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Date: 22nd March 2010 |
Compiled by: M Sathya Kumar |
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Historically,
in Recognizing
the increasing usage of such complex contracts worldwide, a comprehensive
solution in the form of detailed measurement, accounting, presentation and
disclosure norms has been prescribed in International Accounting Standard
(IAS) 39 Financial Instruments: Recognition and Measurement. From
This
need not be perceived as a conceptual whirlwind. By unlearning what has been
learnt and letting go of structured thinking, the exemplified explanation
that follows will be enlightening and would help understand the true meaning
of ‘Substance over form’! Derivatives As
per IAS 39, a ‘derivative’ is a financial instrument or other contract
with all three of the following characteristics: a)
its value changes in response to the change in an underlying variable such as
interest rate, commodity or security price; b)
it requires no initial investment, or one that is smaller than would be
required for a contract with similar response to changes in market factors;
and c)
it is settled at a future date. Futures
contracts, forward contracts, options and swaps are the most common types of
derivatives. Examples of underlying relative to derivative contracts include:
·
Interest rates ·
Security prices ·
Commodity prices ·
Foreign exchange
rates ·
Market indices ·
Other variables
like sales volume indices created for settlement of derivatives ·
Non financial
variables (for eg. climatic or geological condition such as temperature or
rainfall) Derivative
instruments may either be free-standing or embedded in a financial instrument
or non-financial contract. Embedded derivatives Literally,
the term ‘embedded derivative’ would lead one to believe that it
is a derivative embedded in another contract. However, an ‘embedded
derivative is just a modification of cash flows (the definition of
derivative, as can be seen above, focuses only on change in value). IAS
39 describes an embedded derivative as ‘a component of a hybrid
(combined) instrument that also includes a non-derivative host
contract—with the effect that some of the cash flows of the combined
instrument vary in a way similar to a stand-alone derivative.’ To
put it in simple terms, embedded derivative is part of a host contract (a
clause or section) i.e. a contract feature which causes the cash flows from
that contract to be modified, based on any specified variable such as interest
rate, security price, commodity price, foreign exchange rate, index of prices
or rates or other variables which frequently change. For
example, an Indian company enters into a sales contract with another Indian
company, creating a host contract. If the contract is denominated in a
foreign currency, such as USD, to be settled at a future date, an embedded
derivative viz. a foreign exchange forward contract is created. In
practice, there are generally a handful of common types of host contracts
that have embedded derivatives. When
an embedded derivative is required to be separated from a host contract, it
must be measured at fair value on balance sheet date, with changes in fair
value being accounted for through the income statement, consistent with the
accounting for a freestanding derivative. The host contract’s carrying
value initially is the difference between the consideration paid or received
to acquire the hybrid contract and the embedded derivative’s fair
value. If
an entity finds it difficult to determine the fair value of the embedded
derivative, the entity will have to fair value the entire contract with gains
and losses recognised in the income statement.
No
| \/
Accounting & Measurement - separation of embedded
derivative from host contract An
embedded derivative is required to be separated from the host contract if,
and only if all three conditions are met: ·
the economic
characteristics and risks of the embedded derivative are not closely related
to the economic characteristics and risks of the host contract; ·
a separate
instrument with the same terms as the embedded derivative would meet the
definition of a derivative; and ·
the entire contract
is not measured at fair value with changes in fair value recognised in income
statement i.e. if the entire contract is fair valued, then separation of
embedded derivative is not required. These
requirements are designed to ensure that mark-to-market through the income
statement cannot be avoided by including – embedding – a
derivative in another contract or financial instrument that is not
marked-to-market through the income statement. What does "Closely related" mean? IAS
39 does not define ‘closely related’. Instead, the Application
Guidance to the standard provides examples of situations where the embedded
derivative is, or is not, closely related to the host contract (some of these
examples have been discussed below). In
general terms, an embedded derivative that modifies an instrument's inherent
risk would be considered as closely related (such as fixed rate to floating
rate swap – where the inherent risk of change in fair value of loan is
modified to interest rate risk & where both the risks depend on the
market rate of interest). Conversely, an embedded derivative that changes the
nature of the risks of a contract would not be closely related (such as
operating lease contract with contingent rentals based on related sales
– where one risk of change in lease rentals is modified to risk of
change in demand of a product, unrelated to the former risk). Common Transactional Examples Leverage embedded features in host contracts Even
if the embedded derivative is closely related to the host contract, it would
have to be separated from the host if there is a ‘leverage’
effect. IAS 39 does not define the term ‘leverage’. In general, a
hybrid instrument is said to contain embedded leverage features if the cash
flows are modified in a manner that multiply or otherwise exacerbate the
effect of changes in underlying. Example Leverage embedded features ABC
Ltd. takes a loan with a bank. The contractually determined interest rate is
calculated as [15 % - 3 X LIBOR] Here,
had the interest rate been [15% - LIBOR], the embedded derivate would have
been said to be closely related to the underlying LIBOR rate and hence not
separable. However, since the rate of interest depends on a multiple of LIBOR
(called ‘leverage’ effect), the embedded derivate shall be
separated. Conclusion:
Leverage embedded features ]Separate accounting Debt host contracts The
value of a debt instrument is determined by the interest rate that is
associated with the contract. The interest rate stipulated is usually a
function of the following factors: ·
Risk free interest
rate ·
Credit risk ·
Expected maturity ·
Liquidity risk Thus,
the embedded derivatives that affect the yield on debt instruments because of
any of the above factors would be considered to be closely related (unless
they are leveraged i.e. or do not change in the same direction). Example Issuer’s call option (similar to a loan payable
on demand) ABC
Ltd. issues five year zero coupon debt for proceeds of Rs. 8 crores (face
value of Rs. 10 crores). The debt is callable at face value in the event of a
change in control. The
application guidance to IAS 39 explains that such options embedded are not
closely related unless the option’s exercise price is approximately
equal to the host debt instrument’s amortised cost on the exercise
date. Here,
if the debt is called by the issuer, the option’s exercise price (face
value) would not be the same as the debt’s amortised cost at exercise
date. Conclusion:
Not closely related ]Separate accounting Example Pre-payment option ABC
Ltd. takes a fixed rate loan with a bank for Rs. 10 crores. It is repayable
in quarterly installments. There is a pre-payment option that may be
exercised on the first day of each quarter. The exercise price is the
remaining capital outstanding plus a penalty of Rs. 1 crore. An
entity may opt to pre-pay if the potential gain (say fall in interest rate)
from pre-payment is more than the penalty. Here,
as ABC Ltd. makes repayments, the amortised cost of the debt will change.
Given the penalty payable is fixed, the option’s exercise price
(outstanding principal + penalty) will always exceed the debt’s
amortised cost (present value of outstanding principal) at each exercise date. Conclusion:
Not closely related ]Separate accounting Example Term extending option ABC
Ltd. issues 9% fixed rate debt for a fixed term of 2 years. The entity is
able to extend the debt before its maturity for an additional 1 year at the
same 9 % interest. IAS
39 prescribes that such an option to extend the term is not closely related
to the host debt instrument, unless there is a reset of interest rate to
current market rate. Here,
ABC Ltd. can extend the term at the same interest rate and there is no reset
to current market rates. Hence it is not considered to be closely related to
the debt host. It is clearly a derivative that gives the option to the issuer
to refinance the debt at 9% if the market rates are rising. Conclusion:
Not closely related ]Separate accounting Example Equity conversion features ABC
Ltd. invests in 10,000 debentures of XYZ Ltd. ABC Ltd. has the option to
convert each debenture after 1 year into one equity share per debenture at
Rs. 500. ABC
Ltd. perspective (investor) Such
an option represents an embedded call option on the issuer’s equity
shares. Here, the host contract is the debentures and the underlying is the
equity shares and equity is never closely related to debt. Conclusion:
Not closely related ]Separate accounting XYZ
Ltd. perspective (issuer) The
written equity conversion option is an equity instrument. Conclusion:
Accounted as equity Lease host contracts Embedded
derivatives may be present in lease host contracts, whether the lease is an operating
lease or a finance lease. The approach for determining whether the derivative
is closely related is similar to that used for a debt host. As
evident from the table above, rent payments determined with reference to
local consumer price index and foreign currency denominated rent payments
could represent embedded derivatives in a lease host contract. It
is to be noted that since lease host contracts are not financial instruments,
the question of the contract being classified as ‘fair value through profit
or loss’ doesn’t arise. Therefore, in such cases, if the embedded
derivative is not closely related to the lease host, separate accounting
would be mandatory. Example Inflation indexed rentals ABC
Ltd. ( As
per AG 33(f) of IAS 39, an embedded derivative is closely related to its host
lease contract if it is an inflation-related index (such as an index of lease
payments to a consumer price index) provided ·
lease is not
leveraged (inflationary adjustment in a lease contract does not have an
effect of increasing the indexed cash flow by more than the normal rate of
inflation) and ·
the index relates
to inflation in the entity’s own economic environment (i.e. the
economic environment in which the leased asset is located) Here,
the rent payments will change in response to changes in the inflation index
of Conclusion:
Closely related ]No separate accounting Example Rentals based on sales ABC
Ltd. leases a property in As
per AG 33(f) of IAS 39, lease contracts may include contingent rentals that
are based on sales of the lessee. Such an embedded derivative is considered
to be closely related to the lease host contract. Conclusion: Closely related ]No separate accounting In
the Indian scenario, though many lease contracts have an escalation clause
that is an estimate of inflation, seldom is it directly related to an
inflation index. Thus, we may henceforth be required to compare the
escalation with the inflation index to decide whether the derivative is
closely related. Further,
the termination clause in the lease agreement that allows the lessee to
terminate the contract on payment of a penalty is also an embedded
derivative. This situation is similar in substance with the prepayment option
in debt instrument discussed above. Executory contracts Executory
contracts are not financial instruments and are scoped out of IAS 39.
However, the following executory contracts may contain embedded derivatives: ·
Contracts to buy or
sell non-financial assets ·
Commitments to meet
expected purchase, sale or usage requirements and expected to be settled by
physical delivery ·
Service contracts Price
adjustment features, inflation related features (similar to lease contracts)
and volume adjustment features are examples of embedded derivatives in
executory contracts. Example Coal purchase contract linked to changes in the price
of electricity ABC
Ltd. enters into a coal purchase contract that links the price of coal to
changes in the prevailing electricity price on the date of delivery. The
coal purchase contract is the host contract. The pricing formula is the
embedded derivative. In
assessing whether the embedded derivative is closely related to the host
executory contract, it would be necessary to establish whether the underlying
in a price adjustment feature is related or unrelated to the cost/fair value
of the goods or services being sold or purchased. Here,
although coal may be used for the production of electricity, the changes in
electricity prices do not affect cost or fair value of coal. Therefore, the
embedded derivative (the electricity price adjustment) is not closely related
to the host contract. Conclusion: Not closely related ]Separate accounting Example Variable penalty on non-fulfillment of buyer’s
commitment ABC
Ltd. enters into a contract guaranteeing to purchase 50 cars for ‘own
use’ from XYZ Ltd. during 2010. Subsequently, ABC Ltd. decides not to
purchase the cars from XYZ Ltd. A penalty of 20% of the market price of the
cars on the date of payment of penalty is charged. A
minimum annual commitment does not create a derivative as long as the entity
expects to purchase all the guaranteed volume for its ‘own use’.
However, if it becomes likely that the entity will not take the product and,
instead pay a penalty under the contract based on the market value of the
product or some other variable, an embedded derivative will arise. On the
other hand, if the amount of penalty is fixed or pre-determined, there is no
embedded derivative. Here,
changes in market price of the cars will affect the penalty’s carrying
value until the penalty is paid. Since it has become clear that non-performance
is likely, the embedded derivative needs to be separated. Conclusion: Not closely related ]Separate accounting Reassessment of Embedded Derivative International
Financial Reporting Interpretations Committee (IFRIC) 9 Reassessment of
Embedded Derivative, while addressing the question of whether separation is
required to be reconsidered throughout the life of the contract, describes
that an entity shall 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 the
contract that significantly modifies the cash flows. IFRS 9: Phase 1 of new standard to replace IAS 39 In
November 2009, International Accounting Standards Board issued IFRS 9
Financial Instruments on classification & measurement of financial
assets. This Standard will eventually replace IAS 39 and is effective from
2013. Consequent to its introduction, once the new Standard is applied,
majority of the contracts would be measured as a whole (i.e. host contract
and embedded derivative) at fair value, and hence no separation would be
required. However,
in Article
by Anand Banka, Chartered Accountant and |
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