Embedded derivative

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Krishna
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Embedded derivative

Post by Krishna »

A company is invoicing its sales to its subsidiary with price linked to Forex rate. Eg: Initial invoice value is USD 100 on 30 Jan 2023 ( considering INR 1= USD 100), if by due date i.e., on 30 March 2023 if exchange rate increases by 1%, invoice rate would be adjusted accordingly ( as per terms of agreement). If the spot rate on 30 March 2023 is INR 1= USD 101, Debit note will be raised for differential value of USD 1.Hence revised invoice value is USD 101

Whether this scenario is considered as embedded derivative ? If yes, how this should be accounted in respective books, both at initial recognition and subsequent measurement ?

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DJP
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Re: Embedded derivative

Post by DJP »

Warning: this is a difficult and judgemental topic.

It is an embedded derivative and needs to be bifurcated because of the option feature (see IFRS 9 B4.3.8 (d)).

I am assuming that the functional currency is the INR. If so, there is a floor on the sales price expressed in INR -- if the INR appreciates against the dollar your USD revenue would be lower in INR terms, and therefore this clause in the contrat adjusts the pricing so that revenue in terms of INR is not affected.

This is a bit judgemental, but one can argue that the sales in USD (or in any other curency) in an INR functional currency entity is an FX forward contract whereby you agree to sell in USD at an agreed rate of 1 INR = 100 USD -- if the rate goes up, you lose; if the rate goes down, you win.

On top of that, you have bought a call option with a strike price at 1 INR = 100 USD, which basically creates a floor on how much you lose in revenue in case the INR appreciates against the USD. If you didn't have this "floor", you wouldn't have to birfurcate the FX forward (becuase the risk would be considered closely related); however, the floor is an option, and options are not considered closely related according to B4.3.8.

According to IFRS 9 B4.3.4 you must treat all embedded derivatives in a single hybrid contract as a single compound derivative and bifurcate them, meaning that you would have to bifurcate the forward and the option. Another view is to only bifurcate the floor, but this may be in contradiction with B4.3.4. I advise you to consult your auditor on this.

As for the recognition and measurement, once you have identified the embedded derivatives you need to initially recognise them at fair value and account for them according to IFRS 9 (at FVPL). You can make a case to show the fair value changes in the revenue line instead of in finance income/expenses. Again, I advise you to consult your auditor.
JRSB
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Re: Embedded derivative

Post by JRSB »

Amazing explanation DJP.

'Keep it simple' is so often overlooked when drafting contracts and option agreements.
DJP
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Re: Embedded derivative

Post by DJP »

Thanks, JRSB. And yes, these clauses that often seem so simple and make a lot of sense from a business point of view, can be quite a headache to account for.
Krishna
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Re: Embedded derivative

Post by Krishna »

Thanks for the clarification..

Extending this example further, In case of accounting in books of buyer, functional currency of buyer is USD and he had procured inventory in USD.
In order to protect his exposure of his purchases due to variable component in pricing linked to INR VS USD rate, if Buyer obtains Non-deliverable forward contract to hedge the risk of price movement, will it be possible to treat the forward contract as Cash flow hedge ? or it will just be a fair value hedge ?
(specifically considering Functional Currency is USD and by executing Non deliverable FWD contract buyer receives differential USD to compensate the loss on purchases)

Regards
DJP
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Re: Embedded derivative

Post by DJP »

If the purchase is a firm commitment, you can either see it as a cash flow hedge or as a fair value hedge (IFRS 9 p6.5.4). If it is a highly probable forecast transaction, it is a cash flow hedge.

However... I'm not sure if you can apply hedge accounting to this transaction. As I understand it, the purchase contract is only creating an one-sided risk -- in case the INR appreciates against the USD, the USD pricing will increase. But the pricing is not adjusted if the INR depreciates against the USD. A non-deliverable FX forward provides protection for both upward and downward movements; but in this case it would actually introduce FX risk to the buyer in case the INR depreciates against the USD.
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Marek Muc
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Re: Embedded derivative

Post by Marek Muc »

JRSB wrote: 20 Feb 2023, 13:19 Amazing explanation DJP.
Couldn't agree more!
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