In continuation of previous articles on "Double-double test, Caps & Floor, Call/Put/ Prepayments, Foreign Currency Bonds ,Credit derivatives & leases related options- Embedded Derivatives as per Ind-AS/ IFRS", Normal sale and purchase transactions (i.e. non financial instruments) which are being done based on delivery basis still can contain embedded derivatives in case of payments have been contracted in foreign currency.
For non- delivery based (or past trend for settling net) sale/ purchase contracts where an entity makes some long term commodity supplies agreement and it can be settled net also has already been explained in previous article refer http://gyanifrs.com/2017/02/take-or-pay-long-term-commodities-contracts-ind-as-ifrs/
Suppose a normal sale/ purchase of non-financial items are contracted to make a payment in some foreign currency then it can be understood in a way to have host contract which is normal sale/ purchase contract and an embedded Currency Swap Derivative which will change foreign currency payments into a functional currency of the counterparty. Standard specifically have mentioned about the cases where such contracts are required to be paid in foreign currency and related guidance to assess whether it is closely related or not.
Let's have a quick reference of the standard which talks about such foreign currency payment for normal sale/ purchase transactions and its related guidances if separation is required-
Para-B-4.3.8 (d) - An embedded foreign currency derivative in a host contract that is an insurance contract or not a financial instrument (such as a contract for the purchase or sale of a non-financial item where the price is denominated in a foreign currency) is closely related to the host contract provided it is not leveraged, does not contain an option feature, and requires payments denominated in one of the following currencies:
(i) the functional currency of any substantial party to that contract;
(ii) the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in commercial transactions around the world (such as the US dollar for crude oil transactions); or
(iii) a currency that is commonly used in contracts to purchase or sell nonfinancial items in the economic environment in which the transaction takes place (eg a relatively stable and liquid currency that is commonly used in local business transactions or external trade).
Let's have clarity about the concept first before we get into an example. Many a times contracts are being made in a currency of the either counterparty (functional currency of seller or buyer) to make the trade feasible and practical for example Indian trader will make an arrangement to get invoice in USD from any US firm and accordingly USD payment will be made to its US counterparty. In this case one of the entities will have some currency risk which standard has specifically admitted and allowed to treat this foreign currency payment related embedded option as closely related. However care should be taken in cases where such foreign currency payments are not in the functional currency of either party and hence it will not be feasible to state/ argue that both parties will bear currency risk and this kind of payment option in foreign currency which is other than the functional currency of either party will NOT be closely related.
Further, there are some commodities which are being normally traded in some specific currency e.g. crude oil which is largely being traded in USD across the world and if such currency are being used to make such payments for the contract then it will still be treated as closely related. There are very few example in practical life where so many commodities (i.e. any non-financial items)will be under this category.
Last para of B.4.3.8(d) of Ind-As 109 talks about in case a small country(usually less stable currency) where the normal trade are being made in some other foreign currency e.g. hyperinflation countries where their own currency has not acceptable for normal trade and usually these countries use some other stable or more liquid currencies e.g. USD, CAD, EURO then these foreign currency contracts will be acceptable to treat this embedded option as closely related.
Let's take an example to understand the overall objective of the standards and its related guidances -
Company A from Australia (functional currency is AUD) has contracted to make physical delivery of COPPER (assuming normally trade in EURO) to Company B who is in China (Functional currency is USD) and as per the agreement below are some specifications-
- The contract has been made to make payments in USD, or
- The contract has been made to make payments in JPY, or
- The contract has been made to make payments in EURO, or
- There is a normal trade of copper which are being made in CAD in china and the contract has mentioned to make payments in CAD only,
Whether the payments in foreign currencies are embedded derivatives to be separated from host contract?
Suggested approach -
- No, The foreign currency payment related embedded derivative will not be separated as USD is a functional currency of one of the parties involved in the contract.
- Yes, Since JPY was neither functional currency of any parties and hence required to be separated,
- No, Even EURO is not a functional currency of either parties involved but we can refer another point which says if the commodity is being routinely traded in that currency then it will be considered as closely related. Euro is the currency in which COPPER is routinely being traded (assumed for illustration purposes),
- No, Since first two point of the para B.4.3.8 (b) are not fulfilled but since the JPY is a currency in which local trade is being done and hence no separation required.
Readers will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle-based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
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