It’s closely related, no matter how it looks!

A European example of challenges in applying one of the more complex aspects of IAS 39

Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 19th edition:

  • “The entity has entered into several multi-year operating leases of buildings in a Member State of the Eurozone, with rental payments denominated in Euro. The contract contained the following specifications regarding the adjustment of the rent:
    • During the first 8 years, the increase in rents is determined by multiplying the change in the Harmonized Index of Consumer Prices (HIPC – a measure of consumer price inflation in the Eurozone) by a factor of 1.85. However, there was a floor to the increase of rents for the first three years of 2.5% (the estimated HICP at inception of the lease, which was known to the parties, was -0.3%). This floor expired in 2012.
    • From year 9 until the end of the lease term, the increase in rent will be determined by multiplying the HIPC with a factor of 1.5.
  • The issuer considered that the rent adjustment represented an embedded derivative, however, in the issuer’s opinion, it was closely related to the host contract and therefore no separation of the embedded derivative was required. According to paragraph AG33(f) of IAS 39, an embedded derivative in a host lease contract is closely related to the host contract if the embedded derivative is an inflation-related index, provided that the index relates to the inflation in the entity’s own economic environment and the lease is not leveraged.
  • As the buildings are located in a Eurozone country with an inflation rate that highly correlates with the development of the Eurozone’s overall inflation rate and as all payments are made in Euro, the issuer was of the opinion that the index relates to the inflation in the entity’s own economic environment.
  • Regarding lease leverage, the issuer noted that although the term “leverage” appears in several examples in paragraph AG33 of IAS 39, the standard does not define this term. The issuer further considered that no guidance is given in IFRS as to whether there is a threshold by which the changes in the rent can exceed the change in the underlying without the lease contract being considered leveraged….”

The enforcer (as ESMA likes to term it) disagreed with this analysis, taking the view that the embedded derivative should be separated from the host contract: “a hybrid instrument has leverage features if the contractual cash flows that are determined by changes in an underlying item are modified in a manner that increases the effect of those changes. In this case the adjustments to the rents are higher than the actual inflation rate therefore the hybrid instrument contains leverage features.”

This for sure is an aspect of IFRS where it’s easy to get tangled up in the detail of the requirements and to lose sight of any “big picture.” The big picture, I suppose, is that if an entity has entered into a derivative contract, with all the potential volatility and measurement uncertainty that usually entails, then the economic reality of that shouldn’t be obscured just because the contract happens to be tagged on to something else. At the same time though, the fact that an arrangement includes a derivative component may be incidental to its overall substance and business purpose. That is, if a lessee and lessor agree that future rent increases will be calculated simply by applying the local rate of inflation, no user is going to gain much from having the fair value of that future exposure represented on the lessee’s balance sheet. If the calculation is to be based on five times the rate of inflation though, then there’s plainly something to the arrangement which goes beyond a reasonable basis for setting rent, and so users of the statements benefit from seeing that exposure represented on the balance sheet. Of course, in between those two extremes, there’s a grey area that’s hard to define both in theory and in practice.

In this case, the issuer may have thought it had identified something of a bright line, because IAS 39.AG33(a), referring to contracts in which the underlying is an interest rate, draws a line across contracts in which the embedded derivative’s holders’ initial rate of return could result in a rate of return that is at least twice what the market return would be for a contract with the same terms as the host contract. On this basis, the issuer says it thought a multiplier of two would be reasonable in assessing the significance of lease-related derivatives. But the enforcer says: “The conclusion in each example is specific to the facts and circumstances described (and) analogous application of the conclusion from one subparagraph to a different situation addressed by another subparagraph is not appropriate.” True enough, but you can’t entirely blame the issuer for thinking the apparent benchmarks provided in one subparagraph should be at least somewhat relevant in working through the others.

The moral, I suppose, is that it takes a lot of work and analysis to demonstrate that an embedded derivative is closely related to the host contract, then you should be highly alert to the possibility that it may actually not be…

The opinions expressed are solely those of the author

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