IFRS PRACTICAL IMPLEMENTATION GUIDE AND WORKBOOK

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Chapter 25 / Financial In struments: Recognition and Measurement (lAS 39)

rency that is commonly used in transactions in the local economic environment in which the transaction takes place Features that would be considered closely related to a host contract are • A call, put, or prepayment option embedded in a host debt contract (i.e., a loan) provided the exercise price is approximately equal to the contract's amortized cost • An inflation index embedded in a host lease contract • An embedded cap or fl oor on the level of interest paid or received on a variabl e debt instru– ment (provided the cap is equal 10 or above the initial market interest rate or the fl oor is equal to or below the initial market interest rate) Example Entity A invests $100,000 in a convertible debt instrument issued by Entity B that pays fix ed inte rest of 7% and that can be converted into 1,000 shares in Entity B in five years at Entity A's opt ion. Otherwise, the bond will pay $100,000 at maturity. Entity A classifies the investment as available fo r sale. In this case, Entity A would be required to separate the equity conve rsion option (the em– bedded derivative) fro m the host debt instrument because (a) the instrument contains an embedded derivative, (b) the instrument is not measured at fa ir value with changes in f air value recognized in profit or loss, and (c) equity and debt characteristics are not closely related. If the estimated f air value of the equity conversion option at initial recognition is $13,000, the jo urnal entry on initial recognition is Dr Available-for-sale investment 87,000 Dr Derivative asset J 3,000 Cr Cash 100.000 (To record the investment in the convertible debt instrument} Subsequently, the equity conversion option is accounted fo r as a derivati ve at fa ir value with changes in fair value recognized in profit or loss, while the host debt instrument is account ed fo r as an available-far-sale fi nancial asset at fa ir value with changes in f air value recognized directly in equity. Moreove r, the difference between the initial carrying amount and the prin cipal amount of the available-far-sale fi nancial asset (i.e., $13,000) is amortized to profit or loss using the effective interest rate method. 7.1.6 If an enti ty is required to se parate an embedde d derivative but is un able to re liably measure the embedded derivative, it is req uired to treat the entire hyb rid ins trument as a financial asset or fi nanci al lia bility that is hel d fo r trad ing (i.e., generally to measure it at fair va lue with changes in fair va lue recogni zed in profit or loss). This case illustrates when to separate embedded derivatives. Facts Entity A is seeki ng to identify embedded derivatives that are require d to be separated under lAS 39. It is considering whether these contracts contain embedded derivatives: (a) An investment in a bond whose interest payment s are linked to the price of gold. The bond is classified as at fair value through profit or loss. (b) An investment in a bond whose interest payments are linked to the price of silve r. The bond is classified as available for sale. (c) An investment in a convertible debt instrument that is classified as ava ilable for sale (d) A lease contract that has a rent adj ustment clause based on inflation (e) An issued convertible debt instrument Required Identify any embedded deriv atives in these cases and, in each case, determine whether any identified embedded derivative requires separate accounting. Solution (a) An investment in a bond whose interest payments are linked to the price of gold contains an embedded derivative on gold. However, because the bond is classified as at fair value through profit or loss, the embedded derivative should not be separated. (b) An investment in a bond whose interest payme nts are linked to the price of silver contains an embedded derivative on silver. Because the bond is not measured at fair value with changes in fair value recognized in profit or loss and a commodity derivative is not close ly related to a host debt contract, the embedded deri vative is separated and accounted for as a derivative. Case Study 13

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