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Contents
12.1 Deciding what instruments come within the scope of section 12.
12.2 Accounting policy choice.
12.2.1 Extract from FRS 102-Sections 12.2–12.2A.
12.2.2.1 What is the accounting policy choice?
12.2.2.2 What accounting policy to choose for an entity.
12.3.1 Extract from FRS 102-Section 12.3–12.5.
12.3.2.1 Items excluded from Section 12 of FRS 102:
12.3.2.2 Items coming within the scope of Section 12 of FRS 102.
12.3.2.2.1.1 Unguaranteed Capital and variation in return linked to a fund.
12.3.2.2.1.2 Collective investment funds.
12.3.2.2.1.3 Loan extension option where rate on the extension is determined at inception.
12.3.2.2.1.5 Variation in return which is dependent on future contingencies.
12.2.2.2.1.7 Investments with profit bonds.
12.3.2.2.1.8 Loans which are linked to value of net assets.
12.3.2.2.1.9 Loan repayments linked to repayments on another loan or tranche of a loan.
12.3.2.2.1.12 Leases with non-standard contractual terms.
12.3.2.2.1.13 Contingent consideration for the seller.
12.3.2.2.1.14.1 The own use exemption.
12.3.2.2.1.16 Warrants that can be settled in cash or in exchange for another financial instrument;
12.3.2.2.1.19 Repurchase agreements;
12.3.2.2.1.20 Compound financial instruments.
12.3.2.2.1.21 A firm commitment which is contractually binding.
12.3.2.2.1.22 Where the variable rate on a loan is leveraged.
12.3.2.2.1.23 Where a bond has a negative yield.
12.4 Initial recognition and subsequent measurement of financial assets and liabilities.
12.4.1 Extract from FRS 102-Section 12.6-12.9.
12.4.2.2 Subsequent recognition.
12.4.2.2.1 Subsequent recognition – General.
12.4.2.2.1.1.1 Financial instruments not permitted to be fair valued under Company Law.
12.4.2.2.1.1.1.1 The accounting treatment where this exception applies.
12.4.2.2.1.1.2.1 The accounting treatment where this exception applies.
12.4.2.2.1.1.3 Where hedge accounting is applied.
12.4.2.2.2 Financial instruments not permitted to be fair valued under Company Law.
12.4.2.2.2.1.1 Financial instruments permitted to be fair valued under Company Law.
12.4.2.2.2.1.1.2.2 Derivative financial instrument.
12.4.2.2.2.1.1.2.2.1 Derivative – defined.
12.4.2.2.2.1.1.2.2.1.1 Examples of Derivatives.
12.4.2.2.2.1.1.2.3 Eliminate an accounting mismatch.
12.4.2.2.2.1.1.2.4 Instrument contains an embedded derivative that is not closely related.
12.4.2.2.2.1.1.2.4.0 Overview.
12.4.2.2.2.1.1.2.4.2 Embedded derivative defined.
12.4.2.2.2.1.1.2.4.3 Identify whether the embedded derivative is or is not closely related.
12.4.2.2.2.1.1.2.4.3.1 Examples where the embedded derivative is not closely related.
12.4.2.2.2.1.1.2.4.3.2 Examples where the embedded derivative is closely related.
12.5.1 Extract from FRS 102 section 12.10 – 12.12.
12.5.2.1 The fair value model to utilise.
12.5.2.2 The fair value of a financial instrument due on demand.
12.5.2.3 Transaction costs and fair value.
12.5.2.4 Examples of fair valuation techniques for complex instruments.
12.5.2.5 Deferred tax and the fair value adjustments.
12.5.2.5.1 Deferred tax and fair value adjustments where they relate to trade assets/liabilities.
12.5.2.5.3 Deferred tax where hedge accounting is applied.
12.5.2.6 Examples of fair valuing financial instruments where market rates are not available.
12.5.2.7 Foreign currency forward contracts.
12.5.2.7.2 Accounting for forward foreign currency contracts – non hedging – Examples.
12.5.2.7.3 Accounting for interest rate swaps – non hedging – Examples.
12.6 Impairment of financial instruments measured at cost or amortised cost.
12.6.1 Extracts from FRS 102 – section 12.3.
12.7 Derecognition of a financial asset or financial liability.
12.7.1 Extract from FRS 102 – section 12.14.
12.7.2.1 Non-hedged instruments.
12.8.1 Extract from FRS102 section 12.15 – 12.17C.
12.8.2.2 Hedged item – defined.
12.8.2.3 Hedging instrument – defined.
12.8.2.4 Purpose of hedge accounting.
12.8.2.5 What can be hedged under hedge accounting?
12.8.2.6.1 Firm commitment – Defined.
12.8.2.6.2 Classification of Firm commitments as a hedge – fair value or cash flow hedge?
12.8.2.6.3 The exception for fair valuing firm commitments – Own use exception to fair value.
12.8.2.6.4 Determining the fair value of a commitment.
12.8.2.7 Forecast transaction.
12.8.2.7.1 Forecast transaction – Defined.
12.8.2.7.2 Forecast transaction – Indicators that such a transaction exists.
12.8.2.8 Intra-group hedging & when hedge accounting can be applied.
12.8.2.8.1 Intra-group hedging – Example.
12.9 Grouping of items as hedged items.
12.9.1 Extract from FRS102-Section 12.16B.
12.10 Hedging a component of an item.
12.10.1 Extract from FRS102-Section 12.16C.
12.10.2.2 Examples illustrating hedging a component of an item.
12.10.2.2.1 Hedging with a forward contract where contract is less than the probable sale amount.
12.10.2.2.2 Hedging part payments.
12.10.2.2.3 Hedging part payments.
12.11.1 Extract from FRS102-Section 12.17-12.17C.
12.11.2.1 What instruments can be classified as a hedging instrument?
12.11.2.2 Portion of a hedging instruments.
12.11.2.3 Instrument used to hedge a foreign currency risk.
12.11.2.4.1 What is an option and what is a written option?
12.11.2.4.2 Determining the fair value of an option and using it as a hedging instrument.
12.12 Conditions for hedge accounting.
12.12.1 Extract from FRS102-Section 12.18-12.18A.
12.12.2.1 When can hedge accounting be applied from and conditions must be met?
12.12.2.2 What is an economic relationship?
12.12.2.3 Designation and documentation.
12.12.2.4 Causes of hedge ineffectiveness.
12.12.2.4.2 Example of hedge ineffectiveness documented for an interest rate swap.
12.13 Accounting for qualifying hedging relationships.
12.13.1 Extract from FRS102-Section 12.19-12.19A.
12.13.2.1 The three types of hedge relationships for hedge accounting.
12.14.1 Extract from FRS102 – Section 12.19B-12.22.
12.14.2.1 What is a fair value hedge and what does it do?
12.14.2.2 The accounting for a fair value hedge.
12.14.2.2.1 Examples of fair value hedges and the accounting for same.
12.14.2.2.1.1 Fixed interest rate on a debt instrument (financial instrument).
12.14.2.2.1.1.1 Amortised cost on cessation of hedging where financial instrument exists.
12.14.2.2.1.2 Firm commitment not recognised on balance sheet.
12.14.2.2.1.3 Hedge of a foreign currency risk of an unrecognised firm commitment.
12.15.1 Extract From FRS 102 – Section 12.22(b) and 12.23.
12.15.2.1 Cash flow hedge defined.
12.15.2.2 Accounting for cash flow hedges – hedge accounting.
12.15.2.3 Examples of cash flow hedge accounting.
12.15.2.3.1 Forward contract for a probable forecasted sale.
12.15.2.3.1.1 Forward contract for a probable forecasted sale.
12.15.2.3.1.2 Forward contract for a probable forecasted purchase.
12.15.2.3.2 Hedge of variability in cash flows in a floating rate loan due to interest rate risk.
12.15.2.3.2.1.1 Fair valuing an interest rate swap.
12.15.2.3.2.3 Hedge of variability in cash flows in a floating rate loan due to interest rate risk.
12.16 Hedges of a net investment in a foreign operation.
12.16.1 Extract from FRS 102 Section 12.24.
12.16.2.1 Net investment in a foreign operation defined.
12.16.2.2 When can a net investment in a foreign operation be hedged?
12.16.2.3 What is the hedged item and instrument in a net investment in a foreign operation?
12.17 Discontinuing hedge accounting.
12.17.1 Extract from FRS102 Section 12.25 to 12.25A.
12.17.2.2 When can/must hedge accounting be discontinued and is it applied retrospectively.
12.17.2.2.1 Fair value hedge and discontinuance rules.
12.17.2.2.2 Cash flow hedge and discontinuance rules.
12.17.2.2.3 Net investment in a foreign operation hedge and discontinuance rules.
12.17.2.2.4 Examples of discontinuance.
12.18 Taxation of fair valuing derivatives – current and deferred tax.
12.19.1 Extract from FRS102-Section 12.25B.
12.20.1 Extracts from FRS 102 section 12.26 – 12.29.
12.20.2.2 Sample Disclosure requirements.
12.20.2.2.1 Extract from accounting policy notes.
12.20.2.2.2 Extract of notes to the financial statements – Financial instruments note disclosures.
12.20.2.2.3 Extract of notes to the financial statements – interest disclosures.
12.20.2.2.3.1 Note: Interest receivable and similar income.
12.20.2.2.3.2 Note: Interest payable and similar expenses.
12.20.2.2.4 – Debtors Disclosures.
12.20.2.2.5 – Creditors disclosures.
12.20.2.2.7 Statement of Comprehensive Income.
12.20.2.2.8 – Statement of Change in Equity.
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The below extracts and guidance is applicable for periods beginning before 1 January 2019 and are based on the September 2015 version of FRS 102. For periods beginning on or after 1 January 2019, the March 2018 version of FRS 102 applies which incorporates the changes made by the Triennial review of FRS 102. Note the March 2018 version of FRS 102 can be voluntarily applies for periods beginning before 1 January 2019. For the extracts from the March 2018 version of FRS 102 and the related guidance please click on the following link. For details of a summary of the main changes as a result of the triennial review please see the following link.
12.4 Initial recognition and subsequent measurement of financial assets and liabilities
12.4.1 Extract from FRS 102-Section 12.6-12.9
12.6 An entity shall recognise a financial asset or a financial liability only when the entity becomes a party to the contractual provisions of the instrument.
Initial measurement
12.7 When a financial asset or financial liability is recognised initially, an entity shall measure it at its fair value, which is normally the transaction price (including transaction costs except in the initial measurement of financial assets and liabilities that are measured at fair value through profit or loss). If payment for an asset is deferred beyond normal business terms or is financed at a rate of interest that is not a market rate, the entity shall initially measure the asset at the present value of the future payments discounted at a market rate of interest for a similar debt instrument.
Subsequent measurement
12.8 At the end of each reporting period, an entity shall measure all financial instruments within the scope of Section 12 at fair value and recognise changes in fair value in profit or loss, except as follows:
(a) investments in equity instruments that are not publicly traded and whose fair value cannot otherwise be measured reliably and contracts linked to such instruments that, if exercised, will result in delivery of such instruments, shall be measured at cost less impairment;
(b) hedging instruments in a designated hedging relationship accounted for in accordance with paragraph 12.23; and
(c) financial instruments that are not permitted by the Small Company Regulations, the Regulations, the Small LLP Regulations or the LLP Regulations to be measured at fair value through profit or loss shall be measured at amortised cost in accordance with paragraphs 11.15 to 11.20.
12.9 If a reliable measure of fair value is no longer available for an equity instrument (or a contract linked to such an instrument) that is not publicly traded but is measured at fair value through profit or loss, its fair value at the last date the instrument was reliably measurable is treated as the cost of the instrument. The entity shall measure the instrument at this cost amount less impairment until a reliable measure of fair value becomes available.
12.4.2 OmniPro comment
12.4.2.1 Initial recognition
As per Section 12.6 of FRS 102 an entity should only recognize and financial instrument when they become a party to the contract.
As per Section 12.7 of FRS 102, the instrument should be valued initially at transaction price and afterwards at fair value. Where there is a financing element (payment deferred beyond normal terms or a non-market rate of interest), then the rules in Section 11 of FRS 102 should be followed with regard to determining the market rate and discounting the asset/liability back to its present value rate using the market rate as the discount rate. See 11.6.2.4.5 of Section 11 for further details.
Section 12.12 of FRS 102 requires any directly attributable transaction costs to be expensed to the profit and loss account immediately where the instrument is to be carried at fair value subsequently.
12.4.2.2 Subsequent recognition
12.4.2.2.1 Subsequent recognition – General
Section 12.8 of FRS 102 provides the rules for subsequent measurement of complex financial instruments. It requires that an entity subsequently measure all instruments which are debt instrument within the scope of Section 12 at fair value on the balance sheet and recognise the changes in fair value in the profit and loss account except in the circumstances detailed at 12.4.2.2.1.1 below. Note where an instrument is repayable on the demand then the fair value of the instrument is equal to the carrying amount as stated at Section 12.11 of FRS 102 (e.g. a loan which meets the definition of complex is initially received of CU100,000 and the terms are that it is repayable on demand – in this case subsequently the fair value will always be the carrying amount on the balance sheet i.e. the amount of the loan less repayments plus interest if any).
12.4.2.2.1.1 The exception to subsequently measuring financial instruments within the remit of Section 12 at fair value
Section 12.8(a) to (c) of FRS 102 provides three exceptions to carrying financial instruments within the scope of Section 12 at fair value with movement in fair value recognised in the profit and loss account. These three exceptions are:
12.4.2.2.1.1.1 Financial instruments not permitted to be fair valued under Company Law
- Financial instruments that are not permitted by Schedule 3 paragraph 38(2)(3) and 39(1)(2) of Companies Act 2014 (for accounting periods beginning before 1 January 2017 assuming the Companies (Accounting) Act 2017 is not early adopted) or Schedule 3 paragraph 38(1)(2) of Companies Act 2014 (which applies for periods ending on or after 1 January 2017) for to be measured at fair value through the profit and loss account.
Note even if the entity is not a company the Company Law rules still apply. See further discussion at 12.4.2.2.2
12.4.2.2.1.1.1.1 The accounting treatment where this exception applies
Where Company law does not permit fair valuing, then under Section 128(c) of FRS 102, such instruments shall be measured at amortised cost in accordance with Section 11.15 to 11.20 of FRS 102 (see 11.6.2 at Section 11).
12.4.2.2.1.1.2 Investments in equity instruments not publicly traded or which cannot be reliably measured
Investments in equity instruments (which give less than an significant influence) that are not publicly traded and which cannot be reliably measured.
Where initially such instruments were fair valued and subsequently they can no longer be reliably measured, then in accordance with Section 12.9 of FRS 102 they should be carried at cost less impairment with the cost being the carrying amount prior to the inability to reliably measure the equity instruments.
12.4.2.2.1.1.2.1 The accounting treatment where this exception applies
In this case the equity instruments should be held at cost less impairment on the balance sheet.
12.4.2.2.1.1.3 Where hedge accounting is applied
- Hedging instruments where hedge accounting applies. Where hedge accounting applies then the instrument will be held at fair value on the balance sheet, however the movement in fair value may go to the fair value/cash flow hedge reserve as opposed to the profit and loss account. See further details at 12.8.2
12.4.2.2.2 Financial instruments not permitted to be fair valued under Company Law
12.4.2.2.2.1 Overview
As discussed at 12.4.2.2.1.1.1 financial instruments that are not permitted by Schedule 3 paragraph 38(2)(3) and 39(1)(2) of Companies Act 2014 (for accounting periods beginning before 1 January 2017 assuming the Companies (Accounting) Act 2017 is not early adopted) or Schedule 3 paragraph 38(1)(2) of Companies Act 2014 (which applies for periods ending on or after 1 January 2017) for to be measured at fair value through the profit and loss account.
Note even if the entity is not a company the Company Law rules detailed here continue to apply.
12.4.2.2.2.1.1 Financial instruments permitted to be fair valued under Company Law
Schedule 3 paragraph 38(1)(2) of Companies Act 2014 states that financial instruments can be fair valued if IFRS permits the items to be fair valued provided the disclosures required by the IFRS are provided. The relevant IFRS standards that apply to financial instruments are IAS 39 and IFRS 9. IFRS permits all financial instruments to be held at fair value. However IFRS only permits the following financial instruments which are financial liabilities to be fair valued if:
- They are held as part of a trading portfolio/where the instrument forms part of a group of financial liabilities that are managed on a fair value basis or
- They are derivative financial instruments (see 12.4.2.2.2.1.1.2.2); or
- They are permitted to be accounted for at fair value under IFRS and the required disclosures of the relevant standard are complied with. IAS 39/IFRS 9 is the standard that deals with Financial instruments (depending on which is applied). It states that a financial liability can only be measured at fair value:
- where they are within the parameters of 1 or 2 above; or
- to eliminate an accounting mismatch (see 12.4.2.2.2.1.1.2.3); or
- if the instrument contains an embedded derivative that is not closely related (see 12.4.2.2.2.1.1.2.4).
12.4.2.2.2.1.1.1 The impact of the Company law rules on financial assets which are financial instruments
As is evident from above, financial instruments that are assets can be recognised in all of the cases as IFRS does not prevent such assets being recognised.
12.4.2.2.2.1.1.2 The impact of the Company law rules on financial liabilities which are financial instruments
12.4.2.2.2.1.1.2.1 Overview
As is evident at 12.4.2.2.2.1.1, fair valuing liabilities is severely restricted under Company Law. If a financial liability is not permitted to be fair valued it must be carried under the amortised cost model. We have looked at the hurdles with regard to company law in further detail below.
They are held as part of a trading portfolio/where the instrument forms part of a group of financial liabilities that are managed on a fair value basis
12.4.2.2.2.1.1.2.2 Derivative financial instrument
12.4.2.2.2.1.1.2.2.1 Derivative – defined
A derivative as defined in Appendix I of FRS 102 is a financial instrument or other contract with all three of the following characteristics:
(a) its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable (sometimes called the ‘underlying’), provided in the case of a non-financial variable that the variable is not specific to a party to the contract;
(b) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and
(c) it is settled at a future date
12.4.2.2.2.1.1.2.2.1.1 Examples of Derivatives
Examples of derivatives would include:
- Forward contracts
- Forward foreign currency contracts
- Interest rate swaps
- Options to purchase.
12.4.2.2.2.1.1.2.3 Eliminate an accounting mismatch
This get out would be very rare with limited instances where this could arise.
12.4.2.2.2.1.1.2.4 Instrument contains an embedded derivative that is not closely related
12.4.2.2.2.1.1.2.4.0 Overview
Where a financial instrument contains an embedded derivative that is not closely related then the liability can be fair valued. We will look at the meaning of this in further detail below.
12.4.2.2.2.1.1.2.4.1 Steps involved in assessing whether a financial liability (which is not part of a trading portfolio and is not a derivative financial instrument – if it was any of these then the must be fair valued) must be measured at fair value
There are a number of steps in identifying whether the financial liability can be fair valued.
For the purposes of the steps below we will assume that a loan exists whereby it is split into two tranches. Tranche 1 has normal repayments and tranche 2’s repayments are linked to the repayments on the tranche 1 loan such that a certain amount of the loan will be written off if the repayments on the Tranche 1 loan are met. Therefore, as there is a contractual provision that could by its terms result in the holder losing some of the principal amount (i.e. a possible write off may occur on this loan) and therefore the lender is at risk of losing the capital it is defined as a complex instrument and therefore must be accounted for under the rules of Section 12.
Step 1: Identifying whether an embedded derivative exists.
(applying this to the example in this case; the host contract is tranche 2 loan and the embedded derivative is the linking of the repayment of the tranche 1 to the repayments to be made on the tranche 2 loan).
See further discussion at 12.4.2.2.2.1.1.2.4.2.
Step 2: Assess whether in fact this is closely related or not. If not closely related there is no requirement to fair value the liability.
Given that the tranche 1 loan is within the overall loan agreement, we would state that the loan agreement is closely related. In this case the repayments are not linked to the equity of the company (i.e. the repayment on the loan are not linked to the price per share of the company); if this was the case they would not be closely related but this is not the case here. Hence this condition would not be met and the instrument would be held at amortised cost.
Examples of items that are not closely related and therefore must be carried at fair value:
- Interest on a loan linked to 2 times the bank variable interest (if it is less than this then it is closely related.
- Profit participation loans where the interest or repayments are linked to the profits of the company and the entity views the profits to be a financial variable. If they view them to be a non-financial variable then such loans would not be carried at fair value as it would not be permitted by company law.
- Repayment of loans linked to the net assets of the entity or the earnings per share.
See further discussion at 12.4.2.2.2.1.1.2.4.3.
Step 3: If it has been determined at step 2 that it is not closely related then an assessment has to be made as to whether the feature considered to be an embedded derivative actually meets the definition of a derivative. Non-financial variables specific to the party to a contract are not derivatives under IAS 39. Judgement will be involved in assessing whether items are or are not non-financial variable specific to the contract.
In the example that is being worked through, even if an argument was put forward that the embedded element and the loan were not closely related, the final step in the assessment is to determine whether the repayments were linked to non-financial variables specific to the party to contract. In this case the amount of repayments made on tranche 1 are related to non-financial variables i.e. the general business risks faced by the entity will determine how much of the tranche 1 loan will be repaid as this is based on cash flows of the business which in turn is linked to the general business risks of the business. In addition, many of the drivers of the excess cash flow to repay the tranche 1 loan will be specific to the business (and therefore they are specific to the party to the contract) for example the location of the business, the nature of the goods and management actions. Given that the repayments are linked to non-financial variables and were specific to the party to the contract i.e. the company itself it cannot be fair valued under company law as IFRS does not permit it.
See further discussion at 12.4.2.2.2.1.1.2.4.3.
12.4.2.2.2.1.1.2.4.2 Embedded derivative defined
An embedded derivative is a component of a hybrid (combined) instrument that also includes a non-derivative host contract (the loan itself if we are assessing if a loan liability can be fair valued) — with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. In effect if we take an example of a loan (the host contract), where the debt instrument repayments vary depending on how a tranche of a loan is repaid – by linking to another tranche on the loan as a basis for determining the amount of the current loan tranche principal to be repaid, then this linking is the derivative element.
Here as the repayment of the principal is linked to the repayments made on another loan this is an embedded derivative.
Step 1 therefore involves identifying whether an embedded derivative exists.
12.4.2.2.2.1.1.2.4.3 Identify whether the embedded derivative is or is not closely related
IAS 39 – Appendix A paragraphs 10 to 13 provides detailed guidance as to what is or is not closely related. If it is not closely related then the financial liability must be fair valued.
12.4.2.2.2.1.1.2.4.3.1 Examples where the embedded derivative is not closely related
The economic characteristics and risks of an embedded derivative are not closely related to the host contract (paragraph 11(a) of Appendix A of IAS 39) in the following examples. In these examples, assuming the conditions are met, an entity accounts for the financial instrument at fair value (see further examples at 12.4.2.2.2.1.1.2.4.1).
(a) A put option embedded in an instrument that enables the holder to require the issuer to reacquire the instrument for an amount of cash or other assets that varies on the basis of the change in an equity or commodity price or index is not closely related to a host debt instrument.
(b) A call option embedded in an equity instrument that enables the issuer to reacquire that equity instrument at a specified price is not closely related to the host equity instrument from the perspective of the holder (from the issuer’s perspective, the call option is an equity instrument provided it meets the conditions for that classification under IAS 32, in which case it is excluded from the scope of this Standard).
(c) An option or automatic provision to extend the remaining term to maturity of a debt instrument is not closely related to the host debt instrument unless there is a concurrent adjustment to the approximate current market rate of interest at the time of the extension. If an entity issues a debt instrument and the holder of that debt instrument writes a call option on the debt instrument to a third party, the issuer regards the call option as extending the term to maturity of the debt instrument provided the issuer can be required to participate in or facilitate the remarketing of the debt instrument as a result of the call option being exercised.
(d) Equity-indexed interest or principal payments embedded in a host debt instrument or insurance contract—by which the amount of interest or principal is indexed to the value of equity instruments—are not closely related to the host instrument because the risks inherent in the host and the embedded derivative are dissimilar.
(e) Commodity-indexed interest or principal payments embedded in a host debt instrument or insurance contract—by which the amount of interest or principal is indexed to the price of a commodity (such as gold)—are not closely related to the host instrument because the risks inherent in the host and the embedded derivative are dissimilar.
(f) An equity conversion feature embedded in a convertible debt instrument is not closely related to the host debt instrument from the perspective of the holder of the instrument (from the issuer’s perspective, the equity conversion option is an equity instrument and excluded from the scope of this Standard provided it meets the conditions for that classification under IAS 32).
(g) A call, put, or prepayment option embedded in a host debt contract or host insurance contract is not closely related to the host contract unless:
(i) the option’s exercise price is approximately equal on each exercise date to the amortised cost of the host debt instrument or the carrying amount of the host insurance contract; or
(ii) the exercise price of a prepayment option reimburses the lender for an amount up to the approximate present value of lost interest for the remaining term of the host contract. Lost interest is the product of the principal amount prepaid multiplied by the interest rate differential. The interest rate differential is the excess of the effective interest rate of the host contract over the effective interest rate the entity would receive at the prepayment date if it reinvested the principal amount prepaid in a similar contract for the remaining term of the host contract.The assessment of whether the call or put option is closely related to the host debt contract is made before separating the equity element of a convertible debt instrument in accordance with IAS 32.
(h) Credit derivatives that are embedded in a host debt instrument and allow one party (the ‘beneficiary’) to transfer the credit risk of a particular reference asset, which it may not own, to another party (the ‘guarantor’) are not closely related to the host debt instrument. Such credit derivatives allow the guarantor to assume the credit risk associated with the reference asset without directly owning it.
12.4.2.2.2.1.1.2.4.3.2 Examples where the embedded derivative is closely related
The economic characteristics and risks of an embedded derivative are closely related to the economic characteristics and risks of the host contract in the following examples. In these examples, an entity does not fair value the financial instrument.
(a) An embedded derivative in which the underlying is an interest rate or interest rate index that can change the amount of interest that would otherwise be paid or received on an interest-bearing host debt contract or insurance contract is closely related to the host contract unless the combined instrument can be settled in such a way that the holder would not recover substantially all of its recognised investment or the embedded derivative could at least double the holder’s initial rate of return on the host contract and could result in a rate of return that is at least twice what the market return would be for a contract with the same terms as the host contract.
(b) An embedded floor or cap on the interest rate on a debt contract or insurance contract is closely related to the host contract, provided the cap is at or above the market rate of interest and the floor is at or below the market rate of interest when the contract is issued, and the cap or floor is not leveraged in relation to the host contract. Similarly, provisions included in a contract to purchase or sell an asset (eg a commodity) that establish a cap and a floor on the price to be paid or received for the asset are closely related to the host contract if both the cap and floor were out of the money at inception and are not leveraged.
(c) An embedded foreign currency derivative that provides a stream of principal or interest payments that are denominated in a foreign currency and is embedded in a host debt instrument (e.g. a dual currency bond) is closely related to the host debt instrument. Such a derivative is not separated from the host instrument because IAS 21 requires foreign currency gains and losses on monetary items to be recognised in profit or loss.
(d) An embedded foreign currency derivative in a host contract that is an insurance contract or not a financial instrument (such as a contract for the purchase or sale of a non-financial item where the price is denominated in a foreign currency) is closely related to the host contract provided it is not leveraged, does not contain an option feature, and requires payments denominated in one of the following currencies:
(i) the functional currency of any substantial party to that contract;
(ii) the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in commercial transactions around the world (such as the US dollar for crude oil transactions); or
(iii) a currency that is commonly used in contracts to purchase or sell non-financial items in the economic environment in which the transaction takes place (eg a relatively stable and liquid currency that is commonly used in local business transactions or external trade).
(e) An embedded prepayment option in an interest-only or principal-only strip is closely related to the host contract provided the host contract (i) initially resulted from separating the right to receive contractual cash flows of a financial instrument that, in and of itself, did not contain an embedded derivative, and (ii) does not contain any terms not present in the original host debt contract.
(f) An embedded derivative in a host lease contract is closely related to the host contract if the embedded derivative is (i) an inflation-related index such as an index of lease payments to a consumer price index (provided that the lease is not leveraged and the index relates to inflation in the entity’s own economic environment), (ii) contingent rentals based on related sales or (iii) contingent rentals based on variable interest rates.
(g) A unit-linking feature embedded in a host financial instrument or host insurance contract is closely related to the host instrument or host contract if the unit-denominated payments are measured at current unit values that reflect the fair values of the assets of the fund. A unit-linking feature is a contractual term that requires payments denominated in units of an internal or external investment fund.
(h) A derivative embedded in an insurance contract is closely related to the host insurance contract if the embedded derivative and host insurance contract are so interdependent that an entity cannot measure the embedded derivative separately (ie without considering the host contract).
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Examples
Example 1: Unguaranteed Capital and variation in return linked to a fund.
Example 2: Collective investment funds.
Example 3: Loan extension option (Section 11.9 (AB) of FRS 102).
Example 5: Variation in return (Section 11.9 (aB) of FRS 102).
Example 6: Prepayment options (Section 11.9 (c) of FRS 102.
Example 6a: Investments held at fair values – market rates available.
Example 6b: Fair valuing complex financial instruments where no active market available.
Example 6c: Fair valuing complex financial instruments where no active market available.
Example 6d: Fair valuing complex financial instruments where no active market available.
Example 8: Foreign currency forward contract to hedge a sale.
Example 9: Foreign currency forward contract to hedge a future purchase.
Example 10: Interest rate swap – non hedge accounting.
Example 11: Hedging in a group context.
Example 13: Hedging with a forward contract where contract is less than the probable sale amount.
Example 14: Hedging part payments.
Example 15: Hedging part payments.
Example 16: Partial term hedging.
Example 17: Portion of a hedging instruments.
Example 19: Forward contract option.
Example 22: Hedge of a foreign currency risk of an unrecognised firm commitment.
Example 23: Forward contract for a probable forecasted sale.
Example 24: Probable forecasted purchase of equipment.
Example 26: Fair valuing an interest rate swap.
Example 27: Hedge of variability in cash flows in a floating rate loan due to interest rate risk.
Example 28: Net investment in a foreign operation (Extracted from Appendix to Section 12 of FRS 102.
Example 29: Discontinuance of a cash flow hedge – forecasted sale/purchase.
Example 30: Cash flow hedge example.
Example 31: Interest rate swap – cash flow hedge accounting.
Example 32: Sample Disclosure Requirements.
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