7.2_derivatives_and_embedded_derivatives_(insights_into_ifrs)

7.2 Derivatives and embedded derivatives (IAS 39, IFRIC 9) OVERVIEW OF CURRENTLY EFFECTIVE REQUIREMENTS CURRENTLY EFFECTIVE REQUIREMENTS This publication reflects IFRSs in issue at 1 August 2011. The currently effective requirements cover annual periods beginning on 1 January 2011. The requirements related to this topic are derived mainly from IAS 39 Financial Instruments: Recognition and Measurement. FORTHCOMING REQUIREMENTS AND FUTURE DEVELOPMENTS When a currently effective requirement will be changed by a new requirement that is issued but is not yet effective, it is marked with a # as a forthcoming requirement and the impact of the change is explained in the accompanying boxed text. The forthcoming requirements related to this topic are derived from IFRS 9 Financial Instruments, which is effective for annual periods beginning on or after 1 January 2013. The standard replaces the currently effective requirements in IAS 39 with respect to classification and measurement of financial assets and financial liabilities. The requirements of IFRS 9 is discussed in chapter 7A and, therefore the forthcoming requirements are not added after each currently effective requirement. Several paragraphs in this chapter refer to 'fair value' as the appropriate measurement basis. Guidance on fair value measurement is currently dispersed across various IFRSs. IFRS 13 Fair Value Measurement replaces most of the fair value measurement guidance contained in individual IFRSs with a single definition of fair value, provides fair value application guidance, and establishes a comprehensive disclosure framework for fair value measurements. The standard also changes some of the fair value terminology in other IFRSs. IFRS 13 is effective for annual periods beginning on or after 1 January 2013. See 1.2.57 and 7.6.260.50-269.80 for further details. The currently effective or forthcoming requirements may be subject to future developments and a brief outline of the relevant project(s) is given in Appendix III. 7.2.10  DERIVATIVES 7.2.20 Definition 7.2.20.10 A derivative is a financial instrument or other contract within the scope of IAS 39, the value of which changes in response to some underlying variable (e.g. an interest rate), that has an initial net investment smaller than would be required for other instruments that have a similar response to the variable, and that will be settled at a future date. [IAS 39.9] 7.2.20.20 The definition of a derivative does not require specific settlement features. As such, a contract that allows either net or gross settlement may be a derivative. [IAS 39.IGB.3] 7.2.20.30 In our view, a derivative should not be split into its component parts. For example, an interest rate collar should not be separated into an interest rate cap and an interest rate floor that are accounted for separately. 7.2.30 Change in value based on an 'underlying' 7.2.30.10 A derivative financial instrument is a financial instrument that provides the holder (or writer) with the right (or obligation) to receive (or pay) cash or another financial instrument in amounts determined by reference to price changes in an underlying price or index, or changes in foreign exchange or interest rates, at a future date. A derivative may have more than one underlying variable. [IAS 39.IGB.8] 7.2.30.20 A derivative usually has a notional amount, which can be an amount of currency, a number of shares, a number of units of weight or volume or other units specified in the contract. However, in our view contracts without notional amounts or with variable notional amounts also meet the definition of a derivative. In addition the holder or writer is not required to invest in or receive the notional amount at inception of the contract. [IAS 39.AG9] 7.2.30.30 A contract to pay or receive a fixed amount on the occurrence or non-occurrence of a future event meets the definition of a derivative, provided that this future event depends on a financial variable or a non-financial variable not specific to a party to the contract. For example, an entity may enter into a contract under which it will receive a fixed payment of 1,000 if a specified index increases by a determined number of points in the next month. The settlement amount is not based on and does not need to change proportionally with an underlying. 7.2.30.40 The underlying price change on which a derivative instrument is based may be that of a primary financial instrument (such as a bond or equity security) or a commodity (such as gold, oil or wheat), a rate (such as an interest rate), an index of prices (such as a stock exchange index) or some other indicator that has a measurable value. [IAS 39.IGB.2] 7.2.30.50 An option, forward or swap that is exercisable at the fair value of the underlying always has a fair value of zero. Therefore, it does not meet the definition of a derivative because its value does not depend on an underlying variable. [IAS 39.9] 7.2.30.60 The definition of a derivative excludes instruments with a non-financial underlying variable that is specific to a party to the contract. 7.2.30.70 IFRSs do not provide guidance on how to determine whether a non-financial variable is specific to a party. In our view, the analysis comprises two successive steps. 7.2.30.80 In our view, this exclusion is intended primarily to exclude insurance contracts. For example, a residual value guarantee on a motor vehicle, whereby the holder is compensated not only for declines in the market value of the vehicle but also for the condition of the vehicle, would not meet the definition of a derivative. 7.2.30.90 However, in our view items such as EBITDA, profit, sales volume (e.g. revenue) or the cash flows of one counterparty may be considered to be non-financial variables that are specific to a party to the contract even though such contracts do not meet the definition of an insurance contract (see 5.10.30). In our view, an entity should choose an accounting policy, to be applied consistently, as to whether such items are considered to be non-financial variables that are specific to a party to the contract. 7.2.30.100 If an instrument has more than one underlying variable (i.e. dual-indexed), with one underlying being a non- financial variable specific to one of the parties, then judgement is required in determining whether the instrument is a derivative. The assessment depends, in our view, on the predominant characteristics of the instrument. We believe a dual- indexed instrument is normally a derivative if it behaves in a manner that is highly correlated with the behaviour of the financial underlying variables. 7.2.30.110 For example, a contract to exchange an amount of foreign currency determined by the sales volume of the entity at a fixed exchange rate at a future date is accounted for as a derivative. Another example of a derivative is an 'equity kicker' feature under which the lender of a subordinated loan is entitled to receive shares of the borrower entity free of charge, if the shares are listed. [IAS 39.IGB.8, IGC.4] 7.2.40 No or a 'smaller' initial net investment 7.2.40.10 There is no quantified guidance as to how much smaller the initial net investment should be, compared with the investment required for other contracts that would be expected to have a similar response to changes in market factors, in order for the contract to meet the definition of a derivative. The standard requires that the initial net investment be less than the investment needed to acquire the underlying financial instrument to which the derivative is linked. However, 'less than' does not necessarily mean 'insignificant' in relation to the overall investment and needs to be interpreted on a relative basis. [IAS 39.AG11] 7.2.40.20 Debt and equity securities generally are not derivatives, although their fair values have similar responses to changes in the underlying (e.g. interest rates or a share price) as derivatives on these instruments. 7.2.40.30 Many derivatives, such as at-market forward contracts, do not have any initial net investment. 7.2.40.40 Purchased options normally require payment of an upfront premium, but the amount paid normally is small in relation to the amount that would be paid to acquire the underlying instrument. However, certain call options may have a very low exercise price so that the amount paid to acquire the option is likely to be equivalent to the amount that would be paid to acquire the underlying asset outright at inception of the option. In our view, such options should be treated as a purchase of the underlying asset and not as derivatives. In other words, if an option is so deep in the money, at the date of issue or acquisition, that the cost of the option almost is equal to the value of the underlying asset at that date, then it should be accounted for as an investment in the underlying asset and not as a derivative. [IAS 39.IGB.9] 7.2.40.50 A cross-currency swap meets the definition of a derivative, even though there is an exchange of currencies at inception of the contract, because there is zero initial net investment. [IAS 39.AG11] 7.2.40.60 Any required deposits or minimum balance requirement held in margin accounts as security for derivatives are not considered part of the initial investment. For example, the variation margin required in respect of exchange-traded futures comprises cash collateral for the particular trade rather than being either part of the initial investment in the underlying commodity or an amount paid in settlement of the instrument. [IAS 39.IGB.10] 7.2.40.70 Sometimes part of a derivative is prepaid. The question then arises as to whether the remaining part still constitutes a derivative. This depends on whether all of the criteria of the definition still are met. [IAS 39.IGB.4, IGB.5] 7.2.40.80 If a party to an interest rate swap prepays its pay-fixed obligation at inception but will continue to receive the floating rate leg over the life of the swap, then the floating rate leg of the swap still is a derivative instrument. In this circumstance all of the criteria for a derivative are met: the initial net investment (i.e. the amount prepaid by the entity) is less than investing in a similar primary financial instrument that responds equally to changes in the underlying interest rate; the instrument's fair value changes in response to changes in interest rates; and the instrument is settled at a future date. If the party prepays the pay-fixed obligation at a subsequent date, then this would be regarded as a termination of the old swap and an origination of a new instrument that is evaluated under IAS 39. 7.2.40.90 In the reverse situation, if a party to an interest rate swap prepays its pay-variable obligation at inception using current market rates, then the swap is no longer a derivative instrument because the prepaid amount now provides a return that is the same as that of an amortising fixed rate debt instrument in the amount of the prepayment. Therefore, the initial net investment equals that of other financial instruments with fixed annuities. 7.2.50 Settlement at a future date 7.2.50.10 Derivatives require settlement at a future date. A forward contract is settled on a specified future date, an option has a future exercise date and interest rate swaps have several dates on which interest is settled. An option is considered settled on exercise or at its maturity. Therefore, even though the option may not be expected to be exercised when it is out of the money, the option still meets the criterion of settlement at a future date. Any contract in which there is a delay between the trade date and the settlement date would be a derivative if the other criteria also are met. [IAS 39.IGB.7] 7.2.50.20 A key element of a derivative within the scope of IAS 39 is that the transaction should allow for settlement in the form of cash or the right to another financial instrument. 7.2.50.30 Settlement of a derivative, such as an interest rate swap, may be either a gross or net exchange of cash or other financial instruments. 7.2.60 Exemptions from derivative treatment 7.2.70 Regular way contracts 7.2.70.10 Regular way contracts are contracts to buy or sell financial assets that will be settled within the time frame established by regulation or convention in the market concerned, not necessarily an organised market. Regular way contracts are not treated as derivatives between trade date and settlement date. [IAS 39.9, 38, AG53-AG56] 7.2.70.20 For example, a commitment for three-day settlement of a security is not treated as a derivative if three days is the normal settlement period for this type of transaction in the environment in which the transaction takes place. However, in a market with three-day settlement, if a contract specifies that settlement will take place only in three months, then the exception does not apply and the contract is treated as a derivative between trade date and settlement date. 7.2.70.30 IFRSs do not offer any specific guidance on how to treat a delay in the settlement of a regular way contract. In our view, a delay would not preclude the use of the regular way exemption if the contract requires delivery within the time frame established by the convention in the market and the delay is caused by a factor that is outside the control of the entity. 7.2.80 Derivatives on own equity 7.2.80.10 Derivatives on own equity are excluded from the scope of IAS 39 if they meet the definition of an equity instrument. See 7.3.50 and 180 for further guidance. [IAS 39.2(d)] 7.2.90 Gaming contracts 7.2.90.10 A gaming institution may enter into different transactions with its customers. For example: 7.2.90.20 In our view, the first type of transaction in 7.2.90.10 does not meet the definition of a derivative, as the value of such contracts does not fluctuate based on an underlying variable. These transactions should be accounted for under IAS 18. Conversely, the second type of transaction in 7.2.90.10 normally will meet the definition of a derivative, as the value of such contracts varies depending on the likelihood of the occurrence of a specified event. Therefore, such transactions should be accounted for under IAS 39. 7.2.100  Other 7.2.100.10 Rights and obligations arising on the transfer of a financial asset that does not qualify for derecognition are not treated as derivatives under IAS 39, if recognising the derivative would result in recognising the same rights or obligations twice. [IAS 39.AG49] 7.2.110 EMBEDDED DERIVATIVES 7.2.120  Definition 7.2.120.10 IAS 39 requires an embedded derivative to be separated from the host contract and accounted for as a stand- alone derivative if the following conditions are met: 7.2.120.20 A derivative contract attached to a host contract that is transferable separately from the host contract, or that is added by a third party, is a stand-alone derivative and not an embedded derivative. For example, a finance lease or loan may have an associated interest rate swap. If the swap can be sold separately, then it is a stand-alone derivative and not an embedded derivative, even if both the derivative and the host contract have the same counterparty. [IAS 39.10] 7.2.120.30 Generally, each component of a 'synthetic instrument' is accounted for separately. A synthetic instrument is a combination of separate instruments that, viewed together, 'create' a different instrument. For example, Company D holds a five-year floating rate debt instrument and a five-year pay-floating, receive-fixed interest rate swap; together these two instruments create, for D, a synthetic five-year fixed rate investment. The individual components of synthetic instruments are not embedded derivatives; rather they are stand-alone instruments, which are accounted for separately. [IAS 39.IGC.6] 7.2.120.40 In our view, if an item that is otherwise excluded from the scope of IAS 39 contains an embedded derivative, then the entity evaluates whether the particular IFRS that addresses the accounting for the scoped-out item also addresses the accounting for the embedded derivative. If that IFRS addresses the accounting for the embedded derivative, then the entire hybrid instrument should be accounted for in accordance with that particular IFRS. If the IFRS does not address the accounting for the embedded derivative, then we believe the principles in IAS 39 should be used for evaluating whether the embedded derivative is to be separated. If the embedded derivative is required to be separated, then the host contract is accounted for under the relevant IFRS and the embedded derivative is accounted for under IAS 39. 7.2.120.50 In our view, the entity should evaluate whether the nature of the embedded derivative is such that the hybrid instrument in its entirety does not qualify for the IAS 39 scope exemption. For example, we believe a commitment to enter into a loan in the future under which the principal advanced is fixed but the principal repayable is indexed to the price of a commodity would be regarded at inception as a freestanding derivative rather than a loan commitment. 7.2.120.60 Although lease contracts and insurance contracts generally are excluded from the scope of IAS 39, derivatives embedded in these contracts are subject to the requirements for separation of embedded derivatives. However, an embedded purchase option for a leased asset included in a lease contract is not separated since such an option is accounted for as part of the lease (see 5.1). All other derivatives embedded in lease contracts (e.g. foreign currency derivatives, leveraged escalation clauses etc.) should be considered for separation. [IAS 39.2(b), (e)] 7.2.120.70 If an embedded derivative is separated, then the host contract is accounted for under IAS 39 if it is itself a financial instrument within the scope of IAS 39, or otherwise in accordance with other appropriate IFRSs if it is not a financial instrument. [IAS 39.11] 7.2.120.80 If a single host contract has more than one embedded derivative with different underlying risk exposures that are readily separable and are independent of each other, then they are accounted for separately. For example, a debt instrument may contain an option to choose the interest rate index on which interest is determined and the currency in which the principal is repaid. These are two distinct embedded derivative features with different underlying risk exposures, which are accounted for separately. [IAS 39.AG29] 7.2.120.90 If the hybrid (combined) instrument (i.e. the host contract plus the embedded derivative) is measured at fair value with changes in fair value recognised in profit or loss, then separate accounting is not permitted. [IAS 39.11, 11A] 7.2.120.100 In particular, if a contract is a financial instrument and contains one or more embedded derivatives, then an entity can designate the entire combined contract as a financial asset or financial liability at fair value through profit or loss unless: 7.2.120.110 For example, if an investment in convertible bonds is classified as an available-for-sale asset, then changes in its fair value would be recognised in other comprehensive income. Therefore, an entity would be required to account for and measure the embedded derivative (equity conversion option) separately. However, it may be simpler for an entity to designate the entire investment as at fair value through profit or loss and measure it at its fair value and thereby avoid the need to separately value and account for the embedded conversion option. 7.2.120.120 Another example may be a complex investment product that comprises a host bond contract and a number of embedded derivatives based on interest rates, equity prices etc. It may be simpler for an entity to de