Debt Cap: the available amount: embedded derivatives
IAS 39 or FRS 26 has the concept of an embedded derivative: a provision within a contract (the ‘host contract’) which, if it stood independently, would be classified as a derivative financial instrument. If an embedded derivative is not ‘closely related’ to the host contract, the accounting standards require the derivative element to be recognised separately. There is more detail, and examples at CFM25010 onwards.
For accounting purposes the embedded derivative is split (known as bifurcation) between the loan element and the equity instrument. The loan element is treated as a loan relationship and taxed fully under the loan relationship rules. The difference between the nominal value of the security and the opening value of the host contract is amortised over the life of the security giving rise to a finance charge which is taxed as a loan relationship debit.
However, in the consolidated accounts of the worldwide group, the finance charge on the equity element is not interest or discount, so is not included within the available amount, even though the holders of the security are outside the group and the finance charge is part of the cost of the group’s borrowing.
Regulations 13 and 14 deal with this mismatch by providing that where a UK Company issues an embedded derivative the finance charge element is added to the available amount. References in the Regulations to IAS include reference to accounts prepared under IAS and UK GAAP.