Derivative Financial Instruments

DERIVATIVE FINANCIAL INSTRUMENTS

Reporting Issues THE ACCOUNTING FOR EMBEDDED DERIVATIVES  QUALIFYING HEDGE CRITERIA  DISCLOSURES ABOUT FINANCIAL INSTRUMENTS AND DERIVATIVES. 

EMBEDDED DERIVATIVE PAS39, paragraph 10, defines Embedded derivative as “ a component of a Hybrid or combined instrument that also includes a nonderivative host contract with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone instrument”. In other words, it causes some or all of the cash flows that otherwise would be required by the contract to be modified according to specific interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other underlying variable. NOTE: An embedded derivative is not a separate contract. Both the embedded derivative and the host contract are contained in one instrument.

Embedded derivative accounted for separately: An embedded derivative instrument is to be separated from the host contract and accounted for separately as a derivative instrument by both parties if and only if all the three following criteria are met: (PAS 39, paragraph 11) 1. Risks and economic characteristics are not clearly and closely related to that of the host contract. 2. The hybrid instrument is not measured at fair value with changes reported in earnings; and 3. On a stand alone basis, the embedded feature meets the definition of a derivative. If any of these conditions are not met, the embedded derivative should not accounted for separately.

Examples of embedded derivatives 1. Equity conversion option in a convertible bond instrument that allows the holder to convert the bond into shares of the issuer. 2. Redemption option in an investment in redeemable preference share that allows the issuer to repurchase the preference share. 3. An investment in bond whose interest or principal payment is linked to the price of gold or silver.

Accounting for Embedded Derivative 1.

If the embedded derivative is separated from the host contract, it is accounted for at fair value with changes in FV recognized in profit or loss. The host contract is accounted for in accordance with the relevant accounting standard that applies to the contract.

2.

If an embedded derivative requiring separation from its host , but it cannot reliably measured, the entire contract must be measured at FV. If the FV of the embedded derivative’s FV cannot be determined reliably on the basis of its terms and conditions, if the FV of both HYBRID INSTRUMENT and HOST CONTRACT can be determined, it may be determined indirectly as the difference between the two.

Illustration: - CONVERTIBLE BOND Ultimate Company acquired as investment P 5,000,000 face value convertible bond issued by another entity for P 5,500,000. The bond pays 10% interest and can be converted into 50,000, P 100 par value shares of the issuer at the option of Ultimate Company as ‘available for sale’. It is determined from an active market that the bond w/o the conversion feature can be acquired for P 5,200,000 only. This means that the equity conversion feature has a FV of P 300,000, which is the difference in the acquisition cost of P 5,500,000.

ENTRY:

Ultimate company Initial recognition of investment: Available for sale securities Derivative asset Cash

P 5200000 300000 P 5500000