“Double- double test” – Embedded Derivatives as per Ind-As/ IFRS

Readers will appreciate that to understand full dynamics of the Accounting of Derivatives and to identify them as per the requirements of relevant accounting standards will take substantial amount of time and in the interest of all the readers, I will try to make it in separate series/ topics/ parawise which will essentially be co-relating the practical application of the relevant guidances so that it can be digested/ visualizes in an easy manner.

As an introductory statement, all derivatives which are embedded with any host liability are required to be assessed if that derivative part needs to be separated or not as per the below requirement of Ind-As 109 “Financial Instruments”–

Para 4.3.3 – If a hybrid contract contains a host that is not an asset within the scope of this Standard, an embedded derivative shall be separated from the host and accounted for as a derivative under this Standard if, and only if:

(a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host (see paragraphs B4.3.5 and B4.3.8);

(b) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and

(c) the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (ie a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).

Now,

Let’s be clear on the objective of the standard which essentially says first you need to identify whether derivative is there in any contract (financial or non- financial) or not, if YES then it should be other than Asset, if YES then it should be assessed if it is closely related or not, if NOT closely related then separation will be required and normal derivative (fair value) accounting will be followed unless Fair value designation has been used. That’s the overall objective of the standard related to derivatives.

The standard has specifically excluded all such embedded derivatives where host is an ASSET , which means all financial assets will not required to be assessed for separation of derivatives from any host contract.

All hybrid contracts that are not asset will required to be assessed whether separation of derivative is required or not unless an entity designate at FAIR VALUE THROUGH PL. This option to designate at fair value has been given to avoid complex calculations and a choice to the entity only at inception.

> “Double-double test” related provision

Standard wants to assess all such hybrid contracts where such derivatives exists which are required to be separated unless it qualifies for closely related as per para 4.3.3 of Ind-As 109 (above),

Embedded derivative definition has been defined as per para 4.3.1 of Ind-As 109.

Since we will be focusing only on this relevant part of the standard related to “Double-double” test which can then be applied in all cases where leverage is there and still we can conclude the derivative being closely related.

Let’s first refer the below para as per Ind-As 109 – “Financial Instruments”-

Para  B4.3.8 – “………………

(a) An embedded derivative in which the underlying is an interest rate or interest rate index that can change the amount of interest that would otherwise be paid or received on an interest-bearing host debt contract or insurance contract is closely related to the host contract unless

the hybrid contract can be settled in such a way that the holder would not recover substantially all of its recognised investment

or

the embedded derivative could at least double the holder’s initial rate of return on the host contract and could result in a rate of return that is at least twice what the market return would be for a contract with the same terms as the host contract.

Now,

There are many products/ references around the world in which derivatives could exist and hence it was quite challenging for regulators as well to draft any such accounting standard so that all type of potential derivative products will include in it.

Let’s take some example to understand this para –

Example-

A debt instrument has been issued with its fixed interest payment on yearly basis i.e. 10% for next five years and provide an option to holder to convert this fixed payments into a floating interest rate using LIBOR +2%.

To evaluate whether this option given to holder which allows fixed interest payment to floating interest will required to be separated?

Suggested approach –

The option given to convert from fixed to floating is considered as derivative as per Ind-As 109. Now, we need to assess if this is closely related or not…if not then it is to be separated from host instrument.

There are two separate parts in the para above (highlighted in different colors) and either satisfaction of conditions will be suffice. In the present case the first condition will not be relevant as there would not be any scenario where it can be settled back early. Now, coming to next condition where for example LIBOR increases to 18% then floating rate will be calculated by using 18%+ 2% = 20%  which doubles the initial rate of return i.e.10% Vs. 20% (satisfies first part of second condition) BUT when coming to second part of the second condition which says “could result in a rate of return that is at least twice what the market return” which means  that if we assume the current market rate is same as 18% market rate Vs. rate of return i.e. 20% which is not twice of market rate i.e. 18% and hence second part of second condition fails and it is concluded that this is closely related and does not require any separation.

Essentially standards require more LEVERAGES before it is considered for separation. The future interest rate should be calculated at the inception to evaluate this test and there is no need to re-assesses each time (except some conditions).

Example-

A debt instrument is issued which contains “Inverse Floater Rates” (kind of bond whose coupon rate has an Inverse relationship to a benchmark rate) and as per the contract interest rates will be calculated as (18% – 3% * LIBOR).

Suppose initial LIBOR rate is 4% which gives 6% rate of return.

Suggested approach –

Since this is an inverse floater rates bond, then for example LIBOR rates moves to 7% then rate of return would be negative -3%.

Now, Let’s take first part of the para i.e. “….contract can be settled in such a way that the holder would not recover substantially all of its recognised investment which essentially will be satisfied because holder will not be able to recover substantial part of its investment and hence the “Inverse Floater rate” will not be closely related to the host and requires separation. However substantial has not been defined by the standard.

Once we have satisfied first part of the para as above, then there is no need to go and test another condition.

Expected rates movement (i.e. future LIBOR rates etc) would required to be assessed based on the forward prices available at the inception for these kind of contracts and based on the information available at the inception only and does not require re-assessment generally (with some exceptions).

This para is widely known as “Double-double” test under IFRS regime around the world and one has to ensure these conditions before concluding that a derivative indentified is closely related to the host contract.

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)