Suppose entity ABC enters into a contract to issue a bond, and the payment of interest and principal of the bond is indexed with the price of gold. Here, the payment will increase or decrease according to the movement in the price of gold; and the debt instrument is host contract with an embedded derivative, explains Mukesh Kumar Thakur in ‘Guide to Financial Instruments’ (www.taxmann.com).
Sometimes entities combine the derivatives with some non-derivative items; for example, a contract having a derivative characteristic may be combined in a loan, bond, share, lease, insurance contract or purchase or sale contract, he writes.
“When a derivative feature is combined in a non-derivative contract, the derivative is referred to as embedded derivative and such non-derivative contract is called host contract. The combined contract is called hybrid contract.”
Where a derivative contract is combined with other types of contract, check if the entity measures the derivative at fair value, the book cautions. It speaks of how Accounting Standard 30 prescribes controls to prevent entities from circumventing the recognition and measurement requirements for derivatives merely by embedding them in other types of contract.
The standard requires embedded derivatives to be accounted separately from their host contract if the following three criteria are met, the book elaborates: “(a) On a standalone basis, the embedded feature meets the definition of derivatives; (b) the combined contract is not measured at fair value…; and (c) the economic characteristics and risks of the embedded feature are not closely related to economic characteristics and risks of the host contract.”
When all the above three conditions are met, the derivative part of the contract should be separated from the host contract, Thakur writes. “The derivative part of the contract will be accounted as per treatment prescribed for derivative. The host contract will be accounted in accordance with the relevant standard as if it does not have embedded derivative.”
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