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  • IAS 39 PAPER – No. 1
    EMBEDDED DERIVATIVES (PDF; 56 KB)
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This paper sets out a proposed interpretation for determining whether contracts have embedded derivatives, and if so when and how these should be assessed. Due to the diversity of contracts, unique contractual terms and differing market structures each company must perform its own assessment to determine whether the embedded derivative criteria is met and how these should be valued.

Prior to the formation of liquid markets in the energy industry, many contracts contained pricing terms linked to the cost of inputs, for example power contracts linked to gas and coal. Such contracts make economic sense in the absence of a liquid market as these inputs are commonly used as a fuel source in the assets used to produce electricity and therefore comprise the most significant portion of the cost of generation. Additionally, in less deregulated markets, certain commodities may be priced off of similar or substitute commodities (i.e. gasoline priced off of less refined crude oil) or commodities that are obtained concurrently from production operations (i.e. natural gas priced off of low sulphur fuel oil).

The application of IAS 39 would indicate that these pricing terms are embedded derivatives under the definition given in the standard, which unless they can be defined as closely related to the host contract, need to be separated and fair valued in the financial statements. This paper proposes that the assessment of embedded derivatives to determine whether they are closely related to the eco­nomic risks of the host contract should occur at inception of the contract, reflecting market conditions when the contract was entered into. As such inception of the contract should be the critical date for determining whether the embedded derivative is closely related. The review of closely related embedded derivatives should always be performed on a qualitative basis. Where quantitative data is available, and where this adds value to the discussion, this should also be provided.

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