Accounting for Derivatives. Ramirez Juan

or loss by a change in fair value of another financial instrument. In reality, such instances are expected to be rare, unless an entity, for example, holds an asset whose fair value is linked to the fair value of the liability.

      The changes in credit risk recognised in OCI are not recycled to profit or loss on settlement of the liability.

      The following instruments, when recognised at FVTPL, are not required to isolate the change in fair value attributable to credit risk (i.e., all gains and losses are presented in profit or loss):

      • financial guarantee contracts; and

      • loan commitments.

      Measurement of a Liability's Credit Risk

      IFRS 9 largely carries forward guidance from IFRS 7 on how to determine the effect of changes in credit risk. An entity determines the amount of the fair value change that is attributable to changes in its credit risk either:

      • as the amount of change in its fair value that is not attributable to changes in market conditions that give rise to market risk (e.g., a benchmark interest rate, the price of another entity's financial instrument, a commodity price, a foreign exchange rate or an index of prices or rates); or

      • using an alternative method, if it provides a more faithful representation of the changes in the fair value of the liability attributable to the changes in its credit risk.

      IFRS 9 clarifies that this would include any liquidity premium associated with the liability.

      If the only significant relevant changes in market conditions for a liability are changes in an observed (benchmark) interest rate, under IFRS 9 the amount of fair value changes that is attributable to changes in credit risk may be estimated using the so-called default method as follows:

      1. The entity first calculates the liability's internal rate of return at the start of the period using the liability's fair value and contractual cash flows at that date. It then deducts from this internal rate of return the observed (benchmark) interest rate at the start of the period so as to arrive at an “instrument-specific component” of the internal rate of return.

      2. Next, the entity computes a present value of the cash flows of the liability at the end of the period using the liability's contractual cash flows at that date and a discount rate equal to the sum of (i) the observed (benchmark) interest rate at that date and (ii) the instrument-specific component of the internal rate of return determined in 1).

      3. The entity then deducts the present value calculated in 2) from the fair value of the liability at the end of the period. The resulting difference is the change in fair value that is not attributable to changes in the observed (benchmark) interest rate and which is assumed to be attributable to changes in credit risk.

      This default method is appropriate only if the only significant relevant changes in market conditions for a liability are changes in an observed (benchmark) interest rate and that, when other factors are significant, an alternative measure that more faithfully measures the effects of changes in the liability's credit risk should be used. For example, if the liability contains an embedded derivative, the change in fair value of the derivative would be excluded in calculating the fair value change amount attributable to changes in credit risk.

      1.5 THE FAIR VALUE OPTION

      The fair value option is an option to designate financial assets or financial liabilities at FVTPL. The election is available only on initial recognition and is irrevocable. In the case of financial assets, the FVO is available for instruments that would otherwise be mandatorily recognised at amortised cost or at FVOCI, being permitted only if:

      • it eliminates or significantly reduces a measurement or recognition inconsistency (an accounting mismatch).

      In the case of financial liabilities, the FVO is available for instruments that would otherwise be mandatorily recognised at amortised cost, being permitted only if:

      • it eliminates or significantly reduces an accounting mismatch; or

      • a group of financial liabilities (or financial assets and financial liabilities) is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and the information about the group is provided internally on that basis to the entity's key management personnel; or

      • a contract contains one or more embedded derivatives and the host is not a financial asset, in which case an entity may designate the entire hybrid contract at FVTPL unless the embedded derivative is insignificant or it is obvious that separation of the embedded derivative would be prohibited.

      The FVO is only available on initial recognition of the financial asset or liability. This requirement may create a problem if the entity enters into offsetting contracts on different dates. A first financial instrument may be acquired in the anticipation that it will provide a natural offset to another instrument that has yet to be acquired. If the natural hedge is not in place at the outset, IFRS 9 would not allow the first financial instrument to be recorded at FVTPL, as it would not eliminate or significantly reduce a measurement or recognition inconsistency. Additionally, to impose discipline, an entity is precluded from reclassifying financial instruments in or out of the fair value category, unless (in the case of financial assets) the business model for those assets changes.

      Accounting Mismatch

      Sometimes a particular market risk that affects a financial asset or a financial liability is hedged with another financial instrument that behaves in an opposite way to movements in such market risk (i.e., an increase in the market variable would increase the fair value of one of the two items while decreasing that of the other item). In this case, the entity would be interested in measuring the financial asset or financial liability at FVTPL to benefit from their natural offsetting. The entity could apply the FVO because it will eliminate or significantly reduce the measurement or recognition inconsistency that would otherwise arise from measuring these assets or liabilities, or recognising the gains and losses on them, on different bases.

      1.6 HYBRID AND COMPOUND CONTRACTS

1.6.1 Embedded Derivatives in Assets or Liabilities – Hybrid Instruments

Sometimes, a derivative is “embedded” in an instrument – called a hybrid instrument or hybrid contract – in combination with a host contract. The embedded derivative causes some or all of the contractual cash flows to be modified based on a specified interest rate, a security price, a commodity price, a foreign exchange rate, index of prices or rates, or other variables. The accounting treatment depends on whether the host is a financial asset or a financial liability (see Figure 1.6).

Figure 1.6 IFRS 9 hybrid contracts accounting treatment.

      A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument (e.g., an equity warrant attached to a bond), or has a different counterparty, is not an embedded derivative, but a separate financial instrument.

      Host Contract is a Financial Asset

      When the host contract is a financial asset within the scope of IFRS 9, the hybrid financial instrument is not bifurcated; instead it is assessed in its entirety for classification under the standard.

      Existence of a derivative feature in a hybrid instrument might not preclude amortised cost. This may be the case when the economic risks and characteristics of the instrument are closely related to the host contract.

      Example: Investment in an convertible bond

      An entity invests in a convertible bond. Under the terms of the bond, the entity has the right to convert the bond into a fixed number of shares of the bond's issuer. From a structuring perspective, the bond can be split between a debt instrument and an equity option. From an accounting perspective, the convertible