In continuation of previous article “Double-double test & Caps & Floor – Embedded Derivatives as per Ind-As/ IFRS”, it is very common to have call, put or prepayment options associated with any debt instrument which talks about the right/ obligations to issuer/ holder for ending this Instrument by settling agreed amount as defined. That can be of remaining principal amount of debt with or without some penalty clauses or agree to compensate any rate differential to the debt issuer at the time of such prepayments.
Standards objective was to provide a guidance which could be applicable to all such type of options mentioned in any debt instrument and in case the conditions fails then these options will not be treated as closely related and will required to be separated.
Let’s have a quick reference of the standard which talks about such call, put or prepayment options within debt instrument and to guide if separation is required-
Ind-As 109 – Financial Instruments
Para -B-4.3.5 (e) – 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;
(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.
Let’s take an example to understand the overall objective of the standards and its related guidances –
A Company issued a debt instrument of INR 80 M (issued at discount) which has a face value of INR 100 M for the period of 10 years. Below are the different scenarios relating to call, put and prepayment options –
a) Issuer has call option to redeem the debt at amortized cost,
b) Holder has put option to ask for redemption at full value,
c) Holder can prepay the debt early by paying some 1M penalty (fixed amount) on outstanding debt,
d) There is a clause which says that in case of prepayment of debt,the remaining period interest amount will be compared with the current market lending rate and all such excess amount will be paid (present value) by the holder to compensate issuer for any such re-investment risks arises due to this early redemption or clause says some variable amount to be paid as penalty e.g.1.5%,
Suggested approach –
As we have read the relevant provision related to such call, put options where standard says if the exercise price of these options is approximately equal to amortized cost of the debt then it will be closely related. Here the amortized cost means the value which covers any discounts, premiums or other associated cost relating to the debts and considered in its rate of interest called “effective interest rate”. For further discussion to understand effective interest rate please refer earlier article on “Commitment fees and Processing fees on loans- Ind-As”. Hence in case of a debt which has been issued at discount i.e. 80M and has a face value of 100M will be accreted from 80 M to 100M during the period of its life i.e. 10 years and that point of time such calculated value using EIR will be its amortized cost.
a) Under the FIRST situation where issuer has call option to redeem it at its amortized cost i.e. the value which has accreted upto the date of its call option. This is what standard requires in order to qualify such call option as closely related. Hence call option exercise price at amortized cost will be considered as closely related and there is no need to bifurcate such derivative,
b) Under the SECOND situation where holder has put option to ask redemption at its FACE VALUE i.e. 100M which means any time during 10 years, investor can come and ask its full value as redemption amount which will fail the test to qualify as closely related because the exercise price is not at its amortized cost,
c) Under the THIRD situation, When a holder will exercise its prepayment option to pay it early by giving outstanding amount and a FIXED penalty of INR 1 million then unless one will consider the penalty amount is immaterial to overall payment of debt, it will fail the test of exercising option at its amortized cost because each time exercise amount will be OUTSTANDING LOAN PLUS FIXED PENALTY, and hence separation will be required, There are some practices where materiality limits are used and hence if the penalty amount is not so material, it can consider as closely related,
d) Under the FOURTH situation we need to refer second part of the para B 4.3.5 (e) as above which says that in case prepayment option will end by paying all such re-investment risk that would have arisen to the lender who actually had locked its debt for some certain period which holder now wants to break…Hence the idea is to compensate the lender for all such LOST INTEREST (present value) which he would have had lost because of this prepayment and then it can be considered as closely related. In case if it has mentioned to pay some variable percentage i.e.1.5% (as mentioned above) which essentially be related to compensate the issuer for its lost interest and could be considered as closely related,
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)