This document discusses the accounting treatment of embedded derivatives under IFRS 9. It provides guidance on: - When an embedded derivative must be separated from its host contract and accounted for separately. - Examples of common embedded derivatives like interest rate floors and caps, foreign currency features, and equity-linked features. - How to determine if an embedded derivative is closely related to the host contract or requires separate accounting. - The accounting for multiple embedded derivatives within a single hybrid contract.

1. IFRS 9 – FINANCIAL INSTRUMENT (EMBEDDED DERIVATIVES)
 Dhiraj Gadiyani
 dhirajgadiyani1@gmail.com
Contents
Introduction ........................................................................................................................................2
Separation conditions.........................................................................................................................2
Embedded derivative that is no longer closely related ......................................................................3
Reclassification of embedded derivative from liability to equity.......................................................3
Optional & non-optional derivatives ..................................................................................................3
Determination of host contract: debt versus equity ..........................................................................3
Multiple Embedded derivatives..........................................................................................................4
Put, call and prepayment options.......................................................................................................4
Term-extending features ....................................................................................................................4
Indexed interest and principal payments ...........................................................................................5
Adjustment for issuer’s credit risk......................................................................................................5
Adjustment for liquidity of issuer’s debt ............................................................................................6
Foreign currency features...................................................................................................................6
Embedded caps, floors and collars .....................................................................................................6
Negative interest rate environment ...................................................................................................7
Conversion and equity features..........................................................................................................7
Non-cash settlement of interest or principal......................................................................................7
Unit-linking features embedded in host debt instrument..................................................................8
Embedded derivatives in equity host contracts .................................................................................8
Variable lease payments based on variable interest rates.................................................................9

2. Introduction
 Once an embedded derivative has been found, it must then be determined whether the embedded derivative
needs to be separately accounted for under IFRS 9.
 Not all embedded derivatives are required to be separated out from the host contract in which they reside.
 For financial assets in the scope of IFRS 9, an entity is not required to assess embedded derivatives because the
classification model in IFRS 9 requires the entire instrument to either be measured at amortised cost or fair
value.
 IFRS 9 states that an embedded derivative is a component of a hybrid instrument that also includes a non-
derivative host contract that is not an asset within the scope of IFRS 9 – with the effect that some of the cash
flows of the combined instrument vary in a way similar to a stand-alone derivative.
 A derivative that is attached to a financial instrument but is contractually transferable independently of that
instrument, or has a different counterparty from that instrument, is not an embedded derivative but a separate
financial instrument.
Separation conditions
 Not all embedded derivatives should be separated from their host contracts. An embedded derivative is
separated from its host contract and accounted for separately as a stand-alone derivative if the host contract is
not an asset in the scope of IFRS 9 and all of the following criteria are met:
› the economic characteristics and risks of the embedded derivative are not closely related to the
economic risks and characteristics of the host contract.
› a separate instrument with the same terms as the embedded derivative would meet the definition of a
derivative; and
› the hybrid instrument is not measured at fair value with changes in fair value recognised in profit or
loss
 The condition in IFRS 9 means that any financial liability that is held at fair value with changes in fair value
recognised through profit or loss should not be assessed to see if it contains any embedded derivatives. Any
embedded derivative that is not closely related to its host and meets the definition of a derivative will be
accounted for as if it were a stand-alone derivative – i.e. measured at fair value, with changes in fair value
recognised in profit or loss.
 Designating a hybrid financial liability as at FVTPL may provide benefit to entities with more complex instruments
where the search for and analysis of embedded derivatives significantly increases the cost of compliance with
IFRS 9.
 If it is determined that an embedded derivative is closely related to the host contract, it should not be separated
from the host contract because the entire hybrid contract is accounted for in accordance with the relevant
Standard that deals with the host contract.
 If an identified embedded derivative is not closely related to the host contract, then it must be separately
accounted for as if it were a stand-alone derivative.
 Subsequent reassessment of whether an embedded derivative is closely related is generally prohibited unless
there is a change in the terms of the contract that significantly modifies the cash flows that would otherwise be
required under the (original) contract.
 If an embedded derivative must be separated from its host contract, but it cannot be valued, the entity must first
determine both the fair value of the whole contract and the fair value of the host contract. The difference
represents the fair value of the derivative instrument to be separated. If an entity is unable to compute the fair
value of the derivative on this basis, the entity must designate the entire instrument as at FVTPL.

3. Embedded derivative that is no longer closely related
 This is particularly relevant when the modification occurs without cash consideration or when the cash
consideration differs from the value of the embedded derivative derecognised.
 The carrying amount of the embedded derivative, being its fair value, at the date of modification of the contract,
will be recognised in profit or loss, remain in the statement of financial position or be recognised in other
comprehensive income in the period or future periods depending on the substance of the modified terms of the
contract.
Reclassification of embedded derivative from liability to equity
 The first approach is to not reassess the classification because there has been no change in terms of the contract.
 The second approach is to reassess the classification despite no change in contractual terms because the liability
has expired.
Optional & non-optional derivatives
 Embedded non-optional derivatives must be determined so that they have a fair value of zero at inception of the
contract. This could be done by separating embedded derivatives with terms that create leverage, asymmetry or
another risk exposure that does not exist in the hybrid contract.
 Embedded optional derivatives will not necessarily have a fair value (or intrinsic value) of zero at inception. The
fair value of such an embedded derivative will depend on its strike price or rate. Therefore, the separation of an
option from a hybrid contract should be based on the stated terms of the option feature.
Determination of host contract: debt versus equity
 Debt indexed to the share price of the issuer – example
› Entity A issues a five-year debt instrument. Entity A will pay the principal amount plus or minus the
change in the fair value of 10,000 shares of Entity C.
› The host contract is a debt instrument because the hybrid instrument has a stated maturity, i.e. it does
not meet the definition of an equity instrument.
› The debt instrument is accounted for as a zero coupon debt instrument. Thus, in accounting for the
host instrument, Entity A imputes interest over five years being the difference between the amount
allocated to the debt instrument at initial recognition and the redemption amount of the debt host
contract.
 Shares with embedded written put option – example
› Entity A issues an instrument to Entity B that has the legal form of shares, and embedded within the
shares is a put option allowing Entity B to put the shares back to Entity A for the higher of:
 the fair value of the shares; and
 an amount based on the initial investment with compounded interest based on LIBOR.
› Entity B will receive a rate of return that is at least equal to the return on a debt instrument. Entity A
should account for the instruments as a debt host contract with an embedded derivative not closely
related to the host contract.

4. Multiple Embedded derivatives
 It is possible for a contract to contain more than one embedded derivative. In such circumstances, each
embedded derivative should be identified and it should be determined if they relate to the same or different
risks.
 When contracts contain multiple embedded derivatives, they are generally treated as a single compound
embedded derivative. Only if the embedded derivatives relate to different risk exposures and are readily
separable and independent of each other are they accounted for separately from each other.
 Example - Conversion feature and put option
› Entity X issues convertible bonds under which the conversion feature may result in Entity X issuing its
equity shares to the holder of the bonds.
› The conversion feature fails the definition of equity in IAS 32 and, therefore, it is not a compound
instrument; rather it is a financial liability in its entirety.
› In addition to the conversion feature, the holder of the bonds can choose to put the bonds back to
Entity X. When Entity X assesses for embedded derivatives, it will be necessary to consider both the
conversion option and the put option.
Put, call and prepayment options
 Contractual terms that allow either party to terminate the contract early and accelerate the repayment of the
outstanding principal, either in whole or in part, are often embedded derivatives. Examples of such terms include
call options of the issuer, put options of the holder, and prepayment features.
 These embedded derivatives are not closely related to the host debt contract unless the exercise price is
approximately equal to the debt host contract’s amortised cost on each exercise date, or in the case of a
prepayment option, the exercise price reimburses the lender for an amount up to the approximate present value
of lost interest for the remaining term of the host contract.
 Investor put option – example
› Entity A issues 10-year bonds with a par value of 10 crore for proceeds of 10 crore. The bonds have a
coupon of 10 per cent. Embedded in the bonds is a clause that allows the investors to put the bonds
back to Entity A for 10 crore in the event the Nifty50 declines by 5 per cent. It is reasonably possible
that the Nifty50 will decline by 5 per cent in the near future.
› The embedded put option would not be accounted for separately, even though the put option is
contingent on an event that is not related to the host instrument.
 Investor contingent put option – example
› Entity A issues 10 crore 7 per cent cumulative preference shares. Dividends are payable quarterly
subject to the availability of distributable profits. Issue costs are insignificant. The preference shares are
puttable at par to Entity A for cash if interest rates move by 175 basis points. Any dividend that remains
accumulated and not paid becomes payable when the shares are put to Entity A.
› The put feature is an option that is considered to be closely related to the host because the exercise
price of the put option is the amortised cost of the preference shares.
Term-extending features
 When the term of the debt is extendable, and there is no concurrent adjustment to the approximate current
market rate of interest at the time of the extension, the embedded term-extension option is not closely related
to the host debt contract. To be closely related, the reset to market rates must result in a reset of both current
interest rates and current credit spread for the issuer.

5.  Term-extending option – automatic extension of the debt maturity when MIBOR increases above specified level –
example
› Entity A issues debt of 10 crore with a 10 per cent coupon and a maturity of five years. If MIBOR
increases by 175 basis points within any one year, the maturity of the bonds will be extended for
another three years at the same 10 per cent coupon rate.
› The likelihood of MIBOR increasing by 175 basis points in a year is not a consideration when
determining whether the embedded derivative is closely related.
› If the possibility of MIBOR increasing by 175 basis points is considered low, the value of the embedded
derivative will be relatively small.
Indexed interest and principal payments
 When interest or principal payments in a debt contract are indexed to changes in a specified security price,
commodity price, foreign exchange rate, or index of prices or rates, the host debt contract contains an
embedded derivative.
 Such an embedded derivative will not be closely related to the host debt contract if the amounts of interest or
principal are indexed to the price of a commodity or to the change in value of an equity instrument.
 Generally, an embedded derivative that adjusts interest and/or principal amounts paid on the debt contract will
not be closely related to the host debt when the underlying that drives the value of the derivative is different
from the economic factors that drive the value of the host debt contract.
 Contingent embedded derivative: probability assessment – example
› Entity A issues 10 crore in debt with a 9 per cent coupon. However, if MIFOR increases by 600 basis
points within any one year, the bonds mature and the holder receives 7 crore in total.
› The likelihood of MIFOR increasing by 600 basis points is not relevant when making this determination.
The test in IFRS 9 is based around the possibility of the holder not recovering its recognised investment
or obtaining double its initial rate of return.
› However, if the probability of this event occurring is low then the fair value of the embedded derivative
at inception will be relatively small compared to the fair value of the host contract.
 ‘Double-double’ test – example
› Entity X issues 20-year variable rate debt. The debt is indexed to the 3-month LIBOR rate plus 4 per
cent. As of the date of issuance, the 3-month LIBOR rate was 2 per cent. The debt’s terms also specify
that if the 3-month LIBOR rate increases to 5 per cent, the debt issuer is required to pay 23 per cent for
the remaining term of the bonds.
› If Entity X were to issue 20-year variable rate debt without any embedded derivatives (i.e. the interest
rate reset feature), it would pay a coupon of 3-month LIBOR plus 6 per cent.
› It is necessary to determine whether the embedded derivative could at least double the holder’s initial
rate of return on the host contract. Therefore, when 3-month LIBOR increases to 5 per cent, the 23 per
cent interest rate feature more than doubles the initial rate of return of 8 per cent on the host
contract.
› It is then necessary to perform an analysis to determine whether the embedded derivative results in a
rate of return that is at least twice what otherwise would be the then-current market rate of return for
a host contract when 3-month LIBOR is at 5 per cent. Therefore, when 3-month LIBOR increases to 5
per cent, the 23 per cent interest rate feature is more than twice the then current market rate of return
of the host contract of 11 per cent (3-month LIBOR of 5 per cent plus 6 per cent.)
› Entity X would be required to treat the feature as a non-closely related embedded derivative.
Adjustment for issuer’s credit risk
 It is reasonable to conclude that credit features that relate to the credit quality of the issuer (e.g. the issuer’s
credit rating, default or ratios indicative of its credit status) should be viewed as closely related to the host debt
contract if the credit feature is not leveraged and is designed to reflect the approximate credit risk borne by the
lender. In economic terms, such features directly affect the value of the host debt contract.

6.  Cash versus synthetic credit default obligations – example
› There are two types of structures:
 the assets in the structured entity are actual corporate debt (e.g. TAMO & TAPO corporate
bonds), referred to as 'cash CDOs' because the structured entity has to own the actual cash
instruments; or
 the assets in the structured entity are derivatives over the corporate debt (e.g. credit default
swaps (CDS) over TAMO & TAPO), referred to as 'synthetic CDOs' because the structured
entity will or may hold synthetic instruments rather than holding cash instruments.
› Cash CDO - Because the entity must own the underlying cash instruments, the issued CDO liability does
not have a credit derivative that requires separation. The beneficiary (the structured entity) is
transferring the credit risk of its referenced assets to a guarantor (the investor in the CDO notes).
› Synthetic CDO - The beneficiary (the structured entity) is transferring the credit risk of referenced
assets to a guarantor (the investor of the CDO notes) but does not own the underlying referenced
assets. The notes issued by the structured entity have credit embedded derivatives that require
separation.
Adjustment for liquidity of issuer’s debt
 IFRS 9 does not provide specific guidance when the cash flows of a debt instrument in the scope of IFRS 9 are
adjusted for changes in the relative liquidity of that debt instrument. Provided that the adjustments are not
leveraged, the adjustment is likely to be closely related to the debt host contract because the liquidity of the
instrument is inherent in the debt host contract.
Foreign currency features
 Debt contracts in the scope of IFRS 9 may require the issuer to make payments of interest or principal in a foreign
currency. An example of such a contract is a dual currency bond where the principal is paid in a foreign currency
but interest is paid in the entity’s functional currency. The foreign currency feature in a dual currency bond is an
embedded derivative (foreign currency swap or foreign currency forward) but it is not separated from the host
debt instrument because foreign currency gains and losses on a dual currency bond are already recognised in
profit or loss.
 Foreign currency option features are generally viewed by IFRS 9 as taking on an additional foreign currency risk
that is not normally present in transactions and will not be fully reflected by the requirements of IAS 21. Such an
option in a debt host contract is not closely related and needs to be accounted for separately.
Embedded caps, floors and collars
 An embedded cap or floor on the interest rate of a debt instrument, where the cap or floor is not leveraged, is
closely related to the host debt contract provided that the cap is at or above the market interest rate and the
floor is at or below the market interest rate when the instrument is issued. The assessment as to whether an
embedded cap or floor is closely related to a host debt contract is made at issuance and is not subsequently
revised.
 Example - Embedded interest rate floor
› Entity A issues 10 crore debt with a 5 year maturity. The interest rate is 3-month MIBOR plus 2 per cent fixed spread,
with the 3-month MIBOR component floored at 5 per cent.
› The market rate of interest for a similar instrument without a floor is 8 per cent (comprised of the five year swap
rate of 4 per cent and all spreads).
› In this example, the lender accepts a lower initial rate of return of 7 per cent (5 per cent MIBOR floor plus 2 per cent
fixed spread) compared to a market rate of 8 per cent because the floor protects it against a fall in MIBOR. The
difference in the spread compared to the same instrument without the floor represents the premium paid by the
lender for the floor.
› Therefore assuming vanilla terms (e.g. no other embedded derivatives), comparing the overall floor rate to the
market rate of a similar contract without a floor, as defined in the IFRIC agenda decision, is expected to result in the
embedded floor being closely related (i.e. the overall floor rate is expected to be lower than the market rate for a
loan without a floor to make economic sense for the borrower).

7.  Example - Embedded interest rate collar
› If a debt contract has an embedded collar which caps interest rates at 7 per cent and has a floor of 4
per cent, the collar will be closely related to the host debt contract provided that both the cap and the
floor are out of the money when the debt is issued and the collar is not leveraged.
Negative interest rate environment
 IFRS 9 should be applied to an interest rate floor in a negative interest rate environment in the same way as it
would be applied in a positive interest rate environment;
 In a positive or negative interest rate environment, an entity should compare the overall interest rate floor (i.e.
the benchmark interest rate referenced in the contract plus contractual spreads and, if applicable, any premiums,
discounts or other elements that would be relevant to the calculation of the effective interest rate) for the hybrid
contract to the market rate of interest for a similar contract without the interest rate floor (i.e. the host
contract); and
 In order to determine the appropriate market rate of interest for the host contract, an entity is required to
consider the specific terms of the host contract and the relevant spreads (including credit spreads) appropriate
for the transaction.
Conversion and equity features
 A conversion feature that allows the holder of the debt contract to convert the outstanding amount into equity
of the issuer is an embedded derivative that is not closely related to the host debt contract for the issuer if the
conversion feature fails the definition of equity.
 Equity Kicker embedded in debt host contract
› These are debt instruments which provide for the lender to receive shares of the borrower for nothing,
or a very low amount, if the borrower lists its shares on a stock exchange.
› Similar to convertible debt, debt with an equity kicker carries a coupon that is lower than the rate on a
comparable debt without the equity kicker.
› The equity kicker meets the definition of a derivative because its value will change in response to
changes in the borrower’s share price, it has little initial net investment, and it is settled at a future
date. This is true even though the right to receive the shares is contingent on an unrelated event.
› For the issuer, if the equity kicker fails the definition of equity, it will be recognised as an embedded
derivative that is not closely related to the host debt contract and therefore will require separation at
FVTPL.
Non-cash settlement of interest or principal
 Entity A lends Entity B, a newspaper publisher, 10 crore for 5 years. Each year instead of paying interest, Entity B
agrees to give Entity A predetermined amount of free advertising space in a newspaper.
 For Entity B the debt instrument, excluding the fair value of the free advertising space, is in the scope of IFRS 9
and will be measured at fair value at initial recognition.
 If the sale of advertising space did not meet the normal purchase, sale or usage requirements exemption for
Entity B (e.g. because Entity B was not a newspaper publisher), then that feature would be in the scope of IFRS 9.
The delivery of non-cash consideration embedded in the loan meets the definition of a derivative because it has
an underlying (the price of the advertising space), no initial net investment, and it will be settled at future dates.
The economic characteristics and risks of the embedded derivative and debt are not closely related and,
therefore, the non-cash consideration feature would be separated and measured at FVTPL.

8. Unit-linking features embedded in host debt instrument
 A unit-linking feature embedded in a host debt instrument in the scope of IFRS 9 is closely related to the host
debt instrument if the unit-denominated payments are measured at current unit values that reflect the fair
values of the assets of the fund. A unit-linking feature is a contractual term that requires payments denominated
in a unit of an internal or external investment fund.
 The above guidance suggests that unit-linking features would only be considered closely related where the unit
denominated payments are measured in such a way that they reflect the fair value of the assets of the fund to
which they are linked. In any case, even if the unit-linking feature is determined to be closely related to a debt
host contract IFRS 9 would be applicable for subsequent measurement of the hybrid instrument if it was
measured at amortised cost. Applying IFRS 9 would result in the carrying amount of the hybrid instrument
reflecting the amount expected to be paid or received which would incorporate the unit linking feature.
Embedded derivatives in equity host contracts
 Convertible preference shares
› Entity X issues perpetual preferred shares where all payments are at the discretion of the issuer and
which are convertible into a fixed number of ordinary shares at the option of the holder. The
conversion feature represents an embedded call option on Entity X's ordinary shares that meets the
definition of equity in accordance with IAS 32. Entity X would not account for the embedded option
separately because on a free-standing basis, the option would be an equity instrument of Entity X.
 Contingent share conversion based on interest rates
› The preference shares include a provision stating that if interest rates increase by 200 basis points, the
holders will additionally receive 100,000 ordinary shares in Entity A.
› The embedded option is not separated by the issuer because both option and the host instrument are
equity instruments of the issuer. Although the option is triggered by a change in interest rates, the
value of the option is indexed to the change in fair value of, and is settled in, the issuer’s shares.
Equally, from the perspective of a holder the embedded option is closely related to the host.
 Contingent cash payment based on interest rates – example
› Entity A issues 100 crores of perpetual, irredeemable preference shares that pay a discretionary, fixed
dividend of 9 per cent. Because the entity has true discretion as to whether or not, and the extent to
which, dividends are paid, the host contract meets the definition of equity in IAS 32. Embedded in the
shares is a provision that states if MIBOR increases to 12 per cent or more, the holders will become
entitled to receive a one-off payment of cash calculated by a predetermined formula.
› The issuer cannot avoid an outflow of cash in respect of the amount prescribed by the formula if
› MIBOR reaches 12 per cent, i.e. the embedded feature is an embedded derivative liability. Entity A
account for this derivative separately from the host instrument at FVTPL.

9. Variable lease payments based on variable interest rates
 Lease linked to interest rates
› Entity A enters into a lease under which the payments are indexed to 6-month MIBOR. The embedded
derivative does not need to be separated because the indexation is to interest rates inherent in Entity
A’s local economy.
 Lease linked to sales
› Variable lease payments based on related sales are considered to be closely related to the host lease
contract; accordingly, the sales-related derivative should not be separated from the lease.
 Lease linked to profits
› While variable lease payments based on related sales are closely related to a host lease contract, the
same is not true of variable lease payments based on profit after tax. Several of the balances that are
added together to reach profit after tax (such as cost of sales and tax) do not have economic
characteristics and risks similar to those of the lease contract. Therefore, the embedded derivative is
not closely related to the host lease contract and separate accounting is required.
 Lease linked to share price index
› Variable lease payments based on changes in NIFTY 50 are not closely related to the host lease
contract; consequently, the embedded derivative would need to be separated from the host lease
contract.