Embedded derivative

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Jonny
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Embedded derivative

Post by Jonny »

Hi
A Pre-payment option in debt instruments could not be closely related to the host debt contract and needs to be separated. IFRS 9 para B4.3.5(e). The ifrs are clear in this case.

Instead a Pre-payment option in a in executory contracts or service contracts entered into to meet the entity’s expected purchase, sale or usage requirements (‘own use contracts’) might contain embedded derivatives that need to be accounted for separately from the host executory contract?

For example a service administration contract the has a pre payment option might contain an embedded derivative or the requirement is only for debt instruments/insurance contract?

I suppose that most of contracts have a pre-payment option. Could they be potentially embedded derivatives?

Thank you
pub_acco
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Re: Embedded derivative

Post by pub_acco »

Is it possible to account for prepayment options separately? I'm not able to come up with a specific case. Unlike debt instruments, non-financial purchase agreements don't usually give rise to an asset or liability until the buyer receives goods or services.
Jonny
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Re: Embedded derivative

Post by Jonny »

thanks for your input

but as far as I know it is possible to account a floor or a cap option separately at inception in a "own use" selling contract of goods if the floor (or cap ) is "in the money"

can you help me understand the different situation?
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Marek Muc
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Re: Embedded derivative

Post by Marek Muc »

a floor or a cap relates to the price that you will pay for eg commodity, so such an option has economic value

what do you mean exactly when you refer to a 'prepayment option' in relation to non-financial services? an option to pay in advance for those services?
Jonny
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Re: Embedded derivative

Post by Jonny »

an option to pay in advance and terminate the contract
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Marek Muc
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Re: Embedded derivative

Post by Marek Muc »

It's not a derivative instrument, there's no 'underlying':

https://ifrscommunity.com/knowledge-bas ... -in-ifrs-9
JRSB
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Re: Embedded derivative

Post by JRSB »

I guess if that were an asset/liability there would be no end of similar 'derivatives' for various commercial clauses in revenue contracts.
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Marek Muc
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Re: Embedded derivative

Post by Marek Muc »

True
Jonny
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Re: Embedded derivative

Post by Jonny »

I agree that there isn’t a underlying in this case.

I have an other example coming on.
What about a contract to sell steel 1000 ton at a fixed price (40 euro/ton) for 2 years with an option for the buyer to terminate the contract after one year with a penalty defined in this way:

a) amount equal to quantity not sold at the moment of termination multiplied by 5 euro/ton where 5 euro is the difference between 40 euro and 35 euro (the price of the steel in the market at the date of signing)

Or

b) amount equal to quantity not sold at the moment of termination multiplied by the difference between 40 euro and the price of the steel in the market at the date of termination. The penalty can not be positive for the buyer

Only in case b) I see an underlying, requires no initial net investment and it settled at a future date.

As it is an own use contract we need to understand if the option is closely related to the host contract.

Do you agree?
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pub_acco
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Re: Embedded derivative

Post by pub_acco »

It sounds like the parties adjust the allocation of steel price risk in a reasonable way related to the host steel sale/purchase agreement. If so, the option is closely related to the host.

Is it regarded as a "prepayment" option by the way?
Jonny
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Re: Embedded derivative

Post by Jonny »

do you think is just a penalty or ED with the same risk and economic characteristics of the host contract?
pub_acco
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Re: Embedded derivative

Post by pub_acco »

I think so.
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