Embedded derivatives

Embedded derivatives under IFRS 9: the logic as it stands today

Embedded derivatives are one of those accounting topics that many professionals think they understand, largely because they once mastered them under IAS 39. That is precisely where the risk lies. IFRS 9 did not merely “simplify” embedded derivatives; it repositioned the concept entirely. Anyone still approaching embedded derivatives primarily as a separation exercise risks applying the wrong mental model.

At its core, an embedded derivative exists when a contract contains both a non-derivative host and a feature that causes some of the cash flows to vary in a way similar to a stand-alone derivative. That definition has not changed. What has changed fundamentally is when this definition still matters.

Under IFRS 9, embedded derivatives are no longer a general accounting problem. They are a conditional problem, relevant only once a more fundamental question has been answered: what is the nature of the host contract?

IFRS 9 deliberately draws a hard conceptual line between two worlds:

Hybrid contracts whose host is a financial asset, and

Hybrid contracts whose host is not a financial asset (financial liabilities and non-financial contracts).

This distinction is not cosmetic. It reflects a deeper design choice in IFRS 9: for financial assets, embedded features are not analysed in isolation anymore. Instead, they are absorbed into a holistic classification and measurement assessment of the instrument as a whole.

In practical terms, this means the following.

If the host contract is a financial asset within the scope of IFRS 9, the question “does this contract contain an embedded derivative?” is no longer decisive. IFRS 9 explicitly prohibits separation in this case. The entire instrument must be assessed as a single unit against two tests:

the business model test, and

the contractual cash flow characteristics test (the SPPI test).

Any embedded leverage, indexation or optionality that would once have triggered separation under IAS 39 now expresses itself through failure of the SPPI test, resulting in measurement at fair value through profit or loss. The embedded derivative does not disappear; it simply stops being accounted for separately.

This is why modern IFRS 9 practice treats embedded derivatives in financial assets as a classification outcome, not a separation exercise.

By contrast, where the host contract is not a financial asset—for example a financial liability, a lease, or a long-term purchase contract—the embedded derivative concept remains fully alive. In those cases, IFRS 9 deliberately retains the IAS 39 logic of separation, because classification mechanics cannot absorb the embedded risk in the same way.

This dual approach explains much of the confusion seen in practice. Many errors stem from applying financial-asset logic to financial liabilities, or vice versa. IFRS 9 does not operate on a single embedded-derivative model; it operates on two parallel but conceptually different models, depending on the host.

Understanding this architecture is essential. Without it, decision trees feel arbitrary. With it, they become intuitive.

Read IFRS 9 Financial Instruments on IFRS.org.

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Step 1 – What problem IFRS 9 is actually solving

Embedded derivatives are often taught as a technical nuisance: small clauses hidden in contracts that accountants must detect and surgically extract. That way of thinking is understandable—but under IFRS 9 it is fundamentally misleading.

IFRS 9 is not primarily concerned with where variability in cash flows comes from. It is concerned with what that variability represents economically.

At a very high level, IFRS 9 draws a simple but powerful distinction. Some financial instruments behave like loans: capital is advanced, time passes, interest compensates for the passage of time and credit risk, and principal is repaid. Other instruments do something else. They may still look like debt on the surface, but economically they behave more like participations, wagers, or structured exposures to prices, indices or events.

The accounting challenge IFRS 9 addresses is therefore not:
“Is there a derivative hidden somewhere in this contract?”
but rather:
“Does this instrument still behave like a basic lending arrangement, or has it crossed that line?”

Once that question is answered, most technical consequences follow naturally.

This perspective is crucial for understanding why embedded derivatives no longer occupy the central role they once did in financial assets. If an instrument’s cash flows fluctuate because they are linked to commodity prices, equity indices, or other non-interest variables, that fluctuation is not an accounting defect to be corrected. It is an economic signal. The instrument is no longer a pure loan; it embeds exposure to something else.

IFRS 9 therefore treats variability not as something to be isolated and neutralised, but as something to be recognised and reflected transparently in measurement.

This explains a design choice that often surprises practitioners: for financial assets, IFRS 9 does not attempt to disentangle “normal” cash flows from “derivative” cash flows. Instead, it looks at the instrument as a whole and asks whether its overall behaviour still fits within the boundaries of a basic lending relationship. If it does not, fair value measurement is not a penalty—it is the most faithful representation of what the instrument really is.

Seen from this angle, embedded derivatives are no longer the starting point of the analysis. They are symptoms, not the disease. They indicate that economic risks have been introduced that change the nature of the instrument itself.

This shift in thinking is subtle but decisive. It moves the discussion away from technical detection and toward economic classification. It also explains why IFRS 9 applies very different logic depending on whether an entity holds an instrument as an asset or has issued it as a liability. The accounting question is not symmetrical, because the economic questions are not symmetrical either.

Only once this intuition is clear does it make sense to introduce formal decision logic, tests and charts. Without it, even perfectly correct rules will feel arbitrary.

Also read the IFRIC-paper regarding Assessing Whether to Separate an Embedded Prepayment Option from Host Contract.

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Step 2 – The one fork in the road that determines everything

Once you accept that IFRS 9 is fundamentally about classifying economic behaviour, the next question almost asks itself:

Whose behaviour are we trying to describe?

This is where IFRS 9 makes its most consequential distinction—one that quietly governs everything that follows, including the treatment of embedded derivatives.

IFRS 9 does not apply a single accounting logic to all contracts. Instead, it draws a clear line between two situations:

• the entity holds a contract as a financial asset, or
• the entity has issued a contract, or entered into a non-financial arrangement.

At first glance this may seem like a technical scope distinction. In reality, it reflects a deeper economic asymmetry.

When an entity holds a financial asset, the question IFRS 9 asks is forward-looking and economic:
What kind of returns does this asset generate, and why?
If those returns resemble the predictable pattern of a loan—principal and interest—one measurement model is appropriate. If the returns are driven by exposure to prices, indices or other variables, a different model is needed.

When an entity has issued a financial liability, or entered into a non-financial contract, the question shifts. The issue is no longer how returns are generated, but what risks the entity has written into its own obligations. In that context, isolating and measuring those risks separately may still be necessary to faithfully represent performance and risk exposure.

This is why IFRS 9 treats embedded variability very differently depending on whether it appears in a financial asset or somewhere else. The distinction is not arbitrary; it follows from the economics of holding versus issuing.

For financial assets, IFRS 9 takes a holistic view. The standard assumes that all contractual features—plain or complex—combine to define the economic nature of the asset. If those features together move the instrument away from a basic lending profile, the accounting response is to reflect that shift directly through measurement of the whole instrument. There is no attempt to “repair” the asset by breaking it into parts.

For financial liabilities and non-financial contracts, that approach does not work in the same way. The host contract often has a clear, dominant purpose—borrowing funds, purchasing goods, leasing an asset—while additional features introduce risks that are economically distinct. In those cases, separating those features can still be the most transparent way to show what is really going on.

This single fork—financial asset or not—is therefore not a procedural step. It is the conceptual hinge on which the entire analysis turns. Once it is resolved, many questions that feel complex at first simply fall away. Others, by contrast, only begin to matter after this point.

The mistake practitioners most often make is to rush past this fork, assuming that all embedded derivative questions are variations on the same theme. IFRS 9 is explicit that they are not.

Only after this distinction is firmly understood does it make sense to introduce structured decision logic. Without it, any chart or checklist risks becoming a mechanical exercise divorced from the economic reasoning the standard is trying to enforce.

Also read from the ISDA on Treatment of Instruments with Embedded Derivatives.

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Step 3 – From economic understanding to structured decision-making

The conceptual groundwork is now in place. We have established that IFRS 9 is concerned with the economic behaviour of contracts, and that the decisive distinction is whether an entity is dealing with a financial asset or with a different type of obligation or arrangement. At this point, the analysis must move from general understanding to consistent application.

This transition is necessary because contracts that contain variable cash flows quickly become difficult to assess on intuition alone. Similar-looking instruments may lead to very different accounting outcomes if the underlying questions are asked in a different order. IFRS 9 addresses this risk by imposing a disciplined sequence of analysis, even where professional judgement remains essential.

That sequence can be expressed as a small number of ordered questions. Their purpose is not to mechanise judgement, but to ensure that judgement is exercised at the correct stage of the analysis.

The logic begins with a simple threshold: whether the contract contains cash flow variability linked to an underlying variable. Without such variability, there is no embedded derivative question to consider. If variability is present, the analysis immediately turns to the nature of the host contract. This step is decisive. Where the host is a financial asset, IFRS 9 requires a holistic assessment of the instrument as a whole. Where the host is not a financial asset, further differentiation is required.

Only in this latter category does it become relevant to assess whether a contractual feature meets the definition of a derivative and, if so, whether its economic characteristics are closely related to those of the host contract. Separation is therefore not a general principle, but a conditional outcome that arises only after more fundamental questions have been answered.

This ordered approach is not an optional interpretation technique. It reflects the internal architecture of IFRS 9 and ensures that economically similar instruments are treated consistently, while economically different instruments are not forced into the same accounting outcome.

For practical purposes, this sequence of questions can be summarised in a single decision framework. Presented visually, it provides a stable reference point for applying IFRS 9 to contracts with embedded variability without reverting to ad hoc or historically driven reasoning.

Also read our blog on: Embedded derivatives with a financial liability host contract.

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A few examples to explain it all

Example 1 – Financial asset (IFRS 9 applies to the whole instrument)

The contract

An entity purchases a bond issued by a third party.

The bond has the following features:

• Principal amount: €1,000
• Maturity: 5 years
• Interest: annually, linked to the price of gold
• The entity holds the bond as an investment

This is a hybrid contract: it looks like a debt instrument, but its cash flows depend on a commodity price.

Step 1 – Is there contractual variability linked to an underlying?

Yes.
The interest payments vary with the price of gold, which is an underlying variable.
➡ The embedded-derivative analysis is triggered.
Proceed to Step 2.

Step 2 – What is the host contract?

The entity holds the contract as an investment.

The host contract is therefore a financial asset within the scope of IFRS 9.

This is the decisive fork in the flowchart.

Step 3 – What does IFRS 9 require in this case?

Because the host contract is a financial asset:

• Embedded derivatives are not separated
• The contract is assessed as a single instrument under IFRS 9

No further steps are taken.

There is no assessment of:

• whether the feature meets the definition of a derivative, or
• whether it is closely related.

Those questions are irrelevant once this path is chosen.

Outcome (financial asset path)

The bond is classified and measured in its entirety under IFRS 9.
Because the cash flows depend on a commodity price, they do not represent a basic lending arrangement. The accounting consequence is that the instrument is measured at fair value through profit or loss as a whole.

Key learning point
For financial assets, the flowchart forces an early stop. The variability is reflected through classification and measurement, not through separation.

Also read this blog: Embedded derivatives with financial asset host.

Example 2 – Financial liability / non-financial host (separation may apply)

The contract

An entity issues a five-year loan note to an investor.

The loan note has the following features:

• Principal amount: €1,000
• Fixed interest: 4% per year
• Additional feature: the investor receives extra interest if a specified equity index exceeds a defined level

The entity is the issuer of the instrument.

Step 1 – Is there contractual variability linked to an underlying?

Yes.
The additional interest depends on the performance of an equity index.

➡ The embedded-derivative analysis is triggered.
Proceed to Step 2.

Step 2 – What is the host contract?

The entity has issued the instrument.
The host contract is therefore a financial liability, not a financial asset.

This means the financial-asset shortcut does not apply.
➡ Proceed to Step 3.

Step 3 – Does the feature meet the definition of a derivative?

The equity-linked feature:

• changes in response to an underlying variable (equity index),
• requires little or no initial net investment, and
• is settled in the future through additional interest payments.

Yes — the feature meets the definition of a derivative.

➡ Go to Step 5, if NO continue with Step 4.

Step 4 – Is the embedded derivative closely related to the host?

The host contract is a plain borrowing arrangement.
The embedded feature introduces exposure to equity price movements.

Those risks are not closely related.

Outcome (liability / non-financial host path)

The embedded derivative is separated:

• The embedded equity-linked derivative is measured at fair value through profit or loss
• The host loan is accounted for separately under the relevant IFRS standard

Key learning point
Only because the host is not a financial asset, do the later separation questions become relevant. The flowchart ensures that separation logic is applied only where IFRS 9 intends it to apply.

Step 5 – Accounting consequences after separation

Once separation is required, the accounting follows automatically:

1. The embedded derivative is recognised as a stand-alone derivative and measured at fair value through profit or loss at each reporting date.
2. The host contract continues to be accounted for independently, applying the relevant IFRS requirements for that contract.
3. Subsequent changes in fair value of the embedded derivative affect profit or loss, while interest expense on the host loan follows its own measurement basis.

At this point, the embedded-derivative analysis is complete. No further reassessment of separation is required unless the contractual terms themselves are modified.

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Judgement, documentation and audit focus under IFRS 9

The two examples above may give the impression that embedded-derivative accounting under IFRS 9 is largely mechanical. In practice, that is not the case. While the decision framework itself is structured and disciplined, the quality of the outcome depends heavily on where and how judgement is applied.

Importantly, IFRS 9 concentrates judgement in a small number of decisive points. This is deliberate. It allows entities, auditors and regulators to focus their attention where it actually matters, rather than dispersing judgement across every technical detail.

Where judgement really sits

In practice, three judgement areas dominate.

The first, and most critical, judgement concerns identifying the host contract. As the examples demonstrate, once the host is correctly identified as a financial asset or not, large parts of the analysis either fall away or become unavoidable. Errors at this stage cannot be repaired later by careful application of separation criteria. This is why disagreements in practice often trace back not to “closely related” assessments, but to inconsistent views on whether a contract should be analysed as an asset, a liability or a non-financial arrangement.

The second judgement area arises when the host is not a financial asset and the analysis reaches the definition of a derivative. While the definition itself is clear, applying it to real-world contractual features can be less straightforward than it appears, particularly where settlement occurs through non-cash mechanisms such as volume adjustments, rebates or contingent pricing. Here, judgement lies in understanding the economic substance of settlement, not merely its legal form.

The third and most scrutinised judgement is the “closely related” assessment. This is not a technical test but an economic one. It requires a comparison of risk profiles: what risks the host contract naturally exposes the entity to, and whether the embedded feature introduces risks of a fundamentally different nature. This assessment is highly context-dependent and must be anchored in the economics of the business, not just in generic examples from the literature.

Documentation: what actually needs to be written down

From a documentation perspective, IFRS 9 does not require encyclopaedic memoranda. What it requires is clarity at the right points.

Well-prepared documentation typically focuses on three questions:

• Why the contract was classified as a financial asset, financial liability or non-financial contract.
• Why a particular feature does or does not meet the definition of a derivative.
• Why the risks introduced by an embedded feature are, or are not, closely related to the host.

What is striking in enforcement cases is that problems rarely arise because entities failed to cite the correct paragraph numbers. They arise because the economic reasoning was implicit rather than explicit. A short, well-reasoned explanation of why risks are considered aligned or misaligned is far more defensible than a long technical checklist.

Equally important is consistency. Similar contractual features should be analysed in similar ways across the organisation. Where outcomes differ, the documentation should make clear why the economics differ.

Audit focus and common challenges

From an audit perspective, embedded derivatives under IFRS 9 tend to attract attention not because they are frequent, but because their impact can be material and volatile. Auditors typically focus on three areas.

First, they challenge whether management has stopped the analysis at the correct point. In particular, they will test whether separation logic has been applied inappropriately to financial assets, or conversely, whether it has been avoided where the host is not a financial asset.

Second, auditors scrutinise the boundary between “closely related” and “not closely related” features. This is where boilerplate language is most likely to be challenged. Assertions that risks are “clearly aligned” without reference to the business model or commercial rationale are unlikely to be persuasive.

Third, auditors assess the interaction with disclosure. Where embedded derivatives are separated, the resulting fair-value volatility must be explained in a way that is consistent with the accounting analysis. Inconsistencies between accounting policy notes, risk disclosures and management commentary are a frequent source of audit findings.

Governance implications

At board and audit-committee level, embedded derivatives rarely feature as a standalone agenda item. Nevertheless, the judgements involved touch on broader governance themes: risk appetite, transparency of performance, and the explainability of results to users of the financial statements.

Well-governed organisations ensure that:

• the decision framework is understood by finance leadership,
• significant judgements are escalated and discussed when first applied, and
• the rationale for classification and separation decisions can be explained without resorting to technical jargon.

In that sense, embedded-derivative accounting under IFRS 9 is a good example of how technical standards and governance discipline intersect. The standard provides the structure; governance determines the quality of its application.

Conclusion – Embedded derivatives start with the host, not the feature

Embedded derivatives under IFRS 9 are often perceived as a technical trap: something to be detected, dissected and neutralised. This article has deliberately taken the opposite approach. The decisive question is not what feature is embedded, but where that feature sits.

IFRS 9 is explicit in its architecture. Once the host contract is identified as a financial asset, the analysis stops. Variability is absorbed through classification and measurement of the instrument as a whole. Only where the host is not a financial asset does separation logic become relevant—and even then, only after disciplined, sequential questions have been answered.

This “host-first” mindset is not a simplification. It is the conceptual backbone of IFRS 9. Applied consistently, it prevents over-analysis, improves documentation quality, and makes accounting outcomes easier to explain to auditors, boards and users of the financial statements.

Final takeaway

Embedded derivatives

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If there is one principle to retain, it is this:

Always identify the host contract first.
Everything else follows—or does not follow—from that determination.

That principle, more than any individual rule, captures how IFRS 9 expects embedded derivatives to be understood and applied.

Also read IFRS vs US GAAP Derivatives and hedging on our blog.

The following FAQs summarise the key implications.

FAQ’s – Embedded Derivatives under IFRS 9