GC 3450 Guideline: Embedded Derivatives

These requirements apply prospectively to new contracts entered into on or after April 1, 2022, or to amendments to existing contracts where the amendment causes a significant change to the cash flows under the contract after April 1, 2022.

Departments must review all contracts worth $10 million or more. Accounting policies need not be applied to immaterial items. Departments may establish thresholds for contracts below $10 million based on materiality.

The following flow chart may be used to decide whether to review contracts for the purchase or sale of goods or services for embedded derivatives.

Figure 1 - Text version

• Does the contract exceed the established materiality threshold?
  • If no, no further action required.
  • If yes, is the contract a commodity contract* or a public-private partnership (P3) agreement?
    • If yes, assess the contract for embedded derivatives or as a stand-alone derivative.
    • If no, is the contract an “own use” contract or a contract for which payments are based on volumes of sales or revenues of one of the parties to the contract?
      • If no, assess the contract for embedded derivatives or as a stand-alone derivative.
      • If yes, no further action required.

* Entities have the option to first analyze the commodity contract to determine whether it meets the definition of an own use contract, that is, whether the quantities are not in excess of the entity’s purchase or usage requirements, in order to exclude the contract from the review for embedded derivatives.

Commodities are goods or raw materials that can be bought, sold, or traded. As basic goods, commodities, such as oil, metals and agricultural goods, are interchangeable with other goods in the same category.

According to PS 3450.A13:

Some contracts to buy or sell non-financial items that can be settled net or by exchanging financial instruments, or in which the non-financial item is readily convertible to cash, are within the scope of this Section as if they were financial instruments.

As commodities are readily convertible to cash, commodity purchase or sale contracts may be derivatives in their entirety or fail the own use exemption. Consequently, it is advised to include such contracts in the contract review, although entities may instead determine whether the contract meets the own use exemption as noted above.

A review for embedded derivatives should be performed for the following types of contracts if the contract value exceeds the established materiality threshold:

1. financial contracts, such as loans receivable, portfolio investments, market debt and loan guarantees;
2. leases, such as operating leases and capital leases; and
3. non-financial contracts, such as:
   • purchase or sales contracts where quantities are in excess of purchase, sale or usage requirements, and where the contract can be net settled (no physical delivery);
   • commodity contracts;
   • public-private partnership (P3) contracts;
   • insurance contracts; or
   • contracts involving payments based on a climatic or geological variable.

When a contract under review is determined to be in scope of PS 3450, it should be assessed for embedded derivatives.

A contract may include embedded derivatives when there is a change in contractual cash flows:

1. due to pricing features based on an underlying variable; or
2. based on optional contract features.

3.1.1 Examples of changes in contractual cash flow due to pricing features based on an underlying variable include:

1. Foreign currency: cash flows vary based on a foreign exchange rate. Assess whether the currency is:
   • the functional currency of the counterparty,
   • the currency in which commercial transactions for the good or service are routinely denominated globally, or
   • a currency commonly used in contracts to purchase or sell non-financial items in the economic environment of the transaction;
2. Inflation index: cash flows that are adjusted by:
   • inflation indices based on Canadian or non-Canadian rates, or
   • leveraged inflation and CPI adjustments (factor above 2);
3. Cash flows adjusted by any other underlying variable (for example, share price, commodity price, interest rate index, credit risk of a third party, stock exchange); or
4. Settlement permitted with non-cash consideration whose value changes with an underlying variable (that is, with warrants, options of a company, shares or commodities).

3.1.2 Examples of changes in contractual cash flows based on optional contract features include:

1. Cash flows that are modified by a pricing cap or floor. Assess whether the cap is above or below the market rate or whether the floor is below or above the market rate;
2. Call, put, prepayment or redemption option that requires the payment of a penalty that:
   • is fixed, or
   • varies based on current interest rates or some other variable;
3. Term-extension option or options. Consider whether this option is at a market or non-market rate;
4. Complex interest rate features or formulas that calculate the contractual cash flows. Assess whether the holder would not substantially recover their investment or would receive a return that is at least twice the market return; or
5. Terms allowing the transfer of credit risk of a reference asset. Consider whether this is related to the creditworthiness of the obligor.

3.1.3 Assessment to determine whether the embedded derivative is closely related to the host contract (PS 3450.A25-.A26).

Not all contracts containing provisions with the features of an embedded derivative will warrant the recognition of the embedded derivative and measurement of its value. When an embedded derivative is closely related to the host contract, it has the same economic characteristics as the host contract. In such instances, the embedded derivative does not need to be accounted for as a separate derivative instrument. In addition to the examples provided in PS 3450.A25-.A26, the following table includes examples that indicate host contracts with embedded derivatives that are closely related or not closely related to the contract.

If the embedded derivative is determined to be closely related to the host contract at inception, it is not separated from the host contract and there are no further accounting requirements (PS 3450.A19-.A.26).

Subsequent reassessment of the embedded derivative is prohibited unless there are changes to the contract that significantly modify the cash flows (PS 3450.A21).

When it has been determined that the embedded derivative is not closely related to the host contract (PS 3450.A25), there are two accounting options available:

1. Measure the combined (hybrid) contract at fair value at inception and throughout its life (PS 3450.A22). Embedded derivatives in financial instruments classified in the fair value category are not separated (PS 3450.A19(c)); or
2. Separate the embedded derivative and account for it separately as a stand-alone derivative, as long as a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative (PS 3450.A19(b)).

Apply the accounting requirements for derivatives in PS 3450 as follows:

1. Determine the fair value^{Footnote 1} of the hybrid contract or the embedded feature at inception (PS 3450.A24) and continue to measure the derivative at fair value throughout the life of the contract;
2. Recognize the derivative asset or derivative liability on the statement of financial position; and
3. Present unrealized fair value gains or losses on the derivative in the statement of remeasurement gains and losses until settlement, except for unrealized exchange gains and losses that are recognized directly in the statement of operations (according to Government of Canada accounting policy election).

Contact the Office of the Comptroller General for specific coding requirements.