CFM37630 - Loan relationships:‘hybrid’ securities with embedded derivatives: bifurcation of embedded derivatives: accounting treatment

{#IDAH0JKD}

This guidance applies to the bifurcation of embedded derivatives under IAS39 and IFRS9 (and previously FRS26). It also applies to companies that apply FRS102 and which choose to apply the recognition and measurement requirements of IAS39 or IFRS9.

The accounting treatment of bifurcation under IAS39

CFM25040 outlines the accounting principles that determine whether a company must bifurcate under IAS39. Broadly, bifurcation allows different accounting methods to be used for the two components. This is necessary because IAS 39 generally requires derivatives (such as options and ‘contracts for differences’) to be accounted for at ‘fair value’, whereas most companies will account for the loan element on an amortised cost basis.

In practice, not all holders of convertibles and exchangeables will bifurcate under IAS39. The asset may be classified as ‘held for trading’ (CFM21530). This exception will apply mainly to banks and other financial traders holding securities on trading account. Alternatively, the security may be accounted for at fair value through profit and loss (FVTPL) where it has been so designated.

It is more common for bifurcation to be required in respect of instruments issued by a company, as against financial assets. Bifurcation will normally apply under IAS39 unless, exceptionally, there is no readily available way of attributing a ‘fair value’ to the embedded option or equity component, or they are issuing the security in the course of a financial trade. Again, the security may be accounted for at fair value through profit and loss (FVTPL) where it has been so designated.

The accounting requirements of FRS26 (which has not been withdrawn) were aligned with IAS39.

The accounting treatment of bifurcation under IFRS9

The requirements for embedded derivatives under IFRS9 are broadly aligned with that of IAS39 explained above for financial liabilities. However, bifurcation of embedded derivatives is not permitted under IFRS9 in respect of financial assets. Typically such instruments will be required to be measured at fair value.

The accounting treatment of bifurcation under FRS102

Sections 11 and 12 of FRS102 do not allow for the bifurcation of embedded derivatives. However, companies which apply FRS102 have the option to apply the recognition and measurement requirements of IAS39 or IFRS9, as explained above.

It should be noted that in legal form, a compound or ‘hybrid’ security is a single instrument, not two. Bifurcation should be thought of as an accounting device only.

Non-bifurcators {#}

Where a company accounts for the security as a single instrument, it is taxed as a normal loan relationship, with all profits, gains and losses taxed or relieved as income in the usual way, see CFM37625 {#} For periods of account beginning on or after 1 January 2015, this will be the case unless the company applies IAS39 or the option in FRS102 to apply the recognition and measurement principles of IAS39 to all of its financial instruments.