Strategic Business Reporting (International) · Financial instruments

Derivatives and Embedded Derivatives under IFRS 9 for ACCA SBR

Updated 11 October 2026 · Fact-checked

A derivative is a financial instrument whose value changes with an underlying variable, needs little or no initial investment and is settled at a future date. Under IFRS 9 it is measured at fair value through profit or loss unless hedge accounting applies. Embedded derivatives are separated only when the host is not a financial asset within IFRS 9.

Understand Derivatives and Embedded Derivatives

A derivative is a contract whose value moves with something else, such as an interest rate, a commodity price, a share price or an exchange rate. You do not need to own the underlying item. You only agree to a future exchange based on it.

IFRS 9 gives three characteristics. First, the value changes in response to an underlying variable. Second, there is no initial net investment, or one much smaller than other contracts with similar market response would need. Third, it is settled at a future date. If all three are met, the contract is a derivative. Do not rely on the name of the contract. Test it against the definition.

The common types are forwards (a private agreement to buy or sell at a fixed price on a future date), futures (standardised forwards traded on an exchange), options (the holder has the right but not the obligation to buy or sell, and pays a premium) and swaps (an exchange of cash flows, for example fixed interest for floating interest). Each is initially recognised at fair value when you become party to the contract. This is normally the transaction price. A forward usually has a fair value of nil at the start. An option's initial fair value is normally the premium paid (an asset for the holder) or received (a liability for the writer). Transaction costs on a derivative measured at FVTPL are expensed to profit or loss.

After initial recognition, derivatives are measured at fair value through profit or loss (FVTPL). Gains and losses go to profit or loss. The exception is a derivative designated as a hedging instrument in an effective hedge, where the hedge accounting rules decide where the gain or loss goes. A derivative with a positive fair value is an asset. One with a negative fair value is a liability.

An embedded derivative is a component of a hybrid contract that also contains a non-derivative host. It makes some cash flows behave like a stand-alone derivative. Examples are a bond whose redemption is linked to a share index, or a purchase contract for goods priced in a currency that is not the functional currency of either party and is not commonly used in that economic environment.

A currency feature is closely related to the host, so not separated, if the currency is the functional currency of a substantial party to the contract, the currency in which the price of the goods or services is routinely denominated in commercial transactions around the world, or a currency commonly used in contracts for such items in that economic environment. It is separable only when it fails these conditions and the other separation criteria are met.

If the host is a financial asset within the scope of IFRS 9, you do not separate. You classify the whole hybrid asset by its cash flow characteristics and business model. If the host is a financial liability or another non-financial contract, you separate the embedded derivative when it is not closely related to the host, a separate instrument with the same terms would meet the definition of a derivative, and the hybrid is not measured at FVTPL as a whole. Once separated, the derivative is at FVTPL and the host follows its own standard.

Key rules to remember

Definition of a derivative: Value changes with an underlying + no or small initial net investment + settled at a future date; All three characteristics must be met. State each one and apply it to the scenario.
Initial measurement: Derivative recognised at fair value on the date you become party to the contract; Initial fair value is normally the transaction price. A forward is normally nil at inception. An option is normally the premium paid or received. Transaction costs on derivatives at FVTPL are expensed to profit or loss.
Subsequent measurement: Fair value through profit or loss, unless designated in a hedge; Gain or loss in profit or loss. The hedge accounting rules apply only if the hedge criteria are met.
Forward contract fair value (simple form): Fair value = (forward rate now for the same remaining maturity − contract rate) × amount, discounted to present value if material; Use a forward rate quoted for the same maturity as the contract, and discount at an appropriate rate when the effect is material. 'To buy' means the entity has contracted to buy the underlying at the fixed contract rate: a positive result is an asset. For a contract to sell, reverse the sign.
Embedded derivative separation test: Separate if: host not an IFRS 9 financial asset AND not closely related AND meets derivative definition AND hybrid not at FVTPL; If the host is a financial asset in IFRS 9, never separate. Classify the whole asset.

How to solve Derivatives and Embedded Derivatives questions

Use this method for any question on derivatives or embedded derivatives. Write each step so the marker sees your reasoning.

1Identify the contract and its terms: underlying, notional amount, settlement date, premium or upfront payment.
2Test against the three-part derivative definition. State whether each part is met and why.
3If it is a hybrid, identify the host and decide whether it is a financial asset within IFRS 9 or something else.
4For a non-asset host, apply the separation test: closely related, derivative definition, and not already at FVTPL.
5Measure at initial recognition: fair value, which is normally the transaction price. This is normally nil for a forward and the premium for an option. Expense any transaction costs to profit or loss.
6Measure at the reporting date at fair value and calculate the gain or loss. Take it to profit or loss unless a valid hedge exists.
7Present the result: asset or liability, the double entry, and the effect on profit. Mention hedge accounting if the scenario gives hedging intent.
8Add the professional skills point: comment on the commercial reason, the judgement involved or the risk of manipulation.

Quickest way: Three-question triage

When to use it: Use this when time is short and the scenario describes a contract with an unusual feature.

Ask: does the value depend on an underlying with no real upfront investment and settle later? If yes, it is a derivative.
Ask: is the host a financial asset under IFRS 9? If yes, no separation. Assess the whole asset.
If not, ask: is the feature closely related to the host? If not, separate and put the derivative at FVTPL.
Write the journal: derivative at fair value, transaction costs and gains or losses to profit or loss, host under its own standard.

Common mistakes in Derivatives and Embedded Derivatives

Separating an embedded derivative from a hybrid financial asset.
Students remember the separation rule from the old standard, IAS 39.
Fix: Under IFRS 9, if the host is a financial asset in scope, classify the whole contract using the business model and contractual cash flow test.
Recording a forward contract at its price at inception.
Students confuse the contract amount with the fair value.
Fix: A forward normally has nil fair value at inception, so no entry is needed. Only changes in fair value are recorded afterwards.
Ignoring the premium paid on an option.
Students treat the option as free because no underlying asset changes hands.
Fix: Recognise the option at the premium as a financial asset. Then remeasure to fair value at each reporting date.
Taking gains and losses on all derivatives to other comprehensive income.
Hedge accounting is mixed up with the default rule.
Fix: Default treatment is FVTPL. Only a designated and effective hedging relationship changes this.
Saying a contract is a derivative because it is called a futures or swap.
Students rely on labels rather than on the definition.
Fix: Test the three characteristics every time and state the result.
Treating a closely related feature as separable.
Students assume every unusual clause is a derivative.
Fix: Check the economic characteristics and risks of the feature against the host. If they are closely related, keep the contract together.

Worked examples

Example 1

On 1 October 20X1, Meru Co, which has a $ functional currency, enters a forward contract to buy €1,000,000 on 31 March 20X2 at a rate of $1.10 per €1. The contract costs nothing to enter and is not designated as a hedge. At 31 December 20X1 the forward rate for 31 March 20X2 is $1.14 per €1. Ignore discounting. Explain whether the contract is a derivative and show the accounting at 31 December 20X1.

Show the solution

Value depends on the €/$ exchange rate, which is the underlying.
There is no initial net investment, as the contract cost nothing.
It will settle on 31 March 20X2, a future date. All three characteristics are met, so it is a derivative.
At 1 October 20X1 the fair value is nil, so no entry is made.
At 31 December 20X1 the contract lets Meru buy at 1.10 when the market forward rate is 1.14.
Fair value = (1.14 − 1.10) × 1,000,000 = $40,000 gain.
Because no hedge is designated, the derivative is measured at FVTPL.
Journal: Dr Derivative asset $40,000; Cr Profit or loss (gain) $40,000.

Answer: The forward is a derivative. At 31 December 20X1 Meru recognises a derivative asset of $40,000 and a gain of $40,000 in profit or loss.

Example 2

Pavo Co issues a bond for $5 million. It is repayable in five years at an amount linked to the performance of a stock market index, so the redemption amount could be higher or lower than $5 million. Treat the host as a $5 million bullet debt repayable at par at the end of five years, with the index-linked feature as the embedded derivative. Pavo has not designated the bond at FVTPL. Explain whether an embedded derivative must be separated.

Show the solution

The bond is a hybrid contract: a $5 million bullet debt host plus an index-linked redemption feature.
Pavo is the issuer, so the host is a financial liability, not a financial asset. The separation rules apply.
The index-linked redemption feature is not closely related to a debt host, as its risk is equity market risk rather than credit or interest risk.
A separate contract with the same terms would meet the derivative definition: it moves with the index, needs no investment, and settles later.
The hybrid is not measured at FVTPL as a whole, as it has not been designated.
All the criteria are met, so the embedded derivative is separated.
The derivative is measured at fair value at issue. The host is the residual: the $5 million proceeds less that fair value, measured at amortised cost.
The host is then accreted to the $5 million par amount over five years using an effective interest rate based on the host cash flows.
The derivative is remeasured at fair value through profit or loss at each reporting date.

Answer: Pavo must separate the index-linked redemption feature. It is accounted for as a derivative at FVTPL. The host $5 million bullet debt is carried at amortised cost, at the proceeds less the derivative's fair value at issue, using an effective interest rate based on the host cash flows.

Exam tips

Quote the three-part definition and tie each element to the facts. Marks are given for application, not for the definition alone.
For embedded derivatives, always state the host first. Check if it is a financial asset in scope of IFRS 9 before looking at anything else.
Show journals for the derivative and for the host. Label gains and losses clearly as profit or loss.
If a scenario mentions hedging, say whether hedge accounting could apply and link to the criteria. Do not apply it unless designation and documentation exist.
Add a professional skills point, such as how derivatives can be used to hide risk or smooth profit, and recommend clear disclosure.

Practice questions from Financial instruments

Derivatives and Embedded Derivatives in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CA FinalSeparation of Embedded Derivatives

Derivatives and Embedded Derivatives: frequently asked questions

What is the definition of a derivative under IFRS 9?

A derivative is a financial instrument or other contract in scope of IFRS 9 with three features. Its value changes with an underlying variable, it needs no or a small initial net investment, and it is settled at a future date. All three must be met.

When do you separate an embedded derivative under IFRS 9?

You separate it when the host is not a financial asset within IFRS 9, the feature is not closely related to the host, and a separate instrument with the same terms would be a derivative. The hybrid must also not be measured at FVTPL as a whole. If the host is a financial asset, you do not separate.

How are options accounted for under IFRS 9?

A purchased option is recognised as an asset at the premium paid. It is then remeasured to fair value at each reporting date, with changes going to profit or loss unless it is a designated hedging instrument. A written option is a liability measured in the same way.

Is a forward contract always a derivative?

Not always. A contract to buy or sell a non-financial item can fall outside IFRS 9 under the own-use exemption, if it was entered into and is held to receive or deliver the item in line with your expected purchase, sale or usage needs. The exemption does not apply if you have a past practice of settling similar contracts net in cash, or of taking delivery and selling shortly afterwards to profit from short-term price changes. It also does not apply to a written option that can be settled net. Even where the exemption would apply, you can irrevocably designate the contract at FVTPL if that removes or reduces an accounting mismatch.