How should an embedded derivative be accounted for?

The accounting treatment of an embedded derivative is based on whether it is economically distinct from the host contract. When an embedded derivative can be separated from its host contract and meets specific criteria, it is treated as a separate standalone derivative for accounting purposes. This means it needs to be measured at fair value, with changes in that fair value recognized in profit or loss.

This treatment is grounded in the principle that derivatives are financial instruments whose value is derived from the value of another asset or index. If the embedded derivative has characteristics that significantly affect its cash flows and is not closely related to the economic characteristics of the host contract, it should be accounted for separately.

This approach ensures that users of financial statements gain clarity and transparency regarding the risks and rewards associated with the embedded derivative, separate from the host contract. In contrast, if the embedded derivative is not economically distinct, it would be combined with the host, reflecting its integral nature to that contract.