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1.6.1 Embedded Derivatives in Assets or Liabilities – Hybrid Instruments

Sometimes, a derivative is “embedded” in an instrument – called a hybrid instrument or hybrid contract – in combination with a host contract. The embedded derivative causes some or all of the contractual cash flows to be modified based on a specified interest rate, a security price, a commodity price, a foreign exchange rate, index of prices or rates, or other variables. The accounting treatment depends on whether the host is a financial asset or a financial liability (see Figure 1.6).

Figure 1.6 IFRS 9 hybrid contracts accounting treatment.

A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument (e.g., an equity warrant attached to a bond), or has a different counterparty, is not an embedded derivative, but a separate financial instrument.

Host Contract is a Financial Asset

When the host contract is a financial asset within the scope of IFRS 9, the hybrid financial instrument is not bifurcated; instead it is assessed in its entirety for classification under the standard.

Existence of a derivative feature in a hybrid instrument might not preclude amortised cost. This may be the case when the economic risks and characteristics of the instrument are closely related to the host contract.

Example: Investment in an convertible bond

An entity invests in a convertible bond. Under the terms of the bond, the entity has the right to convert the bond into a fixed number of shares of the bond's issuer. From a structuring perspective, the bond can be split between a debt instrument and an equity option. From an accounting perspective, the convertible bond would be classified at FVTPL in its entirety as the conversion right causes 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.