Accounting for corporate finance: hybrid debt: not closely related embedded derivatives under IAS 39
This guidance applies to companies which adopt IAS 39 (or FRS 26 under Old UK GAAP).
Derivatives that are not closely related
A company issues 5-year bonds, carrying a fixed coupon of 3%. At maturity, they redeem at a premium linked to any growth in the FT-SE 100 index over the 5 years. The holder receives back their original capital if the index has fallen.
The bonds constitute debt contracts into which are embedded option contracts linked to the FT-SE 100. Because the economic characteristics of equity investment differ from those of the host contract, the derivatives are not closely related and must be separated.
A company issues loan notes with a two-year maturity and an interest coupon of 6%. After two years, the issuing company has the option to extend the term of the debt for a further two years. The interest coupon would remain at 6%.
The option to extend the term of the debt is an embedded derivative, whose underlying subject matter is interest rates. The IASB regards the term extension as not being closely related to the host contract where the interest rate does not reset to a market rate.
A UK company enters into a contract to provide services to another UK company. The purchaser of the services has the option of settling the contract in either sterling or Swiss francs. The Swiss franc is not the functional currency of either company.
The host contract here is a contract for services, which contains an embedded currency option. The currency option is not closely related to the host contract, and therefore is required to be separated.