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HMRC internal manual

Corporate Finance Manual

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Accounting for corporate finance: hybrid debt: accounting treatment

Hybrid debt: accounting treatment

Prior to the implementation of IFRS in 2005, the standard applying to hybrid debt was FRS 4.

Under FRS 4, the issuer of convertible debt measured such debt at cost (less issue costs) as a single liability. On conversion, equity was issued and measured at the value of the liability on the date of conversion.

The holder of the debt held the asset at cost or market value.

Hybrid debt under IAS 39

Prior to IFRS, most derivative contracts did not appear on the balance sheet of an entity, because there was little or no economic cost to be recorded at historic cost. Under IFRS, however, the general rule for derivative contracts is that they do appear on the balance sheet measured at fair value, and changes in fair value are taken to the income statement.

Hybrid debt by its very nature will frequently contain within the overall debt contract (the ‘host contract’) a derivative. This is termed an ‘embedded derivative’ (see CFM25030). IAS 39 often requires the host contract and embedded derivative to be separated into two notional contracts (a process known as ‘bifurcation’), the derivative element being treated as if it was a stand-alone derivative while the host element is treated as a separate contract.

This treatment under IAS 39 will currently apply to all companies which use EU-endorsed IFRS, FRS 101 or which choose the recognition and measurement requirements of IAS 39 under FRS 102. In addition, FRS 26 under Old UK GAAP had the exact same requirements as IAS 39.

See CFM25040 for more detail on when separation is required under IAS 39.

Hybrid debt under IFRS 9

In July 2014, the International Accounting Standards Board (IASB) produced a new accounting standard for financial instruments, IFRS 9. This has the same concept of bifurcation as IAS 39. However, IFRS 9 does not permit a company to bifurcate an embedded derivative out of a financial asset. In many cases it is likely that the whole instrument will be measured at fair value. Bifurcation is still required in respect of financial liabilities and non-financial contracts where the criteria are met.

As of January 2015, IFRS 9 has not been endorsed by the EU. As a result, companies which use EU-endorsed IFRS or FRS 101 are not permitted to use IFRS 9. Companies which use FRS 102 can however choose to apply the recognition and measurement requirements of IFRS 9.

Hybrid debt under FRS 102

Under FRS 102 the general rule for derivative contracts is also that they appear on the balance sheet measured at fair value, and changes in fair value are taken to profit or loss.

FRS 102 does not use the term ‘embedded derivative’. There is no requirement or ability for a company which chooses to account for financial instruments in accordance with the requirements of sections 11 and 12 of FRS 102 to separate the host contract and embedded derivative. It is expected that the existence of an embedded derivative will generally result in the entire contract being measured at fair value with changes in fair value recognised in profit or loss. As noted above, a company which chooses to apply the recognition and measurement provisions of IAS 39 or IFRS 9 will be required to separate embedded derivatives where required by IAS 39 or IFRS 9 respectively.