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Date:16th March 2010 |
Compiled by: Sathya |
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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
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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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