5.2.1.C Commonly
used
currencies
........................................
3469
5.2.1.D
Examples and other practical issues .......................... 3471
5.2.2
Inputs, ingredients, substitutes and other proxy pricing
mechanisms ......................................................................................... 3472
5.2.3 Inflation-linked features ................................................................... 3473
5.2.4 Floors
and
caps ................................................................................... 3473
5.2.5
Fund performance fees ..................................................................... 3473
5.3
Leases .................................................................................................................... 3474
5.3.1
Foreign currency derivatives ........................................................... 3474
5.3.2 Inflation-linked
features
...................................................................
3474
5.3.3 Contingent
rentals
based on related sales ..................................... 3474
5.3.4
Contingent rentals based on variable interest rates .................... 3474
5.4
Insurance contracts ............................................................................................ 3474
6 IDENTIFYING THE TERMS OF EMBEDDED DERIVATIVES AND HOST
CONTRACTS ................................................................................................ 3475
6.1
Embedded non-option derivatives ................................................................. 3475
6.2 Embedded
option-based derivative ...............................................................3476
6.3 Multiple
embedded derivatives ....................................................................... 3477
7 REASSESSMENT OF EMBEDDED DERIVATIVES .......................................... 3477
7.1
Acquisition of contracts .................................................................................... 3478
7.2 Business
combinations
...................................................................................... 3478
7.3 Remeasurement
issues
arising from reassessment ...................................... 3478
8 LINKED AND SEPARATE TRANSACTIONS AND ‘SYNTHETIC’
INSTRUMENTS............................................................................................. 3479
List of examples
Example 42.1:
Notional amount of a derivative ..................................................... 3448
Example 42.2:
Derivative containing no notional amount ................................... 3449
Example 42.3:
Derivative containing two underlyings ......................................... 3449
Example 42.4:
Borrowing with coupons linked to revenue ................................. 3451
Financial
instruments:
Derivatives and embedded derivatives 3445
Example 42.5:
Currency swap – initial exchange of principal ........................... 3453
Example 42.6:
Prepaid interest rate swap (prepaid fixed leg) ............................. 3453
Example 42.7:
Prepaid interest rate swap (prepaid floating leg) ......................... 3453
Example 42.8:
Prepaid forward purchase of shares .............................................. 3454
Example 42.9:
Interest rate swap – gross or net settlement ................................ 3454
Example 42.10:
In-substance derivative – offsetting loans ................................... 3456
Example 42.11:
Leveraged inverse floater – not recovering substantially
all of the initial investment .............................................................. 3460
Example 42.12:
Leveraged inverse floater – ‘double-double test’ ....................... 3460
Example 42.13:
Embedded prepayment option ........................................................ 3461
Example 42.14:
Extension and prepayment options ............................................... 3462
Example 42.15:
Bond linked to commodity price .................................................... 3466
Example 42.16:
Equity kicker .......................................................................................3467
Example 42.17:
Oil contract denominated in Swiss francs ..................................... 3471
Example 42.18:
Oil contract, denominated in US dollars and containing a
leveraged foreign exchange payment ............................................. 3471
Example 42.19:
Separation of embedded derivative from lease ............................3476
Example 42.20:
Investment in synthetic fixed-rate debt .........................................3479
3446 Chapter 42
3447
Chapter 42
Financial instruments:
Derivatives and
embedded derivatives
1 INTRODUCTION
Under IFRS 9 – Financial Instruments, the question of whether an instrument is a
derivative or not is an important one for accounting purposes. Derivatives are normally
recorded in the statement of financial position at fair value with any changes in value
reported in profit or loss (see Chapter 46 at 2), although there are some exceptions, e.g.
derivatives that are designated in certain effective hedge relationships.
For many financial instruments, it will be reasonably clear whether or not they are
derivatives, but there will be more marginal cases. Accordingly, the term derivative is
formally defined within IFRS 9, and this definition, together with examples of
derivatives, is considered further at 2 and 3 below.
IFRS 9 also contains the concept of an embedded derivative which is described as a
component of a hybrid or combined instrument that also includes a non-derivative host
contract. In certain circumstances embedded derivatives are required to be accounted
for separately as if they were freestanding derivatives. The IASB introduced this
concept because it believes that entities should not be able to circumvent the
accounting requirements for derivatives merely by embedding a derivative in a non-
derivative financial instrument or other non-financial contract, e.g. by placing a
commodity forward in a debt instrument. In other words, it is chiefly an anti-abuse
measure designed to enforce ‘derivative accounting’ on those derivatives that are
‘hidden’ in other contracts. [IFRS 9.BCZ4.92].
Embedded derivatives, and the situations in which they are required to be accounted
for separately, are considered in more detail at 4 to 7 below. Under IFRS 9 the concept
of embedded derivatives applies to financial liabilities and non-financial items only.
Embedded derivatives are not separated from financial assets within the scope of
IFRS 9 and the requirements of IFRS 9 ar
e applied to the hybrid contract as a whole.
In addition to assessing when a financial instrument or other contract should be
accounted for as if it were two contracts, we consider at 8 below situations when two
3448 Chapter 42
financial instruments should be accounted for as if they were one, together with the
question of linkage (for financial reporting purposes) of transactions more generally.
This chapter does not deal with valuation of derivative financial instruments.
Chapter 14 outlines the requirements of IFRS 13 – Fair Value Measurement, a standard
that defines fair value and provides principles-based guidance on how to measure fair
value under IFRS. Additional guidance affecting the valuation of derivatives can be
found in Chapter 49 at 3 and 6.
This chapter refers to a number of discussions by the IASB and the Interpretations
Committee on topics relevant to derivatives and embedded derivatives. A number of
these discussions were held in the context of IAS 39 – Financial Instruments:
Recognition and Measurement, prior to the effective date of IFRS 9 on
1 January 2018. Those discussions which remain relevant to IFRS 9 have been
retained in this chapter.
2
DEFINITION OF A DERIVATIVE
A derivative is a financial instrument or other contract within the scope of IFRS 9 (see
Chapter 41 at 2 and 3) with all of the following characteristics:
(a) its value changes in response to the change in 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
(sometimes called the ‘underlying’);
(b) it requires no initial net investment, or an initial net investment that is smaller than
would be required for other types of contracts that would be expected to have a
similar response to changes in market factors; and
(c) it is settled at a future date. [IFRS 9 Appendix A].
These three defining characteristics are considered further below.
2.1
Changes in value in response to changes in underlying
2.1.1 Notional
amounts
A derivative usually has a notional amount, such as an amount of currency, number of
shares or units of weight or volume, but does not require the holder or writer to invest
or receive the notional amount at inception.
Example 42.1: Notional amount of a derivative
Company XYZ, whose functional currency is the US dollar, has placed an order with a company in France
for delivery in six months’ time. The price to be paid in six months’ time is €2,000,000. To hedge the
exposure to currency risk, Company XYZ enters into a contract with an investment bank to convert US
dollars to euros at a fixed exchange rate. The contract requires the investment bank to remit €2,000,000 in
exchange for US dollars at a fixed exchange rate of 1.65 (US$3,300,000). The notional amount of the contract
in euro term is €2,000,000.
However, while a derivative usually has a notional amount, this is not always the case:
a derivative could require a fixed payment or payment of an amount that can change
Financial
instruments:
Derivatives and embedded derivatives 3449
(but not proportionally with a change in the underlying) as a result of some future event
that is unrelated to a notional amount. For example, a contract that requires a fixed
payment of €1,000 if six-month LIBOR increases by 100 basis points is a derivative,
even though a notional amount is not specified (at least not in the conventional sense).
[IFRS 9.BA.1]. A further example is shown below.
Example 42.2: Derivative containing no notional amount
Company XYZ enters into a contract that requires payment of $1,000 if Company ABC’s share price increases
by $5 or more during a six-month period; Company XYZ will receive $1,000 if the share price decreases by $5
or more during the same six-month period; no payment will be made if the price swing is less than $5 up or down.
The settlement amount changes with an underlying, Company ABC’s share price, although there is no
notional amount to determine the settlement amount. Instead, there is a payment provision that is based on
changes in the underlying. Provided all the other characteristics of a derivative are present, which they are in
this case, such an instrument is a derivative.1
2.1.2 Underlying
variables
It follows from the definition (see 2 above) that a derivative will always have at least one
underlying variable. The following underlying variables are referred to in the standard, but
this is not an exhaustive list (we have provided an example for each of the underlyings):
• specified interest rate (e.g. LIBOR);
• financial instrument price (e.g. the share price of an entity);
• commodity price (e.g. the price of a barrel of oil);
• foreign exchange rate (e.g. the £/$ spot rate);
• index of prices or rates (e.g. Consumer Price Index);
• credit rating (e.g. Fitch);
• credit index (e.g. AAA rated corporate bond index); and
• non-financial variable (e.g. index of earthquake losses or of temperatures).
The application guidance explains that a contract to receive a royalty, often in exchange
for the use of certain property that is not exchange-traded, where the payment is based
on the volume of related sales or service revenues and accounted for under IFRS 15 –
Revenue from Contracts with Customers (see Chapter 28 at 9.5) is not accounted for as
a derivative. [IFRS 9.B2.2].
Derivatives that are based on sales volume are not necessarily excluded from the
scope of IFRS 9, especially where there is another (financial) underlying, as set out in
the next example.
Example 42.3: Derivative containing two underlyings
Company XYZ, whose functional currency is the US dollar, sells products in France denominated in euros.
Company XYZ enters into a contract with an investment bank to convert euros to US dollars at a fixed
exchange rate. The contract requires Company XYZ to remit euros based on its sales volume in France in
exchange for US dollars at a fixed exchange rate of 1.00.
The contract has two underlying variables, the foreign exchange rate and the volume of sales, no initial net
investment, and a payment provision. Therefore, as the implementation guidance explains, it is a derivative.
[IFRS 9.IG B.8].
3450 Chapter 42
However, contracts that are linked to variables that might be considered non-financial,
such as an entity’s revenue, can sometimes cause particular interpretative problems.
2.1.3
Non-financial variables specific to one party to the contract
The definition of a derivative (see 2 above) refers to underlyings that are non-financial
variables not specific to one party to the contract. This reference was introduced by
IFRS 4 – Insurance Contracts – to help determine whether or not a financial instrument
is an insurance contract (see Chapter 41 at 3.3). An insurance contract is likely to
contain such an underlying, for example the occurrence or non-occurrence of a fire
that dam
ages or destroys an asset of a party to the contract. For periods beginning on
or after 1 January 2021, IFRS 4 will be replaced by IFRS 17 – Insurance Contracts. Non-
financial variables that are not specific to one party to the contract might include an
index of earthquake losses in a particular region or an index of temperatures in a
particular city. [IFRS 9.BA.5]. Those based on climatic variables are sometimes referred to
as ‘weather derivatives’. [IFRS 9.B2.1].
A change in the fair value of a non-financial asset is specific to the owner if the fair value
reflects not only changes in market prices for such assets (a financial variable) but also the
condition of the specific non-financial asset held (a non-financial variable). For example,
if a guarantee of the residual value of a specific car exposes the guarantor to the risk of
changes in the car’s physical condition, the change in that residual value is specific to the
owner of the car, and so would not be a derivative. [IFRS 9.BA.5].
Contracts with non-financial variables arise in the gaming industry where a gaming
institution takes a position against a customer (rather than providing services to manage
the organisation of games between two or more parties). For example, a customer will
pay a stake to a bookmaker such that the bookmaker is contractually obliged to pay the
customer a specified amount in the event that the bet is a winning one, e.g. if the specified
horse wins a given race. The underlying variable (the outcome of the race) is clearly non-
financial in nature, but it is unlikely to be specific to either party to the contract.
Accordingly such contracts will typically be derivative financial instruments.2
It is not clear whether the reference to non-financial variables specific to one party to the
contract means that all instruments with such an underlying would fail to meet the definition
of a derivative or only those contracts that are insurance contracts, for which the reference
was originally introduced. Until the standard is clarified, in our view, a legitimate case can
be made for either view.
The Interpretations Committee considered this issue in the context of contracts
indexed to an entity’s revenue or EBITDA and initially came to a tentative conclusion
that the exclusion was not restricted to insurance contracts.3 However, that
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 681
