International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
Page 658
another financial instrument, or by exchanging financial instruments, in accordance
with (a) or (d) should be accounted for under IFRS 9 and does not qualify for use of the
normal purchase or sale exemption. [IAS 32.10, IFRS 9.2.7, BCZ2.18].
The conditions associated with the use of the normal purchase or sale exemption often
pose problems for mining companies and oil and gas companies because, historically,
they have settled many purchase and sales contracts on a net basis.
A further problem may arise when a mining company or oil and gas company holds a written
option 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 – because IFRS 9 would require
such contracts to be accounted for as derivative financial instruments.
Finally, from time to time mining companies and oil and gas companies may need to
settle contracts for the sale of commodities on a net basis because of operational
problems. Such a situation may mean that the company would usually need to treat
those contracts as derivative financial instruments under IFRS 9 as they may now have
a practice of settling net under (b) or (c) above. Where this situation is caused by a unique
event beyond management’s control, a level of judgement will be required to determine
whether that would prevent the company from applying the own use exemption to
similar contracts. This should be assessed on a case by case basis.
Judgement will also be required as to what constitutes ‘similar contracts’. The
definition of similar contracts in IFRS 9, [IFRS 9.2.6], considers the intended use for such
contracts. This means that contracts identical in form may be dissimilar due to their
intended use, e.g. own purchase requirements versus proprietary trading. If the
intended use is for normal purchase or sale, such an intention must be documented at
inception of the contract. A history of regular revisions of expected purchase or sale
requirements could impair the ability of a company to distinguish identical contracts
as being dissimilar.
IFRS 9 provides a fair value option for own use contracts which was not previously
available under IAS 39 – Financial Instruments: Recognition and Measurement. At the
inception of a contract, an entity may make an irrevocable designation to measure an
own use contract at fair value through profit or loss (the ‘fair value option’) even if it was
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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 requirement. However,
such designation is only allowed if it eliminates or significantly reduces an accounting
mismatch that would otherwise arise from not recognising that contract because it is
excluded from the scope of IFRS 9. [IFRS 9.2.5].
See Chapter 41 at 4 for more information on the normal purchase and sales exemption.
The extract below from AngloGold Ashanti’s 2008 financial statements illustrates how this
could affect an entity’s reported financial position. (Note that in October 2010, AngloGold
Ashanti removed the last of its gold hedging instruments and long-term sales contracts.)
Extract 39.21: AngloGold Ashanti Limited (2008)
Risk management and internal controls [extract]
Risks related to AngloGold Ashanti’s operations [extract]
A significant number of AngloGold Ashanti’s forward sales contracts are not treated as derivatives and fair valued
on the financial statements as they fall under the normal purchase sales exemption. Should AngloGold Ashanti fail
to settle these contracts by physical delivery, then it may be required to account for the fair value of a portion, or
potentially all of, the existing contracts in the financial statements. This could adversely affect AngloGold Ashanti’s
reported financial condition.
13.2 Embedded
derivatives
A contract that qualifies for the normal purchase and sale exemption still needs to be
assessed for the existence of embedded derivatives. An embedded derivative is a
component of a hybrid or combined instrument that also includes a non-derivative host
contract; it has the effect that some of the cash flows of the combined instrument vary
in a similar way to a stand-alone derivative. In other words, it 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 underlying
variable (provided in the case of a non-financial variable that the variable is not specific
to a party to the contract). [IFRS 9.4.3.1].
The detailed requirements regarding the separation of embedded derivatives and the
interpretation and application of those requirements under IFRS 9 are discussed in
Chapter 42. A number of issues related to embedded derivatives that are of particular
importance to the extractive industries are discussed at 13.2.1 to 13.2.4 below.
13.2.1
Foreign currency embedded derivatives
The most common embedded derivatives in the extractive industries are probably
foreign currency embedded derivatives which arise when a producer of minerals sells
these in a currency that is not the functional currency of any substantial party to the
contract, the currency in which the price of the related commodity is routinely
denominated in commercial transactions around the world or 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. [IFRS 9.B4.3.8(d)]. A more detailed
analysis of these requirements can be found in Chapter 42 at 5.2.1.
3326 Chapter 39
13.2.2
Provisionally priced sales contracts
As discussed above at 12.8.1, sales contracts for certain commodities (e.g. copper and
oil) often provide for provisional pricing at the time of shipment, with final pricing based
on the average market price for a particular future period, i.e. the ‘quotational period’.
If the contract is cancellable without penalty before delivery, the price adjustment
feature does not meet the definition of a derivative because there is no contractual
obligation until delivery takes place.
If the contract is non-cancellable, the price adjustment feature is considered to be an
embedded derivative. The non-financial contract for the sale or purchase of the
product, e.g. copper or oil, at a future date would be treated as the host contract.
For non–cancellable contracts, there will be a contractual obligation, but until control
passes to the customer, the embedded derivative would be considered to be closely
related to the non-financial host commodity contract and does not need to be
recorded separately.
As discussed at 12.8.1 above, revenue is recognised when control passes to the
customer. At this point, the non-financial host commodity contract is considered to
be satisfied and a corresponding receivable is recognised. However, the receivable is
still exposed to the price adjustment feature. As discussed at 12.8 above, und
er
IFRS 9, embedded derivatives are not separated from financial assets, i.e. from the
receivable. Instead, the receivable will need to be measured at fair value through
profit or loss in its entirety. See Chapter 44 at 2 for more information on the
classification of financial assets.
13.2.3
Long-term supply contracts
Long-term supply contracts sometimes contain embedded derivatives because of a
desire to shift certain risks between contracting parties or as a consequence of existing
market practices. The fair value of embedded derivatives in long-term supply contracts
can be highly material to the entities involved. For example, in the mining sector
electricity purchase contracts sometimes contain price conditions based on the
commodity that is being sold, which provides an economic hedge for the mining
company. While the electricity price component (if fixed) would meet the definition of
an embedded derivative, it would be considered closely related to the host contract and
hence would not have to be separated. However, the linkage to the commodity price
would be unlikely to be considered closely related and would likely have to be
separately accounted for as an embedded derivative. In the oil and gas sector the sales
price of gas is at times based on that of electricity, which provides an economic hedge
for the utility company that purchases the gas, and would also likely represent an
embedded derivative that has to be separately accounted for. See Chapter 42 at 5.2.2
for further discussion.
As can be seen in the following extract from BHP Billiton’s 2007 financial statements,
the pricing terms of embedded derivatives in purchase (sales) contracts often match
those of the product that the entity sells (purchases).
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Extract 39.22: BHP Billiton plc (2007)
Notes to Financial Statements [extract]
28 Financial instruments [extract]
Embedded derivatives
Derivatives embedded in host contracts are accounted for as separate derivatives when their risks and characteristics
are not closely related to those of the host contracts or have intrinsic value at inception and the host contracts are not carried at fair value. These embedded derivatives are measured at fair value with gains or losses arising from changes
in fair value recognised in the income statement.
Contracts are assessed for embedded derivatives when the Group becomes a party to them, including at the date of a
business combination. Host contracts which incorporate embedded derivatives are entered into during the normal
course of operations and are standard business practices in the industries in which the Group operate.
The following table provides information about the principal embedded derivatives contracts:
Maturity
date
Volume
Exposure
2007
2006
2007
2006
price
Commodity Price Swaps
Electricity purchase
31 Dec 2024
31 Dec 2024
240,000
240,000
MWh Aluminium
arrangement (a)
Electricity purchase
30 June 2020
30 June 2020
576,000
576,000
MWh Aluminium
arrangement (a)
Gas sales (b)
31 Dec 2013
31 Dec 2013
1,195,572
1,428,070
‘000
Electricity
therms
Commodity Price Options
Finance lease of plant and
31 Dec 2018
30 Dec 2018
38.5
39.5 mmboe
Crude Oil
equipment (b)
Copper concentrate
31 Dec 2007
31 Dec 2006
52
41
‘000
Copper
purchases and sales (b)
tonnes
Lead concentrate purchases
31 Dec 2007
1 January 2007
11
67
‘000
Lead
and sales (b)
tonnes
Zinc concentrate purchases
31 Dec 2007
2 January 2007
51
6
‘000
Zinc
and sales (b)
tonnes
Silver concentrate sales (b)
31 Dec 2007
–
4,604
–
‘000
Silver
ounces
(a)
The volumes shown in these contracts indicate a megawatt volume per hour for each hour of the contract.
(b)
The volumes shown in these contracts indicate the total volumes for the contract.
13.2.4
Development of gas markets
Where there is no active local market in gas, market participants often enter into long-
term contracts that are priced on the basis of a basket of underlying factors, such as oil
prices, electricity prices and inflation indices. In the absence of an active market in gas,
such price clauses are not considered to give rise to embedded derivatives because there
is no accepted benchmark price for gas that could have been used instead.
An entity that applies IFRS 9 is required to assess whether an embedded derivative is
required to be separated from the host contract (provided that host contract is not a financial
asset (see 12.8 above for more information)) and accounted for as a derivative when the
entity first becomes a party to the contract. [IFRS 9.B4.3.11]. Subsequent reassessment of
embedded derivatives under IFRS 9 is generally prohibited. [IFRS 9.B4.3.11]. See Chapter 42
3328 Chapter 39
at 7 for more information. Therefore, in the case of gas, when an active market subsequently
develops, an entity is not permitted to separate embedded derivatives from existing gas
contracts, unless there is a change in the terms of the contract that significantly modifies the
cash flows that otherwise would be required under the contract. However, if the entity
enters into a new gas contract with exactly the same terms and conditions, it would be
required to separate embedded derivatives from the new gas contract.
Judgement is required in determining whether there is an active market in a particular
geographic region and the relevant geographic market for any type of commodity. Where
no active market exists consideration should be given to the industry practice for pricing
such commodity-based contracts. A pricing methodology that is consistent with industry
practice would generally not be considered to contain embedded derivatives.
The extract below from BP shows the company’s previous approach to embedded
derivatives before and after the development of an active gas trading market in the UK,
and demonstrates that the fair value of embedded derivatives in long-term gas contracts
can be quite significant.
Extract 39.23: BP p.l.c. (2014)
Notes on financial statements [extract]
28. Derivative financial instruments [extract]
Embedded derivatives [extract]
The group is a party to certain natural gas contracts containing embedded deriva
tives. Prior to the development of an
active gas trading market, UK gas contracts were priced using a basket of available price indices, primarily relating to oil products, power and inflation. After the development of an active UK gas market, certain contracts were entered into or
renegotiated using pricing formulae not directly related to gas prices, for example, oil product and power prices. In these circumstances, pricing formulae have been determined to be derivatives, embedded within the overall contractual
arrangements that are not clearly and closely related to the underlying commodity. The resulting fair value relating to
these contracts is recognized on the balance sheet with gains or losses recognized in the income statement. [...]
The commodity price embedded derivatives relate to natural gas contracts and are categorized in level 2 and 3 of the fair value hierarchy. The contracts in level 2 are valued using inputs that include price curves for each of the different products that are built up from active market pricing data. Where necessary, the price curves are extrapolated to the expiry of the contracts (the last of which is in 2018) using all available external pricing information; additionally, where limited data exists for certain products, prices are interpolated using historic and long-term pricing relationships. [...]
The following table shows the changes during the year in the net fair value of embedded derivatives, within level 3
of the fair value hierarchy.
$
million
2014
2013
Commodity
Commodity
price
price
Net fair value of contracts at 1 January
(379)
(1,112)
Settlements
24
316
Gains recognized in the income statement
219
142
Transfers out of level 3
–
258
Exchange adjustments
10
17
Net fair value of contracts at 31 December
(126)
(379)
The amount recognized in the income statement for the year relating to level 3 embedded derivatives still held at
31 December 2014 was a $220 million gain (2013 $67 million gain related to derivatives still held at 31 December 2013).
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13.3 Volume flexibility in supply contracts
It is not uncommon for other sales contracts, such as those with large industrial