2.1.1 Notional amounts

A derivative usually has a notional amount, such as an amount of currency, number of shares or units of weight or volume, but does not require the holder or writer to invest or receive the notional amount at inception.

However, while a derivative usually has a notional amount, this is not always the case: a derivative could require a fixed payment or payment of an amount that can change (but not proportionally with a change in the underlying) as a result of some future event that is unrelated to a notional amount. For example, a contract that requires a fixed payment of €1,000 if six-month LIBOR increases by 100 basis points is a derivative, even though a notional amount is not specified (at least not in the conventional sense). [IFRS 9.BA.1]. A further example is shown below.

2.1.2 Underlying variables

It follows from the definition (see 2 above) that a derivative will always have at least one underlying variable. The following underlying variables are referred to in the standard, but this is not an exhaustive list (we have provided an example for each of the underlyings):

• specified interest rate (e.g. LIBOR);
• financial instrument price (e.g. the share price of an entity);
• commodity price (e.g. the price of a barrel of oil);
• foreign exchange rate (e.g. the £/$ spot rate);
• index of prices or rates (e.g. Consumer Price Index);
• credit rating (e.g. Fitch);
• credit index (e.g. AAA rated corporate bond index); and
• non-financial variable (e.g. index of earthquake losses or of temperatures).

A contract to receive a royalty, often in exchange for the use of certain property that is not exchange-traded, where the payment is based on the volume of related sales or service revenues and accounted for under IFRS 15 – Revenue from Contracts with Customers (see Chapter 31 at 2.5) is not accounted for as a derivative.

Derivatives that are based on sales volume are not necessarily excluded from the scope of IFRS 9, especially where there is another (financial) underlying, as set out in the next example.

However, contracts that are linked to variables that might be considered non-financial, such as an entity's revenue, can sometimes cause particular interpretative problems as discussed below.

2.1.3 Non-financial variables specific to one party to the contract

The definition of a derivative (see 2 above) refers to underlyings that are non-financial variables not specific to one party to the contract. This reference was introduced by IFRS 4 – Insurance Contracts – to help determine whether or not a financial instrument is an insurance contract (see Chapter 45 at 3.3). An insurance contract is likely to contain such an underlying, for example the occurrence or non-occurrence of a fire that damages or destroys an asset of a party to the contract. For periods beginning on or after 1 January 2021, IFRS 4 will be replaced by IFRS 17 – Insurance Contracts. Non-financial variables that are not specific to one party to the contract might include an index of earthquake losses in a particular region or an index of temperatures in a particular city. [IFRS 9.BA.5]. Those based on climatic variables are sometimes referred to as ‘weather derivatives’. [IFRS 9.B2.1].

A change in the fair value of a non-financial asset is specific to the owner if the fair value reflects not only changes in market prices for such assets (a financial variable) but also the condition of the specific non-financial asset held (a non-financial variable). For example, if a guarantee of the residual value of a specific car exposes the guarantor to the risk of changes in the car's physical condition, the change in that residual value is specific to the owner of the car, and so would not be a derivative. [IFRS 9.BA.5].

Contracts with non-financial variables arise in the gaming industry where a gaming institution takes a position against a customer (rather than providing services to manage the organisation of games between two or more parties). For example, a customer will pay a stake to a bookmaker such that the bookmaker is contractually obliged to pay the customer a specified amount in the event that the bet is a winning one, e.g. if the specified horse wins a given race. The underlying variable (the outcome of the race) is clearly non-financial in nature, but it is unlikely to be specific to either party to the contract. Accordingly such contracts will typically be derivative financial instruments.²

It is not clear whether the reference to non-financial variables specific to one party to the contract means that all instruments with such an underlying would fail to meet the definition of a derivative or only those contracts that are insurance contracts, for which the reference was originally introduced. Until the standard is clarified, in our view, a legitimate case can be made for either view.

The Interpretations Committee considered this issue in the context of contracts indexed to an entity's revenue or EBITDA and initially came to a tentative conclusion that the exclusion was not restricted to insurance contracts.³ However, that conclusion was later withdrawn and the Interpretations Committee referred the issue to the IASB, recommending that the standard be amended to limit the exclusion to insurance contracts.⁴

The IASB confirmed that it had intended the exclusion to apply only to contracts that are within the scope of IFRS 4⁵ however, the IASB eventually decided not to proceed on this issue and the existing definition of a derivative (see 2 above) was incorporated into IFRS 9 without alteration, leaving the issue unaddressed.

A further issue arises in that it is not always clear whether a variable is non-financial. This is illustrated in the following example (in this case the underlying is associated with an embedded feature which might or might not meet the definition of a derivative).

It is not only contracts with payments based on revenue that can cause such problems. Some contracts may require payments based on other measures taken or derived from an entity's financial statements such as EBITDA. The Interpretations Committee considered this matter in July 2006⁶ and in January 2007 referred the matter to the IASB.⁷ However, the IASB eventually decided not to deal with this issue.

Whilst it is tempting to regard an entity's revenue and EBITDA as financial variables, they are driven by a number of different factors many of which are clearly non-financial in nature, for example the general business risks faced by the entity. In addition, many of the drivers of EBITDA and revenue will be specific to that business, for example the location of the business, the nature of its goods or services and managements actions.

One company that has faced this issue in practice is Groupe Renault. This company has issued liabilities on which coupons are linked to revenue and net profit. As can be seen in the following extract, Groupe Renault states that its revenue-linked and net profit-linked features are not considered embedded derivatives and the liabilities are therefore carried at amortised cost. The extract below is from Groupe Renault's 2018 accounts.

In 2009 the Interpretations Committee was asked to consider the accounting treatment for an instrument that contains participation rights by which the instrument holder shares in the net income and losses of the issuer. However, the Interpretations Committee considered the issue without reconsidering the assumptions described in the request, including one that the financial liability did not contain any embedded derivatives.⁸ In other words, the Interpretations Committee implicitly accepted that such a feature need not be separated but did not indicate that separation was necessarily prohibited.

In practice, we believe that an entity may make an accounting policy choice as to whether the entity's revenue, EBITDA or other measures taken or derived from the entity's financial statements, are financial or non-financial variables. Once an entity elects a particular policy, it must consistently apply that approach to all similar transactions.

5.1.1 Foreign currency monetary items

A monetary item denominated in a currency other than an entity's functional currency is accounted for under IAS 21 – The Effects of Changes in Foreign Exchange Rates – with foreign currency gains and losses recognised in profit or loss. The embedded foreign currency derivative is considered closely related to the debt host and is not separated. In other words it would not be considered a functional currency monetary item and a foreign currency forward contract. This also applies where the embedded derivative in a host debt instrument provides a stream of either principal or interest payments denominated in a foreign currency (e.g. a dual currency bond). [IFRS 9.B4.3.8(c)].

5.1.2 Interest rate indices

Many debt instruments contain embedded interest rate indices that can change the amount of interest that would otherwise be paid or received. One of the simplest examples would be a floating rate loan whereby interest is paid quarterly based on three month LIBOR. More complex examples might include the following:

• inverse floater – coupons are paid at a fixed rate minus LIBOR;
• levered inverse floater – as above but a multiplier greater than 1.0 is applied to the resulting coupon;
• delevered floater – coupons lag overall movements in a specified rate, e.g. coupons equal a proportion of the ten year constant maturity treasuries rate plus a fixed premium; or
• range floater – interest is paid at a fixed rate but only for each day in a given period that LIBOR is within a stated range.

In such cases the embedded derivative is closely related to the host debt instrument unless:

1. the combined instrument can be settled in such a way that the holder would not recover substantially all of its recognised investment; or
2. the embedded derivative could at least double the holder's initial rate of return on the host contract and could result in a rate of return that is at least twice what the market return would be for a contract with the same terms as the host contract (often referred to as the ‘double-double test’). [IFRS 9.B4.3.8(a)].

If a holder is permitted, but not required, to settle the combined instrument in a manner such that it does not recover substantially all of its recognised investment, e.g. puttable debt, condition (a) is not satisfied and the embedded derivative is not separated. [IFRS 9.IG C.10]. The standard does not define ‘substantially all’ and therefore judgement will need to be applied, considering all relevant facts and circumstances.

To meet condition (b), the embedded derivative must be able to double the initial return and result in a rate of return that is at least twice what would be expected for a similar contract at the time it takes effect. If it meets only one part of this condition, but not the other, the derivative is regarded as closely related to the host. Due to the requirement ‘could result in a rate of return that is at least twice what the market return would be for a contract with the same terms as the host contract’, the derivative embedded in a simple variable rate loan would be considered closely related to the host because the variable rate at any specific time would be a market rate.

As with all embedded derivatives, the assessment of condition (a) and (b) above is made when the entity becomes party to the contract on the basis of market conditions existing at that time (see 4 above). It is important to note that the assessment is based on the possibility of the holder not recovering its recognised investment or doubling its initial return and obtaining twice the then-market return. The likelihood of this happening is ignored in making the assessment. Therefore, even if the likelihood of this happening is low, the embedded derivative has to be separated from the host contract. The valuation of the embedded derivative would however consider the low probability of this happening, possibly resulting in a relatively low fair value at inception.

An example where the holder would not recover substantially all of its recognised investment would be a bond which becomes immediately repayable if LIBOR increases above a certain threshold, at an amount significantly lower than its issue price. A further example is set out below.

An example of condition (b) above, the ‘double-double test’, is set out below.

5.1.3 Term extension and similar call, put and prepayment options in debt instruments

The application guidance explains that a call, put or prepayment option embedded in a host debt instrument is closely related to the host instrument if, on each exercise date, either i) the option's exercise price is approximately equal to the debt instrument's amortised cost or ii) the exercise price reimburses the lender for an amount up to the approximate present value of lost interest for the remaining term of the host contract; otherwise it is not regarded as closely related. [IFRS 9.B4.3.5(e)]. For embedded derivatives with more than one exercise date, there is no requirement to apply only assessment i) or ii) above to all dates, i.e. provided that either of the assessments is met for each exercise date, the embedded option will be considered to be closely related.

There is no elaboration on what is meant by the term ‘approximately equal’ and so judgement will need to be applied. In assessing whether the exercise price is approximately equal to the amortised cost at each exercise date, should one consider the amortised cost of the hybrid that would reflect the entity's original expectations regarding the future exercise of the prepayment option, or potential revised estimates applying the catch up method to the amortised cost? This question is illustrated in the following simple example (which also provides further illustrations of the application of the effective interest method to instruments containing prepayment options).

Unfortunately, the standard is silent on this issue and preparers of accounts will be required to exercise judgement as to the most appropriate method to use in their individual circumstances.

The standard also says that an option or automatic provision to extend the remaining term to maturity of a debt instrument is not closely related to the host unless, at the time of the extension, there is a concurrent adjustment to the approximate current market rate of interest. [IFRS 9.B4.3.5(b)]. The current market rate of interest would take into consideration the credit risk of the issuer. Taken in isolation, this paragraph and the first paragraph in this section on call, put or prepayment options appear reasonably straightforward to apply. However, in some situations, they are contradictory as set out in the following example.

As set out at 6.2 below, an embedded option-based derivative should be separated from its host contract on the basis of the stated terms of the option feature. However, in situations similar to the one described above, there is significant diversity in practice and we are aware of at least two ways in which entities have dealt with this contradiction in practice. Some entities have looked to the wording in the contract so that what is described as an extension option (or a prepayment option) is evaluated in accordance with the guidance for extension options (or prepayment options). Other entities have determined the most likely outcome of the hybrid instrument based on conditions at initial recognition and the alternative outcome is regarded as the ‘option’. Under this latter approach, if Company Z in the example above considered it was likely to repay its loans from Bank A and Bank B after three years, both loans would be regarded as having a two-year extension option. The first approach is based on the contractual terms, while the second approach is substance-based.

Another complication is that, viewed as a separate instrument, a term extension option is effectively a loan commitment. As loan commitments are generally outside the scope of IFRS 9, with the exception of derecognition and impairment provisions, (see Chapter 45 at 3), some would argue they do not meet the definition of a derivative (see 2 above). Accordingly, when embedded in a host debt instrument, a loan commitment would not be separated as an embedded derivative or, alternatively, would be separated and accounted for as a loan commitment.⁹

The Interpretations Committee discussed both of the above contradictions in March 2012, noting significant diversity in practice and recommended that the IASB consider this issue when it redeliberated the classification and measurement requirements of financial liabilities under IFRS 9. The Committee decided that if the Board did not address this issue as part of its redeliberations, then the Committee would revisit this issue and consider whether guidance should be provided to clarify the accounting for the issuer of a fixed-rate-debt instrument that includes a term-extending option.¹⁰ This issue remains unaddressed in IFRS 9 with no indication from the Interpretations Committee about bringing it back onto its agenda. Preparers of financial statements are therefore left to apply their own judgement considering all the facts and circumstances.

For put, call and prepayment options, there is a further complication that the determination as to whether or not the option is closely related depends on the amortised cost of the instrument. It is not clear whether this reference is to the amortised cost of the host instrument, on the assumption that the option is separated, or to the amortised cost of the entire instrument on the assumption that the option is not separated. As can be seen in Chapter 50 at 3.4, the existence of such options can affect the amortised cost, especially for a portfolio of instruments. Although one trade body has published guidance explaining that where early repayment fees are included in the calculation of effective interest, the prepayment option is likely to be closely related to the loan,¹¹ entities are largely left to apply their own judgement to assess which appears the most appropriate in the specific circumstances.

Prepayment options are also considered closely related to the host debt instrument if the exercise price reimburses the lender for an amount up to the approximate present value of lost interest for the remaining term of the host contract. For these purposes, lost interest is the product of the principal amount prepaid multiplied by the interest rate differential, i.e. the excess of the effective interest rate of the host contract over the effective interest rate that the entity would receive at the prepayment date if it reinvested the principal amount prepaid in a similar contract for the remaining term of the host contract. [IFRS 9.B4.3.5(e)(ii)]. In other words, in order for the prepayment option to be considered closely related to the host, the exercise price of the prepayment option would need to compensate the lender for loss of interest by reducing the economic loss from that which would be incurred on reinvestment. [IFRS 9.BCZ4.97]. In making this assessment, the question may arise what interest rate should be used to discount the interest payments that would be lost if the prepayment option was exercised. If the discount rate used reflects an equivalent credit risk of the issuer, this would seem reasonable. However, the guidance does not prescribe the discount rate to be used and since the assessment is whether the lender would be reimbursed for an amount that is ‘approximately equal’ to the present value of lost interest, there is scope to exercise judgment in determining the appropriate discount rate.

Another question that may arise, is whether the lost interest test requires the lender to be reimbursed for lost interest over the full remaining contractual term at the date of exercise. The assessment states that the interest may be ‘an amount up to’ the present value of the remaining interest. This suggests that the amount may be less than the remaining contractual interest over the full remaining contractual term. Where this is the case, the prepayment option would be deemed to be closely related.

From the perspective of the issuer of a convertible debt instrument with an embedded call or put option, the assessment of whether the option is closely related to the host debt instrument is made before separating the equity element in accordance with IAS 32. [IFRS 9.B4.3.5(e)]. This provides a specific relaxation from the general guidance on prepayment options above because, for accounting purposes, separate accounting for the equity component results in a discount on recognition of the liability component (see Chapter 47 at 6.2), which means that the amortised cost and exercise price are unlikely to approximate to each other for much of the term of the instrument.

An embedded prepayment option in an interest-only or principal-only strip is regarded as closely related to the host contract provided the host contract (i) initially resulted from separating the right to receive contractual cash flows of a financial instrument that, in and of itself, did not contain an embedded derivative, and (ii) does not contain any terms not present in the original host debt contract. [IFRS 9.B4.3.8(e)]. Again this is a specific relaxation from the general guidance on prepayment options above.

If an entity issues a debt instrument and the holder writes a call option on the debt instrument to a third party, the issuer regards the call option as extending the term to maturity of the debt instrument, provided the issuer can be required to participate in or facilitate the remarketing of the debt instrument as a result of the call option being exercised. [IFRS 9.B4.3.5(b)]. Such a component is presumably considered to represent part of a hybrid financial instrument contract rather than a separate instrument in its own right (see 4 above).

5.1.4 Interest rate floors and caps

An embedded floor or cap on the interest rate on a debt instrument is closely related to the host debt instrument, provided the cap is at or above the market rate of interest, and the floor is at or below the market rate of interest, when the instrument is issued (in other words it needs to be at- or out-of-the-money), and the cap or floor is not leveraged in relation to the host instrument. [IFRS 9.B4.3.8(b)].

The standard does not clarify what is meant by ‘market rate of interest’, or whether the cap (floor) should be considered as a single derivative or a series of caplets (floorlets) to be evaluated separately. Where the cap (floor) is at a constant amount throughout the term of the debt, historically entities have often compared the cap (floor) rate with the current spot floating rate at inception of the contract to determine whether the embedded derivative is closely related. However, in the current extremely low, or negative, interest rate environment of many economies, floors are more commonly being set at higher rates than current spot rates. As a result, entities are starting to evaluate whether more sophisticated approaches to evaluate these features are more appropriate, e.g. by comparing the average forward rate over the life of the bond with the floor rate or by comparing the forward rate at each interest reset date with each floorlet rate. We do not believe it is necessary for both a cap and a floor to be present to be considered closely related. For example, a cap (or floor) on the coupon paid on a debt instrument without a corresponding floor (or cap) could be regarded as closely related to the host, provided it was above (or below) the market rate of interest on origination.

The Interpretations Committee was asked, in January 2016, to clarify the application of the embedded derivatives requirements in a negative interest rate environment. The Interpretations Committee observed that:

• paragraph B4.3.8(b) of IFRS 9 does not distinguish between positive and negative interest rate environments. As such an interest rate floor in a negative interest rate environment should be treated in the same way as in a positive interest rate environment;
• when applying paragraph B4.3.8(b) of IFRS 9 in a positive or negative interest rate environment, an entity should compare the overall interest rate floor (i.e. benchmark interest rate referenced in the contract plus contractual spreads and if applicable any premiums, discounts or other elements that would be relevant to the calculation of the effective interest rate) for the hybrid contract to the market rate of interest for a similar contract without the interest rate floor (i.e. the host contract); and
• the appropriate market rate of interest for the host contract should be determined by considering the specific forms of the host contract and the relevant spreads (including credit spreads) appropriate for the transaction. They also noted that the term market rate of interest is linked to the concept of fair value as defined in IFRS 13 and is described in IFRS 9 as the rate of interest ‘for a similar instrument (similar as to currency, term, type of interest and other factors) with a similar credit rating’. [IFRS 9.B5.1.1].

The Interpretations Committee determined that neither an Interpretation nor an amendment to a Standard was necessary and did not add this issue to its agenda.¹²

In practice entities perform the assessment of whether a cap or floor is ‘at or below market interest’ by either considering the cap or floor as a single instrument and applying the current swap rate, or by considering the component caplets and floorlets making up the overall cap or floor using the forward rate for the payment date of each particular caplet or floorlet.

Where, in making the assessment on the cap or floor as a single instrument, an entity determines that the cap or floor is not closely related, then the whole embedded cap or floor is accounted for as a single non-closely related embedded derivative at fair value through profit or loss.

5.1.5 Inflation-linked debt instruments

It is quite common for some entities (and governments) to issue inflation-linked debt instruments, i.e. where interest and/or principal payments are linked to, say, a consumer price index. The only embedded derivative guidance in IFRS 9 relating to embedded inflation-linked features is provided in the context of leases (see 5.3.2 below). If that guidance is accepted as applying to finance leases, it should also apply to debt instruments because finance leases result in assets and liabilities that are, in substance, no different to debt instruments (see Chapter 45 at 2.2.4). Further, in much finance theory, either real (applied to current prices) or nominal (applied to inflation adjusted prices) interest rates are used, suggesting a strong link between inflation and interest rates. Finally, a government or central bank will generally raise short-term interest rates as inflation rises and reduce rates as inflation recedes, which also suggests a close relationship between the two.

Therefore, we believe it would often be appropriate to treat the embedded derivative in inflation-linked debt as similar to an interest rate index and refer to the guidance at 5.1.2 above to determine whether the index is regarded as closely related to the debt. Typically, the index will be closely related to the debt where it is based on inflation in an economic environment in which the bond is issued/denominated, it is not significantly leveraged in relation to the debt and there is a sufficiently low risk of the investor not recovering its initial investment (only sometimes do such instruments provide an absolute guarantee that the principal will not be lost, although this situation will normally only arise if, over the life of the instrument, cumulative inflation is negative). However, some may argue that even if there is a very small risk of the initial investment not being recovered, the embedded derivative should be separated.

The staff of the Interpretations Committee has expressed a view that it would be appropriate to treat the embedded derivative in inflation-linked debt as closely related in economic environments where interest rates are mainly set so as to meet inflation targets, as evidenced by strong long-run correlation between nominal interest rates and inflation. In such jurisdictions they considered the characteristics and risks of the inflation embedded derivative to be closely related to the host debt contract.¹³ Further, in debating the application of the effective interest method to such instruments (see Chapter 50 at 3.6) they have implicitly acknowledged that these instruments do not necessarily contain embedded derivatives requiring separation.

5.1.6 Commodity- and equity-linked interest and principal payments

Equity-indexed or commodity-indexed interest or principal payments embedded in a host debt instrument, i.e. where the amount of interest or principal is indexed to the value of an equity instrument or commodity (e.g. gold), are not closely related to the host debt instrument because the risks inherent in the embedded derivative are dissimilar to those of the host. [IFRS 9.B4.3.5(c)-(d)]. This is illustrated in the following example.

A common type of transaction is where refiners of commodities enter into purchase contracts for mineral ores, whereby the price is adjusted subsequent to delivery, based on the quoted market price of the refined commodity extracted from the ore. These arrangements, often called provisionally-priced contracts, can provide the refiner with a hedge of the fair value of its inventories and/or related sales proceeds which vary depending on subsequent changes in quoted commodity prices. Like the debt instruments noted above, any payable (or receivable) recognised at the time of delivery will contain an embedded commodity derivative. In these circumstances, provided the payable is held at fair value through profit or loss, it is unlikely to make much difference to the amount recognised whether the embedded derivative is separated or not. Since the receivable is an asset within the scope of IFRS 9 the embedded derivative could not be separated.

However, it would not normally be regarded as necessary to account separately for such an embedded derivative prior to delivery of the non-financial item. This is because, until delivery occurs, the contract is considered executory and the pricing feature would be considered closely related to the commodity being delivered (see 5.2.2 below).

5.1.7 Credit-linked notes

Credit derivatives are sometimes embedded in a host debt instrument whereby one party (the ‘beneficiary’) transfers the credit risk of a particular reference asset, which it may not own, to another party (the ‘guarantor’). Such credit derivatives allow the guarantor to assume the credit risk associated with the reference asset without directly owning it. [IFRS 9.B4.3.5(f)].

Whilst the economic characteristics of a debt instrument will include credit risk, should the embedded derivative be a credit derivative linked to the credit standing of an entity other than the issuer, it would not normally be regarded as closely related to the host debt instrument if the issuer were not required, through the terms of the financial instrument, to own the reference asset.

For example, an entity (commonly a structured entity) may issue various tranches of debt instruments that are referenced to a group of assets, such as a portfolio of bonds, mortgages or trade receivables, and the credit exposure from those assets is allocated to the debt instruments using a so called ‘waterfall’ feature. The waterfall feature itself does not normally result in the separation of an embedded credit derivative; it is the location or ownership of the reference assets that is most important to the assessment.¹⁴ If the structured entity is required to hold the reference assets, the credit risk embedded in the debt instruments is considered closely related. However, if the issuer of the debt instruments held a credit derivative over the reference assets rather than the assets themselves, the embedded credit derivative would not be regarded as closely related.

5.1.8 Instruments with an equity kicker

In some instances, venture capital entities provide subordinated loans on terms that entitle them to receive shares if and when the borrowing entity lists its shares on a stock exchange, as illustrated in the following example.

Similarly, the derivative embedded in a bond that is convertible (or exchangeable) into equity shares of a third party will not be closely related to the host debt instrument.

5.1.9 Puttable instruments

Another example of a hybrid contract is a financial instrument that gives the holder a right to put it back to the issuer in exchange for an amount that varies on the basis of the change in an equity or commodity price or index (a ‘puttable instrument’). Where the host is a debt instrument, the embedded derivative, the indexed principal payment, cannot be regarded as closely related to that debt instrument. Because the principal payment can increase and decrease, the embedded derivative is a non-option derivative whose value is indexed to the underlying variable (see 6.1 below). [IFRS 9.B4.3.5(a), B4.3.6].

From the perspective of the issuer of a puttable instrument, that can be put back at any time for cash equal to a proportionate share of the net asset value of an entity (such as units of an open-ended mutual fund or some unit-linked investment products), the effect of the issuer separating an embedded derivative and accounting for each component is to measure the combined instrument at the redemption amount, that would be payable at the end of the reporting period, if the holder were to exercise its right to put the instrument back to the issuer. [IFRS 9.B4.3.7].

For the holder of such an instrument, the requirements of the standard are applied to the instrument as a whole, resulting in such investments in puttable instruments being recognised at fair value through profit or loss in their entirety. [IFRS 9.4.3.2].

This treatment was clarified by the Interpretations Committee in May 2017 when the Committee confirmed that the election to present subsequent changes in fair value in other comprehensive income was not available to these instruments, as they did not meet the definition of an equity instrument.¹⁵

Whilst it was not explicitly stated, the ineligibility of such instruments to make this election means they must be recognised at fair value through profit or loss.

5.2.1 Foreign currency derivatives

An embedded foreign currency derivative in a contract that is not a financial instrument is closely related to the host contract provided it is not leveraged, does not contain an option feature and requires payments denominated in one of the following currencies:

1. the functional currency of any substantial party to the contract – see 5.2.1.A below;
2. the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in commercial transactions around the world (such as the US dollar for crude oil transactions) – see 5.2.1.B below; or
3. a currency that is commonly used in contracts to purchase or sell non-financial items in the economic environment in which the transaction takes place (e.g. a relatively stable and liquid currency that is commonly used in local business transactions or external trade) – see 5.2.1.C below.

Therefore, in such cases the embedded foreign currency derivative is not accounted for separately from the host contract. [IFRS 9.B4.3.8(d)]. An example would be a contract for the purchase or sale of a non-financial item, where the price is denominated in a foreign currency that meets one of the three criteria outlined above.

5.2.2 Inputs, ingredients, substitutes and other proxy pricing mechanisms

It is common for the pricing of contracts for the supply of goods, services or other non-financial items to be determined by reference to the price of inputs to, ingredients used to generate, or substitutes for the non-financial item, especially where the non-financial item is not itself quoted in an active market. For example, a provider of call centre services may determine that a large proportion of the costs of providing the service will be employee costs in a particular country. Accordingly, it may seek to link the price in a long-term contract to supply its services to the relevant wage index, effectively to provide an economic hedge of its exposure to changes in employee costs. Similarly, the producer of goods may index the price of its product to the market value of commodities that are used in the production process.

The standard contains little or no detailed guidance for determining whether or not such pricing features should be considered closely related to the host contract. However, the general requirement of the standard to assess the economic characteristics and risks would suggest that where a good link to the inputs can be established, such features will normally be considered closely related to the host, unless they were significantly leveraged.

Other proxy pricing mechanisms may arise in long-term supply agreements for commodities where there is no active market in the commodity. For example, in the 1980s, when natural gas first started to be extracted from the North Sea in significant volumes, there was no active market for that gas and thus no market price on which to base the price of long-term contracts. Because of this, suppliers and customers were willing to enter into such contracts where the price was indexed to the market price of other commodities such as crude oil that could potentially be used as a substitute for gas. For contracts entered into before the development of an active gas market, such features would normally be considered closely related, especially if similar pricing mechanisms were commonly used by other participants in the market.

Where there is an active market price for the non-financial items being supplied under the contract, different considerations apply. The use of the proxy pricing mechanism is a strong indication that the entity has entered into a speculative position and we would not normally consider such features to be closely related to the host. The separation of these types of embedded derivatives can be seen in the following extract from BP's financial statements. Although this was disclosed under IAS 39 there is no reason to believe that the outcome would be different under IFRS 9.

5.2.3 Inflation-linked features

Apart from that related to leases (see 5.3.2 below), there is no reference in the guidance to contracts containing payments that are linked to inflation. Many types of contracts contain inflation-linked payments and it would appear sensible to apply the guidance in respect of leases to these contracts. Consider, for example, a long-term agreement to supply services under which payments increase by reference to a general price index and are not leveraged in any way. In cases such as this, the embedded inflation-linked derivative would normally be considered closely related to the host, provided the index related to a measure of inflation in an appropriate economic environment, such as the one in which the services were being supplied.

5.2.4 Floors and caps

Similar to debt instruments (see 5.1.4 above), provisions within a contract to purchase or sell an asset (e.g. a commodity) that establishes 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. [IFRS 9.B4.3.8(b)].

5.2.5 Fund performance fees

In the investment management industry, it is common for a fund manager to receive a fee based on the performance of the assets managed in addition to a base fee. For example, if a fund's net asset value increases over its accounting year, the manager may be entitled to a percentage of that increase. The contract for providing investment management services to the fund clearly contains an embedded derivative (the underlying is the value of the fund's assets). However, whilst not addressed explicitly in the standard, we would normally consider it appropriate to regard such features as closely related to the host contract. Performance-based fees are discussed in more detail in Chapter 29 at 2.2.3 and Example 29.5.

5.3.1 Foreign currency derivatives

A lessor's finance lease receivable or a lessee's lease payable, which is recognised in accordance with IFRS 16 – Leases, is accounted for as a financial instrument, albeit one that is not subject to all of the measurement requirements of IFRS 9 (see Chapter 45 at 2.2.4). Therefore, a lease denominated in a foreign currency will not generally be considered to contain an embedded foreign currency derivative requiring separation, because the payable or receivable is a monetary item within the scope of IAS 21.

However, under IFRS 16, an operating lease for a lessor and a short-term lease for a lessee, is accounted for as an executory contract. Accordingly, where the lease payments are denominated in a foreign currency, the analysis at 5.2.1 above is applicable and it may be necessary to separate an embedded derivative. See Example 46.19 at 6.1 below for an example of a foreign exchange currency derivative requiring separation from a (hybrid) lease contract.

5.3.2 Inflation-linked features

An embedded derivative in a lease is considered closely related to the host if it is an inflation-related index such as an index of lease payments to a consumer price index, provided that the lease is not leveraged and the index relates to inflation in the entity's own economic environment. [IFRS 9.B4.3.8(f)(i)].

5.3.3 Contingent rentals based on related sales

Where a lease requires contingent rentals based on related sales, that embedded derivative is considered to be closely related to the host lease. [IFRS 9.B4.3.8(f)(ii)].

5.3.4 Contingent rentals based on variable interest rates

If a derivative embedded within a lease arises from contingent rentals based on variable interest rates, it is considered closely related. [IFRS 9.B4.3.8(f)(iii)].