Embedded Derivative McCarthyism
By Charles Hattingh CA (SA) Chartered Financial Analyst
With AC133 becoming GAAP this year, the auditing profession seems to be on a witch-hunt looking for
embedded derivatives under every bed cover. Stand-alone derivatives such as cover contracts, futures,
options, swaps, etc. are easy to identify. But what is mostly concerning the profession is the derivatives
they know nothing about that may be lurking in various contracts entered into by the company, which must
(should/shall) now be exposed, considered for separate accounting and, if necessary, be measured and
recognised.
The word “embedded” gained notoriety during the recent Iraqi war (remember the embedded journalists?).
According to my Oxford Advanced Learner’s Dictionary of Current English “embedded” means “fixed
firmly in a surrounding mass”. A common example of an embedded derivative would be a convertible
bond. The bond itself is the “surrounding mass” and the call option on the company’s equity is the
“embedded derivative”.
The word “derivative” should be interpreted based on the meaning in AC133. It is a financial instrument:
1. Whose value changes in response to a change in some “underlying”.
2. That requires no or little net investment.
3. That is settled at a future date.
The first problem facing preparers and auditors is to identify where these little things could be buried.
Some places to look would be in:
 Lease agreements
 Insurance policies
 Supply contracts
 Investments
 Loans
 Other derivative instruments
Management should develop a search system to identify these derivatives and the auditors should assess
and test the system for effectiveness.
After identifying an embedded derivative, one should consider whether or not it is necessary to separate it
from its host contract. Separation IS necessary if:
1. The economic characteristics and risks of the embedded derivative are NOT closely related to those of
the host contract. AND
2. A separate instrument with the same terms as the embedded derivative WOULD meet the definition of
a derivative. AND
3. The combined instrument is NOT measured at fair value with changes in fair value reported in net
profit or loss.
So if a company owns a convertible debenture and recognises it at fair value with value changes going
through income, it is not necessary to separate the derivative from the host contract. Why? Because the
derivative is effectively being fairly valued in the balance sheet with fair value changes going through
income.
The major query I am receiving at present is how to deal with embedded derivatives in sales and purchase
supply contracts. The guidance given in the statement in this respect is that separation is NOT necessary if
the contract itself is not a financial instrument and it requires payments denominated in:
1. The currency of the primary economic environment in which any substantial party to that contract
operates OR
2. The currency in which the price of the related good or service that is acquired or delivered is routinely
denominated in international commerce, e.g. crude oil.
The following further guidance is given in the examples published by the IASC on this statement:
Question 25.2
An embedded derivative should be separated from a supply contract where payment is not in the currency
of the primary economic environment of either party or the currency in which the product is routinely
priced in international commerce.
Question 25.5
The meaning of “routinely denominated in international commerce” is a currency that is used for similar
transactions all around the world, not just in one local area.
Question 25.6
The meaning of “primary economic environment in which any substantial party to the contract operates”
means the currency used in measuring items in the financial statements of the party to the contract or the
currency of the country in which the party to the contract is domiciled.
Example 1
A small local private company entered into a supply contract to sell 10 000 items of a certain product for
$100 each to a company in France. At the date the contract was entered into the exchange rate was $1 =
R6,00, at the date the goods were delivered the rate was $1 = R7,00 and at the date payment was received
the rate was $1 = R8,00. The company’s year-end was after the contract was signed but prior to delivery of
the goods. At this date the rate was $1 = R7,50. For the purpose of the entries below, I have assumed that
the spot rate and the cover rate are equal, i.e. there are no forward premiums.
Journal Entries (R’000)
At Year End
Embedded derivative
Gain
10 000 x $100 x R(7,50 – 6,00)
At Date of Sale
Loss
Embedded derivative
10 000 x $100 x R(7,50 – 7,00)
Receivable
Sales
Embedded derivative
10 000 x $100 x R7,00
At Date of Receipt
Receivable
Gain
10 000 x $100 x R(8,00 – 7,00)
Cash
Receivable
10 000 x $100 x R8,00
Summary
AC133
Cash
8 000
Sales
6 000
Forex gain
1 000
Gain on derivative
1 000
Notes
1.
Dr.
Cr.
1 500
1 500
Dr.
Cr.
500
500
Dr.
Cr.
Cr.
7 000
6 000
1 000
Dr.
Cr.
1 000
1 000
Dr.
Cr.
8 000
8 000
AC112
8 000
7 000
1 000
Logic
8 000
6 000
2 000
AC112 states that the sale should be recorded at the rate ruling at the transaction date. Accountants
have been arguing for years that the transaction date is the date of delivery. I have always maintained
that the transaction date is the date the order was accepted. Maybe I have been right all along?
2.
For commercial reasons, one may cancel a supply contract to keep good relations with the customer. It
is, therefore, illogical to take a profit of R1 million before the contract is consummated.
Example 2
As in example 1 only our small local private company takes out a forward contract (sells dollars forward) at
the date the contract is entered into to protect itself from the ever-strengthening rand. Assume for this
purpose, to keep the example simple, that the cover rate is the same as the spot rate, i.e. there is no cover
premium.
Journal Entries (R’000)
At Year End
Embedded derivative
Gain
10 000 x $100 x R(7,50 – 6,00)
Loss
Cover contract
10 000 x $100 x R(7,50 – 6,00)
At Date of Sale
Loss
Embedded derivative
10 000 x $100 x R(7,50 – 7,00)
Cover contract
Gain
10 000 x $100 x R(7,50 – 7,00)
Receivable
Sales
Embedded derivative
10 000 x $100 x R7,00
At Date of Receipt
Receivable
Gain
10 000 x $100 x R(8,00 – 7,00)
Loss
Cover contract
10 000 x $100 x R(8,00 – 7,00)
Cash
Cover contract
Receivable
10 000 x $100 x R8,00
Summary
AC133
Cash
6 000
Sales
6 000
Forex gain
1 000
Embedded derivative gain 1 000
Cover contract loss
2 000
In Conclusion
Dr.
Cr.
1 500
1 500
Dr.
Cr.
1 500
1 500
Dr.
Cr.
500
500
Dr.
Cr.
500
500
Dr.
Cr.
Cr.
7 000
6 000
1 000
Dr.
Cr.
1 000
1 000
Dr.
Cr.
1 000
1 000
Dr.
Dr.
Cr.
6 000
2 000
8 000
AC112 Logic
6 000 6 000
7 000 6 000
1 000
So our stressed out small private company exporter who is trying to compete with similar companies in the
UK must pass eight journal entries each time it exports goods to Europe, or any other country, where the
deal is denominated in dollars. If UK GAAP for small enterprises applied in RSA, our local small private
company would have to pass two journal entries:
At Date of Sale
Receivable
Sales
10 000 x $100 x R6,00
At Date of Receipt
Cash
Receivable
10 000 x $100 x R6,00
So logic still prevails in the UK!
Dr.
Cr.
6 000
6 000
Dr.
Cr.
6 000
6 000