Some contracts (that may or may not be financial instruments themselves) may have derivatives embedded in them. For example, an entity may issue a bond which is redeemable in five years’ time with part of the redemption price being based on the increase in the FTSE 100 index.
IFRS 9 requires embedded derivatives that would meet the definition of a separate derivative instrument to be separated from the host contract unless:
- the economic characteristics and risks of the embedded derivative are closely related to those of the host contract; or
- the hybrid (combined) instrument is measured at fair value through profit or loss; or
- the host contract is a financial asset within the scope of IFRS 9; or
- the embedded derivative significantly modifies the cash flows of the contract.
JAF Bank is based in the United Kingdom and has sterling as its functional currency. In the ordinary course of business it entered into the following contract:
The bank signed a 15-year lease for a new building paying a rental of £270,000 per annum. The contract however has a rent adjustment clause based on the change in the inflation rate.
The embedded derivative on inflation is considered to be closely related to the host lease contract and is not required to be separated. The derivative element is merely an additional means of determining the rentals payable.
Entity A invests $100,000 in a debt instrument which pays a coupon that is based on the gold price (gold linked note).
The note matures in three years and pays a coupon based on the market price for gold.
Question: How should Entity A account for the note under IAS 39 and IFRS 9?
The instrument contains:
- Debt host contract to receive $100,000 in three years.
- Derivative that is based on the market price of gold which is not closely related to the debt host contract.
The entity therefore has two options:
- Bifurcate the instrument: Gold linked derivative at FVTPL & host debt contract at amortized cost.
- Designate entire contract at FVTPL.
No embedded derivative for financial assets under IFRS 9.
Thus, consider the instrument in its entirety:
- The coupon rate is linked to the value of the gold price and does not reflect the consideration for the time value of money and credit risk.
- Therefore, the instrument fails the SPPI test for classification at amortized cost.
Accordingly, the entity must account for the entire instrument at FVTPL.