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similar contract without the interest rate floor (i.e. the host contract); and
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• the appropriate market rate of interest for the host contract should be determined by
considering the specific forms of the host contract and the relevant spreads (including
credit spreads) appropriate for the transaction. They also noted that the term market
rate of interest is linked to the concept of fair value as defined in IFRS 13 and is
described in IFRS 9 as the rate of interest ‘for a similar instrument (similar to currency,
term, type of interest and other factors) with a similar credit rating’. [IFRS 9.B5.1.1].
The Interpretations Committee determined that neither an Interpretation nor an
amendment to a Standard was necessary and did not add this issue to its agenda.12
In practice entities perform the assessment of whether a cap or floor is ‘at or below
market interest’ by either considering the cap or floor as a single instrument and
applying the current swap rate, or by considering the component caplets and floorlets
making up the overall cap or floor using the forward rate for the payment date of each
particular caplet or floorlet.
Where, in making the assessment on the cap or floor as a single instrument, an entity
determines that the cap or floor is not closely related, then the whole embedded cap or
floor is accounted for as a single non-closely related embedded derivative at fair value
through profit or loss.
5.1.5
Inflation-linked debt instruments
It is quite common for some entities (and governments) to issue inflation-linked debt
instruments, i.e. where interest and/or principal payments are linked to, say, a consumer
price index. The only embedded derivative guidance in IFRS 9 relating to embedded
inflation-linked features is provided in the context of leases (see 5.3.2 below). If that
guidance is accepted as applying to finance leases, it should also apply to debt instruments
because finance leases result in assets and liabilities that are, in substance, no different to
debt instruments (see Chapter 41 at 2.2.4). Further, in much finance theory, either real
(applied to current prices) or nominal (applied to inflation adjusted prices) interest rates are
used, suggesting a strong link between inflation and interest rates. Finally, a government or
central bank will generally raise short-term interest rates as inflation rises and reduce rates
as inflation recedes, which also suggests a close relationship between the two.
Therefore, we believe it would often be appropriate to treat the embedded derivative
in inflation-linked debt as similar to an interest rate index and refer to the guidance
at 5.1.2 above to determine whether the index is regarded as closely related to the debt.
Typically, the index will be closely related to the debt where it is based on inflation in
an economic environment in which the bond is issued/denominated, it is not
significantly leveraged in relation to the debt and there is a sufficiently low risk of the
investor not recovering its initial investment (only sometimes do such instruments
provide an absolute guarantee that the principal will not be lost, although this situation
will normally only arise if, over the life of the instrument, cumulative inflation is
negative). However, some may argue that even if there is a very small risk of the initial
investment not being recovered, the embedded derivative should be separated.
The staff of the Interpretations Committee has expressed a view that it would be
appropriate to treat the embedded derivative in inflation-linked debt as closely related
in economic environments where interest rates are mainly set so as to meet inflation
3466 Chapter 42
targets, as evidenced by strong long-run correlation between nominal interest rates and
inflation. In such jurisdictions they considered the characteristics and risks of the
inflation embedded derivative to be closely related to the host debt contract.13 Further,
in debating the application of the effective interest method to such instruments (see
Chapter 46 at 3.6) they have implicitly acknowledged that these instruments do not
necessarily contain embedded derivatives requiring separation.
5.1.6
Commodity- and equity-linked interest and principal payments
Equity-indexed or commodity-indexed interest or principal payments embedded in a
host debt instrument, i.e. where the amount of interest or principal is indexed to the value
of an equity instrument or commodity (e.g. gold), are not closely related to the host debt
instrument because the risks inherent in the embedded derivative are dissimilar to those
of the host. [IFRS 9.B4.3.5(c)-(d)]. This is illustrated in the following example.
Example 42.15: Bond linked to commodity price
A mining company issues a ten year debt instrument for its par value of US$15m. Interest is payable annually
and consists of guaranteed interest of 5% per annum and contingent interest of 0.5% if the price of commodity
A increases above US$300 in the relevant year, 1% if the price of commodity A increases above US$400 in
the relevant year or 1.5% if the price of commodity A increases above US$500 in the relevant year. The
mining company could have issued the bond without the contingent interest rate feature at a rate of 6%.
The commodity price feature is a swap contract to receive 1% fixed interest and pay a variable amount of
interest depending on the price of commodity A. This feature is not closely related to the debt host contract.
A common type of transaction is where refiners of commodities enter into purchase
contracts for mineral ores, whereby the price is adjusted subsequent to delivery, based
on the quoted market price of the refined commodity extracted from the ore. These
arrangements, often called provisionally-priced contracts, can provide the refiner with a
hedge of the fair value of its inventories and/or related sales proceeds which vary
depending on subsequent changes in quoted commodity prices. Like the debt instruments
noted above, any payable (or receivable) recognised at the time of delivery will contain
an embedded commodity derivative. In these circumstances, provided the payable is held
at fair value through profit or loss, it is unlikely to make much difference to the amount
recognised whether the embedded derivative is separated or not. Since the receivable is
an asset within the scope of IFRS 9 the embedded derivative could not be separated.
However, it would not normally be regarded as necessary to account separately for such
an embedded derivative prior to delivery of the non-financial item. This is because, until
delivery occurs, the contract is considered executory and the pricing feature would be
considered closely related to the commodity being delivered (see 5.2.2 below).
5.1.7 Credit-linked
notes
Credit derivatives are sometimes embedded in a host debt instrument whereby one party
(the ‘beneficiary’) transfers the credit risk of a particular reference asset, which it may not
own, to another party (the ‘guarantor’). Such credit derivatives allow the guarantor to assume
the credit risk associated with the reference asset without directly owning it. [IFRS 9.B4.3.5(f)].
&nbs
p; Whilst the economic characteristics of a debt instrument will include credit risk, should
the embedded derivative be a credit derivative linked to the credit standing of an entity
other than the issuer, it would not normally be regarded as closely related to the host
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debt instrument if the issuer were not required, through the terms of the financial
instrument, to own the reference asset.
For example, an entity (commonly a structured entity) may issue various tranches of
debt instruments that are referenced to a group of assets, such as a portfolio of bonds,
mortgages or trade receivables, and the credit exposure from those assets is allocated
to the debt instruments using a so called ‘waterfall’ feature. The waterfall feature itself
does not normally result in the separation of an embedded credit derivative; it is the
location or ownership of the reference assets that is most important to the assessment.14
If the structured entity is required to hold the reference assets, the credit risk embedded
in the debt instruments is considered closely related. However, if the issuer of the debt
instruments held a credit derivative over the reference assets rather than the assets
themselves, the embedded credit derivative would not be regarded as closely related.
5.1.8
Instruments with an equity kicker
In some instances, venture capital entities provide subordinated loans on terms that
entitle them to receive shares if and when the borrowing entity lists its shares on a stock
exchange, as illustrated in the following example.
Example 42.16: Equity kicker
A venture capital investor, Company V, provides a subordinated loan to Company A and agrees that in
addition to interest and repayment of principal, if Company A lists its shares on a stock exchange,
Company V will be entitled to receive shares in Company A free of charge or at a very low price (an ‘equity
kicker’). As a result of this feature, interest on the loan is lower than it would otherwise be. The loan is not
measured at fair value with changes in fair value recognised in profit or loss.
The economic characteristics and risks of an equity return are not closely related to those of the host debt instrument.
The equity kicker meets the definition of a derivative because it has a value that changes in response to the change
in the price of Company A’s shares, requires only a relatively small initial net investment, and is settled at a future
date. It does not matter that the right to receive shares is contingent upon the borrower’s future listing [IFRS 9.IG C.4]
(although the probability of this event occurring will influence the fair value of the embedded derivative).
Similarly, the derivative embedded in a bond that is convertible (or exchangeable) into
equity shares of a third party will not be closely related to the host debt instrument.
5.1.9 Puttable
instruments
Another example of a hybrid contract is a financial instrument that gives the holder a
right to put it back to the issuer in exchange for an amount that varies on the basis of
the change in an equity or commodity price or index (a ‘puttable instrument’). Where
the host is a debt instrument, the embedded derivative, the indexed principal payment,
cannot be regarded as closely related to that debt instrument. Because the principal
payment can increase and decrease, the embedded derivative is a non-option derivative
whose value is indexed to the underlying variable (see 6.1 below). [IFRS 9.B4.3.5(a), B4.3.6].
From the perspective of the issuer of a puttable instrument, that can be put back at any
time for cash equal to a proportionate share of the net asset value of an entity (such as
units of an open-ended mutual fund or some unit-linked investment products), the
effect of the issuer separating an embedded derivative and accounting for each
component is to measure the combined instrument at the redemption amount, that
would be payable at the end of the reporting period, if the holder were to exercise its
right to put the instrument back to the issuer. [IFRS 9.B4.3.7].
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For the holder of such an instrument, the requirements of the standard are applied to
the instrument as a whole, resulting in such investments in puttable instruments being
recognised at fair value through profit or loss in their entirety. [IFRS 9.4.3.2].
This treatment was clarified by the Interpretations Committee in May 2017 when the
Committee confirmed that the election to present subsequent changes in fair value in
other comprehensive income was not available to these instruments, as they did not
meet the definition of an equity instrument.15
Whilst it was not explicitly stated, the ineligibility of such instruments to make this
election means they must be recognised at fair value through profit or loss.
5.2
Contracts for the sale of goods or services
5.2.1
Foreign currency derivatives
An embedded foreign currency derivative in a contract that is not a financial instrument
is closely related to the host contract provided it is not leveraged, does not contain an
option feature and requires payments denominated in one of the following currencies:
(i)
the functional currency of any substantial party to the contract – see 5.2.1.A below;
(ii) the currency in which the price of the related good or service that is acquired or
delivered is routinely denominated in commercial transactions around the world
(such as the US dollar for crude oil transactions) – see 5.2.1.B below; or
(iii) a currency that is commonly used in contracts to purchase or sell non-financial
items in the economic environment in which the transaction takes place (e.g. a
relatively stable and liquid currency that is commonly used in local business
transactions or external trade) – see 5.2.1.C below.
Therefore, in such cases the embedded foreign currency derivative is not accounted for
separately from the host contract. [IFRS 9.B4.3.8(d)]. An example would be a contract for
the purchase or sale of a non-financial item, where the price is denominated in a foreign
currency that meets one of the three criteria outlined above.
5.2.1.A
Functional currency of counterparty
In principle, the assessment of exception (i) above is straightforward. In practice, however,
the functional currency of the counterparty to a contract will not always be known with
certainty and, in some cases, can be a somewhat subjective assessment even for the
counterparty’s management (assuming the counterparty is a corporate entity) – see
Chapter 15 at 4. Consequently, entities will need to demonstrate they have taken
appropriate steps to make a reasonable judgement as to their counterparties’ functional
currencies. Where available, a counterparty’s financial statements will provide evidence of
its functional currency. Otherwise, it would often be appropriate to assume that an entity
operating in a single country has that country’s currency as its functional currency, although
if there were indicators to the contrary these would have to be taken into account.
Another practical problem that arises in applying this exception is identifying which
; parties to a contract are ‘substantial’. IFRS 9 does not provide any further guidance, but
it is generally considered that such a party should be one that is acting as principal to
the contract. Therefore if, as part of a contract, a parent provides a performance
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guarantee in respect of services to be provided by its operating subsidiary, the parent
may be seen to be the substantial party to the contract and not the subsidiary, where
the subsidiary is acting as an agent. However, if the guarantee is not expected to be
called upon, the parent would not normally be considered a substantial party to the
contract. Particular care is necessary when assessing a contract under which one party
subcontracts an element of the work to another entity under common control, say a
fellow subsidiary with a different functional currency, although in most cases it will only
be the primary contractor that is considered a substantial party.
5.2.1.B Routinely
denominated
in commercial transactions
For the purposes of exception (ii) above, the currency must be used for similar
transactions all around the world, not just in one local area. For example, if cross-border
transactions in natural gas in North America are routinely denominated in US dollars
and such transactions are routinely denominated in euros in Europe, neither the US
dollar nor the euro is a currency in which the good or service is routinely denominated
in international commerce. [IFRS 9.IG C.9]. Accordingly, the number of items to which this
will apply will be limited – in practice it will be mainly commodities that are traded in,
say, US dollars throughout much of the world. Examples include crude oil, jet fuel,
certain base metals (including aluminium, copper and nickel) and some precious metals
(including gold, silver and platinum). One other notable item might be wide-bodied
aircraft where it appears that Boeing and Airbus, the two major manufacturers,
routinely denominate sales in US dollars.
In September 2014 the Interpretations Committee received a request relating to the
routinely denominated criterion. They were asked to consider whether a licensing
agreement denominated in a currency, in which commercial transactions of that type