CFM37640 - Loan relationships: ‘hybrid’ securities with embedded derivatives: bifurcation: mechanics of bifurcation

This guidance applies to the bifurcation of embedded derivatives under IAS39 and IFRS9 (and previously FRS26). It also applies to companies that apply FRS102 and which choose to apply the recognition and measurement requirements of IAS39 or IFRS9.

How a company bifurcates

As explained at {CFM37630}, under IAS39 a company which is a creditor or debtor for a convertible or exchangeable security, or an asset-linked security, is generally required to account separately for the loan and the ‘embedded derivative’, from the time it first acquired the security. Similar treatment applies under IFRS9 in respect of the debtor (bifurcation is not permitted under IFRS9 for the creditor).

Where bifurcation applies, it must allocate initial values to the two components whether or not it was a party to the security when originally issued.

Valuation of the components is a specialised exercise, see CFM25000. The embedded derivative (the conversion or exchange rights or obligations in the case of a convertible or exchangeable security, or the asset link rights in the case of an asset linked security) within a hybrid financial instrument is measured at fair value. The fair value of the derivative component is determined separately using an appropriate valuation model. The different between the fair value of the derivative and the fair value of the contract as a whole is allocated to the loan host contract (that is, the loan host contract is valued as a residual amount).

If, however, it is impossible to reliably value the derivative as a separate instrument (for example, because the derivative is based on unquoted shares), its fair value is taken as being the difference between the fair value of the whole instrument and the fair value of the loan component.

See example at CFM37650.