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What is an Embedded Derivative?
An embedded derivative is a part of a financial instrument that modifies its cash flows by tying it to an underlying asset. Usually, derivatives are separate financial instruments that are independent. However, embedded derivatives are a part of a financial contract. This contract, which holds the embedded option, is known as the host contract.
Embedded derivatives are a term or criteria in a host contract. Usually, these host contracts are non-derivatives. Due to the existence of the embedded derivative, they become a hybrid instrument. Usually, a particular part of the cash flows from the underlying contract depends on the embedded derivative. The accounting treatment of embedded derivatives may require the reporting entity to report the derivative separately.
What is the accounting treatment of Embedded Derivatives?
The accounting treatment of embedded derivatives may depend on whether the reporting entity is using IFRS or GAAP. When it comes to the IFRS accounting treatment for these derivatives, IFRS 9 Financial Instruments is applicable. On the other hand, the hedge accounting standard ASC 815 deals with the accounting treatment under GAAP.
IFRS accounting treatment of Embedded Derivatives
IFRS 9 contains specific requirements related to embedded derivatives. Under this standard, reporting entities have two options. Firstly, if the non-derivative host is a financial asset that comes under IFRS 9’s scope, then the entity must not separate both components for accounting purposes. Therefore, the classification criteria of the standard will apply to the financial asset as a whole.
However, the entity must separate embedded derivatives from the non-derivative host if the contract meets three predefined criteria. These criteria relate to the risks of the derivative and the host contract, the derivative’s terms, and whether the entity measures the hybrid contract at fair value. For transferrable embedded derivatives, IFRS 9 requires the entity to treat them as a separate financial instrument.
If the first case applies, then the accounting treatment for the embedded derivative will be simple. The entity will only need to recognize a single financial instrument. Therefore, the double entries for it will be as follows.
Dr Cash/Bank
Cr Financial Instrument
However, if the second case applies, then the accounting treatment will differ, as follows.
Dr Cash/Bank
Cr Financial Instrument
Cr Embedded Derivative
GAAP accounting treatment of Embedded Derivatives
The GAAP accounting treatment for embedded derivatives is similar to that of IFRS 9. At the acquisition date, the reporting entity must determine whether there is a need to separate the embedded derivative from the host contract. This analysis requires judgment and is an ongoing process until the entity disposes of the hybrid contract.
The criteria to determine whether the bifurcation method will apply are different from IFRS. Under GAAP, the reporting entity must look at the treatment of the host contract, whether the embedded derivative can be independent of the contract and how closely it relates to the host contract. Once the reporting entity makes the decisions, the accounting entries will be similar. However, GAAP requires the entity to determine the valuation of the derivative and its host before recognizing it.
Conclusion
Embedded derivatives are derivatives that exist within the host contracts. These derivatives affect the cash flows from the underlying financial instrument. The accounting treatment of embedded derivatives depends on whether entities use IFRS or GAAP. Usually, reporting entities need to determine whether they should separate the host contract from the embedded derivative. However, the criteria differ under both standards.
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