Historically, in
India, a well-drafted contract could mean designing one’s financial statements.
Even if there is no specific need or desire to let contract terms dictate how
the balance sheet looks, it is clear that our accounting pronouncements often
fail to capture the true representation of the substance of transactions. One
such transaction is a contract containing embedded derivatives.
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 India’s
standpoint, these specific norms for accounting of financial instruments are
expected to be one of the major impact on convergence with International
Financial Reporting Standards (IFRS). Come 2011, entities will have to exercise
diligence when drafting contracts, bearing in mind their accounting
repercussions. The implication can be best understood with an example: a vanilla
convertible debenture will no longer be merely disclosed as a ‘Secured Loan’
with its Terms of Redemption or Conversion in parenthesis. Now, based on its
substance and true economic effect, it will be accounted as two contracts- a
‘debt instrument with an early settlement provision’ and ‘warrants to purchase
equity shares’, with both elements being assigned their fair values.
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 speci fied 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.
|
Instrument |
Host Contract |
Embedded Derivative |
|
Equity Instrument |
|
|
|
Irredeemable convertible
preference shares |
Ordinary shares/ Equity shares |
Written call option |
|
Debt Instrument |
|
|
|
Convertible bond |
Debt instrument |
Call option on equity securities |
|
Callable Debt |
Debt instrument |
Prepayment Option |
|
Leases |
|
|
|
Lease payments indexed to inflation in a with reference to
inflation-related index different economic environment |
Operating lease |
Payment determined with reference to
inflation-related index |
|
It is important to note that
although the requirement to separate an embedded derivative from a host contract
applies to both parties to a contract, the accounting treatments in the books of
both the parties might differ. For example, in the above case, if the lessor and
lessee are in different economic environments and the lease payments are
determined with reference to inflation-related index of the lessor’s economic
environment, only the lessee would be required to separate the embedded
derivative |
|
|
|
Operating lease payable in foreign currency |
Operating lease |
Foreign currency de nominated rent payments– foreign ex change forward
contacts |
|
Contingent rentals based on related sales in
operating lease contract
Executory Contracts
Purchase/ sale of goods in foreign currency |
Operating lease
Purchase/ sale contract |
Contingent Rentals
Foreign exchange forward contract |
|
Purchase/ sale of goods with option to make payment
in alternative currencies Convertible bond |
Purchase/ sale contract |
Option to make payment in
alternative currencies |
|
Is the contract classified as ‘fair value through profit or loss’ |
No
---------> |
Would it be a
derivative if it was free standing? |
Yes
---------> |
Is it closely
related to the host contract? |
No |
\/
|
Split & separately
account |
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
pay able
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. (India)
leases a property in UK to XYZ Ltd. The rentals are paid in pounds and increase
annually with the increase in inflation in UK.
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
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 UK. The
embed ded derivative is not leveraged
and relates to the economic environment in which the leased asset is located.
Therefore, it is closely related to the host lease.
Conclusion:
Closely related
]No
separate accounting
Example Rentals
based on sales
ABC Ltd. leases a
property in India to XYZ Ltd. The rentals consist of a base rental of Rs.
100,000 plus 5% of the lessee’s sales.
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 in flation,
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
India, ICAI has issued AS 30 Financial Instruments: Recognition and Measurement,
which is based on IAS 39. From the Indian standpoint, all entities other than
Small and Medium-sized Entities would have to apply the provisions of AS 30/ IAS
39. This implies that gaining knowledge of identification and separation of
embedded derivatives is absolutely inevitable for all accountancy professionals.
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