Embedded derivatives are part of a financial instrument that also includes a non-derivative host contract. The embedded derivative requires that some portion of the contract’s cash flows be modified in relation to changes in a variable, such as an interest rate, commodity price, credit rating, or foreign exchange rate. If a derivative is contractually transferable separately from the contract, then it is not an embedded derivative.
From IAS 39 to IFRS 9 – reduced complexity
An embedded derivative is a component of a hybrid contract that also includes a non-derivative host, with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative.
The embedded derivative concept that exists in IAS 39 has been included in IFRS 9 to apply only to hosts that are not financial assets within the scope of the Standard, i.e. financial liabilities and host contacts not in the scope of IFRS 9, such as leases, purchase contracts, service contracts, etc. Consequently, embedded derivatives that, under IAS 39, would have been separately accounted for at FVTPL, because they were not closely related to a host financial asset will no longer be separated. Instead, the contractual cash flows of the financial asset are assessed in their entirety, and the asset as a whole is measured at FVTPL if the contractual cash flow characteristics test is not passed.
The embedded derivative guidance that exists in IAS 39 is included in IFRS 9 to help identify when an embedded derivative is closely related to a financial liability host contract or a host contract not within the scope of the Standard (e.g. lease contracts, insurance contracts, contracts for the purchase or sale of non-financial items).
The IAS 39 definition and guidance on separation of embedded derivatives and accounting for hybrid instruments is carried forward to IFRS 9 for instruments where the host contract is not a financial asset within the scope of IFRS 9.
If the host contract is a financial asset within the scope of IFRS 9, the embedded derivative is not separated from the host. Rather, the hybrid instrument is assessed for classification as a whole using the classification requirements for financial assets discussed here (valuation at amortised costs, fair value through other comprehensive income or fair value through profit or loss).
XYZ Ltd. issues bonds in the market. However, the payment of annual interest and principal component of the bond is indexed with the price of Gold. In such a scenario the payment of annual interest will increase or decrease in direct correlation with the price of gold in the market.
Analysing the case leads to the following determinations:
The bond issued by XYZ ltd. is the debt instrument (Non-derivative), while the interest payments are linked with another instrument which in this case is gold (Derivative component). This derivative component is known as embedded derivative.
The non-derivative component here is also referred as host contract and the combined contract is hybrid in nature.
Under IAS 39, the fair value option for financial assets can also be applied when the asset is part of a group of assets or assets and liabilities that is managed on a fair value basis or when it has an embedded derivative that is not closely related.
Under IFRS 9 assets managed on a fair value basis are by default accounted for at FVTPL because they fail the business model test. Hybrid debt instruments that are financial assets with non-closely related embedded derivatives under IAS 39 would generally fail to meet the contractual cash flow characteristic test, and thus would also be accounted for at FVTPL under IFRS 9.
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