How do I account for embedded derivatives in hybrid financial instruments?

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AcadiFi · Accepted Answer

IFRS 9 distinguishes between hybrid instruments where the host is a financial asset and those where the host is a financial liability or non-financial. For financial asset hosts, no separation of embedded derivatives is permitted; the entire hybrid is classified based on its contractual cash flow characteristics and the business model, typically landing at FVTPL because the embedded option fails the SPPI test.

For Braithford's purchase of a third-party convertible bond: the conversion feature causes contractual cash flows to fail the solely-payments-of-principal-and-interest (SPPI) test, so the entire instrument is measured at FVTPL. No bifurcation.

For liability hosts (Braithford's own issued callable bond) and non-financial hosts, IFRS 9 retains the IAS 39 bifurcation rules. The embedded derivative must be separated if three conditions are met: (1) economic characteristics and risks are not closely related to the host; (2) a separate instrument with the same terms would meet the derivative definition; and (3) the hybrid is not measured at FVTPL.

For Braithford's callable bond, the call option is closely related to the interest rate risk of the host debt (assuming the call price is close to amortized cost), so no separation. If instead the bond had an equity-indexed redemption amount, that embedded derivative is not closely related to interest-rate-host debt and must be separated and measured at FVTPL with the remaining host at amortized cost.

Under ASC 815, bifurcation rules apply broadly to both asset and liability hybrids.

How do I account for embedded derivatives in hybrid financial instruments?

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