Agenda decision on embedded prepayment options in loan contracts

One of the criteria in IFRS 9 Financial Instruments for requiring embedded derivatives to be accounted for separately from the non-derivative host contract (a financial liability) is that the economic characteristics and risks of the embedded derivative are not closely related to those of the host.

Paragraph B4.3.5(e) gives an example of a prepayment option embedded in a host debt contract, which does not have to be separated because it is closely related to the host contract. This occurs if either of the following applies:

1. The option’s exercise price is approximately equal on each exercise date to the amortised cost of the host debt instrument, or
2. The exercise price of a prepayment option reimburses the lender for an amount up to the approximate present value of lost interest for the remaining term of the host contract.
   
   Lost interest is calculated as follows:
   
   Principal amount prepaid X interest rate differential
   
   The interest rate differential is calculated as:
   
   Effective interest rate of the host contract minus the effective interest rate the entity would receive at the prepayment date if it reinvested the principal amount prepaid in a similar contract for the remaining term of the host contract.

Question put to the Committee

When the borrower considers a prepayment option in a financial liability, and lost interest in (ii) above, does the ‘entity’ refer to the lost interest from the perspective of the lender or the reporting entity (the borrower)?

The distinction can have a significant impact on accounting. If the exercise price of the prepayment option in (ii) does not compensate the lender for the approximate present value of lost interest (i.e. it is more or less), then the prepayment option must be separated and accounted for as an embedded derivative at fair value through profit and loss, which is more time consuming and complex than accounting for the entire financial liability at amortised cost.

Committee findings

Evidence gathered by the Committee indicated no diversity in practice in interpreting the term ‘entity’ that could have a material effect on entities’ financial statements. Feedback suggested that stakeholders read the requirements as referring to the lender.

Conclusion

The Committee concluded that this matter did not have a widespread effect and, therefore, decided not to undertake a standard-setting project to amend IFRS 9 in this regard.

More information

Please refer to the agenda decision for more information.