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-: An embedded derivative is simply a derivative
that is included within a non-derivative host contract.
We use the term hybrid instrument
to refer to the combination of the host contract
and the embedded derivative.
The host contract refers to business contracts
for things such as the sale or purchase of goods.
The embedded derivative is the aspect
or part of a host contract that presents an exposure
to changes in an underlying variable
such as the inflation rate or a foreign exchange rate.
Consider a business contract for an Australian organisation
to export furniture priced in US dollars.
The host contract is the contract to sell the furniture.
The embedded derivative is the part of the contract
that converts an Australian dollar host contract
into US dollars
just like a Forward Exchange Contract or FEC.
While we now know what an embedded derivative is,
the question becomes why do we need to know this?
The reason comes back to accounting standards
and the provision of useful information
to users of financial reports.
Derivatives provide leveraged exposure
to underlying variables
and can change the risk profile of an organisation.
So users of financial statements want to know
whether there are any derivatives impacting
on the financial standing of the organisation.
The purpose of assessing
whether an embedded derivative exists in a host contract
is therefore to determine whether it should be accounted for
separately in the financial statements.
So once we have determined
that an embedded derivative exists,
how do we determine whether it should be accounted for
separately in the financial statements?
There is a three-step process to determine this.
Firstly, is the host contract fair valued?
If the host contract is already fair valued
in the financial statements,
with fair value changes going directly to profit and loss,
then there is no need to separately account
for the embedded derivative.
This is because the embedded derivative
is already being fair valued as part of the host contract.
Secondly, does the embedded derivative
make the accounting definition of a derivative?
That is, its value changes
in response to changes in an underlying price, rate,
or other variable.
It doesn't require an initial net investment
or only requires a small leveraged initial net investment.
And it is settled at a future date.
If it doesn't meet the definition of a derivative,
then it won't be separately accounted for.
Thirdly, is the embedded derivative closely related
to the host contract?
Here, we are looking at the economic characteristics
and risks of the embedded derivative
to see how closely they relate to the host contract.
To be closely related,
the embedded derivative should not be leveraged.
If the embedded derivative is closely related,
then there is no need to separately account for it.
However, if it is not closely related,
then it needs to be separately accounted for.
The standards refer to
characteristics of embedded derivatives
that exempt them from being separated.
Firstly, for a borrowing contract
where the contract interest rate increases
by less than a factor of two
each time the reference interest rate increases.
Secondly, for a borrowing contract
where the current interest rate sits above a floor rate
and/or below a cap rate.
Thirdly, for a sales or purchase contract
where payment is made in the functional currency
of a contract party or in the currency that the goods
are routinely bought and sold such as the US dollar
or in a currency that matches
the economic environment of the transaction
such as USD for a trade in China.
Lastly, for a lease contract
where there is an inflation adjustment clause
that relates to the entity's own economic environment.
In all of these situations,
the embedded derivative would be deemed closely held
and would not need to be separately accounted for.
However, if the embedded derivative
does need to be separately accounted for,
it should be treated as a derivative and valued accordingly.
An embedded non-option derivative
such as a forward or a swap
will have a fair value of zero at inception.
In this situation,
the host contract will have the full carrying amount.
An embedded option derivative will have a fair value
reflecting its terms and features.
In this situation, the carrying amount of the host contract
will be reduced by the embedded option
that has been separated.
The embedded derivative is then revalued
at the end of each period and the gain or loss
will be taken direct to profit and loss.
To recap, embedded derivatives are simply derivatives
that are included within a host contract
together forming a hybrid instrument.
Embedded derivatives can change the characteristics
and risks of the host contract
and this information is important
to users of financial statements.
There are a number of steps to determine
whether such embedded derivatives
should be separately accounted for
in the financial statements.
The end result is that they are fair valued
to profit and loss whether separately
or as part of the hybrid instrument.