conclusion was later withdrawn and the Interpretations Committee referred the issue
to the IASB, recommending that the standard be amended to limit the exclusion to
insurance contracts.4
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The IASB confirmed that it had intended the exclusion to apply only to contracts that
are within the scope of IFRS 45 however, the IASB eventually decided not to proceed
on this issue and the existing definition of a derivative (see 2 above) was incorporated
into IFRS 9 without alteration, leaving the issue unaddressed.
A further issue arises in that it is not always clear whether a variable is non-financial.
This is illustrated in the following example (in this case the underlying is associated with
an embedded feature which might or might not meet the definition of a derivative).
Example 42.4: Borrowing with coupons linked to revenue
Company F, a manufacturing entity, issues a debt instrument for its par value of €10m. It is repayable in ten
years’ time at par and an annual coupon is payable that comprises two elements: a fixed amount of 2.5% of
the par value and a variable amount equating to 0.01% of Company F’s annual revenues. Company F does
not designate the instrument at fair value through profit or loss.
It is assumed that if Company F had instead issued a more conventional fixed rate borrowing for the same
amount with the same maturity it would have been required to pay an annual coupon of 4% of the par value.
Therefore, on the face of it, the debt contains an embedded feature that represents a swap with an initial fair
value of zero whereby Company F receives a fixed amount annually (1.5% of €10m) and pays a variable
amount annually (0.01% of its revenues). The question is now whether this feature represents an embedded
derivative that should be separated from the host contact by Company F and accounted for separately; see
embedded derivative guidance at 4 below.
It is very hard to argue that the economic characteristics and risks of this embedded feature are closely related
to the debt instrument and the variable (Company F’s revenue) is clearly specific to Company F. The key
issue is whether Company F’s revenue is a financial or non-financial variable and therefore whether the
embedded feature meets the definition of a derivative.
It is not only contracts with payments based on revenue that can cause such problems.
Some contracts may require payments based on other measures taken or derived from
an entity’s financial statements such as EBITDA. The Interpretations Committee
considered this matter in July 20066 and in January 2007 referred the matter to the
IASB.7 However, the IASB eventually decided not to deal with this issue.
Whilst it is tempting to regard an entity’s revenue and EBITDA as financial variables,
they are driven by a number of different factors many of which are clearly non-
financial in nature, for example the general business risks faced by the entity. In
addition, many of the drivers of EBITDA and revenue will be specific to that business,
for example the location of the business, the nature of its goods or services and
management actions.
One company that has faced this issue in practice is Groupe Renault. This company has
issued liabilities on which coupons are linked to revenue and net profit. As can be seen
in the following extract, Groupe Renault states that its revenue-linked and net profit-
linked features are considered embedded derivatives. The extract below is from
Groupe Renault’s 2017 accounts. Although this was disclosed under IAS 39 there is no
reason to believe that the outcome would be different under IFRS 9.
3452 Chapter 42
Extract 42.1: Groupe Renault (2017)
4.2.6 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENT [extract]
4.2.6.2 – ACCOUNTING POLICIES AND SCOPE OF CONSOLIDATION [extract]
Note 2 – Accounting policies [extract]
W – Financial liabilities of the Automotive segment and sales financing debts [extract]
Redeemable shares [extract]
In accordance with IAS 39, the Group considers that the variable interest on redeemable shares is an embedded
derivative [...]
Note 23 – Financial liabilities and sales financing debts [extract]
Redeemable shares [extract]
The redeemable shares issued in October 1983 and April 1984 by Renault SA are subordinated perpetual shares. They
earn a minimum annual return of 9% comprising a 6.75% fixed portion and a variable portion that depends on
consolidated revenues and is calculated based on identical Group structure and methods. [...]
The return on Diac redeemable shares issued in 1985 comprises a fixed portion equal to the annual monetary rate,
and a variable portion calculated by multiplying an amount equal to 40% of the annual monetary rate by the rate of
increase in net consolidated profit of the Diac sub-group compared to the prior year.
In 2009 the Interpretations Committee was asked to consider the accounting treatment
for an instrument that contains participation rights by which the instrument holder shares
in the net income and losses of the issuer. However, the Interpretations Committee
considered the issue without reconsidering the assumptions described in the request,
including one that the financial liability did not contain any embedded derivatives.8 In
other words, the Interpretations Committee implicitly accepted that such a feature need
not be separated but did not indicate that separation was necessarily prohibited.
In practice, we believe that an entity may make an accounting policy choice as to whether
the entity’s revenue, EBITDA or other measures taken or derived from the entity’s
financial statements, are financial or non-financial variables. Once an entity elects a
particular policy, it must consistently apply that approach to all similar transactions.
2.2
Initial net investment
The second key characteristic of a derivative is that it has no initial net investment, or one
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 (see 2 above). [IFRS 9 Appendix A].
An option contract meets the definition because the premium is less than the
investment that would be required to obtain the underlying financial instrument to
which the option is linked. [IFRS 9.BA.3].
The implementation guidance to IAS 39 suggested that the purchase of a deep in the
money call option would fail to satisfy the original ‘little net investment’ test if the
premium paid was equal or close to the amount required to invest in the underlying
instrument. However, the implementation guidance on which Example 42.8 below is
based explains that a contract is not a derivative if the initial net investment approximates
the amount that an entity otherwise would be required to invest. [IAS 39.IG B.9, IFRS 9.IG B.9].
Currency swaps sometimes require an exchange of different currencies of equal value
at inception. This does not mean that they would not meet the definition a derivative,
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Derivatives and embedded derivatives 3453
i.e. no initial net investment or an initial investment that is smaller than would be
&
nbsp; required for other types of contracts that would be expected to have a similar response
to changes in market factors, as the following example demonstrates.
Example 42.5: Currency swap – initial exchange of principal
Company A and Company B enter into a five year fixed-for-fixed currency swap on euros and US dollars.
The current spot exchange rate is €1 = US$1. The five year interest rate in the US is 8%, while the five year
interest rate in Europe is 6%. On initiation of the swap, Company A pays €2,000 to Company B, which in
return pays US$2,000 to Company A. During the swap’s life, Company A and Company B make periodic
interest payments to each other without netting. Company B pays 6% per year on the €2,000 it has received
(€120 per year), while Company A pays 8% per year on the US$2,000 it has received (US$160 per year). On
termination of the swap, the two parties again exchange the original principal amounts.
The currency swap is a derivative financial instrument since the contract involves a zero initial net investment
(an exchange of one currency for another of equal fair values), it has an underlying, and it will be settled at
a future date. [IFRS 9.BA.3].
The following examples illustrate how to assess the initial net investment characteristic
in various prepaid derivatives – these can provide guidance when assessing whether
what appears to be a non-derivative instrument is actually a derivative.
Example 42.6: Prepaid interest rate swap (prepaid fixed leg)
Company S enters into a €1,000 notional amount five year pay-fixed, receive-variable interest rate swap. The
interest rate of the variable part of the swap resets on a quarterly basis to three month LIBOR. The interest
rate of the fixed part of the swap is 10% per annum. At inception of the swap Company S prepays its fixed
obligation of €500 (€1,000 × 10% × 5 years), discounted using market interest rates, while retaining the right
to receive the LIBOR-based interest payments on the €1,000 over the life of the swap.
The initial net investment in the swap is significantly less than the notional amount on which the variable
payments under the variable leg will be calculated and therefore requires 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 conditions, such as a variable rate bond. It therefore fulfils the ‘no initial net investment
or an initial investment that is smaller than would be required for other types of contracts that would be
expected to have similar response to change in market factors’ criterion. Even though Company S has no
future performance obligation, the ultimate settlement of the contract is at a future date and its value changes
in response to changes in LIBOR. Accordingly, it is a derivative. [IFRS 9.IG B.4].
Example 42.7: Prepaid interest rate swap (prepaid floating leg)
Instead of the transactions in Example 42.6, Company S enters into a €1,000 notional amount five year pay-
variable, receive-fixed interest rate swap. The variable leg of the swap resets on a quarterly basis to three
month LIBOR. The fixed interest payments under the swap are calculated as 10% of the notional amount,
i.e. €100 per year. By agreement with the counterparty, Company S prepays and discharges its obligation
under the variable leg of the swap at inception by paying a fixed amount determined according to current
market rates, while retaining the right to receive the fixed interest payments of €100 per year.
The cash inflows under the contract are equivalent to those of a financial instrument with a fixed annuity stream
since Company S knows it will receive €100 per year over the life of the swap. Therefore, all else being equal,
the initial investment in the contract should equal that of other financial instruments consisting of fixed annuities.
Thus, the initial net investment in the pay-variable, receive-fixed interest rate swap is equal to the investment
required in a non-derivative contract that has a similar response to changes in market conditions. For this reason,
the instrument does not exhibit characteristic ‘no initial net investment or an initial investment that is smaller
than would be required for other types of contracts that would be expected to have similar response to changes
in market factors’ requirement and is therefore not a derivative. [IFRS 9.IG B.5].
The conclusions in Examples 42.6 and 42.7 above are fundamentally different for what,
on the face of it, appear to be very similar transactions. The key difference is that in
3454 Chapter 42
Example 42.7 all possible cash flow variances are eliminated and, consequently, the
resulting cash flows exhibit the characteristics of a simple non-derivative instrument,
i.e. an amortising loan.
Example 42.8: Prepaid forward purchase of shares
Company S also enters into a forward contract to purchase 100 shares in Company T in one year. The current
share price is €50 per share and the one year forward price €55. Company S is required to prepay the forward
contract at inception with a €5,000 payment.
The initial investment in the forward contract of €5,000 is less than the notional amount applied to the underlying,
100 shares at the forward price of €55 per share, i.e. €5,500. However, the initial net investment approximates the
investment that would be required for other types of contracts that would be expected to have a similar response
to changes in market factors because Company T’s shares could be purchased at inception for the same price of
€50. Accordingly, the prepaid forward does not exhibit characteristic ‘no initial net investment or an initial
investment that is smaller than would be required for other types of contracts that would be expected to have
similar response to changes in market factors’ criterion and is therefore not a derivative. [IFRS 9.IG B.9].
Many derivative instruments, such as futures contracts and exchange traded written
options, require margin payments. The implementation guidance explains that a margin
payment is not part of the initial net investment in a derivative, but is a form of collateral
for the counterparty or clearing-house and may take the form of cash, securities, or
other specified assets, typically liquid assets. Consequently, they are separate assets that
are accounted for separately. [IFRS 9.IG B.10].
However, while accounted for separately, the margin call and the derivative would be
presented net in the statement of financial position if the offsetting requirements of
IAS 32 – Financial Instruments: Presentation – are met (see Chapter 50 at 7.4.1). In
some jurisdictions, depending on the precise terms of the related contracts, margin
payments may actually represent a partial settlement of a derivative.
2.3 Future
settlement
The third characteristic is that settlement takes place at a future date. Sometimes, a
contract will require gross cash settlement. However, as illustrated in the next example,
it makes no difference whether the future settlements are gross or net.
Example 42.9: Interest rate swap – gross or net settlement
Company ABC is considering entering into an interest rate swap with a counterparty, Company XYZ. The
proposed terms are that Company ABC pays a fixed rate of 8% and receives a variable amount based on three
month LIBOR, reset on a quarterly bas
is; the fixed and variable amounts are determined based on a €1,000
notional amount; Company ABC and Company XYZ do not exchange the notional amount and
Company ABC pays or receives a net cash amount each quarter based on the difference between 8% and
three month LIBOR. Alternatively, settlement may be on a gross basis.
The contract meets the definition of a derivative regardless of whether there is net or gross settlement because
its value changes in response to changes in an underlying variable (LIBOR), there is no initial net investment
and settlements occur at future dates – it makes no difference whether Company ABC and Company XYZ
actually make the interest payments to each other (gross settlement) or settle on a net basis. [IFRS 9.IG B.3].
The definition of a derivative also includes contracts that are settled gross by delivery
of the underlying item, e.g. a forward contract to purchase a fixed rate debt instrument.
An entity may have a contract to buy or sell a non-financial item that can be settled net,
e.g. a contract to buy or sell a commodity at a fixed price at a future date; if that contract
is within the scope of IFRS 9 (see Chapter 41 at 4), then the question of whether or not
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Derivatives and embedded derivatives 3455
it meets the definition of a derivative will be assessed in the same way as for a financial
instrument that may be settled gross. [IFRS 9.BA.2].
Expiry of an option at its maturity is a form of settlement even though there is no
additional exchange of consideration. Therefore, even if an option is not expected to
be exercised, e.g. because it is significantly ‘out of the money’, it can still be a derivative.
[IFRS 9.IG B.7]. Such an option will have some value, albeit small, because it still offers the
opportunity for gain if it becomes ‘in the money’ before expiry even if such a possibility
is remote – the more remote the possibility, the lower its value.
3
EXAMPLES OF DERIVATIVES
3.1 Common
derivatives
The following table provides examples of contracts that normally qualify as derivatives.
The list is not exhaustive – any contract that has an underlying may be a derivative.
Moreover, as set out in Chapter 41 at 3, even if an instrument meets the definition of a
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