In continuation of previous article “Double-double test – Embedded Derivatives as per Ind-As/ IFRS”, the next para of the relevant section talks about the caps & floor related to host contracts which are to be assessed if a separation is required or not.
Let’s first understand what does CAPS & FLOORS means in Financial Market and why these are being used in various lending arrangements.
An interest rate cap is a type of interest rate derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.
Similarly an interest rate floor is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price.
Caps and floors can be used to hedge against interest rate fluctuations
Refer https://en.wikipedia.org/wiki/Interest_rate_cap_and_floor
Now,
As one can see that these Caps & Floors are being used to hedge against interest rate risk and these are being classified as derivatives as per the definition of Ind-As 109 – “Financial Instruments”
Refer below the relevant para reference which specifically talks about the instances where Caps & Floors are being used in a debt Instrument and an approach towards the assessment if it is closely related to the host Instrument –
Ind-As 109 – “Financial Instruments”
Para B.4.3.8 –“…………(b) An embedded floor or cap on the interest rate on a debt contract or insurance contract is closely related to the host contract, provided the cap is at or above the market rate of interest and the floor is at or below the market rate of interest when the contract is issued, and the cap or floor is not leveraged in relation to the host contract. Similarly, provisions included in a contract to purchase or sell an asset (eg a commodity) that establish a cap and a floor on the price to be paid or received for the asset are closely related to the host contract if both the cap and floor were out of the money at inception and are not leveraged.
Now,
Let’s take an example to understand the overall objective of the standards and its related guidances –
Example-
A Financial Institution issues a Debt Instrument which carries a Variable Interest Loan which was 10% at inception together with a Caps and Floor of 14% and 7% accordingly.
Whether Caps & Floor embedded in the Host Debt agreement to be accounted separately?
Suggested approach –
As we discussed above, the Caps & Floors embedded to this host agreement is a derivative as per Ind-As 109. Now, question is whether this is closely related to the host debt agreement or not.
Standard says the assessment relating to the separation of any Embedded Derivative should be done at inception only and no need to re-visit in future with some exceptions. Hence in our example the loan carries a variable interest rate of 10% at inception and related Cap & Floor rates were 14% and 7% respectively which is OUT OF THE MONEY at the inception and hence considered closely related.
It means, Cap rates are more than the market rate and Floor rates are less than the market rate which is true in our case. The another interesting thing to note here is that the last line of the para above contains “……and are not leveraged” which means there should not be any leverage associated with these Caps & Floors.
Leverage is nothing but something which is more than ONE (numeric number) and is being multiplied by related variable. E.g. anything multiplied by “1” will always give same value but anything multiplied by greater than 1 will increase the output significantly and these kind of Levers will be considered for separation from host debt contract.
The same logic will be applied for any non-fianncial item i.e. commodity etc.
It could be used for kind of a planning for the entities those who are actually trying to buy/ borrow some kind of funds which contains caps & floors and accordingly process change can be initiated.
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 anuj@gyanifrs.com or Whatsapp +91-9634706933)
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