A.108 above.

Example 2 – Bond with embedded forward and option features
 
An entity issues a debt instrument at par with a term of 5 years. The debt is callable 3 years after the issue. If the debt is called, the holder will receive an amount that is adjusted by the percentage change in the FTSE 100 index and that amount doubles if the FTSE 100 index exceeds a certain level.
 
In the above instrument, there are two embedded derivatives – a forward contract that pays double if the FTSE 100 index exceeds a certain level and an option that is linked to changes in the FTSE 100 index. It is not appropriate to separate both a forward and an option on the equity index, because those derivative features relate to the same risk exposure. Instead the forward and option elements are treated as a single compound, embedded derivative.

Accounting for embedded derivatives - Embedded derivatives as hedging instruments

Publication date: 08 Dec 2017


6.3A.117 IAS 39 does not restrict the circumstances in which a derivative might be designated as a hedging instrument provided the hedge accounting criteria are met (subject to some limitations on written options). [IAS 39 para 72]. Therefore, embedded derivatives that are accounted for separately can be designated as hedging instruments, like any free-standing derivatives, as long as the hedge accounting criteria are met. Hedge accounting is considered in chapter 46.
 
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