Embedded Derivative - Ind AS - Indian Accounting Standards - Companies Law

Embedded Derivative An embedded derivative is: a component of a hybrid contract that also includes a non-derivative host with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. A derivative is embedded in a Normal Host contract, Host Contract can be Financial Liability [eg loan taken from a bank] Non-Financial Item [eg purchase/sale of Goods, PPE etc.] When 'host Contract' Dervative embedded in it are 'Not closely Related' then we need to separate Host Contract Embedded Derivative. Precondition for segregation of embedded derivatives - An embedded derivative is required to be separated from the host contract and accounted for separately as a financial instrument provided all the below conditions are satisfied: Economic characteristics and risks of the embedded derivative are not closely related to those of the host. A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative. Hybrid contract not measured at fair value through profit or loss. A call, put, or prepayment option embedded in a host debt contract or host insurance contract is not closely related to the host contract unless: Paragraph 4.3.5, Ind AS 109 the option's exercise price is approximately equal on each exercise date to the amortised cost of the host debt instrument or the carrying amount of the host insurance contract; OR the exercise price of a prepayment option reimburses the lender for an amount up to the approximate present value of lost interest for the remaining term of the host contract. Lost interest is the product of the principal amount prepaid multiplied by the interest rate differential. The interest rate differential is the excess of the effective interest rate of the host contract over the effective interest rate the entity would receive at the prepayment date if it reinvested the principal amount prepaid in a similar contract for the remaining term of the host contract. Foreign currency derivative embedded in contract for purchase or sale of non-financial items: An embedded foreign currency derivative in a host contract that is an insurance contract or not a financial instrument is closely related to the host contract provided it is not leveraged, does not contain an option feature, and requires payments denominated in one of the following currencies: the functional currency of any substantial party to that contract; the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in commercial transactions around the world (such as the US dollar for crude oil transactions); or a currency that is commonly used in contracts to purchase or sell non- financial items in the economic environment in which the transaction takes place (eg a relatively stable and liquid currency that is commonly used in local business transactions or external trade). Unless the above exceptions apply, the embedded foreign currency derivative should be separated from the host contract. Certain guidance on how to carry out the separation are enumerated below in detail: 1. The host contract is a sale or purchase contract denominated in the functional currency of the reporting entity. 2. The amount of functional currency is determined using the relevant forward exchange rate (to the date of delivery) at the date the contract is entered into. 3. The embedded derivative is a forward currency contract to buy or sell the applicable amount of the contract currency for the functional currency, at the same forward exchange rate. The effect is that the fair value of the embedded derivative is initially zero. 4. Subsequent changes in the fair value of the embedded derivative are recorded in profit or loss. 5. On delivery of the non-financial item, the host contract is fulfilled and the embedded derivative is effectively settled. A foreign currency debtor or creditor is recognised for the contract amount, translated at the spot rate in accordance with Ind AS 21. The closing carrying amount of the embedded derivative is added to the functional currency amount of the host contract to give the initial carrying amount of the debtor or creditors