In continuation of previous articles on “ Double-double test, Caps & Floor, Call/Put/ Prepayments, Foreign Currency Bonds, Credit derivatives , leases related options & Normal sale/purchase transactions– Embedded Derivatives as per Ind-As/ IFRS”, any Debt Instrument normally contains a clause which talks about its term (life of the debt Instrument) along with a clause stating that to renew or extend the same debt at same terms for further period. Since the extension could be seen as kind of written option given by the lender to provide extension on the same terms (even same interest rates) which is known today and hence derivative is to be assessed if required to be separated from the Host debt instrument.
The term extension clause could be kind of automatic or could be at the option of borrower which indicates that if the rates at which the extension can be done is below market rate then borrower will surely go for extension. It essentially giving a benefit to the borrower to get cheaper loan after the expiry of Original loan and hence if the extension related interest rates are fixed at inception will be such embedded derivatives which are required to be separated.
Let’s have a quick reference of the standard which talks about such Term Extension clauses in normal debt instruments that are being issued and its related guidances if separation is required-
Ind-As 109 – “Financial Instruments”
Para -B-4.3.5 (b) – 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.
Let’s have clarity about the concept first before we get into an example. There are some options like term extension which can fall under the definition of Loan Commitment also. To understand the concept and definition of Loan commitment please refer earlier article http://taxguru.in/finance/commitment-fees-processing-fees-loans-indas-ifrs.html
Now, If such term extension are being considered as Loan commitment (a policy choice) and such loan commitment are not within the scope of Ind-As 109 then there is no derivative accounting allowed i.e. no separation is required. Conversely if it is being considered as loan commitment and it is within the scope of Ind-As 109 then fair value accounting will be required.
If an entity (by a policy choice) chooses this term extension related to host debt instrument not a loan commitment then one has to see if the rates will be re-set as per current market rate then this will be treated as CLOSELY related. If the extension clause is available at fixed price (not to be re-set at current market rate) then this term extension plan will NOT BE CLOSELY related.
Let’s take an example to understand the overall objective of the standards and its related guidances –
Bank A has given loan to Company X for 3 years for fixed rate of 8% p.a. and given a clause stating TERM EXTENSION based on the below scenarios-
a) Further extension will be available at the same rate which is 8% p.a., or
b) Extension will be made as per the current market price at the end of Year 3
Suggested approach –
a) Extension which is being made at fixed price will not be considered as closely related and hence separation will be required for the embedded derivative. However if the extension clause is being chosen to classified as Loan commitment and if it falls under the Ind-As 109 (as mentioned above) then fair value accounting will be applied,
b) Since re-set of interest rate is being done, the option of terms extension will be treated as closely related and no separation is required.
Readers will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
(Author of this article is an experienced chartered accountant who has specialization on various GAAP conversions assignments covering different industries around different part of the world including acting as an Independent IFRS Advisor & Corporate Trainer. He can be reached via email at email@example.com or Whatsapp +91-9634706933)