Accounting for corporate finance: hybrid debt: closely related embedded derivatives: examples under IAS 39
This guidance applies to companies which adopt IAS 39 (or FRS 26 under Old UK GAAP).
Closely related embedded derivatives: examples
A building society offers capped mortgage loans to customers. The loans carry interest at the building society’s standard variable rate (currently 6.25%), but are capped at 7.5%.
The host contract (a debt contract) contains a derivative (a cap) whose underlying subject matter is interest rates. However, since interest rates are closely linked to debt, and the cap is set at a level above the market rate of interest at the start of the loan, the derivative is closely related to the host contract, and does not have to be separated.
A company holds its headquarters building on a 10-year lease. The lease provides that rental payments are increased annually in line with the Retail Price Index (RPI).
The host contract is a lease, into which is embedded a forward agreement indexed to inflation. The IASB regards the economic characteristics of the index-linking term to be closely allied to the economic characteristics of the lease, so the derivative does not have to be separated. If, however, the adjustment was leveraged - for example, if the rent adjustment was 3 times the increase in the RPI - the derivative would not be “closely related”.
A UK aviation company, whose functional currency is sterling, enters into a contract to buy aviation fuel. The contract is priced in US dollars, to be paid within 30 days of delivery.
The purchase contract contains an embedded currency feature, since the sterling amount the company pays will depend on sterling/dollar exchange rate movements. The currency contract does not need to be separated, because the currency concerned is routinely used for aviation fuel transactions. (The embedded derivative would also be ‘closely related’ if the US dollar was the functional currency of the other party to the contract). Furthermore, the contract contains no option or leverage feature (compare example 3 in CFM25070).