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Identification of embedded derivatives
An embedded derivative causes some or all of
the cash flows of the host contract to be modified,
based on 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 [IAS39R.10].
Embedded derivatives can arise from deliberate
financial engineering, for example the inclusion
of an equity linked return in low interest-rate
debt. However, many are inadvertently created
through market practices or common contracting
arrangements. These 'incidental' embedded derivatives
also modify the cash flows arising from the
host contract. One example of an 'incidental'
embedded derivative is an office lease denominated
in a currency that is different from the functional
currencies of both the lessor and the lessee
.
Generally, multiple embedded derivatives in
a single instrument are treated as a single
embedded derivative. However, embedded derivatives
that relate to different risk exposures and
that are readily separable and independent of
each other are accounted for separately [IAS39R.AG29].
Identification of embedded derivatives requires
the entity to consider all financial assets
and liabilities that are carried at amortised
cost or classified as available for sale and
all executory contracts such as operating leases,
purchase and sale contracts and commitments.
Closely related
Embedded derivatives must be separated from
the host contract and classified as "financial
assets or financial liabilities at fair value
through profit or loss" unless the economic
characteristics and risks of the derivative
are closely related to those of the host contract
[IAS39R.11(a)]. IFRS does not provide detailed
guidance on how to make the 'closely related'
judgment, but provides examples of what is and
is not closely related. The assessment of whether
an embedded derivative is closely related is
primarily qualitative rather than quantitative
and requires an understanding of the economic
characteristics and risks of both instruments.
An embedded derivative that modifies an instrument's
inherent risk (such as a fixed to floating interest-rate
swap embedded in a fixed rate debt instrument)
would be considered closely related. Conversely,
an embedded derivative that changes the nature
of a contract's risks is not closely related
.
Equity- or commodity-linked features embedded
in a debt instrument are not closely related
. These features may include:
put options that force the issuer to reacquire
an instrument based on changes in a commodity
price or index: equity- or commodity-indexed
interest or principal payments; and equity conversion
features .
Puts or calls on equity instruments at prices
other than the market price on the date of exercise
are seldom closely related. However calls, puts
or surrender options on debt instruments may
be closely related if the exercise price is
approximately equal to the amortised cost of
the instrument. This remains the case even if
an insignificant prepayment penalty is payable
[IAS39R.AG30(g)]. 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
[IAS39R.AG30(c)]. Embedded
credit derivatives allowing one party to transfer
the credit risk of a particular reference asset,
which it may not own, to another party are not
closely related to a host debt instrument [IAS39R.AG30(h)].
By contrast, most embedded interest rate derivatives
that modify the interest flows on a debt instrument
(caps, floors, collars, swaps), if issued at
appropriate rates, are considered closely related
. An embedded stream of foreign
currency payments in a debt instrument, such
as a dual currency bond, are considered closely
related and not separated from the host, as
foreign exchange gains or losses on a monetary
item are already recognised in the income statement
under IAS 21R.
An embedded derivative that results in payments
in a purchase or sale contract or a lease being
denominated in a foreign currency is deemed
closely related if the foreign currency is any
of the following:
| a) |
the functional currency of any substantial
party to the contract; |
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| b) |
the only currency in which contracts for
a particular commodity are priced internationally
[IAS39R.AG33(d)] ; or |
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| c) |
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 last condition
is particularly likely to apply in countries
with high inflation rates or restricted
currency markets where market participants
generally prefer to transact in a stable
currency [IAS39R.AG33(d)] . |
Inflation adjustments and contingent rentals
based on sales or on changes in interest rates
are embedded derivatives commonly found in lease
contracts. Under IFRS, such embedded derivatives
are closely related to the host lease contract
[IAS39R.AG33(f)] .
Measurement
All separated embedded derivatives are accounted
for as "Financial assets or financial liabilities
at fair value through profit or loss",
unless they are designated as hedging instruments
and the criteria for hedge accounting are met
(in which case the hedge accounting rules are
applied). When separating an embedded derivative
from its host contract, the derivative element
is valued first and the residual is assigned
to the host contract. The host contract is accounted
for in accordance with the requirements of the
relevant IFRS [IAS39R.11] .
If an entity is unable to determine reliably
the fair value of an embedded derivative on
the basis of its terms and conditions, the fair
value is measured as the difference between
the fair value of the hybrid instrument and
the fair value of the host contract, if those
can be determined under IAS 39R [IAS39R.13].
When an entity is unable to measure an embedded
derivative using this method, the entire contract
is classified as held for trading and is measured
at fair value through profit or loss [IAS39R.12].
This is expected to be a rare circumstance.
Presentation and disclosure
There are no specific presentation or disclosure
requirements in IFRS for embedded derivatives.
As for all other financial instruments, disclosure
is required about the extent and nature of the
instruments, including significant terms and
conditions that may affect the amount, timing
and certainty of future cash flows, and the
accounting policies and methods adopted [IAS32R.60].
Neither IAS 32 nor IAS 39 addresses whether
an embedded derivative shall be presented separately
on the face of the financial statements. It
is common for derivatives embedded in non-derivative
financial instruments to be presented in the
same balance sheet classification as the host
contract [IAS39R.11].
Entities are required to present a classified
balance sheet [IAS1R.51] and must identify all
assets and liabilities expected to be recovered
or settled in (a) less than and (b) more than
twelve months from the balance sheet date [IAS1R.52]. Some embedded derivatives (e.g.
early redemption options) may affect this distinction.
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