There is going to be a biggest change in accounting standards on convergence with International Financial Reporting Standards (IFRS). Implementation of IFRS cannot be dealt with as a year-end accounting issue. One area where the education is required is ‘derivative accounting’. Derivatives make headlines every other day, and, almost always for the wrong reasons. What are derivative contracts? Where do they trade? Why do they exist? While a seemingly endless number of derivative contract structures will appear, do not be misled. Only two basic contracts exist – a forward and an option. All other product structures are nothing more than portfolio of forwards and options. Similarly, derivative products are offered by an almost endless number of institutions in the market - brokerage houses, banks, investment houses, commodity exchanges, and so on. Again, do not be misled. Fundamentally there are only two types of derivative markets – exchange traded markets and over-the-counter (OTC) markets. Exchanges facilitate trading in standardized contracts. OTC markets, on the other hand, can tailor contracts to meet customer needs; however, counterparties are left to their own devices to arrange protection from counterparty default. Finally, why do derivatives markets flourish, considering that they are redundant securities, that is, they derive their value from the price of the underlying security? The answer is plain and simple. They are generally less expensive to trade, or, in many instances, circumvent trading restrictions that impede trading in the underlying securities market. Because derivative contracts are redundant means that they are effective risk management tools. Because they are cheaper to trade and may circumvent trading restrictions means they are cost-effective.
In this article, we look at the accounting for embedded derivatives, under the new Accounting Standard (AS) 30 Financial Instruments: Recognition and Measurement.
Embedded derivatives are those instruments that are contractually attached to another non-derivative contract what AS 30 terms a "host contract". A common example would be a convertible bond that has a host debt contract and an equity conversion option embedded within it. Such embedded derivatives can arise through specific structures with the intention to shift certain risks between the counterparties or may arise inadvertently through market practices and common contractual arrangements.
AS 30 requires all derivatives to be measured at fair value on the balance sheet, with changes in fair value being accounted through profit and loss, except for derivatives, that are designated as hedging instruments. The principle in respect of embedded derivatives is that the fact that a derivative is not a legally separate individual contractual instrument should not prevent it from being accounted for in the same way as other stand-alone derivatives under the standard. The result of this is that in many circumstances, embedded derivatives must be separated from their host contracts and accounted for in the same way as stand-alone derivative instruments. There are certain exceptions to this however and the thought process that is employed to determine whether or not an embedded derivative must be separated from its host contract is discussed below.
If the entire financial instrument as a whole is held at fair value with gains and losses reported in the income statement, bifurcation is not required as the embedded derivative is already being treated as it would be if it were stand-alone. Equally if the embedded derivative does not in fact meet the derivative definition in the standard it is not bifurcated from the host contract. Both of these questions are generally easy to answer. The complexity in the implementation of the embedded derivatives rules of AS 30 is in the assessment of whether or not the economic characteristics and risks of the embedded derivative are "closely related" to the host contract.
AS 30 provide a number of examples through which it demonstrates the application of the "closely related" principle and states that certain derivatives are considered to be closely related to their host contracts. The basis for this is not economic value; indeed many closely related derivatives can have significant economic impacts. For example, debt instruments may have put and/or call options embedded in them that allow either the holder to put it back to the issuer or the issuer to call it back from the holder. If the strike price of the call or put is not at the accreted amount of the debt instrument the derivative is considered closely related to its host. This option, if exercised, will not result in an accounting gain or loss as the strike will equal the carrying amount, but the derivative could have significant economic value nevertheless.
Embedded derivatives do not only appear in financial instruments, they are also common in other contracts that might be outside the scope of AS 30. Essentially if a derivative is embedded in another contract, any contract, it is quite possible that the derivative will need to be bifurcated from the host and fair valued with gains and losses taken to the income statement. Common examples of contracts that are outside the scope of AS 30 but that have embedded derivatives that are within the scope are leases, insurance contracts and purchases or sale orders.
The concept of an embedded derivative is intellectually supportable from an accounting perspective, but what does it mean in practice for a corporate?
Firstly, in order to ensure all transactions are properly accounted for, it is necessary for corporate to perform a full analysis of their current contracts. On the face of it this may seem a simple if time-consuming task. However, not all embedded derivatives are as easy to spot as equity conversion features in convertible debt. For example, regular rent reviews in a lease could, depending on the basis of the review, be an embedded derivative that requires bifurcation.
To perform the transition to IFRS thoroughly and properly there is a level of training and education that will be necessary. It is important to ensure that appropriately qualified people are looking for these instruments that could, after all, have a material impact on the financial statements. Moreover, it would be prudent, when considering entering into certain transactions to analyze them from an AS 30 perspective in order to understand the potential impact on the financial statements - although clearly the accounting for a transaction should never be a singular driver for whether or not to do a particular piece of business.
In this article, we look at the accounting for embedded derivatives, under the new Accounting Standard (AS) 30 Financial Instruments: Recognition and Measurement.
Embedded derivatives are those instruments that are contractually attached to another non-derivative contract what AS 30 terms a "host contract". A common example would be a convertible bond that has a host debt contract and an equity conversion option embedded within it. Such embedded derivatives can arise through specific structures with the intention to shift certain risks between the counterparties or may arise inadvertently through market practices and common contractual arrangements.
AS 30 requires all derivatives to be measured at fair value on the balance sheet, with changes in fair value being accounted through profit and loss, except for derivatives, that are designated as hedging instruments. The principle in respect of embedded derivatives is that the fact that a derivative is not a legally separate individual contractual instrument should not prevent it from being accounted for in the same way as other stand-alone derivatives under the standard. The result of this is that in many circumstances, embedded derivatives must be separated from their host contracts and accounted for in the same way as stand-alone derivative instruments. There are certain exceptions to this however and the thought process that is employed to determine whether or not an embedded derivative must be separated from its host contract is discussed below.
If the entire financial instrument as a whole is held at fair value with gains and losses reported in the income statement, bifurcation is not required as the embedded derivative is already being treated as it would be if it were stand-alone. Equally if the embedded derivative does not in fact meet the derivative definition in the standard it is not bifurcated from the host contract. Both of these questions are generally easy to answer. The complexity in the implementation of the embedded derivatives rules of AS 30 is in the assessment of whether or not the economic characteristics and risks of the embedded derivative are "closely related" to the host contract.
AS 30 provide a number of examples through which it demonstrates the application of the "closely related" principle and states that certain derivatives are considered to be closely related to their host contracts. The basis for this is not economic value; indeed many closely related derivatives can have significant economic impacts. For example, debt instruments may have put and/or call options embedded in them that allow either the holder to put it back to the issuer or the issuer to call it back from the holder. If the strike price of the call or put is not at the accreted amount of the debt instrument the derivative is considered closely related to its host. This option, if exercised, will not result in an accounting gain or loss as the strike will equal the carrying amount, but the derivative could have significant economic value nevertheless.
Embedded derivatives do not only appear in financial instruments, they are also common in other contracts that might be outside the scope of AS 30. Essentially if a derivative is embedded in another contract, any contract, it is quite possible that the derivative will need to be bifurcated from the host and fair valued with gains and losses taken to the income statement. Common examples of contracts that are outside the scope of AS 30 but that have embedded derivatives that are within the scope are leases, insurance contracts and purchases or sale orders.
The concept of an embedded derivative is intellectually supportable from an accounting perspective, but what does it mean in practice for a corporate?
Firstly, in order to ensure all transactions are properly accounted for, it is necessary for corporate to perform a full analysis of their current contracts. On the face of it this may seem a simple if time-consuming task. However, not all embedded derivatives are as easy to spot as equity conversion features in convertible debt. For example, regular rent reviews in a lease could, depending on the basis of the review, be an embedded derivative that requires bifurcation.
To perform the transition to IFRS thoroughly and properly there is a level of training and education that will be necessary. It is important to ensure that appropriately qualified people are looking for these instruments that could, after all, have a material impact on the financial statements. Moreover, it would be prudent, when considering entering into certain transactions to analyze them from an AS 30 perspective in order to understand the potential impact on the financial statements - although clearly the accounting for a transaction should never be a singular driver for whether or not to do a particular piece of business.
If one has invested Rs 3 lakh in an infrastructure bond and the central banks lowers the repo and reverse repo rates, the floating benchmark in this case will lead to an interest rate decline, which would also mean a decline in your assets. However, in such a scenario one can hedge this risk with the use of IRFs, by taking long position in the segment.
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