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Embedded derivatives: Key differences between U.S. GAAP and IFRSs

Under U.S. GAAP, ASC 815 is the primary source of guidance on derivative instruments and hedging activities.

Under IFRSs, IAS 39, Financial Instruments: Recognition and Measurement, is the primary source of guidance on derivative instruments and hedging activities. IAS 39 is also the primary source of guidance on recognition, derecognition, and measurement of all financial instruments.

As part of its project to revise financial instruments guidance under IFRSs, the IASB is superseding IAS 39 in phases and incorporating that guidance (as amended by any subsequent standard setting) into IFRS 9, Financial Instruments. The introduction to IFRS 9 notes the following:

The IASB intends that IFRS 9 will ultimately replace IAS 39 in its entirety. However, in response to requests from interested parties that the accounting for financial instruments should be improved quickly, the IASB divided its project to replace IAS 39 into three main phases. As the IASB completes each phase, it will create chapters in IFRS 9 that will replace the corresponding requirements in IAS 39. . . .

In November 2009 the IASB issued the chapters of IFRS 9 relating to the classification and measurement of financial assets. In October 2010 the IASB added to IFRS 9 the requirements related to the classification and measurement of financial liabilities. . . .

This includes requirements on embedded derivatives and how to account for own credit risks for financial liabilities that are measured at fair value.

In November 2013, the IASB added a new chapter to IFRS 9, which introduces a new general hedge accounting model to IFRSs.

For entities that have adopted IFRS 9 (2009), IFRS 9 (2010), or IFRS 9 (2013), IFRS 9 is the primary source of guidance on classification and measurement, recognition, and derecognition of financial assets and financial liabilities (including derivatives) that were previously within the scope of IAS 39. With regard to hybrid financial instruments, IFRS 9 eliminates the requirement under IAS 39 to bifurcate an embedded derivative from a financial asset host contract. Rather, the requirements of IFRS 9 are applied to the entire contract. Conversely, the October 2010 revisions to IFRS 9 retain and incorporate the bifurcation requirements of IAS 39 for a derivative embedded in a host contract that is not an asset within the scope of IFRS 9 (e.g., financial liabilities within the scope of IFRS 9, leasing contracts, insurance contracts, and contracts for the purchase or sale of a nonfinancial item).

IFRSs contain much less interpretive or implementation guidance than U.S. GAAP on the accounting for derivative instruments and hedging activities; Appendix A of IAS 39 and "Guidance on Implementing IAS 39 Financial Instruments: Recognition and Measurement," as well as Appendixes A and B of IFRS 9 and related IAS 39 and IFRS 9 implementation guidance, contain only limited application guidance. A secondary source of guidance that affects the scope of financial instruments accounted for as derivatives is IAS 32, Financial Instruments: Presentation. Certain derivative disclosures also are required by IFRS 7, Financial Instruments: Disclosures.

References to IAS 39 and any related application guidance (i.e., paragraph references beginning with "AG") pertain to the current guidance in IAS 39 (i.e., before the adoption of IFRS 9). References to IFRS 9 and related implementation guidance pertain to the October 2010 revisions to IFRS 9.

The table below summarizes the key differences between U.S. GAAP and IFRSs in accounting for embedded derivatives and is followed by a detailed explanation of each difference.1

IFRSs
Subject U.S. GAAP IAS 39 IFRS 9

Definition of a derivative and scope exceptions

One condition for separating an embedded derivative is that it must meet the definition of a derivative.

One condition for separating an embedded derivative is that it must meet the definition of a derivative. However, differences in the definition of a derivative and in the scope of derivative accounting between U.S. GAAP and IFRSs can lead to differences in conclusions about the accounting for embedded derivatives.

An embedded derivative is not separated from a financial asset host contract that is within the scope of IFRS 9 (i.e., all assets previously within the scope of IAS 39). Rather, the classification and measurement requirements of IFRS 9 are applied to the entire hybrid contract. Conversely, IFRS 9 retains the requirements of IAS 39 to separate an embedded derivative from a host contract that is other than an asset within the scope of IFRS 9 if the applicable criteria are met (refer to the IAS 39 column).

Hybrid contracts measured at fair value through earnings

Another condition for separating an embedded derivative is that the hybrid contract in which it is embedded must not be measured at fair value with changes in fair value reported in earnings.

Another condition for separating an embedded derivative is that the hybrid contract in which it is embedded must not be measured at fair value with changes in fair value reported in earnings. However, differences in the conditions that must be met to elect to carry hybrid contracts at fair value through earnings under U.S. GAAP and IFRSs can lead to differences in conclusions about whether separation of an embedded derivative in a hybrid contract is required.

An embedded derivative is not separated from a financial asset host contract that is within the scope of IFRS 9 (i.e., all assets previously within the scope of IAS 39). Rather, the classification and measurement requirements of IFRS 9 are applied to the entire hybrid contract. Conversely, IFRS 9 retains and incorporates the requirements of IAS 39 to separate an embedded derivative from a host contract that is other than an asset within the scope of IFRS 9 if the applicable criteria are met (refer to the IAS 39 column). Like IAS 39, IFRS 9 may differ from U.S. GAAP with respect to the conditions that such contracts need to meet to qualify for the fair value election.

Not clearly and closely related

A third condition for separating an embedded derivative is that its economic characteristics and risks must not be clearly and closely related to those of the host contract.

A third condition for separating an embedded derivative is that its economic characteristics and risks must not be closely related to those of the host contract. However, there are detailed application differences between IFRSs and U.S. GAAP related to items such as (1) puts, calls, and prepayment options; (2) embedded derivatives in purchase, sale, and service contracts; (3) insurance contracts; (4) caps and floors on interest rates; and (5) foreign currency features. Each of these items is discussed in more detail below.

An embedded derivative is not separated from a financial asset host contract that is within the scope of IFRS 9 (i.e., all assets previously within the scope of IAS 39). Rather, the classification and measurement requirements of IFRS 9 are applied to the entire hybrid contract. Conversely, IFRS 9 retains and incorporates the requirements of IAS 39 to separate an embedded derivative from a host contract that is other than an asset within the scope of IFRS 9 if the applicable criteria are met. (Thus, differences described in the IAS 39 column also may exist under IFRS 9.)

Multiple embedded derivatives

Multiple derivatives embedded in a single hybrid instrument are combined and measured as if they were a single, compound embedded derivative.

Multiple derivatives embedded in a single instrument are accounted for separately if they relate to different risk exposures and are "readily separable and independent of each other." In addition, embedded equity derivatives are accounted for separately from embedded derivatives classified as assets or liabilities.

The guidance on multiple derivatives does not apply to embedded derivatives within a financial asset host contract because embedded derivatives are not separated from a financial asset host contract that is within the scope of IFRS 9. Conversely, multiple embedded derivatives within a host contract that is other than an asset within the scope of IFRS 9 should be accounted for in a manner consistent with IAS 39.

Reassessment of embedded derivative status

An entity typically reassesses whether an embedded feature must be separated whenever the contract’s terms change and when certain events (such as an initial public offering (IPO)) occur.

Entities are not permitted to reassess whether an embedded derivative must be separated unless there is a change in the contract’s terms that significantly modifies the cash flows or a financial asset is reclassified out of the fair value through profit or loss category.

Reassessment of embedded derivative status is not applicable for embedded derivatives within a financial asset host contract because embedded derivatives are not separated from a financial asset host contract that is within the scope of IFRS 9. Conversely, an embedded derivative within a host contract that is other than an asset within the scope of IFRS 9 should be reassessed for separation in a manner consistent with IAS 39.

Presentation of embedded derivatives (combined with the host or separate)

Presentation of embedded derivatives is not explicitly addressed. However, Section II.M.3 of the SEC's Current Accounting and Disclosure Issues in the Division of Corporation Finance (as updated November 30, 2006) states, in part, "Although bifurcated for measurement purposes, embedded derivatives should be presented on a combined basis with the host contract, except in circumstances where the embedded derivative is a liability and the host contract is equity."

IAS 39 does not address whether an embedded derivative should be presented separately on the face of the financial statements.

IFRS 9 does not address the financial statement presentation of embedded derivatives within host contracts that are other than assets within the scope of IFRS 9. Embedded derivatives within a financial asset host contract that is within the scope of IFRS 9 are not separated from the host contract for classification and measurement purposes.

Grandfathered contracts

Upon adoption of Statement 133 (codified in ASC 815), an entity was permitted to select January 1, 1998, or January 1, 1999, as its transition date for embedded derivatives. For an entity making such an election, embedded derivatives in preexisting contracts, except those that are substantively modified after the transition date, are grandfathered from the bifurcation requirements.

IAS 39 does not grandfather any preexisting embedded derivatives. If a first-time adopter of IFRSs cannot reliably determine the initial carrying amounts of an embedded derivative and a host contract, it must treat the entire hybrid contract as a financial instrument held for trading.

IFRS 9 does not grandfather any preexisting embedded derivatives. If a financial asset host contract is within the scope of IFRS 9, the classification and measurement requirements of IFRS 9 are applied to the entire hybrid contract. If an entity measures such a hybrid contract at fair value and had not determined the fair value of the hybrid contract in comparative reporting periods, the entity must measure the hybrid contract as the sum of the components (i.e., the nonderivative host and the embedded derivative) at the end of each comparative reporting period.

Definition of a Derivative and Scope Exceptions

Under U.S. GAAP, IAS 39 and IFRS 9 (for hybrid contracts whose host is not an asset within the scope of IFRS 9), one condition for separating an embedded derivative from the host contract is that a separate instrument with the same terms as the embedded derivative must meet the definition of a derivative (see ASC 815-15-25-1(c), paragraph 11(b) of IAS 39, and paragraph 4.3.3(b) of IFRS 9). The definition of a derivative under U.S. GAAP is not the same as that under IFRSs. For example, under U.S. GAAP, a derivative must have a notional amount or payment provision and must meet a net settlement criterion. Under IFRSs, however, a notional amount or payment provision is not required and there is no net settlement criterion; instead, settlement need only occur by a future date. This difference could lead to differing conclusions about whether an embedded derivative exists. For instance, if an embedded conversion option in an investment in convertible debt meets the definition of a derivative except for the net settlement characteristic, it would not meet the definition of a derivative under U.S. GAAP but would meet the definition of a derivative under IFRSs.

In addition, U.S. GAAP and IFRSs have differing scope exceptions in accounting for derivatives. These scope exceptions also apply to embedded derivatives and thus could lead to differing conclusions about whether an embedded derivative requires bifurcation.

Embedded derivatives are not separated from a financial asset host contract that is within the scope of IFRS 9. Rather, an entity determines whether the entire hybrid contract is to be classified and measured at either fair value or amortized cost under IFRS 9. Conversely, IFRS 9 retains and incorporates the guidance in IAS 39 for host contracts that are not assets within the scope of IFRS 9. Therefore, an entity should apply the guidance in paragraph 4.3.3 of IFRS 9 (which is carried forward from IAS 39) to determine whether it must separate an embedded derivative from such host contracts. If the embedded derivative is separated, the entity should account for the host contract in accordance with other IFRSs.

Hybrid Contracts Measured at Fair Value Through Earnings

ASC 815-15-25-1(b) under U.S. GAAP and paragraph 11(c) of IAS 39 and paragraph 4.3.3(c) of IFRS 9 under IFRSs indicate that an embedded derivative cannot be separated from its host if the entire hybrid instrument is carried at fair value, with changes in fair value recognized in earnings. The financial-instruments-related classification and measurement guidance in U.S. GAAP differs from that in IFRSs. U.S. GAAP and IFRSs differ regarding an entity's ability to elect the fair value option for hybrid instruments. In particular, an entity is not permitted to elect the fair value option for a hybrid contract under IAS 39 or IFRS 9 if (1) "the embedded derivative(s) do(es) not significantly modify the cash flows that otherwise would be required by the contract" or (2) "it is clear with little or no analysis when a similar hybrid instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost" (as indicated in paragraph 11A of IAS 39 and carried over to paragraph 4.3.5 of IFRS 9). Under U.S. GAAP, ASC 815-15-25-4 does not have a similar restriction, although an entity must determine that a financial instrument has an embedded derivative requiring bifurcation before it can make the fair value election.

Therefore, it is possible that the accounting for a hybrid contract under U.S. GAAP could differ from that under IFRSs, which may result in different accounting for the embedded derivative (although, as noted below, entities that have adopted IFRS 9 would not separate any derivative from a hybrid instrument that has an asset host that is within the scope of IFRS 9).

Embedded derivatives are not separated from financial asset host contracts that are within the scope of IFRS 9. Rather, for such contracts, an entity determines whether the entire hybrid contract is to be classified and measured at either fair value or amortized cost under IFRS 9. Conversely, derivatives embedded within hybrid instruments that have a host that is other than an asset within the scope of IFRS 9 should be evaluated in a manner consistent with IAS 39 (in accordance with paragraph 4.3.3 of IFRS 9). For more information, see the "Definition of a Derivative and Scope Exceptions" section above.

Not Clearly and Closely Related

Under U.S. GAAP, ASC 815-15-25-1(a) indicates that an embedded derivative is only bifurcated and accounted for separately from its host contract when (among other criteria) the "economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract" (emphasis added).

Paragraph 11(a) of IAS 39 and paragraph 4.3.3(a) of IFRS 9 similarly indicate that an embedded derivative is only bifurcated and accounted for separately from its host contract when (among other criteria) "the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract" (emphasis added).

Embedded derivatives are not separated from a financial asset host contract that is within the scope of IFRS 9 (i.e., all assets previously within the scope of IAS 39). Rather, an entity determines whether the entire hybrid contract is to be classified and measured at either fair value or amortized cost under IFRS 9. Conversely, derivatives embedded within hybrid instruments that have a host other than an asset that is within the scope of IFRS 9 should be evaluated in a manner consistent with the requirements of IAS 39, which have been retained and incorporated into IFRS 9. Therefore, the discussion below of the application of the term "not closely related" applies to hybrid contracts within the scope of IAS 39 and, under IFRS 9, to hybrid contracts in which the host is other than an asset that is within the scope of IFRS 9.

While the phrases "not clearly and closely related" and "not closely related" convey a similar principle, there are application differences. For instance, the application guidance on some topics in U.S. GAAP is more detailed than it is in IFRSs. Thus, an entity may not necessarily reach the same conclusion under IFRSs as under U.S. GAAP. IAS 39, IFRS 9, and U.S. GAAP also differ in their guidance on how to apply the principle.

The paragraphs below illustrate examples of certain application differences between U.S. GAAP and IAS 39 (and IFRS 9) regarding the terms "not clearly and closely related" and "not closely related."

Debt With Puts, Calls, or Prepayment Options

Under both U.S. GAAP and IAS 39 (and IFRS 9), an entity should assess contractual provisions that allow either party to terminate a debt instrument (such as a debt security or a loan) early and accelerate the repayment of the outstanding principal, either wholly or partly, to determine whether these features must be separated as embedded derivatives. Examples of such provisions include call options of the issuer, put options of the holder, and prepayment features.

Under U.S. GAAP, ASC 815-15-25-402 states:

Provided the call (put) options also are considered to be clearly and closely related to the debt host contract under paragraph 815-15-25-26, call (put) options that can accelerate the repayment of principal on a debt instrument are considered to be clearly and closely related to a debt instrument that requires principal repayments unless both of the following conditions exist:

a. The debt involves a substantial premium or discount (which is common with zero-coupon bonds.

b. The call (put) option is only contingently exercisable.

In addition, ASC 815-15-25-42 outlines the following four-step decision process for determining whether a call or put option that can accelerate the settlement of debt instruments should be considered clearly and closely related to a debt host contract:

  • Step 1: Determine whether the amount paid upon settlement (i.e., the payoff) is adjusted on the basis of changes in an index (e.g., changes in the S&P 500). If so, proceed to step 2; otherwise, continue to step 3.
  • Step 2: Determine whether the payoff is “indexed to an underlying other than interest rates or credit risk.” If so, the embedded feature would not be considered “clearly and closely related to the debt host contract.” If no, then continue to steps 3 and 4 and perform the analysis required by ASC 815-15-25-1 and ASC 815-15-25-6.
  • Step 3: Determine whether the debt involves "a substantial premium or discount." If so, proceed to step 4. If no, the option should be further analyzed under ASC 815-15-25-26, if applicable (i.e., ASC 815-15-25-26 is only applicable if the only underlying is an interest rate or interest rate index).
  • Step 4: Determine whether a "contingently exercisable call (put) option accelerate[s] the repayment of the contractual principal amount." If so, the embedded feature would not be considered clearly and closely related to the debt host contract; however, if the option is not contingently exercisable, it must be further analyzed under ASC 815-15-25-26.

ASC 815-15-25-26 indicates that for debt contracts containing an embedded derivative for which the only underlying is an interest rate or interest rate index, a put or call is not clearly and closely related to the debt host if (1) "[t]he hybrid instrument can contractually be settled in such a way that the investor . . . would not recover substantially all of its initial recorded investment" or (2) "[t]here is a possible future interest rate scenario . . . under which the embedded derivative would at least double the investor's initial rate of return on the host contract" and, for any of those scenarios, "the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return . . . for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception." The latter part of ASC 815-15-25-26 is commonly referred to as the "double-double" test.3

IFRSs do not provide an explicit decision process but contain numerous examples of when the economic characteristics and risks of an embedded derivative are, or are not, closely related to the host. Paragraph AG30 of IAS 39 (paragraph B4.3.5 of IFRS 9) outlines the following examples related to put, call, and prepayment options:

  • AG30(a) (paragraph B4.3.5(a) of IFRS 9) indicates that "[a] put option embedded in an instrument that enables the holder to require the issuer to reacquire the instrument for an amount of cash or other assets that varies on the basis of the change in an equity or commodity price or index is not closely related to a host debt instrument."
  • AG30(g) (paragraph B4.3.5(e) of IFRS 9) indicates that a call, put, or prepayment option is not closely related to the host debt contract unless (1) the option's exercise price is approximately equal to the debt's amortized cost on each exercise date or (2) a prepayment option's 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" (commonly referred to as a "make-whole provision"). Lost interest is computed, as of the prepayment date, as the prepaid principal amount multiplied by the difference between the effective interest rate of the host contract and the effective rate the lender would receive if it reinvested the prepaid principal amount in a similar contract for the remaining term of the host contract.

In addition, paragraph AG33(a) of IAS 39 (paragraph B4.3.8(a) of IFRS 9) outlines an analysis similar to ASC 815-15-25-26, including a "double-double" test similar to that under U.S. GAAP:

An embedded derivative in which the underlying is an interest rate or interest rate index that can change the amount of interest that would otherwise be paid or received on an interest-bearing host debt contract or insurance contract is closely related to the host contract unless the [hybrid contract] can be settled in such a way that the holder would not recover substantially all of its recognised investment or 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.

Embedded Derivatives in Purchase, Sale, and Service Contracts (Adjustments for Unrelated Factors)

Under U.S. GAAP, if the pricing terms in a purchase, sale, or service contract are not clearly and closely related to the asset being sold or purchased, or are denominated in a foreign currency that meets none of the criteria in ASC 815-15-15-10(b) (see the foreign currency discussion below), the application of the normal purchases and normal sales exemption is precluded and the entire contract may thus have to be accounted for as a derivative. (See ASC 815-10-15-22 through 15-51 and ASC 815-15-15-4.)

Under IAS 39, pricing terms that are not closely related to the asset to be sold or purchased do not preclude an entity's application of the "own use" scope exception under paragraphs 5 through 7 of IAS 39 (i.e., the IFRS equivalent of the U.S. GAAP normal purchases and normal sales scope exception) to the host contract. However, the pricing terms may require separation as an embedded derivative. This is particularly relevant when executory contracts are denominated in certain foreign currencies that are not considered closely related to the executory host contract under paragraph AG33(d) of IAS 39 (paragraph B4.3.8(d) of IFRS 9). For more information, see the "Foreign Currency Features and Use of the Parent’s Functional Currency When Highly Inflationary" section below.

Embedded Derivatives Within Insurance Contracts

Paragraph AG33(h) of IAS 39 (paragraph B4.3.8(h) of IFRS 9) states, "A derivative embedded in an insurance contract is closely related to the host insurance contract if the embedded derivative and host insurance contract are so interdependent that an entity cannot measure the embedded derivative separately (ie without considering the host contract)." Because U.S. GAAP do not contain the same guidance, the conclusions reached under U.S. GAAP may be different from those reached under IFRSs. In addition, the application guidance in U.S. GAAP and IFRSs on assessing embedded derivatives in insurance contracts sometimes differs. See Example 2 in Guidance on Implementing IFRS 4, Insurance Contracts (paragraph IG4), which illustrates the treatment of various types of embedded derivatives in insurance contracts under IFRSs. Under U.S. GAAP, entities should consider, for example, ASC 815-10-15-52, ASC 815-10-15-55 through 15-57, ASC 815-10-15-67, ASC 815-10-55-32 through 55-40, ASC 815-10-55-132 through 55-134, ASC 815-15-15-20 and 15-21, ASC 815-15-55-1 through 55-4, ASC 815-15-55-12, ASC 815-15-55-54 through 55-76, ASC 815-15-55-101 through 55-109, ASC 815-15-55-120 through 55-127, ASC 815-15-55-227 through 55-238, and ASC 944-815-25-1 through 25-6.

Caps and Floors on Interest Rates

The guidance in IFRSs on evaluating whether caps and floors on interest rates are clearly and closely related to a debt host contract differs from that in U.S. GAAP. Paragraph AG33(b) of IAS 39 (paragraph B4.3.8(b) of IFRS 9) states, "An embedded floor or cap on the interest rate on a debt contract or insurance contract is closely related to the host contract, 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 contract is issued, and the cap or floor is not leveraged in relation to the host contract." ASC 815-15-25-32 specifies that an embedded floor or cap on interest rates on a debt instrument is clearly and closely related to the host contract unless the conditions in either ASC 815-15-25-26(a) or (b) are met — that is, (1) the "hybrid instrument can contractually be settled in such a way that the investor . . . would not recover substantially all of its initial recorded investment" or (2) there is "a possible future interest rate scenario . . . under which the embedded derivative would at least double the investor's initial rate of return on the host contract" and, for any of those scenarios, "the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return . . . for a contract that has the same terms as the host contract."

Foreign Currency Features and Use of the Parent's Functional Currency When Highly Inflationary

Under U.S. GAAP, ASC 815-15-15-10 states, in part:

An embedded foreign currency derivative shall not be separated from the host contract and considered a derivative instrument under paragraph 815-15-25-1 if all of the following criteria are met:

a. The host contract is not a financial instrument.

b. The host contract requires payment(s) denominated in any of the following currencies:

1. The functional currency of any substantial party to that contract

2. The currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce (for example, the U.S. dollar for crude oil transactions)

3. The local currency of any substantial party to the contract

4. The currency used by a substantial party to the contract as if it were the functional currency because the primary economic environment in which the party operates is highly inflationary (as discussed in paragraph 830-10-45-11)

c. Other aspects of the embedded foreign currency derivative are clearly and closely related to the host contract. [Emphasis added]

Under IFRSs, paragraph AG33(d) of IAS 39 (paragraph B4.3.8(d) of IFRS 9) states, in part:

An embedded foreign currency derivative in a host contract that is an insurance contract or 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:

i.   the functional currency of any substantial party to that contract;

ii.  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); or

iii. 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 (eg a relatively stable and liquid currency that is commonly used in local business transactions or external trade). [Emphasis added]

Criterion (iii) in IAS 39 (and IFRS 9) is worded more broadly than the criterion in U.S. GAAP ((b)(3) above), which requires denomination of such payments in the "local currency of any substantial party to the contract." IAS 39 and IFRS 9 also lack the fourth condition (criterion (b)(4) above) under U.S. GAAP, which permits denomination of such payments in the "currency used by a substantial party to the contract as if it were the functional currency because the primary economic environment in which the party operates is highly inflationary." Under IFRSs, even if a foreign currency derivative requires payments that are denominated in the reporting currency of a parent, an entity must still determine whether the payments are denominated in one of the currencies, as explained in paragraph AG33(d) of IAS 39 (paragraph B4.3.8(d) of IFRS 9).

Example

Assume that Entity X enters into a contract to sell nonfinancial goods to Entity Y in Country A and that the payments are made in Mexican pesos. The Mexican peso is not the functional currency or the local currency of either X or Y and is not the currency in which the price of goods is routinely denominated in commercial transactions around the world. In addition, the Mexican peso is commonly used in contracts in the economic environment in which the transaction takes place (i.e., in Country A), but is not the local currency in Country A. Neither X nor Y operates in a primary economic environment that is highly inflationary. In this case, both parties would conclude that the Mexican peso exposure is closely related under IFRSs. This is because the Mexican peso is commonly used in Country A and therefore meets criterion (iii) of paragraph AG33(d) of IAS 39 (paragraph B4.3.8(d) of IFRS 9). However, both parties would conclude that the Mexican peso exposure is not clearly and closely related under U.S. GAAP. This is because it does not meet any of the criteria in ASC 815-15-15-10(b).

Note that under U.S. GAAP, ASC 815-10-15-30 indicates that if a nonfinancial contract contains an embedded foreign currency derivative that is not clearly and closely related, the entire contract does not qualify for the use of the normal purchases and normal sales scope exception; accordingly, it would have to be accounted for as a derivative if it meets the other derivative criteria in ASC 815. IFRSs do not contain this provision; therefore, an embedded derivative may need to be separated while the host contract may continue to be eligible for the "own use" scope exception and treated as an executory contract.

Moreover, note that under U.S. GAAP, ASC 830-10-45-11 requires that the financial statements of foreign entities in highly inflationary economies be remeasured as if the functional currency were the reporting currency. In accordance with paragraph 14 of IAS 21, The Effects of Changes in Foreign Exchange Rates, IFRSs do not permit a foreign subsidiary with a highly inflationary functional currency to use the reporting currency of its parent as its functional currency only because it is operating in a highly inflationary economy. Therefore, when a subsidiary is operating in a highly inflationary economy, contracts denominated in the functional currency of the subsidiary's parent are not necessarily considered closely related under IFRSs; however, these contracts are exempt from bifurcation under U.S. GAAP.

Multiple Embedded Derivatives

Under U.S. GAAP, entities must treat multiple features embedded in a single contract and requiring bifurcation as if they were a single, compound embedded feature, regardless of interdependencies between the features (see ASC 815-15-25-7 through 25-10). Under IFRSs, paragraph AG29 of IAS 39 (paragraph B4.3.4 of IFRS 9) states:

Generally, multiple embedded derivatives in a single [hybrid contract] are treated as a single compound embedded derivative. However, embedded derivatives that are classified as equity (see IAS 32) are accounted for separately from those classified as assets or liabilities. In addition, if a [hybrid contract] has more than one embedded derivative, and those derivatives relate to different risk exposures and are readily separable and independent of each other, they are accounted for separately from each other.

Under IFRS 9, the existence of multiple embedded derivatives in a financial asset host contract within the scope of IFRS 9 would not affect the accounting for the contract. Because embedded derivatives are not separated from a financial asset host contract that is within the scope of IFRS 9, an entity determines whether the entire hybrid contract must be classified and measured at either fair value or amortized cost under IFRS 9. Conversely, multiple embedded derivatives in a hybrid contract that has a host that is other than an asset that is within the scope of IFRS 9 should be evaluated in a manner consistent with paragraph 11 of IAS 39 (paragraph 4.3.3 of IFRS 9 and, as it relates to multiple embedded derivatives, paragraph B4.3.4 of IFRS 9 as discussed above).

Reassessment of Embedded Derivative Status

Under U.S. GAAP, entities must reassess whether an embedded derivative must be separated. As a general rule, an entity should evaluate a contract for embedded derivatives at inception or acquisition of the contract, whenever the contract’s terms change, and when certain events (such as an IPO) occur. However, see ASC 815-15-25-26 and 25-27 and ASC 815-15-15-10 for exceptions to this general rule."

Under IAS 39, as interpreted in IFRIC Interpretation 9, Reassessment of Embedded Derivatives, an entity is not permitted to reassess whether an embedded derivative must be separated unless (1) there is a change in the terms of the contract that significantly modifies the cash flows that would be required under the contract or (2) an entity reclassifies a financial asset out of the fair value through profit or loss category. For more information, see IFRIC 9.

Under IFRS 9, the reassessment of embedded derivative status does not apply to derivatives embedded within a financial asset host contract because embedded derivatives are not separated from a financial asset host contract that is within the scope of IFRS 9. Conversely, an embedded derivative within a hybrid contract whose host is other than an asset that is within the scope of IFRS 9 cannot be reassessed for separation unless there is a change in the terms of the contract that significantly modifies the cash flows that would be required under the contract. If there is such a change in terms, reassessment is required (paragraph B4.3.11 of IFRS 9).

Presentation of Embedded Derivatives

The presentation of embedded derivatives is not explicitly addressed in U.S. GAAP. However, Section II.M.3 of the SEC's Current Accounting and Disclosure Issues in the Division of Corporation Finance (as updated November 30, 2006) indicates, "Although bifurcated for measurement purposes, embedded derivatives should be presented on a combined basis with the host contract, except in circumstances where the embedded derivative is a liability and the host contract is equity." Thus, under U.S. GAAP, SEC registrants would present the embedded derivative on a combined basis with its related host, except when the embedded derivative is a liability and the host contract is equity.

IFRSs do not address the presentation of embedded derivatives in the balance sheet. Paragraph 11 of IAS 39 explicitly states that IAS 39 "does not address whether an embedded derivative [must] be presented separately in the statement of financial position."

IFRS 9 also does not address the financial statement presentation of embedded derivatives within hybrid contracts that have a host that is other than an asset within the scope of IFRS 9 (paragraph 4.3.4 of IFRS 9). Embedded derivatives within a financial asset host contract within the scope of IFRS 9 are not separated from host contracts for classification and measurement purposes.

Grandfathered Contracts

Upon adoption of Statement 133 (as codified in ASC 815), entities were given the choice to (1) recognize all embedded derivatives or (2) select either January 1, 1998, or January 1, 1999, as a transition date for embedded derivatives. Entities that selected a transition date avoided having to bifurcate any embedded derivatives in existence as of the selected transition date. Thus, such preexisting contracts are "grandfathered" from needing to conform to the requirements of Statement 133 for separating embedded derivatives.

IAS 39 does not grandfather any preexisting embedded derivatives. As stated in paragraph 104 of IAS 39, entities are required to retrospectively apply IAS 39. Paragraph IG55 of IFRS 1, First-time Adoption of International Financial Reporting Standards, indicates that a first-time adopter of IFRSs that "cannot determine the initial carrying amounts of the embedded derivative and host contract reliably [is required to treat] the entire combined contract as a financial instrument held for trading." (This guidance in IFRS 1 was later amended by IFRS 9 to state that the entity is required to measure the "entire combined contract as at fair value through profit or loss.")

Likewise, IFRS 9 does not grandfather any preexisting embedded derivatives, and entities are required to apply its guidance retrospectively. Because embedded derivatives are not separated from a financial asset host contract that is within the scope of IFRS 9, an entity determines whether the entire hybrid contract must be classified and measured at either fair value or amortized cost under IFRS 9. In situations in which (1) a hybrid contract must be measured at fair value under IFRS 9 and (2) an entity had not determined the fair value for that contract in comparative reporting periods, paragraph 7.2.5 of IFRS 9 requires an entity to measure the fair value of the hybrid contract in the comparative reporting periods as "the sum of the fair values of the components (ie the non-derivative host and the embedded derivative) at the end of each comparative reporting period."

Paragraph 7.2.6 of IFRS 9 requires an entity, as of the date it initially applies IFRS 9, to recognize any difference between the fair value of an entire hybrid contract and the sum of the fair values of the components of a hybrid contract (1) "in the opening retained earnings of the reporting period of initial application if the entity applies [IFRS 9] at the beginning of a reporting period" or (2) "in profit or loss if the entity initially applies [IFRS 9] during a reporting period."

For a U.S. GAAP entity that elected a transition date to avoid the need to bifurcate preexisting embedded derivatives and that later adopts IFRSs, the implication of this difference is that upon adoption of IFRSs, previously grandfathered embedded derivatives are no longer grandfathered and must be evaluated under IAS 39 or IFRS 9.

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1 Differences are based on comparison of authoritative literature under U.S. GAAP and IFRSs and do not necessarily include interpretations of such literature.

2 In March 2016, the FASB issued ASU 2016-06, Contingent Put and Call Options in Debt Instruments. ASU 2016-06 addresses inconsistent interpretations of whether an event that triggers an entity’s ability to exercise an embedded contingent option must be indexed to interest rates or credit risk for that option to qualify as clearly and closely related. ASU 2016-06 supersedes ASC 815-15-25-40 and amends ASC 815-15-25-37 and ASC 815-15-25-41 and 25-42. Public business entities must apply the ASU for financial statements issued for fiscal years (inclusive of interim periods) beginning after December 15, 2016; all other entities must adopt the guidance for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within fiscal years beginning after December 15, 2018. An entity can early adopt the ASU, including in an interim period. Adoption of the ASU will not affect the conclusions in this Q&A.

3 ASC 815-15-25-29, ASC 815-15-25-33, and ASC 815-15-25-37 and 25-38 discuss certain exceptions to the requirements of ASC 815-15-25-26.

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