Separately accounting for an embedded derivative
Should an embedded derivative contained in a financial liability be separated and accounted for?
When a hybrid contract contains a host contract and it is not a financial asset, the embedded derivatives portion should be separated from the host and accounted for as a derivative if and only if the following conditions are met:
- The economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host
- A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
- The hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (ie, a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).
When the embedded derivative portion is separated from the hybrid contract, the remaining portion, namely the host contract should be accounted for in accordance with the appropriate Ind AS standard.
If a contract contains one or more embedded derivatives and the host is not an asset within the scope of this Standard, an entity may designate the entire hybrid contract as at fair value through profit or loss unless:
- the embedded derivative does not significantly modify the cash flows that otherwise would be required by the contract; or
- it is clear with little or no analysis when a similar hybrid instrument is first considered that separation of the embedded derivative is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost.
