International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
Page 684
contract. With LIBOR being 0.5% this will most likely be the case, leaving both parts of condition (b)
above fulfilled. The embedded derivative is therefore not closely related to the host contract and will be
accounted for separately. If however, it is concluded that 9% is not twice the market return for a contract
with the same terms as the host contract, then only one part of the condition under (b) above would be
fulfilled and the embedded feature would be considered closely related to the host with no requirement
to record it separately.
5.1.3
Term extension and similar call, put and prepayment options in debt
instruments
The application guidance explains that a call, put or prepayment option embedded in a
host debt instrument is closely related to the host instrument if, on each exercise date,
the option’s exercise price is approximately equal to the debt instrument’s amortised
cost or the exercise price reimburses the lender for an amount up to the approximate
present value of lost interest for the remaining term of the host contract; otherwise it is
not regarded as closely related. [IFRS 9.B4.3.5(e)].
There is no elaboration on what is meant by the term ‘approximately equal’ and so
judgement will need to be applied. In assessing whether the exercise price is
approximately equal to the amortised cost at each exercise date, should one consider
the amortised cost of the hybrid that would reflect the entity’s original expectations
regarding the future exercise of the prepayment option, or potential revised estimates
applying the catch up method to the amortised cost? This question is illustrated in the
Financial
instruments:
Derivatives and embedded derivatives 3461
following simple example (which also provides further illustrations of the application of
the effective interest method to instruments containing prepayment options).
Example 42.13: Embedded prepayment option
Company P borrows €1,000 on terms that require it to pay annual fixed-rate coupons of €80 and €1,000
principal at the end of ten years. The terms of the instrument also allow Company P to redeem the debt after
seven years by paying the principal of €1,000 and a penalty of €100.
The debt instrument can be considered to comprise the following two components:
• a host debt instrument requiring ten annual payments of €80 followed by a €1,000 payment of principal;
and
• an embedded prepayment option, exercisable only at the end of seven years with an exercise price
of €1,100.
If, at inception, the prepayment option was expected not to be exercised, the effective interest rate of the
hybrid would be 8%. This is the rate that would discount the expected cash flows of €80 per year for ten
years plus €1,000 at the end of ten years to the initial carrying amount of €1,000. The table below provides
information about the amortised cost, interest income and cash flows using this assumption.
(a)
(b = a × 8%)
(c)
(d = a + b – c)
Amortised cost at the
Interest and similar
Amortised cost at the
start of the year
income Cash
flows end of the year
Year (€)
(€)
(€)
(€)
1 1,000
80
80
1,000
2 1,000
80
80
1,000
3 1,000
80
80
1,000
4 1,000
80
80
1,000
5 1,000
80
80
1,000
6 1,000
80
80
1,000
7 1,000
80
80
1,000
8 1,000
80
80
1,000
9 1,000
80
80
1,000
10 1,000
80
80
+
1,000
–
However if, at the outset, the option was expected to be exercised, the effective interest rate of the hybrid
would be 9.08% as this is the rate that discounts the expected cash flows of €80 per year for seven years, plus
€1,100 at the end of seven years, to the initial carrying amount of €1,000. The table below provides
information about the amortised cost, interest income and cash flows using this alternative assumption.
(a)
(b = a × 9.08%)
(c)
(d = a + b – c)
Amortised cost at the
Interest and similar
Amortised cost at the
start of the year
income Cash
flows
end of the year
Year (€)
(€)
(€)
(€)
1 1,000
91
80
1,011
2 1,011
92
80
1,023
3 1,023
93
80
1,036
4 1,036
94
80
1,050
5 1,050
95
80
1,065
6 1,065
97
80
1,082
7 1,082
98
80
+
1,100
–
On the face of it, therefore, comparing the amortised cost of the hybrid with the exercise price of the option
at the date it could be exercised suggests the prepayment option might be considered closely related if it was
3462 Chapter 42
likely to be exercised (since the amortised cost will be approximately equal to the exercise price of €1,100)
but not if exercise was unlikely (since the amortised cost of €1,000 is not approximately equal to the exercise
price of €1,100).
Unfortunately, the standard is silent on this issue and preparers of accounts will be
required to exercise judgement as to the most appropriate method to use in their
individual circumstances.
The standard also says that an option or automatic provision to extend the remaining
term to maturity of a debt instrument is not closely related to the host unless, at the time
of the extension, there is a concurrent adjustment to the approximate current market
rate of interest. [IFRS 9.B4.3.5(b)]. The current market rate of interest would take into
consideration the credit risk of the issuer. Taken in isolation, this paragraph and the
first paragraph in this section on call, put or prepayment options appear reasonably
straightforward to apply. However, in some situations, they are contradictory as set out
in the following example.
Example 42.14: Extension and prepayment options
Company Z borrows €1,000 from Bank A on which it is required to pay €50 per annum interest. Under the
terms of the borrowing agreement, Company Z is required to repay €1,000 in three years’ time unless, at
repayment date, it exercises an option to extend the term of the borrowing for a further two years. If this
option is exercised €50 interest per annum is payable for
the additional term.
Company Z also borrows €1,000 from Bank B on which it is required to pay €50 per annum interest. Under
the terms of this borrowing agreement, Company Z is required to repay €1,000 in five years’ time unless, at
the end of three years, it exercises an option to redeem the borrowing for €1,000.
It can be seen that in all practical respects these two instruments are identical – the only difference is the way
in which the terms of the embedded options are expressed. In the first case the guidance indicates that the
(term extension) option is not closely related to the debt as there is no concurrent adjustment to market interest
rates. However, in the second case the (prepayment) option is considered closely related provided the
amortised cost of the liability would be approximately €1,000, the exercise price of the settlement option, at
the end of year three (which it should be).
As set out at 6.2 below, an embedded option-based derivative should be separated from
its host contract on the basis of the stated terms of the option feature. However, in
situations similar to the one described above, there is significant diversity in practice
and we are aware of at least two ways in which entities have dealt with this
contradiction in practice. Some entities have looked to the wording in the contract so
that what is described as an extension option (or a prepayment option) is evaluated in
accordance with the guidance for extension options (or prepayment options). Other
entities have determined the most likely outcome of the hybrid instrument based on
conditions at initial recognition and the alternative outcome is regarded as the ‘option’.
Under this latter approach, if Company Z in the example above considered it was likely
to repay its loans from Bank A and Bank B after three years, both loans would be
regarded as having a two-year extension option. The first approach is based on the
contractual terms, while the second approach is substance-based.
Another complication is that, viewed as a separate instrument, a term extension option
is effectively a loan commitment. As loan commitments are generally outside the scope
of IFRS 9, with the exception of derecognition and impairment provisions, (see
Chapter 41 at 3), some would argue they do not meet the definition of a derivative (see 2
above). Accordingly, when embedded in a host debt instrument, a loan commitment
Financial
instruments:
Derivatives and embedded derivatives 3463
would not be separated as an embedded derivative or, alternatively, would be separated
and accounted for as a loan commitment.9
The Interpretations Committee discussed both of the above contradictions in March 2012,
noting significant diversity in practice and recommended that the IASB consider this issue
when it redeliberated the classification and measurement requirements of financial
liabilities under IFRS 9. The Committee decided that if the Board did not address this issue
as part of its redeliberations, then the Committee would revisit this issue and consider
whether guidance should be provided to clarify the accounting for the issuer of a fixed-
rate-debt instrument that includes a term-extending option.10 This issue remains
unaddressed in IFRS 9 with no indication from the Interpretations Committee about
bringing it back onto its agenda. Preparers of financial statements are therefore left to apply
their own judgement considering all the facts and circumstances.
For put, call and prepayment options, there is a further complication that the
determination as to whether or not the option is closely related depends on the
amortised cost of the instrument. It is not clear whether this reference is to the
amortised cost of the host instrument, on the assumption that the option is separated,
or to the amortised cost of the entire instrument on the assumption that the option is
not separated. As can be seen in Chapter 46 at 3.4, the existence of such options can
affect the amortised cost, especially for a portfolio of instruments. Although one trade
body has published guidance explaining that where early repayment fees are included
in the calculation of effective interest, the prepayment option is likely to be closely
related to the loan,11 entities are largely left to apply their own judgement to assess
which appears the most appropriate in the specific circumstances.
Prepayment options are also considered closely related to the host debt instrument if
the exercise price reimburses the lender for an amount up to the approximate present
value of lost interest for the remaining term of the host contract. For these purposes,
lost interest is the product of the principal amount prepaid multiplied by the interest
rate differential, i.e. the excess of the effective interest rate of the host contract over
the effective interest rate that the entity would receive at the prepayment date if it
reinvested the principal amount prepaid in a similar contract for the remaining term of
the host contract. [IFRS 9.B4.3.5(e)(ii)]. In other words, in order for the prepayment option
to be considered closely related to the host, the exercise price of the prepayment option
would need to compensate the lender for loss of interest by reducing the economic loss
from that which would be incurred on reinvestment. [IFRS 9.BCZ4.97].
From the perspective of the issuer of a convertible debt instrument with an embedded
call or put option, the assessment of whether the option is closely related to the host
debt instrument is made before separating the equity element in accordance with
IAS 32. [IFRS 9.B4.3.5(e)]. This provides a specific relaxation from the general guidance on
prepayment options above because, for accounting purposes, separate accounting for
the equity component results in a discount on recognition of the liability component
(see Chapter 43 at 6.2), which means that the amortised cost and exercise price are
unlikely to approximate to each other for much of the term of the instrument.
An embedded prepayment option in an interest-only or principal-only strip is regarded
as closely related to the host contract provided the host contract (i) initially resulted
3464 Chapter 42
from separating the right to receive contractual cash flows of a financial instrument that,
in and of itself, did not contain an embedded derivative, and (ii) does not contain any
terms not present in the original host debt contract. [IFRS 9.B4.3.8(e)]. Again this is a specific
relaxation from the general guidance on prepayment options above.
If an entity issues a debt instrument and the holder writes a call option on the debt
instrument to a third party, the issuer regards the call option as extending the term to
maturity of the debt instrument, provided it can be required to participate in or facilitate
the remarketing of the debt instrument as a result of the call option being exercised.
[IFRS 9.B4.3.5(b)]. Such a component is presumably considered to represent part of a hybrid
financial instrument contract rather than a separate instrument in its own right (see 4 above).
5.1.4
Interest rate floors and caps
An embedded floor or cap on the interest rate on a debt instrument is closely related to
the host debt instrument, provided the cap is at or above the market ra
te of interest,
and the floor is at or below the market rate of interest, when the instrument is issued
(in other words it needs to be at- or out-of-the-money), and the cap or floor is not
leveraged in relation to the host instrument. [IFRS 9.B4.3.8(b)].
The standard does not clarify what is meant by ‘market rate of interest’, or whether the
cap (floor) should be considered as a single derivative or a series of caplets (floorlets) to
be evaluated separately. Where the cap (floor) is at a constant amount throughout the
term of the debt, historically entities have often compared the cap (floor) rate with the
current spot floating rate at inception of the contract to determine whether the embedded
derivative is closely related. However, in the current extremely low, or negative, interest
rate environment of many economies, floors are more commonly being set at higher rates
than current spot rates. As a result, entities are starting to evaluate whether more
sophisticated approaches to evaluate these features are more appropriate, e.g. by
comparing the average forward rate over the life of the bond with the floor rate or by
comparing the forward rate at each interest reset date with each floorlet rate. We do not
believe it is necessary for both a cap and a floor to be present to be considered closely
related. For example, a cap (or floor) on the coupon paid on a debt instrument without a
corresponding floor (or cap) could be regarded as closely related to the host, provided it
was above (or below) the market rate of interest on origination.
The Interpretations Committee was asked, in January 2016, to clarify the application of
the embedded derivatives requirements in a negative interest rate environment. The
Interpretations Committee observed that:
• IFRS 9.B4.3.8(b) does not distinguish between positive and negative interest rate
environments. As such an interest rate floor in a negative interest rate environment
should be treated in the same way as in a positive interest rate environment;
• when applying paragraph B4.3.8(b) of IFRS 9 in a positive or negative interest rate
environment, an entity should compare the overall interest rate floor (i.e. benchmark
interest rate referenced in the contract plus contractual spreads and if applicable any
premiums, discounts or other elements that would be relevant to the calculation of
the effective interest rate) for the hybrid contract to the market rate of interest for a