were routinely denominated around the world, held an embedded foreign currency
derivative that was closely related to the economic characteristics of the host contract.16
The Interpretations Committee noted that the issue related to a contract for a specific
type of item and observed that an assessment of routinely denominated criterion is
based on evidence of whether or not such commercial transactions are denominated in
that currency all around the world and not merely in one local area. They further
observed that the assessment of the routinely denominated criterion is a question of
fact and is based on an assessment of available evidence.
5.2.1.C
Commonly used currencies
The IASB noted that the requirement to separate embedded foreign currency
derivatives may be burdensome for entities that operate in economies in which business
contracts denominated in a foreign currency are common. For example, entities
domiciled in small countries may find it convenient to denominate business contracts
with entities from other small countries in an internationally liquid currency (such as
the US dollar, euro or yen) rather than the local currency of any party to the transaction.
Also, an entity operating in a hyperinflationary economy may use a price list in a hard
currency to protect against inflation, for example an entity that has a foreign operation
in a hyperinflationary economy that denominates local contracts in the functional
currency of the parent. [IFRS 9.BCZ4.94].
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Unfortunately, however, the assessment of whether or not a particular currency meets
this requirement in a particular situation has not been straightforward in practice and
this question reached the attention of the Interpretations Committee in May 2007.
The Interpretations Committee debated this matter in four consecutive meetings before
referring the matter to the IASB. During its debates, the Interpretations Committee
noted that entities should:17
• Identify where the transaction takes place.
This is not as straightforward as it might seem. For example, consider a Polish
company that manufactures components in Poland and exports them to a third
party in the Czech Republic. Should the sale of components be regarded as a
transaction occurring in Poland or in the Czech Republic?18 It is likely that the
Polish company would regard it as occurring in Poland and the Czech entity in the
Czech Republic, but this is not entirely beyond debate; and
• Identify currencies that are commonly used in the economic environment in
which the transaction takes place.
Entities need to address what the population of transactions in the economic
environment is. Some might suggest that transactions to which (i) or (ii) above apply
should be excluded, although this is not a view shared by the staff of the Interpretations
Committee which considered that all transactions should be included.19
Entities should also consider what an economic environment is. The guidance, on
which Example 42.17 below is based, implies that a country could be an economic
environment. The references to local business transactions and to external trade
in (iii) above suggest that other examples of economic environment are the
external trade or internal trade environment of the country in which the
transaction takes place. The question remains as to whether there could be other
economic environments, for example the luxury goods market in a country.
Depending on the view taken, a different treatment could arise.20 In considering
the issue subsequently, the IASB staff noted their understanding that all of these
views (and possibly more, such as the internal or external trade of a specific
company) were being applied in practice.21
The Interpretations Committee had also been asked to provide guidance on how
to interpret the term ‘common’, but understandably was reluctant to do so.22 The
IASB staff noted that there is no guidance as to the quantum of transactions or
value that would need to be denominated in a foreign currency to conclude that
the currency was commonly used and that a related matter is whether ‘common’
should be considered in the context of a particular entity, of an industry, or of
a country.23
The IASB staff noted other related interpretive questions raised by constituents
including the following:24
• What evidence does an entity require to support the notion that the use of a
currency is common?
• Does the reporting entity need to investigate published statistics?
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• If the reporting entity has to look for statistics, what percentage of business needs
to be conducted in that currency to assert that use of the currency is common?
• Whether the consideration that a currency is commonly used should exclude from
the population set those transactions falling under (i) or (ii) above.
They concluded that there are a variety of views on the appropriate interpretation of
this guidance and, consequently, that there is significant diversity in practice.25
Ultimately, however, no additional guidance has been included within IFRS 9.
5.2.1.D
Examples and other practical issues
The application of the guidance above is illustrated in the examples below.
Example 42.17: Oil contract denominated in Swiss francs
A Norwegian company agrees to sell oil to a company in France. The oil contract is denominated in Swiss
francs, although oil contracts are routinely denominated in US dollars in international commerce and
Norwegian krone are commonly used in contracts to purchase or sell non-financial items in Norway. Neither
company carries out any significant activities in Swiss francs.
The Norwegian company should regard the supply contract as a host contract with an embedded foreign
currency forward to purchase Swiss francs. The French company should regard it as a host contract with an
embedded foreign currency forward to sell Swiss francs. [IFRS 9.IG C.7].
The implementation guidance on which this example is based does not state in which
currency the host contract should be denominated (this will also be the currency of the
second leg of the embedded forward contract). The currency should be chosen so that
the host does not contain an embedded derivative requiring separation. In theory,
therefore, it could be Norwegian krone or euro (the functional currencies of the parties
to the contract) or US dollars (the currency in which oil contracts are routinely
denominated in international commerce). Typically, however, an entity will use its own
functional currency to define the terms of the host contract and embedded derivative.
A second issue arises where the terms of the contract require delivery and payment on
different dates. For example, assume the contract was entered into on 1 January, with
delivery scheduled for 30 June and payment required by 30 September. Should the
embedded derivative be considered a six-month forward contract maturing on 30 June,
or a nine-month forward contract maturing on 30 September? Conceptually at least,
the latter approach seems more satisfactory, for example because
it does not introduce
into the notional terms cash flows at a point in time (i.e. on delivery) when none exist
in the combined contract. In practice, however, the former approach is used far more
often and is not without technical merit. For example, it avoids the recognition of an
embedded foreign currency derivative between the delivery and payment dates on
what would be a foreign currency denominated monetary item, something that is
prohibited by IFRS 9 (see 5.1.1 above).
Example 42.18: Oil contract, denominated in US dollars and containing a
leveraged foreign exchange payment
Company A, whose functional currency is the euro, enters into a contract with Company B, whose functional
currency is the Norwegian Krone, to purchase oil in six months for US$1,000. The host oil contract will be
settled by making and taking delivery in the normal course of business and is not accounted for as a financial
instrument because it qualifies as a normal sale or contract (see Chapter 41 at 4). The oil contract includes a
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leveraged foreign exchange provision whereby the parties, in addition to the provision of, and payment for,
oil will exchange an amount equal to the fluctuation in the exchange rate of the US dollar and Norwegian
Krone applied to a notional amount of US$100,000.
The payment of US$1,000 under the host oil contract can be viewed as a foreign currency derivative because the
dollar is neither Company A nor Company B’s functional currency. However, it would not be separated as the
US dollar is the currency in which crude oil transactions are routinely denominated in international commerce.
The leveraged foreign exchange provision is in addition to the required payment for the oil transaction. It is
unrelated to the host oil contract and is therefore separated and accounted for as an embedded derivative.
[IFRS 9.IG C.8].
In practice, all but the simplest contracts will contain other terms and features that can
often make it much more difficult to isolate the precise terms of the embedded foreign
currency derivative (and the host). For example, a clause may allow a purchaser to
terminate the contract in return for making a specified compensation payment to the
supplier – the standard offers little guidance as to whether such a feature should be
included within the terms of the host, of the embedded foreign currency derivative or,
possibly, of both. Other problematic terms can include options to defer the specified
delivery date and options to order additional goods or services.
5.2.2
Inputs, ingredients, substitutes and other proxy pricing mechanisms
It is common for the pricing of contracts for the supply of goods, services or other non-
financial items to be determined by reference to the price of inputs to, ingredients used
to generate, or substitutes for the non-financial item, especially where the non-financial
item is not itself quoted in an active market. For example, a provider of call centre
services may determine that a large proportion of the costs of providing the service will
be employee costs in a particular country. Accordingly, it may seek to link the price in
a long-term contract to supply its services to the relevant wage index, effectively to
provide an economic hedge of its exposure to changes in employee costs. Similarly, the
producer of goods may index the price of its product to the market value of
commodities that are used in the production process.
The standard contains little or no detailed guidance for determining whether or not
such pricing features should be considered closely related to the host contract.
However, the general requirement of the standard to assess the economic
characteristics and risks would suggest that where a good link to the inputs can be
established, such features will normally be considered closely related to the host, unless
they were significantly leveraged.
Other proxy pricing mechanisms may arise in long-term supply agreements for
commodities where there is no active market in the commodity. For example, in the
1980s, when natural gas first started to be extracted from the North Sea in significant
volumes, there was no active market for that gas and thus no market price on which to
base the price of long-term contracts. Because of this, suppliers and customers were
willing to enter into such contracts where the price was indexed to the market price of
other commodities such as crude oil that could potentially be used as a substitute for
gas. For contracts entered into before the development of an active gas market, such
features would normally be considered closely related, especially if similar pricing
mechanisms were commonly used by other participants in the market.
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Where there is an active market price for the non-financial items being supplied under
the contract, different considerations apply. The use of the proxy pricing mechanism is
a strong indication that the entity has entered into a speculative position and we would
not normally consider such features to be closely related to the host. The separation of
these types of embedded derivatives can be seen in the following extract from BP’s
financial statements. Although this was disclosed under IAS 39 there is no reason to
believe that the outcome would be different under IFRS 9.
Extract 42.2: 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 derivatives. 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.
5.2.3 Inflation-linked
features
Apart from that related to leases (see 5.3.2 below), there is no reference in the guidance
to contracts containing payments that are linked to inflation. Many types of contracts
contain inflation-linked payments and it would appear sensible to apply the guidance
in respect of leases to these contracts. Consider, for example, a long-term agreement to
supply services under which payments increase by reference to a general price index
and are not leveraged in any way. In cases such as this, the embedded inflation-linked
derivative would normally be considered closely related to the host, provided the index
related to a measure of inflation in an appropriate economic environment, such as the
one in which the services were being supplied.
5.2.4
Floors and caps
Similar to debt instruments (see 5.1.4 above), provisions within
a contract to purchase
or sell an asset (e.g. a commodity) that establishes a cap and a floor on the price to be
paid or received for the asset are closely related to the host contract if both the cap and
floor were out-of-the-money at inception and are not leveraged. [IFRS 9.B4.3.8(b)].
5.2.5
Fund performance fees
In the investment management industry, it is common for a fund manager to receive a
fee based on the performance of the assets managed in addition to a base fee. For
example, if a fund’s net asset value increases over its accounting year, the manager may
be entitled to a percentage of that increase. The contract for providing investment
management services to the fund clearly contains an embedded derivative (the
underlying is the value of the fund’s assets). However, whilst not addressed explicitly in
the standard, we would normally consider it appropriate to regard such features as
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closely related to the host contract. Performance-based fees are discussed in more
detail in Chapter 28 at 6.2.3 and Example 28.40.
5.3 Leases
5.3.1
Foreign currency derivatives
A finance lease payable or receivable, which is recognised in accordance with IAS 17 –
Leases, is accounted for as a financial instrument, albeit one that is not subject to all of
the measurement requirements of IFRS 9 (see Chapter 41 at 2.2.4). Therefore, a finance
lease denominated in a foreign currency will not generally be considered to contain an
embedded foreign currency derivative requiring separation, because the payable or
receivable is a monetary item within the scope of IAS 21.
However, under IAS 17, an operating lease is accounted for as an executory contract.
Accordingly, where the lease payments are denominated in a foreign currency, the
analysis at 5.2.1 above is applicable and it may be necessary to separate an embedded
derivative. See Example 42.19 at 6.1 below for an example of a foreign exchange
currency derivative requiring separation from a (hybrid) lease contract.
For lessors under IFRS 16 – Leases – the above considerations will not change.
For lessees under IFRS 16 a lease liability is also accounted for as a financial instrument
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