DERIVATIVE

FINANCIAL
INSTRUMENTS
Reporting Issues

 THE ACCOUNTING FOR EMBEDDED

DERIVATIVES
 QUALIFYING HEDGE CRITERIA
 DISCLOSURES ABOUT FINANCIAL
INSTRUMENTS AND DERIVATIVES.
 EMBEDDED DERIVATIVE
PAS39, paragraph 10, defines Embedded derivative as “ a
component of a Hybrid or combined instrument that also
includes a nonderivative host contract with the effect that some
of the cash flows of the combined instrument vary in a way similar
to a stand-alone instrument”.

In other words, it causes some or all of the cash flows that

otherwise would be required by the contract to be modified
according to specific interest rate, financial instrument price,
commodity price, foreign exchange rate, index of prices or rates,
credit rating or credit index, or other underlying variable.

NOTE: An embedded derivative is not a separate contract. Both the embedded

derivative and the host contract are contained in one instrument.
Embedded derivative accounted for separately:
An embedded derivative instrument is to be separated from
the host contract and accounted for separately as a
derivative instrument by both parties if and only if all the
three following criteria are met: (PAS 39, paragraph 11)

1. Risks and economic characteristics are not clearly

and closely related to that of the host contract.
2. The hybrid instrument is not measured at fair value
with changes reported in earnings; and
3. On a stand alone basis, the embedded feature meets
the definition of a derivative.
If any of these conditions are not met, the embedded derivative should
not accounted for separately.
Examples of embedded derivatives

1. Equity conversion option in a convertible bond instrument that

allows the holder to convert the bond into shares of the issuer.

2. Redemption option in an investment in redeemable preference share

that allows the issuer to repurchase the preference share.

3. An investment in bond whose interest or principal payment is linked

to the price of gold or silver.
 Accounting for Embedded Derivative

1. If the embedded derivative is separated from the host contract, it is

accounted for at fair value with changes in FV recognized in profit
or loss.

The host contract is accounted for in accordance with the relevant

accounting standard that applies to the contract.

2. If an embedded derivative requiring separation from its host , but it

cannot reliably measured, the entire contract must be measured at
FV.

If the FV of the embedded derivative’s FV cannot be determined reliably

on the basis of its terms and conditions, if the FV of both HYBRID
INSTRUMENT and HOST CONTRACT can be determined, it may be
determined indirectly as the difference between the two.
Illustration: - CONVERTIBLE BOND
Ultimate Company acquired as investment P 5,000,000 face value
convertible bond issued by another entity for P 5,500,000. The
bond pays 10% interest and can be converted into 50,000, P 100
par value shares of the issuer at the option of Ultimate Company
as ‘available for sale’.

It is determined from an active market that the bond w/o the

conversion feature can be acquired for P 5,200,000 only. This
means that the equity conversion feature has a FV of P 300,000,
which is the difference in the acquisition cost of P 5,500,000.
ENTRY:
Ultimate company

Initial recognition of investment:

Available for sale securities P 5200000
Derivative asset 300000
Cash P 5500000