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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)]. 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 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,
or [IAS39R.AG33(d)] ; |
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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 39
[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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