Accordingly, IAS 32, IFRS 7 and IFRS 9 apply to written options that can be settled net
according to the terms of the contract or where the underlying non-financial item is
readily convertible to cash (see (a) and (d) at 4.1 above). [IAS 32.10, IFRS 9.2.7, BCZ2.18].
Example 41.4: Determining whether a put option on an office building is within
the scope of IFRS 9
Company XYZ owns an office building. It enters into a put option with an investor, which expires in five
years and permits it to put the building to the investor for £150 million. The current value of the building is
£175 million. The option, if exercised, may be settled through physical delivery or net cash, at XYZ’s option.
Financial instruments: Definitions and scope 3439
XYZ’s accounting depends on its intention and past practice for settlement. Although the contract meets the
definition of a derivative, XYZ does not account for it as a derivative if it intends to settle the contract by
delivering the building in the event of exercise and there is no past practice of settling net.
The investor, however, cannot conclude that the option was entered into to meet its expected purchase, sale,
or usage requirements because it does not have the ability to require delivery. The contract may be settled
net and is a written option. Regardless of past practices, its intention does not affect whether settlement is by
delivery or in cash. Accordingly, the investor accounts for the contract as a derivative. As noted in Chapter 46
at 2, this will involve remeasuring the derivative to its fair value each reporting period with any associated
gains and losses recognised in profit or loss.
However, if the contract were a forward contract rather than an option, required physical delivery and the
investor had no past practice of settling net (either in cash or by way of taking delivery and subsequently
selling within a short period), the contract would not be accounted for as a derivative. [IFRS 9.A.2].
4.2.4
Electricity and similar ‘end-user’ contracts
There have been problems in determining whether or not IAS 32, IFRS 7 and IFRS 9
apply to contracts to sell non-financial items (for example electricity or natural gas) to
‘end-users’ such as retail customers. The non-financial items will often be considered
readily convertible to cash (see 4.1 above), at least by the supplier. Accordingly,
contracts to supply such items might be considered contracts that can be settled net.
Furthermore, end-user contracts often enable the customer to purchase as much of the
non-financial item as needed at a given price to satisfy its usage requirements, i.e. the
supplier does not have the contractual right to control whether or not the sale will take
place. This might suggest that, from the perspective of the supplier, the contract is a
written option with the consequence that it could not regard it as meeting the normal
sale and purchase exemption (see 4.2.3 above).
However, many argued that this was not necessarily the case, particularly in the
following circumstances:
• the non-financial item is an essential item for the customer;
• the customer does not have access to a market where the non-financial item can
be resold;
• the non-financial item is not easily stored in any significant amounts by the
customer; and
• the supplier is the sole provider of the non-financial item for a certain period of time.
In circumstances such as these, the apparent optionality within the contract is not
exercisable by the retail customer in any economic sense. The customer will purchase
volumes required whether the terms in the contract are advantageous or not and
would not have the practical ability to sell any excess amounts purchased. Such a
contract can have both a positive value and a negative value for the supplier when
compared with market conditions and therefore fails to exhibit one of the key
characteristics of an option, i.e. that it has only a positive value for the holder (the
customer) and only a negative value for the writer (the supplier). In many respects the
positive value stems from an intangible, rather than financial, aspect of the contract,
being the likelihood that the customer will exercise the option. Accordingly, it was
often argued that such contracts should not be considered written options (and
therefore not within the scope of IFRS 9).
3440 Chapter 41
Even if contracts such as these are considered to be within the scope of IFRS 9, it is
common for the supplier to have the ability to increase the price charged at relatively
short notice. Also, the customer may be able to cancel the contract without penalty and
switch to another supplier. Features such as these are likely to reduce any fair value
that the contract can have.
Only a small number of energy suppliers appeared to regard these contracts as falling
within the scope of IFRS 9. The Interpretations Committee noted that the guidance
already explains what constitutes a written option, essentially confirming that in this
context a written option arises where a supplier does not have the contractual right to
control whether or not a sale will take place.13
The Interpretations Committee also noted that ‘in many situations these contracts
are not capable of net cash settlement’, and therefore would not be within the scope
of IFRS 9. No detailed explanation was provided of why the ability of the supplier
to readily realise the non-financial item for cash does not enable it to settle the
contract net (as that term is used in IFRS 9).14 However, we understand the reason
underlying the comment to be the inability of the counterparty to realise the non-
financial item (and hence the contract) for cash. This establishes a useful principle
that may be applied in similar situations, i.e. a contract is not capable of net
settlement if the contract is an option and the option holder cannot readily realise
the non-financial item for cash.
4.2.5
Other contracts containing volume flexibility
It is not uncommon for other sales contracts, such as those with large industrial
customers, to contain volume flexibility features. For example, a supplier might enter
into a contract requiring it to deliver, say, 100,000 units at a given price as well as giving
the counterparty the option to purchase a further 20,000 units at the same price. The
customer might well have access to markets for the non-financial item and, following
the guidance of the Interpretations Committee, the supplier might consider such a
contract to be within the scope of IFRS 9 as it contains a written option.
However, the supplier could split the contract into two separate components for
accounting purposes: a forward contract to supply 100,000 units (which may qualify as
a normal sale) and a written option to supply 20,000 units (which would not).
Arguments put forward include:
• the parties could easily have entered into two separate contracts, a forward
contract and a written option; and
• it is appropriate to analogise to the requirements for embedded derivatives and
separate a written option from the normal forward sale or purchase contract
because it is not closely related (see Chapter 42 at 5).
The In
terpretations Committee was asked to consider the appropriate treatment of
such contracts but in spite of noting significant diversity in practice the issue has not
been addressed. In our view, entities may apply either of these interpretations as an
accounting policy choice.
Financial instruments: Definitions and scope 3441
4.2.6
Fair value option
Own use contracts are accounted for as normal sales or purchase contracts (i.e.
executory contracts), with the idea that any fair value change of the contract is not
relevant given that the contract is used for the entity’s own use. However, participants
in several industries often enter into similar contracts both for own use and for trading
purposes and manage all the contracts together with derivatives on a fair value basis (so
as to manage the fair value risk to close to nil). In such a situation, own use accounting
leads to an accounting mismatch, as the fair value change of the derivatives and the
trading positions cannot be offset against fair value changes of the own use contracts.
To eliminate the accounting mismatch, an entity could apply hedge accounting by
designating own use contracts as hedged items in a fair value hedge relationship.
However, hedge accounting in these circumstances is administratively burdensome and
often produces less meaningful results than fair value accounting. Furthermore, entities
enter into large volumes of commodity contracts and, within the large volume of
contracts, some positions may naturally offset each other. An entity would therefore
typically hedge on a net basis. [IFRS 9.BCZ2.24].
Alternatively, IFRS 9 provides a ‘fair value option’ for own use contracts. At inception
of a contract, an entity may make an irrevocable designation to measure an own use
contract at fair value through profit or loss in spite of it being 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].
On transition to IFRS 9, entities can apply the fair value option on an ‘all-or-nothing’
basis for similar types of (already existing) own use contracts (see Chapter 49 at 12.2).
[IFRS 9.7.2.14A].
References
1 Information for Observers (May 2007 IFRIC
3
IFRIC Update, November 2007. Whilst the
meeting),
Gaming Transactions, IASB,
IFRIC discussion was held in the context of
May 2007, paras. 25 to 27 and IFRIC Update,
IAS 39, the discussion also holds true under
July 2007. Whilst the IFRIC discussion was
IFRS 9.
held in the context of IAS 39, the discussion
4
IFRIC Update, May 2008. Whilst the IFRIC
also holds true under IFRS 9.
discussion was held in the context of IAS 39,
2 Information for Observers (November 2007
the discussion also holds true under IFRS 9.
IFRIC Meeting), Deposits on returnable 5
IFRIC
D23,
Distributions of Non-cash Assets to
containers (Agenda Paper 7B), IASB,
Owners, IASB, January 2008, paras. 9 to 11.
November 2007, paras. 1 and 2. Whilst the
Whilst the IFRIC discussion was held in the
IFRIC discussion was held in the context of
context of IAS 39, the discussion also holds
IAS 39, the discussion also holds true under
true under IFRS 9.
IFRS 9.
3442 Chapter 41
6 IFRIC Update, January 2013. Whilst the IFRIC 10 IFRIC Update, March 2016.
discussion was held in the context of IAS 39, a
11 IFRIC Update, November 2005.
similar analysis would apply under IFRS 9.
12 IFRIC Update, August 2005. Whilst the IFRIC
7
IASB Update, June 2009.
discussion was held in the context of IAS 39,
8 Information for Observers (March 2009 IASB
the discussion also holds true under IFRS 9.
meeting), IAS
39 Financial Instruments: 13 IFRIC Update, March 2007 and Information
Recognition and Measurement – Scope
for Observers (January 2007 IFRIC meeting),
exemption for business combination contracts
IAS 39 Financial Instruments: Recognition and
(IAS 39.2(g)) (Agenda Paper 10C), IASB,
Measurement – Written options in retail energy
March
2009, paras.
13 and
15. Whilst the
contracts (Agenda Paper 14(iv)), IASB,
IFRIC discussion was held in the context of
January 2007, paras. 9 to 11. Whilst the IFRIC
IAS 39, the discussion also holds true under
discussion was held in the context of IAS 39,
IFRS 9.
the discussion also holds true under IFRS 9.
9 Information for Observers (March 2009 IASB
14 IFRIC Update, March 2007 and Information
meeting), IAS
39 Financial Instruments:
for Observers (January 2007 IFRIC meeting),
Recognition and Measurement – Scope
IAS 39 Financial Instruments: Recognition and
exemption for business combination contracts
Measurement – Written options in retail energy
(IAS 39.2(g)) (Agenda Paper 10C), IASB,
contracts (Agenda Paper 14(iv)), IASB,
March 2009, paras. 9 and 10. Whilst the IFRIC
January
2007, para.
15. Whilst the IFRIC
discussion was held in the context of IAS 39,
discussion was held in the context of IAS 39,
the discussion also holds true under IFRS 9.
the discussion also holds true under IFRS 9.
3443
Chapter 42
Financial instruments:
Derivatives and
embedded derivatives
1 INTRODUCTION .......................................................................................... 3447
2 DEFINITION OF A DERIVATIVE .................................................................. 3448
2.1
Changes in value in response to changes in underlying ............................ 3448
2.1.1
Notional amounts .............................................................................. 3448
2.1.2 Underlying
variables ......................................................................... 3449
2.1.3
Non-financial variables specific to one party to the
contract ................................................................................................ 3450
2.2
Initial net investment ........................................................................................ 3452
2.3 Future
settlement
...............................................................................................
3454
3 EXAMPLES OF DERIVATIVES ...................................................................... 3455
3.1
Common derivatives .........................................................
................................ 3455
3.2 In-substance
derivatives
..................................................................................
3456
3.3 Regular
way
contracts
....................................................................................... 3456
4 EMBEDDED DERIVATIVES .......................................................................... 3456
5 EMBEDDED DERIVATIVES: THE MEANING OF ‘CLOSELY RELATED’ ....... 3458
5.1
Financial instrument hosts ............................................................................... 3458
5.1.1
Foreign currency monetary items .................................................. 3458
5.1.2
Interest rate indices ........................................................................... 3459
5.1.3
Term extension and similar call, put and prepayment
options in debt instruments ............................................................. 3460
5.1.4
Interest rate floors and caps ............................................................ 3464
5.1.5 Inflation-linked
debt instruments .................................................. 3465
5.1.6 Commodity-
and
equity-linked interest and principal
payments ............................................................................................. 3466
3444 Chapter 42
5.1.7 Credit-linked
notes
...........................................................................
3466
5.1.8
Instruments with an equity kicker ..................................................3467
5.1.9 Puttable
instruments ..........................................................................3467
5.2
Contracts for the sale of goods or services ................................................... 3468
5.2.1
Foreign currency derivatives .......................................................... 3468
5.2.1.A
Functional currency of counterparty ........................ 3468
5.2.1.B Routinely
denominated
in
commercial
transactions .................................................................... 3469
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 680
