How to interpret IFRS 9 B4.3.4 - embedded derivatives

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DJP
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How to interpret IFRS 9 B4.3.4 - embedded derivatives

Post by DJP »

Hello,

IFRS 9 B4.3.4 tell us that multiple embedded derivatives in a single hybrid contract are treated as a single compound embedded derivative, unless the risks they relate to are different, in which case different risk exposures are accounted for separately. Question is -- is this only applicable to embedded derivatives that must be bifurcated, or to all embedded derivatives included in the contract?

For example, an oil purchase contract (firm commitment) in USD by a GBP company from a EUR company is an embedded derivative, but it does not need to be bifurcated according to B4.3.8 (d) (ii). However, if that contract includes a cap and a floor on the USD/GBP rate, then the cap and the floor are not closely related according to B4.3.8 (d) because they are option features. Given that the cap and the floor need to be bifurcated and accounted for separately, does this mean that the USD firm commitment also needs to be treated as part of the single compound embedded derivative because it relates to the same risk (FX risk) according to B4.3.4?

Thanks in advance for any views on this.
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Marek Muc
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Re: How to interpret IFRS 9 B4.3.4 - embedded derivatives

Post by Marek Muc »

Maybe the cap and the floor on the USD/GBP rate are still closely related? They may be treated as in essence a cap and floor on the oil price, which would lead us to para B4.3.8(b): "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."
DJP
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Re: How to interpret IFRS 9 B4.3.4 - embedded derivatives

Post by DJP »

That is a good point, but paragraph B4.3.8 (d) specifically addresses embedded foreign currency derivatives, whereas B4.3.8 (b) seems to address caps and floors only on interest rates and asset prices. It seems that the foreign currency risk in non-financial instrument contracts has a special treatment when it comes to concluding on whether EDs are closely related or not, and option features are not considered closely related according to B4.3.8 (d).
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Marek Muc
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Re: How to interpret IFRS 9 B4.3.4 - embedded derivatives

Post by Marek Muc »

OK you're right

coming back to your original question: I would bifurcate only the floor and cap focusing on IFRS 9.4.3.3, but it certainly is not clear-cut

and what is your opinion?
DJP
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Re: How to interpret IFRS 9 B4.3.4 - embedded derivatives

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I share the same opinion. Only bifurcate EDs that are not closely related. But I appreciate that a literal interpretation of B4.3.4 may lead to a different conclusion. Thanks!
DJP
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Re: How to interpret IFRS 9 B4.3.4 - embedded derivatives

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Please note that one of the Big 4 seems to suggest in its manual of accounting that this is an accounting policy choice.
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Marek Muc
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Re: How to interpret IFRS 9 B4.3.4 - embedded derivatives

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It only confirms that IFRS 9 is not unambiguous in this respect :)

Which Big4 firm?
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Re: How to interpret IFRS 9 B4.3.4 - embedded derivatives

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Deloitte
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