Accounting for Derivatives - Ramirez Juan

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the instrument to fail the SPPI test.

      Host Contract is a Financial Liability or a Non-financial Host

      When the host contract is either (i) a financial liability within the scope of IFRS 9 or (ii) an instrument not within the scope of IFRS 9, an assessment is performed to determine whether the embedded derivative must be separated from the host (i.e., whether the embedded derivative should be accounted for separately).

IFRS 9 does not require the separation of the embedded derivative (see Figure 1.7):

      • if the derivative does not qualify as a derivative if it were free-standing; or

      • if the host contract is accounted for at fair value, with changes in fair value recorded in profit and loss; or

      • if the economic characteristics and risks of the embedded derivative are closely related to those of the host contract.

Figure 1.7 Bifurcation of embedded derivative in financial liabilities – decision tree.

      Contracts with embedded derivatives to be separated include:

      • options to extend the maturity date of fixed rate debt, except when interest rates are reset to market rates;

      • any derivative that “leverages” the payments that would otherwise take place under the host contract;

      • credit-linked notes, convertible bonds, equity or commodity indexed notes, notes with embedded currency options.

      Examples of contracts not requiring separation include:

      • debt without leveraged interest rates;

      • debt without leveraged inflation;

      • debt with vanilla interest rate options (i.e., caps and floors);

      • debt with cash flows linked to the creditworthiness of a debtor.

      Example: Issuance of an exchangeable bond

      An entity might issue a low coupon bond that is exchangeable for shares in another listed company. Under IFRS 9, the amount received for the exchangeable bond is split between:

      • a liability component – an obligation to pay the scheduled coupons and, when the bond is not converted, the principal; and

      • an embedded derivative – the conversion right by the bondholders (a sold call option on the third-party shares).

1.6.2 Liability Compound Instruments

The concept of compound instruments is similar to that of hybrid instruments (see Figure 1.8). A hybrid instrument is comprised of a liability component (the host contract) and an embedded derivative, while a compound instrument is comprised of a liability component (the host contract) and an equity component. An example of a compound instrument is a bond issued by the entity that is convertible into a fixed number of shares of the entity, which can be split between:

      • a liability component – an obligation to pay the scheduled coupons and, when the bond is not converted, the principal; and

      • an equity component – the conversion right by the bondholders (a sold call option on own shares).

Figure 1.8 Hybrid and compound instruments.

      Compound instruments are defined in IAS 32. The liability and equity components of a compound instrument are required to be accounted for separately, upon initial recognition, and the separation is not subsequently revised. The split between the two components is implemented in two steps:

      The fair value of the liability component is calculated, and this fair value establishes the initial carrying amount of the liability component,

      The fair value of the liability component is deducted from the fair value of the instrument in its entirety, with the residual amount being an equity component.

      I have included several cases that cover the accounting of convertible bonds in Chapter 9.

      Chapter 2

      The Theoretical Framework – Hedge Accounting

      The objective of this chapter is to summarise the key theoretical issues surrounding hedge accounting under IFRS 9. This chapter also covers the fair valuation of derivatives under IFRS 13 Fair Value Measurement, a standard that has a substantial effect on hedge accounting.

      2.1 HEDGE ACCOUNTING – TYPES OF HEDGES

      Whilst other instruments (e.g., a loan denominated in a foreign currency) may also be used, derivatives are the most common instruments transacted to reduce or mitigate exposures to market risks.

2.1.1 Derivative Definition

      Under IFRS 9, a derivative is a financial instrument (or other contract within the scope of IFRS 9) with all of the following characteristics:

      1. Its value changes in response to changes in a specified “underlying” interest rate, financial instrument price, commodity price, foreign exchange (FX) rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract.

      2. It requires no initial 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.

      3. It is settled at a future date.

      Some commodity-based derivatives are not considered derivatives under IFRS 9. See Chapter 10 for a detailed discussion regarding which commodity contracts can be treated as IFRS 9 instruments.

2.1.2 Hedge Accounting

      The objective of hedge accounting is to represent, in the financial statements, the effect of an entity's risk management activities that use financial instruments to manage market risk exposures that could affect profit or loss (or OCI in the case of equity investments at FVOCI).

      Hedged Item and Hedging Instrument

      In a hedging relationship there are two elements: the hedged item and the hedging instrument.

      • The hedged item is the item that exposes the entity to a market risk(s). It is the element that is designated as being hedged.

      • The hedging instrument is the element that hedges the risk(s) to which the hedged item is exposed. Frequently, the hedging instrument is a derivative.

      For example, an entity hedging a floating rate loan with a pay-fixed receive-floating interest rate swap and applying hedge accounting would designate the loan as the hedged item and the swap as the hedging instrument.

      Hedge Accounting

      Hedge accounting is a technique that modifies the normal basis for recognising gains and losses (or revenues and expenses) associated with a hedged item or a hedging instrument to enable gains and losses on the hedging instrument to be recognised in profit or loss (or in OCI in the case of hedges of equity instruments at FVOCI) in the same period as offsetting losses and gains on the hedged item. Hedge accounting takes two forms under IFRS 9:

      • Fair value hedge – recognising gains or losses (or revenues or expenses) in respect of both the hedging instrument and hedged item in earnings in the same accounting period.

      • Cash flow hedge or net investment hedge – deferring recognised gains and losses in respect of the hedging instrument on the balance sheet until the hedged item affects earnings.

      The following example compares the timing of the impacts on profit or loss when applying, or not applying, hedge accounting. Assume that an entity enters in 20X0 into a

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