International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
Page 687
and therefore will not generally be considered to contain an embedded foreign
currency derivative requiring separation, because the liability is a monetary item within
the scope of IAS 21.
5.3.2 Inflation-linked
features
An embedded derivative in a lease is considered closely related to the host if it is an
inflation-related index such as an index of lease payments to a consumer price index,
provided that the lease is not leveraged and the index relates to inflation in the entity’s
own economic environment. [IFRS 9.B4.3.8(f)(i)].
5.3.3 Contingent
rentals
based on related sales
Where a lease requires contingent rentals based on related sales, that embedded
derivative is considered to be closely related to the host lease. [IFRS 9.B4.3.8(f)(ii)].
5.3.4 Contingent
rentals
based
on variable interest rates
If a derivative embedded within a lease arises from contingent rentals based on variable
interest rates, it is considered closely related. [IFRS 9.B4.3.8(f)(iii)].
5.4 Insurance
contracts
The guidance at 5.1.2 to 5.1.4, 5.1.6 and 5.2.1 above also applies to insurance contracts. IFRS 4
added two further illustrations to IFRS 9 that deal primarily with insurance contracts.
A unit-linking feature embedded in a host financial instrument, or host insurance
contract, is closely related to the host if the unit-denominated payments are measured
at current unit values that reflect the fair values of the assets of the fund. A unit-linking
feature is a contractual term that requires payments denominated in units of an internal
or external investment fund. [IFRS 9.B4.3.8(g)].
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Derivatives and embedded derivatives 3475
A derivative embedded in an insurance contract is closely related to the host if the
embedded derivative and host are so interdependent that the embedded derivative
cannot be measured separately, i.e. without considering the host contract.
[IFRS 9.B4.3.8(h)].
Derivatives embedded within insurance contracts are covered in more detail in
Chapter 51 at 4 for IFRS 4 and Chapter 52 at 4.1 for IFRS 17.
6
IDENTIFYING THE TERMS OF EMBEDDED DERIVATIVES
AND HOST CONTRACTS
The IASB has provided only limited guidance on determining the terms of a separated
embedded derivative and host contract. Accordingly, entities may find this aspect of the
embedded derivative requirements particularly difficult to implement. In addition to
the guidance set out below, Examples 42.17 and 42.18 above also identify the terms of
an embedded derivative requiring separation.
6.1
Embedded non-option derivatives
IFRS 9 does not define the term ‘non-option derivative’ but suggests that it includes
forwards, swaps and similar contracts. An embedded derivative of this type should be
separated from its host contract on the basis of its stated or implied substantive terms,
so as to result in it having a fair value of zero at initial recognition. [IFRS 9.B4.3.3].
The IASB has provided implementation guidance on separating non-option derivatives in
the situation where the host is a debt instrument. It is explained that, in the absence of
implied or stated terms, judgement will be necessary to identify the terms of the host (e.g.
whether it should be a fixed rate, variable rate or zero coupon instrument) and the embedded
derivative. However, an embedded derivative that is not already clearly present in the hybrid
should not be separated, i.e. a cash flow that does not exist cannot be created. [IFRS 9.IG C.1].
For example, if a five year debt instrument has fixed annual interest payments of £40
and a principal payment at maturity of £1,000 multiplied by the change in an equity
price index, it would be inappropriate to identify a floating rate host and an embedded
equity swap that has an offsetting floating rate leg. The host should be a fixed rate debt
instrument that pays £40 annually because there are no floating interest rate cash flows
in the hybrid instrument. [IFRS 9.IG C.1].
Further, as noted above, the terms of the embedded derivative should be determined
so that it has a fair value of zero on inception of the hybrid instrument. It is explained
that if an embedded non-option derivative could be separated on other terms, a single
hybrid instrument could be decomposed into an infinite variety of combinations of host
debt instruments and embedded derivatives. This might be achieved, for example, by
separating embedded derivatives with terms that create leverage, asymmetry or some
other risk exposure not already present in the hybrid instrument. [IFRS 9.IG C.1].
Finally, it is explained that the terms of the embedded derivative should be identified
based on the conditions existing when the financial instrument was issued, [IFRS 9.IG C.1],
or when a contract is required to be reassessed (see 7 below).
3476 Chapter 42
The following example illustrates how a foreign currency derivative embedded in a
(hybrid) lease contract, that is not closely related, could be separated.
Example 42.19: Separation of embedded derivative from lease
Company X has Indian Rupees (INR) as its functional currency. On 1 January 2018 Company X entered into
a nine month lease over an item of PP&E which required payments of US$100,000 on 31 March 2018,
30 June 2018 and 30 September 2018. The functional currency of the lessor is not US dollars; the price of
such leases is not routinely denominated in US dollars and US dollars is not a currency that is commonly
used in the economic environment in which the lease took place (see 5.3.1 above). Accordingly the embedded
foreign currency derivative is not closely related to the lease.
On 1 January 2018 the spot exchange rate was 40 and the forward exchange rates for settlement on
31 March 2018, 30 June 2018 and 30 September 2018 were 41, 42 and 43 respectively. The terms of the
embedded derivative could be determined as follows:
31 March 2018
Pay US$100,000
Receive INR4,100,000
30 June 2018
Pay US$100,000
Receive INR4,200,000
30 September 2018
Pay US$100,000
Receive INR4,300,000
Given the terms of the embedded derivative above, the host contract will be a nine month lease over the same
PP&E as the hybrid lease contract, commencing 1 January 2018 and with scheduled payments of INR 4,100,000,
INR 4,200,000 and INR 4,300,000 on 31 March 2018, 30 June 2018 and 30 September 2018. It can be seen that
this host after separation of the foreign currency derivative, an INR denominated lease, does not contain an
embedded derivative requiring separation and the combined terms of the two components sum to the terms of the
hybrid contract. IAS 17 or IFRS 16 will be applicable to this lease (see Chapters 23 and 24 respectively).
6.2
Embedded option-based derivative
As for non-option derivatives, IFRS 9 does not define the term ‘option-based
derivative’ but suggests that it includes puts, calls, caps, floors and swaptions. An
embedded derivative of this type should be separated from its host contract on the basis
of the sta
ted terms of the option feature. [IFRS 9.B4.3.3].
The implementation guidance explains that the economic nature of an option-based
derivative is fundamentally different from a non-option derivative and depends
critically on the strike price (or strike rate) specified for the option feature in the hybrid
instrument. Therefore, the separation of such a derivative should be based on the stated
terms of the option feature documented in the hybrid instrument. Consequently, in
contrast to the position for non-option derivatives (see 6.1 above), an embedded
option-based derivative would not normally have a fair value of zero. [IFRS 9.IG C.2].
In fact, if the terms of an embedded option-based derivative were identified so as to
result in it having a fair value of zero, the implied strike price would generally result in
the option being infinitely out-of-the-money, i.e. it would have a zero probability of
the option feature being exercised. However, since the probability of exercising the
option feature is generally not zero, this would be inconsistent with the likely economic
behaviour of the hybrid. [IFRS 9.IG C.2].
Similarly, if the terms were identified so as to achieve an intrinsic value of zero, the
strike price would equal the price of the underlying at initial recognition. In this case,
the fair value of the option would consist only of time value. However, this may also be
inconsistent with the likely economic behaviour of the hybrid, including the probability
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Derivatives and embedded derivatives 3477
of the option feature being exercised, unless the agreed strike price was indeed equal
to the price of the underlying at initial recognition. [IFRS 9.IG C.2].
6.3
Multiple embedded derivatives
Generally, multiple embedded derivatives in a single instrument should be treated as a
single compound embedded derivative. However, embedded derivatives that are
classified as equity are accounted for separately from those classified as assets or
liabilities (see Chapter 43 at 6). In addition, derivatives embedded in a single instrument
that relate to different risk exposures and are readily separable and independent of each
other, should be accounted for separately from each other. [IFRS 9.B4.3.4].
For example, if a debt instrument has a principal amount related to an equity index and
that amount doubles if the equity index exceeds a certain level, it is not appropriate to
separate both a forward and an option on the equity index because those derivative
features relate to the same risk exposure. Instead, the forward and option elements are
treated as a single compound embedded derivative. For the same reason, an embedded
floor or cap on interest rates should not be separated into a series of ‘floorlets’ or
‘caplets’ (i.e. single interest rate options).26
On the other hand, if a hybrid debt instrument contains, for example, two options that
give the holder a right to choose both the interest rate index on which interest payments
are determined and the currency in which the principal is repaid, those two options
may qualify for separation as two separate embedded derivatives since they relate to
different risk exposures and are readily separable and independent of each other.27
7
REASSESSMENT OF EMBEDDED DERIVATIVES
It is clear that, on initial recognition, a contract should be reviewed to assess whether it
contains one or more embedded derivatives requiring separation. However, the issue
arises whether an entity is required to continue to carry out this assessment after it first
becomes a party to a contract, and if so, with what frequency. [IFRS 9.BCZ4.99].
The question is relevant, for example, when the terms of the embedded derivative do
not change but market conditions change and the market was the principal factor in
determining whether the host contract and embedded derivative are closely related.
Instances when this might arise are embedded foreign currency derivatives in host
contracts that are insurance contracts or contracts for the purchase or sale of a non-
financial item denominated in a foreign currency. [IFRS 9.BCZ4.100, IFRS 9.B4.3.8(d)].
Consider, for example, an entity that enters into a purchase contract denominated in
US dollars. If, at the time the contract is entered into, US dollars are commonly used in
the economic environment in which the transaction takes place, the contract will not
contain an embedded foreign currency derivative requiring separation. Subsequently,
however, the economic environment may change such that transactions are now
commonly denominated in euros, rather than US dollars. Countries joining the
European Union may encounter just such a scenario.
Clearly, in this situation, an embedded foreign currency derivative would be separated
from any new US dollar denominated purchase contracts, assuming they would not
3478 Chapter 42
otherwise be considered closely related. However, should the entity separately account
for derivatives embedded within its existing US dollar denominated contracts that were
outstanding prior to the change in the market?
Conversely, the entity may have identified, and separately accounted for, embedded
foreign currency derivatives in contracts denominated in euros that were entered into
before the economic environment changed. Does the change in economic
circumstances mean that the embedded derivative should now be considered closely
related and not separately accounted for as a derivative? [IFRS 9.BCZ4.100-101].
IFRS 9 confirms that entities should assess whether an embedded derivative is required
to be separated from the host contract and accounted for as a derivative when the entity
first becomes a party to the contract. Subsequent reassessment is prohibited unless
there is a change in the terms of a contract that significantly modifies the cash flows
that otherwise would be required under the contract, in which case an assessment is
required. An entity determines whether a modification to cash flows is significant by
considering the extent to which the expected future cash flows associated with the
embedded derivative, the host contract or both have changed and whether the change
is significant relative to the previously expected cash flows on the contract.
[IFRS 9.B4.3.11].
For a financial liability, a change to the terms of the contract which significantly
modifies the cash flows may also require derecognition of the original instrument and
recognition of a new instrument. This is discussed in more detail in Chapter 48 at 6.
7.1
Acquisition of contracts
IFRS 9 requires an entity to assess whether an embedded derivative needs to be
separated from the host contract and accounted for as a derivative when it first becomes
a party to that contract. Therefore, if an entity purchases a contract that contains an
embedded derivative, it assesses whether the embedded derivative needs to be
separated and accounted for as a derivative on the basis of conditions at the date it
acquires it, not the date the original contract was established. [IFRS 9.BCZ4.106].
7.2 Business
combinations
From the point of view of a consolidated entity, the acquisition of a contract
within a
business combination accounted for using the acquisition method under IFRS 3 –
Business Combinations – is hardly different from the acquisition of a contract in
general. Consequently, an assessment of the acquiree’s contracts should be made on the
date of acquisition as if the contracts themselves had been acquired. [IFRS 3.15, 16(c)].
Neither IFRS 9 nor IFRS 3 applies to a combination of entities or businesses under
common control or the formation of a joint venture. [IFRS 3.2, IFRS 9.B4.3.12].
However, in our view, if the acquisition method is applied to such arrangements, the
requirements set out in IFRS 3 should be followed.
7.3
Remeasurement issues arising from reassessment
IFRS 9 does not address remeasurement issues arising from a reassessment of
embedded derivatives. One of the reasons for prohibiting reassessment in general was
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Derivatives and embedded derivatives 3479
the difficulty in determining the accounting treatment following a reassessment, which
is explained in the following terms.
Assume that an entity, when it first became party to a contract, separately recognised a
host asset not within the scope of IFRS 9, and an embedded derivative liability. If the
entity were required to reassess whether the embedded derivative was to be accounted
for separately and if the entity concluded some time after becoming a party to the
contract that the derivative was no longer required to be separated, then questions of
recognition and measurement would arise. In the above circumstances, the entity could:
[IFRS 9.BCZ4.105]
(a) remove the derivative from its statement of financial position and recognise in
profit or loss a corresponding gain or loss. This would lead to recognition of a gain
or loss even though there had been no transaction and no change in the value of
the total contract or its components;
(b) leave the derivative as a separate item in the statement of financial position. The
issue would then arise as to when the item is to be removed from the statement of
financial position. Should it be amortised (and, if so, how would the amortisation
affect the effective interest rate of the asset), or should it be derecognised only
when the asset is derecognised?
(c) combine the derivative (which is recognised at fair value) with the asset (which may