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IAS 39 — Financial instruments: recognition and measurement

Date recorded:

Agenda Paper 9: Separation of an embedded floor from a floating rate host contract in a negative interest environment

The Senior Technical Manager opened the session on IAS 39. The agenda paper illustrated the issue of an interest floor at zero per cent. The submitter had asked whether the floor should be separated from a floating rate host and accounted for as a derivative in a negative interest rate environment. IAS 39 required separation of an embedded derivative if it was not closely related to its host. IAS 39.AG33(b) stated that an embedded floor was closely related to the economic characteristics and the risks of the host contract if the floor was at or below the market rate of interest when the contract was issued and the floor was not leveraged in relation to the host contract. That meant that a floor that was ‘in the money’ when the contract was issued required separation.

The submitter had identified two views for the issue. View 1 required separation and accounting for the floor as a derivative while View 2 did not require separation on the grounds of a zero per cent floor being a special case with negative interest rates representing a fee for depositing money. The outreach conducted by the staff had revealed that European regulators, standard-setters and accounting firms preferred View 2. Some argued that the market rate of interest referred to in IAS 39.AG33(b) was an overall interest rate that included spreads above the benchmark interest rate. Even if the benchmark rate was negative, the overall interest rate including the spread would be positive and the zero per cent floor would be out of the money. However, some respondents preferred separation.

The staff was in the view that negative interest is a form of interest as IFRS 9 indicated that in extreme economic circumstances, interest could be negative.  Therefore, IAS 39.AG33(b) was also applicable in a negative interest rate environment. When considering the ‘market rate of interest’ an entity was required to include the relevant credit or other spreads. IAS 39 therefore contained sufficient guidance to resolve the issue raised by the submitter.

Many Committee members agreed with the staff view. One Committee member said that even when including the spread sometimes the market interest could be negative, albeit this was a very rare scenario. He asked whether the interest could be hedged if there was no bifurcation. One Committee member asked if jurisdictions that did not allow having interest below zero had an implicit floor in every contract.

Some Committee members struggled with negative interest being interest. One Committee member said that the Committee had previously decided that negative interest should be presented in an appropriate expense category which did not automatically make it interest expense. The Technical Director warned that not seeing the negative interest as interest could lead into problems with the SPPI test in IFRS 9. If it was argued that this was a special case, this would have to be cut out very clearly. One Committee member saw it as a penalty but wondered whether IFRS 9 could be analogised to account for the penalty. The Chairman said that IFRS 9 clarified that interest was a composite. This was picked up by an observing Board member who said that the discussion around interest should be conducted very carefully. She said that the overall interest would still be interest even if one component dominated. The Technical Director warned that this could also trigger a debate about the justification of discounting items in the balance sheet.

Some Committee members said that it should be clarified that comparing the benchmark interest and the market interest was not in accordance with IAS 39.AG33(b). Instead the total coupon should be compared. The Technical Director acknowledged this and said that the agenda decision should reflect this discussion. One Committee member said that it needed to be clarified what the market was when determining the market interest rate.

When called to vote, 11 of the 14 Committee members supported the agenda decision with some revision to the wording.

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