When a company holds or issues a contract with a derivative built into it, its accounting staff test each contract against the conditions below to decide whether to separate the embedded derivative.

Embedded derivatives and host contracts

An embedded derivative is a component built into a host contract, which is a contract that is not itself a derivative. It changes some of the contract's cash flows according to a variable such as an interest rate, a security price, a commodity price, a foreign exchange rate, or an index1.

The contract that combines a host and an embedded derivative has a different name in each framework. International Financial Reporting Standard (IFRS) 9 calls it a hybrid contract. ASC 815-15 in US GAAP calls it a hybrid instrument. Japanese GAAP calls it a compound financial instrument123.

A derivative attached to a contract is not an embedded derivative, but a separate financial instrument, if it can be transferred independently of that contract or has a different counterparty1.

The Financial Accounting Standards Board (FASB)'s reasoning explains why the part is separated. Standards require derivatives to be measured at fair value, but building a derivative into the terms of a bond or an equity contract would let a company avoid that requirement. The FASB therefore decided that, when certain requirements are met, the embedded part is separated from the host and accounted for as a derivative2.

Deciding whether to separate

Separating an embedded derivative is called bifurcation. IFRS 9 and ASC 815-15 start the decision at different points, depending on the type of host.

Under IFRS 9, if the host is a financial asset within the scope of the standard, the embedded derivative is not separated, and the classification and measurement requirements for financial assets apply to the whole contract4. Under ASC 815-15, the same three conditions apply whether the host is a debt instrument, an equity instrument, a lease, or anything else5.

Bifurcation is required only when all three of the following conditions are met. Under IFRS 9 this applies when the host is not a financial asset; under ASC 815-15 it applies whatever the host6.

  • The economic characteristics and risks of the embedded part are not closely related to those of the host (in ASC 815-15, "not clearly and closely related").
  • A separate instrument with the same terms as the embedded part would meet the definition of a derivative. The elements of the definition are that its value changes with an index such as an interest rate or a price, that it requires no initial investment or a small one, and that it is settled at a future date (the three elements of the IFRS 9 definition)7. Under ASC 815-15, in addition to meeting the definition of a derivative, the separate instrument must also fall outside the scope exceptions5.
  • The whole contract is not measured at fair value with changes recognized in profit or loss.

The third condition means that when the whole contract is already measured at fair value through profit or loss, there is no need to separate. For example, under IFRS 9 a derivative embedded in a financial liability measured at fair value through profit or loss (FVTPL) is not separated8. The three conditions in ASC 815-15 have no required order of evaluation, and if the whole contract is measured at fair value through earnings, there is no need to evaluate whether the features are closely related5.

The decision for each framework is shown in a figure. The first is IFRS 9.

YesNoIs the host somethingother than a financialasset within the scope ofthe standard?Notseparated;classify itas a wholeYesNoIs the embedded part afeature not closelyrelated to the host?Notseparated;account forit as a wholeYesNoWould a stand-aloneinstrument with the sameterms be a derivative?Notseparated;account forit as a wholeYesNoIs the whole contractsomething other than onemeasured at FVTPL?Notseparated;account forit as a wholeSeparationis required
Figure 1Deciding whether to separate an embedded derivative under IFRS 9
Figure description

The figure checks whether IFRS 9 requires separation, using four questions. The entry point is whether the host is a financial asset. If it is, the derivative is not separated and the whole contract is classified as a financial asset. The remaining three questions are the three conditions, and they have no required order of evaluation. A no to any of them means the derivative is not separated and the contract is accounted for as a whole. If the answer to all four questions is yes, separation is required.

Even when separation is required, if the entity cannot measure the embedded derivative separately, it designates the whole contract as FVTPL9. Instead of separating, an entity can also choose to measure the whole contract at FVTPL.

ASC 815-15 has no entry point that depends on the type of host. The decision turns only on whether all three conditions are met.

YesNoIs the embedded part afeature that is notclearly and closelyrelated to the host?Notseparated;account forit as a wholeYesNoWould a stand-aloneinstrument with the sameterms be accounted for asan ASC 815 derivative?Notseparated;account forit as a wholeYesNoIs the whole contractsomething other than onemeasured at fair valuethrough earnings?Notseparated;account forit as a wholeSeparationis required
Figure 2Deciding whether to separate an embedded derivative under ASC 815-15
Figure description

The figure checks whether ASC 815-15 requires separation, using three questions. The three questions are the three conditions, and they have no required order of evaluation. The second question includes not only the definition of a derivative but also whether a scope exception applies. If the answer to any of them is no, the derivative is not separated and the contract is accounted for as a whole. If the answer to all three is yes, separation is required. The same questions apply whether the host is a debt instrument, an equity instrument, or a lease.

Both figures are a skeleton built around the three conditions.

Examples of the decision

Consider a hypothetical example in which, in each of the three contracts below, a separate instrument with the same terms as the embedded part meets the definition of a derivative.

  • Example 1: Company C (fictional) holds a bond whose redemption amount is linked to an equity index. Under IFRS 9, the host is a financial asset within the scope of the standard, so the derivative is not separated and the classification and measurement requirements for financial assets apply to the whole contract4. Under ASC 815-15, changes in the value of an equity interest are given as an example that is not closely related to the interest rate on a debt host, so unless the whole contract is measured at fair value through earnings, all three conditions are met and separation is required510. Even for the holder of this bond, the entry point for deciding whether to separate differs by framework.
  • Example 2: Company C issues a bond whose redemption amount is linked to an equity index, and measures the whole contract at FVTPL. Linkage to an equity index is an example in Appendix B of IFRS 9 that is not closely related to a debt host11. Even so, the whole contract is measured at FVTPL, so the third condition is not met and the embedded derivative is not separated8. Under ASC 815-15 as well, if the whole contract is measured at fair value through earnings, there is no need to evaluate whether the features are closely related5.
  • Example 3: The bond in Example 2 is not measured at FVTPL as a whole. From the issuer's side, the host is a financial liability, and linkage to an equity index is not closely related11. All three conditions are met, so both IFRS 9 and ASC 815-15 require the embedded derivative to be separated10. Once separated, the embedded derivative is measured at fair value, with changes recognized in profit or loss. The host is measured under the standard that applies to it12.

Examples 2 and 3 show that, even when the economic substance of the contract is the same, whether the whole contract is measured at fair value through profit or loss changes whether it is separated. In Example 2, where there is no separation, the whole contract is measured at fair value. In Example 3, where there is separation, only the changes in the fair value of the embedded derivative appear in profit or loss, and the host is measured under a different standard.

The table below shows examples from Appendix B of IFRS 9 in which the host is a debt instrument (for example, a financial liability from the issuer's point of view). Whether the embedded derivative is separated depends also on whether the other two of the three conditions are met.

Embedded feature Closely related to the host?
Interest or principal is linked to an equity index or a commodity price Not closely related (the nature of the risk is different)11
A put option whose redemption amount varies with an equity index or a commodity price Not closely related11
A credit derivative that transfers credit risk Not closely related11
An option such as a prepayment option or a call option Not closely related, except where the exercise price is approximately equal to the amortized cost, among other cases11
The amount of interest varies with an interest rate or an interest rate index Closely related, with two exceptions13
An interest rate cap and an interest rate floor on the interest on a debt instrument Closely related if the cap is at or above the market rate and the floor is at or below the market rate when the contract is issued, and neither is leveraged13
Principal and interest payments are denominated in a foreign currency (a dual currency bond) Closely related13

In the following two cases, the feature does not fall under "closely related" in this example. One is where the holder could fail to recover substantially all of its investment. The other is where the embedded derivative could at least double the holder's initial rate of return. The return could then be at least twice the market return on a contract with the same terms13.

How the three frameworks differ

Point IFRS 9 ASC 815-15 Japanese GAAP (March 2006 commentary)
Term for the link between economic characteristics closely related clearly and closely related a close relationship in economic nature and risk14
Choosing to measure the whole contract at fair value instead of separating For a contract whose host is not a financial asset, the entity can designate the whole contract as FVTPL15 For a financial instrument that requires bifurcation, the entity can irrevocably elect to measure the whole instrument at fair value16 There is a treatment that measures the whole at fair value14
When the embedded derivative cannot be measured separately The entity designates the whole contract as FVTPL9 Measure the whole contract at fair value, with changes recognized in profit or loss17 The whole is measured at fair value14

The Japanese GAAP column rests on the commentary at the time Implementation Guidance No. 12 was issued (March 2006). The IFRS 9 column rests on the text of the December 2014 version.

Treatment under Japanese GAAP

This section rests on the 1999 opinion of the Business Accounting Council and the March 2006 commentary by the Daiwa Institute of Research. It does not reflect later revisions, so the content cannot be said to match the current standard.

Bifurcation under Japanese GAAP means separating the derivative part from a bond or similar instrument, measuring it at fair value, and recognizing the valuation gain or loss in profit or loss14.

The 1999 opinion treated compound financial instruments that include a part that could increase paid-in capital (such as bonds with subscription rights to new shares and convertible bonds) separately from other compound financial instruments. The latter include instruments in which a derivative is combined with a cash (non-derivative) financial asset or liability, such as a loan with an interest rate option3. The opinion said that, in principle, the latter are accounted for as a single unit without separation. However, where risk could extend to the underlying financial asset or liability and the valuation difference of the compound instrument is not reflected in profit or loss, the opinion said they are to be separated3.

The March 2006 commentary covers ASBJ Guidance No. 12, which the ASBJ issued that month. According to the commentary, a compound financial instrument that required bifurcation under the earlier standard and practical guidance was one that met all three of the following14.

  1. The risk of the embedded part could extend to the original financial asset or liability.
  2. If made into a stand-alone contract on the same terms, that part would have the characteristics of a derivative.
  3. The valuation difference of the whole compound financial instrument is treated so that it does not appear in profit or loss.

Guidance No. 12 revised how the first condition is treated. If the economic nature and risk of the embedded derivative are closely related to those of the cash instrument, and the possibility that the risk reaches the initial principal is low, the first condition is not met14. Using inflation-linked government bonds as an example, the commentary says that bifurcation is not required and the bond is accounted for as a single bond14.

Accounting after bifurcation

Under IFRS 9, a bifurcated embedded derivative is measured at fair value from initial recognition, and subsequent changes are recognized in profit or loss. The host is accounted for under the standard that applies to it12. The initial carrying amount of the host is the amount left after the embedded derivative is separated. In separating, the terms of a non-option such as a forward or a swap are set so that its initial fair value is zero. An option such as a cap, a floor, or a call is separated on the basis of its stated terms18. IFRS 9 does not address whether the separated part is presented separately in the statement of financial position19.

Under ASC 815-15 as well, a bifurcated embedded derivative is measured at fair value, with changes recognized in profit or loss. The host is accounted for under the standard that applies to it and is not continuously measured at fair value. Changes are recognized in other comprehensive income only when the bifurcated embedded derivative is designated as the hedging instrument in a qualifying cash flow hedge or a hedge of a net investment in a foreign operation20. The substance of hedge accounting is covered on the Hedge Accounting Basics page.

How to measure the fair value of an embedded derivative is covered on the Fair Value Measurement: IFRS 13, ASC 820 and the Fair Value Hierarchy page.

Typical products

Under ASC 815-15, the conversion right of a convertible bond into shares is an example that is not closely related to the interest rate on a debt host. A commentary gives changes in the value of an equity interest, such as a conversion feature, as such an example5. Japanese GAAP sets out compound financial instruments that include a part that could increase paid-in capital, as convertible bonds do, separately from other compound financial instruments3. Bonds with share acquisition rights for which the issue was resolved on or after the effective date of the Companies Act follow ASBJ Guidance No. 1722.

Japanese practical guidance cites equity-linked notes and currency-linked notes as structured notes whose principal is exposed to risk: their redemption principal rises or falls with the average share price or the exchange rate at redemption. Whether such a note qualifies as a held-to-maturity debt security is a separate question from whether its embedded derivative is bifurcated23.

Notes

  1. AASB 9 "Financial Instruments" (December 2014; the opening "COMPARISON WITH IFRS 9" says that an entity that complies with AASB 9 also complies with IFRS 9), paragraphs 4.3.1 and 4.3.2. Paragraph numbers for IFRS 9 below follow this document. ↩ ↩2 ↩3

  2. Deloitte & Touche LLP, "Deloitte's Roadmap: Derivatives," 1.3 "Concept of Embedded Derivatives" (the quotation of ASC 815-15-05-1, the explanation of host contract and hybrid instrument, and the FASB's reasoning about avoidance). A commentary by an audit firm. ↩ ↩2

  3. Business Accounting Council, "金融商品に係る会計基準の設定に関する意見書" (Opinion on the Establishment of Accounting Standards for Financial Instruments, our translation; in Japanese; January 22, 1999), "VII. Compound financial instruments." The paragraph describing the scope of financial assets and liabilities in the same opinion states that financial instruments include those that combine several kinds of financial assets or liabilities (compound financial instruments). ↩ ↩2 ↩3 ↩4

  4. AASB 9 paragraph 4.3.2. When the host is an asset within the scope of the standard, paragraphs 4.1.1 to 4.1.5 apply to the whole contract. ↩ ↩2

  5. Deloitte's Roadmap: Derivatives, 4.3.1 "Overall Framework" (order of the conditions; treatment when the whole contract is measured at fair value through earnings; the equity-interest example) and 4.3.2.1 "Background" (types of host). A commentary by an audit firm. ↩ ↩2 ↩3 ↩4 ↩5 ↩6

  6. AASB 9 paragraph 4.3.3 (IFRS 9). Deloitte's Roadmap: Derivatives, 4.3.1 "Overall Framework," quoting ASC 815-15-25-1 (the three conditions of ASC 815-15). ↩

  7. AASB 9 Appendix A, definition of "derivative" ((a) its value changes in response to an underlying variable, (b) it requires no initial net investment or one smaller than for other contracts with a similar response to market factors, (c) it is settled at a future date). ↩

  8. AASB 9 paragraph 4.3.3(a) to (c). Item (c) says that a derivative embedded in a financial liability at fair value through profit or loss is not separated. ↩ ↩2

  9. AASB 9 paragraphs 4.3.6 and 4.3.7. When the embedded derivative cannot be measured separately, the whole contract is designated. ↩ ↩2

  10. Deloitte's Roadmap: Derivatives, 6.2.2.4 "Equity-Indexed Payment Features" (an equity-indexed payment feature normally requires separation unless the whole contract is measured at fair value with changes recognized in profit or loss; there is no separate scope exception for an equity-indexed payment feature embedded in a debt host). A commentary by an audit firm. ↩ ↩2

  11. AASB 9 paragraph B4.3.5(a), (b), (c), (d), (e), (f). Those examples in Appendix B that are described as not closely related. ↩ ↩2 ↩3 ↩4 ↩5 ↩6

  12. AASB 9 paragraphs B4.3.1 and 4.3.4. ↩ ↩2

  13. AASB 9 paragraph B4.3.8(a), (b), (c). Those examples in Appendix B that are described as closely related. ↩ ↩2 ↩3 ↩4

  14. Daiwa Institute of Research, "物価連動国債、区分処理は不要に(確定版)" (Inflation-linked government bonds will not require bifurcation, final version, our translation; in Japanese; March 31, 2006), pages 1 to 3 (the definition of bifurcation, the three conditions in the earlier guidance, fair value measurement of the whole, and Guidance No. 12). A commentary by a private research institution. ↩ ↩2 ↩3 ↩4 ↩5 ↩6 ↩7

  15. AASB 9 paragraph 4.3.5. For a contract whose host is not an asset within the scope of the standard, the whole contract can be designated as measured at fair value through profit or loss, except where the embedded derivative does not significantly modify the cash flows and where it is clear with little or no analysis that separation is prohibited. ↩

  16. Deloitte's Roadmap: Derivatives, 4.4.6.1 "Eligibility," quoting ASC 815-15-25-4. A quotation of the standard within an audit firm's commentary. ↩

  17. Deloitte's Roadmap: Derivatives, 4.4.5.1 "Recognition and Measurement," quoting ASC 815-15-30-1 and 35-2. ↩

  18. AASB 9 paragraph B4.3.3. ↩

  19. AASB 9 paragraph 4.3.4. ↩

  20. Deloitte's Roadmap: Derivatives, 4.4.3.2 "Subsequent Measurement" (including the quotation of ASC 815-10-35-1). ↩

  21. AASB 9 paragraph B4.3.11. ↩

  22. Japanese Institute of Certified Public Accountants, Accounting Systems Committee Statement No. 14, "金融商品会計に関する実務指針" (in Japanese; version before abolition, see the note on jicpa-68), paragraph 185–2. The accounting for bonds with share acquisition rights for which the issue was resolved on or after the effective date of the Companies Act is done by applying ASBJ Guidance No. 17. ↩

  23. Japanese Institute of Certified Public Accountants, Accounting Systems Committee Statement No. 14, "金融商品会計に関する実務指針" (Practical Guidelines on Accounting for Financial Instruments, our translation; in Japanese; last revised April 14, 2015; the Statement was abolished as of July 1, 2024 and its content transferred to guidance issued by the Accounting Standards Board of Japan, and the paragraph numbers cited here are those of the version before abolition), paragraph 68, the passage on the condition of redemption at face value among the conditions for held-to-maturity debt securities. ↩