ACCA Strategic Business Reporting (SBR) Practice Exam

Which of the following correctly describes an embedded derivative?

1. A financial instrument without any risk

2. An instrument requiring reclassification under specific conditions

3. A component of a host contract that belongs to the issuer

4. A separate contract issued independently

The correct answer is: An instrument requiring reclassification under specific conditions

An embedded derivative is correctly described as a component of a host contract where the derivative's cash flows are dependent on the performance of an underlying variable, such as interest rates or stock prices. The essence of an embedded derivative is that it often requires separate accounting and may necessitate reclassification if certain conditions are met, particularly when these derivatives exhibit characteristics that can significantly alter the risk or cash flows of the host contract. For example, in situations where the host contract is classified as a financial instrument, and the embedded derivative can be separated, the reporting entity may need to account for it independently, potentially leading to changes in its classification. This aligns with specific accounting standards that dictate how financial instruments must be reported, ensuring that financial statements reflect the true economic realities and risks involved. The other options do not accurately capture the nature of embedded derivatives. The mention of a financial instrument without risk does not align with the concept of derivatives, which by nature involve risk and uncertainty. Similarly, a notion of a separate contract issued independently contradicts the fundamental idea of an embedded derivative being part of a host contract. Finally, attributes such as ownership or belonging to the issuer are also not characteristics of embedded derivatives, as they are contingent on the underlying financial activities, not solely on issuer