derivative, it may not fall within the scope of IFRS 9.
Type of contract
Main underlying variable
Interest rate swap Interest
rates
Currency swap (foreign exchange swap)
Currency rates
Commodity swap
Commodity prices
Equity swap
Equity prices (equity of another entity)
Credit swap
Credit rating, credit index, or credit price
Total return swap
Total fair value of the reference asset and interest rates
Purchased or written bond option (call or put)
Interest rates
Purchased or written currency option (call or put) Currency rates
Purchased or written commodity option (call or put)
Commodity prices
Purchased or written stock option (call or put)
Equity prices (equity of another entity)
Interest rate futures linked to government debt Interest rates
(treasury futures)
Currency futures
Currency rates
Commodity futures
Commodity prices
Interest rate forward linked to government debt Interest rates
(treasury forward)
Currency forward
Currency rates
Commodity forward
Commodity prices
Equity forward
Equity prices (equity of another entity) [IFRS 9.B.2]
3456 Chapter 42
3.2 In-substance
derivatives
The implementation guidance explains that the accounting should follow the substance
of arrangements. In particular, non-derivative transactions should be aggregated and
treated as a derivative when, in substance, the transactions result in a derivative.
Indicators of this would include:
• they are entered into at the same time and in contemplation of one another;
• they have the same counterparty;
• they relate to the same risk; and
• there is no apparent economic need or substantive business purpose for
structuring the transactions separately that could not also have been accomplished
in a single transaction. [IFRS 9.IG B.6].
The application of this guidance is illustrated in the following example.
Example 42.10: In-substance derivative – offsetting loans
Company A makes a five year fixed rate loan to Company B, while at the same time Company B makes a
five year variable rate loan for the same amount to Company A. There are no transfers of principal at
inception of the two loans, since Company A and Company B have a netting agreement.
The combined contractual effect of the loans is the equivalent of an interest rate swap arrangement, i.e. there is
an underlying variable, no initial net investment, and future settlement. This meets the definition of a derivative.
This would be the case even if there was no netting agreement, because the definition of a derivative
instrument does not require net settlement (see Example 42.9 at 2.3 above). [IFRS 9.IG B.6].
The analysis above would be equally applicable if the loans were in different currencies
– such an arrangement could synthesise a cross-currency interest rate swap and should
be accounted for as a derivative if that is its substance.
3.3
Regular way contracts
A regular way purchase or sale is a purchase or sale of a financial asset under a contract
whose terms require delivery of the asset within the time frame established generally
by regulation or convention in the marketplace concerned. [IFRS 9 Appendix A].
Such contracts give rise to a fixed price commitment between trade date and settlement
date that meets the definition of a derivative. However, because of the short duration of
the commitments, they are not accounted for as derivatives but in accordance with special
accounting rules. These requirements are discussed in Chapter 45 at 2.2. [IFRS 9.BA.4].
4 EMBEDDED
DERIVATIVES
An embedded derivative is a component of a hybrid or combined instrument that also
includes a non-derivative host contract; it has the effect that some of the cash flows of
the combined instrument vary in a similar way to a stand-alone derivative. In other words,
it causes some or all of the cash flows, that otherwise would be required by the contract,
to be modified according to a specified interest rate, financial instrument price,
commodity price, foreign exchange rate, index of prices or rates, credit rating or credit
index, or other underlying variable (provided in the case of a non-financial variable that
the variable is not specific to a party to the contract). [IFRS 9.4.3.1].
Financial
instruments:
Derivatives and embedded derivatives 3457
Common examples of contracts that can contain embedded derivatives include non-
derivative financial instruments (especially debt instruments), leases, insurance
contracts as well as contracts for the supply of goods or services. In fact, they may occur
in all sorts of unsuspected locations.
Under IFRS 9 the concept of embedded derivatives applies to only financial liabilities
and non-financial items. Embedded derivatives are not separated from financial assets
within the scope of IFRS 9 and the requirements of IFRS 9 are applied to the hybrid
contract as a whole. [IFRS 9.4.3.2].
Normal sale or purchase contracts (see Chapter 41 at 4) can also contain embedded
derivatives. This is an important difference from US GAAP, under which a contract for
the sale or purchase of a non-financial item, that can be settled net, cannot be treated
as a normal sale or purchase at all if it contains an embedded pricing feature, that is not
clearly and closely related to the host contract – instead the whole contract would be
accounted for as a derivative.
In the basis for conclusions to IFRS 9, the IASB asserts that, in principle, all embedded
derivatives that are not measured at fair value with gains and losses recognised in profit
or loss ought to be accounted for separately, but explains that, as a practical expedient,
they should not be where they are regarded as ‘closely related’ to their host contracts.
In those cases, it is believed less likely that the derivative was embedded to achieve a
desired accounting result. [IFRS 9.BCZ4.92].
Accordingly, only where all of the following conditions are met should an embedded
derivative be separated from the host contract and accounted for separately:
(a) the
economic
characteristics and risks of the embedded derivative are not closely
related to the economic characteristics and risks of the host contract;
(b) a separate instrument with the same terms as the embedded derivative would meet
the definition of a derivative; and
(c) the hybrid (combined) instrument is not measured at fair value with changes in fair
value recognised in profit or loss. [IFRS 9.4.3.3].
If any of these conditions are not met, the embedded derivative should not be
accounted for separately, [IFRS 9.4.3.3, IFRS 9.B4.3.8], i.e. an entity is prohibited from
separating an embedded derivative that is closely related to its host contract. The
process is similar, although not identical, to that applied when separating the equity
element of a compound instrument by th
e issuer under IAS 32 (see Chapter 43 at 6).
The assessment of the closely related criterion should be made when the entity first
becomes a party to a contract or in other words, on initial recognition of the contract
(see 7 below). [IFRS 9.B4.3.11].
The accounting treatment for a separated embedded derivative is the same as for a
standalone derivative. Such an instrument (actually, in this case, a component of an
instrument) will normally be recorded in the statement of financial position at fair value
with all changes in value being recognised in profit or loss (see 1 above, Chapter 46 at 2),
although there are some exceptions, e.g. embedded derivatives may be designated as a
hedging instrument in an effective hedge relationship in the same way as standalone
derivatives (see Chapter 49 at 3.2).
3458 Chapter 42
A derivative that is attached to a financial instrument but is contractually transferable
independently of that instrument, or has a different counterparty from that instrument,
is not an embedded derivative, but a separate financial instrument. [IFRS 9.4.3.1].
Where the embedded derivative’s fair value cannot be determined reliably on the basis
of its terms and conditions, it may be determined indirectly as the difference between
the hybrid (combined) instrument and the host instrument, if their fair values can be
determined. [IFRS 9.4.3.7]. If an entity is unable to measure an embedded derivative that
is required to be separated from its host, either on acquisition or subsequently, the
entire contract is designated at fair value through profit or loss. [IFRS 9.4.3.6].
5
EMBEDDED DERIVATIVES: THE MEANING OF ‘CLOSELY
RELATED’
The standard does not define what is meant by ‘closely related’. Instead, it illustrates
what was intended by providing a series of situations where the embedded derivative
is, or is not, regarded as closely related to the host. Making this determination can prove
very challenging, not least because the illustrations do not always seem to be consistent
with each other. This guidance is considered in the remainder of this subsection.
5.1 Financial
instrument
hosts
Where a host contract has no stated or predetermined maturity and represents a
residual interest in the net assets of an entity, its economic characteristics and risks are
those of an equity instrument. From the issuer’s perspective a hybrid instrument which
meets the conditions for classification as equity under IAS 32 (see Chapter 43) is
excluded from the scope of IFRS 9.
More commonly, if the host is not an equity instrument and meets the definition of a
financial instrument, then its economic characteristics and risks are those of a debt
instrument. [IFRS 9.B4.3.2]. From the issuer’s perspective the application of these
principles to debt hosts is considered at 5.1.1 to 5.1.8 below and to instruments that may
be debt or equity hosts are considered at 5.1.9 below.
The application of these principles are not relevant to the holder of debt or equity
instruments as embedded derivatives are not separated from financial assets within the
scope of IFRS 9 and the requirements of IFRS 9 are applied to the hybrid contract as a
whole. [IFRS 9.4.3.2].
5.1.1
Foreign currency monetary items
A monetary item denominated in a currency other than an entity’s functional currency
is accounted for under IAS 21 – The Effects of Changes in Foreign Exchange Rates –
with foreign currency gains and losses recognised in profit or loss. The embedded
foreign currency derivative is considered closely related to the debt host and is not
separated. In other words it would not be considered a functional currency monetary
item and a foreign currency forward contract. This also applies where the embedded
derivative in a host debt instrument provides a stream either of principal or of interest
payments denominated in a foreign currency (e.g. a dual currency bond). [IFRS 9.B4.3.8(c)].
Financial
instruments:
Derivatives and embedded derivatives 3459
5.1.2
Interest rate indices
Many debt instruments contain embedded interest rate indices that can change the
amount of interest that would otherwise be paid or received. One of the simplest
examples would be a floating rate loan whereby interest is paid quarterly based on three
month LIBOR. More complex examples might include the following:
• inverse floater – coupons are paid at a fixed rate minus LIBOR;
• levered inverse floater – as above but a multiplier greater than 1.0 is applied to the
resulting coupon;
• delevered floater – coupons lag overall movements in a specified rate, e.g.
coupons equal a proportion of the ten year constant maturity treasuries rate plus
a fixed premium; or
• range floater – interest is paid at a fixed rate but only for each day in a given period
that LIBOR is within a stated range.
In such cases the embedded derivative is closely related to the host debt instrument unless:
(a) the combined instrument can be settled in such a way that the holder would not
recover substantially all of its recognised investment; or
(b) the embedded derivative could at least double the holder’s initial rate of return on
the host contract and could result in a rate of return that is at least twice what the
market return would be for a contract with the same terms as the host contract
(often referred to as the ‘double-double test’). [IFRS 9.B4.3.8(a)].
If a holder is permitted, but not required, to settle the combined instrument in a manner
such that it does not recover substantially all of its recognised investment, e.g. puttable
debt, condition (a) is not satisfied and the embedded derivative is not separated. [IFRS 9.IG
C.10]. The standard does not define ‘substantially all’ and therefore judgement will need
to be applied, considering all relevant facts and circumstances.
To meet condition (b), the embedded derivative must be able to double the initial return
and result in a rate of return that is at least twice what would be expected for a similar
contract at the time it takes effect. If it meets only one part of this condition, but not the
other, the derivative is regarded as closely related to the host. Due to the requirement
‘could result in a rate of return that is at least twice what the market return would be
for a contract with the same terms as the host contract’, the derivative embedded in a
simple variable rate loan would be considered closely related to the host because the
variable rate at any specific time would be a market rate.
As with all embedded derivatives, the assessment of condition (a) and (b) above is
made when the entity becomes party to the contract on the basis of market
conditions existing at that time (see 4 above). It is important to note that the
assessment is based on the possibility of the holder not recovering its recognised
investment or doubling its initial return and obtaining twice the then-market return.
The likelihood of this happening is ignored in making the assessment. Therefore,
even if the likelihood of this happening is low, the embedded derivative has to be
se
parated from the host contract. The valuation of the embedded derivative would
however consider the low probability of this happening, possibly resulting in a
relatively low fair value at inception.
3460 Chapter 42
An example where the holder would not recover substantially all of its recognised
investment would be a bond which becomes immediately repayable if LIBOR increases
above a certain threshold, at an amount significantly lower than its issue price. A further
example is set out below.
Example 42.11: Leveraged inverse floater – not recovering substantially all of the
initial investment
Company A issues a leveraged inverse floater loan note for its par value of US$20m. Interest is payable
annually and is calculated as 10% minus 2 times three month LIBOR. At the time Company A issues the
loan note, three month LIBOR is 3%, giving an initial return of 4%. There is no floor imposed on the interest
rate and the rate could therefore be negative if LIBOR increases above 5%. In such a case, the investor would
need to pay interest on its investment, which would leave it unable to recover substantially all of its
recognised investment. The embedded derivative is therefore not closely related to the host contract and will
be accounted for separately by Company A.
An example of condition (b) above, the ‘double-double test’, is set out below.
Example 42.12: Leveraged inverse floater – ‘double-double test’
Assume the same fact pattern as in Example 42.11, except that there is a floor imposed on the coupon
rate so that rate could not be negative. In such a case, the investor would recover substantially all of its
recognised investment, meaning that no embedded derivative needs to be separated based on condition
(a) above. However, before Company A could conclude on whether or not an embedded derivative needs
to be recognised separately, it would need to evaluate condition (b) above. The first step is to assess
whether there is a possible scenario in which the initial return of the investor would at least double. If
LIBOR falls to 1% or to below 1%, say 0.5%, then the interest rate on the loan note would be 9%, which
is more than double the investor’s initial rate of return of 4%. The first part of the condition under (b)
above is therefore fulfilled.
The question is now whether 9% is twice the market return for a contract with the same terms as the host
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 683